Although federal cannabis legalization feels closer than ever before, most would agree it’s not imminent, unfortunately. Senator Charles Schumer (D-NY) has acknowledged he does not yet have the votes to push his federal legalization bill through the Senate. Even if the bill eventually does pass the Senate and House, it remains unclear whether President Joe Biden—who has not expressed support for full legalization—would sign it.
This lack of federal guidance and regulation has contributed to the rapidly growing industry’s scattershot, “wild west” reputation. It’s also a factor in the somewhat erratic valuations for cannabis M&A (mergers and acquisitions), which have slowed over the past three years.
According to S&P Global Market Intelligence, 324 cannabis M&A deals closed in 2018, accounting for $7 billion in value. Those numbers stand in sharp contrast to the 124 deals (valued at $615 million) closed by the end of 2020’s third quarter. It’s not a leap to attribute 2020’s sixty-four canceled M&A transactions to the impact of the global pandemic; however, cannabis M&A activity was already on the rebound by mid-2021, with several substantial merger announcements from major companies like Hexo Corp, Curaleaf, and Trulieve in amounts ranging from around $60 million to $2 billion. Going forward, expect to see continued industry consolidation focused on smaller, more strategic deals as large companies look to acquire synergistic businesses, scale up, and tap into new markets.
Valuation considerations
While all M&A transactions face challenges and complexities, cannabis businesses deal with three distinct valuation considerations and risks other industries don’t, all of which can make them a more challenging M&A prospect for buyers.
Regulatory issues. While twenty-one states and territories have legalized recreational marijuana for adult users, cannabis is, of course, still federally illegal under the Controlled Substances Act. The unknown risks around the lack of federal legalization and the complicated patchwork of laws in each state can deter buyers.
Tax and banking laws. Cannabis businesses face far more complex tax rules and higher levels of tax and banking scrutiny. For example, Internal Revenue Code 280E mandates no costs can be considered tax-deductible except those directly linked to the production, processing, and storage of cannabis. It’s a directive that can lead to low profitability for otherwise successful businesses. Additionally, many companies still operate on an all-cash basis due to a lack of banking options. These tax and banking hurdles make cannabis companies bigger and easier targets for potential theft, fraud, and tax-evasion issues, and they also make conducting the financial due diligence needed to craft a solid and well-supported valuation difficult.
Lack of historical data. Cannabis is still a nascent industry compared to other regulated markets. As such, most businesses are still in relatively early stages with a limited operating history. They may be reporting low or negative profits or have not been in business long enough to derive meaningful market multiples, making it significantly harder to project reliable expected future cash flow numbers. In addition, rules and regulations are different at the county, state, and jurisdiction levels, hampering the types of apples-to-apples comparisons typically used to generate reliable valuations.
Address these issues
In addition to being mindful of these pitfalls, what else should cannabis businesses do to prepare for a merger or acquisition and maximize their value? The most important task is to ensure the business can jump through all necessary legal and regulatory hoops. If a company is not prepared to undergo heavy buyer scrutiny and demonstrate regulatory compliance, any potential deal is likely to fall apart.
Here are the essential items all cannabis companies seeking a future merger or acquisition should begin addressing now.
Quality financials. If this hasn’t been a focus from the beginning, start working on the necessary fixes now. Potential sellers must show buyers consistent, thorough, and up-to-date books, records of short- and long-term debt and payment obligations, lines of credit, cash flow, and how much cash is going toward ongoing operational costs versus debts. Poor financial reporting is the number-one threat to obtaining the highest valuation and purchase price.
Proof of state and local licensing. Research and learn the appropriate state regulations for a sale. A sale will not happen if the company lacks proper and up-to-date licensing and a clear understanding of what is needed to transfer ownership to someone else.
Proof of tax reporting. Ensure the company has proof of all federal, state, and local tax reporting and, most importantly, evidence of compliance with 280E.
Proper record-keeping. Maintain logs of any regulatory violations, compliance visits, employee and visitor access controls, etc.
Strong contracts and agreements. Unfortunately, handshake agreements are still relatively common in the cannabis industry. However, for a successful M&A transaction, the business must have legally binding and written copies of fully executed contracts and licensing agreements with all vendors, suppliers, customers, and consultants. Always have signed employee non-compete agreements on file.
Ownership of intellectual property. The company should have contracts for everyone who has worked on or helped develop any element of its intellectual property, including products, software code, website, logo, innovation pipeline, etc. This also entails ensuring that all trade secrets, processes, and proprietary business methods are contractually protected and owned.
Thorough and complete corporate formalities and records. The company’s capitalization table, proof of ownership, ownership disclosures, and executed ownership agreements must all be clean and up to date.
Settlement of litigation or potential claims. If these items can’t be settled before the sale process begins, it’s imperative to be up-front about your circumstances. Do not try to hide anything from a potential buyer; instead, take the bull by the horns and explain the situation at the outset.
A well-prepared management team. Buyers are not just acquiring the company; they also want an experienced, qualified team in place to run the business. In fact, a marketing analytics survey of investors found 97 percent frequently turn down investment opportunities due to what they perceive as a weak management team. That’s why it’s particularly important to prioritize strong leadership, clearly communicate with them about the business’s M&A goals, and properly incentivize them to help grow and prepare the company for a merger or acquisition. A lack of proactive communication or a misaligned, unengaged leadership team can sow seeds of distrust, decrease engagement and productivity, and even kill a deal entirely.
Prepare this information
Once all the above preparation is well underway, the final piece of the M&A prep puzzle is to build out a compelling company growth story and narrative that a buyer will love. It should include an overview of the following items:
The company’s competitive advantage in the marketplace. How does the business rank among its competition in quality, pricing, growth rate, cost structure, and market share?
- Revenue growth and profitability.
- Business model.
- Market size, share, and scalability.
- Expertise—aka your “secret sauce.”
- Passionate, real examples of and testimonials from happy customers.
Until federal legalization passes, cannabis companies will continue to face legal headwinds and M&A complications that don’t exist in other industries. However, well-prepared businesses will stand out to buyers and be far more likely to experience a seamless and profitable sale.
Julie Herzog is managing partner and head of the corporate/securities practice at Fortis Law Partners and Full Velocity Consulting. She has handled transactions valued at more than $4 billion for major public companies and investment banks. Before joining Fortis in 2003, she practiced corporate and securities law for more than eight years at major international law firms Morrison & Foerster and Jones Day.
