Protect Your Cannabis Business from Crime Risks

by Johnathan Bench, Attorney at Harris Bricken

Previously we wrote about equity compensation for cannabis employees from the perspective of companies. We have been dealing with more and more companies adding equity to their overall compensation scheme, so now is a good time to revisit it from the employee perspective. For an overview of the types of equity compensation available, see here.

Equity compensation for cannabis employees: potential employment tax issues

Many companies assume that there are federal exemptions for startups that allow them to compensate early-stage cannabis employees solely in equity, but that is not the case. Minimum wage and overtime laws still apply, and the value of stock and stock options is not included in determining whether an employee is receiving at least the minimum wage. This means that the employer is still responsible for remitting the employer’s side FICA/FUTA and state employer taxes. The employer is also an agent for the federal and state government and is responsible for collecting the employee’s side of federal and state employment taxes, including requiring the employee to indicate what level of withholding the employer should be applying to the employee’s wages.

Equity compensation for cannabis employees: determining compensation valuation

Beyond these general wage issues, there is the issue of compensation value, which is different from company valuation. If a cannabis company goes through a formal valuation process and is reasonably worth a million dollars, that does not mean an employee’s one percent stake in that company has a present value of $10,000.

All new companies and an overwhelming majority of cannabis companies are closely held, meaning they are owned in full by a small group of owners. The shares or ownership interest of the company are not openly available in the public market, and they cannot be made available for general sale unless the company registers its ownership interests under federal securities laws. So the present value of the employee’s one-percent stake in a closely held cannabis business is not the same as the same stake would be in a publicly-traded company.

Resale value isn’t the sole measure of the equity compensation held by a cannabis employee. There are also things like distribution rights and redemption rights. The devil is in the details here because everything depends on the company’s governing documents.

There is no general requirement that a limited liability company or corporation distribute profits to its owners. In fact, unless limited by the LLC operating agreement or the bylaws of the corporation, owners and officers can compensate themselves as salaried employees of the company, potentially eliminating any funds that would be available for distribution.

Even in a company where that isn’t the case, officers often want to hold on to cash to use for reinvestment in the business, as opposed to distributions to owners. Though that may be good for increasing the value of the company overall, it does not increase the present value of an ownership stake that cannot be sold.

Many startup cannabis companies either cannot afford or do not want to spend precious startup funds to determine the exact value of the equity compensation for their cannabis employees. This common scenario is not ideal for the company or the employee.

Equity compensation for cannabis employees: potential employee traps

Cannabis employees should be wary of companies that offer equity compensation in lieu of any pay at all. Employees with equity stakes have some legal protections as employees and minority owners, and they can potentially negotiate for greater protections in the company’s governing documents. Many of the rights and protections mirror what any minority owner of a closely held company would benefit from.

If, as described above, there is a worry that the company’s owners will drain cash by paying themselves excessive salaries, it is in the employees’ and other minority shareholders’ interests to require the company mandate no salaries or maximum salaries for owners and proportional distributions otherwise. That means that if the company is making money and the majority owners want to pull cash out of it, minority owners like employees would also get a proportional cash distribution. This negotiation must occur before the employee accepts the compensation arrangement.

Some shares or membership interests have redemption rights, which are limited rights to force the company to repurchase the ownership interests of the company from the owner. If this were an immediate right to cash, it would defeat one of the purposes of equity compensation for the employer (pay less cash and more equity in the early stages while the company is cash-poor). Many companies have structures in place to offer repurchases of some or all of the ownership interests that employees or other minority owners have, often over extended terms that are favorable to the company.

An additional right that employees and other minority owners can negotiate for are so-called tag-along rights. These are rights that ensure that if majority owners sell a portion of the company to a third party, minority shareholders can participate in proportion to their ownership interest.

Equity compensation for cannabis employees: balancing all of the issues

In general, a cannabis employee offered equity compensation should understand the limitations that come with that offer. Marijuana is heavily regulated in states with licensing programs, and resale options for equity ownership are limited by both securities law and by various state regulations on marijuana company ownership. If a company does not intend to or is not able to pay big cash distributions to its owners, employee equity holders need to realize that the value of their stakes may end up being worth nothing, and the timing on that intelligence is going to be unpredictable.

Cannabis employees should treat the offer of equity compensation like they would any business decision. Research the company. Ask for relevant documents to help you with that research. Ask the owners and management team hard questions, and make your decision once you understand all of the potential parameters.