The Business of Cannabis

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

In recent times, especially in California, cannabis has emerged as a multi-billion-dollar industry that has “taken root” in sectors including healthcare, pharmaceuticals, consumer goods and agriculture. Public companies with growing valuations are making waves in innovation, while established blue-chip companies are partnering with or purchasing cannabis-related businesses to gain entry into the industry.

As the legal landscape around cannabis continues to evolve and public support for the products and services grows, 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, developing 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 insights.

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

Zachary R. Wasserman, Attorney, Wendel Rosen LLP: Isolation and being homebound are major factors increasing desire for and, therefore, demand for cannabis products. As people return to work, this demand will likely slow down. However, we will not return to everyone going in to work all the time and, therefore, demand should remain higher than pre-pandemic. Working on the balance between supply and demand will be difficult as the virus waxes and wanes, so reading the CDC website and other sources for gauging outbreaks in the areas that cannabis companies serve will be as important as knowing the state and local regulatory schemes that apply to cannabis activities. A parallel issue is safety for cannabis workers – whether production workers, retail workers or distribution people - because this is not an industry that can produce its products remotely.

Q: What are some of the legal and regulatory risks and challenges that are faced by cannabis businesses in the current climate?

Priya Sopori, Co-Chair & Partner, Cannabis Industry Group, Greenberg Glusker LLP: Effective July 1 of this year the city of Los Angeles amended its municipal code. The new ordinance grants the city the authority to revoke a license at any time without a hearing. The city contends that the regulation applies only to “temporary licenses,” but the reality is that virtually all licenses are “temporary licenses.” According to the Department of Cannabis Regulation, the amendment benefits applicants, because applicants would receive an earlier determination of land-use compliance for cannabis licenses. From the perspective of a cannabis business, however, the amendment could be a wolf in sheep’s clothing – seeking to deprive businesses of a property right, while stripping them of their right to due process. Should the city lack the capacity to complete the review process and issue a permanent license, every dispensary could lose its license without notice at any time based on, for example, nothing more than unfounded social or political pressure to move a retailer elsewhere.

Irán Hopkins, Partner, Cannabis and Real Estate Practice & Joshua R. Mandell, Partner, Cannabis and Litigation Practice, Akerman LLP: Compliance and licensing are expensive, and the process is slow, especially in California. The rules vary by jurisdiction and continue to change, and the changes can be hard to track. As a result, carrying costs are large and often more than budgeted. Meanwhile, anticipation is growing to see what and when federal regulatory changes are announced and take effect. Federal politicians talk about cannabis on a daily basis, and more than ever before, federal legalization or decriminalization looks increasingly likely within the next few years. Real change at the federal level will undoubtedly unleash tremendous interest to get into the industry that will generate new competition and opportunities.

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

Wasserman: Proven track record, proven track record, proven track record. Although this refrain applies a little more to “should look for” than “are looking for,” it is the predominant theme. Too many investors have relied on high hopes and pretty business plans, with no demonstration of success in this challenging industry. Having said that, second is a solid business plan, including a detailed description of zoning issues for the places the company intends to do business. Third is scalability – few individual operations make sense for significant investment, but the ability to scale production, distribution or branding/retail is what makes an investment sensible. Institutional investors know these criteria, less sophisticated investors need to take them seriously.

Hopkins and Mandell: Investing or engaging in cannabis companies must be carefully considered and approached conservatively. Proper due diligence often proves difficult because the licensing process is slow, the rules continue to change, and most cannabis businesses are startups lacking the historic records sophisticated investors require and expect. Of course, each deal depends on the particular facts and circumstances, but it is critically important to independently verify that the cannabis activity is properly licensed, permitted, and operating in compliance with state and municipal law, including local land use permits for physical locations where cannabis activity is conducted.

Q: What are the biggest challenges for a cannabis business owner in California in 2021?

