June 20, 2023

Operating Agreements in the Hemp Space: Create your Liability Shield

I’ve said it once and I’ll say it again. Operating agreements are so necessary, especially in the hemp and cannabis space.

So I’ve talked about operating rooms before, but we talked about them in general. There are things about operating agreements that can be very, very helpful in the cannabis space when it comes to doing business with yourself, with your partners, and with third parties.

Operating agreements are legal documents that talk about the operation of your partnership and or your business. Think of it as the prenuptial agreement for your business. Some people may liken businesses to babies. I like to liken them to marriage, especially if you have a partner. An operating agreement outlines what the rules and expectations are for everybody who’s involved in your business.

They also help provide an extra layer of legitimacy for your liability shield.

A lot of times when you are forming a limited liability company or a corporation or some sort of business entity that is separate from yourself, you’re doing that to prevent liability from what happens in your business, from touching you personally. That’s what we call a liability shield.

One of the ways to ensure that that liability shield is held in place is to have an operating agreement. Because to the outside world and regulators in at the IRS and to courts, that is one way to legitimize the business being separate from you personally. So having a well thought out operating agreement adds a level of legitimacy to that liability shield and offers you further personal protection from your business.

What do they do for you as an equity stakeholder? So as a member of a company, it’s going to help you know what your role is. It’s going to help, you know, how you get in your business, how you get out of your business, how decisions are made for you as a company. In addition to that liability shield, it makes you look more legitimate to potential investors, to potential other equity stakeholders that you want to bring in.

It also helps you, your business, survive much longer because it outlines how you’re going to grow. And if you decide not to grow anymore, how you’re going to dissolve their necessary for every business, whether you’re a solo practitioner or you’re in a partnership, whether it’s simple or multi-tier. And in fact, for different reasons, they are each equally as important as a solo practitioner.

If you form a limited liability company and you want to make sure that the IRS understands that they should be taxing your business and not you, that liability doesn’t come through to you personally. An operating agreement is very important in a way to protect yourself and your personal assets. It also can be a very effective estate planning tool, whether you are housing assets just in the business, whether you are trying to build a legacy business that passes on to your children.

An operating agreement is one of the best ways to do that. Partnerships. Disputes and resolutions that is more often than not, how your operating agreement comes into play, because at one point or another in every partnership, everything is going to go sideways and you’re not going to agree on anything and everybody’s going to be very unhappy. And you need an operating agreement to tell you how to deal with that situation.

In the hemp and cannabis space, an operating agreement is even more important.

Why? Because as we’ve talked about in many of my previous videos, the opportunity to slide from a civil issue to a criminal issue still exists in almost every part of this business. And so your liability shield is even more important, not just for yourself and for your business, but a shield from each of your partners and potentially their criminal activity.

So let’s talk about some of the things in an operating agreement that you want when you’re drafting or having someone draft for you. You want to consider that are specific to the hemp and cannabis space. The first is choice of law. So if you’re in the regulated cannabis space, your operating agreement and your business and your license all have to be in the same state where you’re licensed and operating.

You don’t really get to choose if you are a Colorado based cannabis business, your choice of law is going to be Colorado. However, if you’re in the hemp space at the moment, like any other type of business, you can choose what your ruling jurisdiction is. For a long time, the a lot of people would say Delaware. Delaware is the place that you should choose for corporate law because they have the best laws when it comes to limited liability companies and corporate protections, etc..

Well, that’s not necessarily the case for your hemp business. You need to look at what your products are, what your plans are, what kind of services you’re offering, and then choose your jurisdiction based on the best set of laws for you. Limiting indemnification provisions For anybody who’s read a contract before, you’ve probably seen an indemnification clause somewhere in there and thought to yourself, I don’t really know what this is, but looks important.

Looks like a lot of legalese. I’m sure it’s fine and moved on, but it’s very important to understand what indemnification clauses are in an operating agreement. It’s indemnifying all the members, all the stakeholders from anything that happens in the business.

