Dirty Dancing: Flips and Tricks of Cannabis Social Equity in L.A.

Phase II cannabis licensing in the City of Los Angeles (for only non-retail activity) kicked off on August 1 at 12 p.m. (and it will conclude on September 13th). To qualify for a City of Los Angeles cannabis license during this timeframe, an applicant must, among other things, be eligible for the City’s cannabis social equity program. This qualification factor has propelled a search for business partners who will make them eligible for Phase II cannabis licensing. Though this momentum is spurring business marriages all over the City many of these “partnerships” are little more than ruses for circumventing the social equity requirements.

It’s not unusual in the cannabis industry to see people rush into half-baked, hasty business marriages for fear that some grand opportunity will pass them by if they don’t. This is why the cannabis litigation lawyersat my firm spend so much time litigating cannabis business ownership disputes. LA’s social equity component has created a new breed of business “relationship” ripe forscamsand potential applicants on both sides of the social equity aisle need to be aware of the tricks being used to game this new system.

The below are some examples of what our Los Angeles cannabis lawyers have been seeing and are likely to see from social equity cannabis business unions in L.A.:

1. The Tier 1 and Tier 2 Straw Men. To qualify for social equity in Los Angeles you need some combination of “low income” status, a “cannabis conviction,” or having lived in a “disproportionately impacted area” in the City for a certain amount of time. (For a detailed explanation of LA’s social equity qualification requirements go here.) Based on what you can prove as a social equity applicant, your cannabis business will be categorized as a Tier 1 or a Tier 2 business. To be Tier 1, the social equity applicant must have at least 51% of the equity in the cannabis business. To be Tier 2, the social equity applicant must have at least 33.3% of the equity in the cannabis business. Government rules that require sharing equity make even hardened business people nervous about losing voting control and search for ways around this rule. We expect to see Tier 1 and 2 cannabis businesses claim on paper (via operating agreements, bylaws, or subscription agreements) that they have the requisite equity spread while utilizing a “side letter” or a handshake to ensure that the actual social equity applicant has little to no real economic or control rights.
2. The Incubator Terminator. L.A.’s social equity program has a Tier 3 cannabis business category that does not involve equity sharing. To qualify as a Tier 3, you must provide space, utilities, capital, business assistance, and licensing help to a Tier 1 or 2 business for no less than two years. Los Angeles is a very competitive cannabis market and I would not expect many will want to assist their competition and certainly not for free. This means we are bound to see Tier 3 businesses seek to sabotage their Tier 1 or 2 “roommates” so as to strengthen the competitive landscape for their own business. Oakland has shown what can happen when an incubator drags its feet during the entitlement process to the detriment of the social equity applicant, and unless Los Angeles mandates reporting requirements from Tier 1s and 2s to ensure Tier 3s are actually providing the help required by law, we can expect to see a Tier 3s working for the death of “their” Tier 1s and 2s during the mandatory assistance term.
3. “Show Me the Money” Tier 1s and 2s. We have already seen Tier 1 and 2s essentially selling their status to multiple parties for a quick pay out without any actual plans to compete in the Los Angeles cannabis market. These sorts of deals go against the purpose of the social equity program, which wasto ensure those most negatively affected by The War on Drugs get a meaningful share of Los Angeles’s legal cannabis market.
4. Is Your Partner Really a Tier 1 or 2?Many in Los Angeles wrongly believe one cannabis conviction is automatically enough to qualify for Tier 1 or 2 status. If you’re looking to partner with a Tier 1 or 2 be sure to do your due diligence to ensure they actually do meet the required criteria.
5. Predatory Matchmakers. There aren’t many ways for legitimate Tier 1s and 2s to meet legitimate and willing Tier 3s, and our Los Angeles cannabis lawyers have been seeing more than a few questionable 11th hour brokered deals rushed to finish by the September 13th deadline. Many of  “brokerage” agreements we’ve seen have been inadequate and many deals are going through with little to no due diligence conducted by either party. These agreements are mostly boilerplate forms pulled down from the internet and badly re-purposed for social equity in L.A. Though satisfying L.A.’s requirements to qualify for Phase II is clearly important, you should not forget that these agreements will also serve as your legal foundation for a real business relationship with real obligations and liabilities and it is important thatt your agreement get the details right on things like company financing, leasing, voting, and managing day-to-day operations. Most of the “social equity brokers” putting these deals together care only about getting paid their percentage.
6. Tier 3 Management Companies. There’s no such thing as a free lunch and many Tier 3s giving space, time, money, and assistance to Tier 1s and 2s will be expecting a lot back in return. We are already hearing of Tier 3s insisting they become management companies to the Tier 1s and 2s they plan to assist. L.A. is planning to address the issue of management companies generally in the City and that means we will likely see regulations aimed at preventing management companies from cannibalizing the opportunities intended for Tier 1s and 2s.

Los Angeles’s cannabis social equity program is a complicated undertaking and if just a handful of Tier 1 and Tier 2 cannabis businesses thrive in Los Angeles that will constitute a significant victory for the cannabis industry as a whole.