Sopori: I have to go with unlicensed competition, especially those that sell counterfeits of branded product, and are a scourge of the industry. We need to recall that for over two decades prior to the legalization of recreational cannabis, California had a prolific “gray market” for medical cannabis. Many of those operators have zero incentive to enter the regulated market. The unlicensed business is able to under-sell the licensed, because the former avoids the expense of complying with laws and regulations, including those that exist for the safety of the consumer. The unlicensed business does not pay prohibitively high cannabis taxes and can sell product that has not been tested or approved. Not only are licensed businesses at a competitive disadvantage, but licensed businesses can also find themselves wrongfully sued on the basis of illegal conduct perpetrated by an unlicensed business that used the trademark or name of a licensed business.

Q: What recent state and federal regulatory changes are cannabis businesses facing?

Mandell & Hopkins: July 2021 was a big month for California cannabis. Multiple local changes Newsom signed a much-anticipated bill consolidating California’s three state licensing agencies into one new agency, the Department of Cannabis Control, along with corresponding consolidation of those agencies’ three sets of state regulations into one new one. Among other things, state-level consolidation streamlines direct communication between state and local regulators, facilitates identification of indirectly affiliated cannabis licensees and locations, and makes clear the duty to ensure absolute compliance falls equally on all persons directly and indirectly in the chain of title or custody of cannabis at the business and property levels (including landlords, suppliers and ancillary service providers). Failure to comply is a daily statutory violation subject to fines and license suspension and constitutes misbranding and adulteration of cannabis per se, and grounds for embargo, recall and destruction.

Wasserman: It is certainly possible that as COVID-19 restrictions continue to ease, enforcement of illegal cannabis operations will increase. Part of this will be fueled as local jurisdictions and even some states recognize that helping lawful cannabis operations succeed and not be undercut by illegal operations and street sales will increase taxes. The other big issue, of course, is the possibility of banking becoming legal through the SAFE Act and/or the Senate’s Cannabis Administration and Opportunity Act – either would open great opportunities for cannabis businesses to expand. The legalization of banking could also open many new opportunities for both entrepreneurs and investors. Perhaps most significantly it could open the way for many new institutional investors to get into the business.

Q: What are the benefits of businesses buying cannabis, CBD or hemp insurance?

Mandell & Hopkins: Insurance is a critical component of a robust cannabis risk management plan. Some outdoor growers have been devastated by recent wildfires and could have benefited from crop insurance or better coverage. Fire loss is also heightened for volatile extraction manufacturers. Product liability insurance is vital against future claims of injury from products manufactured or sold. Of course, most plant-touching businesses continue to operate with cash in volumes disproportionate to other businesses, which heightens the risk of theft, loss, and crime at insured premises. At the very least, cannabis licensees and their landlord property owners should have the minimum insurance coverage required by state and local regulations for the cannabis activity and licenses registered to a particular location and keep evidence of coverage readily available for inspection.

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

Sopori: Because the federal government continues to classify cannabis as a controlled substance, cannabis businesses risk running afoul of federal law in their daily operations unless they steer clear of all things controlled by federal law. All aspects of the business directly related to cannabis must originate in and remain in California. Banking must be with institutions that are not FDIC insured. Even the use of credit cards by consumers is problematic. The high volume of cash transactions increases vulnerability to theft and security issues. On the other hand, a cannabis business may use interstate commerce to purchase equipment, supplies, and insurance, to name a few. When a lack of clarity meets risk, businesses will always be at risk of liability, and because the cannabis space is notoriously underserved by the insurance industry, businesses have difficulty obtaining policies that meet their unique needs (including the risk of liability)!

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

Mandell & Hopkins: From a tax perspective, engaging in commercial cannabis activity today is similar in complexity and consequence to international operations and cross-border transactions, in the sense that effective tax rates and tax bills can easily equal or exceed the economic profits and cash resources of a business unit unless structured carefully and thoughtfully. We recommend any business or person directly or indirectly involved with cannabis plant-touching dollars adopt robust risk management plans with safeguards like: (1) implementation of cash handling policies with strict protocols and mandatory training for IRS Form 8300 compliance; (2) preparing for audit and tax controversy by any regulatory agency for seven years after fiscal year-end; and (3) building reserves to pay future contingent liabilities and prior year taxes determined at audit – especially critical for cannabis operations classified as “partnerships” for federal tax purposes given the changes to partnership audit rules.

