More than a few fledgling enterprises have failed in recent years as a result of bad deals that often end in litigation and insolvency
You have worked hard to build your cannabis company and have just started to gain traction. Now you are sitting across the table from an investor who is offering to provide growth capital.
You have studied the voluminous press coverage on the range of financing options considered by cannabis investors, including friends and family, family offices, hedge funds and Canadian public companies. You have your eye on mergers, acquisitions and cross-border opportunities. You are focused on how to “raise money right.” And you are thinking, “I’ve got this covered.” You go to the internet and find a good subscription agreement form.
Stop. Right. There.
Before shackling your company with potentially fatal investment terms, recognize that there is more to taking in funds than just receiving the money. It is critical to negotiate and draft proper investment agreements to allow for likely future business events, both positive and negative, as well as complying with securities laws. More than a few fledgling cannabis companies have failed in the last couple of years as a result of entering into bad deals, often resulting in litigation and insolvency. Without an attorney with experience in cannabis-specific securities, investment money can wind up costing a company more than it was worth.
Hurdles to Overcome
Before you are tempted by a capital infusion, please weigh the following important considerations as well as the awesome responsibility of accepting any outside money. The cannabis industry cannot sustain the prevailing “Wild West” mentality and must embrace the growing complexity of a highly regulated industry.
– Complex regulatory environment: In the United States, high tax rates plague the legal cannabis industry. In California, the largest marijuana market in the world, state sales tax, local taxes, cannabis excise taxes and wholesale tax can add up to as much as 45%. Additionally, since roughly 4 out of 5 California jurisdictions do not allow legal marijuana dispensaries, the illegal market continues to thrive, forcing legal dispensaries to drop prices to compete.
– Overenthusiastic market valuations: A year ago, as Canada was becoming the first industrialized country in the world to legalize recreational cannabis, marijuana stocks could do no wrong. Valuations for nearly all pot stocks were soaring on the expectation that the global cannabis industry would grow by a strong, double-digit percentage for years to come.
– Criminal intent: Amid the froth, certain companies misrepresented facts and violated the law. For example, CannTrust Holdings (NYSE:CTST) admitted in July 2019 that it grew cannabis in five unlicensed rooms for a period of six months (October 2018 to March 2019). Moreover, then-CannTrust CEO Peter Aceto knew of and allowed this illegal production. Notwithstanding his eventual termination, Health Canada subsequently suspended the company’s ability to cultivate cannabis or sell cannabis products. In November 2019, Health Canada announced the indefinite continuation of the suspension until the company regains compliance in the eyes of Health Canada.
You will not raise money from a reputable source if you don’t have your ducks in a row. Investors and acquirers will conduct a thorough review of all your company’s material (and sometimes immaterial) documents and records.
The diligence process serves two purposes. The investor wants to make sure they know what they are investing in. And you want to make sure that you have disclosed every possible material issue that your company has or is likely to face. When in doubt, over-disclose. Disclosure is your best prevention of not only litigation, but also years of poor investor relations. An upset major stakeholder can throw a real wrench into your future plans.
That means it’s important to take steps now to maintain business records in real time. You want to be ready should an investment or acquisition opportunity present itself. Failing to be prepared can result in costly and messy cleanup processes or complex securities laws issues. In addition to the financial aspects of the company, cannabis businesses also must document compliance by showing that the company obtained all necessary regulatory approvals and local and state government authorizations to conduct its business, as applicable.
Examples of cannabis compliance documents include permits (including, but not limited to building, conditional use, zoning variances and any related specifically to cannabis growing, production and sales); business licenses; cannabis licenses; other authorizations, if applicable; and communications from regulatory agencies.
Keep in mind that cannabis-oriented agreements must comply with the specifics of cannabis licensure and regulations, which may differ from state to state (and even at the municipal level). Improper material contracts entered into by the company will limit it or create problematic investment terms. Examples of material agreement provisions that often need specific cannabis disclaimers or other language include: leases; agreements reflecting obligations of or to the company in excess of certain dollar thresholds; exclusivity agreements; agreements with most favored nations provisions; agreements with restrictions or penalties, or agreements that are difficult or problematic to terminate; and agreements that are violated on a change of control or ownership of the company.
How to Maintain Control
Your records are clean, your taxes are paid, your financials are spot on. You are ready to go! Now look to the future. Unless you are selling your entire business, you need to watch out for your ability to maintain control. It is not as simple as keeping a majority of the equity. Many investors will want approval rights over future equity issuance, incurrence of debt, executive compensation, changes or additions to lines of business. The list goes on and on. Even the most self-sufficient companies need professional help. Your investor likely has experienced counsel that not only knows how to negotiate these terms, but knows what to ask for in the first place — and why. You cannot have a successful transaction without matching that expertise. At the end, poor or non-existent legal counsel will be much more expensive than hiring appropriate advisors.
Very few businesses have everything in perfect form. As business owners you always have more to do than time allows, even if you have trusted and competent accounting and legal support.
The best things you can do to avoid being next year’s sad news article are to keep a running list of potential due diligence items and to work through your list with competent professionals. And do not rush into any investment relationship and never sign or agree to terms unless you fully understand what you are committing to (this includes “non-binding” term sheets).
Anne van Leynseele is a cannabis and hemp regulatory and deal attorney, often working across sovereign borders. She advises multi-state and multi-national cannabis clients on governance, compliance, licensing, acquisition, asset management, and import/export matters. Prior to joining Zuber Lawler, she spent four years as a federal attorney advisor in Washington, D.C. She is a summa cum laude graduate of the University of Washington and a cum laude graduate of the University of Seattle School of Law. She can be reached at firstname.lastname@example.org.
Josh Lawler leads Zuber Lawler’s emerging technologies group, with a particular emphasis on blockchain (distributed ledger), artificial intelligence, robotics, biotechnology, virtual/augmented reality, cybersecurity and related technologies. He counsels clients in respect to securities and regulatory matters, including issue of tokens and digitized assets, as well as development, licensing, commercial use, acquisition and disposition of all manner of intellectual property and has represented clients in M&A and finance transactions with an aggregate value over $1.5 billion. He can be reached at email@example.com.