We write a lot about cannabis business fundraising here, but it’s usually in the context of private offerings. Getting investment from friends and family or by directly pitching investor funds and venture capitalists is the traditional model for most new businesses, and cannabis is no different. More companies, however, are starting to explore the idea of public financing — which creates its own unique set of issues. Investors like the idea of public financing because it potentially provides a short-term avenue for liquidity that doesn’t exist for private companies. Companies like it because they are more likely to get the valuation they want in large public capital markets than when pitching to individual venture capitalists. I’ll write a bit here about what is involved in public capital raising, but then I will bust the balloon by mentioning some of the reasons our cannabis business lawyers generally advise against it for cannabis companies.
Any type of financing that includes a “general solicitation” can be considered a “public” issuance of securities. Publicly traded companies are often associated with famous listed exchanges like the New York Stock Exchange and NASDAQ, but a company could list its shares on Craigslist and accept orders and be considered to have essentially gone public, though we certainly would not advise doing that. The primary barrier to companies going public are securities laws. Prior to initially offering publicly available shares, a company needs to register the class of shares being sold and file an S-1 to register the individual shares available for purchase. These registrations include significant substance and formal review by the Securities Exchange Commission (SEC) before being accepted.
To date, no cannabis company that we know of has successfully gone public in the United States using that traditional route. Instead, they use something called a reverse merger. A reverse merger happens when a private company purchases a controlling interest in a public company and transfers its primary line of business to the new combined public company. The only asset the public company generally has in this scenario is that it has already gone through the registration process with the SEC — the private company is benefitting by being able to skip the regulatory step involving registration of a share class. But the company still isn’t able to issue new shares to the public before it files an S-1 to register the new individual shares it wants to sell.
That S-1 step can be very expensive and and is often why you don’t see companies do a traditional public offering in the first place. That said, companies strapped for cash can still get there. New capital is still raised on private markets through a PIPE — private placement in public equity. A PIPE is simply a private fundraising transaction from a publicly reporting company. Because there still is no registration statement, stock issued in a PIPE has to be restricted against resale on the open market and is discounted in value because of the restriction. But after a successful PIPE, a company now has some money and a registered class of securities. It can engage in broader public fundraising and allow for trading of its shares on the open market as soon as it files an S-1 that gets accepted by the SEC. And though that can be challenging, we know the SEC has accepted S-1s for cannabis companies in the past.
All of that being said, we tend to advise our clients against public markets for a few reasons. First, for those of us based in Washington State, any type of public financing is impossible. Under Washington State regulations, every single shareholder in a licensed cannabis business must be vetted by the state prior to acquiring an interest in a licensed cannabis company. Other states have similar restrictions that make public company work impossible. But even if you are in a state like Oregon or Nevada that has looser restrictions on who can own shares in your company, having owners you don’t know presents some risks. One takeaway from the Department of Justice’s 2013 Cole Memo was that federal law enforcement was (and still is) worried about legal marijuana systems being used as a front for illegal activity. Any system that allows for even partial shadow ownership of a business is more likely to run against Cole Memo priorities. A marijuana business that is fully engaged in its compliance work should do its best to ensure that none of the value it is creating and none of the profits that it is distributing are being diverted to illegal destinations.
Practically speaking, the reverse merger we just discussed still involved a private placement using a PIPE, so the company often has at least some exposure to private markets. A lot of headache could be avoided by continuing to raise capital in private markets. There are reasons most tech companies avoid going public for years. Your early stage investors are looking to get value over time when the company really takes off — they don’t necessarily need the short-term liquidity public markets can provide. And there are still many cannabis investors. If you feel like the private investment market isn’t giving you what you want, it’s worth sitting back and thinking about whether those investors are correct before dismissing them and raising money from public shareholders. The government generally lets wealthy investors take what risks they want and it doesn’t make it easy for them to sue companies when their investments go sour. But if you have public shares, the SEC and your state agencies are going to be much more protective of those shareholders.
And that brings up the last point, which is that publicly traded markets of cannabis stock are rife with fraud. Even if you are raising money publicly for completely legitimate means, being public in the cannabis space will raise red flags from regulators, the public, and federal law enforcement. If that’s not the kind of attention you want, going public will probably not be the best route for you.