The cannabis market saw enviable growth in 2020. The designation of cannabis businesses as essential by Arizona, California, Colorado, Nevada, and Oregon caused a dramatic increase in sales. Sales in those states were up nearly 21% Year-over-Year last year, reaching $4.8 billion in July, according to the BDSA.
Meanwhile, the BDSA expects global sales to more than double over the coming years. The global legal market is predicted to reach $47 billion by 2025. And US sales make up a huge proportion of that market – 84% in 2019. With legalization looming in several more states, it’s little wonder that the US cannabis market is turning the heads of investors.
Business Owners in the Cannabis Industry Face Significant Challenges.
While the growth and market potential have certainly piqued the interest of entrepreneurs and investors, the significant challenges cannabis businesses need to overcome does stifle investment and growth.
These are some of the common challenges business owners face in the cannabis industry:
- Cannabis owners can’t access loans from traditional financiers.
- Zoning regulations means sourcing a shopfront can be problematic.
- You can’t currently ship cannabis across state lines.
- Unfavorable federal tax rules, specifically section 280E, mean cannabis companies can’t deduct operating expenses that are otherwise usually deductible. So, cannabis businesses pay more taxes and get access to fewer deductions.
- Expansion through franchising is complicated, especially across state lines.
5 Common Legal Issues To Pay Attention To When Launching a Cannabis Business in 2021
In addition to the practical business challenges of operating within the cannabis industry, there are significant legal issues cannabis businesses need to be aware of. These are the 5 top legal issues cannabis business owners should pay attention to in 2021:
1. Cannabis businesses are illegal at the federal level.
Cannabis is considered a Schedule I Controlled Substance under the federal Controlled Substances Act, alongside heroin, peyote, and ecstasy. These drugs are illegal according to federal law.
Federal illegality presents significant obstacles for cannabis businesses, including a lack of access to banking, limited opportunities for growth, and increased tax liabilities. Practically, its federally illegal status has a considerable impact on cannabis operations. It means, for instance, that cannabis must be sold in the state in which it is grown – since it can’t be shipped across borders between states. This results in operational headaches and inefficiencies, as well as reduced profit margins.
The federal illegality also means that, technically, a cannabis business (or the legal cannabis industry) could be shut down by the federal government at any moment. Moreover, operators could face criminal penalties for their involvement in the sale of a federally-controlled substance. We haven’t seen this type of enforcement in the US in many years, and we aren’t likely to under the Biden administration. But it is possible.
Finally, federal illegality means that any foreign nationals participating in US cannabis businesses can face immigration issues. Foreign investors can be turned away at the border, or even banned from entering the country. We have seen enforcement like this in the past, with a slew of Canadian cannabis investors being banned in 2018 and 2019. This, again, reduces access to investors and diminishes investor interest.
2. Cannabis businesses are heavily regulated and come with high compliance costs.
The cannabis industry is heavily regulated in every state where it has been legalized. Often, the burdensome state regulations are convoluted by the web of county-level laws. This makes compliance more expensive and more onerous for cannabis businesses across their operations, from licensing to delivery, and from marketing to security. It results in increased training costs for staff who need to comply with strict Standard Operating Procedures. Meanwhile, you can see it in the packaging disclosure requirements, which minimize branding opportunities – and, again, erode profitability and growth potential.
The compliance burden also makes it essential for cannabis businesses to engage regulatory counsel with cannabis expertise. Oversight is required for cannabis contracts, licensing applications, and operations, at a minimum. The stakes for non-compliance with operational requirements are incredibly high, with enforcement potentially leading to license revocation or suspension, fines, and lengthy bans.
3. Licenses for cannabis businesses are not transferrable.
In many states, cannabis licenses are not transferrable. This has several implications:
First of all, it means that they have no extrinsic value and should not be thought of as an investment. A license is not an asset or piece of property, but an entitlement for the holder(s) to conduct business.
Where the licenses cannot be transferred, it limits the ability of companies to be bought outright. For a California cannabis business to remain operational while a new owner submits their information (or even applies for a new license), some of the owners of the original business must remain in the business. This means cannabis business owners can’t rely on being completely bought out as their exit strategy.
Finally, licenses are tied to a specific location in many states. This means that a cannabis business cannot move locations without seeking a new license. As outlined above, licensing is a lengthy, costly, and uncertain process. This further restricts the ability of cannabis businesses to operate profitably, since finding more affordable premises is cost prohibitive.
4. Investors in cannabis businesses often need to be disclosed to regulators.
Investors in and owners of cannabis businesses need to undergo extensive disclosure to regulators in many states. Ownership disclosure in California requires, for instance, a criminal background check, details of civil claims you are or have been involved in, and for the owner’s fingerprints to be submitted via the Live Scan process.
We’ve seen long-negotiated deals fall through because investors have found out quite late that they are going to be subjected to disclosure requirements, and they’re not comfortable with them.
