Knowing what others want is a key ingredient when it comes to achieving what you want in life. Whether your “want” is launching a startup operation, working with businesses in the industry, or becoming an investor yourself, understanding the most common investor concerns empowers you to make informed choices on the journey ahead, so read on!
Early investors in the industry were less focused on accounting and transparency when it came to choosing where they wanted to invest their money. Seemingly good ideas, like MedMen, had trendy appeal. Investment dollars rolled in, and investors learned the hard way that successful businesses are not made solely on “good ideas” or gimmicky names. After a slew of lawsuits, MedMen’s founders were ousted from the California-based company in 2020. Only time will tell if the company recovers after restructuring. Investors have learned that they must take a hard look at the numbers involved as well.
Today’s investors are much more demanding of Cannabis, CBD, and Hemp startups. Since they don’t want to risk fines, penalties, or loss of license, they expect for the businesses they invest in to have their accounting and taxes done correctly, for the entity structure to suit their needs, and for compliance with HR, OSHA, USDA, FDA, state, and city regulations to be a top level priority. Requiring anything less would not be prudent no matter how much they like a particular brand’s story or innovative approach.
Correct accounting, tax preparation, and reporting in the Cannabis industry requires proper operational setup and processes, expertise, and tools. Maximizing tax benefits can be challenging to impossible if the right steps are not taken at the right time. As the industry grows throughout the nation, more accountants are attempting to serve these businesses. Unfortunately, mistakes made by well-intentioned accounting professionals are rife. Rather than abide by 280E, many ignore it and still try to claim deductions as they would for a traditional business. Doing so can and will trigger IRS audits, as it should.
Informed Cannabis accountants have both a big picture and granular understanding of IRC 280E. Correct operational set up that accords with the specific needs of the vertical (dispensary/retail, manufacturing, cultivation) enables them to assist Cannabis CEOs and operators with laying the necessary groundwork it requires to run their businesses in accordance with compliance standards and hone in on actual operational costs and expenditures, and ultimately make better forecasts and projections.
While 280E makes taking deductions impossible for Cannabis businesses, correct adherence to another tax code provides at least part of the solution. Through proper reliance on IRC 471, which is, unlike 280E, a very complex code, accountants and CFOs can determine which costs that can be allocated to inventory, and eventually into COGS (Cost of Goods Sold).
Using 471 correctly, and understanding how and when to use it is of paramount importance. Mistakes can be extremely costly if implemented improperly. 471-11 is the applicable Internal Revenue Code for growers, processors, and manufacturers while 471-3 will apply to retailers. Through correct adherence to 471-3, taxable income for retailers can be lowered only via COGS. Doing so requires very exacting standards to be maintained in day-to-day business operations as well as a maintained paper trail for every transaction.
Compliance with 280E, 471, and other applicable tax codes requires knowledge of cost accounting for Cannabis, CBD, and Hemp businesses. Accounting systems fall short of being able to meet the needs of these businesses, especially if they are operating in different verticals. Nevertheless, all of it is necessary if businesses want to maximize their chances of gaining investors, and getting their businesses up and running, or expanding existing operations. (Want to learn what not to do? Lessons in Compliance from 4 Notorious Cannabis Cases).
The entity structure a budding Cannabis CBD/Hemp business chooses largely determines which kinds of investors they can attract. Protecting their personal assets and mitigating risk has a lot to do with this. That being said, individuals who are looking to found a company have a certain vision and goals they want to achieve. Therefore, consulting a corporate lawyer and Cannabis CFO prior to choosing an entity structure is a prudent decision to help ensure a startup looks good to investors without compromising the vision behind it.
Cannabis investors tend to prefer C corporations, aka C corps. This kind of legally structured corporation consists of shareholders who are taxed separately from the entity, as the shareholders are legally separate from the corporation itself. The company can gain in profits and issue shares while limiting the liability of its shareholders and directors. With the C-Corp structure it’s easier to raise capital, the corporation pays a tax of 21% (currently), and potential financial exposure is limited.
