Equity Compensation for Cannabis Employees Part 2

Last year, I wrote about equity compensation for cannabis employees from the perspective of companies. We have been dealing with more and more companies moving toward adding equity to their overall compensation scheme, so now is a good time to revisit it from the employee perspective.

Cannabis equity

At the outset, employees should be wary of companies that offer equity in lieu of any pay at all. Many companies assume that there are federal startup exemptions that allow them to compensate early stage employees solely in equity, but that’s not the case. Minimum wage and overtime laws still apply, and the value of stock and stock options is not included in determining whether an employee is receiving at least the minimum wage.

Beyond the minimum wage issue, there is the issue of value, which is different from valuation. Let’s say a company goes through a formal valuation process and is reasonably worth a million dollars. That does not mean a one percent stake in that company has a present value of $10,000. All new companies and an overwhelming majority of cannabis companies are closely held, meaning they are owned in full by a small group of owners. The shares or ownership interest of the company are not openly available in the public market, and they can’t be made available unless the company registers them under federal securities laws. So the present value of that one percent stake in a closely held cannabis business isn’t the same as the same stake would be in a publicly traded company.

Resale value isn’t the sole measure of worth of a minority ownership interest in a closely held business. There are also things like distribution rights and redemption rights. The devil is in the details here, however, and everything depends on the company’s governing documents. There is no general requirement that a limited liability company or corporation distribute profits to its owners. In fact, unless limited by the LLC operating agreement or the bylaws of the corporation, owners and officers can compensate themselves as salaried employees of the company, potentially eliminating any funds that would be available for distribution. Even in a company where that isn’t the case, officers often want to hold on to cash to use for reinvestment in the business, as opposed to distributions to owners. Though that may be good for increasing the value of the company overall, it doesn’t increase the value today of an ownership stake that can’t be sold.

Employees with equity stakes do have some legal protections, and they can negotiate for greater protections in the company’s governing documents. Many of the rights and protections mirror what any minority interest owner of a closely held company would benefit from. If, as described above, there is a worry that the company’s owners will drain cash by paying themselves lavish salaries, it is in the employees’ and other minority shareholders’ interests to require the company mandate no salaries or maximum salaries for owners and proportional distributions otherwise. That means that if the company is making money and the majority owners want to pull cash out of it, minority owners like employees would also get a proportional cash distribution.

Some shares or membership interests have redemption rights, which are limited rights to force the company to repurchase the shares of the company. If this were an immediate right to cash, it would defeat one of the purposes of equity compensation for the employer (pay less cash and more equity in the early stages while the company is cash-poor), but many companies have structures in place to offer repurchases of some or all of the shares that employees or other minority owners have, often over extended terms. An additional right that employees and other minority owners will hope for are so-called tag-along rights. These are rights that ensure that if majority owners sell a portion of the company to a third party, minority shareholders can participate in proportion to their ownership interest.

In general, an employee offered equity compensation in a cannabis business should understand the limitations that come with that. Marijuana is a heavily regulated industry, and resale options for equity ownership are limited by both securities law and by various state regulations on marijuana company ownership. If a company doesn’t intend to or isn’t able to spit out big cash distributions to its owners, employee equity holders need to realize that the value of their stakes may or may not end up being worth anything, and the timing on that is going to be unpredictable.

Source: Canna Law Blog