On-Demand: Building Your Cannabis Ecosystem
- Apr 22, 2021
Our expert panelists from EisnerAmper, Centri and Moriconi Flowers discussed the steps for building a successful cannabis ecosystem and provided timely information you need to position your organization for success.
Eric Altstadter:Welcome everyone to today's event. Our event today is Building Your Cannabis Ecosystem. With New Jersey's cannabis landscape in a state of flux, and as rules get put into place, we thought it'd be an appropriate time to talk about a couple of things such as, the New Jersey application process, capital structure, finance and accounting, and capital sourcing.
Eric Altstadter:I'm pleased to welcome Kevin McLaughlin from Centri Business Consulting and Justin Moriconi of Moriconi Flowers to join me today.
We did pick this date because we didn't want to pick 420 because we figured everyone in this space is pretty busy on 420. So we picked a date that was close to 4/20. 4/20, for those that are unaware, is kind of an official/unofficial cannabis holiday. I think we wanted to first discuss, and I'm going to turn it over to Justin in a second, the New Jersey licensing situation. The New Jersey cannabis saga started when Jon Corzine signed the Compassionate Use Medical Marijuana Act into law on January 8th, 2010, which was his last day in office.
When Governor Phil Murphy took office in January 2018, he declared in his inaugural address that a stronger and fairer New Jersey embraces comprehensive criminal justice reform, including a process to legalize marijuana. New Jersey residents went to the polls last winner and overwhelmingly supported the ballot question as to whether or not to legalize adult use recreational cannabis. About 67% voted to legalize or voted for the measure. When Governor Murphy signed three laws into law in February, recreational cannabis became legal in New Jersey.
This also puts a lot of pressure on the Mid-Atlantic states. In March, Governor Andrew Cuomo signed legislation legalizing adult use cannabis in New York. The questions are always, what happens next? We're going to focus a lot on New Jersey. The core of the New Jersey law is that the licensure of the adult use marketplace established six classes of licensees to be issued by the Cannabis Regulatory Commission.
Those six classes were cultivators for growing, manufacturers or processors for preparing and packaging, wholesalers for selling to other licensees for resale, distributors for transporting items in bulk, retailers for selling to consumers and permitting onsite consumption, and deliverers for providing retail and courier services to consumers. There has been a lengthy discussion about social equity programs, which had been created within the Cannabis Regulatory Commission.
The Cannabis Regulatory Commission will determine the maximum number of licenses to issue based on market demand, but about 30% must be given to minorities and women or disabled veterans. A panel within the Cannabis Regulatory Commission will be responsible for certifying those groups. Priority will also be given to impact zones, those impacted by unemployment, poverty, or past marijuana activity. Priority is given to applicants that have a significant person who has resided in the impact zone for three or more years.
The Cannabis Regulatory Commission will also look to grant licenses to applicants that employ 25% of their workforce from those impact zones. With that, Justin, why don't you go into a little bit more detail about the whole application process.
Justin Moriconi:Thanks, Eric. I appreciate that. Couldn't have done it better myself as far as summarizing the law. We're about to lift off in New Jersey, and it's kind of an exciting time. We've been waiting for an adult use law for a number of years now, and it does look like it's moving forward at a pretty good pace. For a very brief background just on the current licensing and application rounds in New Jersey, there was an initial first round of six vertical licenses.
What I mean by that is both cultivating, manufacturing or processing, and retail sales all under one license. The original license in New Jersey were given out in this way, and there are six currently that were given in the first round. There was another round of another six vertical licenses given out in 2018. And then there was another round, a third round, in the summer of 2019 where four vertical permits were up for application, five horizontal permits on cultivation at different canopy levels, two at 30,000 square feet, two at 20,000 square feet, and one at 5,000 square feet, and 15 standalone retail locations.
Those permits have not been awarded yet. There were a number of lawsuits that were filed mostly have to doing with the application process itself and issues with the application. I'll touch on that a little bit in a moment. But right now, we're in a bit of a holding pattern between these horizontal permits that are in stay, if you will, and another four verticals. In New Jersey, after all those permits are awarded, which we expect to happen very shortly, you'll have six verticals that already existed, another six from 2018, and another four verticals that will be awarded in 2021 from a 2019 application period.
