Is Selling to An ESOP Beneficial For All Types of Cannabis Businesses or Just Some?

By: Darren Gleeman, Managing Partner of MBO Ventures

An Employee Stock Ownership Plan (ESOP) is ultimately a way for business owners to sell their company. Typically, there are three options for selling a business: to a private equity firm, to a strategic buyer, or to the employees via an ESOP structure (an ESOP doesn’t cost the employees anything).

For decades, mainstream businesses and large corporations, such as Publix, have sold their company to ESOPs. Why? The IRS actually incentivizes business owners to sell their company to the ESOP by giving them a tremendous package of incentives and subsidies such as deferred capital gains taxes. Plus, the company itself, once it’s structured as an ESOP, is able to operate income tax-free—zero federal income tax and zero state income tax.

In cannabis, being able to operate tax-free means that IRC tax code 280E, which prevents cannabis businesses from deducting business expenses, becomes irrelevant. As such, selling to an ESOP has become an increasingly popular exit strategy for cannabis business owners.

Is an ESOP beneficial for all cannabis businesses, especially when planning your exit? The short answer is yes. But the long answer is a bit more nuanced than that. It’s time to unpack the ESOP use cases for cannabis businesses, including cultivation, manufacturers, and dispensaries.

Why is Selling to An ESOP a Good Exit Strategy?

Given the current financial landscape, there’s no money or buyers in the cannabis industry. Companies are struggling to find exit strategies. Right now, in the cannabis industry, valuation multiples are very low, especially compared to the early days around 2020-2021, when they were much higher. Back then, a company making $5 million in net income on $20 million in revenue could sell for $100 million to an investor—an inflated valuation that no longer exists. Instead, they might offer you a small amount in cash and the rest in company stock.

This situation is driving more businesses to consider ESOPs as a viable option since the valuation is similar to what you’d get on the open market.

Whether you’re in manufacturing, cultivation, or running a dispensary, the valuations are roughly the same. However, if you’re a multi-state operator, you might see higher valuations and therefore get more money by selling to an ESOP. The bigger your company, the higher your valuation, and the more attractive an ESOP becomes.

Ultimately, ESOPs are appealing due to the extraordinary tax benefits received and the lack of other exit strategies in the cannabis industry. Selling to an ESOP allows owners to defer capital gains taxes by reinvesting in another U.S. operating company, such as stocks or bonds. This strategy can lead to long-term wealth accumulation without the immediate tax burden of a traditional sale.

Which Cannabis Businesses Benefit Most From the Tax Benefits of An ESOP?

An ESOP offers significant tax advantages, especially for cannabis dispensaries, which has a greater tax burden than manufacturing and cultivation firms. However, once the owners sell the business to an ESOP, all three of these types have zero income tax burden. An ESOP makes all expenses, including the Cost of Goods Sold (COGS), irrelevant for tax purposes.

Due to certain quirks in the tax code, cultivation and manufacturing cannabis businesses have a lower effective tax rate than dispensaries. For example, cultivation firms might have an effective tax rate of 55%, while dispensaries might face a 65% effective tax rate.

Despite these differences, the benefits of an ESOP are largely similar across cultivation, manufacturing, and dispensary operations: no income tax, deferred capital gains tax, and other financial perks.

Yet, the main advantage for dispensaries lies in their higher tax burden, making the tax relief from an ESOP all the more impactful.

When considering ESOPs, the current tax environment is key. If cannabis is rescheduled and 280E is removed, the advantages of an ESOP would be equally beneficial across all sectors. But if Section 280E remains, dispensaries will undoubtedly benefit more from selling to an ESOP.

So, is selling to an ESOP beneficial for all types of cannabis businesses or just some? While all cannabis businesses can take advantage of an ESOP’s associated tax breaks, dispensaries have the most to gain from adopting an ESOP structure.