Consolidation is coming to the cannabis industry. Mergers-and-acquisitions activity in the cannabis space has skyrocketed in recent years, rising from $146 million across 53 deals in 2016 to more than $10.1 billion over 306 deals in 2022 according to data from MJBiz. This trend is expected to accelerate in 2022 due to lower interest rates and pressure on larger companies to expand their footprints and boost revenue.
As cannabis operators know, getting a new license to grow, process, distribute, retail, or test cannabis products can be an arduous, expensive, and time-consuming process. Cannabis licensure requires approval from a variety of regulatory bodies, specialized expertise, and patience. Rather than going through the entire process from the beginning, many investors choose to acquire established cannabis businesses with licenses already in place, so they can focus their time and attention on activities most likely to add immediate value, like superior marketing and achieving scale. Whether a particular business will be one of the few that will profit from this wave of interest may depend on its level of preparedness for a transaction that proceeds with as little friction as possible. Here are some basic steps an early-stage cannabis business should take to ensure it is an attractive target for potential acquirers.
Whatever form of corporate organization chosen for the cannabis business, it must develop a set of governance documents for the directors/managers of the business as well as a set of equity agreements for the shareholders/members of the company.
For corporations, one of the primary corporate documents needed are bylaws, which are a comprehensive set of governing policies and rules of how the corporation will conduct its business vis-à-vis its board and its officers. For equity owners, agreements such as Shareholders Agreements, Buy-Sell Agreements, or Restricted Stock Purchase Agreements often define the rights and obligations of the corporation’s shareholders. These contracts often restrict the fungibility of the corporation’s shares and place specific parameters on how the stock made be sold, if at all, to third parties. For limited liability companies (LLCs), the Operating Agreement is the principal document that contains both governance terms and economic terms for the division of profit/loss among its members.
Regardless of the corporate form chosen, the equity documents must establish:
- The division of equity interests and voting rights in the business among its owners;
- Restrictions on sales, transfers, encumbrances, and other dispositions of equity interests by ownership;
- Rights to dividends or other distributions of capital from the entity;
- Which officers, employees or other representatives of the business have authority to represent the company in negotiations over major corporate actions;
- Mechanisms and procedures for approval of major corporate actions by the business’s board of directors and/or shareholders;
- Priority of payments of proceeds of an acquisition transaction; and
- Procedures for winding down the business
Once equity documents are in place, companies should create and maintain a “cap table” setting forth the entity’s ownership interests. This necessary documentation is critical for giving equity owners and any potential acquirer a snapshot of your business’s stakeholders. Cap tables should include:
- Names and contact information of each stakeholder, including holders of common equity, preferred equity, convertible debt, SAFEs, options, warrants, unvested equity, and any treasury stock held by the corporation, organized by the type of interest each stakeholder holds.
- The number of shares controlled by each stakeholder.
- The percentage of the entity’s economic rights and voting rights represented by each stakeholder’s interests, given as a share of the outstanding equity and on a fully-diluted basis.
- Information specific to your non-common equity interests, e.g.: mandatory dividends on preferred equity; strike prices for options, warrants, SAFEs, and convertible debt; vesting schedules for unvested equity interests; and acceleration provisions on any change of control or sale.
Preparing for cannabis-specific diligence
One of the most important aspects of any corporate acquisition is the due diligence process, during which the acquiring company investigates the economic and legal bona fides of the target company. Potential acquirers in the cannabis space must also be satisfied that their target’s cannabis local and state licensure is in good standing and that the company is operating in full compliance with its regulatory obligations. There are three primary concerns for potential acquirers.
First, though California cannabis licenses themselves are not transferrable, they are usually the most valuable assets in a transaction of this kind. In order to go through with the deal, any potential acquirer must ensure that your license is in order and not in jeopardy from your operations.
Second, even if regulatory violations do not pose the threat that a target’s license may be revoked, many carry the possibility of incurring fines and other penalties that can add up quickly and destroy the economic value of the transaction. Under Section 26031.5(a) of the Business and Professions Code, each day a cannabis licensee operates in violation of the of the code counts as a separate violation of the code subject to its own independent administrative fine. With fines authorized up to $5,000 per violation, even a brief period of noncompliance can result in enormous potential liabilities.
Third, even under a best-case scenario in which the target’s business is being run in perfect compliance with every applicable regulation, the time and labor involved in establishing that fact to the satisfaction of a potential acquirer during the diligence process may prove fatal to the deal if the target does not have appropriate structures and systems in place to facilitate diligence. It is not enough to merely run your cannabis business by the book; you must be able to prove your compliance to a skeptical third party. The more easily and concretely you are able to establish these matters in the diligence, the stronger representations you can make in the final acquisition agreement, driving up the value of the deal.
To be prepared for a potential acquisition in the future, companies should take the following steps now to ensure a smooth diligence process:
- Proactively conduct a thorough, independent review of business operations to ascertain whether they are operating in compliance with applicable regulations.
- Establish and maintain procedures to verify and document ongoing compliance.
- Establish and maintain a data room centralizing all financial, regulatory, and legal records.
General Diligence Considerations
In addition to the unique regulatory risks posed by operation of a cannabis business, potential acquirers will need to be satisfied that with more ordinary commercial matters as well. In particular, acquirers will want to be aware of contractual restrictions on the ability to change control or assign rights and responsibilities or other legal liabilities.
In order to ease the diligence process and assuage those fears, you should:
- Scrutinize your leases, debt instruments, and other commercial contracts to determine whether and under what conditions they are assignable or allow for a change in control of your business and centralize this information within your data room.
- Conduct ongoing review of liabilities related to ongoing or potential litigation, workers compensation, and other issues that may be outstanding at the time of negotiation.
Time kills most deals. Following the steps herein will allow a target company to be “acquisition ready.” Target companies that are organized and transparent from the outset will inspire confidence in their acquirers, thereby speeding up the deal and increasing the likelihood of a successful close to the transaction.