In addition to the five horizontal canopy growers, you're talking about a total of 21 cultivation or manufacturing permits that will be in operations in New Jersey when this next round of adult use permitting occurs. We tried to address a lot of the questions that were pre-submitted on the form. To the extent we don't answer them, feel free to email us after the program. But to touch on the timeline, a few of you asked about what were the timelines for the next round of permitting.
The way that the law is structured is it's governed by a board. The board has to set the regulations, as well as the application timelines for the adult use law. There's five members to the board. The five members were just appointed, and they met last Monday. We're sitting here, it was the 12th of April. After their first meeting under the law, they have six months to come up with regulations and another round of applications. The law caps the cultivations in New Jersey at 37.
If you take the meeting that they had in April, they have until about October to come out with regulations and applications. That being said, with the limit capped at 37, there's already 21 that will have been awarded under the past application rounds. There will be 16 cultivations left to be awarded in the next round. We don't know if they're going to give them all out at once, or they're going to phase them in in multiple rounds. To note, in New Jersey, the way they've written the law, they want to get away from the vertical type of permitting.
In New Jersey, for two years after they award permits for adult use, a cultivator cannot own a retail location, a manufacturer or processor cannot own a retail location, and a retail location in turn cannot own a cultivation or manufacturing permit. After the two-year window, they are free then to vertically integrate to the extent that they want to or can. When people go and apply for these permits in New Jersey in different states, and my firm has handled applications in about 12 different jurisdictions across the United States, there's different ways to go about it.
In New Jersey, like Pennsylvania, it's one RFP, so request of proposal, that you would submit to the state. Normally it is graded by employees of the state. Occasionally, states like Illinois will come in and hire an accounting firm like KPMG to do the scoring. And that's what happened in that state. Unfortunately, because of that, there has been a number of lawsuits that have been filed based on the applications that were awarded there. In New Jersey, we kind of liked the process of submission, grading, and award, rather a step through process.
That's what we expect here coming out in New Jersey within that six month window. You should note a bit about the application process itself. Usually it comes out. It's released with not a lot of notice. There can be a frequently asked questions period. In 2019, they held a webinar. Actually it was also an in person meeting where they answered all the questions by would be applicants. I remember I didn't attend the meeting. I did attend the webinar, but there was over 800 attendees at that meeting.
We anticipate a very competitive round here coming up in New Jersey on adult use. When a group is getting ready to apply for an application, for a permit, there's always some standard sections that go into the composition of the application, your security, your record keeping, your tracking progress, your waste, your environmental plans, your local community impact, which is very important, your quality assurance and quality control. In New Jersey, they allowed municipalities to opt out of either medical marijuana and now adult use marijuana.
They can't opt out and prevent delivering into jurisdictions that they don't allow operations, but they can ban operations. To date, just under the medical law, my firm has tracked up to 72 different municipalities in Pennsylvania that have effectively banned marijuana operations within their borders. Now, that still leaves about 500 or so municipalities that do allow it or don't have anything on the books that prevents it. But nonetheless, it's difficult to find the piece of real property that's not only in an area where the municipality allows it, but that fits the operation itself.
On the cultivation and manufacturing side, of course, your power, your water access, your ease of delivery and your access to the different retail markets is very important. Getting real property in line with zoning work and with dealing with the local community leaders is very important very early on. I would highly recommend anyone anticipating to apply in New Jersey, if they haven't already, to start looking for real property. We can certainly help you do that.
When you go to apply in almost all the states at this point, but particularly New Jersey, they have a number of different sections that the applicants, and an applicant is really termed as a person or entity that owns 5% or more of the cannabis operation, and ownership is defined under the law, person is, of course, defined under the law, but it's really that 5% window that below that, you don't have to make as many disclosures as you do for entities or people above that.
You have to execute affidavits of truth to say that what you are writing and what you are planning, the contracts that you may have in place and your operational expertise is what it is. You go through background checks. You must submit the background check information to the state, both on the federal and the state New Jersey level, and those results are usually sent directly to the state, so you don't even see them. Advised to get your FBI background check done prior to submitting.
A classic story just to digress, we had an application for a client a number of years ago and they had a security individual identified as part of the team, which is another important piece. He was very well highly decorated officer in the police force. He had served his country. He had held up the anti-terrorism unit. He was in the K-9 unit. He headed up the marine unit. And wouldn't you know, we did all the FBI background checks and his was the only one that came back with something on the list and it was a simply disorderly conduct ticket that he received when he was probably 18 years old.
