Raising capital in the cannabis industry: Strengthen your operational and financial fitness to attract investors

The current challenge

The COVID-19 pandemic has established the cannabis industry as “essential,” and the industry’s financial and operational growth throughout the U.S. has created new opportunities. To take advantage of this growth and the race for licenses, some companies continue to find themselves eager to expand and to replenish the capital needed to face what is now a much more complex and competitive environment.

Access to capital has historically been a challenge for aspiring and established operators alike, for a range of reasons: The nascent nature of the industry, the risks associated with regulatory actions, state-by-state differences, and the fact that cannabis is still federally illegal, to name a few. But we’ve been seeing positive trends, including:

• Increasingly, some private equity and hedge fund investors who were previously restricted are now investing in the cannabis space.
• As companies are maturing (along with the industry as a whole), rigorous metrics, accounting records, processes, and systems are evolving, which is helping to increase investors’ confidence in the industry and these businesses.
• Since banks and credit unions that do business with cannabis companies often charge hefty fees to offset the increased compliance burden, traditional financial services can be out of reach for smaller cannabis concerns. But banks’ reluctance to lend to the sector is slowly making way for more lending with closer-to-market interest rates, and the increasing competition is leading to more options for plant-touching companies.

Overall, despite the disruptions of 2020 and 2021, capital access has improved, investor pools are widening, and consolidation of the industry is underway. Growth and maturity are proceeding at an exciting pace.

But it’s not yet time for operators to take their feet off the gas. To keep the momentum going, the road to the future is going to require greater financial savvy and operational fitness and getting “deeper into the weeds” than ever before.

Steps toward growth through capital in an ever-changing industry

Whatever the current maturity level of your business, a solid focus on finance and business management is critical to success, especially in efforts to raise capital. Companies that already have good tax and financial records, customer relationships, and brand recognition will still have an easier time sourcing capital if they can prove financial fitness and show that they’re either profitable or on the way to being so. For new companies seeking licenses and market entry, accessing capital will be contingent on demonstrating a sound strategic plan and strong management, as well as having adequate financial resources, including a bank account and tax return history, which may be problematic for companies still dealing largely in cash.

Even when cash flow is positive, cannabis CEOs should be focused on raising capital, in case they find themselves in a situation where they need the money to be able to continue to grow.

Take these crucial steps to help ensure you have the capital you need for growth:

• Continuously communicate with investors to keep them up to date on performance.
• Have a pipeline of investors.
• Make sure you have the systems and processes in place to generate up-to-the-minute KPIs.
• Produce thorough, professional-looking reports that cover cash flow, collateral, and how much equity or debt is in the company’s capital structure.
• Develop and/or invest in the quality of your management team. Investors like to see a team that works together, is aligned on strategy and goals, and has sufficient experience to take the company to the next level.
• Evaluate the need for dilutive equity instead of debt.
• Confirm that the timing for a capital raise is appropriately based on cash flow projections, timing of markets, and your long-term plans. The key is to not take money earlier than you need it so as not to negatively impact your valuation.

One of the issues most relevant to sourcing capital, especially in the cannabis space, is investor fit. While all money is created equal, all investors are not. Finding the right synergy with a potential investor is critical for long-term success. Do you want an active partner, or one who takes a back seat on day-to-day operations? Do you want an investor who has a long- or short-term horizon? Discuss these factors up front and thoughtfully choose a like-minded partner on your own terms so that you can access funding at the right time, i.e., when you’re getting the optimum valuation, but not under a time pressure. If you’re considering a sale to a multi-state operator (MSO) with the intention of rolling your equity and staying on with the acquiror, be prepared to receive a significant portion of the proceeds in stock, as that allows acquirers to keep cash for liquidity needs and other growth-related activities. And, consider some form of reverse due diligence to ensure your comfort with the buyer’s financial position and ability to invest in the business you have worked so hard to develop.

Of course, there is the debt market to consider. As noted above, there are a growing number of providers that have been finding solutions to working with cannabis businesses, such as specialized intermediaries or collateral-based lending that covers equipment and real estate (e.g., cultivation and processing facilities, warehouses, greenhouses, and retail locations).

It is important to keep in mind that establishing and growing any business requires careful consideration of how to deploy both debt and equity – there is a need for both. The key is finding the appropriate balance between the two. Ultimately, achieving the most effective weighted average cost of capital is paramount, and that may not always be the lowest cost of capital since terms of both debt and equity often have nuances. Debt is generally viewed as less expensive than equity, but it is much more structured and must be paid back; we should ascribe value to the patience and flexibility that may come with equity. Cannabis industry capital structures are obviously more nuanced given the constraints that exist in the market; there are not as many sources of either form of capital, and knowledge and understanding among any capital provider is more limited.

Debt products currently available for cannabis operators include term loans that are edging closer to typical commercial market rates, whereas the cannabis debt instruments of the past tended to be convertible notes at well-above-average rates and by definition skew the balance of debt vs. equity in the capital structure. In the cannabis industry, particularly with large, public MSOs, we are seeing the cost of capital going down as the industry matures and as additional financial institutions enter the market. Along with the increase in number and size of debt providers have come more competitive rates and terms. However, the single-digit rates noted in public company filings are likely reserved for the larger MSOs, due to their size, documented revenue, and ability to raise additional capital in the public markets. While smaller operators have more options than they have had in the past, loans for this subset will likely remain consistent with traditional mezzanine financing rates, but may vary dependent on documented revenue and profitability (such as in audited financial statements), hard assets included on the balance sheet, and measured market capture – which is state-by-state specific. We expect that over time, continued strides in industry acceptance (including mainstream, brand adoption, and proof of profitability) will continue to help spur legislation and perception changes that will make the industry more bankable, lower overall debt rates, and make its participants more profitable.

Best practices from the renewable energy industry

The cannabis industry can learn a lot from the renewable energy industry, as there are parallels between the two. As an emerging sector 15 years ago, renewable energy was highly regulated state by state, funding was often backed by assets including real estate, and there was a rush to buy up distressed assets and enter new states as quickly as allowed. Years later, not everyone who started is still in the game.

The difference in what made some companies winners and some losers in the consolidation can be attributed to many of the same factors that would spell success for cannabis companies, among them quality of management, financial acumen, organization skills, vision, conscious growth, internal controls, strong compliance, and investor preparedness.

Take two example companies, A and B. Company A came to market aggressively and didn’t leverage their growth effectively. They started out as a solar panel manufacturer, then quickly added development, and ultimately issued expensive equity to break off into two separate companies. They went bankrupt.

Company B partnered with a well-managed family office, focused on one area until they got good at it, and grew at a reasonable pace with a clear vision. They funded growth with debt that didn’t dilute their ownership. They ultimately sold out to a consortium at a massive exit for their founders and investors.

Like those in renewable energy, cannabis companies that focus on strengthening their operational and financial performance will have the best shot at becoming winners.

Key takeaways

• The challenges around funding for cannabis companies are being somewhat mitigated by recent strong financial results and the industry’s status as “essential.”
• Options for raising capital continue to increase as the cannabis industry matures.
• Still, strong operational and financial performance will be critical to sourcing capital for future growth and viability.
• Cannabis companies can best position themselves to tap funding opportunities by maintaining continual conversations with investors, seeking reliable professional advice, and keeping a strong focus on rigorous performance measures, tax filings, and financial statements.