Corporate governance is a basic requirement of any business. So of course, cannabis businesses often just ignore it. Some of them may pay a lawyer to put together a simple set of bylaws and an organizational resolution (or operating agreement for an LLC), and then basically close their files until something “big” comes up. This is an absolutely terrible plan and leads to tons of mistakes – many of which are easily avoidable.
In 2021, I wrote a post about why corporate governance is important. Today I want to revisit that post and hopefully hammer home again why this is so important.
What is corporate governance?
First of all, let’s break down what corporate governance even is. As I wrote back in 2021: “a strong corporate governance program is one in which a cannabis business (1) adopts procedures for running the cannabis business, and then – and this is the hard part- (2) actually follows them.”
To break this down even further, lets imagine a cannabis business is formed as a multi-member LLC. This is done by filing articles (or in some states certificates) of organization with the state’s secretary of state. The articles often have barely any information in them so by default the LLC will be governed by the state’s LLC act. LLCs generally don’t have to do anything beyond forming the LLC and getting a tax ID number, but in a multi-member situation, it’s a really bad idea not to.
Better corporate governance would mean that the LLC’s members draft an organizational resolution and operating agreement. Unless the members are lawyers, and even in some cases if they are, they should hire a law firm to do this. It really does not need to be complicated or expensive for cannabis businesses with good corporate counsel (unless there’s an exotic or complicated corporate structure at play), but ripping templates of Google is never a good idea.
Most cannabis businesses go through these steps and then … do next to nothing else. This is where things get hectic. Corporate governance agreements (the good ones at least) will often explicitly require things like holding meetings or properly waiving them, documenting myriad different company actions via a secretary or good record keeping principals, and so on. If companies don’t do this, it not only is nearly impossible to see under the hood in future deals (more on that below), but it can even throw into question actions taken by members of the company.
What are some pitfalls of bad corporate governance at the outset?
Cannabis businesses that don’t even go the first step of getting initial corporate governance documents in place are in for a bumpy road. They’ll be forced to live with their state’s basic laws without any chances to add protective provisions that fit their specific situation. They also won’t be able to take advantage of state-specific laws that might allow them to toss provisions of state law that they don’t want to govern them (this can be done in many states).
I’ll give a good example here, something I’ve seen variations of in the past. Generally, state laws do not impose rights of first refusal, drag-along rights, or preemptive rights on members of a company. Rights of first refusal require members who want to sell their interest to offer it to the company and/or other members before doing so. Drag rights allow the majority member to force the minority members into a sale. Preemptive rights require the company to, before issuing new securities to a third party, offer them to the existing members. All of these are extremely valuable for running a company.
Now imagine an LLC never adopted an operating agreement and the members didn’t have any of these rights. Imagine that the member holding 80% of the unites wanted to sell the company to a third party, and the third party wanted to buy the entire company (and not just the 80%). That 80% member would need to go around and get the approval of ALL LLC members to sell the company. He or she couldn’t just force the other members into the sale (as he or she would have been able to do with an operating agreement with drag rights). There are endless ways in which things like this can lead to massive consequences and even kill viable deals.
What are some pitfalls of bad ongoing corporate governance?
Let’s assume that a cannabis business did the basics and paid a lawyer to get an operating agreement in place. Many of these businesses then drop the ball and operate their companies. Bad idea! Here are some things that can easily go south, many of which I have seen before.
Example 1: The owners of the company haven’t kept good records and don’t know the exact composition of the cap table. They have to spend weeks reconstructing investments and prior deals to figure out who is even a member of a company.
Example 2: Company X gets sued. The plaintiff also sues the officers of Company X, asking the court to “pierce the corporate veil” and impose individual liability against them. This can actually end up happening. One of the elements of a veil piercing claim looks at whether the company adhered to corporate governance practices. Companies that don’t risk exposing their owners and operators to personal liability – the very thing entities are supposed to avoid.
Example 3: Members of a company are in a dispute. One of the issues concerns whether a company action was authorized at a company meeting where no minutes were recorded. One member says the members decided X, another says Y. Now there is a “he said, she said” dispute, depositions need to be taken for thousands of dollars a pop, and the parties are ultimately at the whim of a jury. All of this could be avoided with a simple set of minutes.
Example 4: A company had 1,000 shares of stock authorized but issued 5,000 to investors. The issuances would potentially be invalid. The officers of the company have to go back and amend their articles of incorporation and explain to investors why this happened. The company needs to ratify the past issuances. All of this costs money. All of it makes the officers look bad. And all of it is avoidable.
Corporate governance is key
For cannabis businesses and cannabis business owners that do not want to spend hundreds of thousands of dollars litigating avoidable disputes, risk personal liability for their owners and operators, and even risk losing out on a deal, corporate governance is a must. Time and time again, our corporate attorneys have seen shoddy corporate governance practices lead to disastrous and incredibly expensive outcomes.
Many of these problems can be avoided by investing in good corporate governance agreements up front. And as I said, that does not need to be expensive in many cases especially for non-complicated governance structures. Those cannabis businesses can avoid operational problems by simply reading and following these corporate governance documents. Cannabis businesses that do this are never guaranteed to avoid all problems, but there are a host of “unforced errors” that can be avoided with simple business basics.
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