Q: What can a cannabis business do to make sure it understands how it may be affected by California cannabis zoning laws?

Wasserman: The simplest answer is to get good legal representation, preferably with experience in the localities the business is looking at. Attorneys at Wendel Rosen have this expertise, however, self-education is also important. There are still legal practitioners who are not fully knowledgeable about some of the details of local zoning and business license laws, so the cannabis operator should know what questions to ask – which will differ depending on whether the business is production, retail sales, or distribution and will be different in almost every jurisdiction. One potential source of education is the website that most cities will have regarding regulations if the city allows cannabis businesses. This is also an instance in which getting an opinion or overview from at least two law firms makes sense unless they have prior good experience with a particular law firm.

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

Mandell & Hopkins: Starting operations in other states essentially requires establishing new state-specific businesses or new business ventures/arrangements with cannabis licensee local partners. Existing California cannabis operators know from California’s intense regulatory environment how important it is to find a knowledgeable team of advisors on the ground in those other states. Multi-state operators (MSOs) know that legal cannabis is a patchwork of laws and that there’s never one size that fits all. Akerman’s national cannabis practice group is comprised of attorneys with deep knowledge of the laws in many of the biggest and most important markets in the U.S. and abroad.

Sopori: In a nutshell, don’t do it without assistance! Under current law, operations in other states are illegal. Any attempt to skirt those laws or to set up straw entities to disguise those operations would only create the appearance that a California business knew the operation was illegal (and that appearance would, in fact, reflect reality). A proper, legal expansion requires corporate separation and formalities, compliance with brand new regulations and ordinances that literally affect everything from seed to sale, including where and how the plant is farmed and the employees who are hired to sell it to a store. Moreover, it’s crucial to first solidify your company’s market position in California. 2019 saw major companies prioritize expansion over branding and profitability, and the results were less than desirable! Be conservative in your modeling. Lower operating expenses result in higher EBITDA, and a stable balance sheet is necessary to support an expansion.

Q: When it comes to commercial real estate, does each business model come with its own requirements, and do requirements vary depending on where a business is located?

Wasserman: Absolutely yes. The state and local requirements for cultivation, retail sales, delivery and distribution will differ from place to place. A good business model needs to understand and apply both the state and local regulations for each type of business in each location the business is looking at to locate. This can affect issues from timing of the application process (including competitive processes and public hearings) to specific locations to building permit and constructions issues. Issues regarding availability of product, distribution areas (which may cover more than one locality with special legal requirements) and competitors will also vary from place to place. It is important for both the owner/applicant for an operation and investors to look at these different local issues for every type of operation and locality covered by the business plan. Again, Wendel Rosen attorneys are experts in this area as well and can help avoid any legal issues from a commercial real estate perspective.

Mandell & Hopkins: In California, all commercial cannabis activity starts with real estate since the applicable local law depends on the physical location where the commercial cannabis activity is proposed to be conducted (by Assessor’s Parcel Number). This means the location of the proposed cannabis activity/licensee determines the playing field and what rules apply, starting with whether the proposed business is possible at that location, if licenses are available, and whether applications are being accepted.

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

Sopori: In five to ten years, federal law will likely decriminalize cannabis. That will open the gates for (more) institutional investors and well-funded companies to enter the market and attempt to muscle out the smaller businesses. If we see an attempt at complete federal regulation, hold on to your vape pens, because we may see what happened with big tobacco happen with cannabis, which seems somewhat contrary to the independent – dare I say it – cowboy nature that has been cultivated (so to speak) by the cannabis industry itself!