Colorado Law Change Puzzles Marijuana Investors
Originally published on May 18, 2015. Updated on June 2, 2014, to address an additional perspective.
On May 6, 2015, Colorado legislators approved a measure that appears to ease restrictions on out-of-state investment in marijuana businesses. Although the law does not eliminate the existing two-year residency requirement for investors, it creates a work-around that, according to Amanda Ostrowitz, Co-Founder and Chief Strategy Officer of CannaRegs, Ltd., “will make investment significantly more appealing and ultimately support the creation of an efficient secondary market for capital and debt investments in the legal cannabis trade.”
Others are not so sanguine. Jonathan Cooper, CEO of ebbu, LLC, sees the measure as confirming the legitimacy of an already-existing practice with respect to convertible notes, but restricting the ability of legal Colorado businesses to seek capital from non-U.S. persons. In his words, “It is still impossibly difficult for licensed Colorado marijuana businesses to raise capital because of the two-year residency requirement.”
Colorado law currently provides that a license will not be issued to a prospective marijuana business owner who has not been a resident of Colorado for at least two years prior to the date of the application. The restriction seems an effort to demonstrate good faith in honoring the Cole memorandum’s focus on preventing revenue from the sale of marijuana from going to criminal enterprises and preventing the diversion of marijuana from states where it is legal under state law to states in which it is not.
But it discourages investment. As Steve DeAngelo, co-founder of the ArcView Group told the Atlantic in 2013, “The investors are here. They want to do the deal. But the deal can’t be done because Colorado law won’t allow it.”
For out-of-state investors, the two-year residency requirement makes equity investing impossible and debt financing less attractive because of the hurdles a lender must overcome to convert a loan into equity. Some creative approaches to the latter problem have arisen, but they have the unfortunate side effect of making financing arrangements opaque, precisely the opposite of the residency requirement’s intended effect.
How much difference will the new law make? The regulations, to roll out by January 1, 2016, are expected to confirm that cannabis businesses may raise funds through the issuance of convertible notes to out-of-state individuals, but not foreign investors. The term of art is “permitted economic interests.”
This arrangement allows the holders of debt to purchase equity when they otherwise meet the state’s requirements for ownership of a licensed cannabis business.
How investors will respond is uncertain, but the disappointment expressed when the residency requirement was first imposed suggests that there may be pent up demand. As far as Colorado cannnabusinesses are concerned, the jury is still out.
On one hand, optimists hope that the change could make a big difference. Ostrowitz anticipates that:
- The larger potential pool of investors should drive down the interest rate on debt financing, which is critical to equipment dependent sectors such as infusion and extraction,
- Companies will be able to offer equity to investors at a more competitive price. This may ultimately allow entrepreneurs to hold on to a greater ownership interest in the businesses they have nurtured from the beginning of the green rush, and
- Businesses will be able to raise the kind of funds they will need to grow. It essentially levels the playing field for Colorado enterprises that compete for investment with businesses in states with no residency requirement. Some expect to see consolidation and an explosion of multiple-location chains.
Realists or pessimists, on the other hand, see no basic change in law, except that the clarity precludes certain kinds of out-of-state and non-U.S. equity investment.
The question remains about whether the current residency requirement serves legitimate law-enforcement goals or just starves legal businesses of the capital necessary for growth. The will to invest is certainly there, but only time will tell whether the new regulations will invite capital or discourage it.