There is a direct correlation between the complexity of a state marijuana business licensing system and the complexity of financial deals that industry participants undertake. Washington, Oregon and most of all, California, provide fertile grounds for increasingly complex deals. Outside of cannabis, my firm sees similarly complex transactions proposed in our international business practice, especially in our China law practice which is another body of law requiring specialized knowledge. Regardless of circumstance, though, it is vitally important that parties to a deal firmly understand how the deal shifts and manages risk.
Complex transactions can feel like a game of hot potato. Here is a relatively simple example that demonstrates some of the complexity I’m talking about: Sally signs a supply contract with a large processor to provide bulk raw material. Sally realizes that she can’t service this herself, so she asks Henry, who has a background in servicing large orders like this, to use his experience in coordinating and managing production to service the contract. Henry realizes that he needs significant capital to expand capacity and turns to outside investors. Those outside investors want security before they invest, so they ask for, among other things, a pledge from Sally of her contract rights to receive payment from the processor as collateral.
In a perfect world, Henry gets the investment and uses it to provide the raw material. Sally and Henry provide them to the processor and split the contract fees they receive, some of which go to pay back the investors. Everybody wins.
Sometimes deals like this do work for everyone. But there are so many different ways that they can go wrong. None of the parties should enter into the deal without understanding what the consequences would be of various potential failure risks. In the example deal, there are plenty of potential failure points:
- Can Sally coordinate production to service the contract?
- Can Henry actually produce?
- If Sally and Henry can produce, can the processor actually pay?
- What if state regulations change and disallow contracts like this midway through the production cycle after money has been spent?
All of the parties in the deal need to understand their exposure at each stage of the deal from beginning to end, in order to negotiate the arrangement but also to perform under the contracts. We have seen deals like this look like they are on a good path until, at the last possible moment, the processor decides that they can’t pay for the product.
But that’s the crux of almost any business arrangement. There is a moment where a party spends money with the anticipation of receiving that back with a return. Whether or not the return comes is a function of risk. Businesses that do best are those that can understand and quantify risks and that understand how best to shift risk and hedge against downside. Whether the hedging/shifting mechanism is through security agreements, outside insurance, or reliance on lawsuits, parties need to understand the costs and benefits of each in order to properly manage their risk position.
Risk isn’t necessarily bad. But if a party is taking on a significant portion of the risk in a deal and that risk isn’t properly hedged, that party should receive the lion’s share of the potential upside.