How an MSO in the Cannabis Industry Used an ESOP to Eliminate Taxes and Secure Long-Term Growth
Tax Elimination Through ESOP Ownership
Becoming a 100% ESOP-owned S-Corp allowed the MSO to eliminate all federal and state corporate income taxes—freeing up millions in annual cash flow.
Empowered Employees, Stronger Performance
By giving employees ownership stakes, the company increased engagement, reduced turnover by 25%, and saw a measurable rise in productivity.
A Founder-Friendly Exit Without Giving Up Control
The ESOP structure gave the founding partners a gradual, tax-deferred exit plan—preserving company culture while securing their financial future.
Introduction
The cannabis industry is expanding rapidly, yet business owners face significant financial, regulatory, and operational hurdles. One of the most pressing challenges is Section 280E of the Internal Revenue Code, which prevents cannabis companies from deducting standard business expenses, leading to effective tax rates as high as 70%. This financial burden restricts growth, limits reinvestment opportunities, and makes long-term sustainability a struggle.
Beyond tax burdens, cannabis businesses must also navigate:
Banking Restrictions:
Due to federal prohibition, most major banks refuse to provide traditional loans or banking services, forcing businesses to operate in cash-heavy environments that increase security risks.
Regulatory Compliance Costs:
State-by-state legalization means cannabis businesses must constantly adapt to changing regulations, increasing legal fees and operational overhead.
Market Saturation & Competition:
As more states legalize cannabis, new entrants flood the market, intensifying price competition and reducing profit margins.
Supply Chain Challenges:
Cannabis companies often struggle with product distribution bottlenecks, high licensing costs, and inventory restrictions that prevent scalability.
Investor Hesitation:
Due to ongoing legal uncertainty, many traditional investors are reluctant to fund cannabis businesses, making it harder to secure growth capital.
For one Multi-State Operator (MSO) in the cannabis space, these obstacles became a major concern. Despite a thriving business and strong revenue, the company’s three founding partners sought a long-term solution that would:
- Reduce their tax burden
- Ensure financial stability
- Reward their employees and maintain company culture
- Avoid private equity buyouts that often strip control from founders
Traditional exit strategies, such as private equity acquisitions, debt financing, or strategic mergers, were not appealing due to high-interest rates, restrictive terms, or loss of control. Instead, the company turned to MBO Ventures to explore an innovative ownership transition strategy: a 100% Employee Stock Ownership Plan (ESOP).
Why an ESOP Was the Optimal Solution
An Employee Stock Ownership Plan (ESOP) allows employees to own shares in the company while offering significant tax and financial advantages. Unlike external sales, which often shift control to outside investors, an ESOP keeps ownership within the company, benefiting both employees and leadership.
For this MSO, transitioning to a 100% ESOP-owned S-Corporation resulted in:
Full Elimination of Corporate Income Taxes:
As an ESOP-owned S-Corp, the company became tax-exempt, unlocking millions in additional cash flow.
Controlled Exit for Owners:
The founding partners could gradually sell their shares, ensuring a stable transition while securing their financial future.
Enhanced Employee Engagement & Retention:
With employees now owning a stake, they became more committed, leading to higher productivity and lower turnover.
Step-by-Step: How the MSO Transitioned to an ESOP
1.
Evaluating Traditional Exit Strategies
Before committing to an ESOP, the company considered several traditional business transition options:
- Private Equity Buyouts: This would have stripped operational control from the founders and prioritized short-term investor gains over long-term stability.
- Strategic Buyer Acquisition: Many potential buyers lacked interest due to Section 280E tax issues or only sought select company assets.
- Debt Financing for Expansion: High-interest rates (12%-15%) made borrowing unsustainable, limiting expansion potential.
With these barriers in mind, the founders pursued an ESOP to retain control, eliminate taxes, and reward employees while maintaining financial stability.
2.
Structuring the ESOP Transaction
The transition followed a strategic phased approach:
- Business Valuation: A third-party valuation assessed the company’s fair market value.
- Seller-Financed Buyout: The founders structured the ESOP as a seller-financed transaction, meaning the ESOP purchased shares over time using company profits.
- ESOP Trust Formation: A legal trust was created to hold employee shares, ensuring a structured transition.
- Tax-Exempt S-Corp Status: Once fully ESOP-owned, the company elected S-Corporation tax status, making it completely exempt from corporate taxes.
The Financial & Strategic Benefits of the ESOP
1.
Evaluating Traditional Exit Strategies
One of the biggest advantages of an ESOP for cannabis companies is its ability to legally bypass Section 280E. Under a traditional structure, cannabis businesses are taxed on gross revenue rather than profit, but once fully ESOP-owned, this MSO became completely tax-exempt, freeing up millions annually.
2.
Increased Cash Flow & Faster Debt Repayment
With the elimination of federal and state corporate taxes, the company’s free cash flow surged, allowing for:
✔ Rapid repayment of seller-financed debt
✔ Expansion into new legal markets
✔ Better employee compensation & benefits
3.
Enhanced Employee Engagement & Productivity
Employees became stakeholders, leading to a 25% decrease in turnover and a 5%-12% increase in productivity. Studies show that ESOP companies tend to outperform non-ESOP companies, as engaged employees drive higher profitability and operational efficiency.
4.
Secure Financial Future for the Founders
Instead of an immediate buyout, the partners gradually liquidated their shares, ensuring:
✔ Financial security while remaining in leadership roles
✔ Deferred capital gains taxes through Qualified Replacement Property (QRP)
✔ An option to repurchase shares via warrants
Long-Term Success for Cannabis Companies Post-ESOP Transition
Since transitioning to an ESOP, this MSO has:
Expanded into two new markets using its increased free cash flow.
Boosted profitability, leading to higher employee salaries and bonuses.
Maintained a competitive edge, thanks to engaged employee-owners who are more invested in the company's success.
With strong cash reserves and a stable ownership structure, this MSO is now positioned for sustained long-term growth, a model that many cannabis companies can replicate.
Could an ESOP Work for Your Cannabis Business?
For cannabis operators navigating high taxation, limited financing options, regulatory challenges, or employee retention struggles, an ESOP could be the optimal solution. By transitioning to a 100% ESOP-owned company, cannabis businesses can:
Eliminate corporate taxes and maximize profitability
Create a stable exit strategy that benefits both founders and employees
Increase employee loyalty and drive long-term success
At MBO Ventures, we specialize in structuring and executing customized ESOP transitions for cannabis companies. Our team provides comprehensive guidance to ensure a seamless, tax-efficient transition while securing long-term financial success.