5 Talks to Have Now to Avoid a Bad Cannabis Business Breakup Later

At the start of every business relationship, no one wants to envision potential failures and disagreements between the business owners. Starting a business is a time full of hope and opportunity; dreams of success and future growth rightfully dominate discussions as the owners look to expand and thrive in their industry.

Unfortunately, not all businesses are successful, and business relationships built on the concept of a “handshake deal” can often be the messiest when partners part ways. A “business divorce” refers to the legal separation of business partners, co-members, co-owners, or co-managers who can no longer effectively run a business together and seek to dissolve their professional relationship with one another. A business divorce can occur with respect to a variety of business entities, including corporations, partnerships, and limited liability companies. Like a marital divorce, business divorces focus on distributions of assets, responsibilities, and allowing the parties to go their separate ways, oftentimes requiring the guidance of legal and financial advisers in order to complete.

To avoid a business divorce, or to minimize its damage, business owners can engage in a number of steps to mitigate concerns or damages to the company. Business owners may seek out third parties to act as mediators or decision-makers to help break difficult deadlocks. Some business owners may seek legal remedies such as restraining orders, injunctions, or other steps in the courtroom to prevent a situation that the company cannot salvage. Some of these strategies are critical with respect to regulated cannabis businesses because any business divorce, or the situation resulting in a business divorce, likely has regulatory consequences.

Unfortunately, these steps may not prevent a business divorce and, in some cases, are not viable options. Once a business divorce becomes inevitable, the next step is to decide how to resolve the remaining business disputes between the owners and reach a resolution that will end the “marriage” between the owners.

To ensure a simple resolution that is fair for both parties, it is important to start potentially uncomfortable and difficult conversations with your business partner(s) prior to starting your business to avoid the complications that arise in breaking apart a business based on a “handshake deal.” 

Here are the top five conversations—decision authority, capital, exits, distributions, and dissolution—you should be having with your business partner(s) prior to opening your doors for business:

1. Who should make the ultimate decisions with respect to the business, and what should we do if we disagree?

This conversation is one of the most difficult to have when starting a new business, as partners generally have a similar sense of direction for a business when launching and are reluctant to designate a particular person who can make decisions on behalf of the company. For businesses with two partners, consider what will happen to the business in the event of a deadlock, where one partner wants the business to move in one direction, and the other partner wants the business to move in another direction.

If major decisions of the business require both partners to agree, effectively, nothing can be accomplished until a resolution is achieved. If you and your partner both desire equal control over the business, consider documenting who should mediate business disputes, or consider selecting a third party who can break the tie in the event of a deadlock. If there are more than two partners in your business, consider allowing business decisions to be made with less than a unanimous vote to avoid disastrous standstills in decision-making, such as failing to take necessary action to avoid regulatory noncompliance.

Whatever option you choose with your business partners, make sure it is documented in writing in the formation documents of your business to avoid costly litigation and time-consuming mediation when a problem arises.

2. What should we do if we need more money?

Even successful businesses find themselves in situations where additional capital is needed to further the growth, development, and future success of the business. You and your partner(s) may start the business with the idea that you will be equal business partners, but if additional capital is needed, that may complicate things. Should the company be permitted to take a loan from one or more of the business partners? Should the owners be forced to put up additional capital or have their ownership interests diluted? Can one or more of the partners agree to add an additional partner (or partners) to the business in exchange for a buy-in from that person?

Discussing the answers to these questions in advance can help reach a fair, speedy, and equitable solution. Regardless of the agreed-upon solution, remember to be mindful that member loans, dilution of ownership, or new business owners may all trigger reporting requirements for state-regulated cannabis businesses.

Oftentimes when additional cash is needed, individual biases and viewpoints on the particular issue from each owner can cloud the overall problem—the company needs cash. Solving this issue in advance can remove the biases and create a neutral discussion on how best to service the company.

3. What if one of the owners wants to exit the business or is forced to do so?

One challenge that business owners often face is the departure of one or more owners from the business, either expectedly or unexpectedly. Divorce, death, or disability can often lead to large changes in the ownership of the company. A criminal arrest or conviction, and sometimes even a regulatory or criminal investigation, may require a cannabis business owner to abandon his or her ownership to save the regulatory viability of the company.

Planning for these obstacles in advance can lead to a smooth transition in ownership and keep the company on track. For example, setting a fair valuation for the repurchase of the ownership interests for an owner who has died can avoid the heirs and assigns of such owner becoming owners and involved in the day-to-day business of the company, or denoting some devaluation if an owner is automatically divested for regulatory purposes.

Conversely, succession planning within the formation documents can be documented in a way to anticipate passing ownership from one generation to the next, embracing the passing of the company to a new generation and actively planning for the company to be passed down to the heirs of the owners.