In practice, it also means cannabis businesses need to perform due diligence on their potential investors to ensure nothing in the investor’s background would disqualify them. These conversations can be uncomfortable, particularly when they need to occur so early in the relationship.
5. Contracts in the cannabis industry are essential – and complicated.
Handshake deals seem to be commonplace in the cannabis industry. This artifact of the decades of black-market dealings leaves cannabis businesses with no legal recourse if (or, more likely, when) business deals aren’t honored. We’ve also seen remarkable resistance to detailed cannabis contracts, which some stakeholders consider to be too long.
Cannabis businesses should rely on contracts for protection in business dealings, just as companies do in all other (legal) industries. These contracts should outline the exact terms and scope of any agreement, as well as what happens if the contract is breached or otherwise not performed. Without robust contracts that align with the cannabis regulations, businesses are operating without adequately minimizing their risk.
How To: Avoid These Pitfalls When Launching a Cannabis Business
These are our three top tips for avoiding these common pitfalls when launching your cannabis business:
Create a culture of regulatory compliance in your cannabis business.
Your business will benefit if everyone is aware of cannabis compliance requirements and common issues. This means everyone , from managers to investors to staff.
The CDPH requires manufacturers to submit a standard operating procedure (SOP) for its quality control processes. It’s likely that an attorney or consultant assisting with the license application will put together the SOP based on a template. Such templates are helpful for getting an application approved, but businesses might not always know or understand the procedures. This leads to them not being followed. As a consequence, businesses could find themselves facing an enforcement action if a regulator finds that the SOPs aren’t being followed. Regulators can inspect cannabis businesses at any point, so this is actually quite a likely scenario.
We suspect that regulators will get into enforcement mode in the coming year. This means that cannabis businesses are likely to be subject to consequences for not following the SOPs that they don’t really understand. A culture of training and compliance at your cannabis business is the antidote. It ensures your staff understands the importance of following the SOPs you supplied to receive your license.
Use cannabis-industry-specific contracts as standard across your business operations.
There are countless terms in standard form contracts that just don’t fit the cannabis industry. Provisions that outline recourse through the Federal Courts, for instance, are problematic because cannabis is illegal at the federal level.
These clauses are dangerous for suppliers and retailers because they can leave you in breach of contract from the outset. This should be of concern to the parties to the contract, because it leaves room for the contract to be rescinded – which means either party has room to get out of the contract. Alternatively, you may need to renegotiate and redraft key provisions in the contract down the line.
The legal costs associated with issues that arise later are usually significantly higher than the costs of getting the contract right in the first instance. It’s worthwhile incurring the legal expenses and relying on cannabis-specific contracts to protect your business.
Integrate regulatory counsel into your cannabis business advisory team.
Imagine the legal headache of purchasing a cannabis business to find out you can’t take over the current operating license. At a minimum, you could incur potentially hundreds of thousands of dollars in additional costs to apply for a new license. You would not be able to operate at this point, while still paying the lease, employee salaries and other overheads. Worst case, you aren’t eligible for a license at all. Then, you need to go through the costly process of disentangling yourself from the purchase.
Relying on an advisory team that includes corporate and regulatory counsel is essential if you want to avoid these common legal pitfalls. As we outlined above, the costs of rectifying the issues with cannabis contracts can be catastrophic.
The Biggest Mistake To Avoid When Operating A Cannabis Business
We believe the biggest mistake cannabis business owners and investors make is relying on the law to change.
Late last year, we saw close to 14% of LA’s cannabis businesses be threatened with closure when they filed renewal paperwork too late. They were thrown a lifeline when the city promised not to participate in enforcement action, with a motion pending to allow late renewal. The state regulatory body, the Bureau of Cannabis Control, could deny the renewal of state licenses for the businesses that are currently technically operating on expired city licenses. It’s unlikely, but it’s possible. Businesses should, instead, aim to operate within the bounds of the law at all times – no matter the burden.
Similarly, we’ve seen plenty of hype about the potential for the MORE Act passing under the Biden administration. While it’s more likely than it was under Trump, it’s nowhere near assured. Cannabis businesses which base their operational forecasts around relief from 280E taxation, or plan to grow through increased trade, may find themselves disappointed.
The legal cannabis framework is still in its infancy and has a lot of growing to do. Cannabis businesses need to do their best to operate within the current regulatory system, however imperfect it is, if they want to gain a level of certainty in an uncertain industry.
Launching a Cannabis Business? CGL Can Help
If you need help navigating cannabis compliance, reach out. We’re here to help! Or check out our other cannabis resources:
- Conversations with CGL Podcast: No Regulatory Counsel, No Cannabis Business.
- Conversations With CGL: What Happened in The Cannabis Market in 2020
- CGL Insights on Cannabis
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