The cannabis industry continues to grow in remarkable ways with larger and more institutionalized players increasingly investing in new and promising companies. Of course, it is no secret that this influx of “big players” has been causing for concern among grass-root community members and policy advocates who worry about the adverse effects of generic commercialization. But, this discussion is beyond the scope of this article!
Today, we are going to consider one of the more interesting legal mechanisms large companies may use to obtain and control smaller companies. Whether you are the investor or investee, the obtainer or the obtained, this article will hopefully contain some useful information for your business’s development.
The Founding Principle
Before we venture into the legal bush, it’s important to remind ourselves why precisely individuals engaging in business form legal entities in the first place; protection. Indeed, the fundamental purpose of a legal business entity is to shield the owners of the company from liability. If something goes wrong with Company X and an aggressive plaintiff sues it, Company X is liable but not (generally speaking) the owners of Company X.
What is a Holding Company?
Holding companies are legal entities, which do not actually produce or sell any products. This is rather counter-intuitive. Why start a company if you don’t intend to do anything with it? Well, the answer is slightly abstract but actually quite simple. While holding companies do not sell a product, per se, they buy, sell and retain assets (companies, stock, real property, intellectual property, etc.).
Thus, the purpose of the holding company is not to promote and sell a single product or service but rather to amass capital through the ownership of subsidiary companies that sell a product or service. The holding company is the proverbial, Guy Behind the Guy, developing high-level strategic growth plans to buy and sell companies and allow each asset to run independently of and parallel to the others.
Why a Holding Company?
If you recall from only a few paragraphs ago, companies (and the board members who are ultimately responsible for them) are always and forever singularly focused on limiting liability. The name of the game is advance while covering your flanks. How does a holding company advance, financially, while “covering its flanks”? By legally isolating and cordoning off its different subsidiary properties so that if one were to declare bankruptcy/get sued, its failure would have little to no bearing on the other subsidiary companies or the mother company. Clever, huh.
A Cannabis Holding Company: A Practical Example
Imagine for the moment that Jeremy and Bobby decide that after years of dominating the real estate industry, they want a bit more excitement in their lives and decide to form a corporation called Green Surprise Corp., which will exclusively target the cannabis space. Jeremy and Bobby proceed to file the Articles of Incorporation of this C-Corp with the State of California and are 50/50 equity partners in the business.
Naturally, these savvy entrepreneurs recognize their own limitations and understand that while they know nearly nothing about the workings of the cannabis space, they know quite a lot about managing money and running a business. So, Jeremy and Bobby, through Green Surprise Corp. hold an open house in their San Francisco office for cannabis companies to enter their “Shark Tank”. If Jeremy and Bobby like what they hear, they will either invest or purchase outright the startups while allowing the original founders to stay on board and continue to run their businesses as executive officers.
After several rounds of interviews, Green Surprise Corp. decides to purchase Vaporizer Novelty LLC (worth 1 Million dollars), Canna Star LLC (worth $400,000), and Green House Tech LLC (worth $200,000).
Even though Green Surprise Corp. now owns all of these companies, each respective business is still run out of its original headquarters and is managed by its original owners. Neither the companies nor their owners, have any interaction with one another and each company continues to maintain its original bank accounts and business operations.
Furthermore, Jeremy and Bobby make the very wise decision to keep each of these companies as autonomously registered LLCs with Green Surprise Corp becoming the owner and managing member of them all. Simply, these companies are now subsidiaries of the Green Surprise Corp., the holding company.
Two months after Green Surprise Corp acquires these companies, Vaporizer Novelty LLC and Canna Star LLC continue to thrive and have managed to triple their revenue. Green House Tech LLC, however, is entirely out of capital and is in debt $500,000 to a private investor (a loan meant to fund a new lighting system).
This private investor wants his money back but to his horror, discovers that Green House Tech LLC is completely broke and has no way to return the outstanding loan. Still, this investor is no dummy and after some investigation, determines that Green Surprise Corp, the parent company of Green House Tech LLC, owns several businesses worth millions of dollars. Can the investor sue Green Surprise Corp. to recoup his money?
Hopefully, the astute and now informed reader will conclude that the investor can with near certainty not go after Green Surprise Corp. (barring some extreme circumstances). This is the power of the holding company structure; As long as Green Surprise Corp. did not render itself liable for the outstanding debt by co-signing the loan, it will not (again, generally speaking) be subject to the debt requirements. Similarly, the investor cannot make the lateral move and sue the very profitable Vaporizer Novelty LLC and Canna Star LLC for the outstanding debt.
Ultimately, while Green House Tech LLC will go bankrupt and Green Surprise Corp. will lose its original $200,000 investment in the company, Vaporizer Novelty LLC and Canna Star LLC will experience no negative consequences and will continue to earn richly for the holding company, Green Surprise Corp.
Abe Cohn is a Managing Attorney at THC Legal Group, a Marijuana Law Firm specializing in the cannabis industry. Their attorneys assist startups, entrepreneurs and established businesses to protect their most prized assets. Connect with them to learn more. As always, #PROTECTYOURSTASH
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