But these things have a way of staying in the system, so it's highly recommended that you get a precheck on your background. Certainly, for principals heading up their companies, you want to make sure that all the members of your team you've adequately vetted prior to applying. There's no worst surprise than finding out that your application must be amended or resubmitted because of a failure like that. Normally the state say if there is a problem, they will contact you and you'll be able to change the application.
That happens very rarely. That's usually pretty subjective on the part of the state and it's not always the case that you have an opportunity to amend. So act early. One of the things that held up the New Jersey application process in 2019 and one of the reason why we're still waiting for the results, and by the way, most of my clients who are awaiting these results have had property on option for all this time, meaning they're paying the entire time to keep that property in play.
One of the requirements of the application is that you have control over that property for purposes of receiving the award. You have to keep that property in hand. It will be a very interesting analysis to see if the awards come out and there are applicants that no longer have control of their property and how the state deals with that. As part of the application process, there are what are called personal history disclosure statements.
These go everything from your educational background to any lawsuits that you've been involved with, whether they were for fraud or something else. Examinations into your personal/professional history. If you hold any licenses like a law license, accounting licenses, anything like this, has there been any adverse action against those licenses? Again, a good idea to get those. If there's been any notices of violation for any professional permit that one person on your team may hold, you want to know that before you apply as well.
One of the lawsuits that was filed to hold up this program was based just upon that issue. There was a PDF form that was submitted as part of the application for the personal history disclosure and the actual form itself was not filling correctly. Just logistically, nothing to do with the law, nothing to do with the actual practicalities of it, but just logistically, people were having trouble filling in the PDF form. In fact, they would fill out the form. They would submit it and upload it, and it would come out blank in some sections.
If you weren't looking at this constantly and going back and revising, we spent many days dealing with these forms and thought it was maybe unique to use or our clients or the software we're running. It turns out it wasn't. Many people applied. They applied with the PDF form. The PDF form did not fill out, and they got kicked out, or they were not scored because they didn't satisfy the minimum requirements to get a review. That generated lawsuits.
Eventually the court came down and said, "No. It wasn't Adobe's fault. You got to check the form. The onus is on the applicant." You want to be very careful to make sure that what you upload is there. Check and double check. Usually we like the application to be in final form at least five to seven days before the applications are due. There are a number of corporate documents that must be disclosed for the application. Your municipal zoning approvals and your local support letters have to be part of your application.
What do I mean by that? Obviously, zoning is fairly straightforward. You have to have control of your property, and you have to have the use approval for where you're going to be. In New Jersey, like some other states, Massachusetts is a good example, you have to have some support from the community. This, again, was a subject of litigation post permit application period where the support letters were not directly from the municipality, meaning not from the mayor or not from a commissioner, but from local business leaders.
And the question was, since the application wasn't specific as to the support letter, what qualifies? That held up the entire process. The court finally came down and said, "No. It doesn't have to be from the municipality itself or an officer thereof. It can be from the local community business leaders. It can be from a resident." In fact, we have seen a mix now of those types of support letters. The most competitive applications have both municipality support, as well as local business and community support.
One of the hurdles to applying in any state but certainly in a very competitive state for competitive application like a cultivation permit where there are a limited number of licenses is a financial demonstration of your ability to actually run the operation as a going concern and get all the capital expenses that you need. Eric and Kevin are going to touch on that a little bit later, but just enough to say for purposes of the application, you have to show your financial debts, as well as showing your cap and OPEX dollars and where they're going to come from.
Normally for a cultivation and manufacturing permits and entities usually like to join those permits together, both cultivation and then processing the product together. There's no cap on the number of manufacturing permits in New Jersey. I would advise any cultivator applying there to also apply for a manufacturing permit. The amount of money you need to do an operation like that depends on your size of your canopy. But sufficed to say, on a 50,000 square foot canopy, which is fairly large, you're going to have to show about $15 million to logistically do that.
There are usually lower thresholds in these operations. Some people like to show at least $2 million or more. We like to show a lot more money. Because when we go to the proforma on the application, you show exactly how the money is going to be spent, and it quickly adds up between site work, construction, and your operating expenses to get your cash flow positive point.
That being said, the pre-permit costs are really just the amount of money that you're going to spend to hold your real property, any other zoning relief that you may have to spend money doing, engineer's drawings, attorney's fees, as well as application fees. In New Jersey, there were two checks that you had to submit when you did your application. One was for $18,000 and one was for $2,000. If you didn't win the application, you get the $18,000 back. They actually just destroy the check.
