Ask any good lawyer the question, “is cannabis corporate governance important?” The answer will be a resounding yes. So why is it often ignored? Why do so many cannabis businesses treat governance as a box to tick on a checklist just once?
Here’s a fact pattern our cannabis attorneys have seen time and time again: an entrepreneur forms a cannabis company, throws together a few shoddy governance contracts with templates pulled off of Google, tosses them into a folder on their desktop, never thinks about them again, and starts working.
Today, I’ll break down the necessity of good corporate governance practices and documents for a cannabis business — and specifically those businesses in the marijuana side of the industry where the concerns are different from hemp or cannabinoid businesses. But first, I need to define corporate governance.
What is Corporate Governance?
Forming a cannabis company is as simple as filing forms with a state agency. Actually managing a company is a much different story. When lawyers and businesspeople talk about corporate cannabis governance, they refer to “the system by which companies are directed and controlled.”
In plain English, a strong corporate governance program is one in which a cannabis business (1) adopts procedures for running the cannabis business, and then – and this is the hard part- (2) actually follows them. This may sound simple and clear enough, but believe it or not, many cannabis entrepreneurs treat corporate governance as a procedural hurdle at the beginning of a cannabis entity’s history. This is a terrible idea!
Are Corporate Governance Agreements Really Necessary?
The short answer is yes. In some states and in some contexts, certain corporate governance documents may not be legally necessary for a business to exist or function. But they are often de facto required to get a cannabis business off the ground. For example, a bank is going to ask to see an LLC’s operating agreement before opening an account. A state or local regulator may request a corporations bylaws, shareholder agreement, and shareholder ledger before issuing a license.
Cannabis companies are typically formed to apply for a specific cannabis license at a specific licensed premises. So the requirement to pony up corporate governance agreements applies at the inception – a time when the cannabis company may not have a lot of cash sitting around. Many cannabis entrepreneurs try to pull samples off Google or ask their lawyer for a “short form” (translation, very cheap) set of governance agreements to replace later after their business grows. This is a bad idea which I’ll circle back to below.
Necessary v. Ideal
Even where governance documents are not strictly necessary, it pays to have them and it pays to have good ones. For an LLC (which is generally simpler on the governance side), the main document will be the operating agreement. Corporations have bylaws that set out the rules of the company, and can also have a shareholder and voting rights agreements among the shareholders that can function somewhat similarly to an LLC operating agreement.
For newer cannabis companies issuing equity to raise money, getting the corporate governance documents right up front is important. This is because any time a business wants to amend its governance agreement, it will need to get at least some (if not all) of the owners to sign off. That’s very easy to do when there’s just one or two owners. But what about if there are 30?
This, unfortunately, happens quite often. A cannabis company throws together a template operating agreement on day one and after two years, decides to put a good one in place. If amending the original cannabis operating agreement requires the consent of all members (and they usually do) and there are a lot of members, that will be a huge time suck at best. At worst, a renegade member could throw a wrench in the process and start a massive partnership dispute. Is that an ideal setup? Of course not! But yet we see it all the time. The two biggest reasons are (1) skimping on costs up front and (2) failing to anticipate these common situations up front. This brings me to the next point.
It Pays to Pay for Cannabis Governance Contracts
The desire to save costs up front is totally understandable. Most cannabis entrepreneurs can’t justify dropping tens of thousands or often even several thousand dollars on an initial stack of governance documents. Governance contracts pulled off of page 7 of a Google search are guaranteed to be bad, completely inapplicable to the business at hand, or (most often) both.
Lawyers are not cheap, we get it. But in life, you get what you pay for. Cannabis corporate governance is important. A good set of governance contracts prepared by a lawyer who asks the right questions can avoid tons of headaches, like the one I described in the last heading. Our corporate lawyers do this stuff every day and we know that it does not have to be an overwhelming expense for the average company unless they want an exotic or overly complicated structure.
Keeping Eyes on the Corporate Governance Papers
Let’s say a business did everything right: it took the correct view that corporate governance is important, hired a good lawyer, and drafted thoughtful corporate governance documents. What should happen next?
Corporate governance documents are like roadmaps for a company. To paraphrase a little, they’ll say things like “the company has a CEO, and that CEO can do X, Y, and Z.” That way, the CEO knows what he or she is supposed to do and the company has grounds to discipline him or her for violating a corporate mandate.
In practice though, this doesn’t happen much of the time. Especially for smaller cannabis companies, a corporate director or officer that onboarded after bylaws were adopted may not even have read them. This is very silly, but it happens all the time. You cannot know if a cannabis company is operating correctly if you haven’t read the operations manual. Training and periodic review is essential.
Common Corporate Governance Mishaps
A host of common things can come up in the course of operating a cannabis company that often require forensic “fixing” by attorneys. That should be avoided where possible. Here are a few of my favorite examples:
1. The Over-Issuance
A cannabis business has articles of incorporation that authorize it to issue 1,000 shares but it issues 1,500. The validity of that issuance is now at issue.
2. The Director Gap
A cannabis entrepreneur forms a California corporation with just herself as the sole shareholder, officer, and director. The company issues additional shares to investors, and has six shareholders but she remains the only director and the bylaws only authorize one director. California law though requires at least three directors here. The validity of recent actions taken by the sole director is now in question.
3. The Deadlock
Two best friends form a cannabis LLC and each own 50%. Turns out they both have very different ideas as to how to run the company, and those ideas become more extreme as the company starts to lose money. Every decision they try to vote on results in a deadlock. They are best friends. They did not think about this when they wrote the operating agreement themselves. And it was based on a template from one of their friends’ single-member restaurant businesses. Of course, there’s no procedure for them to resolve their deadlock. They will probably end up in very expensive litigation. The company will fail.
Don’t Forget that Cannabis Corporate Governance is Important!
This kind of stuff happens a whole lot more than you would expect. If a cannabis company knows corporate governance is important, hires a good lawyer, and acts diligent in governing itself, it will probably save a lot of time and money. Spending a few thousand dollars and developing a compliance program at the beginning can save a cannabis company from expensive litigation, animosity, dissolution and more.