Like tech startups, or any new business, cannabis startups need investment. Though most tech startups are organized as corporations, with the ultimate goal of acquisition or IPO, cannabis businesses are more often (but not always) organized as LLCs. But cannabis startups too often fail to realize that if they are seeking investors, they are probably selling securities.
Tech startups begrudgingly accept that compliance with securities laws are a fact of business life. With each financing, their attorney tells them: utilize a securities exemption or register the securities.
LLC membership interests, however, don’t fit into the common perception of the term “security.” Even many attorneys wrongly believe that securities are limited to stocks, bonds, and the like, and that a minority stake in an LLC is not an investment in securities.
In 2008, the case of US v. Leonard defined when a membership interest constitutes an “investment contract” — “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” The court wrestled with extending the definition to LLC membership interests but concluded that LLC interests require a “case-by-case analysis” into the “economic realities” of the underlying transaction.
In short, the investor must “exercise meaningful control over his investment.” The touchstone of what constitutes a security is not the form of investment, but rather whether or not it is a “passive investment.” If the investment requires active management engagement by the investor, it is not a security. But if it is a passive investment where the investor relies on others to run the business, it is a security.
Investors often have the right to give input into management decisions but do not ever actually exercise this right. The trend in securities regulation is to look beyond the terms of the agreement to analyze the practical realities. Cannabis businesses should be aware that in US v. Leonard, the individuals were convicted of securities fraud and went to prison.
The big takeaway is that businesses can choose to have all investors as active member-managers, and thus can plan around (and draft their operating agreement around) the need for securities compliance. The following are some practical points to ensure that your investors are “active member-managers” rather than “passive investors”:
- Investors have voting rights in the LLC operating agreement, and exercise those rights in practice.
- Investors have a management role and are “actively engaged” – they can have titles or membership on committees tasked with certain aspects of business operations.
- Investors have input into and negotiate the terms of the LLC agreement.
- Investors have full information rights, and actually receive and approve reports regularly.
- Investors have input on key company strategic decisions – major decisions are made after consultation with investors.
Ensuring that your investors have an active, participatory role in management allows you to avoid entirely having to deal with securities law. When choosing your investors, you can help yourself in this context by seeking out investors that, in addition to money, have experience in the cannabis industry or in management so they can provide a value-add to your business.
Of course, this type of active management role won’t be acceptable to investors in every circumstance. As the number of cannabis investors grows and becomes more geographically diverse, however, the more likely they are to be considered “passive.” Marijuana businesses must understand that taking on passive investors means it’s time for securities compliance. At that point your attorney should be telling you to utilize a securities exemption and make the appropriate filing, or register the securities.
California cannabis businesses may recognize “management control” from California’s recently-released proposed regulations. We’ve written about these here and here. The regulations define as an “owner” any person who participates in the “direction, control, or management” of the cannabis business. Individuals having management rights will need to be disclosed to and vetted by state regulators in license application processes. Therefore, securities compliance and cannabis regulatory compliance are now two sides of a coin. Investors either lack management rights, meaning they are passive investors and securities compliance is required. Or investors have management rights, meaning they are “owners” and disclosure to cannabis regulators is required.