But they keep the $2,000 and that was the cost to apply. That's a fairly reasonable number from what we've seen across the state. But in other jurisdictions, they've had much higher thresholds like Pennsylvania, $200,000 just for the grow application to apply. And that was a cashier's check to the state. In looking at that, we think it's fairly reasonable what New Jersey is doing. I'd be remiss to not mention social equity portions of the application process. Eric touched on a little bit, but I would also add that there are micro business licenses available in New Jersey.
They have to be 51% owned by a minority who lives in the municipality or borders on the municipality where the operation is going to be located. You have to have union involved in as well, and that means a labor peace agreement. We've typically done with it the United Food Workers Commercial, but I know that Teamsters are always involved and there's some healthcare unions that are also available to partner with on labor peace. The bottom line is, New Jersey's a very big market. It's certainly huge.
It's completely untapped. It is medical right now. They are going to convert into adult use. And when they do that, almost all of the medical permits are going to participate in adult use program. Then it's just a matter of expanding out the current adult use program to get more retail locations and more products on the shelves for the consumers. With that, I think we want to turn over to capital structure a little bit, Eric. What do you think?
Eric Altstadter:I agree. I agree.
Justin Moriconi:All right. I'm going to kick it off a little bit by talking about the capital structure just from the legal perspective, and then I'll kick it back to Eric to talk about tax stuff. And of course, I think it involves 280E. Something I want nothing to do with. Anyway, when we usually structure these businesses for the capital call, it's a big deal. You have to make sure we organize it such that the different parts of the business have different responsibilities and roles. What do I mean by that?
When we go and acquire the real estate, we like to have a separate entity that will own the real estate that will deal with the real estate, buy it or lease it, and then lease it or sublease it to the operator. We like to split up the investment arm and the operations arm, so that money that's flowing in through the entity is coming in through another vehicle, such that we're able to divide out and separate the tax liabilities for each of these companies and the general liabilities for the members as part of each one, because one set of member's investment might not be a part of the operational entity, for instance.
There's lots of opportunities here when you're talking real estate and structuring your capital to reflect a good value for the real estate. I've seen many companies go under just on construction alone. If you don't forecast that and you take on too little money on construction, you're going to be behind the eight ball getting diluted down before you've had a chance to enjoy any kind of cashflow. There was a question post about Qualified Opportunity Zone in New Jersey.
Unfortunately, very unfortunately, and we've seen different things in different states, but in New Jersey, cannabis businesses cannot take advantage of any of the Qualified Opportunity Zone or any tax break real estate opportunity zone that may exist, either state or federal. I don't know how they can be on the federal. But nonetheless, you can't take advantage of it. In Pennsylvania, you can. In New York, you can.
That maybe something that we would look to amend in the future. But right now, specific to a few of you who asked this question, fortunately, that doesn't have to go onto the analysis for your capital structure and your real estate entity. Whenever you're going and you're raising money, of course, it goes without saying that you need.
If you are going out and really shopping it, if you will, you need a private placement memo and you need something drafted that's going to protect you with all the fancy legal lease that would normally accompany any other type of business that was going out and acquiring a capital or shopping around for good investment dollars. You want to think about units of, usually we set up an LLC. But you can make your tax selection, right? You can be a C corp. You can be an S corp. You can be a pass through, a partnership.
But you want to think about is it going to be units of the LLC or percentages of the LLC. That can come into play if you have an exit event where you're selling the company and now you have to value your units or your percentages, depending on what type of entity it is, and usually it's a set of entities as an umbrella that will come in and be acquired as a larger asset. I like to keep on the investment side. We were talking about legal and capital structure to keep the investors diversified.
It's like the Goldilocks test. Not too many, not too little, right? But enough that if one investor doesn't satisfy their capital call, the other investor can come in and take their place or buy them out entirely. That puts pressure on investors to come up with the dollars or seek debt facilities to satisfy their capital calls. One thing to note when you are structuring these entities, some operators, I should say, like to give bonuses or incentives to their managers so they can vend into some equity based on their sweat into the company.
The only thing I'll prevent and saying that's fine, you definitely want to make people motivated, but you certainly want to limit any data access, so high level management data access, to a certain number of people. We've seen some significant data breaches within the cannabis industry just in the last year during the pandemic. They become a target. When there are managers who then share passwords and such and access things from home, it can get very problematic.
