In light of the $2 billion blockbuster deal between Trulieve and Harvest announced on May 10, 2021, and buzz about other mega-mergers, it might be a good time to take a deep dive into the world of cannabis mergers and acquisitions.
This article will only address the cannabis-specific issues impacting deals. Mergers and acquisitions in the cannabis industry are not like M&A in other industries. The parties need approval from state and local regulators, increasing the complexity and slowing down the process significantly.
This regulatory overlay creates myriad traps for first-time buyers and sellers. The following are some of the most common obstacles that the parties face.
Local license transfer uncertainty
In some states, the parties need the approval and permission of local officials before a sale can go through. However, most cities have never processed a license transfer. To make matters worse, some cities do not even have language in their cannabis ordinances that describes the change-in-ownership process.
All of this translates into uncertainty as to what is required and how long it will take.
This uncertainty puts the burden on the seller or the seller’s representatives to investigate what the city will require in order to process the transfer. Investigating the city’s requirements can take time, especially if there is not a clear chain of command at the city. The decision-maker can be the city attorney, zoning and planning department head or someone else.
The reason that the seller has to be the contact point is that many regulators will only communicate with the specific person listed on the existing license.
Buyers should expect delays and uncertainty in cities that have not previously processed a license transfer or change in ownership.
Tax liability overhang
Thanks to Section 280E of the Internal Revenue Code and the federal illegality of cannabis, cannabis companies must comply with 280E in filing their tax returns. Section 280E is a complicated and technical provision that is not easily interpreted by the average accounting professional.
Historically, most cannabis companies have not utilized highly skilled accounting professionals internally, or externally in the form of outside CPAs. This has resulted in cannabis companies taking overly aggressive deductions and underreporting income in the eyes of the IRS.
The challenge for buyers tends to be guesstimating the extent of the tax liability resulting from the target’s underpayment of taxes, plus penalties and interest.
Our clients tend to utilize holdbacks and escrows to provide protection against the acquisition target’s potential tax liabilities.
Waiver of buyer’s closing conditions
Buyers will often want an assurance that all necessary governmental approvals have been obtained before closing. Otherwise, the buyer would be paying the seller for something that it cannot own. This concept is typically written into the deal document as a closing condition for the buyer.
Some regulators, like the Bureau of Cannabis Control in California, may require the buyer to waive this closing condition as a prerequisite to completing their review. In practice, this means that the buyer must close the transaction on the assumption that the regulator will approve the acquisition and sale.
By imposing this requirement, a regulator shifts all of the risk to the buyer in the event that regulatory approval is not forthcoming. Potential buyers must be aware of the risk that a regulator will request this waiver and have a contingency plan in place just in case.
Communication bottlenecks with regulators
As mentioned above, most regulators will only communicate with a specific person on the seller’s side. This can create delays in the approval process if the point person does not cooperate, is sick or goes on vacation.
While this issue mostly affects buyers, both sides can be impacted if regulators ask for information or documents and they are not provided to them on a timely basis.
Buyers should closely monitor communications with governmental authorities to make sure that the regulators promptly receive the information they request.
Escrow agent availability
Many cannabis M&A transactions require escrow accounts so that buyers can deposit payments for holdbacks or purchase price payments.
The problem is that very few escrow companies will hold funds and/or securities for cannabis transactions.
Finding an escrow agent willing to accept these funds, and with availability, can take a great deal of time, which can delay closings. In a worst-case scenario, the parties’ inability to find an escrow will require a rewrite of the key documents and renegotiation of deal terms.
Parties should begin their search for an escrow agent willing to accept funds and assets well before the closing.