Cannabis business transactionOur cannabis attorneys see many cannabis deals and on a daily basis we see term sheets, pitch decks, prospectuses, fund summaries, etc. Though we’re always on the legal side, we are also often asked for advice we’d label “business advice” — ranging from the specific (here’s our deck, what valuation can we demand?) to the very general (as investors where should we put our money ahead of what’s going to happen with California cannabis in 2018?). In this post I offer our thoughts on some common issues.

 

Company Founders Ask: What are Investors Looking for?

If you spend too much time and thought reworking the numbers on a term sheet, or even believing those numbers play a big role in driving investor interest, you’ve got it wrong. I for one have never heard an investor say “the product misses the mark and the team is mediocre, but with these investment terms I’d be crazy not to jump in!” Though Shark Tank isn’t what life is really like out in the trenches, it does get the investment decision process in the right order: first the sharks meet the team and get their pitch, then they discuss and negotiate numbers.” If you’re too focused on the numerical terms, you’re better off not having a term sheet — a pitch deck (or even a one-pager) that focuses on the following is much more likely to drive an investor discussion forward:

  • the size of the opportunity
  • capturing the imagination of the investor
  • selling the investor on the team – the people – as the right ones to execute and seize the opportunity

 

Investors Ask: Where are the Big Returns?

Many investors assume higher risk companies will mean higher returns. And with this assumption often comes another one: companies that “touch the [cannabis] plant” (and are therefore unsuitable for nearly all institutional capital) will generate the highest returns. For investors using debt instruments and looking purely at interest rates as their ROI, this may be true. But for equity investors, it’s all about scale, and companies whose primary business is one that “touches the plant” rarely have the highest scalability. Though there aren’t nearly enough company exits to say for sure, the big returns are far more likely to be found in business-to-business ancillary cannabis companies – software, data metrics, equipment leasing, and other business services.

 

Everybody Asks: How can we insulate ourselves from federal criminal liability?

You cannot, not with 100% certainty. You cannot be involved in the cannabis industry and be completely insulated from federal criminal liability. That said, there are tiers of risk, and they generally break down as follows:

Tier 1 (highest risk):

  • Business operators that cultivate and sell cannabis
  • Business operators that process, test, extract or otherwise “touch the plant”

Tier 2:

  • Investors in Tier 1, above

Tier 3 (lowest risk):

  • Advisors and service providers to Tier 1 businesses and Tier 2 investors
  • Vendors and others that enter into “arms-length” transactions with cannabis companies

 

Company Founders Ask: Where do we meet investors?

  • Introductions
  • Industry associations
  • Conferences and networking events
  • Not cold-calling

Speaking of great places to meet investors, keep your eyes and ear peeled for our California Cannabis Investment Forum, coming soon in San Francisco!

California cannabis financing

For cannabis companies in California, 2017 is a period when neither companies nor investors are living in the moment. In addition to all of the risk factors cannabis investors need to heed, everyone is planning for future uncertainty because of  the recent passage of MAUCRSA. The state is currently working on MAUCRSA regulations, and local governments are changing policies with what seems like every public hearing – not to mention comments from our federal leadership that seem tailor-made for cooling investment into cannabis companies (the job creators!).

At the same time, California cannabis companies need funding now to scale up their operations in anticipation of future licensure under MAUCRSA and to appease local regulators through local licensing and permitting processes. The result of all this is that our California cannabis lawyers are seeing and working on many deals involving hybrid financing structures – an element of cash investment now, and warrants, options, and convertible debt later. Each has different triggers and rights for the cannabis company and investors, but all are in essence a different form of “kicking the can down the road” to 2018.

Three big factors are driving hybridized financing in The Golden State:

1. Regulatory Uncertainty and Red Tape.

Investors inherently accept risk in any investment, but they do not enjoy reading the tea leaves on major issues that are out of the control of company and investor – any of which could pose an existential threat to their entire investment. This means investors are searching for creative ways to mitigate these risks, and risks abound in cannabis regulations that change pretty much all the time. Many cannabis investors are uncertain whether they want to cross the 20% ownership threshold to be considered an “owner” under MAUCRSA, which ultimately requires they be disclosed to and heavily vetted by California state regulators.

2. License Transfer and Corporate Structuring Issues.

California’s draft cannabis business regulations make clear that future licenses are not transferable. And many local governments are also making sure cannabis operators cannot transfer their permits or local licenses after-the-fact. Further, most existing medical cannabis operators are organized as non-profit entities pursuant to Proposition 215, and there’s an outstanding question as to whether these entities will be able to merge into for-profits once they have their state licenses under MAUCRSA, though such a move could potentially jeopardize state and local licensure altogether. Though all parties should undertake their cannabis financings with this knowledge, investors understandably still want to reduce risk by withholding some of their investment until 2018 when more of these questions will likely have been resolved by state and local governments.

3. The Size of the Opportunity.

In the last two weeks, we’ve seen the situation in Nevada where despite a 33-37% tax on all retail sales, dispensaries simply cannot keep up with demand and are selling out of supply. In the event California has a similar supply crunch, we are seeing investors in California cannabis cultivators seeking warrants or options as a “kicker” for additional upside – more equity in the event the opportunities prove even greater than anticipated.

This is not to say that investors are dictating all terms in the world of cannabis finance. Cannabis companies, too, can and do negotiate for control of the trigger points or adjustments to the future exercise price (or regulatory triggers). Some cannabis companies are choosing hybrid investment structures because they, too, want to feel out the size of the opportunities and many believe they will be able to demand much greater valuations and investment terms in 2018, once the initial dust settles on the regulatory sphere.

