The Problem with Marijuana Industry Startups

By Brett Melson Monday, January 9, 2017

cannabis startups

The cannabis industry is one of the nation's fastest growing industries and is generating enormous interest from entrepreneurs, investors and, of course, regulators and tax authorities. 

Twenty-eight states and the District of Columbia have legalized medical marijuana, with fourteen states authorizing the sale and use of medical marijuana just within the last five years. 

Eight states and the District of Columbia have gone further and passed laws permitting the recreational use of cannabis and cannabis products.

Despite the impediments the industry faces from practical and regulatory obstacles, the legal cannabis market is presently valued at $2.7 billion dollars annually; in Colorado alone, cannabis sales reached $1 billion within the first ten months of 2016.  

Since Delaware is known as the Incorporation Capital of the world, we have also seen a large number of startup companies that are operating in the medicinal or recreational marijuana industry.   

The easiest part of opening a business in the cannabis industry is the formation of the company. While Delaware allows the formation of companies in the marijuana industry, it will not allow the use of the word “marijuana” or any similar terms in a company’s formation documents.

Stocks associated with corporations in the industry that are listed on the publicly traded markets have seen tremendous gains in the last year. However, despite the growth and potential of the cannabis industry, there are a number of difficulties for those operating in the space, primarily due to the treatment of cannabis under federal law. 

Marijuana remains illegal under federal law. It is a Schedule 1 controlled substance. Even in the jurisdictions that have legalized medical and/or recreational use of marijuana at the state level, the cultivation, sale and possession of marijuana remains a violation of federal law.

medical marijuana industry

Per a Supreme Court precedent, federal law criminalizing the use of marijuana trumps any state laws that legalize its use.

The Obama administration has adopted a policy allowing states to implement marijuana legalization laws; under this administration, federal agencies have not sought to prosecute those operating in accordance with applicable state laws. 

Since marijuana remains illegal under federal law, most federally chartered banks and financial services companies will not open accounts for, or process transactions with, businesses operating in the cannabis industry. 

Proceeds from the production and sale of cannabis products are currently considered drug proceeds under federal law; as a result, banks that deal with cannabis companies risk potential seizures and/or enforcement activities by federal agencies. 

Although some smaller banks are willing to assume a greater risk in dealing with cannabis companies, most large banks simply find the emerging cannabis industry too risky from a regulatory perspective.  As a result, many cannabis companies cannot open or maintain bank accounts or process credit card transactions.

Due to these banking complications, cannabis companies cannot use traditional banks or other financial services, so they often operate as cash businesses and thus have difficulty documenting the source and movement of funds for tax filings.

Holding significant cash not only raises security issues (robberies of cannabis companies are a very real problem), but it also brings intense scrutiny from the IRS, state tax agencies and the Treasury Department, which polices money laundering.  

Cannabis companies are a frequent target of IRS audits, state tax agency investigations and Treasury Department inquiries.

In addition to the operational difficulties related to the inability to access banking and financial services, cannabis companies are often unable to obtain bank loans or even mortgages on properties that will be used in the operation of a cannabis business. 

Other market participants, such as commercial landlords and insurers, are also hesitant to do business with cannabis companies. Many commercial leases contain provisions that prohibit use of a leased property for activities that are illegal under federal law. 

As a result of these issues, cannabis companies generally pay far higher rates of interest on lending from alternative capital providers; pay higher rents from landlords willing to lease these businesses space; and are forced to forego insurance that any business would otherwise obtain.

Even if the federal government were to soften its stance toward cannabis, it is likely that the Food and Drug Administration will move to regulate cannabis. Such FDA regulation, among many other potential sources of regulation, could prove to be highly burdensome. 

Thus legalization may not cure the marijuana industry's regulatory woes and may, in fact, increase them. However, there is a growing number of enterprising startups that are trying to solve these problems, such as Tokken, which aims to help marijuana dispensaries manage their huge influx of cash.

It is unclear how state and federal laws and policies will evolve, although many people feel complete legalization is inevitable.

Until then, participants may see the cannabis industry as a tremendous opportunity and a new gold rush (or green rush), but they will need to overcome a number of practical and regulatory obstacles and deal with significant operational headaches until cannabis has become more widely accepted by government agencies, traditional financial services institutions and the market as a whole.

Next: Cannabis Industry Guide



*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source’s content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.

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There is 1 comment left for The Problem with Marijuana Industry Startups

Marijuana Seeds Bank said: Tuesday, June 5, 2018

Thank you for this informative and valuable article. Such a big help for us.

HBS Staff replied: Tuesday, June 5, 2018

Thanks for reading our blog!

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