Often in the cannabis industry, companies looking to effectuate, otherwise normal, business decisions face countless regulatory hurdles and rely on custom tailored management agreements to address regulatory concerns with lesser barriers to growth. As discussed here, cannabis businesses often rely on Management Services Agreements to ease these pain points when they wish to acquire another cannabis business/ location or to acquire a partner for a new or existing business while maintaining compliance with these ever changing regulations.
Quite dramatically, the impact of not exercising proper due diligence in the asset acquisition phase, and not taking the time to draft a thoughtful MSA may result in the financial failure of the company and the loss of a cannabis license. In order to avoid the aforementioned corporate demise and ensure the Sponsor’s management services to be provided to the Portfolio are clearly articulated in the MSA.
Below, we will explore the ways in which management services agreements function in the California commercial cannabis industry in more details and highlight a few specific terms and conditions that are crucial to consider when drafting a MSA in the California cannabis industry.
I. What is a Management Services Agreement?
A Management Services Agreement (“MSA” or “Agreement”) is a business agreement between two parties which sets out the terms and conditions under which a portfolio company (“Portfolio”), agrees to pay a set of management and advisory fees and any associated out of pocket expenses, in exchange for an equity sponsor firm’s (“Sponsor”) advisory and consulting services, subject to key performance indicators. Under the Agreement, a Sponsor or it’s affiliate would assume operations of the Portfolio company under the MSA.
II. MSAs Function in Unique Ways Within the Legal California Cannabis Industry
A. Portfolio Companies’ Use of MSAs to Grow their Business.
For cannabis businesses looking to grow, MSAs can serve to efficiently improve profitability and provide technical and operational expertise. This has become a staple in the industry and several established companies and brands now “specialize” in providing management services to the cannabis industry.
In more nascent cannabis markets, these management companies can endow the Portfolio company with an extensive understanding and a wide range of industry specific experience and investment. For example, new businesses or social equity applicants may partner with investors and brands who operate cannabis management services companies as a way to provide services to help propel that business forward.
Moreover, the benefit here is mutual in that the Sponsor has access to maximize returns from an operational cannabis license without the delay and costs of obtaining its own license.
III. 5 Key Provisions To Include in a Commercial Cannabis MSA
Whether the Sponsor and Portfolio have come together for an MSA as part of a larger transaction or simply to improve operations and growth for the portfolio, there are many commonalities in what should be included in the Agreement itself.
A. Regulatory Disclosures & Responsibilities for Ongoing Compliance
It’s essential that the parties agree within the MSA to abide by “Ownership” disclosure requirements set by their local and state regulatory agency. Under the California Department of Cannabis Control (“DCC”) regulations, an applicant is required to disclose all owners of a commercial cannabis business and an owner is defined as, inter alia, “an individual who manages, directs, or controls the operations of the commercial cannabis business, including but not limited to .. [a] general manager or their equivalent.” In combination with these state regulations, most local jurisdictions in California define “Owner” similarly and also require their timely disclosure, often within 14 calendar days.
Whether this is an MSA for a larger transaction or for operational management, in either case, the management company may qualify as an “Owner” under the regulations. Some of the considerations here would include whether the management company has day to day control and more broadly makes strategic decisions on behalf of the company, and/or receives substantial profits or revenue.
Moreover, operators run the risk of violation of the regulations if they fail or neglect to disclose a management agreement to the DCC and likely the local agency as well. Under DCC rules, if the licensee fails to properly maintain their records and fails to disclose their current ownership the DCC can impose disciplinary action upon the licensee. This violation would typically be a Tier 1 Violation, which may result in a “5 to 15-day suspension, a fine or a combination of a suspension and fine.”
- MSAs Should Assign Responsibility of Licensing Costs and Ongoing Regulatory Compliance
Within the MSA, Parties must address and assign which party will be responsible for the licensing costs and ongoing regulatory and corporate compliance during the term of the MSA. Including, for example, who will be responsible for completing and submitting the requisite ownership change documentation, whose counsel will be responsible for the filings, and which party will be responsible for the applicable fees. Notably, under applicable laws, notwithstanding the MSA, the Portfolio, retains the risks to the license(s). Accordingly, the Parties should agree on comprehensive indemnifications.
B. Importance of Due Diligence: Carefully Consider License Transfer Issues
All too often, Portfolios lack proper resources to maintain compliance with complex ownership change processes. Sponsors should conduct competent due diligence on the Portfolio’s license ownership registrations and records with the licensing agencies as compared to corporate records and documents and commit to correcting those as a condition of the closing.
For example, the Portfolio may have changed hands prior to the current transaction and the ownership may not have been properly recorded with the local and state regulatory agencies. During the due diligence phase, Sponsor counsel often discovers that the ownership listed on the local and state cannabis license applications don’t align (e.g. State license application was updated, the City application was not).
Here, the risk of noncompliance can be quite steep and can include fines, suspensions and a combination of both. As a last resort, noncompliance can always lead to DCC license revocation. As such, Sponsors must proactively identify as many of these potential licensing and compliance hiccups during due diligence. Once discovered, Sponsor and Portfolio must work together to act swiftly to cure these regulatory issues.
C. Assumption and/or Retention of Certain Liabilities
As discussed herein, many Portfolios have operated their commercial cannabis business for a significant amount of time and, as a result, have incurred varying liabilities, including without limitation outstanding tax liabilities, outstanding employment issues/settlements, and outstanding litigation. During due diligence, it is important that the Portfolio disclose all known liabilities and the parties agree as to which known liabilities are assumed or retained and who assumes unknown liabilities.
In the case of an MSA for a Portfolio’s operational efficiency, profitability and overall improvement, MSAs may lay out broad indemnities provided to the Sponsor for their decisions made under the MSA. The purpose of this is to act as a liability shield in order for the Sponsor to be able to make decisions for the business without the immense pressure that may result from business decisions gone wrong and the liability that may follow from those decisions.
D. MSA to Address Potential Lease Agreement Issues
In most licensed cannabis jurisdictions, one of the most important aspects of a cannabis operation is the ability to provide “evidence that the [Portfolio] has the legal right to occupy and use the proposed location that complies” with the regulations set by that jurisdiction.
During the MSA due diligence period it is essential to review all leases that the Portfolio is a party to and assess whether there are conflicting terms amongst those leases (e.g. different named lease, different payment terms, conflicting expiration dates, leases that don’t include all units that are under control of the licensee). If there are duplicative leases or conflicting terms, they should be amended in connection with the MSA.
Notably, in California, “a licensee shall not sublet or allow another person to conduct operations in any area designated as the licensed premises for the licensee’s commercial cannabis activity.”
Here, the penalty for noncompliance is a Tier II violation, which may result in penalties ranging from a 15-30 day suspension, and/or a fine, all the way to having the DCC license revoked.
Thus, the MSA in conjunction with the lease must list the Portfolio as a tenant without the ability to sublease and identify whether the management Company needs to be disclosed to the Landlord or added as a party to the lease agreement in order to operate the business at the licensed premises.
E. Key Performance Indicators
To clarify objectives and expectations, MSAs should lay out reasonable expectations for the Sponsor’s agreed-upon performance targets and milestones. KPIs will vary, depending on the structure of the transaction and the parties’ mutual expectations.
IV. Conclusion
As the legal cannabis industry matures and state sponsored legalization is ever increasing, Management Service Agreements will continue to serve as an important tool in cannabis equity transactions as well as operational management.
These Agreements should be thoughtful, detailed, and negotiated transaction documents that serve to encapsulate the details of the expertise, resources, and services provided by the Sponsor to the Portfolio.