We've seen some data breaches, particularly having to do with patient sign ups, which is a HIPAA violation in and of itself. Just to keep that in mind. Last point, the aspect of local involvement. I really can't stress this enough in New Jersey. There has to be a significantly involved person in New Jersey who's a New Jersey resident that has at least 5% of the New Jersey company. If you don't have that, don't bother applying.
That being said, I would stress wherever your property is located, if you don't have anybody in New Jersey, you should find somebody from the area where the municipality is. Always need to file entities, whether you are an existing company coming into New Jersey or an existing MSO that has operations all over the United States, you want to form New Jersey specific corporate entities. The form filing from Pennsylvania into New Jersey normally isn't enough and just the optics of that on the application don't speak well enough in my opinion.
With that, Eric, I will kick it over to you to talk a little bit about tax implications with these capital structures. And I probably raised a whole myriad of tax liability issues with my few short statements there.
Eric Altstadter:Thank you, Justin. Afterwards, I'm going to turn it over to Kevin. Kevin is going to discuss the accounting and finance complexities that occur in the cannabis space. As Justin was talking about, there's something called 280E. To give you a little background, 280E came about as kind of a throwback from the Reagan administration. It originated from a 1981 court case in which a convicted cocaine trafficker asserted his right under federal law to deduct ordinary business expenses.
In 1982, Congress created to 280E to prevent other drug dealers from following suite. Now, what 280E basically says, and I'll just read this real quickly. “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
Now, I mentioned the Controlled Substances Act. What the Controlled Substances Act did was defined or created five distinct categories of drugs, depending on the drug's acceptable use, abuse, or dependency potential. Schedule I have a high potential for abuse and a potential to create severe psychological and/or physical dependence. And as the drug schedule changes to Schedule II, Schedule III, et cetera, so does the abuse potential. Schedule V drugs representing the least potential for abuse.
Drugs that are listed on Schedule I or Schedule II are required to follow 280E. I know I recited the law before, but that basically means that these companies can only deduct the cost of product, the cost of goods sold. The normal expenses of carrying on a business such as salary of sales personnel, office supplies, rent for office, things like that that are normally deductible to most other businesses are not deductible to companies that are on Schedule I and Schedule II.
As a result, in effect, the effective tax rate for cannabis companies is well above the effective tax for all other businesses. Sometimes as high as 70%. There have been a number of cases that have gone to court recently. The two main cases I'll mention are Alpenglow and Harborside. Those companies took the IRS to court. I will, before I turn it over to Kevin, highlight the fact that the IRS has never lost a cannabis tax court case yet. They always are able to win those tax court cases.
Harborside was important because Harborside kind of said that the other businesses that the company was operating in such as sales of other product were incidental to its operations. It also stressed the fact that deductions which would normally not be deductible could not be made deductible by utilizing 263A and capitalizing those costs. The IRS is taking a careful look and making companies follow 471 rather than 263A.
It's again, limiting the deductions that a cannabis company can take to that cost of goods sold. Kevin, why don't you talk a little bit about some of the complexities in the accounting and finance areas for these cannabis companies?
Kevin McLaughlin:Thanks, Eric. First off, I just want to spend some time going over financial and cash flow projections. Obviously very important in properly planning for the growth of really any business. But as you're setting out, whether it's the application process or already have a cannabis business, it's essential to be able to have written controls and policies and procedures specifically around cash, right? Any cycle or area of the business should have some type of policy and procedures.
When it comes to cash, you're especially necessary in handling that within cannabis, right? You want to make sure that you're managing deposits, making payments, reconciling your POS system that you have in place if you're at stage in your business. Too important to have cash counts. You want to make sure that you're comfortable with all the amounts of cash that you're recording and have on your books and records.
If you have a dispensary or a retail site, making sure that you have safe on site procedures that cash transactions are handled in a way where you feel good about your controls and whatnot. Before you even get to the projection piece of your cash and financial analysis, it's important to have some of those we'll call business management tools to really be able to feel comfortable about your cash flow projections and overall really well-being of your business.
The basic objective of a cash flow forecast is really you want to be able to generate a cash balance prediction to make sure that all your obligations can be met. It's a feature that any potential challenges or issues that may arise, you're going to be able to get an understanding of your business, right?
To make sure that if you need to increase or reduce barring or revise payment terms or change credit policies or adjust potential investment needs, if you have some type of investor that maybe you're in a good place where maybe you don't need any additional capital, or you might have to go back to the drawing board and maybe long-term you feel like you might need more.
