You have an incredible idea. You know exactly how you’re going to execute it. You’ve started raising capital and building out your prototype.  But….. your cannabis company still does not officially exist.

Cannabis Startups require more than time, money, and ideas to flourish – they need a strong legal base. Indeed, new companies consistently falter as a result of structural mismanagements. Make sure your company has the appropriate legal infrastructure in place, before the company’s launch, rather than after it has already started to succeed.

The Basic Premise: Limit Liability and Maximize Profit

Our cannabis lawyers often speak to entrepreneurs with incredible ideas but who nevertheless lack the appropriate business acumen to begin the process. The first sentence of each conversation usually starts with some formulation of the following:  “I have a great idea and would like to start working on my business but I just don’t know where to start?!”.  

Launching a new venture can be overwhelming and our cannabis lawyers strive to impress upon our clients the importance of implementing strong legal fundamentals.  Certainly, the most critical imperative of any new business is to limit liability and maximize profitability.  While intuitive, this basic premise must be consciously considered when deciding upon the particular business structure to best serve this objective.

Selecting the Right Business Entity

When launching your new marijuana startup, it is not enough to simply announce that you have launched a company – you must instruct your State government of your intention to form your company in an official capacity. While there are several different types of business structures (with idiosyncratic iterations of each one), the three main options cannabis startups should consider include the LLC, S Corporation, and C Corporation.  

Importantly, the fundamental purpose of establishing a business entity is to limit one’s personal liability.  If the owner of the company performs negligently or issues a product with a defect and a customer is injured as a result, the business entity will be liable (generally) for the damages and not the individual owner.   

Keeping this thought in tow, let’s return to the three most common business structures.  Undoubtedly, the Limited Liability Company, or LLC, is the most popular entity and is renowned for its simplicity, flexibility, and protection; the owners of the cannabis startup are afforded great leeway under the LLC to develop their own rules and procedures, running the business as they see fit.  Unlike a Corporation, LLC is not bound by nearly as many legal mandates.  

Also, a company’s profits are taxed at an individual level, rather than at the company level.  Indeed, known as a “pass-through tax”, the duty to pay taxes runs directly to the owners of the company and not to the company itself. As we shall see, this tax benefit is markedly more appealing than the onerous tax requirements under a C-Corp.

C Corporations are often necessary for those seeking to raise venture capital or obtain funding from angel investors.  Quite simply, if a cannabis startup intends to raise capital in excess of $750k, a C Corp is a must.  C Corporations are immensely powerful in that they can issue several types of stock.  Most commonly, C Corps issue both common and preferred stock, with the latter representing an equity interest with greater financial and managerial rights than the former.

However, unlike an LLC, C Corporations are taxed twice – both at the corporate level and then again as the owners of cannabis disburse dividends company.

Finally, S Corporations, like LLCs, are taxed at the individual level but can issue stock like C Corps.  S Corporations, however, are far more restricted than C Corps in that they can issue only one type of stock and only to 100 stockholders.  Again, if you are building your Canna startup with the goal of rivaling the next Apple, an S Corp will not cut it.

Operating Agreements – Establishing the Contours of the Company

Beyond the legal requirements and restrictions involved in establishing a business entity, drafting operating agreements serve the equally important purpose of setting managerial parameters within the company.  Which founder is responsible for the finances of the cannabis startup?  Which founder is responsible for managing the client base and operations of the business?  Which founder has the capacity to fire employees and does that founder need the other founders’ consent first?

The harsh reality is that interpersonal relationship’s between startup founders often break down and if the mechanics of the day-to-day duties are not sufficiently delineated in advance, havoc may ensue.  Developing a formal structure with agreed upon roles and responsibilities will establish legal boundaries (with legal consequences) between the partners and the company. As always, treat yourself like a boxer and “protect yourself at all times.”

Abe Cohn manages THC Legal Group, a Marijuana Law Firm specializing in the cannabis industry.  Their attorneys assist startups, entrepreneurs and established businesses protect their most prized assets.  Connect with them to learn more.

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