(Editor’s note: This story is part of a recurring series of commentaries from professionals connected to the cannabis industry. Marc Hauser is an attorney and vice chair of the Cannabis Law Team at Reed Smith in San Francisco.)
In the midst of an extended economic downturn, cannabis companies have few options for raising capital.
Equity remains elusive, while debt and sale-leasebacks are generally available only to those with sufficient hard assets to underwrite, such as real estate and equipment.
This has some distressed operators looking to consolidation as a lifeline, with investors and better-positioned companies eyeing acquisitions as an opportunity.
However, consolidation – like everything else in cannabis – is not so simple, all driven by the highly regulated and illegal nature of cannabis in the United States (“cannabis” in this story does not include industrial hemp).
1. Purchase price
Cash is tight across the cannabis industry.
As a high-growth, early stage enterprise with a steep cost of doing business, positive net income is elusive.
Buyers want to preserve cash as best they can. So, these days, acquisitions are generally getting done with stock as the only currency, or perhaps with a little bit of cash.
This means sellers need to know something about the stock they are getting.
If the buyer is public, the sellers should know when (under securities laws) and how the stock may be sold (will the broker execute a trade in a cannabis stock?).
If the buyer is private, the sellers should consider doing due diligence on the buyer.
Another consideration is valuation. If the buyer is public, the value of the stock issued is easier to fix.
But it could be months before a company is sold, so there is market risk to that value.
If the buyer is private, the sellers need to understand and agree on the enterprise value of the buyer.
Takeaway: As a seller, don’t expect cash for your business in the current environment. If the buyer is private, consider getting a third-party valuation of both companies to make sure the deal is fair. If the buyer is public, know how you are going to be able to get liquidity.
2. Change of control
One of the most challenging aspects of cannabis consolidation is the licensing.
For the most part, state and municipal codes do not allow a buyer to acquire a seller’s cannabis license as a stand-alone asset, viewing the permit as an entitlement for the benefit of the business itself.
So, acquisitions are generally done at the entity level, meaning as a stock purchase or a merger.
Even though the entity itself is being transferred in a stock purchase or merger, most state and municipal authorities require some sort of vetting and approval for the change in control.
This adds a significant amount of time delay and uncertainty to close, a luxury distressed companies cannot necessarily afford.
Creative structures (such as management staying on board, pending approval, or selling the stock in two parts) might work within some regulatory schemes.
But you’re tempting fate. How do you unwind the deal – in other words, return the purchase price and the equity – if the regulator refuses to approve the buyer?
Takeaway: Understand the implications of state and municipal change-of-control approvals, and always prepare for the worst.
3. Legacy liabilities
When a buyer acquires the stock of, or merges with, another company, all the target’s liabilities, obligations and other baggage go along with the target company to the acquirer.
In other words, the buyer does not have the luxury of picking and choosing assets and liabilities to leave behind, as it can in an asset acquisition.
What this means is that the cannabis acquirer, which is effectively forced into this structure, needs to conduct heightened due diligence to understand the full picture of the target’s problems.
Which, in a distressed scenario, could be extensive – suppliers, service providers, landlords, taxes, insider transactions, etc. That includes both current and past problems.
Takeaway: You must take the good with the bad, so make sure you don’t skimp on diligence. And hire the right professionals who know what to look for.
4. Dealing with debts
Not every buyer wants to take over a company with hairy liabilities, such as a long-term lease, defaulted debt and unpaid trade creditors.
The buyer will want to make sure those creditors are dealt with, lest they file suit to collect the day after closing.
In other industries, a distressed company can file for protection under the U.S. Bankruptcy Code, allowing it to restructure its debts, conduct a sale of the company as a going concern free and clear of most debts, or liquidate – all without the pressure of creditor lawsuits.
With a prepackaged plan of reorganization or a sale with a stalking horse bidder preloaded, bankruptcy can be a powerful tool in clearing out debts and facilitating distressed transactions.
However, U.S. bankruptcy courts have made it clear that cannabis businesses and related companies may not take advantage of federal bankruptcy protections.
Related state-level remedies such as receivership and assignment for the benefit of creditors simply do not offer distressed companies an equivalent or useful level of protection.
This leaves the distressed company and the interested buyer with little choice but to negotiate with creditors.
Some will be happy to take a haircut to get paid.
Some will be willing to take stock in the deal.
Some will simply refuse to negotiate and must be paid in full.
The buyer will need to underwrite this cost and decide whether the payoff of creditors reduces the purchase price.
Takeaway: As a buyer, make sure you have a complete understanding of all creditors and a plan for how to deal with each one. And always ask for a release.
Marc D. Hauser is an attorney and vice chair of the Cannabis Law Team at Reed Smith in San Francisco. He can be reached at 415-659-4814 or mhauser@reedsmith.com.
The previous installment of this series is available here.
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