Seed to Sale: Keeping Out of the Weeds in Corporate and Financial Transactions
In the latest installment of the Seed to Sale webinar series for the cannabis industry, Womble Bond Dickinson attorneys Taber Cathcart, Greg Chabon, George Kurlyandchik and Brian Meltzer examine the regulatory and real-world challenges surrounding financing, supply chains, and corporate transactions in the cannabis sector, as well as best practices for overcoming these hurdles.
For most start-ups and growing companies, obtaining financing, establishing a supply chain, completing a corporate transaction, or working with a bank are just routine parts of doing business. Not so in cannabis, where conflicts between state and federal law, and a complex array of regulations can make even normal business challenging. Such challenges can hinder a cannabis company’s efforts to raise capital, receive needed supplies, engage in transactions with other companies, and grow the business.
Fortunately, there are steps cannabis companies can take to address some of these challenges. But those steps typically require a great deal of consideration, planning—and, generally, legal guidance.
Equity Financing and M&A Sales
Equity financing and mergers and acquisitions transactions are ways to take a cannabis company to the next level. But such transactions aren’t without risks and require extensive due diligence.
“On the M&A side, we have asset sales, equity structure sales and mergers. There’s different pros and cons for each of these,” Meltzer said.
Asset sales, in which a buyer only acquires certain operations or assets from another company, have a huge advantage for the buyer, Meltzer said, in that liabilities can be left behind. These may include pending litigation, breaches of contract disputes, unprofitable divisions, or other unwanted assets. But he said it is harder for assets to change hands compared to the whole company.
In an equity structure sale, everything stays in place, making it more of a change in control. But unlike in an asset sale, buyers don’t get a tax step-up (which reduces the tax liability).
Mergers are similar to equity structure agreements, but Meltzer said that it is easier to secure stockholder agreement for a merger
Equity financing is when a company issues new shares of ownership. Depending on how many shares are sold, such an arrangement could cause a change in control over the company. Meltzer said “sweeteners” to equity financing transactions can be things like convertible debt, warrants, things that bring in capital now to mitigate the dilution that may happen now when the company isn’t worth as much.
M&A Asset Sales
The company is the seller
Assets change hands
Liabilities can be left behind
M&A Equity Structure Sales
Shareholders are the sellers
Assets do not move
M&A Merger Structure
Two (or more) companies combine
Similar to an equity structure
Requires fewer votes to approve
Company sells new shares
Includes protective mechanisms for investors
May have “Sweeteners”
“The specter—and we’ll likely talk about this with any cannabis transaction—is the state law versus federal law issue,” Meltzer said. “Right now, federally, a lot of cannabis activity isn’t legal. Unfortunately, this is a politicized topic, so every four years, you might get a different focus on this. It changes the risk profile of doing a deal.”
"The specter—and we’ll likely talk about this with any cannabis transaction—is the state law versus federal law issue."
BRIAN MELTZER, PARTNER, WOMBLE BOND DICKINSON (US) LLP
Licensing is the big concern at the state level. State licenses are required to operate a cannabis business, but they can be hard to obtain and require a great deal of due diligence.
These due diligence questions include: Was the license issued based on shareholder demographics? What must be done with a license in the event of a change in control? Is a license assignable? What counts as an assignment? Are any of the new owners/investors subject to restriction? Companies entering a transaction involving a cannabis company should keep these licensing questions in mind.
Other due diligence concerns include scalability, so that they can accommodate growth and geographic expansions. Also make sure clean background checks are done on employees—a particularly important consideration in a regulated industry. Companies also will want to make sure management is skilled in legal compliance matters and that internal policies are in place to safeguard against possible violations. Having such policies on the books will help make corporate transactions easier, Meltzer said.
“Without a license, most of these businesses can’t operate and they are almost impossible to transfer. So the license is incredibly valuable,” Meltzer said. That value is driven by the length, scarcity and restrictions placed on that license.
From the company’s side, they need to make sure investors are committed and good business partners. This may require “reverse due diligence” on the part of the seller.
Other items to hash out in commercial transactions include working with landlords to ensure real estate needs are covered and making sure any zoning and marketing requirements are met.
In a transaction, “You will have to deal with the assignment of virtually every contract that is important to the company,” Meltzer said. Beyond contracts, all parties should examine relationships with vendors and consumers and make sure they will remain strong after a transaction takes place.
