“You need more lawyers” is a phrase most early-stage startup CEOs never want to hear, and for good reason: It usually means something has gone horribly wrong.
As an angel investor and advisor, I never expected (or wanted) to have to say it to a founder. Then I founded Gateway.
Gateway is an early-stage accelerator for startups in the cannabis industry, and although there are many similarities between starting a cannabis company versus a technology company, there are also very important differences.
Typically, technology founders are taught to treat legal details around company formation seriously, but at the same time to minimize legal expenses. Often this means using services like Cooley GO or StartupDocuments for initial formation, but saving the big-name firms for later on, once fundraising starts.
Alternatively, it can mean utilizing a deferred-fee program in order to skimp now and pay later. The problem with this strategy for cannabis startups, especially companies that “touch the plant,” is that while the big names in Silicon Valley are all competent firms, they know practically nothing about cannabis law, and are usually uninterested in learning.
That’s a real problem, because while screwing up company formation can cost you money, screwing up compliance with cannabis law can land you in jail.
Founders try to solve this problem by hiring lawyers who specialize in cannabis law, which is a great idea that can definitely help you to avoid jail (and to deal with unconventional cannabis tax law). If you’re not trying to build the kind of scalable company that will seek venture capital someday, these lawyers might be enough.
But if you plan to raise venture money and build the next Starbucks of cannabis, you may run into problems that your cannabis lawyers have trouble anticipating. Some of these are small and solvable, like making sure you have a Delaware C-corporation separate from your mutual benefit corporation (or other legal entity required by your state).
Make sure that the agreement between those entities is clear and tight, with as much value as possible accruing to the investable C-corp. Other problems might be more difficult to solve retroactively, such as the need to correct a messy capitalization table. Certainly, you’d rather have Fenwick & West sitting across the table from your first institutional investor than a great cannabis lawyer with little experience negotiating a Series A.
That’s why, for companies that “touch the plant,” we at Gateway recommend something unusual: two sets of lawyers. Yes, that can be more costly, but it can also keep you out of jail and ensure that you look as attractive as possible to prospective investors, at least from a legal perspective. Ultimately, you should make the time commitment to manage two legal teams. And, en route, you need to understand each team’s area of responsibility, as well as how and when the teams overlap in terms of work. As a cannabis founder, you’ll likely find that spending extra time on legal work is unavoidable.
Other issues that should be on your radar include:
Incompatible Legal Templates
Most templates for legal agreements contain a reasonable-sounding clause prohibiting the parties from engaging in any activities “in violation of federal law.” This normally makes perfect sense, but as a cannabis company you need to scrutinize leases, employment agreements, formation documents and other contracts to make sure that an exception is made that will permit you to do exactly that.
Reliance on Courts
Even though a cannabis business may have a legal contract, in the event of a dispute, a federal court may not hear the case if it’s connected to a federally illegal activity — which selling cannabis is. We recommend including arbitration clauses in all your contracts to keep disputes out of the courts as much as possible (even this doesn’t always work).
As PJ O’Rourke once wrote, “When buying and selling are controlled by legislation, the first things to be bought and sold are legislators.” A material impact of federal prohibition is that local governments — cities and counties — often view the exploding cannabis industry as an opportunity for graft. Petty city council members with no understanding of business (let alone of cannabis) weasel their way into the resulting power vacuum and sponsor ridiculous, ill-conceived, and often destructive local regulations.
Their sole purpose, however, is either grandstanding for their next election or rewarding particular businesses and friends. Legal ambiguity from above begets local government at its worst. You need to pay attention to what’s happening locally at the state level as well as the federal one.
Local politics don’t end at the city council meeting. Cannabis companies can be routinely harassed by local law enforcement regardless of state law. Evangelical sheriffs, armed with a dubiously credible “tip” about some trivial violation, their own religious conviction and civil asset forfeiture law, might just choose to raid a cannabis company and steal — oops, I mean confiscate — everything in sight. Just ask the Venice Cookie Company, or more recently, AbsoluteXtracts and Care By Design.
In fact, the founders of one of our accelerator companies decided to move his entire business and family several hundred miles to a friendlier jurisdiction, just so everyone could sleep a bit more peacefully at night.
All of this may be an unfair burden, but it shouldn’t deter a founder passionate about building the next big cannabis company; the opportunity vastly outstrips the risk. If you’re aspiring to be that founder, just make sure you have a firm grasp of how the evolving law applies to you. And yeah, you might need more lawyers.