Perspectives on growth – Cannabis Quarterly insights, Q1 2022

Greg Chin, Kevin Michealan

After a break during the first year of the COVID-19 pandemic, there was a reported rebound in deal activity across the cannabis industry in 2021, with an uptick in both M&A and debt capital raises – and that momentum appears to be carrying into 2022. The conditions for increased deal activity appear poised to persist:

• Still relatively low cost of debt
• More options for raising capital (e.g., debt and SPACs)
• Competition among MSOs to maintain and grow market share and shore up supply
• A still relatively healthy economy, and an overall feeling that we are emerging one way or another from the pandemic

We continue to see consolidation as companies pick up steam and look to expand their capabilities and footprints. And this trend toward footprint-expanding M&A is especially likely to continue as the industry itself continues to mature in terms of market expansion, particularly with new adult-use states New York, New Jersey, and Virginia expected to be operational in 2022, which should increase M&A activity for investors wanting to participate in the large Northeast market.

Amid all of these conditions, the time could be right for operators hoping to be acquired – but it’s critical for sellers to remember that pre-transaction diligence will likely be thorough, and that any surprises could lower a sale price or even derail a deal. Below, we’ll explore some of the tax-related issues we see most often and ways to help address them.

But perhaps more importantly, buyers and sellers alike will need to remember that in addition to pre-transaction financial and tax due diligence, it’s especially critical in this industry to work proactively and collaboratively in considering post-transaction integration. The dust doesn’t just settle following a transaction; that’s often where the real work begins, of aligning people, processes, and technology to support the new organizational culture that sprouts from the fruits of your labor. Even in debt deals, which generally don’t require operational integration, there are often improvements in the accounting/finance functions that companies need to make to comply with lender covenants and financial reporting requirements.

Prepare for tax diligence

Sellers should be aware of these tax-related issues we see often when working with entities on both sides of the cannabis M&A equation – and take steps now to address any that could hamper your deal’s success.

1. Section 280E

Section 280E – the Internal Revenue Code provision that forbids cannabis companies from deducting ordinary business expenses from their income taxes – continues to be the largest tax exposure for buyers and investors in cannabis transactions. Two noteworthy items are:

1. Buyers continue to be less willing to risk-share. Amid improving IRS guidance and continued IRS success challenging positions contrary to IRS guidance and court wins, buyers continue to be less willing to share in target companies’ potential tax exposure, resulting in escrows lasting until the relevant tax year is no longer open to IRS audit.
2. More companies are taking Section 471(c) positions. Section 471(c) was enacted as part of the 2017 Tax Cuts and Jobs Act to simplify tax accounting for inventories for small businesses (i.e., initially, those with average annual gross receipts for the three prior tax years of no more than $25 million). Sellers taking Section 471(c) positions that are inconsistent with the final regulations for post-2020 tax years are unlikely to find success in defending such positions upon IRS audit now that the final regulations are effective.

Your move: Sellers should consider reviewing their income tax positions in respect of Section 280E for all open tax years and taking appropriate action to mitigate or eliminate any tax risk.

2. Sales and use tax

Although Section 280E still needs to be considered in transactions involving ancillary cannabis (and CBD) target companies, their largest tax exposure parallels that of their peers operating in non-cannabis industries: sales and use tax, generally, and particularly for technology companies. As these types of companies continue to expand their operations across the U.S., sales tax exposure is arguably inevitable due to the lack of uniformity among states’ sales and use tax laws and regulations, which are ever-changing and, particularly for technology companies, ever-lagging the way companies do business, plus the subtle nuances within each state’s rules. Unlike the “escrow and release upon expiration of the statute of limitations” approach taken by buyers with Section 280E, buyers simply reduce the price they pay for the target company to cover the cost to remediate sales tax exposure based on long-standing practice in M&A.

Your move: Sellers should consider 1) performing a sales and use tax nexus and taxability study to determine the states in which they are required to file and pay sales and use tax, and 2) taking appropriate remedial action, if any, including filing voluntary disclosure agreements.

3. Payroll tax

Last but not least is payroll tax, with two major areas of concern. First and again, Section 280E is an issue here as well, because in addition to the disallowance of costs not properly includible as costs of goods sold (COGS), Section 280E disallows tax credits. With the enactment of COVID-related payroll tax credits (e.g., the Employee Retention Credit and credits for paid sick leave and family leave), Section 280E has also created potential payroll tax exposure for cannabis companies. However, the second and larger potential payroll tax issue has been fraud perpetrated by payroll companies that have taken advantage of their clients’ trust, their lack of knowledge of the payroll tax rules, or both. We’ve seen payroll tax fraud most often where the cannabis company uses a payroll company to file its payroll tax returns and remit its payroll taxes, and the cannabis company does not review its payroll tax account. When the cannabis company learns of the fraud, the company and its responsible persons, including officers, also learn of the lack of sympathy of the payroll tax rules.

