Oren Bitan, Heather Semenuik and Priya Sopori Give Insights into the Business of Cannabis

The Business of Cannabis panel is produced by the L.A. Times B2B Publishing team in conjunction with Buchalter, Crowe LLP and Greenberg Glusker LLP.

The cannabis industry continues to build upon what has become a multi-billion-dollar success, cross-pollinating into sectors including healthcare, pharmaceuticals, consumer goods and agriculture. Public companies with growing valuations are making innovation waves, while established blue-chip organizations are partnering with or purchasing cannabis-related businesses to gain entry into the industry.

As the legal and financial landscape around cannabis continues to evolve and public support for the products and services mount, an increasing number of consumers, businesses and investors have taken note. As with any emerging industry, learning about the ins and outs of the diverse and fast-growing sector can be overwhelming.

To take a closer look at the latest developments and trends in the business of cannabis, we have turned to some of the region’s leading authorities, who graciously weighed in for a discussion and shared their insights.

Q: What qualities are investors looking for when determining which cannabis companies to invest in?

Priya Sopori, Partner, Co-Chair Cannabis Industry Group, Greenberg Glusker LLP: Using a calculus that is not so different from investors who are looking to invest in non-cannabis companies, potential cannabis investors are most interested in three qualities: first, companies with control over a strong brand with a devoted consumer following; second, scalability of the brand, the product line and business model; and third, the company has secured all licenses necessary to perform the fundamental functions of its core business and has strictly complied with all regulatory requirements. Investing in a cannabis company is not for the faint of heart. As with any investment, evaluation of risk tolerance is especially important. Because most operators are not in a position to avail themselves of traditional banking services, it is crucial that investors trust all involved parties and conduct thorough diligence before moving forward with any deal.

Q: What are the latest trends you have seen in the cannabis industry in California?

Heather Semenuik, Partner, Crowe LLP: The challenges faced by the California cannabis industry are not new – continued struggles with the two-tiered licensing system with many municipalities banning cannabis operations, high imposed taxes, and a dominant illicit market. Sales in early 2022 have trended downward as compared to the last quarter of 2021. The primary reasons are due to decrease in pricing and less demand. With the rise of inflation and the cost of necessities, indicators are showing less discretionary spending by consumers at dispensaries. The tax burden remains an issue resulting in continued pressure for tax reform. Taxes are viewed as one of the reasons contributing to the strong illicit market in California, in which businesses conducting business legally find it difficult to compete. In June 2022, Assembly Bill 195 was adopted by the California legislature which will eliminate cultivation tax, but pressure remains for further tax reform to reduce taxes.

Oren Bitan, Shareholder, Buchalter: Doing business in California’s legal cannabis industry remains a risky endeavor. The majority of the industry is still unlicensed, tax rates at the state and local levels are high (notwithstanding a recent reprieve from California’s cultivation tax), and there are not enough licenses to meet geographic demand throughout the state. By all counts, the majority of the industry in California is unlicensed. Consumers are price sensitive, so fully compliant licensed entities are competing with unlicensed entities that do not test products and do not pay any taxes. Enforcement at the municipal and state levels is therefore essential to preserving and expanding the licensed industry. In addition, we are seeing continuing consolidation among California-based operators, but multi-state operators have not yet taken over the California market.

Sopori: Celebrity endorsements have become increasingly popular with varying degrees of success. Products branded by stars – from lifestyle gurus to notorious rappers – have found a place in the market, and the industry will likely see more of these celebrity endorsements going forward. Beyond a mere entertainer or popular “influencer,” Humphrey Bogart is planning to lend his name and iconic image to a cannabis brand, and we are also likely to see well-known athletes offer endorsements as more athletic organizations come to recognize and respect the medicinal qualities of cannabis.

Q: What do you think cannabis retailers have learned from the rise in demand resulting from COVID-19?

Bitan: When the COVID-19 pandemic struck, it was ironic that the cannabis industry on the one hand remained federally illegal and unable to take advantage of stimulus funds earmarked for small businesses through the Small Business Administration, but on the other hand was deemed to be an essential business that could remain open to serve customers notwithstanding shut down orders. The cannabis industry enjoyed the same “pantry loading” that the wine, beer and liquor industries did, but these sales increases ultimately proved to be relatively short-lived, and the industry now faces structural challenges it faced before the pandemic. Coming out of the pandemic, the industry finds itself once again at the crossroads between being a widely accepted and desired industry that employs hundreds of thousands of people nationwide and one that cannot easily access basic financial services like short-term lending, deposit account banking, or lines of credit.

Q: How would you rate the status of raising capital for cannabis businesses today?

