In an industry where many traditional sources of business capital are off-limits, funding your dreams often requires a bit of help. The world of finance can be complicated, so we spoke with Poseidon Asset Management founders and siblings Morgan and Emily Paxhia to learn more.
Poseidon is a hedge fund entirely focused on the cannabis industry, and it was the first to dive into the space. Since the Paxhias began connecting cannabis brands with funding in 2013, they’ve seen businesses win big, crumble under pressure, and everything in between.
Where is the money? Is there a specific type of person or entity that tends to invest in cannabis companies?
We see money flow into both public and private companies in the industry. Public companies have more opportunities to attract institutional investors than private companies, and they’re able to market to any investor — from individual investors through to institutional — since anyone is free to purchase shares on a public market. However, plant-touching companies in the United States are restricted from U.S. exchanges and, therefore, trade on the U.S. Over-the-Counter (OTC) exchange and the Canadian Securities Exchange (CSE). These platforms add complexity and limit participation, as U.S. brokerage platforms may not allow the ability to trade those names.
If a public company is doing a private placement, they generally are only able to solicit from those who meet the qualified purchaser definition or sometimes accredited investors. This limits the window of potential around these deals.
Private companies typically are supported by accredited investors and family offices, which generally means very wealthy families. Private companies generally are not able to solicit non-accredited investors due to securities regulations. As a result, the lion’s share of capital comes from high-net-worth individuals and families with almost no participation by institutional investors.
How should companies from different areas of the industry pursue funding? Are there options available for ancillary businesses that would not be available to plant-touching businesses?
When we launched Poseidon, we divided up the industry into subsectors, deciding what we thought would be investible categories and segmenting the industry to better assess opportunities. This process helped us dive into and analyze factors such as a segment’s total addressable market, margins, exit pathways, and access to capital, among other things.
In our early days, plant-touching companies struggled with access to capital, but that has completely reversed. Now, those groups have more access to equity, debt, and real-estate financing options. Presently, there is more institutional participation on the debt and real-estate side as equity ownership is still very limited. Ancillary segments, such as software-as-a-service technology, have seen more traditional venture capital backing. Those businesses are still generally cash-burning, so debt is uncommon and undesirable. However, those who can attract venture capital put themselves on an elevator for expansion and continued innovation.
If companies have a choice, how should they weigh their potential funding options? What should they look for in a funder?
Choice is great for a company, as it gives them the ability to analyze the various opportunities and how they might impact the business and ownership. Capital options are a big component, but there is also an assessment of who is offering that capital. What is their reputation? What are their objectives? How have they managed in this space and for how long?
Building a company does not happen overnight or in a straight line. There are ups and downs, and the quality of the investor base can be helpful for navigating these not just from a capital perspective, but also from an insights perspective.
What do you look for when assessing a brand?
We look at industry data sources like Headset to see how a brand is performing in a certain state. Numerous founders have tried to pitch their company as the “top brand,” but when an investor has data, they have a source of truth around sales, inventory levels, etc.
We think revenue is one of the clearest indicators of consumer adoption of a product, which can lead to the longer-term value of a brand. A lot of hype and capital have been lost in chasing brands and not investing or raising money in a prudent fashion around brand-building. Brand-building is complex, it takes time, and it requires patience, extreme focus, and flexibility. In cannabis, this is exacerbated by the limitations around marketing, supply-chain issues, lab-testing snafus, and the fact most brands are launched in a siloed state before expanding nationally.
Expanding a brand is not as seamless in cannabis either. Each state might have different packaging, labeling, and marketing requirements, making it very difficult to get to economies of scale.
We understand the long-term value of brands, but it takes hard work to establish an enduring brand. And just when you think you’ve built the best, you will turn around to find an army of competition. You made it look too good! The gummy and infused pre-roll categories would be perfect examples of areas where the leaders generated fantastic growth stories and now face a fiercely competitive field. These are the joys of a free market — ask Pepsi and Coke — but one must be prepared for the journey on brands.
What can companies do to improve their chances of receiving funding?
Investors almost always are identifying the quality of the team behind the business. A strong team is very important when navigating the launching and scaling of a business, and this is even more important in cannabis, where growing a business involves navigating a plethora of challenges that come at every angle. The only constant is change, and strong teams have a higher probability of successfully navigating business evolutions and friction points.
Preparation for taking investment is key. We have a due diligence checklist we run through when vetting a company. We like to see companies put in the effort to collect the pertinent information as a show of commitment to doing the work worth doing.
We also like to see a well-contemplated strategy for the round of funding. Is the company considering how much capital is needed, how this capital will be used, and what the return on investment might be for the business?
Valuations are important to venture capital and institutional investors, as we are in the business of generating returns for our investors. We know the space well and are not interested in paying above-market prices or nonstandard investment structures without good justification. Be mindful of your valuation, and be prepared to have a conversation about it.
How can founders ensure they retain control of their company after accepting outside capital?
Control of a company cuts a few ways. We are big believers in the founders we back, so we seek to create and support governance that upholds the goals and objectives of the company, but we never aim to micromanage. Boards can be tremendous resources when they are balanced and well-appointed; most productive boards have a mix of founders, investors, and strategic independents. The companies we have seen thrive the most embrace good governance, as they have created a strong infrastructure, transparency in reporting, and a strong feedback loop.
When a founder takes capital from investors, they should expect their ownership to be diluted, and the endgame is owning less of a much bigger pie. Otherwise, it is probably better not to take outside capital and instead build the business on their own. Establish a clear goal at the outset of a fundraising process to establish solid alignment with investors.
