Forming Psychedelic Companies: 10 Lessons from the Cannabis Industry
By Charles Alovisetti
Mar 22, 2023
A new industry is emerging in the United States, and entrepreneurs in the psychedelics space must make critical decisions at the onset of new ventures regarding how to set up and structure their new businesses. While there is a long history of startup formation in the US and extensive coverage and analysis of best practices, much of this may require revision for a new industry that ranges from federally legal, to state legal (but federally illegal), to non-commercial religious use.
Luckily, we have access to another industry with a complex legal framework and a patchwork of different state laws: cannabis. And after forming hundreds of cannabis companies with clients over the past decade, Vicente LLP has lessons to be shared. (Read the “Budding Companies: Forming Cannabis Startups” series as background.)
In no order, here are ten lessons learned from the cannabis industry to help psychedelic companies start smart:
1. Understand the Tax and Governance Basics of Common Entity Types
While this article focuses on the industry-specific nuances of entity formation in the psychedelics industry, there are also critical differences between the typical entities used for startups—corporations and limited liability companies—that will apply across all industry types and are crucial to understand. Primarily, these differences are in how corporate governance works and the default forms of taxation. This article on cannabis startups provides an overview of the differences.
2. Begin with the End in Mind
Entity type and jurisdiction of formation choices will depend on the goal of the business. Suppose the goal is to avoid seeking outside equity capital, or a potential exit. In that case—and as is often the case for a family-owned farm—the considerations are different, and certain entity types rarely used in the startup context make more sense for a business meant to stay family-owned (e.g., an S-corp). This article assumes the typical scenario for a startup in which the founders hope to scale rapidly using outside capital and eventually exit or take the company public, so think hard about your goals before making decisions around formation.
3. Understand the Legal Spectrum of Psychedelic Businesses
As addressed here, psychedelic businesses can vary significantly in their compliance with federal law, which can have critical implications for formation choices. Whether or not a company is subject to 280E (the section of the Internal Revenue Code that prohibits deductions and credits for those trafficking a Schedule I or II substance) should be considered before deciding on an LLC or a C-corp. When setting up a company in the cannabis space, where 280E is a significant factor, it’s essential to consider the dramatic implications of being subject to a unique tax regime. The state-legal but federally illegal, future licensed psychedelic businesses in Colorado and Oregon should be sure to think this through. But other psychedelic businesses, including both FDA-compliant drug development companies and supplement or food businesses that are only tangentially related to psychedelics (e.g., functional/adaptogenic mushroom companies) will fully comply with federal law and not need to think about 280E at all.
4. Psychedelic Business License Holding Requirements
In the cannabis industry, some states require businesses to use their state laws to form a company that will hold a cannabis license. For example, in Massachusetts, all cannabis licenses must be directly owned by a Massachusetts entity (the indirect owners can be foreign entities). So far, we have not seen state-regulated psychedelic markets adopt this requirement. Though, it’s worth noting that currently there is only one set of rules available to evaluate to date: Oregon. But this issue may arise, so it’s important to remember it. (As a reminder, you can now apply for a license in Oregon. )
5. ESG: B Corps and Benefit Corporations
As companies focus beyond profits, there are now options for companies seeking to focus on the triple bottom line. Perhaps to a greater degree than the cannabis industry, where alternative entity types have been discussed but are still relatively infrequent, psychedelic companies looking to focus on matters beyond pure profit are seeking to take advantage of B Corps and benefit corporations. There’s a significant difference between the two options: B Corps are simply a designation from a third party that reflects hitting specific qualifications (and paying a fee), while benefit corporations are an entirely different legal entity under state law. Beginning with the end in mind, potential founders should consider using B Corps and benefit corporations.
(Here’s an article considering using B Corps and benefit corporations for competitive cannabis licensing scenarios).
6. Get it Right from the Start
This lesson is less about legal nuance than the problematic experiences companies can have when they fail to make sure everything is documented correctly at startup. Proper documentation goes beyond simply being thoughtful about entity type and jurisdiction of formation. There is a range of items you want to make sure are correctly documented at formation: initial resolutions, founders’ or shareholders’ agreements, subscription letters, IP assignment agreements, and NDAs. It can be a hassle, but the reality is that if something gets missed at formation, you may not think to fix it until an issue arises. Much better to get it right and set yourself up for success from the start.
7. Vesting Schedules
At the time of formation, the founding team of a startup is usually highly motivated and eager to get to work. However, once the reality of building a business sinks in, many people will balk in the face of years of poorly compensated work. And we have seen plenty of examples of founders ceasing to be full-time contributors, leaving the rest of the team to pick up their slack. Because of the frailty of human nature, it may be a good idea to extend some form of vesting equity beyond just consultants, advisors, and key employees (though it is critical to ensure vesting applies to these groups) to the founders. As a bonus, this vesting concept can also appeal to investors.
8. Management Company Structures
In cannabis, we have seen the emergence of alternative holding structures when there are residency requirements or significant background check requirements. These structures attempt to raise capital into a non-licensed entity, which then enters into carefully drafted agreements with the licensed entity to make transactions possible. We’ve already seen Oregon impose a residency restriction on psilocybin licenses and may see this replicated elsewhere. (To be clear, this is not to advocate for violating any regulations, but to acknowledge what the market will do in response to certain restrictions. Please carefully vet any structure’s legal compliance.)
In addition, in the ketamine clinic world, founders will need to grapple with the corporate practice of medicine. These structures will look very familiar to cannabis investors used to management company constructs.
(”Raising Private Capital in the Cannabis Industry” addresses many of these issues from the cannabis side.)
9. Contract Enforceability
One open question that has existed in the cannabis industry is whether the issue of enforcing illegal contracts (as both cannabis and the Oregon and Colorado psychedelic systems violate federal law) would trip up the corporate governance or commercial contracts of startups. And cannabis businesses have weighed the advantages of choosing states as formation jurisdictions that explicitly make cannabis contracts enforceable, e.g., California. (Complicating matters, most states with statutes making cannabis contracts enforceable only refer to operations authorized by that specific state’s laws, so multi-state operations remain in a gray area.)
The fear is that courts in a typical state of incorporation, like Delaware, might abstain from enforcing the corporate arrangements of a business incorporated under a set of laws that do not explicitly make cannabis contracts enforceable. These concerns haven’t come to fruition, and Delaware remains a significant state of incorporation for cannabis companies.
Notably, Oregon’s statute says that federal illegality does not make psychedelic contracts unenforceable, and the statutory language isn’t limited to activities authorized under Oregon law.
10. Jurisdiction of Formation
This ties in with lesson nine. Given the risk of contract enforceability, is it worth choosing a state like Oregon as the jurisdiction of formation? Time will tell the wisdom of this approach in the psychedelic industry.
In cannabis, despite concerns, most large companies have gone with the typical choice of Delaware to form their holding companies (license-holding entities in states with specific requirements, like Massachusetts, can be further down the structure chart). Delaware remains the preferred jurisdiction for many practitioners and investors as they can rely on robust corporate case law and an informed judiciary if a dispute were to go to trial.
If you are interested in starting a business in the psychedelics space or would like assistance in preparing for psilocybin licensing in Colorado or Oregon, don’t hesitate to get in touch with Vicente’s Psychedelics & Emerging Therapies Team.