Interview: Breaking Down the Benefits of an ESOP for Cannabis Companies

Interview: Breaking Down the Benefits of an ESOP for Cannabis Companies

The announcement that Theory Wellness had become 100% employee-owned last month was met with celebration and some skepticism that one of its benefits – making 280E not applicable – was too good to be true.

But Andrew Nikolai, vice president at CSG Partners and an expert in structuring employee stock ownership plans, recently spoke with Green Market Report about the benefits an ESOP provides for any company – and why there are so few cannabis businesses taking advantage of it.

The interview has been edited for length and clarity.

So just to clarify, CSG Partners isn’t a cannabis-specific firm? How did it get involved in creating cannabis-related ESOPs?

Andrew Nikolai

Nikolai: As a firm, CSG has been around for about 25 years now. And we’ve done probably around 350 ESOP transactions. We’ve done the same transactions in virtually every other industry.

Because there are some unique tax benefits involved in them, it is at the end of the day somewhat of a tax-driven structure and transaction. So, when we learned about 280E and taxation in the (cannabis) industry a couple of years ago, and how punitive it is, that’s when we really started to get interested in using the same structure that we’ve helped our clients with in every other industry.

When we first started talking to people in the industry, there are certainly people who are kind of skeptical of this. I think it’s probably driven by the fact that there’s been other tactics out there to try and help alleviate 280E, and maybe some of them are a little bit more of a gray area in the tax code.

But this absolutely works. We’ve helped companies implement this ESOP voting structure and go tax free in virtually every other industry. It’s written into the tax code. These incentives are in there for a reason, and it’s because you really have support on both sides of the aisle for broader-based employee ownership.

The cannabis industry is no different. (The government) would have to basically rewrite or change the tax code for cannabis companies to not be able to benefit from the same incentives that every other industry can.

The ESOP we’re talking about stands for employee stock ownership plan. Essentially a trust is set up, and all the employees become the beneficiaries of this trust. The equity that’s being bought is bought by this trust. That gets divvied up and allocated out to employees over time to benefit them.

What sector do you typically do this work in?

Nikolai: I would say ESOPs are very common within the construction, engineering, and manufacturing spaces. We’ve done them in the business services space, consumer products like nutritional health supplements, and things of that nature.

Generally, ESOPs can work in any in any industry. Typically, we don’t really see ESOPs in very high-tech, high-multiple industries. So, we’re not really working with software companies that are looking to be valued at a multiple of revenue. These are generally more founder-owned and operated type businesses that have been around for a while or (are) steady cash flowing businesses that are a little bit more mature.

Obviously, the cannabis industry deviates from that a little bit just by it being a newer industry. But that’s typically kind of the profile that we see.

When it comes to cannabis, what has prevented cannabis companies from participating in something like this up until up until now?

Nikolai: If you look at the ESOP industry in general, I believe it’s still accounts for less than 1% of the overall M&A market.

A lot of what we do is really just education and trying to spread awareness about ESOPs. We talk to the owner of a construction company, and they ask us, how did they not know about this before? It seems too good to be true.

There’s I think just lack of awareness and understanding about these transactions. And, obviously, cannabis gets included in that. I don’t think there’s been any specific reason other than that.

It kind of reminds me of the employee retention credit. What kind of company, whether cannabis or not, wouldn’t want to do this?

Nikolai: You have to have an owner that’s looking to sell. If some clients we speak to still think they’re in growth mode, they’re focused on investing every last dollar into the business to open up more retail locations or open a cultivation facility, whatever it may be, an ESOP can still work because we’re unlocking all those tax savings and that cash flow.

But earlier stage, where maybe you haven’t actually realized earnings yet, it may make sense to push it off a little bit until you start to kind of see some return, or you’re not really going to get the value for it today.

That’s one example. Some companies are a little bit too small. Especially with companies in the cannabis industry, where you have a lot of part-time retail employees who generally don’t get included in the ESOP. It’s a benefit for full-time employees. Generally, we tell clients that you need to have about 20 full-time employees for the company to be able to support an ESOP.

I think one of the biggest challenges in the cannabis industry is there’s just not a lot of capital out there to support the industry and these transactions – so, selling your company. The ESOP is set up for this transaction. It’s not like a private equity firm that has deep pockets; they don’t come with any cash.

Typically, outside of the cannabis industry, what we do is raise financing or loan from a bank, and that provides the cash for the transaction. The problem with a cannabis transaction is there’s not a lot of banks that participate in the industry. So, most of these transactions, at least at this stage today, are going to be financed by the sellers. You’re essentially selling your company for a note. And that proposition sometimes isn’t attractive.

(Theory Co-founder and Chief Strategy Officer) Nick Friedman said that it’s essentially a much more robust retirement plan for employees. Do you agree with that?

Nikolai: I would agree, yes. It’s not something that the equity gets allocated out to employees over time.

If they leave the company, you have to roll it over into an IRA or some other retirement type of plan, or else you’re going to face the same penalties as accessing a 401K before retirement age.

What sort of requirements are there other than being a full-time employee?

Nikolai: Each company has the ability to kind of design the plan based on their situation. Most of the time, we see something like a year of service and a thousand hours worked will make you an eligible participant to enter into the ESOP.

And then, similar to a 401K match, there’s typically a vesting schedule that’s attached to the ESOP.

If someone wants to cash out, how would that work?

Nikolai: The way that works is, while you’re employed at the company, you will build up this balance of stock or equity in the company. And each year, there’s an updated valuation that’s done that tells you the price per share.

So, you can see the total value in your account, but it’s different from a 401K in that it’s a value held in a privately held company. It’s not like you can quickly sell the stock and cash it in.

Generally, you’re going to hold onto that value until you reach retirement age, or you leave the company. At that time, the stock is then sold back to the company. So, the company creates a market to cash that stock in.

That’s when you can take that cash value and decide, do you want to pay taxes and penalties to have access to it today? Or do you want to roll it over into some other type of retirement account?

Would rescheduling affect the benefits?

Nikolai: If cannabis does get rescheduled to schedule 3, cannabis companies would no longer be subject to 280E anymore. They would just be subject to corporate taxes like other industries.

Generally, when analyzing the value of the company, it’s the present value of their future cash flows. So, when taxes go down, cash flows go up, and the multiples should go up as well.

But there are ways in these ESOP transactions for the selling owners to retain some economic interests and ownership. Obviously, we’ve had to deal with this question from our clients. “Why would I sell today? If tomorrow cannabis gets rescheduled, valuations go up significantly, and I’m leaving money on the table.”

So, there are certain structures and ways where we can still let the selling shareholders benefit from that increase in value.

Each transaction is structured a little bit differently. I just want to make that clear. But essentially, you can have the selling shareholders retain a package of warrants, which is like a stock option. What that does is it allows the company to still implement the same tax-free structure, but also allows the selling shareholders to retain economic ownership that doesn’t impact that tax-free status, as long as the warrants don’t get exercised.

The last thing I would add is: I can’t understate the benefit to the employees enough.

We’ve seen some of our prior clients with lower level-employees – think of people like a janitor that makes $50,000 a year – ultimately walk away with a million dollars in their ESOP accounts. This is a very real and tangible benefit that becomes even more powerful and meaningful when you’re talking about an industry with a lot of kind of typically lower paid hourly wage retail employees.

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