The next generation of financing is coming to cannabis
Cannabis companies in the United States are at an inflection point, waiting for public financing opportunities to catch up. Historically, even the largest domestic cannabis companies have been able to meet their capital requirements mostly in the private markets.
As new jurisdictions like New York launch their programs, the sector may be evolving to again being perceived as undervalued and ripe with investment opportunity. Some brands are garnering national recognition — for the first time, an adult-use consumer in New Jersey might walk into a dispensary and be able to purchase a brand they liked from a visit to Las Vegas or Denver. Some of these dominant domestic brands have achieved “unicorn” status — a valuation of more than $1 billion dollars while remaining private — a designation historically reserved for the highest performing tech companies.
Today, these industry leaders look more like small-cap public companies and are shrugging off the “Wild West” perception, boasting sophisticated management teams executing on disciplined growth models and backed by several years of audited financials.
First-Gen Cannabis Financing
Initially and to date, the vast majority of U.S. cannabis companies have raised capital in private offerings pursuant to Rule 506 of Regulation D. This “safe harbor” permits raising capital exempt from Securities and Exchange Commission registration and ongoing reporting.
Pursuant to Rule 506(b), a cannabis company (like any other company) can conduct successive offerings of preferred equity or convertible notes. Through a series of successive offering rounds, companies hope to raise increasingly larger amounts of capital at increasingly higher valuations, often while operating at a loss but generating significant revenue. The benefits of this type of capital raise include:
– The ability to raise an unlimited amount of money from an unlimited number of “accredited investors” and up to 35 non-accredited investors, subject to meeting solicitation and other exemption requirements;
– Avoiding the need for a private placement memorandum (PPM), a legal document provided to prospective investors, if all of the investors in the Rule 506(b) offering are accredited; and
– Exemption from ongoing securities reporting with the SEC.
Despite their relative ease of execution, however, Reg D financings tend to be reserved for early and growth stage companies because each successive round is dilutive to the founders and other existing equity holders, and of limited value to the investor because the resulting equity issued is not easily liquidated. In addition, the equity issued fails to capture marked-to-market growth as the company continues to increase in value and companies are limited in the amount of capital that can be raised, since there is a finite number of investment funds and high net worth individuals available to invest in companies, and unless additional regulatory requirements are met, the companies must have pre-existing relationships with investors (i.e., limits on general solicitation).
Considering the limitations of Reg D financings, U.S. cannabis companies are constantly looking for other ways to access capital.
Non-dilutive lending sources, including banks and other financial service businesses have started to emerge; for example, Bespoke Financial is the first licensed commercial lender focused on the cannabis industry, First Federal Bank is a Florida-based community bank with a specialty banking division for cannabis companies, and DAMA Financial is a financial service business providing access to banking and payment solutions for the cannabis industry. But those sources tend to be expensive for companies due to the high cost of the bank’s own FinCEN compliance and limited number of competitors, as well as not always being available to borrowers in certain locations or with limited assets and track records.
– Commercial lending: Given the limited pool of private investment and commercial banking opportunities, U.S. cannabis companies have increasingly demanded access to capital markets. However, because the sale and use of cannabis remains illegal under federal law, stock exchanges such as Nasdaq and the New York Stock Exchange will not list the securities of U.S. cannabis companies that “touch the plant” (whether through direct listings or SPACs). U.S. cannabis companies, therefore, have expanded into the only domestic capital markets that will take them — the over-the-counter or “OTC” markets, and also through “mini-IPO,” pursuant to Regulation A.
– OTC trading: Several U.S. cannabis companies trade on the OTC markets. Because of the liquidity provided by the OTC markets (although generally to a lesser degree than Nasdaq and the NYSE), cannabis companies quoted on the OTC markets have a broader base of investors from whom to raise capital, as compared to private companies.
Most OTC companies raise capital in financing transactions in private offerings that are exempt from the SEC’s registration requirements. The investors in these transactions can then generally sell these securities after meeting a six-month holding period mandated under SEC rules (provided that they are not officers, directors or principal shareholders of the issuer). Trading in OTC securities is reported by the OTC Markets Group, Inc., which maintains a tiered system of “markets” for the securities it reports on. These include OTCPink, OTCQB and OTCQX.
OTCPink companies often provide little or no public information, and the securities of many OTCPink companies trade at a fraction of a penny. OTCQB companies must initially have a trading price of at least $0.01 and issue quarterly and annual financial reports that are available to the public; most OTCQB companies file the same types of quarterly, annual and other reports with the SEC that exchange-listed companies are required to file, such as 10-Qs, 10-Ks and 8-Ks. OTCQX is reserved for companies that meet minimum financial criteria (such as at least $2 million of assets).
– Regulation A+ Financings: Instead of OTC listings, which feature increasingly higher burdens of reporting at the various OTC listing tiers, as well as the volatility associated with being publicly traded, some U.S. cannabis companies have undertaken Regulation A+ offerings.
In 2012, the JOBS Act introduced Regulation A as an alternative method of fundraising, allowing companies to publicly advertise their capital raises with limitations. In 2015, three years after the JOBS Act was initially signed into law, Regulation A+ went into effect, allowing private, growth-stage companies to raise money from U.S. investors. Often referred to as a “mini-IPO,” Reg A expands the potential capital pool for U.S. companies, including cannabis companies, allowing them to accept funds from both accredited and non-accredited investors, through either Tier 1, for offerings of up to $20 million in a 12-month period, or Tier 2, for offerings of up to $75 million in a 12-month period.
Reg A+ offerings do have some securities compliance requirements — notably, preparing a Form 1-A, producing reviewed or audited financials and clearing comments from the SEC before being “qualified.”
However, the initial public disclosure and reduced (or in the case of Tier 1, absent) ongoing public reporting is often considered acceptable by cannabis companies looking to access larger capital pools from a broader pool of retail investors.
Considering that cannabis remains federally illegal, becoming a publicly traded company still presents a unique challenge. To date, flower-touching U.S. companies can only be publicly listed on the Canadian Stock Exchange and trade on the OTC in the United States.
Currently, U.S. cannabis companies exploring the public route may start the IPO process through confidential submissions to the SEC, which gives them more flexibility regarding the timing of going public and/or the decision to actually go public, as opposed to starting the process through a public filing that may, inadvertently, create artificial stress on the company to actually go public when the economic environment is not ripe to do so.
To its credit, Congress has been trying to address this issue. For example, on June 23, 2022, Representatives Troy Carter (D-La.) and Guy Reschenthaler (R-Penn.) proposed the Capital Lending and Investment for Marijuana Businesses Act (CLIMB Act) which would “create a safe harbor for national securities exchanges to list the securities of issuers that are cannabis-related legitimate businesses.” In other words, the CLIMB Act would allow cannabis companies to be listed on the NYSE and Nasdaq.
The CLIMB Act would also bar federal agencies, like the Department of Justice, from bringing civil or criminal actions against other government agencies, such as the Small Business Administration, for providing services to state-legal cannabis companies.
If the CLIMB Act or similar legislation passes, more cannabis companies may see this as a viable path to raise capital, subject to the strength of the capital markets, of course.