Welcome to the Jungle: Changes in Ownership, Financial Interests, and Entities for California Cannabis Businesses

18 Jul Welcome to the Jungle: Changes in Ownership, Financial Interests, and Entities for California Cannabis Businesses

We’ve written a lot about cannabis M & A, entity selection choices, and financing on the Canna Law Blog and how these transaction and changes do not amount run of the mill transactions because of the invasive regulatory overlay in almost all states. California though stands alone when it comes to the regulatory gauntlet on changes of ownership, entity, and or financing for a cannabis business. In particular, those licensees governed by the Bureau of Cannabis Control (“BCC”) (specifically, retailers, distributors, labs, and delivery services) face the worst of it though California Department of Public Health and California Department of Food & Agriculture are no picnic either. And where a lot of publicly traded money (including from Canada) is now playing in the California cannabis space, issues of changes of ownership, changes of entities, and changing financial interests are hotter than ever with a good amount of licensees breaking the laws and rules without even knowing it.

1.     Change in Ownership.

Don’t forget that state licenses are not transferable: only the businesses that hold those licenses can be bought and sold. So, changes of ownership are inevitable as the secondary market for licenses picks up. Under current, final BCC regulations (which were adopted on January 16 of this year), in the event of “the sale or other transfer of the business or operations covered by the licensee… if one or more of the owners of a license change, the new owners shall submit [all owner information] for each new owner to the [BCC] within 14 calendar days of the effective date of the ownership change.”

Doesn’t sound so bad other than the 14-day timeline, but here’s the real catch:

The business may continue to operate under the active license while the [BCC] reviews the qualifications of the new owner(s) in accordance with the [Medicinal and Adult-Use Cannabis Regulation and Safety Act (“MAUCRSA”)] and these regulations to determine whether the change would constitute grounds for denial of the license, if at least one existing owner is not transferring his or her ownership interest and will remain as an owner under the new ownership structure. If all owners will be transferring their ownership interest, the business shall not operate under the new ownership structure until a new license application has been submitted to and approved by the [BCC], and all application and license fees for the new application have been paid.”

Translated: if you want your cannabis business to continue to operate while the new owners are vetted by the BCC, you need to leave on an original “owner” from the time of initial licensing. Note that “ownership interest” is not defined under the BCC rules or by MAUCRSA. However, to conservatively satisfy this rule, licensees should ensure that at least one original owner maintains at least 20% in equity in the cannabis company (where the definition of owner includes the ownership of 20% or more of a cannabis company).

In California M&A, what this has led to most of the time is two closings, an initial and a final. At the initial closing, the purchaser takes 80% of the cannabis company and one original owner stays on 20%. Then, once the purchaser is recognized as an “owner” by the BCC (which there is no official approval for that, but that recognition will show up in the licensee’s licensing portal), the purchaser moves to close on the final 20%. Importantly:

“[a] change in ownership does not occur when one or more owners leave the business by transferring their ownership interest to the other existing owner(s). In cases where one or more owners leave the business by transferring their ownership interest to the other existing owner(s), the owner or owners that are transferring their interest shall provide a signed statement to the Bureau confirming that they have transferred their interest.”

The last important issue to point out is that the BCC will not pre-vet owners or a transaction; the purchaser has to close, become an “owner”, submit the change of ownership request (via this form) with all corresponding owner information within the 14-day deadline, and then hang on while it’s vetted by the BCC.

2.     Change in Financial Interest Holders.

Unlike other industries, cannabis companies cannot take money from just anyone for financing. With very few exceptions in California, anyone who loans money to, makes an investment in, or has an equity interest (i.e., profit share interest) in a cannabis business must be disclosed to the state as a “financial interest holder” upon the filing of the license applicant’s annual application. And there is now continued reporting requirement when your financial interest holders change. Pursuant to BCC regulations:

“[w]hen there is a change in persons with financial interest(s) in the commercial cannabis business that do not meet the requirements for a new license application under this section, the licensee shall submit [required financial interest holder information]  within 14 calendar days of the change. In turn, any time a new entity or person lends money to a cannabis business, that transaction has to be reported within 14 days to the BCC.”

Same thing goes for the extension of equity interests/profit sharing, and if a person or entity profit shares at 20% or more, they may be considered an owner, which must adhere to the “change of ownership” reporting above. Again, proceed with caution on new financing sources in California.

3.     Changes to Entity.

Because of the Compassionate Use Act of 1996, many California cannabis operators (and retailers in particular, especially in the City of L.A.) operated as non-profits. And a lot of those operators were grandfathered in for continued operations in their cities and counties, which if you want to get a state license, you must first secure local approval, so these operators have some very valuable entitlements. If you’re a non-profit and you want to sell that entity, you can’t: there’s no equity to sell in a non-profit, so you must reincorporate as an entity that creates equity to sell (and don’t forget that many of these old non-profits don’t even have bylaws or structures that permit for a lawful conversion). In California, as a non-profit corporation, you must first convert to a corporation and that corporation can then reincorporate as any other business entity, including a limited liability company. However, in California cannabis, you can no longer convert without consequence if you have a state license. Earlier in July, the BCC had posted on one of its FAQ pages, the following statement:

“Licenses issued by the Bureau are issued to a specific person (business entity or individual). Licenses may not be transferred to a new entity or individual. If a licensee wishes to convert their business entity, such as from an LLC to a corporation, they must submit a new application and obtain a new license under the new entity. A licensee who wishes to convert from a non-profit to a for-profit, or vice versa, should contact the Bureau to confirm whether the conversion would require a new application.”

However, the BCC recently changed this language to say:

A licensee that changes their business entity type will usually be required to submit a new application and obtain a new license issued to the new entity. However, a licensee who is converting business entity types must meet all of the requirements of the Corporations Code to be considered the same entity for the purposes of licensing and may not be required to submit a new application.

Translated: if you’re converting your non-profit corporation to a for-profit corporation and your California entity number and other corporate data do not change, the chances of you having to get a new license are probably low. However, if you convert into anything beyond a for-profit corporation and your corporate identification number and data changes, you’re probably going to have to get a new license whether or not there’s also a change of ownership.

Again, regular business changes that happen every day in corporate America are severely curtailed in cannabis and especially in the Golden State. If you’re contemplating any of the above changes, you really need to do your homework before execution or you could end up losing your licensing and incurring months of delay in trying to secure a new state license. Proceed with caution accordingly.