In other words, investors do not have to worry about an audit of a business they have invested in extending into their own personal assets. Only the C corporation itself can be audited. Protecting personal assets is obviously a huge concern for investors, so those who choose to form an LLC should be fully aware of how doing so may impact how attractive their business looks to investors.
Another thing investors like about the C corp entity is Internal Code Section 1202, aka the Small Business Stock Gains Exclusion. The impetus behind it was to inspire greater investment in small businesses, and the incentives are definitely substantial. Section 1202 allows 100% of capital gains to be excluded from federal taxation, as long as the stock is held for a minimum of five years. The limit on the amount of capital that can be excluded is $10 million, or ten times the adjusted basis of the stock.
Ask many lawyers and founders outside of the Cannabis CBD/hemp industry what they think of the C corp and they’ll likely list double taxation and the corporate tax as its drawbacks. While it is true that increases in the corporate tax rate can increase the amount of tax burden on C-Corp businesses, the LLC entity structure often falls short of adequately mitigating risk for investors.
The biggest drawback for the C corp structure is double taxation. As an entity, C corps pay income tax at the corporate tax rate. Shareholders are paid dividends from the C corporation’s after-tax income. The C corps’ shareholders are required to claim their dividends on their personal income tax statements, hence the “double taxation” drawback. Then, there’s also the paperwork.
C Corporations require the following documentation which must be kept current:
While double taxation is the biggest drawback of the C corporation structure, greater exposure to audit liabilities as well as annual taxable income distributed via a K1, is what often makes the LLC a less desirable choice. In corporations with many investors the risk of exposure to any one individual may be limited, but in those with relatively few, the consequences can equate to financial ruin.
If, for example, a business has only three investors and two of them have little to no assets, the investor with the most is subject to lose the most. The words “limited liability” are a misnomer. IRS audits can and have extended to personal assets. Nevertheless, there are situations where the LLC can be better for all involved. Oftentimes, meeting the needs and interests of the shareholders and operators is a balancing act. Hence, the consultation of an experienced corporate attorney (not a Cannabis attorney) and a knowledgeable cannabis CFO would be needed prior to moving forward in such situations.
Better tax rates are possible in an LLC entity structure, but the specifics vary greatly depending on the investors/shareholders concerned. There is no double taxation with LLCs, and whereas C corps definitely require a lot to maintain, LLCs can be set up easily, oftentimes within just a few hours.
Depending on their amount of qualified business income (QBI), LLC members may be eligible for a QBI deduction by as much as 20%. Thresholds have a number of variables that need to be considered to have a ballpark estimate of QBI.
Furthermore, unlike C corps, with Limited Liability Corporations, 1202 capital gain exclusions do not apply, so capital gains taxes are a very real matter for investors to consider. (Want to learn about multi-entity structure? Read this blog post.)
There is no limit to the amount of compliance concerns Cannabis CBD/Hemp companies need to stay on top of. Human resources, OSHA, USDA, the FDA, as well as state and city ordinances, regulations, and licenses and permits make compliance a very hefty matter. The long and short of it is this: there are dozens of agencies, departments, regulating bodies, and organizations that need to be worked with regularly. Is doing so fun or interesting? No. Nevertheless, it’s highly necessary.
Understanding Cannabis investors’ concerns is crucial whether you’re starting out as a Cannabis investor yourself, want to support investors, or are working with Cannabis, CBD, and Hemp startups or recently-funded businesses in the space.
Whether you are setting your sights on building a thriving business as a Cannabis CBD/Hemp entrepreneur, or are an accounting professional and want to support them, DOPE CFO can help. Accountants and CFOs with Cannabis-industry-specific expertise can help you chart your course towards success. Knowledge is key and having the right support systems in place is vital. No one can do it alone, so reach out!
Want to learn more? 8 Ways Cannabis Startups Differ from Traditional Startups.
50% Complete