Your move: In addition to reviewing their payroll tax positions in respect of Section 280E for all open tax years and taking any appropriate remedial action, sellers should consider making their payroll tax payments directly to the taxing authorities and regularly reviewing their payroll tax accounts to make sure their accounts are not delinquent.

Conclusion

Not surprisingly, there are many more and, particularly for cross-border transactions, more complex tax issues for both buyers and sellers in a cannabis transaction. Talk to your trusted advisors to make sure that you are well-prepared to address any potential exposures, with proper protocols to facilitate compliance and the right people in place to support them.

Look for deeper dives into the many aspects of cannabis transactions, including post-transaction integration, in future issues of CannaQuarterly; subscribe now to make sure you don’t miss a thing.

Contact

Greg Chin, CPA, Partner, Transactional Advisory Services

857.264.3939

Kevin Michealan, Senior Manager, Transactional Advisory Services

617.648.1196

Andrew Lines, Anna Kamenova

In the early days of the cannabis boom, operating companies faced almost universally high cost of capital. Those days are over. Today, we’re seeing significant disparity across the industry between capitalization rates and debt rates for large multi-state operators (MSOs) compared with those that have more limited operations — especially those that operate in open-license states.

Three to five years ago, almost all sale-leasebacks of cannabis real estate had capitalization rates in the mid to high double-digits. Today, we’re seeing the largest MSOs demanding single-digit rates, which in many cases are nearly on par with traditional industrial real estate. A growing number of privately owned operators are finding ways to scale without having to list their companies on Canadian stock exchanges.

Cost of capital remains high for many

Not all cannabis companies have the leverage to demand single-digit rates. Cost of capital remains high for newer operators, which also face stricter loan terms, such as added fees, prepayment penalties, and recourse terms.

Companies in states with open licensure (i.e., low barriers to entry) also face higher cost of capital, since they are viewed as inherently riskier than companies in limited-license states (i.e., high barriers to entry). Achieving profitability in more mature cannabis markets requires an exceptionally well-crafted business strategy, given the higher level of competition and lower product prices. Specific nuances within your state – like rules around selling clones, or allowing consumers to grow multiple plants at home – may demand more scrutiny in your business plans, which ultimately may impact cost of capital.

How operators can help lower cost of capital

When operators step up to the table to discuss their capital needs, they need to be aware of how debt or equity investors view their operations so they can put themselves in the best light possible. Based on our experience, here are five steps cannabis companies can take to help lower the cost of capital.

1. Hire and retain strong leaders. One of the biggest points of exposure for a cannabis company is the management team, which is why investors focus so much attention on this critical area. While they do not necessarily need experience in the cannabis space, cannabis managers do need strong business backgrounds. Many cannabis operators don’t yet have robust accounting teams, so a company with an experienced CFO or controller from a different industry (say, consumer products or retail) can be a real asset for a cannabis company looking to refinance.

2. Tell your story well. Know what separates your company from the rest and come to the table prepared to share that story. Investors and debt financers want to know where you excel, how you will use those competencies to address an opening in the market, and what milestones you will hit as you grow.

3. Watch for comparable transactions in your market. Financers will find your story more compelling if you can make comparisons with recent transactions, using those companies’ milestones to graph your own trajectory. Professional advisors that work with many cannabis companies can help you keep your finger on the pulse of cannabis deals.

4. Do your due diligence. Financers don’t want to waste their time. They expect you to come to the table with clean financial statements and tax records, and be prepared to provide ready access to these and other key documents. If you don’t already have one, build a data room – an online repository of critical documents that provides controlled access to third parties who need insight into the business’ operations.

5. Keep shopping. Despite the reality of double-digit debt for many newer and smaller operators, in general, more capital is available for cannabis companies today than even a few years ago. Like water, capital flow is finding more and more ways to get into the space. We’re even starting to see some cases of traditional, FDIC-insured banks financing cannabis companies at attractive interest rates, and cannabis real estate investment trusts (REITs) taking on more risk and diversifying into different types of real estate.

As the cannabis industry continues to mature, sources of capital are rewarding businesses that come to the table with clean books, differentiated brands, and a professional management team. While the management team doesn’t always need deep experience in the cannabis industry, financers will look more favorably on a company if it has professional advisors with experience in the cannabis space.

Contact

Andrew Lines, MAI, Principal, Valuation Advisory, Transactions & Turnaround Advisory

312.508.5892

Anna Kamenova, Director, Valuation Advisory, Transactions & Turnaround Advisory

704.837.7599

Swami Venkat

As more states legalize medical and adult use of cannabis, large and small-scale legal cannabis businesses have created a heavy demand for banking services. The cannabis industry has come a long way in the last decade – it’s no longer a cash-only business with no access to banking or other types of financial services. Regional banks and credit unions are filling the void left by the large federally insured banks that are unwilling to provide banking services to cannabis operators – and we are starting to see more FDIC-insured banks getting involved with legal cannabis and cannabis-related businesses, albeit very carefully, offering limited services. There are also other financial institutions that will provide different financial services, such as payroll, HR, and insurance. 