Can funders do more than just provide money? Is it wise to seek out an investor with particular knowledge or expertise that could benefit your business?
We see this as a major differentiator among funding groups. An equity investment is a long-term relationship, and it makes sense to get to know each other first. The pandemic made travel and in-person interaction quite challenging, and we all moved to virtual. There is a real value to virtual meetings, but almost nothing replaces working together in person.
Ideally, we have the opportunity to work with investors who have analog experiences they can bring to the space. The mix of cannabis experts and those with non-endemic history is a really strong pairing and has proven successful so far.
How would you define success from a venture capitalist’s standpoint?
Success is defined at the outset and revisited periodically. What is the company’s objective, strategy, and exit pathway or returning-capital strategy? It is very important for us as venture capitalists to know your intentions as we underwrite to see if this matches with our return expectations.
Venture capital carries inherent risk, and data has shown over the years that most venture companies will fail. Cannabis ventures are no different. We are in the investing business to generate returns for our investors while building an industry. We expect some businesses to fail and, while it is not a smooth process for all involved, it is part of the journey.
The purest form of success is a very large exit that generates many multiples of invested capital back to the shareholders within a venture period of five to eight years. We look forward to seeing more of that in cannabis!
How does funding through an organization like Poseidon differ from traditional bank financing?
Capital is very precious, especially in this industry. The last eighteen months have been very challenging for operators and investors, as equity flows have remained very muted compared to pre-pandemic levels. We have seen a number of companies fail, with a lot more on the horizon. We have seen significant debt raised and deployed in very risky areas, so we expect to see some challenges there. As a result of this tight capital environment, we also have seen several venture capital funds exit the space. This is a painful yet natural process that is not uncommon in other emerging markets.
There are still investment groups successfully raising capital for the purposes of financing early- and growth-stage companies. These pools of capital are very helpful for the industry’s continued growth, as other pathways for capital like bank loans are still largely nonexistent. We have been active investors in this space for almost nine years, and it still feels very early. Capital has expanded to debt funds and real-estate funds, which are also quite helpful for the industry. We see the potential for a lot more capital to flow in the space, especially after some long-overdue federal progress like the SAFE Banking Act.
Will the landscape for investment change anytime soon?
The pathways are getting more and more established for raising capital. In 2021 alone, we have seen more than $1 billion raised in cannabis debt financing at historically low rates. A good number of the creditors in these transactions are institutional investors who are clearly watching the industry and seeking ways to participate. The credit markets are leading the way on institutional capital, and we have seen a lot of debt and real estate investment trust funds.
We expect equity capital to return, as that has been quite limited since the outset of the pandemic. There is a large pool of capital sitting on the sidelines, waiting for some signal like perceived federal progress. That pool is made up of institutional investors and more family offices that continue to do their work ahead of their entry on the equity side.
Can investors play a role in promoting social equity in the industry?
We see ourselves as educators and thought leaders. We regularly are asked to attend and speak at various events and professional organizations to share our knowledge about this industry. There are still so many people who have yet to hear about cannabis as an investment opportunity, which is great. It takes a lot of hours and time on the road, but it is required to reach more potential investors. This is a growth industry requiring a lot more capital than what is currently available, so we all have to be out there doing what we can to educate.
We see this education process as a means of expanding the potential capital pools, especially for investors with a passion for providing a broader array of equity. Unfortunately, our elected officials have been very poor with action here. They spend far too much time talking and overcomplicating the matter, and that is exacerbating the divide.
What advice do you have for investors?
Poseidon is in its ninth year of investing outside capital with a dedicated focus on cannabis and hemp companies. It has been a long journey on a spectrum of very scary to incredibly exciting. We have seen countless “investors” come and go, usually flocking in when there is incredible excitement and much harder to find when things get challenging.
We always caution new investors to take their time and learn, especially those who think they can take a one-off shot on some promising new venture. It is still early days for cannabis, and we see a rich environment to generate great returns, but it takes process, discipline, and knowledge.
For entrepreneurs both existing and new, our view is very similar: Take the time to learn, find your path, and stay focused on your objective.
In the end, many different events will occur along the lifeline of a business. However, one of the most important aspects of all of this is knowing when to exit the business; this is true for both founders and investors. Timing is as important as the capital involved. Tracking trends in the market and knowing when to capitalize on these various cycles truly can determine whether the whole endeavor is worth the effort and investment.
This is a time when consolidation is already rampant and will continue to be a key theme. One never wants to sell too early but, ideally, companies exit in a position of strength and momentum for the best possible outcome.
8 Steps to Take Now to Set Up Your Company for Investment
The operators who prepare and are ready to be investible will be among the first to receive funding. Some steps operators can take now include:
- Engage investor-approved or -experienced legal firms. It’s a good idea to ask around to see who has worked across from investors in successful transactions.
- Establish investor-ready entities, often C corps, for the purpose of taxes and employee stock ownership plans.
- Domicile — or redomicile — the company where most appropriate.
- Engage a solid financial controls process and ensure the firm is following Generally Accepted Accounting Principles.
- Track and understand the business’s key performance indicators or objectives and key results so investors can understand how success and growth are being measured and reviewed.
- Research the cannabis investor community and those adjacent to the industry who are watching but have not yet invested. Start keeping a database of who might be a good fit for the raise.
- Start providing updates to interested investors so they can track your progress and stay informed for when an investment might be a fit.
- Attend events, meet investors, and share your company’s vision.