How to head off partnership disputes before they happen

(This story appears in the February issue of Marijuana Business Magazine.)

Partnership disputes — whether between business partners or owners and investors — continue to be an ugly feature of the marijuana and hemp industries. Such conflicts can be costly and time-consuming; plus, they can sink a cannabis company.

But there are steps companies can take to head off disputes—or at least manage them more effectively when they do happen, which is all too often.

“In terms of litigation in the cannabis industry to date, the most common issue we probably see is partnership disputes,” said Cassia Furman, managing partner of Vicente Sederberg’s California practice.

For any business, a fight between partners can divert millions of dollars in financial resources into legal fees. That is especially true with cannabis companies. The industry is young and rife with inexperienced operators as well as friend-and-family investors who might neglect to draft documents governing their business relationships.

In addition, many legal operators are former illicit-market players who didn’t draw up contracts before legalization because they didn’t want to leave a paper trail for law enforcement. Now, these owners have carried that habit over into the legal market.

To avoid legal pitfalls, marijuana operators can take a variety of steps to mitigate the risk of and damage from partnership disputes. Those steps boil down to:

• Vetting partners and investors beforehand.
• Putting ownership, investments and other business relationships on paper through formal contracts and agreements.
• Having attorneys review those documents to ensure they don’t contain terms that could be detrimental.

Many Different Conflicts

Disputes typically arise at two points in a business relationship, said Katy Young, managing partner at Ad Astra Law, a cannabis-focused law firm in San Francisco.

Disputes can happen when the company is doing poorly, prompting the partners to start fighting and blaming each other. Conversely, disputes can come up when the company is making lots of money and partners get greedy and try to push others out.

Young said it is also important to recognize the types of personalities and situations that can give rise to conflicts.

One problem she often sees is when startup marijuana business owners overpromise the amount of money investors will earn. These investors often are friends and family, and the owner ends up owing too much money to too many people.

Another common situation includes what Young calls the “absentee financier.” In this case, a financier might give a grower a large sum of money to purchase a greenhouse. Next, the investor gives the marijuana operator—who often has relatively little business experience—control of the bank account, like any other company owner.

The investor takes their “eyes off the ball” for several weeks or months—only to return and find the bank account is empty and the cultivator has only excuses to show for it: The crop was stolen, for example, or bad weather damaged the plants.

In other cases, Young said, partners neglect to write contracts or agreements when they tap friends and family for loans or investments, complicating the settlement of any disputes that develop.

Another problem is mismatched personalities—for example, one partner funds a venture and the other puts in sweat equity and works much harder. In the end, the funder feels more entitled because of the financial risk he or she took. By contrast, the other partner feels more entitled because he or she worked much harder.

Garrett Graff

“Oftentimes, we see partnership disputes arise out of half-baked partnerships, operating agreements or bylaws and shareholder agreements that do not appropriately encapsulate the relationship,” said Garrett Graff, managing partner at the Hoban Law Group in Denver.

Put It in Writing

Such partner disputes can be relatively easy to avert — or at least be made easier to settle — without having to go through litigation if the parties formally record their relationships on paper through investment agreements, loan agreements, operating agreements, shareholder agreements or company bylaws.

“At their heart, partnership disputes are contractual disputes,” Young said.

Those documents govern the relationships the company has with its owners and shareholders. If those terms are breached, that can lead to a lawsuit. Without the documents and contracts, individuals and the business itself are unprotected, Young said.

But many groups fail to create written contracts—or when they do, the contracts are often poorly executed.

“We’re are often dealing with disputes that have very little paper evidence,” Young said.

When operators do have the foresight to have contracts drafted, they often do it superficially. For example, they will try and draft legal documents with the help of web-based tools or templates. But without an attorney’s expertise, such a document can omit critical terms, leaving parties to the contract without legal protections found in professionally drafted documents.

Furman stressed that partnership disputes aren’t just an early stage company issue. They can come up in more mature and growing companies, too.

“You’re going to need to raise capital to scale, which is going to involve contractual obligations with the lender or investor,” Furman said. “Expanding in other states can also mean connecting with new partners—and that is another set of contracts.”

Contracts Are Not the Enemy

State-legal cannabis business operators shouldn’t fear contracts being used against them by federal authorities. Rather, marijuana business owners should view contracts as a shield. The more seriously a business owner takes its contracts—and the more competent the lawyer who drafts them—the stronger the shield will be.

“Have a voice in it. Be active. Hire a lawyer who is knowledgeable about local and state regulations,” Young said. “Never enter a contract unless you’ve had a lawyer look at it.”

Attorneys stressed that disputes turn unwieldy and ugly when there aren’t well-constructed agreements that govern ownership and how assets will be distributed when a partner exits the business, among other situations.

“It’s important to hire a really good transactional lawyer to help you form your corporation right in the first place,” Young said.

Indeed, dealing with these issues now can save tens of thousands of dollars in litigation later, depending on whether you’re working with a boutique law office or a national law firm. And that’s not counting additional, costly expenses such as gathering evidence to bolster your case.

“If there is evidence scatted all over the internet that proves investments or loans or expenses you’ve incurred, it costs money to get vendors to retrieve that information and pay paralegals to put it together. It’s usually five or six figures,” Young said.

Furman advises clients to talk about the relationship that they’re forming and what they want to get out of it before actually committing to a definitive agreement.

“Come up with a detailed term sheet and actually find out if there is a meeting of minds with either the investor or the white-label relationship that you’re trying to enter it through,” she said.

Beyond that, official documents such as operating or shareholder agreements can help push partners to consider important details that can make any future breakup less harmful to the business and the individual parties.

“Not only does it set the legal parameters for how to conduct and, if needed, unwind the business, but it also forces parties to think about term sheets and where they might be in a year or two if the company is successful, or if the company is not successful. Have some of those discussions at the outset,” Furman added.

“You could do all sorts of diligence on your partners, and that’s always helpful. But it’s difficult to have that crystal ball as a business owner to know how the relationship is going to develop until it’s actually tested. So, protecting your interests with contracts is certainly a recommended protection.”

Factors to Consider

Graff said scores of issues must be considered in any agreements. These issues include:

• Voting rights—such as how much do votes count for, and are they per person or per share?
• The provisions governing a partnership or company’s dissolution. For example, if one partner or shareholder wants to sell, does he or she face restrictions governing the terms of the sale or the potential buyer? The other partners or shareholders, for example, might not want shares or ownership interests transferred to a personality that doesn’t mesh with the remaining team.

When drafting agreements, Graff said, lawyers should consider how the partners are working in the present and anticipate potential scenarios should they not work well down the road.

“Those are tough conversations to have when the going is good and everyone is still in that honeymoon phase,” Graff said. “Of course, it becomes far more subjective and emotional when you’re in an actual dispute.”

Omar Sacirbey can be reached at [email protected]