Understanding Convertible Debt for Cannabis Companies

If you’re in the early stages of exploring cannabis financing or attempting to raise cannabis capital, you’ve probably come across the concept of convertible debt. Cannabis ventures, in particular, tend to find the option of issuing convertible debt attractive for a number of good reasons. But all too often, entrepreneurs fail to understand the tax implications of convertible debt, leaving them exposed when they can least afford it.

Cannabis Financing: Understanding Convertible Debt Structure

At its most basic, convertible debt documents a loan from an investor to a company. They’re especially prevalent in the cannabis industry because they can potentially raise money quicker with fewer costs.

Instead, a company issues a promissory note with a two- or three-year term. If the company has raised money during that period, the note holder can convert it from debt to shares.

Accounting and Tax Implications of Convertible Debt

There’s a great deal more to know about convertible debt and why it might appeal to cannabis operators. But we’re going to pivot to the question of tax implications for holders (and issuers) of convertible debt, as it’s a subject that, in our view, doesn’t get enough coverage. As a result, all too often, we’ve seen parties unpleasantly surprised come tax time. And that’s something we don’t want to happen to you.

As you may already have surmised, using a convertible debt structure implies features of debt—specifically before it’s converted by its holder—and features of equity, in that it grants its holder stock once it’s been converted.

The timing in which the lender recognizes interest income can often be misunderstood. For example, under certain circumstances, the tax law requires recognition of taxable interest income regardless of whether the interest is paid out or converted to equity in any specific year. This interest income is reported on a form 100 OID.     But in actual practice, many companies neglect to report the OID appropriately and issue a 1099-INT tabulating the total interest when the note comes due and is converted.

As you might expect, this can cause unwelcome surprises down the road. That’s why we always advise our cannabis accounting clients to discuss tax plans with potential investors. Understanding the implications of convertible debt—and communicating with investors in a clear, timely, and transparent manner—is the best way to ensure a mutually beneficial and sustainable partnership.

Bridge West CPAs: Expert Advice on Cannabis Capital and Cannabis Financing

At Bridge West CPAs & Advisors, we devote a great deal of time and focus on helping businesses and entrepreneurs to reduce their tax liability. So, if you’re seeking guidance on how to raise cannabis financing, we invite you to get in touch.

Now into our second decade of helping cannabis entrepreneurs succeed, Bridge West CPAs & Advisors stand ready to help get you on the road to success. We look forward to working with you!