What are you seeing out there by way of California cannabis funding?

 

We’ve written previously on options cannabis companies have when seeking financing. Since passage of Proposition 64, investor activity has noticeably picked up in California. It’s not surprising, as California is both the largest projected cannabis marketplace as well as home to roughly half of the country’s venture capital investors.

Cannabis Financing 101
Cannabis Financing 101

How are these investments structured? Below is a list of the more common types of cannabis investments we’re seeing, mostly in California, but in Washington State and in Oregon as well, in rough order of popularity:

Equity Financings. Our firm is doing “priced rounds” in the form of Series A equity financings with multiple investors, as well as individual investors purchasing minority ownership interests in LLCs. Cannabis companies are generally (but not always) preferring to have all investors within California so that they can do an intrastate offering for securities purposes.

Debt Financings. Companies with a track record of success are often preferring debt, as are investors that prefer not to have the exposure that comes with equity ownership. However, uncertainty on licensure processes and the timing when companies can fully operate has made payment schedules particularly risky for companies counting on revenues to pay back loans.

Convertible Notes. Convertible debt is traditionally used pre-Series A when a company is developing a product and still determining the size of the opportunity. A Convertible Note corrects for the difficulty in determining valuation at such an early stage by kicking the valuation can down the road to the Series A, but ensuring the investor gets at least as much value (and almost always more value) for their invested dollar, compared to the Series A investor. Typically notes have low interest rates, as investors are seeking equity upon conversion rather than by repayment.

For cannabis companies in California, convertible notes are taking on a new purpose: extending the question of valuation until 2018, when more will be known about the state’s cannabis regulatory regime. Conversion that is not automatic, but rather the option of the investor, also gives the investor an “out” should the investor not like the political climate around cannabis in 2018.

A slight variation on a convertible note is a “debtquity” arrangement where an investor provides a line of credit with a sliding scale of equity issuance based on the amount of capital accessed.

Alternative Financing Arrangements. Cannabis companies are proposing some non-traditional financing structures, such as investment via equipment leases, consulting arrangements, turn-key real estate, or investor-funded capital improvements. These are often a product of investor preferences or investor residency restrictions. Though these alternative financing arrangments are sometimes trickier for the lawyers to structure than a traditional investment, they often make for a good vehicle to provide cannabis companies with key resources needed at an early stage.

 

 

Cannabis securitiesLike tech startups, or any new business, cannabis startups need investment. Though most tech startups are organized as corporations, with the ultimate goal of acquisition or IPO, cannabis businesses are more often (but not always) organized as LLCs. But cannabis startups too often fail to realize that if they are seeking investors, they are probably selling securities.

Tech startups begrudgingly accept that compliance with securities laws are a fact of business life. With each financing, their attorney tells them: utilize a securities exemption or register the securities.

LLC membership interests, however, don’t fit into the common perception of the term “security.” Even many attorneys wrongly believe that securities are limited to stocks, bonds, and the like, and that a minority stake in an LLC is not an investment in securities.

In 2008, the case of US v. Leonard defined when a membership interest constitutes an “investment contract” — “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” The court wrestled with extending the definition to LLC membership interests but concluded that LLC interests require a “case-by-case analysis” into the “economic realities” of the underlying transaction.

In short, the investor must “exercise meaningful control over his investment.” The touchstone of what constitutes a security is not the form of investment, but rather whether or not it is a “passive investment.” If the investment requires active management engagement by the investor, it is not a security. But if it is a passive investment where the investor relies on others to run the business, it is a security.

Investors often have the right to give input into management decisions but do not ever actually exercise this right. The trend in securities regulation is to look beyond the terms of the agreement to analyze the practical realities. Cannabis businesses should be aware that in US v. Leonard, the individuals were convicted of securities fraud and went to prison.

The big takeaway is that businesses can choose to have all investors as active member-managers, and thus can plan around (and draft their operating agreement around) the need for securities compliance. The following are some practical points to ensure that your investors are “active member-managers” rather than “passive investors”:

  • Investors have voting rights in the LLC operating agreement, and exercise those rights in practice.
  • Investors have a management role and are “actively engaged” – they can have titles or membership on committees tasked with certain aspects of business operations.
  • Investors have input into and negotiate the terms of the LLC agreement.
  • Investors have full information rights, and actually receive and approve reports regularly.
  • Investors have input on key company strategic decisions – major decisions are made after consultation with investors.

Ensuring that your investors have an active, participatory role in management allows you to avoid entirely having to deal with securities law. When choosing your investors, you can help yourself in this context by seeking out investors that, in addition to money, have experience in the cannabis industry or in management so they can provide a value-add to your business.

Of course, this type of active management role won’t be acceptable to investors in every circumstance. As the number of cannabis investors grows and becomes more geographically diverse, however, the more likely they are to be considered “passive.” Marijuana businesses must understand that taking on passive investors means it’s time for securities compliance. At that point your attorney should be telling you to utilize a securities exemption and make the appropriate filing, or register the securities.

California cannabis businesses may recognize “management control” from California’s recently-released proposed regulations. We’ve written about these here and here. The regulations define as an “owner” any person who participates in the “direction, control, or management” of the cannabis business. Individuals having management rights will need to be disclosed to and vetted by state regulators in license application processes. Therefore, securities compliance and cannabis regulatory compliance are now two sides of a coin. Investors either lack management rights, meaning they are passive investors and securities compliance is required. Or investors have management rights, meaning they are “owners” and disclosure to cannabis regulators is required.