However, when it comes to the hemp and cannabis space, there are some times when you don’t want indemnification to apply.

For example, if one of your business partners does something illegal with the business or in the business or in the name of the business, you don’t want them to be indemnified from that. Potentially, you need them to be criminally liable and to be separated from the company, because unless you do that, you may lose your licensing or all of you may be facing criminal violations.

So limiting your indemnify indemnification provisions is something important to consider. Severability Clauses. Severability clauses exist in most contracts. They essentially say that any event that one clause or one part of this contract is invalid or illegal or unenforceable, the rest of it still stands. You want the same thing in any type of contract and including your operating agreement for the camping cannabis space, because again, the chances are that at some point or another potentially one of your clauses or an action or something along those lines could be found to be unenforceable.

Why? As we’ve talked about before, it’s easy to slide from civil to criminal in this space still. But in addition to that, the law here is constantly changing. And so if you write an operating agreement and it’s written well and it lasts for several years, five or six years from now, a provision that applied to your business then that was perfectly enforceable then may no longer be enforceable.

So it’s important that your severability clauses take that into consideration. Transfers of ownership, licensing in the hemp and cannabis space is often very specific to the person or the group of people. Even if you are a business seeking a license, you have to individually identify every person in that business and it is tied to them individually. A lot of operating agreements talk about the ease of transfer ability of assets within the business or without the business, except you can’t just sell your portion of a business when your business owns, let’s say, a regulated cannabis license or even a hemp license, you can sell your portion of the business, but no longer one.

That person who comes in probably isn’t going to own any part of the license that it’s obtained by that business. And your company now has to go and change their license with the regulating body to reflect the new member. So transfer of ownership provisions need to take into consideration what your license is that you have or are seeking as a business and what you’re going to do in the event that your members change fiduciary duty.

Fiduciary duty is a fancy legal term for basically what your job is as a member of your business. And I’m not talking about CEO, CEO, it’s your duty to provide a certain standard of care to the business. A lot of times it’s as simple as don’t do anything criminal, you know, come to the meetings, do what’s asked of you, do what you’ve promised to do.

Oh, but in the hemp and cannabis space, the regulations require a lot more of any participant. So it’s very useful to make sure that you’re operating agreements, requirements of its members. The outlining of the fiduciary duties of each member includes what is required of them by the state, that they’re being regulated under that way. At any point, if somebody fails to do something that could cost you your license or your business in the hemp have been cannabis space, it could also potentially be a breach of their fiduciary duty to the business, which can be very helpful if you ultimately want to oust that person from the business.

Force Out Clauses

Which leads us to force out clauses. Force out clauses are provisions that allow a majority of members. Most often that majority is defined by each operating agreement to force out another member for failing to meet their fiduciary duty or some other type of breach. Criminal activity can pretty much be anything you want to make sure that force out clause One of the force out clauses that’s included is their failure to participate in state and federal regulations that are required for your business to operate.

For example, if you have to renew your license, you guys are having a partnership dispute and one of your partners says, Well, I’m not signing the license renewal or I’m not submitting to this inspection or I’m not submitting this report that we’re required to send to the state unless you give me what I want. If you’re forced out, provisions say that their failure to do that allows you and the rest of a majority of the members to push them out, then they can’t use that as a way to strongarm you into giving them what they want so that your business can continue.

What I hope you’ve learned from what might be at least what Harley thinks is a very boring topic when it comes to hemp and cannabis, is that operating agreements are very necessary. They’re a wonderful tool to protect yourself. They’re a wonderful tool to help you in partnership disputes. But most importantly, they’re necessary to make sure that your business continues to survive.

Without it, you may end up in disputes and litigation and all sorts of other issues that could have been prevented by a good operating agreement. Operating agreements are necessary, legally binding documents that protect you and your company. Yes, you can attempt to draft one yourself. Yes, you can get them off the Internet. But what I hope that you’ve taken from this video is that a well-written operating agreement is going to help protect you now and in the future.

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