Question:  Arizona Department of Health Services’ first draft of the medical marijuana dispensary rules requires that all officers and directors of Arizona medical marijuana dispensaries be Arizona residents for at least three years.  I don’t satisfy the residency requirement so how can I be involved in a dispensary now and become an owner when I qualify?

Answer:  There are several ways.  If your goal is to own an interest in an Arizona medical marijuana dispensary, you must establish Arizona residency for at least three years so the sooner you move to Arizona, the sooner you will meet the residency requirement.  The current DHS rules contain a three year Arizona residency requirement to be an owner, officer or director of a dispensary.  Myself and others have suggested to DHS that it eliminate the residency requirement because the requirement is not contained in Proposition 203 and it is a violation of the equal protection clause of the United States Constitution.  DHS could increase or decrease the residency requirement or eliminate it altogether before it issues the final rules.

A person who has not lived in Arizona for three years could become a paid employee or an unpaid volunteer of a dispensary.  These positions are great learning experiences and can help to establish contacts and relationships with the dispensary owner that could lead to an ownership interest in a dispensary.  However, without a legally binding written contract between you and the nonprofit entity or the owner(s) of the nonnprofit entity to acquire an ownership interest in the dispensary, you probably would never become an owner.

Make a Loan with an Option to Convert the Debt to Equity

A better way for a non-Arizona resident to acquire an ownership interest in an Arizona medical marijuana dispensary is by the non-Arizona resident loaning money to the nonprofit entity and having a written option to convert the loan to an equity (ownership) position after the non-Arizona resident establishes residency and each of the 17 other requirements of ownership currently in the DHS rules.  For example, if you and another person want to own a dispensary and become equal 50/50 owners, the other person could loan or contribute $125,000 to the nonprofit entity and you could loan it $125,000.  The other person would initially be the sole owner of the dispensary.  Your loan documents would provide that once you satisfy all 18 requirements to be an owner of an Arizona medical marijuana dispensary, you would have the option to notify the entity and its owner that you exercise your option to purchase a fifty percent ownership interest in the entity in exchange for releasing the entity from its obligation to repay the loan.  A condition to actually becoming an owner would be that DHS would have to approve you becoming an owner.

During the period of time before the lender becomes eligible to become an owner of the dispensary, the lender could be a paid employee of the nonprofit entity.

What Documents are Needed to Evidence a Debt to Equity Conversion Option

Here are the documents that must be prepared and signed by the appropriate parties do create and document a transaction where the nonprofit entity borrows money and gives the lender an option to convert the debt to equity:

  1. Loan Agreement:  This document sets forth all of the terms and conditions of the loan and the rights and obligations of the parties with respect to the option to convert the debt to equity.  For example, it would state the conditions that must be satisfied before the borrower can exercise the option such as establish residency and each of the 17 other DHS requirements for ownership, state when the option would expire, require the borrower to become a signer on the entity’s governing document [Operating Agreement for an LLC and stockholders agreement for a corporation] and on a buy-sell agreement and state the conversion ratio for converting one dollar of debt into a specified percentage of ownership of the entity.
  2. Promissory Note:  The Note evidences the loan terms and repayment obligation of the nonprofit entity.  It could be interest only for a period of time.  If principal payments are made, the lender would receive a smaller ownership interest in the entity on converting the debt to equity.
  3. Security Agreement:  If the loan will be secured by any personal property of the entity, the lien is evidenced by a Security Agreement signed by borrower and lender.
  4. UCC-1 Financing Statement:  If the borrower obtains a lien on the entity’s personal property, the lender must file a UCC-1 Financing Statement with the Arizona Secretary of State
  5. Deed of Trust on Real Property:  If the nonprofit entity owns any real property, the loan could be secured by a lien on the real property.
  6. Lender’s Title Insurance:  If the loan is secured by a lien on the entity’s real property, the lender should obtain a policy of lender’s title insurance.
  7. Personal Guaranty:  The lender should require the other owners of the nonprofit entity to guaranty the Loan Agreement.
  8. Resolutions of an Action by Unanimous Consent:  The governing body of the entity (board of directors of a corporation or members of an LLC) must hold a duly called and noticed meeting and adopt a resolution authorizing the entity to enter into the Loan Agreement, the Promissory Note and any other documents and designating the person who has the authority to sign the documents on behalf of the entity.  In lieu of holding a meeting, the governing body can sign an Action by Unanimous Consent that adopts all of the necessary resolutions, but all members of the governing body must sign the Action by Unanimous Consent or it will not be valid and the governing body must then hold a duly called and noticed meeting.
  9. Employment Agreement:  Needed if the lender will work for the nonprofit entity and be paid compensation before becoming an owner of the entity.
  10. NonDisclosure & Confidentiality Agreement:  The parties should sign this document to prevent either party from disclosing anything about the loan and to keep information confidential.