Question: I estimate that my Arizona medical marijuana dispensary will need $250,000 to open its retail store. Should I loan the money to the nonprofit entity or should I pay it to the entity as a capital contribution?
Answer: You should discuss this question with your accountant. There are significant differences in the two primary methods (debt vs. equity) of inserting money into a business. Here are some pros and cons associated with each method.
Debt: You could loan the entity $250,000. The loan should be evidenced by a Promissory Note signed by an authorized agent of the entity. The governing body of the entity (members of an LLC or directors of a corporation) should hold a meeting (or sign an action by unanimous consent) and vote to approve the terms and conditions of the loan and designate the person who has the authority to sign the Promissory Note on behalf of the entity. The loan should be commercially reasonable as to the interest rate, payment terms and maturity date. If I were representing the lender, I would recommend that the Promissory Note be secured by a Security Agreement that encumbers all of the assets of the borrower. If I were representing the borrower, I would suggest the loan be unsecured.
There are several advantages for the lender / owner who capitalizes the entity using a loan. First and foremost, the entity becomes indebted to repay the loan according to its terms. A loan creates a greater likelihood of being repaid before a capital contribution because the law of Arizona prohibits an Arizona entity from paying its owners and not paying creditors. A loan may also be a better way to capitalize a medical marijuana entity because presumably Arizona’s medical marijuana laws and the Arizona Department of Health Services rules do not consider the entity’s repayment of a loan to be inconsistent with the require of the law and rules that the entity be operated on a nonprofit basis.
One problem with debt vs. equity is that although the entity has the funds, the infusion of capital does nothing for its balance sheet. The assets of the entity increase by $250,000, but so does the entity’s debt, which means the loan does not increase the net worth of the entity.
If an owner does make a loan to the entity, it is critically important the the loan be properly documented with a good Promissory Note, Security Agreement and a UCC-1 Financing Statement filed with the Arizona Secretary of State (if the loan will be secured by a lien on personal property), and resolutions or an action by unanimous consent of the entity’s governing body. If your entity needs to document a loan, call KEYTLaw business and contracts attorney Jeana Morrissey at 602-906-4953, ext. 4.
Equity: Instead of loaning $250,000 to the entity, you could pay the money to the entity as a capital contribution. Capital contributions have a lower priority the debt on the repayment totem pole. The last people to be paid and recover their investment when a business goes bad are the owners. Some organizational documents such as an Operating Agreement may provide that the owner does not have the right to demand that capital contributions be repaid. Usually capital contributions do not accrue interest although it is possible to accrue interest if company documents provide for the accrual.
Because Arizona medical marijuana dispensaries must be operated on a nonprofit basis, it may also be more difficult to repay a capital contribution than a loan. Currently the DHS rules do not give us any guidance as to whether an entity may freely repay owners their capital contributions so we do not know if a capital contribution in year 1 followed by a total repayment in the same year would be considered an improper use of entity profits contrary to the nonprofit character of the entity required by Arizona law.
An owner could also fund the entity with debt and equity. In the above example, the owner could loan $125,000 to the entity and also make a capital contribution of $125,000.