Consolidation will accelerate with federal legalization
The combination of two or more businesses, whether by merger or acquisition, can present owners and managers with a new range of opportunities and threats. Nowhere is this truer than in the cannabis industry, where rapid growth and a complex patchwork of regulations combine to create a challenging business environment.
There are two major types of business combinations. An acquisition is the purchase of one business by another. This can take the form of either a stock purchase or an asset purchase. With the former, the buyer acquires the business entity, including all assets and liabilities. With the latter, the buyer chooses only those assets and liabilities that it wishes to purchase and leaves the rest with the seller.
A merger, on the other hand, involves a combination of two or more businesses. In some cases, one of the companies continues as the surviving entity. In other configurations, a new entity is created.
Managers pursue business combinations, whether by merger or acquisition, for a number of reasons, including the following:
– Synergistic growth: Simply put, the product is expected to be larger than the sum of its component parts. This should not be the sole objective; by itself, it is not always in the best interests of the companies’ owners.
– Consolidation and economies of scale: Sometimes, functions can be consolidated for a net cost savings. This is especially true of general and administrative expenses, such as human resources, research and development, insurance and accounting.
– Integration: This can be for either strategic or financial gain. Horizontal integration involves M&A across the same level of production, such as grow facilities, testing labs or extraction facilities. This is often done to eliminate competitors or to realize the economies of scale described above. Vertical integration involves M&A across different levels of production, such as a grow facility with an extraction facility, etc. This is often done in order to consolidate separate levels of profit centers.
All of these drivers and more apply to the cannabis industry, and we can expect to see activity in a number of segments.
– Cultivation, storage and processing: It may come as a surprise to anyone who has speculated in commodities to learn that the commodities futures markets were originally conceived as a mechanism to reduce risk to their original participants, the farmer-producers. All crops are risky, and cultivators can suffer from either bad climate or soil conditions, which reduce their saleable output, or good conditions, which increase competitive supply. Unfortunately, so long as marijuana remains illegal under federal law, cannabis growers will not be able to lock in prices for their crops by means of futures sales. Considering also the ease with which home growers can add to supply from their backyards or spare rooms, cultivation may be the riskiest stage of the industry. Just as other types of agriculture have fallen victim to Big Agra, the cannabis cultivation business will likely be subject to consolidation, and the process will only accelerate with federal legalization.
– Extraction and testing: Extraction facilities and testing labs have seen rapid technological advancements in recent years, and owners of businesses in both sectors complain of the same thing — a lack of continuous supply of product. Without an increase in cultivation, this idle capital will be also be subject to consolidation.
– Retail: Some of the larger players in the cannabis space such as MedMen have expanded largely through acquisitions, particularly at the retail level. Some locales, such as Los Angeles County, have adopted “social equity” programs, where preferential treatment is accorded to applicants who may have little ability to commercialize their licenses without assistance from a larger business and financial partner.
On a less sanguine note, many have observed an overexpansion in all sectors, and financial distress could drive less competitive players into the arms of buyers — and at less-than-stratospheric prices.
There are certain issues that appear in all M&A transactions, including the following:
– Valuation: There are three basic valuation methods: discounted cash flow (DCF), which attempts to put a present value on anticipated, future income streams; book value, based on the owner’s equity part of the balance sheet, and closely related to replacement value; and liquidation value, the expected value of company assets that might be realized in a fire sale. For a profitable company, DCF usually produces the highest price.
– Integration: Forbes magazine has estimated that at least 50% of M&A deals fail — meaning they fail of their intended strategic purpose or fail to produce the anticipated increase in revenue. Often this is due to failure to appreciate differences in business culture, overestimating synergies or underestimating the amount of overlap and duplication that results from the business combination.
– Overreaching: Buyers often rush into an acquisition without first adequately establishing the necessary overhead to accommodate the combination.
– Undue influence: Shareholder activist Nell Minnow has famously said, “Investment bankers are like the geishas of the business world. They sit next to the CEO, laugh at all his jokes and talk about how much fun it would be to go out and buy something together.” The sad reality is that many advisers who are indispensable to the acquisition process have a vested financial interest in seeing that the deal closes, after which they have no responsibilities whatsoever.
– Competition: Following the close of a deal, redundant employees are typically shed, especially from the acquired company. In addition, when M&A deals begin to show signs of failure, employees of the acquired company may start to desert on their own.
In addition to these, a number of issues may arise that are specific to the cannabis industry, including the following:
– Licensing: In some states, such as California, the fact that the enabling statute left licensing to local authority was originally hailed as a triumph of local autonomy over centralized power. Unfortunately, this has produced a byzantine patchwork of regulations that tends to frustrate efforts to realize economies of scale.
– Interstate commerce: So long as cannabis remains illegal at the federal level, any transportation of product across state lines will be a federal offense. That’s just the bad news. The worse news is that any transportation, even between two ports within the same state, that involves either air or sea transportation, is within the purview of federal regulation. This will continue to be a lethal “gotcha” for expanding cannabis businesses.
– Valuation: The valuation methods described above have limited applicability to startups with no operating history. We’ve seen this story before in the dot-com era. Illegality makes for uncertainty on steroids.
A new phase of consolidation in the cannabis industry will inevitably be upon us in the near future. Even if legalization occurs at the federal level, many challenges will remain. It’s an era of caveat emptor … and vendor.
William Tolin Gay is a partner at Wilson Elser Moskowitz Edelman & Dicker LLP with more than 30 years of experience as a business/corporate lawyer, culminating in his present transaction-focused practice, which includes corporate law, entity formation, mergers and acquisitions, corporate finance, licensing agreements and technology transfers. He has extensive experience working with domestic and foreign clients in cannabis, securities, real estate, intellectual property and franchising.