When you're creating this forecast and determining those future cash requirements, the first place you want to start really at any point, but if you're early on in a business or you're going through the application process, it's important to project the expenditures that you know you're going to have and determining how often you're going to do that, whether it's weekly, monthly, quarterly, to have an understanding really of how much cash you're going to have on hand. It's essentially to know those things.
Unexpected things happen with any business, whether it's a grow operation or retail or even if it's ancillary, whatever you have. In business, you want to be able to be prepared for anything unexpected to happen and protect yourself as market conditions really change. Putting into place certain considerations of unpredictability, track some of those items, and have an idea of how granular of an analysis you want to forecast.
To touch on a couple of the items of considerations specifically within cannabis, whether, again, you're starting out in the application process or as you move forward into grow operation or more retail, but all these come into play. Some of these I'm going to mention here. Seasonality, raw material costs are going to change over time. It's important really for retailers to understand this, right? Keep an eye on input costs and whatnot that are going to potentially affect your margin. If prices increase, you want to be able to maintain a certain margin.
Understanding the seasonality of some of the raw material costs. Cultivators, depending on what the supply is at different times of the year, obviously there's indoor growth facilities and whatnot, but there are certain seasonality of flower market and dips in prices from that perspective that have an impact on your forecasting. Weather and climate. If we're about New Jersey here, right, it's a state in the Northeast quarter.
In the winter months, is that going to affect if you're a retail operation to the point where your sales are going to be a little less due to the weather. People stay inside more. Just considerations like that. That as overtime, you'll be able to track forecasting to real tangible evidence of impact on sales and revenue. Taxes, right? Taxes are a huge issue in this industry, and it’s really important to understand that as revenue comes in, you need to really track your estimated taxes.
Keep a separate account. Don't jump into that money. Make sure that you're going to be able to cover your tax bill when the time comes. It's very important to forecast for that. As you start to think about building your forecast, it's okay to maybe put one together and have maybe one or two scenarios. One is a little more conservative. One where maybe if everything goes right and you see how that's going to impact your business and think about some of the major factors that are going to play in, right?
Government regulations, new competition or licenses that are going to inevitably happen and just be able to track on a more granular approach. As you look at this, you start to have operations and you're able to compare actuals to forecasting to see maybe where you landed on your financial performance and create a more updated forecast as you progress is important. Not only building out your forecast, but tracking it on a monthly basis versus actuals. As we talked about a little earlier is you're going to start with your fixed expenses, right?
Your rent. Your mortgage. Your insurance. Licensing fees. Any of those types of fixed costs. Initially the expense piece of it is going to be a little more straightforward to forecast. You know the expenses that you're going to have, right? If you're building out a grow facility, there's going to site work, construction, operating expenses specifically relating to the building of your actual facility. To really make your forecast as accurate as possible, you want to build that out details based off of those costs.
And then as you get to a point where you're generating revenue as, okay, well, what's the cost of per square foot of your facility? And understanding the variable coast relative to your revenue, right? You want to be able to determine what the top line revenue numbers you need to hit for your forecast that makes sense. As you look into some of these items and understand, for example, you may some debt on your books and understanding how much debt, excuse me. How much capital do you need, whether it's debt or equity, for the size of your facility?
I think Justin mentioned it a little earlier. If you have a 50,000 square foot facility or 100,000 square foot facility, what's the amount of outside capital you're going to need as you plan and forecast as part of the application process? You're not just going to want to wing it and say, "Okay. Well, we have this size facility. This is how much outside capital we have."
It's important to put into some viable forecast of how that breaks down to the size of your facility, the revenue that you generated, how long of a time period is it going to take to the get to the place where you're generating revenue, and how much capital is needed, whether it's, again, some type of debt or outside infusion from an investor.
Justin Moriconi:To your point, just a footnote on that, I can't ever help but chime in when I hear my name mentioned. To revert back to the capital structure based on your recent discussion, when I talked about form the LLCs and then electing how you'd like to be taxed in that LLC structure, one of the things that was a hot item and is becoming back in vogue now, I had clients doing it and they stopped it doing it and now they're doing it now again, is electing C corp status.
