Recent Cannabis Cases - 280E and Bankruptcy

Friends!  Wanted to alert you to two very recent court cases – tax and bankruptcy – that impact the Cannabis industry and the way it does business.  Some fun reading for the short work week between holidays.

Management Companies and 280E

First, an opinion of the US Tax Court from December 20th that seems to put a fork in the 280E “management company” structures that many Cannabis companies have been using.  As I learned early on in my long, painful career as a deal lawyer, tax influences everything, and this opinion highlights that lesson.

For those not familiar, Section 280E of the Internal Revenue Code bars deductions of expenses for businesses trafficking in a controlled substance.  In short, the “management company” structure seeks to, well, structure around this limitation by having the license-holding entities (cultivation, production, distribution) contract with a management services entity that doesn’t hold a license or “touch the plant”, but instead only provides services to those licensed companies (e.g., holding the lease and providing employees).  The theory has been that, since the management company is only providing services, it’s not trafficking in Cannabis and therefore may take Federal tax deductions. 

TLDR: the US Tax Court rejected outright the defendants’ arguments that the management company wasn’t engaging in “trafficking in controlled substances”.  The Court noted that, among other things, the management company employees were directly involved in the purchase and sale of Cannabis, and the only difference was that the licensed entity held title to the Cannabis while the management entity didn’t.  The result of this is that the management company is fully-taxed, without the right to take deductions due to 280E, and its flowthru members were charged with the additional income (plus a penalty).  To make the point, the Court said that these “tax consequences are a direct result of the organizational structure petitioners employed”.

https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=11855

Going forward, Cannabis companies should consider, among other things:

  • How does the apparent death of the “management company” structure change the economics of my business?

  • Should I continue to use flowthru (S corps and LLCs taxed as a partnership) entities at all?

  • What does this mean for my “management company” returns filed for prior years that claimed deductions?

  • Should I trust any structure that claims to avoid taxes?

  • Why does it seem like, every other day, there’s another roadblock to positive EBITDA?

My suggestion (not legal advice!) - make sure to discuss with your favorite lawyer and/or tax professional.   

Everything in business and law is about balancing risk (certainly something this industry knows well), but when it comes to specialized areas like tax, you want the most sophisticated advice you can get* to fully understand the nature of that risk and make a truly informed decision.  Ventures were set up by Cannabis business owners using the “management company” theory without appreciating that the structure itself hadn’t actually been tested or considered by the IRS.  To quote Homer Simpson: “I agree with you Marge .. in theory.  In theory, Communism works!”

Bankruptcy

Our second contestant today comes from the US Bankruptcy Court in Colorado (thanks to Jason Rosell, a bankruptcy lawyer at Pachulski Stang Ziehl & Jones LLP, for altering me to this**).  The case, In re Way to Grow, Inc., Case No. 18-14330 (MER) (Bankr. D. Colo. Dec. 14, 2018), involved an indoor hydroponic and gardening-related supplies company filing for bankruptcy protection (which is under Federal law).  Federal law makes it a crime to distribute “equipment, chemical, product or material which may be used to manufacture a controlled substance ... knowing, intending, or having reasonable cause to believe, that it will be used to manufacture a controlled substance”.  The Court rejected the debtors’ petition to file for bankruptcy because the debtors were selling, and would continue to sell while in bankruptcy, equipment directly to the Cannabis industry.  What’s notable about this case is that the debtor wasn’t a Cannabis company – it was an equipment manufacturer selling goods to Cannabis grower.

Although it had been clear in the past that a Cannabis company wouldn’t be able to take advantage of Federal bankruptcy protections, this decision broadly expands that limitation to companies servicing the Cannabis industry.  When the next recession hits, and companies touching the Cannabis industry are distressed, how will that play out?  My guess – it’ll be ugly and messy, and there will be many trade creditors to equipment companies taking haircuts and becoming owners.

Excelsior! (and happy new year)

*And, of course, it goes without saying, from your deal lawyer as well...

**See, above, my point about seeking out sophisticated advice in specialized, highly-regulated areas of law.

Written by: Marc Hauser

FDA Nixes CBD in Food

Friends, wanted to call to your attention a statement from the FDA that came out yesterday about CBD and food products.  In short, the FDA is saying that CBD (and THC) in food is still not legal under FDA rules, even though hemp-based CBD is now itself legal.  This runs the gamut from supplements (nutraceuticals!) to beverages.

https://www.fda.gov/NewsEvents/Newsroom/PressAnnouncements/ucm628988.htm

The FDA is focused on the fact that CBD is an active ingredient, and like any other active ingredient that’s added to food products, the FDA gets to regulate that, and they’re not going to allow for now (although they say they’re evaluating it).  They’re also focused on false claims made about the benefits of CBD, similar to any other consumer product.

