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Cannabis Startups and Board Formation

It is often said that life is a game of power and while certain individuals may not choose to live his/her life according to this Machiavellian principle, many others have no greater imperative. Cannabis Startups are of course are no different and as a company increases its number of partners and investors, conflict will inevitably ensue and power struggles will manifest.

The Board and its Fundamental Purpose

As most Cannabis Startups establish as C-Corps (for reasons discussed Here), they are now legally required to form a board of directors. Principally, startups should ensure that its board consists of roughly 5-9 members who between them represent an accumulated skill set in a variety of areas of expertise. Each board member should ideally possess a unique and desirable attribute that will facilitate high-level strategizing and decision-making required for a burgeoning start up company. More on this later.

The Trump Card

One of the most hotly negotiated areas of any startup deal is the number of representatives a VC firm has on the startup’s board and their collective decision making power. The critical point to remember is that board members are ultimately charged with steering the ship and making tough choices on behalf of the company’s investors. Indeed, the board wields a tremendous amount of influence in the governance of the company and should be structured with immense care and prudence.

The Unitary Model

Startups in the United States generally operate according to a unitary model whereby each member has an equally potent vote. Naturally, this model dictates a strength by numbers strategy and compels aggressive VC firms to push for a majority representation on the board. Founders, conversely, will negotiate to minimize the VC firm’s representation on the board in an effort to retain the original founders’ authority. If a founder/s loses control of the board, he/they will be at the mercy of the controlling members who may very well have a different vision of how the startup should function and potentially, terminate.

Everything is Negotiable

It is critical for cannabis startups to remember that there really are no rules (barring specific legal specifications) during the negotiating process of the deal. Complex negotiations between startups and investors involve compromise and disappointment in an effort to maximize the fruition of competing objectives.

Cash Poor? Here’s How to Pay Your Employees

In the early stages of a Start-Up company’s journey, many founders are cash poor and must come up with alternative payment options for their employees. In order to satisfactorily compensate them while holding on to their limited liquidity, Start-Ups often grant stock options. Here, an employee is given the opportunity to purchase, at a later date, a designated number of shares at a pre-set strike price (more on this in a different section).

The option to purchase these shares vests, or becomes exercisable, according to an agreed upon schedule which is further constrained by the fulfillment of a certain set of performance benchmarks. Typically, Start Up’s opt to establish a four-year/one year cliff timetable, in which 25% of the shares can be purchased after the first year with the remaining shares becoming incrementally available for purchase on a monthly basis (assuming performance benchmarks have been met). Clearly, this is a compelling offer for employees as they are motivated to raise the value of the company as much as possible in order to gain maximum profit when purchasing their (soon-to-be) vested shares at the strike price (which is hopefully lower than market price).

Incentive Stock Options:

Indeed, incentive stock options (ISOs) are especially employee friendly and come with the added benefit of not being taxed as ordinary income (which may be very high) but rather as long term capital gains (which are generally much lower than ordinary income tax rates). Here, ISO’s can only be issued to employees of the Startup and cannot account for more than 10%

Non-Qualified Stock Options

Conversely, non-qualified stock options (NSOs) have become increasingly popular among startup companies and involve the taxation on the profit (found by subtracting the exercise price from the market value) at ordinary income tax rates. Start-Up companies favor this option because the company can deduct this employee profit from their its own tax liabilities.

When issuing stock options to companies, it is critical for Company XXX to be mindful of the IRS’s 409(a) restrictions, which govern deferred compensation arrangements. Generally, 409(a) is not a relevent concern for incentive stock options however it is an important consideration for non-qualified stock options. Here, if the terms of 409(a) are violated, an additional 20% penalty tax will be owed in addition to the tax owed on the principle, at the time of the vesting. To ensure that the company is in fact exempt from 409(a), it is critical for the company to award to set the exercise price at fair market value. Indeed, fundamentally, 409(a) requires the company to have a reasonable valuation of its worth, given all relevent factors and considerations (current revenue, profit, cashflow, liabilities, intangible/tangible assets etc). Independent appraisals are particularly useful in satisfying the “reasonable” requirement in determining the fair market valuation under 409a.

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