Written by Jeffrey Welsh and Justin Keller, Frontera Law Group
You’ve heard that cannabis has been legalized for recreational use; you’ve seen billboards around town advertising cannabis delivery services; you’ve walked through the sleek, new dispensary that just opened; you’ve heard about cannabis companies going public in the U.S. and Canada and making millions. You’ve been sitting on the sidelines watching the “green rush” emerge and have decided that it’s time to jump head-first into this unique investment opportunity. Stop. Before you do, there are some important things to think about.
Although cannabis is one of the fastest-growing industries in the world, as a result of federal prohibition and a number of other factors, there are a ton of investment risks that are unique to the cannabis industry. So, before you break into your savings and invest, you should take the time to understand the risks and challenges of investing in this budding new industry. While certain commercial cannabis activities have been legalized under state laws, all cannabis and commercial cannabis activities remain illegal under federal law. This federal illegality presents cannabis businesses with various difficulties and challenges, apart from the challenges associated with operating a business in a highly regulated industry. For example, banks in this country are reluctant to open business accounts or issue credit cards and credit lines for cannabis businesses, thus forcing many of these businesses to transact business in cash and to borrow with high-interest “hard money” loans. Unlike with other industries, the Internal Revenue Service does not allow cannabis businesses to deduct ordinary and necessary business expenses. The sole exception is for cost of goods sold (COGS). Many normal business expenses that can be written off by non-cannabis businesses cannot be written off because they are not COGS. This leads to a high effective tax rate for cannabis businesses, which may range somewhere between 40% and 70%. In addition, states have cannabis-specific taxes, as do local governments.
For cannabis brands, there are challenges associated with protecting intellectual property as well. Because cannabis is illegal under federal law, the United States Patent and Trademark Office will not grant cannabis-related trademarks or patents, which makes it difficult for these businesses to protect their IP. Cannabis businesses are also finding it difficult to obtain adequate insurance coverage. Even if a cannabis business has a policy, many insurance companies will deny claims because of federal illegality, which makes it hard for cannabis businesses to secure against a loss. Since cannabis is a crop, it is susceptible to loss due to acts of nature or infestation of pests. Moreover, cannabis businesses may not resort to bankruptcy laws for protection if faced with financial difficulties. Some have doubts about the value of the high demand of cannabis and manufactured cannabis products. Moreover, all commercial cannabis activity is heavily regulated, resulting in increased operational costs and the risk of potential penalties and license suspension or revocation. Because the regulated market came into effect on January 1, 2018, cannabis businesses operating under temporary licenses, which are valid for four months from the date of issuance. Businesses operating pursuant to temporary licenses must submit a detailed annual license application, and the granting of an annual license is not guaranteed.
Investors who are considering investing in a licensed commercial cannabis business should review the local laws of the city or county where the business is located to determine any requirements and restrictions imposed on the business, in addition to those imposed by state law and regulation. Due to the many applicable laws and regulations, cannabis businesses must implement rigorous standard operating procedures and establish thorough employee-hiring processes.
A business that has inadequate procedures or hires unqualified employees will be at risk of falling out of compliance and jeopardizing its license. Any attempt to acquire an existing cannabis business in California will require approval from the state government. Because the licenses are not transferable, even the successful acquisition of an existing licensed business might not result in the acquiring party maintaining the license to operate. Moreover, the laws and regulations establish requirements and procedures for situations involving a change in ownership. Thus, even an owner who is individually selling an interest in a cannabis business could run into difficulties. At this pivotal time in the evolution of the industry, investing in the right cannabis opportunity could have tremendous upside; however, the opportunity comes with many unique challenges, risks and landmines. Before investing in a cannabis business, make sure you consult with business attorneys who have the expertise to guide you at every step along the way and to make sure you fully understand the investment. Frontera Law Group is a California cannabis business specialty law firm.
To learn more, visit fronteralawgroup.com