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What to Consider When Starting a Cannabis-Focused Business

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With an expected annual growth rate of 24.9% and federal decriminalization potentially on the horizon, cannabis is one of the most untapped markets for new startups. Cannabis is, however, still currently a Schedule I controlled substance in the United States—even though it’s recreationally legal in 20% of states.

This federal/state interplay creates complex regulations which entrepreneurs looking to get involved in the industry need to navigate. Recently I spoke with successful founders and CEOs who specialize in various sides of the market to distill their best practices in building a cannabis-focused business–from legal to SaaS to venture capital.

Let’s meet the players:

      • Troy Dayton is the CEO of The ArcView Group, a cannabis-specific investment network.
      • Amanda Ostrowitz is the founder and CEO of CannaRegs, the industry-leading regulatory data source for all things cannabis.
      • David Hua is the co-founder and CEO of Meadow, which provides compliant software solutions for cannabis retail dispensaries and delivery operators.
      • And I’m Jason Kornfeld, an Atrium attorney with a focus on cannabis law.

During our discussion, we agreed upon three tips to consider whe building a cannabis-focused business:

  • Expect scrutiny
  • Keep tabs on regulation
  • Recognize your unique situation when fundraising

1. Expect Scrutiny

Cannabis is a highly regulated industry, and therefore, startups in the industry must operate within a particular set of legislation. Add in tax regulations and things get even more complicated: Section 280E of the IRS tax code, for instance, prevents cannabis companies from taking general and administrative deductions that are standard for traditional startups. Whether your business actually touches the plant itself or provides ancillary services to the cannabis industry, expect regulatory and other constraints particular to operating in the cannabis industry.

Structure yourself to be legal and compliant

Unlike the majority of venture-backed startups that can form a Delaware corporation and run their entire business out of this one entity, a cannabis startup’s choices are more complicated because Cannabis is illegal in Delaware. For instance, companies cannot incorporate in Delaware and then apply for a cultivation permit in California using that same entity.

However, forming a holding company can be a workaround. For example, forming a holding company in Delaware allows a startup to raise money through the holding company while operating in California through a wholly-owned subsidiary. Even then, forming a Delaware holding company could still bring about concern due to the unknowns of how Delaware courts may treat a company that owns a subsidiary that is a cannabis business. As a result, some companies have chosen to form holding companies in states like Nevada where cannabis is legal and because it has corporate laws similar to that of Delaware.

While structural decisions like these can be nuanced, they’re important to get right. As Hua puts it, “It’s really important to get your company structure right. Otherwise, you may be at the finish line and unable to cross.”

Banking problems are not unusual

Since marijuana is a Schedule I controlled substance, banks accepting money from cannabis businesses could be charged with money laundering. Some banks refuse to work with cannabis companies altogether, even if the company remains legally compliant and doesn’t actually touch marijuana.

Some cannabis companies, however, can find a bank willing to work with them. But even then, a thumbs-up from a bank’s regulator is no guarantee. While being legally compliant is the best defense, many compliant cannabis companies have still found their accounts frozen or closed.

CannaRegs, for instance, was bootstrapping when its founder received a call from their customer-payment system, cutting the company off entirely. As Ostrowitz describes, “I had 97 customer accounts that I didn’t have payment information for. That could have ended my company. I took on some consulting projects and made $30K show up in seven days to make payroll. This stuff is not for the faint of heart.”

Since it’s better to be safe than sorry, the prudent approach is opening multiple accounts with multiple banks–even if those banks are second-tier or the accounts require fees to keep them open. As Ostrowitz puts it, “I never thought I would jump up and down for a 6.9% processing fee.” She was later able to find a payment processor that would give her a 5.9% rate, and eventually ones at 2%, but still keeps the higher-fee accounts open, just in case.

2. Keeping Tabs on Regulation

Cannabis companies that do not pay attention to pending legislation are risking the entire future of the company. This applies to more than just current laws—if you don’t understand legislation coming down the pike, you may wake up to find yourself in an obsolete business model.

Instead, successful cannabis companies will work to influence local legislation, track federal changes, and engage a legal team that stays on top of the ever-changing regulatory environment.

Influence local regulation

Since cannabis is such a nascent industry, regulatory areas are still being defined. When Hua originally founded Meadow in 2014, it began as an “Uber for Weed” model, facilitating deliveries between operators and medical cannabis patients. While California now has a statewide law permitting marijuana delivery, the topic was a gray area back in 2014. Two-thirds of the state had actually enacted prohibitory laws. Meadow helped lobby for delivery regulation, create trade groups, fight for licensing practices, and eventually built a comprehensive software solution to allow both cannabis delivery and retail businesses to operate their core business functions compliantly. As Hua puts it, “You can’t be in the cannabis industry and not care about regulations. If you don’t like it, you’re in the wrong industry.”

Track federal regulations

Since federal changes can alter the whole nation in one fell swoop, they can be even more impactful than local laws. That makes monitoring them of the utmost importance.