Another challenge arises when an owner seeks to sell his or her ownership interests in the company. Consider discussing ahead of time answers to the following questions:

· Should an owner be permitted to sell his or her ownership interests to a third party at any time, or is he or she entirely restricted from selling unless there is a majority or unanimous decision made by the other owners? If a majority of the owners agree to sell to a third party, can they force the remaining owners to sell with them on equal terms (a “drag-along” sale)?

· If one owner is permitted to sell his or her ownership interests, is another owner entitled to sell all or a portion of his or her ownership interests as well (a “tag-along” sale)?

· Should one or more owners be entitled to purchase the ownership interests before allowing them to be sold to a third party (a “pre-emptive right”)?

· If an owner is leaving the company due to certain conditions (competition with the company, misconduct, or other violation of company policy), should the valuation for the repurchase of his or her equity interests be altered?

Be mindful, also, that any such ownership transfer in a cannabis business may require approval from state regulators. Governing documents for the business should reflect such regulatory realities.

4. How should profits be distributed, and in what proportion?

Success can be one of the biggest headaches for businesses when discussions have not been had about profit distributions. First, ensuring all partners understand how much ownership of the business they have and what percentage of the profits they are entitled to is crucial to avoiding disputes.

Second, the partners should discuss what percentage of the profits should be allocated to distributions and what percentage of the profits should be reinvested into the growth and development of the company. In these discussions, owners may consider altering these percentages based on the number of years the business has been operating.

Third, even if profit distributions will not be made for a period of time, consider making distributions to the owners to allow the owners to pay for their portion of the taxes that are passed through by the company to each owner; owners are generally much more agreeable to continue with a business venture if they are not losing money on taxes each year.

5. If, despite our best efforts, we are unable to agree, what should happen to the company?

Even careful and thorough planning can lead to business disagreements and relationship issues that cause it to be in the parties’ best interests to part ways. Generally, it is in the best interests of a company to be sold as an ongoing business rather than selling off individual assets of the business and splitting the profits.

In the formation documents, consider establishing mechanisms in which one or more partners can buy out the remaining partners. What criteria are required to trigger such a buy-out? If the buy-out is triggered and desired, what valuation should be used to value the business with respect to the buy-out, and which third party should be responsible for determining the valuation? How long should the partners have to make payments, i.e., will a promissory note to pay the buy-out over a portion of time be acceptable to the parties? If a buy-out is not desirable, how will the assets be sold, and by whom? Who will be the responsible party for wrapping up the affairs of the business?

Again, any such liquidation or ownership change for a regulated cannabis business is sure to require regulatory oversight, likely in the form of pre-approval before any change. Formation documents that detail these scenarios must also account for that regulatory approval. 

Almost every business will encounter problems along the road, which is why crucial planning and difficult conversations need to be had to keep the business on track. Cannabis businesses are no different. The conversations and questions above provide a good framework for discussions between business partners to help document crucial understandings between the parties in writing. A divorce of business partners who have taken the time to discuss these issues and document them in writing will help to reduce expenses on legal and financial advisers, preserve the relationship between the owners, and avoid long-term undesirable outcomes on the business and the success and profit of the owners involved.

Alex Koenig, attorney with Frantz Ward, focuses his practice on mergers and acquisitions, banking and commercial finance, and long-term care. He represents clients of all sizes in a variety of industries, including public and private companies, and private equity firms, in structuring and negotiating corporate acquisitions and mergers, as well as advising on general corporate matters. Alex also has a wide array of experience in representing lenders and borrowers on commercial financing transactions, including asset-based, cash flow, agented and syndicated loan transactions, and acquisition financing. Alex assists clients in the health care industry including owners and operators of skilled nursing and assisted living facilities across the United States.

Alex represents companies and provides everyday counseling on various corporate matters, including contract review, drafting and negotiation, joint ventures, capital formation, and more.

Keenan Jones, partner at Frantz Ward, represents businesses of all sizes in litigation matters, corporate formation, business development, and protection of intellectual property rights. Since 2017, he has focused his practice on assisting companies operating in the regulated cannabis space, including hemp, marijuana, and ancillary endeavors.

Before joining Frantz Ward, Keenan co-founded Foster & Jones and worked at the Hoban Law Group. In both roles, he guided businesses in the emerging cannabis industry. Keenan also teaches political science courses at Heidelberg University as an adjunct professor and serves as counsel and an ex-officio member of the board of directors of Model United Nations of the Far West.

Tom Haren is partner at Frantz Ward and Chair of the firm’s Cannabis Law Group. Tom has represented cannabis clients since 2016, helping them with innumerable legal issues, including public policy, regulatory compliance, corporate governance, contract negotiations, risk management, litigation and other day-to-day business issues. Tom has led some of the largest M&A transactions in Ohio’s cannabis market, representing both selling license holders and acquiring entities. In addition to his policy and legal work, Tom serves as the chair of Frantz Ward’s Cannabis Law and Policy practice and he was also named to the firm’s Management Committee in January 2024.