Semenuik: The current status can be summed up in one word: “onerous.” According to U.S. federal law, cannabis is listed as a Schedule 1 drug under the Controlled Substances Act resulting in traditional avenues to raise capital not available to cannabis businesses. This means there is an inability to trade on U.S. national securities exchanges, such as the NYSE and Nasdaq, with access limited to the OTC market that has limitations and institutional investors sitting on the sidelines. Companies can explore other options outside of the U.S., such as the Canadian Securities Exchange which larger cannabis businesses have done so. As more states move to legalize cannabis, the demand and support for change at the federal level has grown and it seems change is inevitable. Although there has been no federal legislation passed to date decriminalizing cannabis, the more recent activity in 2022 indicates movements to do so, including discussions regarding SAFE banking, the House passing the MORE Act in April, the CLIMB Act introduced to Congress in June, and submission of the CAOA to the Senate in July.

Q: Describe some of the legal and regulatory risks and challenges that are faced by cannabis businesses in 2022.

Sopori: The biggest challenges in 2022 remain substantially the same as in previous years: banking, taxes, and federal law. Because cannabis remains a controlled substance and illegal under federal law, banks that are governed by federal law and federally insured – virtually all large financial institutions – are extremely hesitant to transact business with cannabis companies. Similarly, cannabis businesses must continue to scrupulously avoid the sale and/or transportation of product across state lines, which would violate federal law. Once upon a time, the procurement and maintenance of a dedicated compliance team may have been considered a luxury. However, in today’s climate of frequently changing local and state regulations, it has become a necessity.

Bitan: Outside financing remains difficult for the cannabis industry to secure funding for equipment, tenant improvements, account receivables and working capital because, under the federal Controlled Substances Act (“CSA”), cannabis remains a Schedule I narcotic. Therefore, entrepreneurs, investors, and lenders who have stakes in state-sanctioned cannabis enterprises expect to see returns that justify the higher level of risk, which places additional financial pressure on cannabis businesses. In addition to the industry-specific challenges, the United States economy is on the verge of a recession that may further hamper the industry notwithstanding the industry’s resiliency during the pandemic when it was deemed to be an “essential” industry that benefited from consumer spending of stimulus monies. These outside pressures increasingly lead to ownership disputes and creditor defaults that result in litigation and the need for restructuring. In some instances, business partners cannot agree on control and finances of the licensed businesses, and in other instances, unpaid creditors file suit to enforce their interest in a company’s assets. And sometimes a local municipality discovers wrongdoing by an operator and initiates a health and safety lawsuit to cease the illegal condition. Bankruptcy reorganization is an option typically utilized by struggling businesses to shed or restructure debt. Cannabis businesses, however, cannot take advantage of bankruptcy remedies because bankruptcy is a product of federal law and federal law still prohibits the sale of cannabis. As a result, stakeholders in legal California cannabis enterprises must consider alternatives to bankruptcy to collect what they can on their loans and investments in the event the enterprise becomes insolvent or requires restructuring. A well-established alternative to bankruptcy is a state court remedy - the appointment of a receiver over the assets of a business or the entire business operations. Through the receivership process, stakeholders may obtain many of the same protections available to them through bankruptcy. There are unique challenges to a receivership in the cannabis industry because state cannabis licenses may not be sold or transferred. A receiver, however, can petition the appointing court for authority to shepherd the process of “selling” the interest in a license with the receiver participating in the regulatory process to maintain a license during the pendency of the receivership and to assist in the amendment of a license while a prospective buyer seeks to obtain its own license.

Semenuik: One ongoing challenge is banking. There has been improvement whereby businesses have access to banking, but options are limited, and the extent of services provided does not fully meet companies’ needs. Reasons stem from concerns over loss of insurance and accounts held with the Federal Reserve, ongoing due diligence costs to monitor companies’ compliance and reputational risk. As a result, the majority of banking is provided by regional banks and credit unions and companies are often subject to high fees. There is no access to national banks, and the use of credit cards is illegal with all major credit card companies not accepting cannabis sales, creating cash management and treasury challenges. However, our cannabis consulting practice continues to see an increase in banks being inquisitive on policies and procedures to address the risks that come with banking with cannabis businesses which is a positive sign.

Q: What are the most common liability risks you see cannabis businesses facing?

Bitan: The most common liability risks for the industry are taxes and product liability. Because cannabis is still illegal at the federal level, it is subject to Section 280e of the IRS tax code, which prohibits the deduction of typical business expenses. This greatly impacts the bottom line for the industry. Product liability is also a big concern because the industry has created hundreds of new products in a relatively short amount of time, so they do not have a long track record. I expect litigation to arise from cannabis vapes and edibles, especially as it pertains to the sensitive portion of the population that may be susceptible to negative ramifications from regular product use. The industry should also be mindful of class-action wage and hour complaints and Proposition 64 claims, both of which are common in other industries and are heavily utilized by plaintiffs’ lawyers.