For one thing, this means that’s it’s highly unlikely that the State of California will change its ban on adding CBD to food/beverages any time soon (I suppose my CBD knish truck concept will have to wait).  It also puts a wrench into plans that beverage companies might have been looking forward in the past week weeks to offering these products in the US (although, other hemp-based products like seed oils may be added, so maybe a hemp seed knish truck?).  However, it creates yet another disconnect in the marketplace, with some companies allowed to use CBD in their products today (e.g., skin care), leaving others (e.g., wine, beer, knishes) having to wait to get that marketing benefit.

This also seems to me to be a good indication of how regulatory agencies are going to react to Cannabis legalization down the road.  Nothing will happen quickly and federal/state/local authorities are going to regulate it just like they regulate other consumer products.*  That, of course, won’t stop investors from pumping too much capital into the industry too soon, as if the industry were fully mature in terms of regulation, infrastructure, supply chains etc.  I suppose that keeps service providers like me in business, however, which is nice.

Excelsior!

*Not a political statement about regulation.

Written by: Marc Hauser

Cannabis Market Moves

Friends – another day, another seismic shift in the industry.  If you haven’t seen it yet this morning, AB InBev announced a strategic deal (US$100mm) with Tilray to develop non-alcoholic THC and CBD beverages up in Canada.

https://www.newcannabisventures.com/tilray-and-ab-inbev-to-invest-up-to-100-million-in-cannabis-beverage-venture/

A few thoughts on this (none of which constitutes legal advice, let alone business advice): 

  • As I’ve said in the past, the Cannabis industry is progressing towards becoming like the wine and beer industries – a handful of large players at the top and lots of small niche-y players at the bottom. 

  • This kind of strategic partnership makes total sense to me.  Successful cannabis companies realize early on that there’s a reason that businesses hire/solicit expertise from other disciplines, both internally (HR/finance/marketing) and externally (outsourcing things like logistics) – not everything can be or should be developed anew.  Why not tap into and leverage the global expertise of a giant, successful alcoholic beverage company to grow and scale?

  • There’s nothing to say that smaller cannabis companies can’t do this either, particularly for the niche-y players who have a specific product/service that isn’t easy to duplicate and can bolt easily onto a larger company.

  • A bit surprising to me that there haven’t been more outright acquisitions of cannabis companies up in Canada.  Yet.  Could be the valuations, while the large beverage/tobacco/pharma companies are waiting for a downturn to snap up non-US companies at a discount with their lower cost of delicious capital.  Could be that their boards are reluctant to dive in whole hog at this early point in the legal cannabis industry’s history.  It’ll be interesting to see what happens over the next 6-12 months with US-based CBD companies and whether CPG companies (healthcare/pharma/neutraceuticals (one of my favorite portmanteaus)) take the same approach of partnership or outright acquisition and integration.

  • It puts more pressure on companies in the US across the size spectrum to figure out their long-term strategy before legalization hits.  Going back to my handy wine/beer industry analogy, the “turf war” (to anonymously quote a friend at a large cannabis company) among the national companies will only continue to accelerate so that there’s enough breadth/market share to be attractive to large beverage/tobacco/pharma, for either strategic partnership or outright acquisition. 

  • I’m guessing that you’ll see more consolidation in the middle market, which, well, there’s plenty of currently.  These are attractive targets for larger companies to quickly acquire licenses and access to local supply chains.  As the cannabis industry morphs over time and becomes less fragmented (see, e.g, the wine/beer market), it’ll be more challenging for middle market companies to distinguish themselves and gain national presence/share/distribution (ibid.).

  • Small companies will have to figure out what they want to be when they grow up, and how they will be able to stand out in a very crowded marketplace.  Walk into any dispensary and already you can see how many products there are that are difficult for the average consumer to distinguish.  Then walk into a wine shop – it’s not that different.  Certainly, in both instances, that’s where the staff adds real value; however, over time, with national players expanding their brand presence, the cannabis market will become much less fragmented than it is right now, and they’ll have better access to national distribution.  So the small company will have to be nimble and specialized – sort of like a cult wine or a craft beer.  Investors in those companies will be asking the same questions that they always have – what’s different about you and how can you scale – but the scale question will need to shift.

