When Y Combinator came out with the original Safe years ago, it became the standard for early-stage company investments. As the cannabis industry has matured, more cannabis startups are looking to raise funds using traditional venture investment instruments such as the Safe. While the Safe can be a great investment vehicle for cannabis startups, the off-the-shelf Safe should not be used without making specific adjustment to reflect the regulatory intricacies of operating in the cannabis industry. This is why, with the permission of Y Combinator, our firm (Mayfield Venture Law) along with Lara Decaro from Leland Paranchini Matzger & Melnick, Khurshid Khoja from Greenbridge Corporate Counsel, Jay Purcell and Nicole Howell of Clark Howell, and the team at Meadow decided that it was time to release a cannabis Safe that will hopefully become the market standard for early-stage cannabis startup investments.
The primary goal of the cannabis Safe is to address the regulatory complexities that come with raising money in the industry. For example, depending on whether a company is raising a priced round (i.e., selling equity at a fixed valuation) or a convertible security round (i.e., a Safe or convertible note), each triggers different regulatory reporting and/or approval processes. When raising on convertible securities in California, this triggers a notice obligation for the company but not a regulatory approval process. However, once the Safe converts into equity whether in connection with a sale of the company or financing event, regulatory approval may be triggered regarding the investor’s equity ownership in the company. Whether seeking a regulatory approval or providing notice of a Safe investment, this will require an investor to cooperate with the company to provide certain information in connection with the notice or approval process. The revisions to the Safe in Section 1(a) ensure that the investor and company agree on the company’s potential notice and/or disclosure obligations ahead of time. To hedge for the unlikely, but possible scenario where a regulatory approval is denied following conversion of the Safe, there is a company right to repurchase any stock issued on conversion of the Safe for the amount paid by the investor. See Section 1(e).
Other important revisions to the Safe are specific to the representations and warranties that the company is able to make to the investors, as well as providing disclosure up front to investors around the company’s potential compliance obligations that may surprise some new investors to the space. Given the conflict between state and federal law and various complications that arise with banking, taxation, insurance, and bankruptcy, it is important that each investor acknowledges its understanding of the legal landscape in which cannabis companies operate. As such, we added Section 4(c), which is an investor acknowledgement, representation, and warranty that the company does not make any representations or warranties related to these areas of the law. Further, in Section 4(d), each investor agrees to cooperate with the company so that the company can fulfill its regulatory and/or notice obligations as discussed above. Section 4(d) also includes an important provision to include that is specific to equity businesses. Given that equity businesses have change of control and ownership threshold restrictions, the bracketed language in 4(d) should be included for equity businesses when raising funds to ensure a more fulsome disclosure to investors.
Overall, the edits to the Safe are intended to align investor and company expectations about what it means to operate a cannabis business in an evolving regulatory environment in order to prevent future surprises (i.e., when a DOJ background check is requested or an investor is surprised by the tax implications 280E has on a business). Lastly, this form of cannabis Safe contemplates an investment into a C corporation operating in California. Should you decide to use this Safe for an investment outside of California or into an entity other than a C corporation, we strongly suggest consulting with counsel to make any necessary adjustments to the document. We intend for this to be an evolving, collaborative document so please reach out with feedback as there will be many iterations of this document as it becomes more widely used.