Founder-friendly deals: Keep your place in your company

Avoid common pitfalls when negotiating a sale or merger

The age of roll-up and consolidation in the cannabis industry has dawned and cannabis news is now dominated by stories of mergers and acquisitions. Those doing the acquiring, for the most part, are large, multi-state operators who are keen to convince smaller, mom-and-pop businesses that consolidation is the only means to survive in this industry.

Undeniably, multi-state operators have the capacity to provide relief to a startup or small business that may be cash poor and/or in need of a stellar team of experts and advisers to guide it through various phases of growth, including licensing, raising capital, operations, team building, real estate transactions, build-out and marketing. However, startups and small businesses rarely have the same bargaining power as multi-state operators, and absent cleverly negotiated financing or an acquisition, risk losing their identity, sacrificing management and control or being completely disenfranchised.

Here are some “founder-friendly” tips to help a startup or small business avoid these common pitfalls.

– Don’t get distracted by shiny objects. A founder-friendly deal is strictly term-specific and has nothing to do with gifts, travel, parties or even a high valuation. Be sure to partner with a multi-state operator that is transparent, honest, responsive and seeks to maximize shareholder value for the long haul.

– Before the deal closes, insist upon officer positions with written employment agreements. These agreements should be for a defined period of time — five to 10 years — with mechanisms for termination only “for cause.” If the employment relationship is “at will,” as opposed to a term of years with clearly defined termination mechanisms, a founder could be terminated for any or no reason as soon as the ink on the deal is dry, particularly if the multi-state operator seeks to employ its own, in-house talent.

– Stay on the board of directors or managers. Also, propose that at least one director/manager be “independent,” meaning somebody who does not have an ownership stake in the company. The board is supposed to represent shareholder interests, establish policies for corporate governance and oversight and make most major decisions (except those which, by law or corporate agreement, are reserved for shareholders). The board will have its finger on the pulse of matters that affect the company’s valuation, liquidity, growth strategies, hiring/firing of officers and other priorities. By preserving a seat at the table for yourself and an independent, you can assure your participation in deliberations, have a vote on crucial matters and know there will be an objective voice in the room.

Insist that major decisions be made by a supermajority of the decision-makers (whether it be the board or the shareholders) — not a simple majority — to ensure that those in control of the company are on the same page with respect to big-ticket items, such as: deciding whether to liquidate, sell the company or its assets, mergers, incurring substantial debt or investing in another entity, hiring/firing key employees, amending the organizational documents in any material respect and materially deviating from the company’s budget.

It is not uncommon to insist upon a veto right over matters of importance that may have attracted the multi-state operator (or financier) to your company in the first instance. For example, if the company was acquired for genetics developed by the founders, the founders may want to insist that any matter related to the commercialization or exploitation of the company’s intellectual property pass through them for the final say.

– Insist upon a variety of minority shareholder protections. These include, at a minimum, protection against dilution (particularly disproportionate dilution), rights of first refusal in the event a shareholder wants to transfer or sell its shares, rights of participation in future fundraising sufficient to retain your pro rata interest in the company (these are generally called “pre-emptive rights”) and “tag-along rights,” which enable minority shareholders to sell their shares on the same terms and conditions as selling majority shareholders. When it comes to a distribution preference (or dividends), while those who made significant capital contributions will want to — and should — get their money back at a priority to those shareholders who did not, don’t allow 100% of available distributable cash to be distributed directly to them. Insist upon a lower threshold, such as 70% or 80%, so that those who contributed sweat equity or other assets, including the license itself, are not cut out completely while waiting for the financiers to be repaid.

It remans to be seen whether partnering with a multi-state operator is the only key to survival, particularly in markets that prohibit vertical integration (as in Washington, or in the proposed New York regulations) or where there may be caps on the number of operations a company may be permitted to support (as in Massachusetts) or on the number of licenses an operator is entitled to own (as in California and as proposed in New York). At the very least, craft and small business operators should avoid “rolling over,” where possible, to increase competition and to preserve diversity and character in the cannabis industry.

 

Lauren Rudick represents investors and startup organizations in all aspects of business and intellectual property law, specializing in cannabis, media and technology. Her law firm, Hiller, PC (www.hillerpc.com), is a white-shoe boutique firm with a track record for success and handling sophisticated legal matters that include business and corporate law.

 

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