  • US-based beverage/tobacco/pharma companies will need to figure out their strategies for when cannabis is legal, and also what they’re going to do about legal hemp-based CBD.  Moves like this InBev deal mean that the larger companies are already figuring out how to position themselves.  Smaller companies can start today to build relationships within the US and do their due diligence to discover whether, if, and how they want to play in the cannabis market.

Excelsior!

Written by: Marc Hauser

Cannabis Lending

Friends, I’m confident you saw the news about Tilray signing a deal with Sandoz for global distribution of medical cannabis.  Indeed, the transformation of the industry continues to accelerate.

But instead, I’d like to call your attention to two smaller deals recently announced.

http://www.abladvisor.com/news/15390/chiron-completes-25mm-transaction-for-u-s-cannabis-producer  (thanks to Seth Freeman at GlassRatner for tipping me off to this news)

https://www.newcannabisventures.com/terrascend-lines-up-75-million-credit-facility-to-fund-u-s-cannabis-acquisitions/

Debt!  And not the convertible kind.  Working capital term, revolving, and equipment loans issued by non-bank lenders.  The kinds of loans that other businesses get all the time from banks.  There’s little info about the first one (the press release doesn’t even announce the name of the borrower – only the name of the shop that shopped the deal).  The TerrAscend is an interesting loan, in that it’s made by an affiliate (JW Asset Management, its largest investor), and the terms are not cheap (8.75% coupon, 1% fee), but generally in line with current high yield offerings.  And one of my friends has been arranging equipment loans for the industry for a while (he didn’t ask me to plug his business).

This is all good for the industry – traditional debt isn’t dilutive and thus produces leverage.  As companies get past the Series A and grow their asset base, they’ll want to find sources of capital that don’t erode the capital structure.  It does require that asset base, and although it’s hard for a lender at this point to put a lien on assets like licenses and flower, things like equipment, leasehold interests, contracts, and intangibles can all be solid collateral.  Leverage, when used wisely, can be a powerful tool – it’s what drives the private equity industry.

This is also good for investors – it’s another way to play in the industry while hedging the risk of pure equity investments.  Plus, at least for now, the borrower can’t file for bankruptcy (another feature of current Federal law). Throw in an equity kicker and that’s good eatin’.

Excelsior!

Written by: Marc Hauser

CBD Opportunities and Risks

Friends, from this lawyer’s perspective*, serious money is about to flow into the (imminently) legal CBD market.  See, e.g.:

https://www.newcannabisventures.com/village-farms-international-to-aggressively-pursue-hemp-and-cbd-opportunities-following-u-s-federal-legalization/

Village Farms (not a client) is a Canadian produce company and they’re viewing this opportunity as a “nutraceutical phenomenon”**.  Anecdotally, other non-cannabis companies (CPG, institutional investors) are scrambling to enter the (imminently) legal CBD market.

This presents yet another whiplash-inducing opportunity and risk for the industry.  For companies that have both CBD products and THC products, do you spin out the (imminently) legal CBD product line, to take advantage of mundane things like bank accounts and lending, tax deductions, traditional institutional capital, and interstate commerce?  Among the many things to consider:

  • Branding – are the two businesses going to share the same brand name?  If so, how does that relationship work to keep the legal CBD business legal?

  • Local Rules – how quickly will local regulations on CBD use (such as those in CA) change to open up how you want to use the product?

  • Taxes – can you split off the legal CBD assets in a tax-efficient manner? (not a 280E question – a traditional tax question)

  • Structure – how is the legal CBD business going to be owned?

  • Strategy – once you’ve got the CBD business separate, what’s your plan to compete?

In other words, yet another day in the Cannabis business.

*As usual, this is definitely not legal advice.

**I don’t know what that means.

Excelsior!

Written by: Marc Hauser

Yuppies and Cannabis (and CBD)

Friends, sharing today a recent article from the Washington Post style section about yuppies using cannabis again.  Putting aside the author’s questionable choice to revive the term “yuppie”, this kind of style section article highlights the mainstreaming of cannabis in the US.  I think that the article does a nice job of capturing the cognitive dissonance in the minds of people who grew up during the time when the term “yuppie” was actually used and were subjected to the Just Say No/DARE campaigns of that era. 

https://www.washingtonpost.com/lifestyle/style/i-dont-feel-like-im-doing-something-wrong-yuppies-have-discovered-weed-and-they-like-it/2018/11/30/dd2b7240-e90c-11e8-a939-9469f1166f9d_story.html?utm_term=.ddf204c8d63c

It shows the challenge and the opportunity for the industry at this moment in time. 

