To expand or not to expand into new states?
That is the question faced by cannabis brands that sell products and have developed customer loyalty in their home state. In a Shakespearian query, we find the dilemma that currently plagues a number of cannabis industry stalwarts as well as start-up companies looking for quick profits.
In the path of easy expansion for cannabis brands are separate state regulatory schemes, lack of systematic inter-state distribution models, and potential lack of product awareness state to state. In addition to the foregoing, due to the nature of the different products and delivery methods for cannabis, some traditional methods for expansion are difficult to employ. For instance, a vaporizer brand may be able to translate across state lines as a hardware device quite easily (put aside state and federal paraphernalia laws for a moment). However, if that device is a disposable vape pen which contains cannabis concentrate, the equation becomes much more difficult.
Is the brand which wants to expand into other states offering to potential partners a joint venture agreement, a distribution agreement, a licensing agreement, or even some other form of contract which allows the parties to work together in some form under the particular legal framework in a particular state? Have the parties considered that depending on how the royalty may be structured they could be in violation of local regulations? For example, a share in percentage of profit in Washington State may be in violation of I-502 rules and Washington Administrative Code.
I do not include hemp based CBD products (which contain less than 0.03% THC) in the discussion. I have generally seen those distributed under a standard wholesale distributor agreement. I am also putting aside what side of the debate I fall on in regard to the legality of selling hemp based CBD across all 50 states. One such agreement which I viewed was essentially a distributorship agreement and was made easy by the parties’ determination that they were not subject to particular state regulations except for a few industry specific clauses.
The focus is on agreements which seek to allow existing and presumably well-branded and profitable cannabis brands to expand to other markets in some legal fashion. Interestingly enough, the position taken by those companies looking to expand is often one based on success in their local markets and a feeling that their product is superior and should command not only consumer loyalty in other states, but well-heeled partners capable of success.
For example, I am aware that a certain Colorado vaporizer company requires a $5,000 up-front vetting fee, two years of tax related documentation, demonstration of business acumen in running a seven figure business, and at least $400,000 in available capital for potential partners. At that point, and at that point only, will this particular company consider working with a potential distribution partner.
A number of other brands that have generated sales and developed brand loyalty in their home market have fielded inquiries from fish nibbling at the bread, without any quality bites. One successful California brand received at least 18 inquiries in a 6 month period from people looking to bring its products to their particular state. Once meaningful discussions started, the prospective partners soon fell by the wayside. It is obviously time consuming to vet all these prospective partners who are just kicking the tires, so to speak.
To some extent, the expectations of brands that have been successful in their local markets as well as the expectations of the potential partners for licensing/distribution are both somewhat unreasonable. I equate their expectations to the two sides in a lawsuit who are often dug in to their respective positions, blinded by their own bias, and ultimately forced to come to a middle ground. I think this is what will happen more and more as brands expand into new states and everybody realizes that the true value is not set until the local market actually sets it.
Royalties and fees are generally comprised of an up-front fee, an ongoing lump sum fee or a rolling royalty. A royalty is usually either a percentage of net sales or gross sales or an amount per unit of product sold. Many valuation methods are traditionally used i.e. a cost approach, comparable market approach or perhaps an income approach (i.e. 25% rule). The problem with all of the approaches in states where the entrenched brand may seek to expand into is that proper data may be lacking to accurately assess a true market comparison or have adequate financial projections from the potential partner to frame a reliable income approach. Even the difference in wholesale cannabis prices may come into play. For instance, as of January 15, 2016 there was an approximately $1300 difference between wholesale prices of cannabis per pound in California as compared to Illinois and Michigan.
It is common for those brands that have a product, such as vape pens or edibles, which in turn are either filled with a concentrate or infused, to provide all the raw ingredients and packaging materials to a local partner that then can produce and finish the processing so the product can then be distributed in the local market. This idea often encompasses the delivery of packaging, hardware, product, and/or other tangible items with only the end cannabis product (the part that can’t be shipped across state lines) to be provided by the licensee.
One would expect that any agreement articulates who is responsible, if at all, for national and/or, depending on negotiations, local marketing budgets and spend. Given that most online publishers, online ad networks, Google, and TV networks, among others, don’t accept cannabis advertising dollars, cannabis marketers have to spend their money creatively. Who is responsible for budget and marketing decisions in the local market or whether the local licensee is obligated to contribute to national media buys, such as the back page of High Times, should be included in any agreement.
I have often seen the desire for some type of up-front fee to be paid either during the initial term with the potential for on-going lump sum often tied to exclusivity. The formulas thereafter have run the gambit from mere dollar amount per product to percentages of gross sales, often with varying definitions of what makes up gross sales. The percentage royalty rate has mirrored that seen in other industries of 4%-10% of the wholesale prices which is interesting as it probably does not take into account the cost of labor and cannabis concentrate to complete production (which is not typically required for other types of product categories).
For example, when a Brazilian distributor negotiates an exclusive agreement to sell a US beauty brand in Brazil, they expect to be shipped pallets of fully packaged products, ready to be immediately placed onto store shelves. They don’t expect to be shipped the component parts, along with kilogram tubs of raw ingredients, to be assembled locally. Assembly is an additional cost.
Additionally, anecdotally, many an agreement, whether it be licensing, distribution or otherwise, include a minimum purchase and/or sale requirements or quarterly attainment numbers. While often seen in the traditional setting, many of the agreements may include this language at inception but ultimately it is removed due to inability to provide reliable projections in a nascent market. It takes a sophisticated potential licensee or partner to model accurate financial forecasting for that particular market, especially in emerging markets which tend to get off the ground rather slowly, i.e., Illinois and New Jersey.
A number of agreements I have looked at are premised on traditional agreements outside of the cannabis space, yet they fail to incorporate some of the particular language that lawyers that may be doing cannabis related work are putting in clauses relative to particular cannabis industry clients, i.e., clauses that are forward-looking for the possibility of potential regulatory changes in a jurisdiction and/or federally, in addition to clauses that address certain defenses germane to the Cannabis topic i.e. waiver of illegality defense.
In summation, as new states legalize medical and / or recreational cannabis and trade shows proliferate to connect players from various states, many well branded and established cannabis products are seeking to expand into new states and many newcomers are seeking partnership opportunities in some form. Unlike distributing coco coir (a grow medium) or some other ancillary product there are many hurdles for those who sell products that contain cannabis.
I am almost left with the impression that some companies are taking shots in the dark at determining deal points while others have turned to traditional legal counsel and distribution experts to help craft frameworks. The real benchmark I suppose exists in how many of the arrangements to date have been successful and lived up to the expectations of either side.
If one is able to effectuate one of the agreements, it is important to think in advance where jurisdiction of the dispute should take place considering that some courts may not enforce an agreement related to cannabis, a federally controlled substance.
Certainly one would want to not subject a particular agreement to state or federal jurisdiction that prohibits cannabis businesses. For instance, the Courts up until 2012 had viewed cannabis contracts unenforceable in states such as Arizona, California, and Colorado. Colorado was certainly on the forefront in 2013 when the General Assembly passed a law indicating “a contract is not void or voidable as against public policy if it pertains to lawful activities authorized by” Colorado’s Constitutional and Statutory Cannabis Law. Recently cases have moved forward in the State of Washington and interestingly enough, Florida wherein the entities involved were tangentially involved in cannabis related activities.