New York’s hemp farms get a head start, but financial questions and regulatory uncertainty loom large for the adult-use market’s early entrants
New York’s cannabinoid hemp farmers are finding themselves belles of the ball in a flurry of promising early market M&A activity, with prospective investors and operators eager to be first in the world’s largest cannabis consumer market.
Despite obvious potential, valuing a conditional cultivator license, for purposes of executing on a finance strategy or endeavoring to cash out and sell, is challenging amidst regulatory uncertainty. It is critical that dealmakers take great care to provide for regulatory contingencies in their transaction documents and accommodate anticipated shifts in New York’s evolving regulatory environment.
In January 2022, New York lawmakers amended the Marijuana Regulation and Taxation Act (New York’s adult-use cannabis legalization measure) to provide conditional authority for some New York hemp farmers to grow adult-use cannabis (containing THC) until June 2024. To qualify, hemp farmers must be authorized to engage in cannabinoid hemp research (distinct from research of hemp for industrial uses or for food or feed).
Conditional cultivators are also permitted to “minimally process” cannabis flower products and to self-distribute those products until June 2023.
Conditional cultivators will sell their products to: (a) conditional processors, who, similar to conditional cultivators, have authority to engage in research regarding cannabinoid hemp processing; and/or (b) conditional retail dispensaries — 100 to 200 merit-based, competitive licenses that the state intends to issue to certain “justice involved” individuals who demonstrate a specific degree of business sophistication.
Notably, the state has imposed narrow eligibility criteria for conditional cultivators and significant size and capacity limitations on permissible “flowering canopy.” Specifically, cannabinoid hemp farmers must have grown and harvested hemp for at least two out of the last four years, shown through documentation such as harvest reports. Their conditional authority to grow adult-use cannabis is limited to only outdoors or in a greenhouse — no indoor.
Outdoor capacity is limited to one acre; greenhouse capacity is limited to 25,000 square feet. If farmers grow both outdoors and in a greenhouse, they will be limited to 30,000 square feet total, with 20,000 square feet inside the greenhouse. Significantly, greenhouse grows may be supported by up to 20 “artificial lights” meeting a photosynthetic photon efficacy of no less than 1.9 micromoles per joule.
To date, New York’s Office of Cannabis Management has granted 90 conditional cultivator licenses, with new licenses slated to be issued every two weeks, through June 2022.
Prospective industry participants anticipate that every single product will easily be sold. Yet, as of this writing, except for proposed regulations related to social equity retail dispensaries and medical cannabis, the OCM has not enacted (or even proposed) regulations governing the adult-use cannabis program. Consequently, to date, there is no regulatory pathway for conditional cultivators to follow when devising their business plans or arriving at a valuation for their businesses.
Convoluting matters further, recent guidance promulgated by the OCM provides that conditional cultivators may be able to “transition” to a full adult-use cultivator license, unrestricted by the capacity limitations described above (including, especially, being able to grow indoors). However, the OCM has not articulated whether this “transition” will be automatic, merit-based, or whether conditional cultivators will be required to compete for a limited number of licenses, begging valuation questions.
Furthermore, conditional cultivators are subject to material transfer restrictions, mandating that the former cannabinoid hemp operators (individuals or entities) own a majority (51%) of the conditional cultivator license for the duration of the conditional period, making it legally impossible to sell the business outright or to make a substantial divestment to accommodate new financing and control.
Investors and out-of-state operators who are eager to own more than 49% of a conditional cultivator license are evaluating creative work-arounds, including structured buyouts and/or providing fee-based management services and/or additional interest-bearing financing, to the same entity in which they own their interest of up to 49%. However, industry participants predict that the OCM will heavily regulate both management services agreements and financial source agreements, as each are commonly used to usurp regulatory restrictions on ownership, defeating social equity programming.
Across the river in New Jersey, individuals and entities are prohibited from providing management services and/or financing to any entity in which they are an “owner.” Both types of agreements are heavily scrutinized for approval by the state, prior to taking effect, to ensure that such agreements are executed on market terms, bargained for at arm’s length, easily terminable without penalty, and are otherwise not “predatory” in nature or confer an unfair advantage (welcome or not).
Should the OCM deem a structure in which an owner also provides management services and/or financing to be unlawful, early market transaction agreements calling for multiple entry points (ownership, services and/or capital) risk being invalidated. Fortunately, a simple, often overlooked boilerplate contractual provision can save an otherwise unlawful and unenforceable agreement: severability (also known as a “savings clause”).
Essentially, severability allows contracting parties to “sever” a contractual term that is deemed (or threatens to be deemed) unlawful or unenforceable, while the remainder of the agreement remains intact and enforced. However, severed provisions, particularly those that are economic in nature, could be the most attractive part of any given deal. Accordingly, severability provisions should also contain “reformation” language, requiring the parties (or the court or arbitrator, as applicable), upon a determination that a material contractual term is unlawful, to reform the offending provision and replace it with a new, enforceable provision, that resembles the parties’ original intent as closely as possible. With this safeguard, early market participants may hedge against regulatory uncertainty.