The cannabis industry has an inherent limitation restricting the launch of billion-dollar brands and it is not money. Large amounts of capital are now flowing into performing cannabis companies of all sizes, whether locally owned small businesses or large, multi-state enterprises backed by private equity. And readily available capital is only expected to increase when the first U.S. capital market listings consummate as soon as the end of 2021.
Even with all the capital, however, enterprise expansion is limited by diffuse state-by-state regulations that define the cannabis industry. The fragmented regulatory system and federal regulations prohibiting brands from operating across state lines are now the primary limitations slowing the growth of national cannabis brands. Companies are still forced to create industry-licensed operations in every state if they want to expand or, where permitted by state regulations, license their brands to other producers.
The result is that many cannabis companies have evolved a self-limited growth strategy over the last few years. The rise of the single-state operator — companies that deliberately only exist in one state — reduces complications and compliance costs, but also limits a cannabis brand’s growth opportunity to a single market. And even single-state operators are limited within their home-state opportunity, since many states cap the number of licenses a single enterprise can own.
For these reasons, both intrastate brands and companies with national ambitions should be looking at franchising as an expansion plan for the cannabis sector.
In general, companies in any industry might consider the franchise model to maximize return on a good idea. In an industry that is brand-loyal, name recognition and goodwill have lasting and portable value. Consumers and B2B purchasers grow comfortable with the brands they know and trust. By franchising, a cannabis business can: expand its footprint more rapidly; harness other people’s capital and management focus to grow; leverage market and industry knowledge; economize on advertising, marketing and promotion; and limit liability and benefit from local owners who know the region.
While cannabis businesses are accustomed to operating in a highly regulated sector, opting to pursue the franchise model adds new compliance hurdles. Franchising, like cannabis, is a regulated industry. The federal government and at least 15 states regulate the offer and sale of franchises, and businesses in the cannabis space have additional challenges when it comes to franchising. Not all states will allow cannabis companies to franchise within their borders — California being one example. Other states, however, such as Illinois and Washington, do not prohibit it.
Some cannabis companies avoid franchising and pursue other options for becoming nationally recognized. Growth and expansion through mergers or acquisitions is popular. However, this is often a slow and expansive process that does not scale efficiently. Each target has unique front-end challenges (identifying viable targets, conducting due diligence and acquiring the target) and back-end challenges (integrating the seller).
Cannabis businesses that pursue brand expansion through licensing, on the other hand, should be mindful of the accidental or inadvertent franchise trap. Licensing allows brands to reach across state lines without doing all the legwork of establishing a new operation in each state. However, a licensor often finds itself facing one of two issues. Merely licensing a brand carries concerns with production quality, product consistency and state and local compliance. Brands must ensure that partners adhere to corporate standards, as well as state guidelines, or risk harming the brand’s image. If the licensor does not set these standards and ensure compliance by its licensees, then the value in the brand diminishes and the licensor can lose ownership of the trademark.
On the other hand, the controls that are desirable may trigger an “accidental franchise,” especially in states with very broad definitions of a “franchise.” An “accidental franchise” may arise because despite calling a business structure something else — a license, direct selling, joint venture, sales agency, distribution or partnership — it meets the legal standards to be considered a franchise. State and federal regulators, as well as the courts, look at structure and execution, not terminology.
Some jurisdictions make it particularly difficult to avoid being deemed a franchise. At the end of the day, if a business meets the definition of a franchise, then it will be considered a franchise. The basic elements of a franchise are:
-Fee structure: Requiring payment of a minimal fee to the franchisor;
-Trademark: Licensing the franchisee to distribute goods or services under, or operate using, the franchisor’s trademark or commercial symbol; and
-Marketing plan or assistance: Providing a marketing plan or rendering significant assistance to the franchisee in operating its business or the franchisee’s method of operation.
With careful legal planning, it may be possible to structure alternative business models such as joint ventures, partnerships or distribution relationships, which avoid triggering franchise regulations. It may also be possible to utilize certain exemptions or exclusions to avoid required compliance with franchise disclosure or registration laws. However, the brand often has to sacrifice something in return. For example, a brand may need to defer collection of initial fees and royalties, forego desirable limited management and responsibility, or limit itself to a smaller pool of potential partners.
The limitations offered by alternative business models is why franchising is often the preferred route to national expansion. It allows franchisees to be in business for themselves without going it by themselves.
Brand equity and distribution are optimized by a legal framework capitalizing on the franchise model. One strategy is to headquarter in a jurisdiction like Colorado, Massachusetts or Vermont, where recreational use is permitted and there are no state-specific franchise regulations. As the brand grows, the company can expand into states with more rigorous compliance requirements while avoiding states like California, which refuse to register cannabis franchise concepts so long as it is prohibited under federal law. In states where there are many individually run mom-and-pop shops, the fastest way to expansion is to convert these already existing locations to franchisees operating under the cannabis franchisor’s brand.
Some cannabis concepts are already franchising cannabis brands and have experienced significant market benefits. With major new adult-use markets in states like New York and New Jersey opening soon, we expect that more brands will turn the corner and franchise to maximize their expansion and growth opportunities.
Elle Gerhards is co-chair of the franchising and distribution practice group at Fox Rothschild LLP. She works with clients in structuring franchise programs, drafting franchise documents and counseling clients on regulatory compliance matters. She can be reached at firstname.lastname@example.org.
Matthew R. Kittay is co-chair of the mergers and acquisitions practice at Fox Rothschild LLP. He has deep experience in structuring mergers and acquisitions and securing capital for a wide range of companies, including the software, cannabis and health care sectors. He can be reached at email@example.com.
Craig R. Tractenberg is co-chair of the franchising and distribution practice group at Fox Rothschild LLP. He has a broad business practice, with strong focuses on franchise, insolvency and infrastructure transactions. He can be reached at firstname.lastname@example.org.