Investing in Cannabis: Residency Requirements at a Glance

This post is part one of a series that highlights some of the most critical issues for cannabis investors.

We often speak with investors who want to invest in the booming cannabis market and need to navigate the constantly changing regulatory landscape and disparate rules implemented in states that have legalized adult-use cannabis consumption. New investors should first understand how the state(s) in which they wish to invest treat the investor (or investment company) based on their residency and their expected role.

Many states have differing treatment for out-of-state residents that are important to understand. For example, Washington permits out-of-state residents to finance cannabis businesses (subject to certain restrictions) but does not permit international financiers to provide the same financial services. In contrast, Colorado generally requires any direct beneficial owner to be a Colorado resident (or have received a finding of suitability from the state) but does not have the same requirement for indirect beneficial owners and qualified limited passive investors. To the limited extent that Colorado permits an out-of-state resident to own an interest in a licensed cannabis business, even one out-of-state investor can trigger a cap on the total number of owners (residents or not) that the business can have.

In addition to residency, the role an investor expects to have in the cannabis company may affect how the state classifies the investor. New investors should understand what each state means by “owner” of a business. In almost all the cases, state regulations classify both the person who actually applies for the cannabis license and intends to run the business (the “applicant”) and the person who provides financial backing to the business, but does not participate in the management of the business (the “financer”), as owners of the business.

In most non-cannabis transactions, the identity of the ultimate owner of a business (i.e., a shareholder in the case of a corporation) is of little to no consequence. Yet, to state regulators of cannabis business, the identity of a shareholder, even if she only owns one share of a corporation, can make or break an entire deal from a regulatory perspective. Despite the regulatory differences in how the states have drafted their cannabis regulations, many states consistently construe ownership by looking through any corporate structure until they have determined every individual holding an interest in the venture. For example, Alaska wants to know “all human persons”. As part of the licensing process, the state will conduct background checks and require fingerprinting for most, if not all, individual “owners”, and their spouses. If one shareholder does not qualify, the company does not qualify.

California, in drafting their new cannabis regulations, seems to have realized that this level of digging can quickly turn into an administrative headache when companies have multiple layers of ownership. California follows all the other states in looking through the corporate entities, but when it reaches the final parent corporation, the state only requires disclosure of those individuals who have a 20% or more ownership interest in the applicant (this can get complicated) or who are directors of the parent company for purposes of background checks and application approval. Therefore, shareholders who hold only small interests in the parent corporation of the investment company will likely not disqualify the entire company.

To complicate matters more, many states do not stop at just those “human persons” that own an interest within the corporate structure of the entity holding the license. Depending on the financial arrangements that third parties have with the licensed cannabis business (e.g., a commercial contract with payment tied to revenue from cannabis sales), state regulators may even treat a non-equity economic relationship as de facto ownership for licensing and regulatory purposes. In practical effect, this means that licensed cannabis businesses need to exercise care in determining not only who their owners are, but who their significant ancillary service providers are.

A holistic strategy to corporate structuring is paramount to a successful investment in the cannabis industry. Please contact us with questions about investing in this industry.

Stephanie Gambino

Stephanie Gambino

As an associate in Dorsey’s Corporate Group, Stephanie’s practice focuses on corporate and transactional matters. She supports clients in both domestic and cross-border transactions ranging from corporate governance matters to securities offerings and general commercial transactions. Stephanie also supports clients with a variety of U.S. regulatory issues, including advising on issues relating to securities offerings and other highly regulated industries.

Jamie Klang

Jamison Klang

Jamison is an associate in the Benefits and Compensation practice group. He advises clients on ERISA, tax and related issues affecting qualified and non-qualified benefit plans as well as executive compensation arrangements.