Now, that election my understanding is for 60 months after you initially make the election and you're kind of locked into it. But what it does, if you have a number of investors coming in, you're worried about the IRS coming back three years later and saying, "Hey, guess what? You owe us about $2.5 million back from 2020." It's now 2023, 2024. In order to insulate the liabilities of the investors, that C corp election can be just another way to insulate the tax liabilities inside the corporation itself, rather than flowing through to the membership and the partners themselves.
For instance, if you elect a flow through partnership structure. To that point, there's thing you can do to insulate those tax liabilities in the event that you either miscalculated, or you think that three year ago, it's too long ago, the IRS isn't going to look, spend the money, do the fit out, do the build out, and now you're dealing with a capital call because you don't have the tax monies there sitting in the coffers. Nonetheless, you maybe insulated in the C corporation so the IRS can then, they can still get to the members. Don't get me wrong. There's things they can do. To Eric's point earlier, the IRS has never lost a dispute hearing in this space. But nonetheless, it is just another thing to insulate those investors. So just a touch on that point.
The one other thing that you did mention is when you talk about these capital costs, the availability of debt right now and going around, my understanding I'd like to hear your thoughts on the banks and the debt, but what I've seen is that based on cannabis monies alone, it's not enough to support the ability to get one of the loans from the banks, meaning they don't count cannabis money as an asset.
When they're going to look to get personal guarantees from all of these people for debt facilities, they don't look at the people who've made the most money in the cannabis business. They look at other businesses and other things. That's what they base their guarantees on. I like to think that that's getting a little bit looser, but it doesn't seem so. Things like the SAFE Banking Act, the MORE Act, things like that, what are your thoughts on those debt facilities, the banking opportunities?
Kevin McLaughlin:Yeah. Like you said, it's certainly evolved overtime from a couple of years ago, right? There's more opportunities. And obviously you're seeing traditional debt facilities, secure debt facilities, even equipment leases or sale these back transactions are becoming a little bit more prevalent and an opportunity to debt agreements. But I think as the industry continues to move forward here, you'll only see more capital sourcing through traditional debt.
If you're looking back from a couple years ago, there's certainly more opportunity from the capabilities of some of these facilities allowing for companies to obtain debt. I know you've obviously dealt with this every day. It's pretty obvious as we've moved along here, there's just more opportunities for obtaining debt and showing capabilities from a capital structure. I know we'll get into probably some of that a little briefly at the end as well in terms of capital sourcing, raising capital as well.
Justin Moriconi:Thanks, Kevin. I appreciate that. I think that's a great point you bring up. The real issue, if we're talking about New Jersey and social equity and micro businesses and owning 51% of the company, it can be very difficult to simply bring on private equity money when you have to keep 51% control of the company, and you're not bringing any capital to the table. If you are a minority living in one of these adversely impacted areas that has some money, but doesn't have the millions necessary to get the operation going, you're going to rely on private equity.
But you'd also like to think you can start to rely on potential debt facilities to actually make that a going concern that will be profitable and that you'll be able to keep that 51%. I'm hoping that in New Jersey, because of its social equity play on the micro business level as well, that we do see banks come into the table with some more aggressive debt terms. Taking an interest in the real estate itself. Leveraging the equipment like you talked about. Those are things that can happen. I'm hoping that opens up, but thanks for that.
Kevin McLaughlin:Yeah, of course. I'll talk a little bit more here about some of the finance/accounting piece of things, and I think it'll transition nicely into additionally talking about some of the capital sourcing. Financial statements are something I wanted to spend a little bit of time on, right? Having a clean set of books and records, while cash projections and forecasting are very important, those monthly, quarterly, monthly financial statements are going to be able to provide details of the complete health of a business, right?
You want to make sure that your books and records are supported properly. As entities scale and we've seen there's been a lot of consolidation and M&A activity within the industry, you want to be able to get the highest possible value as we're already talking about M&A, but you have to be realistic in the way that the industry has grown here. You want to make sure you're in a good place from an accounting/finance perspective, right?
So that as the business grows and you need to integrate the business, you have those pieces of the business in a good place. Again, we've seen things in the past where deals have got derailed based on a business being unable to produce legitimate financial statements or support their financial statements or been unable to get audited. We've seen that in the past here. Ultimately, you want to have best practice of, depending on where you are, periodic financial statements, right?
If you're just starting out, whether it's your grow facility and the retail said is monthly just a balance sheet, a P&L, cash flow, something like that. As you continue to scale and grow and maybe have other locations, maybe you have a review or a compilation or things like that from a financial statement perspective. As laws emerge here, there's going to be, like I said, more opportunity for debt facilities that maybe you might require an audit and whatnot.
