Mechanisms for Out-of-State Ownership in Colorado

Colorado’s regulatory environment for out-of-state ownership of cannabis businesses has changed often since 2014, and more changes are coming January 1 after the legislature voted in May 2016 to finally permit out-of-state ownership. Many of these changes are designed to allow for out-of-state money to flow into the state to alleviate banking and lending concerns so that the industry can maintain its competitive edge while other states seek to legalize marijuana. These reforms have been fast-paced and often poorly implemented or misunderstood. For an out-of-state resident who is interested in owning a cannabis business in Colorado, there are two options: wait until the ownership rules change in January or obtain a permitted economic interest (“PEI”) now to maintain flexibility.

In January, new laws and associated rules from the Colorado Marijuana Enforcement Division (the “MED”) will become effective that allow any U.S. citizen to apply to take an ownership interest in a cannabis business (subject to a criminal background check and other ownership qualifications). Up to 15 out-of-state residents may take complete ownership of a cannabis business if they have a manager, officer, member, director, etc. of the business who has at least one year of residency in Colorado. However, the MED will not permit potential owners to make appointments to begin the two-step application process until January, with a strong possibility that the MED will not approve the first out-of-state owners until the summer of 2017.

While some will wait for these changes to become effective in January, plenty of out-of-state residents since 2015 have obtained an indirect interest in a cannabis business through a PEI, which is a mechanism for individuals who do not already qualify for ownership to obtain a future contingent interest in a cannabis license, subject to regulatory approval.

Colorado law defines a PEI as “any unsecured convertible debt instrument, option agreement, warrant, or any other right to obtain an ownership interest” where the right to obtain ownership is contingent upon the ability of the holder of the interest to qualify as an owner. The vast majority of PEIs have been convertible notes whereby the lender loans money to a cannabis business, but instead of being paid back some or all of the entire loan amount, the lender (once qualified as an owner) can convert the outstanding debt into equity in the business. The MED must approve a PEI before the PEI holder can enforce the right to take ownership in a licensed business.

These types of contingent interests are quite common in the capital markets, but as is often the case, the cannabis rules are more complicated. First, the holder of a PEI must be an individual and not an entity.

Second, one of the MED’s biggest concerns with PEI applications is tracking the source of the PEI’s funding to the licensed cannabis business. In our conversations with the MED in seeking approval of PEIs for our clients, the MED has taken the position that the intent behind the PEI statute is for individuals who possess the financial means, but who do not currently qualify for ownership for other reasons (most commonly residency), to obtain a contingent interest in a cannabis license. That qualification, “who possess the financial means” is key.

The MED relies on federal guidelines when it comes to reviewing PEI applications (namely the Cole Memo). The MED will not approve PEI applications for convertible notes from individuals who have acquired their funding from someone else. Rather, the holder of the PEI must have the financial wherewithal to make the loan (e.g., money in the bank or other liquid securities) If a PEI holder has borrowed the money in order to make a loan to the licensed cannabis business, that person is disqualified from holding a PEI. Whether the MED is applying this same analysis to PEI holders of options or warrants is unclear.

Obtaining an approved PEI now rather than directly taking ownership sometime next year has one important advantage. The approval process for a PEI holder is expected to be similar, if not identical, to the “suitability” determination that out-of-state owners must first navigate next year before applying directly for ownership. Out-of-state ownership in Colorado will be a two-step process. Why not take that first step now rather than wait for the tsunami of suitability applications that will swamp the MED in 2017?