September 21, 2022

Growth of the Legal Cannabis Industry Yields Challenges for Family Law Matters: Perspectives from an Attorney and a Business Appraiser

By Nicholas Parseghian, Partner, Advisory Services, Marcum LLP and Michael Stutman, Founding Partner of SSL, LLP

Growth of the Legal Cannabis Industry Yields Challenges for Family Law Matters: Perspectives from an Attorney and a Business Appraiser Valuation

It was not so long ago that marijuana use was a dagger to the heart of any parent’s hopes to preserve a meaningful role in their child’s life in a custody dispute. Whether affecting the amount of time a child would spend with the parent (physical custody), or a parent’s ability to make decisions for the health, education and welfare of the child (legal custody), a positive toxicology result slammed the door shut.

Yet, in mid-July, a mother in North Carolina was jailed for her failure to deliver her child to the father, pursuant to a Court visitation order, even though the child (a toddler) tested positive for marijuana following a visit to said father.

Times have changed.

As of this writing, 18 states, the District of Columbia, Guam and the Northern Mariana Islands have legalized marijuana for recreational use, and another 13 states have decriminalized the use of marijuana. Thirty-six states have legalized medical marijuana and there are over a dozen other states where legalization legislation is pending.  These legislative developments have resulted in a tectonic shift in child custody matters and, in the business realm, spurred a tremendous upswing in entrepreneurial ventures for the production, manufacture, and distribution of cannabis-related products.

This does not mean it is open season for cannabis consumers and patients. Certainly not every jurisdiction finds itself allied with legalization, and not every judge is ready to cast off a predisposition against marijuana after generations of illegality. Furthermore, the fact that marijuana is still an illegal Schedule 1 drug at the federal level presents significant challenges.

Besides the question of legality, marijuana is commonly known to impair judgment and slow physical reaction times; hence, operating a motor vehicle while under the influence still subjects the driver to criminal consequences.

While it is tempting to analogize the use or abuse of marijuana to that of alcohol, that temptation needs to be avoided, as surveillance mechanisms for the two are substantially dissimilar. Alcohol use can be monitored in real time, accurately and without burdensome costs. Remote testing can be used to bookend periods during which a person is supposed to remain alcohol free (such as the beginning and end of a custodial parenting period), and the results of testing, or a skipped test, can be transmitted electronically and immediately to lawyers, judges, and law enforcement. In addition, devices are available to prevent an automobile’s ignition from being engaged by a driver with a prohibited level of alcohol. However, none of these protocols are available for the monitoring of the use of marijuana or the presence of its active ingredient.

The difficulty of monitoring the use of marijuana has not deterred many states from enacting standards for evaluating parental fitness that are at best ambiguous, if not outright fuzzy. Massachusetts prohibits the use/possession/manufacture or sale of marijuana as the “sole or primary basis” for determining custodial fitness unless there is “clear, convincing and articulable evidence…creating an unreasonable danger.”

The Illinois statute is similar to that of Massachusetts, articulating a standard of “unreasonable danger to the safety” of a child.

New York prohibits disqualification of a parent unless it is determined to be “in the child’s best interest” (which, like pornography, is almost impossible to define, but you know it when you see it) as established by a “fair preponderance of the evidence.”

The headwinds affecting child custody issues are joined by challenges in the valuation of cannabis businesses that may be a marital asset. The process for valuing a cannabis business is consistent with that of any private enterprise and principally includes the collection and analysis of business-specific information, assessment of industry factors and relevant markets, and the application of one or more of the three generally accepted approaches to valuation. However, the legal cannabis industry presents unique nuances – largely a result of continued federal illegality – that can complicate the steps of the valuation process.

Discovery often includes an appraiser’s request for legal documents related to the business (e.g., operating, member or shareholder agreements). To accommodate the highly regulated nature of the industry, legal organizational structures of privately held cannabis enterprises may be more complex than comparable privately held businesses in other industries. Such structures often include multiple entities established for purposes such as holding specific assets like real estate or intellectual property, or to provide management services to a separate entity that owns the licensing required to operate. Understanding the respective ownership, economics, and function of these various entities is as important to the valuation process as an understanding of the capitalization and financing of the entities and whether securities were issued that could be dilutive to the existing equity owners (e.g., promissory notes, convertible debt, simple agreement for future equity).

The federal status of marijuana as a Schedule 1 substance means a national industry or market does not exist, and in effect, each state functions as a separate industry or market. Understanding the dynamics of each state’s programs – medical use only or recreational, the availability and transferability of licenses, industry structure with respect to the permissibility or requirement of integrating different aspects of the supply chain (cultivation, manufacturing, distribution) in one business, and the impact of “unregulated” (i.e., illegal and untaxed) competitors to regulated industry participants – are all relevant to valuation. 

Availability and reliability of financial records may be impaired due to the relatively short operating histories of cannabis businesses, factors which may be further complicated by the propensity of these businesses to be largely cash-based due to limited access to the United States banking system (another aspect of the federal status of marijuana).  As a result, valuation experts commonly may need to rely on benchmarking ratios to assess an enterprise’s financial prospects and ability to generate future income.

A typical valuation considers the applicability of the three valuation approaches (asset, market, and income), each of which must consider the aforementioned cannabis-specific nuances. Under an asset approach, value is derived based on the cost to replace the company’s assets and settle its liabilities. The most valuable asset of a cannabis company may be its license to operate, the value of which may not be recorded on the balance sheet. Therefore, off-balance sheet assets may be significant, and if using an asset approach would need to be valued separately. Challenges in applying a market approach (pricing derived from transactions involving comparable business interests) include state-specific nuances and a rapidly changing marketplace that may render valuation multiples obsolete. Under an income approach, care is required to appropriately reflect income tax considerations that are a distinguishing characteristic of legal cannabis, i.e., taxes are generally computed on gross profits (gross revenues less cost of sales) due to IRS Code § 280E, which limits the deduction of overhead expenses that are not captured in gross profit, as well as unique elements of a cannabis enterprise’s cost of capital and long-term growth rate of free cash flows.

As the market for legal cannabis continues to expand and evolve, its pervasiveness in family law matters will follow, resulting in new considerations regarding both child custody and the valuation of marital assets. Be sure to consult your advisors for the most current information about the considerations applicable to the specifics of your situation.