But you want to be able to continue to not only grow your business operationally, but from some of the nuances of a financial statement and whatnot. Startups and capital raisers, investors, lenders, board members, they're going to have a strict corporate governance and approach the corporate governance and procedures and ensuring that all these type of things are in place. So that if an exit is needed or a consolidation or acquisition, you need to have a good base for these areas.
I know I went into a lot of detail here. Exciting stuff. But with all these things that we've seen in the industry, I think it's a good time to move over to the capital sourcing piece. I'd love to get your guys' thoughts outside of maybe the debt piece that we touched on a bit there.
Eric Altstadter:Sure. Kevin, thank you. We have a couple of minutes left, and I'll just talk for a couple of seconds, if I can. Certainly when you're raising capital, as Justin mentioned, there are two big pieces of legislation out there, the MORE Act and the SAFE Banking Act, that may open up the industry a little bit more. Right now cannabis companies do have a hard time getting a conventional bank to support them, which creates a number of issues, such as maintaining cash in a location. That is not very attractive for the company or the individuals that work at that facility. There is a safety issue when significant cash is maintained on site.
The hope is that the SAFE Banking Act will open up the industry a little bit more and allow more commercial banks to get into the industry. I think commercial banks can do it now. They've chosen not to for the most part because of the reporting requirements and the administrative requirements that are placed on them when dealing with cannabis makes hard to be profitable for a commercial bank so they chose to not get involved in the industry. Most of the banks that are involved in the industry tend to be credit unions or local banks.
To continue what Kevin was talking about, it's important when you go to raise capital, whether it be debt capital or equity, whether you do it from private equity or from family offices, to really have a good deck, a good analysis of what you need, have financial statements, have cashflow projections, which Kevin mentioned, are such an integral of what's needed. Make sure 280E is adequately accounted for in your cash projections also, because not having the proper item in there can really derail your cash flow projections.
And also have a sensitivity analysis. Supposed you're off by 10%, 15%, 20%, what does that mean to your cash flow and your numbers? Those are very important things to talk about, as is a history of your management team and your board of directors. How can they help grow the company? How can they help the entity become a success? You should also, for the cannabis companies, save some board seats available for people that are putting money in. They may desire a board seat as well. Justin, any thoughts before we finish up?
Justin Moriconi:Yeah, just one footnote on that point. The access to banking has always been a huge issue. We've seen the number of banks serving the cannabis industry grow precipitously up year over year. However, there's a litigation that should be mentioned out west with Eaze, a delivery company. It had to do with how they were processing credit card transactions. Normally credit card transactions because you have to get your registration number from the Federal Reserve are prevented from doing credit card transactions in the cannabis business.
You go to the retail location. You buy your pre-roll and you want to pay by credit card, right? Or even in this case, more specifically, you asked Eaze to go pick it up for you and they deliver it to your house and they want to pay by credit card. Well, what happens was Eaze wasn't disclosing to the credit card processor the fact that they were dealing in cannabis. Once they found that out, they tried to skirt around it. And lo and behold, they get sued. It came down that, of course, they're liable.
They agreed. For the liabilities, there were a number of high level C suite that stepped down off of the board. They brought a diversity director to help them out with some other issues as well. But it was a lesson on you can't get around it. We do need some relief federally, to your point, on the MORE Act and the STATES act. Something needs to happen, particularly if you really want to make it a true social equity opportunity for persons and entities and people that were adversely affected by these laws in the past.
And that's a big push for New Jersey. But that footnote of the Eaze litigation was the first of its kind in the industry.
Eric Altstadter:Great. And before I turn it back over to Lexi, I just want to add one other point. I think Justin was talking about the whole application process mentioned in New Jersey, that some municipalities will have the opportunity to opt out. That currently is also being discussed for New York. I know we didn't really get into New York rules, we focused on New Jersey, but New York is having similar discussions about opting out. It's interesting that, so far, two municipalities have said they're going to opt out.
Those two municipalities are Rockville Centre and Freeport, both on Long Island, which are well-known for thriving nightlife communities. It was an interesting opt out. And it remains to be seen what will happen going forward.
Transcribed by Rev.com
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Eric Altstadter CPA is an Audit Partner and Chair of the firm's Cannabis and Hemp practice with over 30 years of experience working with public companies and privately held businesses
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