Sopori: Disputes among partners and co-owners are among the most common risks of liability facing cannabis businesses. Oftentimes, a small fledgling business becomes enormously successful and profits increase, but some owners no longer view their original understandings or agreements (if they exist) with the same perspective. Disagreements with respect to shares of the profits or control over the licenses begin to arise. Another common risk involves intellectual property, especially when it comes to the names of cannabis strains. While the historical names of certain strains are immediately recognizable within cannabis culture, those amusing, ironic names may also be associated with candy, cartoons, or other non-cannabis products. The decidedly unamusing consequence can be trademark infringement actions or accusations and lawsuits that contend the entire industry is marketing products to underage consumers.

Q: What advice from a financial reporting perspective would you provide cannabis business owners that are contemplating raising capital and seeking financing?

Semenuik: Back in 2020 when there was a flurry of activity in the marketplace, many companies were not well prepared to meet the financial reporting requirements needed as part of entering into transactions resulting in significant burdens and costs. Don’t wait until the last minute. The financial reporting requirements vary depending on the form of capital raising and financing, so it is important to formulate short-term and long-term strategies and seek advice from trusted advisors in the industry (such as public accounting firms, legal counsel and investment bankers), understand what will be important to investors, identify existing challenges/gaps, and develop a plan. The plan should incorporate a strong financial reporting framework and even if a deal is not imminent, I have seen situations where the lack of investment in financial reporting has created roadblocks in closing deals that could be avoided with proper planning and execution.

Q: Where should a business in the cannabis, CBD, or hemp industry look when seeking trusted advisors?

Bitan: Cannabis business owners should look for sophisticated practitioners that have knowledge and experience with both the cannabis industry and a specific area of law. For example, I founded Buchalter’s cannabis practice nearly 10 years ago as a restructuring/receivership lawyer and litigator. I combined my prior expertise with industry-specific expertise and can now serve my clients utilizing the full scope of my knowledge. I also act as outside general counsel for my cannabis industry clients and can leverage the expertise of my partners in a number of other areas, including commercial finance, real estate, intellectual property, and employment matters.

Q: What tax considerations should a new cannabis business consider?

Semenuik: Understanding federal, state and local taxes is of utmost importance. Licensed cannabis companies are subject to Internal Revenue Code Section 280E, which generally disallows business deductions with the exception of the cost of goods sold items. While some states, such as California, allow business deductions for state income tax purposes, this provision creates material, federal tax burdens. Businesses frequently create complex legal entity structures bifurcating various trades or businesses to mitigate the impact of these rules, albeit with limited success upon IRS examination. Businesses should make sure to keep separate books and records for each business, clearly document related party transactions, and enter into agreements that clearly stipulate the terms of transactions or sharing arrangements. Businesses also need to make sure they comply with complex, indirect taxes such as sales and use, property, payroll and marijuana excise taxes, which vary by the local jurisdiction. Having competent, specialized cannabis industry tax advisors and legal counsel is a must.

Q: What advice would you offer California-based cannabis companies who want to expand to other states in 2022?

Sopori: As you might expect when expanding any highly-regulated business, you will likely need three different types of specialists – all of whom have experience in the cannabis industry: attorneys, compliance consultants, and accountants. Do not be pennywise and pound foolish by cutting corners and hoping for the best. Expect qualified specialists to charge accordingly. On the other hand, among these three service providers, chances are that your attorneys will be the most expensive. Do not retain an attorney to provide the services of an accountant. Similarly, a compliance specialist within your jurisdiction will have the time and opportunity to closely monitor and report even the tiniest of revisions in the regulations. Bring those reports to your attorneys whose expertise will be best utilized in helping you determine whether and/or how to adapt to those regulations.

Semenuik: Companies should perform due diligence before investing in other states. Regulations amongst different states vary, and it is important to understand such regulations and reporting requirements, what are possible roadblocks; understand the licensing process and how long it can take; obtain local market intelligence where you are looking to expand – is it saturated, what is the competitive landscape, demographics; what are the environment and climate factors existing in the state that could create a challenge? Consult with a tax advisor who understands the state and local taxes; talk to your advisors and other operators already in the state to seek advice; determine options for banking and the related costs. What services are available and at what cost? We have seen a wide range of costs being charged depending on the state and bank.

Q: How do you expect the cannabis industry to change over the next five to 10 years?

Bitan: It is inevitable that federal legality will arrive, but the manner in which federal legality will arrive remains a question because there are industry crosscurrents regarding how that occurs. For example, multi-state operators that have spent considerable resources developing intrastate cultivation and manufacturing operations do not want full interstate commerce because the indoor grows they created in cold temperature climates like Michigan will be rendered unprofitable if California is able to ship product across the country.