Equity Incentives and Cannabis Businesses

17 Nov Equity Incentives and Cannabis Businesses

A common way to get and retain employees is to issue them options or equity securities like corporate stock. But like with everything else, issuing securities is heavily regulated. Today, we’ll look at a few key issues for cannabis businesses that want to offer equity incentives.

How do cannabis companies offer equity incentives?

There are two common ways that cannabis companies offer equity incentives: First, companies may create an equity incentive plan (or EIP). Second, companies may offer equity incentives via a written contract, such as an employment or consulting agreement. In either case, the company will, if done right, use the plan or contract to detail things like:

• Vesting details, such as the timeline of vesting
• Acceleration provisions (i.e., the circumstances upon which vesting “accelerates” upon certain pre-defined changes of control)
• Restrictions on transfer of the equity securities or options
• Company repurchase rights

When employees terminate their relationships with a company, things can often sour quickly. Equity incentive plans or contracts can get incredibly complicated, and we have seen things go south quickly with poorly drafted plans or agreements that did not contemplate common employment issued.

What federal securities laws apply to equity incentives?

Any time equity incentives come into play, cannabis companies must be cognizant of federal securities laws and registration exemption. Fortunately, when it comes to equity incentives, the federal exemption tends to be a lot simpler than other exemptions (such as Regulation A or Regulation D). Securities and Exchange Commission (SEC) Rule 701 provides the key exemption to registration for equity incentives, and states in part as follows:

This section exempts offers and sales of securities (including plan interests and guarantees pursuant to paragraph (d)(2)(ii) of this section) under a written compensatory benefit plan (or written compensation contract) established by the issuer, its parents, its majority-owned subsidiaries or majority-owned subsidiaries of the issuer’s parent, for the participation of their employees, directors, general partners, trustees (where the issuer is a business trust), officers, or consultants and advisors, and their family members who acquire such securities from such persons through gifts or domestic relations orders. This section exempts offers and sales to former employees, directors, general partners, trustees, officers, consultants and advisors only if such persons were employed by or providing services to the issuer at the time the securities were offered. In addition, the term “employee” includes insurance agents who are exclusive agents of the issuer, its subsidiaries or parents, or derive more than 50% of their annual income from those entities.

That’s a lot to chew on, but it essentially says that certain equity incentives are exempt from the federal securities registration requirements. Rule 701 goes on to say in part that it may extend to persons other than just employees:

This section is available to consultants and advisors only if:

(i) They are natural persons;

(ii) They provide bona fide services to the issuer, its parents, its majority-owned subsidiaries or majority-owned subsidiaries of the issuer’s parent; and

So, Rule 701 may provide an exemption for a consultant’s equity incentive, if the consultant is not an entity, provides real services to the company, and doesn’t act as any kind of securities broker.

I should mention though that Rule 701 is limited to the issuance of restricted securities, meaning that the securities are subject to resale limitations.

What do state securities laws say about equity incentives?

Rule 701 does not preempt state law. States are free to impose additional requirements on the issuance of equity securities, and many do. When determining which state’s law applies, a company will need to look at the state of residence of each applicable employee. This makes life more difficult for companies in the remote work era.

State laws can be vary widely here. Some states have no specific notice requirement. California requires companies to submit a form to the Department of Financial Protection and Innovation within 30 days after the initial issuance, whereas Washington has different requirements depending on whether the plan meets certain Internal Revenue Code provisions. This can all get incredibly complicated.

One other thing to point out here is that while Rule 701 itself can exempt transactions with consultants (in qualifying situations), state law does not have to do that. An equity incentive plan that meets the Rule 701, in other words, may not meet the requirements of each state. That’s yet another reason why companies should consider state law well in advance of the issuance.

Equity incentive plans and contracts are immensely popular. Like all companies, cannabis businesses that want to follow the law should be aware of the filing requirements and understand what needs to go in a contract well in advance of any actual issuances.