I spend a lot of time with business owners discussing the value of their cannabis business. Oftentimes, they come to me when they realize they have a problem with a current or former business partner. We all like to assume that our business relationships will continue indefinitely as the value of the project increases and the owners see eye to eye on everything.
In many start-up businesses, but particularly in the context of cannabis, it is not unusual for founders to squabble. Disagreement sometimes occurs very early in the relationship and the co-founder disappears for months or years (see here). the fall out of time In every US state means your long-lost business partners may be out of sight but remembered until the statute of limitations has passed (often nearly 6 years).
Determining the value of a cannabis business: from an appraisal expert
In an ideal world, the formula and criteria for determining the value of your cannabis business would be clearly stated in the operating agreement or shareholder agreement. You can be as creative as you like, including using multiples of gross or net earnings, valuation discounts, and flexible payment structures and timing.
I recently asked a friend who is a Cannabis assessment expert For his recommendation on what language should be used in an operating agreement to avoid fights over the value of the business. He said that the “battle of valuation experts” never reflects the true value of the entity or makes the buyer or seller satisfied. Choosing one appraiser and putting the buyer and seller in a room together for interviews eliminates a lot of ambiguity, uncertainty, bloating, and opacity.
Things get very messy when there is no operating agreement. What follows is a combination of our advice on how to value a minority business interest in cannabis and deal with a problematic minority owner where you do not have an operating agreement or no valuation methodology in your operating agreement.
Determining the value of the cannabis business: a case study
I think showing him $XYZ is a good starting point. You know his temper better than me. Based on what I know about his track record, you may end up paying XYZ dollars or something.
Keep in mind that a negotiated settlement with him is much cheaper than fighting in court or even hiring one or more appraisal firms to agree on his X% value. Also keep in mind that you will need to disclose an ownership interest if you decide to shop around the company for sale if you can’t buy it before then.
Having multiple entities involved complicates this analysis, but we must discuss what was explicitly pledged and documented in an email I sent him. Then we need to think about what kind of assumptions he might have made about his investment in this sub-entity versus the group of entities.
Think of it this way. If an investor XYZ gives you USD at the start of a business for X% of that business entity, they are expected to receive the full benefit of X% ownership and everything the business does from that point on.
They would also have some voting rights (presumably X%) from the start which would give them some input on how to run the company, as well as access to company information. At X%, they will receive notice and rights to participate in meetings, financial oversight, and possibly a veto on major company issues (such as whether they should engage in a merger, sell most of its assets, change the company’s focus, etc.) .
He has not benefited from any of those normal investor rights over the past Z years. All of these “normal” investor rights – including any unexpected deviations (such as lack of voting or information rights) – would have been detailed in both the initial investment contract (we call this a subscription agreement) and the company’s operating agreement. You do not have any of these agreements with him.
Without these agreements in place, some of these terms are governed by LLC law, but the others are undefined or at least undefined. It can only be tangibly identified by your memories and his memories (which are often quite different as you can guess).
We can confirm the terms of its ownership by thoroughly reviewing the emails and text messages that you can locate. You can see how this could spiral out of control into litigation if you can’t come to an agreement now on what you agreed Z years ago regarding his investment and property rights – or at least what is fair to him now.
You need to think about what kind of inputs he would have given over the past Z years if he had been involved, even as a passive owner. If I were his creative attorney for transactions, I would discuss this:
- He is entitled to Z years’ worth of X% of the net profit of the parent company attributable to the operations of that company.
- He is entitled to X% of the value of this company, including assets transferred during the past Z years.
- To determine the full extent of its ownership value, we need a full appraisal of all related entities. This appraisal must be done by an appraiser acceptable to him and paid by the parent company. This is because an appropriate valuation should be based on the value of the continuing enterprise rather than the value of the abstract assets of that entity alone. It does not make sense to value a company solely as the value of its assets sold as part of the liquidation of the entity (balance sheet value or less) because that does not reflect the vibrant and profitable conglomerate value of which this company is a part.
- We also need a full financial audit of all related entities over the past X years, paid for by the parent company, to see if any assets or other revenue of the company has been transferred to the related entities.
The value of the cannabis trade: the conclusion
It is very easy for cannabis business valuation issues to spiral out of control, requiring expensive competitive valuations and potentially more costly lawsuits (see here). Owners who prioritize having a blanket operating agreement or shareholder agreement in place at the beginning of the relationship will thank themselves later when an established business dispute arises between the founders.