In 2009, national support for cannabis companies was strong, in part because President Obama had said he wouldn’t prosecute in states that permitted medical marijuana, and Dayton’s ArcView Group was picking up steam. In 2011, however, the Obama administration made an about-face on the topic and potential investors stopped attending ArcView events. There wasn’t enough momentum to keep the company moving. Out of money but committed to the company, Dayton lived out of his car as he tried to stay afloat in this new, much tougher climate.

On the whole, federal changes are trending toward legalization. While President Trump’s former Attorney General was actively anti-marijuana, his new nomination, William Barr, has stated he is not going to “go after” marijuana businesses. President Trump has also said he probably will support lifting the federal ban on marijuana, but the Trump White House’s policy on marijuana has changed before.

In general, cannabis entrepreneurs must keep tabs on industry regulation, both current and future. It’s just part of the job.

Hire a good lawyer ASAP

Starting a cannabis business comes with a host of unique regulations, so a top-quality lawyer can be worth their weight in gold. Ostrowitz, for instance, hired a lawyer “as soon as [CannaRegs] started spending money.”

Given the industry’s specific requirements, finding the right fit can be tough, which makes starting the search early that much more valuable. Be sure to choose a lawyer with prior experience in cannabis law. Even Ostrowitz, herself a lawyer, “didn’t pick the right lawyer the first time.”

While the importance of quality legal representation cannot be overstated, CEOs still need to keep in mind that lawyers are not entrepreneurs. As Dayton puts it, “If I did everything lawyers told me to do for the last nine years, [Arcview] wouldn’t be here.” Instead, find a lawyer who will provide top-quality legal advice and still respect the business’s strategy.

3. How to Fundraise in the Cannabis Industry

Although cannabis is no doubt a rapidly growing industry, investors can be wary of its additional requirements. Here are three tips for finding the right investors and successfully fundraising:

  1. Solve your structure and legal requirements before fundraising.
  2. Find investors that are comfortable with (or even well-educated in) the industry.
  3. Pitch your solution, not the space itself.

Solve your structure and legal requirements before fundraising

No investor wants to invest in a company that might be regulated out of existence, so de-risking the investment is of paramount importance. That means you need the proper corporate structure as well as any relevant licenses.

While some cannabis companies have received VC funding before being licensed, not having this box checked can make many VCs hesitant. As Dayton describes, “If you are pre-license, it is generally really hard to raise money.”

VCs are in an industry where a very high percentage of their investments fail, so lacking the proper structure simply makes it easier for them to pass on investing in you. It’s safest to take care of every structural danger before speaking to investors.

Find the right investors

Some limited partners in venture funds prohibit these types of investments, which can make investing in a cannabis company a non-starter for their VCs (even if they like the industry and company). Still, however, some top VC firms are taking part. These are typically funds that recognize cannabis’s large potential upside and are willing to take a risk on the industry even though it lacks an established late-stage fundraising ecosystem.

Some investors may pass simply because they don’t like the industry. That’s okay—many others see cannabis’s value. Ultimately, just because an investor thinks that being in the cannabis industry means your company’s valuation receives a discount does not necessarily mean they are wrong. There are a lot of unknowns and investors that are comfortable with the regulatory complexities can be worth the price in order to have a quality adviser and partner in growing your business.

Pitch your team and solution, not the space

While most VC pitches highlight market size, cannabis is different. Any cannabis investor already knows the impressive—and quickly crowding—market. Instead, cannabis entrepreneurs should focus more on their team, specific solution, and understanding of regulatory requirements. As Dayton puts it, “They’re already sold on the space. Don’t waste your time.”

The story surrounding the cannabis industry has also changed in recent years. As Dayton says, “Six months ago very few investors would say federal prohibition is going to end soon. Now there’s a growing consensus in the industry that meaningful federal reform will come.”

The current regulatory climate means that most investors already recognize the value of the industry. Obtaining your temporary permits is just one hurdle most investors will require, but being able to convey an impactful pitch and that you have a team an investor is comfortable funding is more likely to land you the seed investment or Series A term sheet you’re looking for.

Conclusion

Every piece of advice for entrepreneurs navigating the cannabis industry stems from one fundamental fact: it is rapidly changing, be educated. Building properly, keeping a tab on the still-shifting regulations, and adjusting fundraising strategies are crucial tactics for companies taking root in the industry.

If you’re interested to dive even deeper, hear the full discussion between Ostrowitz, Hua, Dayton, and myself in this video. And join us at CannTech, where we’ll be sponsoring and speaking.

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Jason is a corporate attorney in Atrium’s General Counsel Group specializing in the representation of start-ups and emerging growth companies throughout various stages of their life cycle including corporate formation, structuring and governance matters, commercial transactions, venture capital financings, and mergers and acquisitions. He represents many startups across industries with a special focus on cannabis. Previously, Jason worked in the San Francisco office of Covington & Burling. As a startup and venture capital lawyer, Jason works to reinvent the legal services industry by offering technological efficiency and transparent pricing to clients. Outside of the office, Jason can be found skiing, surfing, or traveling. Jason graduated from the University of Southern California’s Gould School of Law and received his Bachelor’s at The University of Colorado Boulder.

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