Editor's note: An extended version of this article originally ran on Cannabis Business Times' website.
The cannabis and hemp industries are growing, but it isn’t just from an increase in retail sales. Venture capital investors and businesses formerly uninterested in (or even opposed to) cannabis in all its forms are now pouring money into the industries, helping fuel their growth. With that, many long-term cannabis and hemp entrepreneurs are looking to parlay their experience and expertise in the field into profitable businesses.
The entrance of big money into the industries certainly provides a solid jumping-off point for businesses that partner with investors to increase profitability and valuation. However, it could also come back to haunt the seasoned cannabis entrepreneur who enters into a partnership without fully understanding the terms of the agreement.
It is imperative for industry veterans to know how they can protect their stake in the business at the beginning of a new venture to avoid potentially time-consuming, expensive legal battles down the road should things turn sour.
The strategies presented here can effectively protect your stake in a developing business, but remember that big money investors often have a “take-it-or-leave-it” mentality. However, just because a venture capitalist is putting up money doesn’t mean he or she holds all the power and leverage in the negotiation. Without your unique skill, product, process or experience—whatever forms the base of the business and sets it apart from competitors—the investment opportunity wouldn’t exist in the first place. If you are critical to the business’s success, you have leverage to steer the deal or walk away if the terms aren’t beneficial to you.
When you’re in the early stages of building a business, it’s easy to get caught up in the euphoria of your new venture’s possibilities. While developing a vision with new teammates and investors, don’t forget to pause and ask difficult but important questions like:
- How will we make management decisions?
- How much of this venture do I own, and how much do my partners own?
- How would we deal with potential disputes between partners? How would my interests be protected if:
- The venture just muddles along or is a bust?
- Everything goes as planned and the business is a moderate success?
- You hit a home run and your founder’s shares are worth millions?
It’s essential to put the terms of the business relationship on paper early to clarify expectations and avoid future misunderstandings or surprises. You should start documenting once you’ve found your core business partners, even if you don’t have all your investors on board yet.
Finding a business-savvy lawyer can be critical early in the process, especially when dealing with outside investors or venture capitalists. A competent attorney can ensure not only correct documentation from the outset, but also that your voice is heard in negotiations and business proceedings.
Draft an Operating Agreement
One essential document an attorney can help you draft is the operating agreement. Sometimes called a shareholder or partnership agreement, an operating agreement defines members’ rights and lays out a framework of operations for events that could render parties in the business unable to continue working together. Think of it as a prenup for a business, intended to protect all parties if things go wrong or a member wants to leave the company. It can prepare the business for events such as:
- Someone wants to amicably leave the business—what happens to their shares?
- The business is booming and new investors want to buy in.
- Majority partners want to sell the business.
- Partners disagree on key management decisions or how to run the business.
Protect Your Stake as a Minority Shareholder
If you’re dealing with angel investors, chances are you will be a minority shareholder, meaning you will own less than 50% of the shares or interest in the company. While you may not own the bulk of the company as a minority shareholder, don’t be quick to sign an agreement that diminishes your rights. Remember to take advantage of your leverage as a key part of the business by including operating agreement provisions that protect your rights and stake in the company.
In the operating agreement, you should identify the types of business decisions that will require consent by a supermajority of shareholders. Supermajority votes are recommended for decisions that affect the trajectory of the business, such as selling the company, liquidating assets, appointing management, spending a certain amount of money, or taking on a certain amount of debt. If, for example, you are one of several minority shareholders and have an angel investor who owns 65% of the company, delineating decisions that require a supermajority vote ensures the angel investor can’t hijack the business or make decisions that inequitably benefit him or her over the minority shareholders.
Tag-along rights, also known as co-sale rights, are another provision to consider including in the agreement. Suppose a majority shareholder decides to sell his or her shares. In that case, tag-along rights would give minority shareholders the right to join the transaction and sell their shares along with the majority shareholder at the same price. Tag-along rights ensure the shares of minority partners are as liquid as those of their majority partners. Angel investors and venture capitalists, who tend to be well-connected businesspeople, may have an easier time selling hundreds of thousands or even millions of dollars’ worth of shares than a boots-on-the-ground minority shareholder.
Conversely, drag-along rights give majority shareholders the power to force minority shareholders to sell their stock if the majority shareholders enter into a sale. Drag-along rights prevent minority shareholders from blocking the sale of a company, but also entitle them to the same terms of sale and conditions as the majority shareholder. Drag-along rights tend to favor majority shareholders and can eliminate 100% of minority shareholders in the event of a sale. These provisions should be evaluated on a case-by-case basis.
Buyout provisions can also protect minority investors by setting a valuation equation or identifying a neutral valuation expert to establish a fair way for buyout terms to be decided. For example, if a majority shareholder wants to buy out your 15% ownership in a company, but you believe those shares will be worth more in the future, a pre-negotiated valuation equation can determine how much your shares might be worth down the line. If you’re being forced to sell while the company is growing, a valuation equation could allow you to capitalize on the company’s growth and improve the price per share you’ll receive.
In some cases, the operating agreement will dictate that minority shareholders receive their shares in the company on a vesting schedule, meaning the shareholder does not fully realize the rights and benefits of the shares until certain conditions are met, such as remaining with the business for a certain period of time. We often see vesting provisions where certain business partners are providing “sweat equity” (i.e., their time, services or expertise) as opposed to monetary investments. Vesting schedules can be set up to allot a set percentage of shares over months, quarters or years, depending on the agreement. Minority shareholders will benefit from vesting schedules that vest more shares upfront or more frequently.
“Cliff vesting,” where a larger percentage of shares vest all at once after a longer period of time (typically a year), requires shareholders to stay at the company for a set time period before they will fully realize their shareholder rights. A typical “cliff vesting” clause provides that 25% of the allotted shares vest after the first year, with the remaining shares vesting over the next three years in equal monthly tranches. This arrangement tends to benefit majority shareholders because it gives them the potential opportunity to push out minority members before a significant portion of their shares have vested.
To protect against this scenario, consider including a provision stating that if a minority member is pushed out of the operation, his or her shares will continue to vest on schedule so long as the shareholder was terminated without cause or separated for a good reason. Conversely, if the member is terminated with cause or leaves without good reason, he or she loses the unvested shares.
“Cause” is typically a defined term in the agreement and will often include “bad” behavior such as: the conviction of a felony, a breach of fiduciary duty, misconduct causing harm to the company, or willful failure to perform substantial duties. The company should tailor this list to best suits its needs.
Similarly, a “good reason” clause provides pre-negotiated situations that are considered acceptable withdrawals from the company that would also trigger vesting or accelerate the vesting schedule. “Good reasons” should be negotiated in the operating agreement and could include:
- Being asked to relocate more than 50 miles from your home;
- Substantial reduction in compensation;
- Substantial reduction in responsibilities or authority.
Remember that the efficacy of the protective measures laid out here depends on the negotiated terms in the operating agreement. You may not be able to convince all parties to agree to all of these provisions, but retaining a lawyer will ensure that you understand your rights before a dispute arises and will increase the likelihood that provisions protective of minority members make it into the final agreement.