Competitive Compensation: Paying Cannabis Employees with Equity

As the marketplace for marijuana business experience becomes more competitive, cannabusinesses will look for creative ways to hold onto talent. The classic response, especially for a new business in a young industry, is to offer equity-based incentive compensation to key employees.

For those who have been a part of the industry since pre-legal days, it may seem like corporatist heresy or perhaps a welcome, if not overdue, piece of the pie.

For transplants from other worlds, like the tech sector, it is simply the way things are done.

For angel investors and venture capitalists, the prospect of sharing equity with employees may not be entirely welcome.

This is marijuana, so of course it’s complicated. Whether it is a good idea to offer equity to employees will depend on a number of factors, including:

  • how urgent it is to keep employees,
  • whether there is a reasonable prospect that the value of the company will increase,
  • how common the practice becomes in the world of legal marijuana,
  • what the corporate structure of the business is, and
  • how and when the majority owners plan to exit.

By contrast, how to do it is intricate and requires good legal and tax advice.

If the business is organized as a publicly traded corporation, which few cannabusinesses are yet, the two most common options are stock grants and restricted stock grants.

In the first option, the key employee is given a certain number of shares. If the business does well, the value of the shares increases so, at least in theory, the employee has an incentive to give his or her best efforts. In practice, stock grants may not be particularly effective incentives in the marijuana industry because success still depends on the legal environment, among many other factors outside of an employee’s control.

Restricted stock grants, on the other hand, are designed to vest at some time in the future, often five years, if the employee does certain things. This may be simply staying with the company or meeting certain contractually defined goals. The reward, although in the future, is more closely linked to factors within the employee’s control.

Another option, a phantom equity plan, really does not involve a stock award at all, but gives the employee an amount of cash at the expiration of a certain period of time that is pegged to an increase in share value. For owners concerned about dilution of control, a phantom equity plan may be a better choice.

Broad-based employee stock ownership plans, or ESOPs, are more likely found in large corporate enterprises, and are often used to prevent corporate takeovers. If consolidation becomes an issue in the cannabis industry as it has in the beer industry, employee ownership of the enterprise through an ESOP is a way to protect independence.

But more cannabis enterprises are actually structured as limited liability companies, or LLCs, than as corporations. Since there is no stock, there can be no stock grants of any kind. Equity in the business takes the form of membership interests. Sharing equity with key employees requires some thinking by analogy. Two basic options have emerged: capital interests and profits interests.

Granting a capital interest shifts a portion of the equity in the LLC to the employee as of the date it is awarded. Thereafter, the employee also receives the benefit of any increase in the value of the business, as he or she would with a stock grant.

Granting a profits interest does not give the employee an ownership interest in the LLC, but only a pro rata share of the future profits and appreciation in value. The members of the LLC lose no control, but the employee who wants a voice in the running of the business may be less than satisfied.

Incentive-based compensation for valued employees, whether equity based or not, may become a feature of the world of legal cannabis. This may be especially true as legalization becomes the norm and the industry attracts talent from other areas of the economy. Whether it is the right choice for a business that is moving out of the rawest start-up phase and into profitability, depends upon the shape of future plans as well as the immediate need to retain talent.

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