By Luke K. Stanton and Jeffrey D. Welsh
With as many as eight new states poised to pass recreational cannabis legislation in 2016 and a national populace increasingly in favor of sensible regulation, the legal cannabis industry has reached its tipping point. The California market, due to its large population and insatiable appetite, accounts for nearly 50 percent of a global industry recently estimated to be worth as much as $10 billion annually. California’s leading recreational initiative has gained tremendous traction, bolstered by a capital infusion from billionaire technology and music industry entrepreneur Sean Parker, and the passage of adult-use legalization seems inevitable in the Golden State.
It should come as no surprise, then, that entertainment studios, agencies, advertisers, content providers, and their respective entertainers and talent assets are beginning to dip their toes into the cannabis space. Though many of the larger players are waiting for passage of recreational legislation or the loosening of federal restrictions before diving in, we have seen several entertainment and cannabis collaborations already, and these deals will become increasingly commonplace as the industry continues to expand.
Entertainment licensing agreements
Despite the entertainment industry’s hesitation, licensing agreements offer a solution for entertainment brands to involve themselves in the nation’s fastest growing industry without the hazards, risks, and difficulties of owning or operating state-licensed cannabis business operations.
Licensing agreements are extremely commonplace in the entertainment industry, and they operate similarly in the legal cannabis space. Brands and entertainment assets, the Licensors, can license the use of the intellectual property associated with their brands, along with any other proprietary assets, to local, state-compliant operating partners, or Licensees. Licensees then have the ability to utilize the Licensor’s intellectual property or brand in conjunction with their products in that state’s legal, intrastate stream of commerce. If the parties can handle the successful execution of the licensing agreement, the result can be a powerful national cannabis brand.
Notable licensing provisions and considerations
There are challenges for each side in navigating a successful license agreement, some of which we covered in our previous article about expanding cannabis businesses into multiple states. The following is a more comprehensive list of levers and deal points to consider when putting entertainment licensing transactions together.
- Quality control rights: Brand dilution can be fatal. In order to ensure the continued success of a talent-endorsed product, it is essential that the licensed products maintain consistency and quality. Strong quality control provisions can address these concerns through the establishment of operational, production, and testing standards, which can be tailored precisely to reflect the quality the brand demands.
- Minimum guarantees: Minimum guarantees are a form of performance insurance whereby an initial sum is paid to the brand or entertainment Licensor irrespective of how the licensed product performs in the market. Minimums are often important to fix the long-term commitment of the Licensor, but also constitute a financial risk for the Licensee, who cannot be certain of achieving sales levels necessary to cover the guarantee. Licensors should be mindful of setting realistic, fair minimums that will encourage long-term success for both parties. Potential Licensees should also remember that in the entertainment world, a “fair” minimum is likely to be large relative to the cannabis industry.
- Performance milestones: In contrast to minimum guarantees, performance milestones provide expectations for the Licensee over time. This can add two elements to an agreement: 1) an incentive for the Licensee to perform, and 2) an escape hatch for the Licensor should the Licensee fail to perform, particularly in the case of exclusive licensing agreements.
- Auditing rights: Each and every word of an audit provision can become the subject of intense scrutiny when it comes time to enforce quality-control standards. Basic audit provisions often fail to detail how an audit will be undertaken, the type of information to be provided, the manner in which information should be transmitted, or the consequences of a Licensee’s reporting failures. Detailed auditing clauses can allow for the identification of risky business partners, support corporate compliance, and strengthen both security and privacy controls.
- Key Person clauses: When an individual is central to an agreement, a Key Person clause can allow for termination of the licensing agreement if one or more “Key Persons” leaves the employ of the relevant party.
- Exclusivity clauses: Exclusivity clauses can ensure the Licensor will not allow a business’s competition to utilize the same brand in a given territory. Exclusivity can be defined geographically, by genre, category, product, brand, or in any number of other ways. Exclusivity is generally desired by the Licensee, and Licensors will often demand minimum guarantees and performance milestones to ensure a Licensee with an exclusive deal will perform. If a Licensor enters into an exclusive licensing arrangement only to discover a better performing potential business partner, they may look for reasons to terminate the license agreement.
- Affiliates: Many license agreements allow the Licensee to hire affiliates or sub-distributors, which can increase a product’s reach and sales potential. However, an unrestricted affiliate arrangement may harm the Licensor through a loss of control over the quality of products, resulting in brand dilution. To strike a healthy balance, add provisions that keep the Licensor in control, which can be as simple as requiring approval of each affiliate or as complex as executing a separate agreement between every affiliate and the Licensor.
- Termination clauses: As larger entertainers and brands move into the space as Licensors, they will attempt to negotiate termination clauses that are very one-sided, allowing the Licensor to terminate the agreement for any reason while at the same time requiring the Licensee to jump through hoops in order to dissolve the relationship. Navigate these provisions extremely carefully.
- Product liability: Which side will be legally responsible should the use, consumption, storage, or transportation of a licensed product cause harm? Licensors, particularly in the emerging cannabis market, will not want to accept any liability for products manufactured by a Licensee who simply applies the Licensor’s logo to the product. However, depending on the level of control exercised by the Licensee in the manufacturing process, complete insulation from liability may not be possible.
There are inherent difficulties in crafting a license agreement that gives both sides what they want. While prior deals can provide some direction, there will always be a degree of molding and shaping necessary, particularly in an industry where there is little precedent to draw from. In the end, the language of a license agreement is unlikely to be examined closely while both parties are proceeding happily and successfully, but should any issue arise, you’ll be forced to work with what was reduced to writing.