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Considerations for CFOs in Cannabis Companies

CFOs for new cannabis companies often face immediate pressure from the company’s CEO and/or founders on finances and accounting. Here are a few things for cannabusiness CFOs to consider in order to enhance the company’s success:

Establishing the Right Organizational Structure

A critical decision for a cannabis CFO is choosing a tax entity status and setting up a corporate structure. While this is relevant for all companies, it is more complex for cannabis companies due to cannabis’ federal illegality.

Choosing a Tax Status

Cannabis companies generally register as either a C corporation or as an LLC. This is typically the first conversation that a CFO has and should be done in conjunction with both legal and tax advisors based on the company’s short and long-term business strategy and cash flow objectives. Despite the apparent tax benefits of pass-through taxation for an LLC, a cannabis company may decide that a C corporation is the best option because of the minimized personal tax liability. A C corporation also maximizes a cannabis company’s cash flow as it does not have to account for tax distributions of “phantom income,” as is often the case outlined in operating agreements of LLCs.

Setting Multiple Entities

Cannabis businesses often set up separate companies for tax structuring strategies and to isolate “plant touching” companies. A two-entity structure also helps to create brand value, which a cannabis company could look to sell or license to another cannabis company. This enables the brand to operate separately and license or sell its products.

Raising Capital and Setting Up Bank Accounts

One major issue for all cannabis CFOs is raising capital. This is challenging for any new company, but it is especially hard for a cannabis CFO as traditional sources of capital are limited due to cannabis’ federal illegality. Setting up bank accounts is also more challenging for cannabis CFOs for the same reason.

Raising Capital

Financing any business requires a balance of debt and equity, with companies ideally looking to minimize its weighted average cost of capital (the combined cost of debt and equity financing). Cannabis companies have historically experienced challenges in issuing debt due to the dearth of institutions willing to lend to them. However, the cannabis industry now has a growing number of debt providers ready to work in the industry. While raising capital is still a challenge for all CFOs, the process can be streamlined by preparing a pitch deck, financial model, and additional supporting documents.

Setting Up Bank Accounts

Demand for banking services has dramatically increased in the last few years, due to the legalization of adult use and medical cannabis in various states. However, companies have only recently gained access to a variety of financial services. While regional banks, credit unions, and a few federal banks are now providing limited banking services, most of the banking problems cannabis companies encounter will not be fully resolved until cannabis is federally legalized. Passage of the SAFE Banking Act would help, but obstacles will remain as banks may still be reluctant to provide services to cannabis companies because of higher overhead costs and the need for more training and education.

Establishing Systems and Controls

CFOs should expect an audit in the early years of operation. In order to facilitate the audit process, it is important to hire a cannabis accountant, establish proper internal controls, and implement the right systems.

Establishing Internal Controls

Cannabis CFOs should have written documents detailing the company’s accounting policies, procedures, and controls. The policy document should include the division of responsibilities and internal controls, such as including information on who reviews materials and approves decisions. It is also critical for a cannabis company to establish accounting controls in order to prepare its business for an IRS or financial statement audit. For example, employees who enter data into seed-to-sale and accounting software should not have access to money and inventory, and their work should be reviewed by someone else.

Focus On Inventory

The same control documents and environment necessary for accounting and cash are relevant for inventory. The lack of proper inventory control may lead to the rejection by the IRS of expenses related to the cost of goods sold (COGS). This is important, as these are the only expenses that cannabis companies can deduct under 280E. Controlling inventory is so important for cannabis companies that every state has a seed-to-sale inventory tracking system, such as METRC. CFOs should ensure that monthly physical inventory counts are performed and reconciled with the state inventory system and accounting software. This ensures that discrepancies are corrected and that the inventory value is accurate.

Cannabis companies generally use generally accepted accounting principles (GAAP) and absorption accounting to value their inventory. Cost accounting for cannabis cultivators and manufacturers is complex and should be managed by someone who has experience with cannabis cost accounting. Inventory costing systems will provide data, but the output should always be reviewed for reasonableness and accuracy.

Not surprisingly, accounting for cannabis inventory is also complex and the key area of focus for a CFO, especially for a cultivator. Growing cannabis plants are measured at the lower of cost and market pursuant to GAAP. All direct and indirect costs incurred to grow cannabis plant products are capitalized until the time of harvest. The carrying cost is evaluated for lower of cost or market (LCM) determination. At the point of harvest, the crops carrying value becomes the basis for the cost of internally produced inventory.

280E Is More Than Just Taxes

As any experienced CFO in the cannabis industry knows, Section 280E of the IRS Tax Code is more than taxes. The critical function for a CFO is to maximize the amount of costs that are allocated to COGS. However, GAAP dictates the types of costs that can be classified as COGS to those that are directly related to creating the product a company offers. It is therefore critical for CFOs to clearly document and set up systems to track expenses for any types of costs that can be split between COGS and SG&A, such as electricity or water.

Financial Reporting and Accounting

Strong accounting and financial reporting provide CFOs the information needed to assess the company’s profitability and liquidity needs. Financial reporting and accounting also enhance a CFO’s ability to make key strategic decisions such as raising capital, opening a new location, making an acquisition, or hiring more staff.

Developing Projections and Dashboard Reports

One of the first jobs for the CFO is developing revenue and cash flow projections and dashboard reports. Major factors to incorporate into the projection model include historical and expected price movements, supply chain and labor inflation, CAPEX requirements and various tax costs.

Keeping Up With Accounting Standards

The rapid legalization of cannabis in the United States has led to significant increases in acquisitions and consolidations of cannabis companies. When contemplating a transaction, CFOs need to assess whether the acquisition qualifies as an asset purchase or a business combination. Most companies would prefer the transaction be classified as an asset acquisition rather than a business combination because the accounting is less complex. In an asset acquisition, companies do not have to determine the fair value of the acquired assets or determine the fair value of any contingent consideration. Transaction costs can also be capitalized in an asset acquisition, and there is no need to assess goodwill impairment every year.

However, if a transaction is accounted for as a business combination, or if a company purchases an intangible asset such as a license, CFOs should consider the effect of a drop in an acquired company’s valuation (due to price compression, market share erosion, or other factors) on the amount recorded for intangibles and goodwill. This may determine the need for an impairment charge.

There has also been an increasing trend towards issuing debt with equity kickers such as warrants. This is done to minimize the already high interest rates cannabis companies are paying when debt financing is available. The accounting for these types of transactions can be complex and often require separate systems to track warrants. CFOs need to be cognizant of the complexity before entering into these transactions.

For more information on how Citrin Cooperman’s Cannabis Advisory Services Practice can assist you with your cannabusiness, please reach out to Kevin Cassidy at kcassidy@citrincooperman.com.

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