Brand licensing, whereby a business leases out the intellectual property that is essential to its brand identity, is becoming an increasingly popular tool for cannabis brands looking to expand their geographic reach and capitalize on the value of their brand identity. For an industry that is still prohibited on a federal level, and subject to a rapidly changing state-by-state patchwork of regulations, brand licensing has become an important tool for multi-state expansion. A cannabis company that wants to sell its product in other states generally needs to go through a costly and time-consuming process of establishing stand-alone operations in the new state, obtaining the necessary licenses and permits for the new state, and adapting its business model and practices to comply with that state’s unique set of laws, regulations and policies. Fortunately, no such obstacles exist for interstate licensing of that same company's intellectual property. An established cannabis brand can shortcut the process of entering a new state by simply licensing the IP related to its brand and products to a business that is already operating in the target state.
While the advantages of brand licensing are undeniable, there are also a number of legal pitfalls to watch out for that are unique to licensing in the cannabis industry. For instance, some states' cannabis regulations have residency requirements that could be triggered by the typical royalty fee structure that is calculated as a percentage of revenue. To get around this, some brand licensing agreements utilize a flat-fee structure instead, but that creates its own set of problems as it forces the parties to guess at future sales or profits.
Another potential legal risk is created when a licensor becomes too involved in the licensee’s operations. It is common in the cannabis industry for a licensor to provide the licensee with a full suite of services that go far beyond the basic right to use the licensor’s name and logo. Licensors often provide consulting services, marketing services, packaging materials and supplier relationships. By providing so many services along with their intellectual property rights, the licensor can more closely replicate its business in other states (and ensure the quality of the product being sold under its name), however, if the licensor is exerting too much control over the process regulators may view it as an in-state operator, and both parties could find themselves in the crosshairs of the state’s cannabis regulatory agency.
Probably the single biggest licensing related risk, and the one that is most often overlooked, is the additional tax liability that the licensee could incur as a result of the licensing relationship. A licensee must report all its revenue from sales of the licensed product, even if a substantial portion of that revenue is ultimately being paid over to the licensor as a licensing fee. A “normal” (i.e. non cannabis) business would simply be able to deduct those license fees as business expenses, but thanks to section 280E of the US tax code, a cannabis business can only deduct those expenses if they are properly categorized as “cost of goods sold” (also known as COGS). While an in-depth discussion of 280E is far beyond the scope of this article, the takeaway is that without proper legal and tax planning, a licensee could find itself paying taxes on substantial amounts of revenue that it never had any right to keep.
In short, brand licensing provide tremendous opportunity for a licensor looking to expand to new markets and capitalize on its intellectual property assets, and for a licensee looking to diversify its product line with a brand name that is already known for quality. However, brand licensing can also be fraught with a number of hidden legal risks, particularly for cannabis companies. Comprehensive legal agreements, drafted by an experienced attorney that is familiar with the industry are essential for managing these relationships. Contact us today to learn more about brand licensing and to determine if it could be a good option for your business.
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