State and federal laws make it tough to offer equity
By Teresa Daggett
Recently, a cannabis processor asked how it could provide equity to its loyal employees. Ordinarily, I would have explained that there are federal and state securities laws that govern. I would suggest an incentive equity plan if the business were a corporation, or a profits interest plan if the business were a limited liability company. However, regulations governing cannabis businesses in Washington raise complications for providing equity to employees.
Equity simply means ownership in a business. The difficulty of providing equity to employees in a Washington cannabis business is that each employee needs to undergo the rigorous scrutiny of the Liquor and Cannabis Board, which requires the following information about any business owners:
– Personal/criminal history statement;
– Fingerprints/criminal background check;
– Copy of approved identification/proof of residency;
– Source of funds statement/copies of bank statements;
– Financial statement.
In addition to the burdensome qualification process, providing equity to employees makes them “true parties of interest” on the cannabis business license. As a result, their later actions could put the license at risk. For example, any true party of interest in a company could jeopardize the license by being convicted of a crime at a later date. Marijuana companies must be willing to accept this risk when providing equity to employees in Washington.
When a company looks at the hurdles to employee ownership, the opportunity may look less attractive.
As noted above, securities — which includes equity in a business — are regulated by federal and state governments. If you are unfamiliar with securities law, the thing to understand is that you cannot issue stock or stock options (for a corporation) or membership interests (for an LLC) without either registering with the Securities and Exchange Commission or relying on an exemption from registration. Since registration is an expensive process and cannabis remains federally illegal, your only choice is to adopt an incentive plan under SEC Rule 701. The plan should be adopted by the board of directors, shareholders or members. There is no requirement to register the plan with the SEC or the state Department of Financial Institutions.
An incentive stock plan is the document that a corporation would use to provide compensatory stock to its employees. The key features of such a plan are:
– The number of shares available. This is sometimes referred to as the “pool” and is typically 10-20% of the shares already owned in the company.
– The people who can receive awards. Plans may allow for awards to go to employees, consultants and members of the board of directors — or some subset of these groups.
– The type of awards. Some plans only provide stock options, but others include restricted stock awards and phantom stock.
Before making any grant, you will need to establish the per share stock price based on a defensible method.
Limited Liability Companies
A limited liability company is more like a partnership than a corporation. Therefore, different rules apply when considering how to provide compensatory equity to your employees. Like a corporation, an LLC may adopt an incentive plan or it may provide for incentive equity in its LLC agreement. Either way, the IRS has provided a safe harbor when an employee receives a grant of profits interest — i.e., the profits interest is not taxable upon grant, if each of these requirements is met:
– The employee receiving the profits interest is a member of the LLC and has the right to vote;
– The profits interest is not related to a predictable stream of income; and
– The profits interest is not sold within two years.
If a founder wants to give some of his or her shares or membership interest in the business to an employee, in addition to the Liquor and Cannabis Board requirements, there are a few things to consider. First, under the securities rules, a person who holds ownership in a business may not transfer the ownership to someone else — whether as a gift or as a sale — if the ownership has not been held for at least a year. Second, tax is due to the IRS upon the transfer of the ownership, since the ownership is being transferred without the employee paying for it.
Considering the Liquor and Cannabis Board’s restrictions on ownership in cannabis businesses, this may be the simplest means of providing an incentive to your employees, provided that the bonus does not exceed the limits set forth by the regulations. As long as the bonus to a salaried employee does not exceed 25% of the employee’s annual compensation, the employee will not be considered a “true party of interest.” To avoid discontent among employees, it is advisable to adopt a bonus plan that establishes either employee milestones or the passage of time as triggers for the payment of cash bonuses.
Providing compensatory incentives to employees in Washington cannabis companies is not as easy as providing incentives to employees of non-cannabis companies. If your business is considering incentives for your employees, you should seek out the guidance of a Washington attorney who is knowledgeable in the state’s legal cannabis industry, securities regulation and tax law.
Teresa Daggett works with businesses to help them through all phases, from formation through merger and acquisition. She is a graduate of University of Washington Law School and is a partner with Gordon Thomas Honeywell. She can be reached at email@example.com.