And there are high hopes for some banking relief on the horizon with the proposed SAFE Banking Act (formally called the Secure and Fair Enforcement Banking Act), which would allow U.S. depository banks and certain other financial institutions, such as federal and state credit unions, to service cannabis businesses in states that have legalized cannabis. The bill, which has been passed in the House of Representatives, would also help ease lending obstacles to cannabis companies, and would facilitate the flow of funds by permitting credit card transactions.

Still, cannabis companies, especially smaller, less established ones, simply do not have the same ease of access or general admission to banking products or lending services as non-cannabis companies. This creates unique banking challenges for cannabis CFOs that their counterparts in non-cannabis businesses generally do not encounter, such as increased costs, more administrative burdens, and restricted access to lending. 72% of cannabis operators in a recent Whitney Economics survey reported lack of banking as their biggest concern. And even if the SAFE Banking Act is passed, which isn’t certain, many of the banking-related headaches that impact the industry would not be fully resolved.

Unique challenges

With the cannabis industry still seen as high-risk, banking opportunities for cannabis companies are still generally limited to regional banks and credit unions, neither of which operate under federal guidelines. But because even those are generally unwilling to provide other financial services, like payroll processing or retirement accounts, or to provide traditional lending facilities, cannabis companies are forced to seek out different financial institutions. And most that do bank for cannabis companies are relatively new to doing so; in a recent survey by BankersHub, only 6% of respondents that were currently banking cannabis companies had been doing so for more than five years, and 44% for less than three years.

There are many other banking-related challenges unique to cannabis companies: For instance, we have observed that they frequently are subject to higher banking fees, more financial oversight, stricter background checks when completing an application, and increased financial data requirements when opening accounts. We have also noticed that banking challenges have contributed to the social inequities within the industry, as operators in economically disadvantaged areas may lack financing needed to pay higher fees. Plus, it’s worth noting that we have seen the banking hesitancy impact not only plant-touching cannabis businesses, but also cannabis-associated businesses such as CBD companies, other ancillary businesses like those that provide lighting for grow operations, and sometimes even investors in cannabis companies. 

Interim solutions 

Many of these issues that cannabis and cannabis-related companies face won’t be fully resolved until cannabis is federally legalized. The passage of the SAFE Banking Act would help, but it wouldn’t cover many types of financial institutions, and we have heard that some banks would still be hesitant to bank cannabis companies because of possible board objections, increased scrutiny by shareholders, higher overhead costs, and the need for more training and education.

In recent years, several fintech companies have emerged to help cannabis companies navigate the difficult lending and banking landscape. These companies make introductions and facilitate the application and verification process to non-bank lenders and other cannabis financial institutions.  We have also noticed other fintech solutions, such as cashless ATMs, emerging as banking alternatives.   

Cannabis companies aren’t waiting, and have taken advantage of certain market opportunities. Well-established large enterprises have been increasing their use of debt; we’ve also seen relatively minor debt deals for smaller public companies and equipment and real estate financings for well-established private cannabis companies. But our experience is that these types of financings are infrequent for small, less-established companies (and, as discussed above, may come with less favorable terms).

The overall takeaway for CFOs of cannabis and cannabis-related operators is that banking and other financial service alternatives are available for many, but not all, and it will likely not be cheap or easy to navigate the process. It’s not sufficient to set up an account with one bank and then walk away. You’ll need a comprehensive, continually updated banking strategy, with careful advance planning, and a watchful maintenance plan. Here are some ideas to keep in mind.

Tips for CFOs navigating cannabis banking

1. Seek experienced banking and lending advisors. The flipside of the BankersHub finding that only 6% had been banking cannabis companies for more than five years is that those more experienced companies are out there, along with the other companies emerging specifically to help cannabis businesses. While the industry is still fragmented and challenging to navigate, there are advisors now to help facilitate the process of obtaining lending and banking services.
2. Don’t wait for a one-stop shop. As different banking institutions have different policies and cannabis comfort levels, it is generally necessary to establish relationships with multiple providers that each handle different functions: day-to-day depository, investment planning, payroll, debt management, escrow accounts, etc. 
3. Be transparent. With cannabis still being a Schedule 1 substance, banks and related organizations are requiring more financial information about a cannabis business and its owners, officers, and even its investors than what is required from non-cannabis businesses. Be prepared with clean books and records so there are no surprises on either side. (A careful data strategy will be helpful in this regard.) And warn your investors that they may be subject to increased scrutiny just by association.

Contact

Swami Venkat, CPA, CISA, CFE, ACA, Partner, CohnReznick Advisory

973.871.4044

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