New cannabis licensees: Setting and managing investor expectations

When you take on investors, managing their expectations will always be a central part of your job. But there are a few factors that will determine just how much time you will need to dedicate.

Corporate structure

For various reasons, many operators adopt a limited liability company (LLC) legal structure that is treated as a partnership for federal income tax reporting purposes. Entity choice is a complicated decision best made in consultation with tax and legal advisors. If your cannabis business chooses a partnership structure, keep in mind that investors can’t file their personal returns until they receive their K-1s – in other words, when your company chooses to extend its corporate return, so must your investors. This fact alone automatically increases the amount of investor communication that is necessary.

Investor demographics

What does your investor pool look like? Is it composed of a few high-net-worth individuals and family offices? If so, you can count on their sophisticated investment acumen; generally their past experience gives them more realistic expectations and an understanding of the business cycle. But if your investors are primarily friends and family who are new to investing, it’s your responsibility to bring them up to speed on investment basics, as well as the fundamentals of the cannabis industry. (More on this below.)

Your level of organization

Without accurate and organized documentation, certain things can slip through the cracks – especially when you’re rushing to put a deal together. It takes care and precision to track the various transfers of interest, preferred returns, and other special deals that may be required to secure the capital you need to get a cannabis operation off the ground. If there’s a 0.05% discrepancy in equity held by one of your 100-plus investors, it might not seem earth-shattering to you – but you better believe it matters to that investor. Keeping your records accurate and up to date will pay off when it’s time for another fundraising round.

Never assume that your investors know anything about the cannabis industry. It’s your responsibility to educate them. Your initial fundraising pitch should cover the fundamentals, such as:

Tax treatment

Here’s an investor question you’ve likely already fielded: “Why does my K-1 show taxable income? I haven’t even gotten a distribution yet!” Very few people outside of the industry have even heard of Section 280E, much less understand how it creates phantom income and impacts their personal tax situation. Before they write a check, new investors need to know that they will be allocated income on their personal tax returns without corresponding cash distributions.

Background checks for investors

Another potential surprise for would-be investors: Many states require investors to go through a background check before they can own a piece of a cannabis business. Some investors drop out when they discover that to proceed would mean the state government would have a record of them owning the cannabis business. Make sure you and your investors understand all state regulations that apply to your business and, before you move forward, confirm that your investors’ backgrounds won’t create an issue.

Capital requirements

Cannabis is a particularly capital-intensive business. After investing hundreds of thousands of dollars to obtain a license, most cannabis operators have to go back to issue another capital call to build out the facility and get the operation up and running. Investors who aren't prepared to participate in these capital calls need to know they will see dilution in their shares.

Realistic timelines for legalization

Not so long ago, we kept hearing that federal legalization was “right around the corner,” which created unrealistic expectations for some investors. While we can’t be certain when that change may come, you can take control of the narrative by sharing what do you know and giving investors your best estimate of when this landmark event may occur. The same goes at the state level. Investors need an overview of applicable state laws as they stand now and the bills that are currently moving through the state legislature. Being honest about what can be reasonably expected and what is unknowable will help build trust.

Remember: Spending time and money up front to educate would-be investors will help minimize the time you spend fielding questions and complaints later.

How profits are put to use

You and your various investors need to be on the same page about how cash flow will be put to use. When you start seeing positive cash flow, will you reward investors with hefty dividends? Or will those profits be invested back into the business? While friends and family might expect (or need) their money back, high-net-worth investors are more likely to keep their sights set on the future liquidity event. Trying to maintain a single investor pool with these two very different mindsets practically guarantees that you will end up disappointing one of those factions.

Exit strategy

Be clear about your exit strategy from the outset. Do you plan to jump on the first offer that comes along, or will you hold steady and focus on growing the value of the business? If you envision a long-term hold, you'll want to exclude investors expecting an early payday.

As in philanthropic fundraising, business investors need ongoing communication to keep them engaged. Radio silence after the first round of fundraising can leave them feeling neglected – or worse, anxious.

So keep in touch with regular updates on your progress, as well as how you’re handling any challenges. And to really build a strong, positive relationship, be sure to bring them along for the highs as well as the lows – allow them to share in your success and major milestones.

Here are just a few reasons you might want to reach out to your investors:

• Projections on when facilities and inspections will be complete
• An invitation to tour a recently completed phase of the building
• Groundbreaking or open house of the new facility
• Updates on new strains and how they are selling
• How you are responding to changes in supply and other market trends
• Hiring of a new operational leader

Taking the time to proactively educate your investors, share how you’re overcoming any setbacks, and celebrate your major milestones will help keep your relationship positive and productive for all involved.

Michael Harlow, CPA, Partner

301.907.2330