The rising tides of consolidation and M&A

Volume has increased and the scale of deals has jumped

2019 was expected to bring an influx of merger and acquisition activity to the cannabis industry, and thus far, it has not disappointed. Not only has the volume of mergers increased over years past, the scale of the deals has jumped up significantly. Mid-sized and larger companies are merging together to create massive multi-state operators, some with international reach through Canadian connections. And because Canada legalized cannabis in October 2018, Canadian entities have access to banks, institutional investors and the stock market, all of which give Canadian investors and operators a leg up.

We’re also seeing giants from the beverage and tobacco world, including Constellation Brands (Corona, Modelo, Pacifico), AB InBev (Anheuser-Busch) and Altria (Marlboro), dip their toes — and sometimes more — into the cannabis market with large-scale investments and strategic acquisitions.

The driving forces behind this trend are geographic reach, overcoming compliance obstacles, branding and the quest for vertical integration. Successful single-state operators will seek to purchase small and mid-sized operators in strategic states and localities like California to expand their geographic footprint and become powerhouse multi-state operators themselves. Larger multi-state operators are seeking to gain footholds in new markets via acquisitions, rather than starting from scratch in unfamiliar territory.

Another force is the tension between brand building and infrastructure development. A few lucky large companies can excel at both, but many operators that have focused on real estate and facilities have sold unbranded flower or manufactured product to operators with a stronger brand presence. We will likely see companies in these situations teaming up to fill in the gaps of their respective former strategies. In addition to a national presence and brand recognition, vertical integration has long been the goal for many cannabis operators. The ability to grow, manufacture and sell cannabis products all under “one roof” allows for total control of product quality while generating sought-after cost-saving efficiencies. A successful acquisition could mean closing the loop for a company looking to dominate more aspects of the industry.

A strong and healthy M&A market is vital to creating a robust and innovative startup environment. With the possibility of a clear exit plan, entrepreneurs and investors will be more likely to invest serious capital and take risks on new ventures. This means more diverse products, ideas and people entering the industry, which is good for consumers and for the entire cannabis industry.

Some argue consolidation stifles growth. In some circumstances it can, but for a new industry like cannabis the consolidation of capital, innovation and infrastructure will give the whole industry a level of security and legitimacy that it previously did not have access to. Without more M&A activity, small and mid-sized cannabis operators would be left to rely on slow and gradual growth, all while battling a fairly healthy black market, high tax rates and putting significant resources into navigating the maze of local and state compliance.

 

How to position your company for a strong exit

As your business grows and you start thinking about positioning your company to be acquired, it’s important to get organized and prepare to be examined under a microscope by potential buyers. Some tips and things to look out for include:

– Create a valuable business: Your primary goal should always be to grow a valuable business that is attractive to investors. Whether your value comes through perfecting your edibles recipe, acquiring strategically valuable land or building a recognizable brand with a loyal following, it’s vital to create something of value that a larger company could not or would not develop on their own.

– Be consistent: Once your business has grown, investors and potential buyers will look to see that your operations are stable, consistent and performing at a high level. Financial metrics like maintaining a strong revenue stream and becoming profitable are important indicators that a company is a strong candidate for acquisition. A chief financial officer well versed in cannabis will be an especially valuable hire as you prepare to attract buyers.

– Local and state licensing: Are your licenses up to date? Do you know the process of updating the owners of the licensed entity? Does your state or locality allow you to transfer a license? Investors must ensure that any company they review has all the proper required state and local permits it needs to operate. Given the new and untested licensing processes in many states, investors will be especially concerned about compliance matters.

– Capitalization and corporate records: A company ready for investment or acquisition should have their corporate documents and records organized and up to date. This often means properly documenting and approving corporate actions, making sure the company is in compliance with its own articles of incorporation and bylaws and knowing about and managing any other risks, such as other “founders” coming out of the woodwork to claim ownership in the company.

– Taxes and financials: Buyers will want to know whether you have appropriate banking arrangements, filed accurate tax returns, paid all your local, state and federal taxes, or if you are at risk for an IRS audit. Like corporate records, it is important that companies keep complete and proper financial records and engage accountants familiar with the cannabis industry and its unique financial challenges.

– Intellectual property: Intellectual property (trademarks, trade secrets, patents, etc.) may be some of the most valuable assets your company owns. Potential buyers will want to examine how well your IP is protected, understanding that federal registration of certain intangible assets may not be available for an “illegal” business activity like cannabis. It is also critical to resolve any third-party claims of ownership on your IP or claims that your IP infringes on another party’s intellectual property.

– Business operations and agreements: Review and resolve any outstanding issues related to employment (such as proper classification of employees, wage and hour issues, etc.); lease agreements and other real estate matters; contracts with customers and suppliers; insurance coverage; adoption of and compliance with internal controls, policies and procedures; compliance with environmental laws; and compliance with other rules and regulations that may apply. Noncompliance in each of these areas could present a risk of liability to investors.

 

Karen J. Balderama and Mia L. Butera are attorneys with law firm Wendel Rosen LLP in Oakland, California. They may be reached at kbalderama@wendel.com and mbutera@wendel.com.

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