As with any other industry, owners of licensed cannabis businesses often determine that their limited time and resources require utilizing the services of an experienced third-party management company to maximize the profitability of a business. This is particularly true when owners decide to expand their businesses by obtaining additional locations and/or license types to maximize revenue. In the cannabis industry, management service agreements (often referred to as “MSA's”) come in all shapes and sizes, but the issues that need to be focused on by the parties remain constant.
So what exactly should go into your MSA? Excluding all of the normal and necessary contract concerns like term, termination standards, material breaches, waiver, assignment, indemnification, disputes, etc., here's a list of considerations that should be specific to a MSA between a licensed cannabis business (“Company”) and a management company or person (“Manager”):
- Scope of Services
The services to be supplied by the Manager can either be specifically set out, or they can be defined broadly as providing “advice” and/or “assistance” in the management or day-to-day operations of the Company. Whatever approach is adopted, the MSA needs to be sufficiently flexible to account for the wide range of services that will be provided by the Manager (i.e., all services reasonably necessary or desirable for the operation of the business).
- Control and Authority
What the Manager can do on behalf of the Company needs to be made very clear. In order to do their jobs, Managers typically need to negotiate contracts (i.e., vendor agreements) and enter into commercial discussions on behalf of the Company. However, it's in the interests of both parties that the MSA makes clear that the Manager cannot bind the Company to any “material contracts” without having first obtained the Company's express approval. This will give the Company comfort that it is being kept informed of all that is going on. For the Manager, it also provides protection in that if a deal later fails it is hard for the Company to blame the Manager if the Company itself approved the deal. What makes a contract rise to the level of “material” is different for everyone - but typically a Company will want to define a “material contract” as any contract that obligates the Company to pay in excess of a predetermined dollar amount outside the normal course of business, or any contract that obligates the Company to add a “financial interest holder” or an additional “owner” to the license.
In the cannabis industry, there is no “standard” approach to how a Manager is compensated for its services. Some Managers are compensated for a set fee, while others are compensated with a percentage of income. There also may be a separate fixed fee for certain services provided by the Manager, such as accounting services, payroll services and marketing services.
Due to the significant overhead involved in operating a licensed business, it is not uncommon for Managers to receive a percentage of net profit (i.e., the actual income earned after the deduction of all costs associated with the business). In this situation, the MSA should clearly define what constitutes “net profit” and the parties should address the Company's right (if any) to approve the budget for the operation of the business.
However the parties finally decide to approach the issue of Manager compensation, it's important that the arrangement is fair to both parties as otherwise, over time, this may become a cause of tension in the relationship.
Management companies often use their own employees to provide services to the licensed business. This, however, often creates confusion - if a Manager's employee is providing services to the Company pursuant to an MSA, then who is the legal employer?
There are two main options. First, the Company and the Manager can maintain clear separation and treat the employee as separately employed by each company. This isn't really a good plan, however, because federal employment laws will likely treat the business entities as an integrated employer anyway.
Another option is for the Manager to serve as an employee leasing company (sometimes called a professional employment organization or “PEO), whereby the Manager will hire the employees, act as paymaster, and lease the employees to the Company. In this arrangement, the employees will not strictly be considered Company employees; rather, they will be considered leased employees who receive their W2's and other employment benefits from the Manager. Accordingly, the Manager is solely responsible for the compliance costs of payroll, employment taxes, workman's compensation, and medical benefits. This approach better protects the Company from being held liable for employment lawsuits filed by employees provided by the Manager.
- Accounting and Audit Rights
One of the best ways to combat the risk of fraud between a Company and a Manager is to ensure that the MSA contains an audit right clause. This is especially the case when the Manager's compensation is based on revenue. When either or both parties have audit rights, there tends to be greater trust in the relationship as it clearly sends a message that the parties will ensure to comply with the financial terms of the MSA.
A typical audit right clause contains such language as: “The Manager shall keep accurate and complete accounting records in compliance with applicable law. Upon no less than 10 days written notice and no more than once per fiscal year, the Company may audit or use a reputable accounting firm to audit, the Manager's records relating to its performance under this Agreement.”
It would also be a best practice to include additional provisions regarding audit findings and costs. For example, if the costs of any audits conducted by the Company are to be borne by the Company, the Company may require that the Manager reimburse the Company for the costs of the audit work if the audit results in substantive findings related to inappropriate accounting, non-performance, misrepresentation or fraud by the Manager.
- Regulatory Disclosures
Depending on the exact terms of the MSA, the odds are that the Manager will be required to be disclosed as either a “financial interest holder” or an “owner” on the Company's license if located in California. Be sure to address this in the MSA and include as a requirement that the Manager will have to submit to owner LiveScans, if necessary. If the Manager is an entity, the Manager will also have to timely disclose its equity owners, financial interest holders AND all individuals in control, direction or management positions. If these disclosures are not timely made to the state or local agencies, the Company will face major rule violations and fines. The MSA should explicitly address the obligations around these disclosures and any remedies upon default.
- Regulatory Changes.
As the industry matures, the rules will continue to change and they may (and likely will) affect your MSA as a result. For this reason, it's important to make sure that you reserve the right to amend the MSA to comply with the rules in the event that regulatory changes affect material terms in the agreement.
Although MSA's have long lived in the cannabis industry as a workaround to restrictions in legislation and regulation (from non-profit days to license caps in Los Angeles), they have drastically evolved in purpose and implementation. Make sure your MSA does not bind your hands or unknowingly drain your profits or violate the law..and of course, Manzuri Law's legal experts can help with this!
Disclaimer: This article has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice.