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Insider Q&A: How Cannabis Operators Can Neutralize 280E Challenges

How ESOPs work, and why more cannabis companies aren't using them.

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This week, MBO Ventures completed the first-ever cannabis employee stock ownership plan (ESOP). Through the ESOP structure, MBO gives cannabis operators a viable solution to navigate Section 280E challenges, which prohibit them from deducting ordinary business expenses on their income tax statements. 

The achievement was spearheaded by Darren Gleeman, managing partner of MBO Ventures. In this exclusive interview with Cannabis Equipment News (CEN), Gleeman discusses how ESOPs work, how MBO is using them to neutralize 280E and why more cannabis companies aren't using them.

CEN: How do ESOPs work?

Darren Gleeman, managing partner of MBO Ventures.Darren Gleeman, managing partner of MBO Ventures.MBO VenturesDarren Gleeman: At their core, ESOPs are mechanisms that encourage employee ownership. They provide an avenue for employees to gain equity in the company, thus aligning their interests with the company's shareholders. This stake in the company is a motivational tool, driving increased productivity and commitment amongst employees, given that they directly benefit from the company's success.

The process of ESOPs involves the establishment of a trust to hold the company's stock. Employees do not directly own the stock; instead, the trust, which is a tax-exempt entity, holds the stock on behalf of the employees. Each employee has an individual account within the ESOP, and the amount of stock they effectively "own" is based on the value of their account.

So, how do we get a business owner to sell their company to the employees via this structure? It would be great if they did it out of the goodness of their own heart, but the government took "goodness" out of the equation and gave business owners tax incentives. 

CEN: What are the tax advantages of ESOPs?

Gleeman: First, capital gains tax on the company's sale is deferred (indefinitely). For example, if a company valued at $25 million sells itself to private equity, the capital gains tax on this sale, on average, would be about $7.5 million. If sold to an ESOP, the capital gains can be deferred. This means $0 capital gains tax; if done correctly, the cap gains deferral becomes permanent. 

Secondly, a company owned by an ESOP pays zero federal and state income taxes forever. Read that again. If you pay zero taxes, deductions don't matter at all; they become completely irrelevant, and 280E is completely neutralized. 

Finally, when you sell the company to an ESOP, the owner can receive warrants to buy back a chunk of the company in the future. This allows the owners to get "a second bite at the apple." This is not a special tax benefit but certainly a financial one. 

CEN: What are the other advantages of ESOPs?

Gleeman: Once an ESOP is put in place, the company will begin to see employee retention skyrocket. Studies show that retention is 300% greater than non-ESOP-owned companies.

Employee-owners are much more wealthy than their non-ESOP compatriots. There's no comparison between the two. Productivity in ESOP-owned companies is much higher than in non-ESOP-owned companies as well.

CEN: How is it working for Theory Wellness? 

Gleeman: Theory is actually one of those companies that did this out of "goodness," they are very much into employee well-being. Theory was even one of the first companies in the cannabis industry to offer a 401k plan. An ESOP is a way for them to further provide employees with more benefits, but this time, it is an actual partnership.

 CEN: Why isn't every cannabis company using an ESOP?

Gleeman: One word: Awareness. Most people have no idea of what an ESOP is all about. Many people have worked at ESOP-owned companies, but all they know is that they make money. They don't know about the company tax benefits. They just think it is some other type of pension plan. The entire financial ecosystem in the United States is geared towards venture capital and private equity. It's not about employee ownership. 

Unless they specialize in it, if you speak to any attorney, accountant or investment banker, they are all about private equity exits. They just don't know about this sliver of finance.

CEN: At what point does an employee become an owner? 

Gleeman: Employees get vested over time, usually 20% per year for five years. Vesting means that they can get all the stock that will be allocated to them. Allocation of stock happens over a longer period of time, about 25 years.

When we structure the ESOP, we like to have a larger chunk for the employees at the very beginning of the ESOP. This way, the employees can see it. It's real. However, they still need to vest.

Because of the structure of the ESOP as a trust, the employees never actually become shareholders. They are beneficiaries of the trust. If an employee is fully vested and they have the equivalent of 1% of the shares, they will receive 1% of the company's value when the company is sold or when they retire, whichever happens first.

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