Cannabis Knowledge & Insights

Cap Table Mistakes That Can Kill Your Cannabis Company (Part 2)

When deciding to go public, your business will be under extreme scrutiny, especially the ownership structure.  And critical cap table mistakes can kill a cannabis company before it even has the chance to IPO

This article will review:

  • Some of the common mistakes cannabis companies make when dividing the pie of their company.
  • How immediate vesting for founders can cause huge issues later on down the road.
  • Poor record-keeping now can be prevent your company from ever going public.

Just like we discussed in Part 1 since you’ll be in the process of raising money from the public, the deal will have to be underwritten by a bank. Therefore, excellent record-keeping is paramount to making it through the IPO process.

Remember, the inability to accurately outline the ownership structure and its future potential changes can prevent you from going public. 

Further, if your cap table is messy, who will want to invest in your business? A clear-cut cap table provides a clear understanding for investors to vet who they’re working with and how you’re managing your business. 

3 Common But HUGE Cap Table Mistakes

Mistake 1 – Immediate Vesting

One of the biggest mistakes operators make is giving immediate vesting for founders and critical first hires, including additional c-suite officers. 

When starting a business, founders have an aligned vision, work ethic, and drive to succeed. But as we know, life happens, and issues arise. But this also means that founders can lose interest or change direction for personal or professional reasons.

The worst case scenario is when you have a founder who holds a substantial stake in the company and they stop contributing. This could ultimately can drag down the entire business, financially and emotionally. 

Instead of immediate vesting, you want to look at vesting over extended periods. For instance, we recommend a minimum of three years. Or, better yet, developing performance-based vesting milestones such as revenue generated or units sold. By analyzing performance and measuring success, you can complete vesting of equity by aligning incentives and consequences. 

Whatever you decide, it’s critical to ensure you are documenting and executing vesting parameters in great detail in your equity tracking document or software.

Mistake 2 – Not Using an Equity Tracking System

Another mistake we often encounter is the failure to utilize a system for recording equity and supporting documentation for those positions. We hit on this topic in Part 1 of this series, but in this portion, we will dive deeper. 

It’s imperative to maintain absolute assurance with record-keeping procedures. If not, it significantly limits the upside of the company. It can also reduce options for future exits and opportunities to gain liquidity.

Let’s look at two common scenarios.

What’s Wrong with Handshake Deals?

Though not a recommended practice, many operators in the cannabis industry still operate on “handshake deals.” 

Lack of documentation and formalization of verbal or handshake agreements can lead to major problems down the road. Your operation runs a massive risk by not clearly outlining business deals and how they impact the financials of the business, such as how you are distributing ownership. And this can lead to misunderstandings when the stakes are significantly higher later on. 

We always recommend that our clients get something down on paper, signed, and agreed upon by all parties. And for more cumbersome business deals, engaging with separate legal counsel may be necessary. 

If all goes well, you look at the contracts two times: once when you sign, and once when you cash out!

Utilization of Poor Record-Keeping Systems

A second common scenario is that some cannabis companies may use a spreadsheet to track stakeholders, such as people and other organizations that own equity in their business. 

We’ve also come across operators relying on paper contracts or emails to document a paper trail for equity. At the same time, some operators still don’t have any type of monitoring in place or set schedules to review equity holdings. 

Either way, this type of laissez-faire attitude towards ownership is incredibly hazardous to the financial well-being of a company. Why? Because you’re dishing out access to your business blindly. 

Think about it, what if you get locked out of old emails, and the contracts are no longer available? Or what if old data is not backed up or appropriately monitored? 

The most important takeaway is not to operate without the guidance of all your important documents to substantiate the ownership allocations of your business. Legal battles over equity can be costly, personally tiring, and leave a blemish on your brand in the financial realm.

You desperately need a sound tracking system in place to effectively monitor your cap table distribution. This responsibility generally falls to the CFO of your company. 

However, if you do not have a CFO or are unsure about how to get started, we have an Outsourced CFO service at GreenGrowth CPAs that can get the job done for you. If not done correctly, this can create huge problems later on when trying to go public or even raise your next private round of capital. 

Mistake 3 – Exercising Options Too Late

The last mistake we will review covers how operators and their employees utilize their options too late in the game. 

Incentive stock options can have substantial tax advantages. 

For example, say a company is still private and a few years out from going public.  At this point in time, when these options are held by employees, they are not responsible for paying taxes on the purchase of stocks. And they only pay after the sale of the stocks. The buying of the stock and selling of the stock happens on different days which can be years apart.

In this first example, the shareholders only pay long-term capital gains taxes (if stocks are held over 1 year). This means lower tax rates in comparison to ordinary incomes taxes or short-term tax gains. 

Now, in a second scenario, if the options are exercised as the company goes public, the buying and selling of the stock happen on the same day. This means that the tax would be higher since the holder gets the income instantly after exercising options. 

By exercising options too late, employees (and other stakeholders) are paying ordinary income taxes on the value they received. And the tax rate can be up to 37% for these types of scenarios.

Next Steps

To learn more about managing your cap table, performing an audit, or going public, reach out to our team of financial experts at GreenGrowth CPAs. We are here to help your cannabis venture through any level of the accounting, tax filing, or business cycle. 

We employ several financial programs to assist the company with its fiscal responsibilities, including tax planning and compliance, outsourced CFO support, audit preparation, tax controversy support, and much more.
For recommendations and assistance with tax planning and accounting services, schedule a free consultation or contact us at 1-800-674-9050.