Law firms can add legal opinion to due diligence to provide an extra layer of protection. “When dealing with an industry like cannabis, that level of opinion is probably going to go beyond basic vanilla,” he said. But this can be costly.
Supply Chain Issues in the Cannabis Industry
“Probably at no time in history has supply chain management been on everyone’s mind like it has been during the pandemic,” Chabon said. Most supply chain challenges apply to almost every industry, not just cannabis.
But there are also challenges unique to cannabis, he said. These include:
Enforceability of agreements
Addressing rejection of product
Traceability of product
Interstate commerce complications, and
So how do cannabis companies begin to meet these challenges? For starters, many of the same strategies employed by other businesses—including supply chain mapping and strong supply chain agreements—are beneficial in the cannabis sector, too.
Chabon said improving the supply chain process begins with mapping the supply chain. “You can’t understand how to improve your supply chain unless you know what’s in it,” he said. That requires supply chain mapping, in which all points on the chain are identified (inbound materials, warehousing, outbound goods, etc.) and each point understood in terms of criticality to the overall chain.
One benefit of supply chain mapping is to identify any “choke points” that create problems or bottlenecks with the supply chain. This map will look differently depending on the company’s role in the cannabis supply chain—grower, retailer, testing lab, contract manufacturer, wholesaler, etc.
“You have to look on both sides of the chain, because your company is both a buyer and a seller,” Chabon said. “The complexities and potential for disruption can be different for each.”
“You can’t understand how to improve your supply chain unless you know what’s in it.”
GREG CHABON, PARTNER, WOMBLE BOND DICKINSON (US) LLP
Also, the risks and opportunities are different for businesses in cannabis production, versus those that simply provide goods which may be used in the cannabis industry, as well as other sectors, he said. “Plant touching” businesses have different regulatory and operations issues, versus companies that supply equipment or packaging. Yet all could be subject to regulation in any specific state.
So should cannabis companies use a purchase order or vendor contract when making supply chain agreements? As is often the case with complex businesses, Chabon said it depends on the situation.
If the company is buying common, off-the-shelf items, a purchase order can be fine, he said. On the sell-side, supply contracts may be better to allow sufficient detail and specificity since there is virtually no “custom and usage” to rely on in the cannabis industry. Supply contracts need to be clear, especially regarding regulatory requirements, product quality and inspection/return terms, and liability concerns.
Regardless of which type of agreement is used, all companies are likely to encounter a vendor/supplier dispute at some point. Chabon said that isn’t necessarily the end of the relationship, though.
“Most often, when there is a problem, the parties try to work it out because the relationship is important to both sides,” he said. “A long-term supply relationship is very beneficial. But the agreement is important to settle those disagreements.”
Good supply chain agreements also help address disruption, particularly in light of recent problems. The parties should try to agree on how disruptions will be handled, especially how inventory will be allocated or how alternate suppliers can be used. As companies are learning with Covid-related supply chain disruptions, waiting until you are in the middle of a disruption leaves you few alternatives.
Finally, cannabis industry officials may want to familiarize themselves with the World Contracting Consortium chart of most negotiated terms, which Chabon said is a good primer for common points of contention in supply chain agreements.
Chabon said although much of the above advice would apply to a wide range of industries, there are some key provisions of specific interest in negotiating a cannabis industry supply chain agreement:
Enforceability – So long as cannabis remains an illegal substance under federal law, any contract dealing with cannabis could be unenforceable because it is “an illegal contract.” Several federal courts have taken this view. There are provisions that can be used in cannabis contracts to mitigate this risk, like carefully considered choice of law clauses and venue/forum clauses.
Traceability—This is particularly important when doing business in states with all-encompassing seed-to-retail traceability systems monitored by state regulators. This is similar to the challenges faced by pharmaceutical and supplement companies, and they have developed technology and processes that can help cannabis companies.
Inspection and Reverse Logistics—In other words, the agreement should spell out how to inspect, reject and return the product. What constitutes a “non-conforming” product can vary widely from the buyer’s perspective.
Force Majeure—This excuses a party from performing if something unavoidable happens that prevents them from performing. A lot of attention is being paid to these agreements in light of the pandemic.
Indemnity and Limitation of Liability—These provisions are always at the top of any list of most negotiated terms, but could have a large impact in cannabis-related contracts.
Cross-State Considerations—Many supply chain entities (particularly logistics) operate across state lines, and their operations, agreements and procedures may need customizing for cannabis supply chain based on state-specific cannabis laws.
Scalability—As new products come online, supply chains must be flexible and scalable to handle changing products and increased demand.
Data—This should include tracking key information from each shipment, including handling, storage, temperature, humidity, etc., as well as buyer and user data. Solid data is key in satisfying inquiries from regulators, customers, investors and other stakeholders.
Supply Chain Disruption Planning and Mitigation—Such disruptions may be the result of shipping delays or labor shortages, and mitigation strategies may include alternative suppliers and processes.
Also, what supply chain complications are unique to the cannabis industry? Chabon said these include a lack of accepted “best practices” in the still-new industry; a changing landscape of state and federal regulatory demands that requires flexibility in supply chain management and contracting, and rapid change in both product categories and distribution channels.
Finance and the Cannabis Industry
As with many other normal business operations, the legal and regulatory environment surrounding cannabis may complicate financing for companies in the cannabis sector.
“For starters, a lot of lenders and law firms will not work directly with a ‘plant-touching’ entity,” Kurlyandchik said.
The typical solution, he said, is for the cannabis company to form a separate, stand-alone entity, with its own set of books, which can serve as the borrower. If the lender requires financial reporting, the cannabis company may have to turn over information just from the non-plant-touching operations or, more likely, it could include the plant-touching entity or even the parent and other subsidiaries. Company officials should decide in advance what the source of the borrower’s revenue will be. The lender is likely to require the non-plant-touching entity to have deposit accounts in its own name.
"A lot of lenders and law firms will not work directly with a ‘plant-touching’ entity.”
GEORGE KURLYANDCHIK, PARTNER, WOMBLE BOND DICKINSON (US) LLP
Also, Kurlyandchik said cannabis operators must ask, “Who owns the dirt and how would the lender gain physical access to its collateral?” Real estate is a key consideration in many financing arrangements.
If the plant-touching entity is leasing its space, the non-plant-touching entity likely will need a sublease, which may require the landlord’s consent. If the non-plant-touching operations are subject to a sublease, will the property owner allow a leasehold mortgage/leasehold deed of trust to secure the debt? Also, the cannabis company must decide what assets the non-plant-touching entity will have, as these could serve as collateral in a loan.
A tri-party agreement is a document between lender, borrower and landlord that protects the lender if problems arise. As long as the loan is outstanding, the landlord will need to subordinate any rights it may have to the lender. The landlord also will have to copy the lender on any default notices, and should the cannabis company be evicted, the lender has the right to become the legal tenant under the same terms. In the event of a casualty or condemnation, all insurance proceeds remain subject to the lender’s rights.
“Be prepared to discuss these types of questions with the lender,” Kurlyandchik said.
The Financial Services Regulatory Environment Surrounding Cannabis
“The federal regulatory landscape is riddled with criminal pitfalls that can get banks in a lot of trouble,” Cathcart said, noting that these pitfalls can impact cannabis companies looking to work with financial institutions.
Under the Bank Secrecy Act of 1970, banks must detect & report money laundering, fraud and other unlawful activities. Marijuana sales are unlawful at the federal level, so banks providing banking services to marijuana companies could be in violation of this federal law. Hemp was legalized in 2018 and so hemp companies can seek loans from banks, but they must comply with extensive, often murky regulations.
“There’s been some guidance, but not a lot, and the risk is still very high for banks,” Cathcart said.
“The federal regulatory landscape is riddled with criminal pitfalls that can get banks in a lot of trouble.”
TABER CATHCART, PARTNER, WOMBLE BOND DICKINSON (US) LLP
Another piece of federal legislation to watch is the SAFE Banking Act. The act has been approved by the House of Representatives, but must clear the Senate. The SAFE Banking Act would allow banking activities for legitimate cannabis-related businesses in states where their activities are legal. Banks also would be able to use cannabis-related assets as collateral.
From the regulatory approval standpoint, states require licenses to cannabis businesses and those must be renewed annually, requiring background checks. Loans typically must be disclosed in these state background checks, for example.
Some states also require lenders to submit to background checks, Cathcart said. In California, all holders of financial interests have to be disclosed. Every U.S. cannabis market only allows licensed entities to have control over the company, which can create problems for lenders in foreclosure. “The guidelines are unclear, but banks aren’t going to be willing to take the risk if they aren’t able to capture their collateral,” she said.
“The upshot for lenders, and banks in particular, is while there is some movement to legally lend money into the cannabis industry, it’s still very unclear,” Cathcart said. “Larger financial institutions don’t have the appetite to take that risk.”