Speaking of challenge and opportunity, as you likely know, the Senate signed the 2018 Farm Bill, moving the industry one step closer to finally being able to sell hemp-based CBD fully legally.*  It’ll certainly cause more work for us lawyers as companies move to split out their hemp CBD businesses, which then would be able to take advantage of such quotidian things as tax deductions and bank accounts, and then raise capital on those businesses.  This is because, I suspect that, once CBD is legal, the floodgates will open and US-based CPG companies will start to put CBD in everything to capture market share, and traditional institutional capital will finally start to fund deals.  This will put pressure on the smaller players, who will need to find ways to distinguish themselves into a more niche market, or else consolidate. 

 This isn’t different from other markets**, which is another way that this industry is (almost) like any other consumer product (which is a good thing). This process should provide a good test case for much of what’ll happen when Cannabis is legalized – how large CPG companies react, how the financial system reacts, how the regulatory agencies react, how plaintiffs’ lawyers filing consumer products claims react, how investors react.

 *yes, I know that the CBD industry takes the position that CBD is already fully legal based on the existing Federal agency regulations.  I won’t comment on that because, as the disclaimer says below, this email isn’t legal advice….

**as I’ve noted to many of you, every day, this industry looks like the wine industry to me

Excelsior!

Written by Marc Hauser

Cannabis and Securities Law

Friends, sharing a good article from MJBizDaily with further perspective on Aphria. 

 https://mjbizdaily.com/aphria-cannabis-stock-plunging/

The article also points to a recent notice issued by the Canadian Securities Administrators (the Canadian securities regulators) warning against misleading/unsupported promotional activities. This comes on the heels of a recent CSA warning about a lack of sufficient disclosures by public Cannabis companies.  This is all also true for US companies, both public and private – companies and boards have duties to their securityholders* and there are very tight rules about sales and disclosures.

 https://www.securities-administrators.ca/aboutcsa.aspx?id=1752

 These help underlie the point that easy money isn’t easy. 

*Well, unless they’re waived because they’re a Delaware LLC and they’ve got a good corporate lawyer drafting the documents….

Excelsior!

By: Marc Hauser

Level Brands Announcement

Friends, as a corollary to my most recent email, Level Brands announced a deal to acquire cbdMD for stock (~$65mm based on 2018 $3.2mm of revenue and $353,561 loss through August, plus a five-year earnout for an additional 15.525mm shares, but I’m not writing today about valuations).  Level Brands owns a bunch of wellness brands, including a licensing deal for CBD products.

What’s interesting about this deal is that one of the closing conditions is the passage of the 2018 Farm Bill with descheduling of CBD (CBD generally, not just hemp-based CBD).  Although the cannabis industry hasn’t been shy about selling CBD products, now that there’s a possibility of legalization, someone (a lawyer, perhaps?) apparently now sees a risk to the industry and/or the market if the bill passes without CBD legalization.   http://ir.levelbrands.com/node/6901/html

Also, since I have your attention if you’ve made it this far, the Wine & Spirits Wholesalers of America are still in support of cannabis legalization, which is good.  What’s notable about this story, which has a copy of the group’s talking points, is that the group is (unsurprisingly) opposed to vertical integration.  This is, in my opinion, going to be a giant lobbying battle that no one is really focused on yet – whether the three-tier system is replicated in cannabis post-legalization.  It’ll be fun to watch. https://www.marijuanamoment.net/major-alcohol-association-briefs-congress-on-marijuana-legalization/

Excelsior!

Written By: Marc Hauser

Cannabis Stocks

Friends, for those of you who’ve been receiving my spammy musings for a while, and for the subset of you who actually read my spammy musings, you may recall that I made a comment a while back about how the Cannabis industry achieved a somewhat dubious milestone when an activist investor targeted a public Cannabis company.  Well, the markets hit another fun milestone today: Ontario-based Aphria is the target of a short seller attack today, which caused Aphria’s stock to plunge (trading down 20% as I write this). 

(Short selling, for the uninitiated, is simply a way for an investor to bet that a stock price will go down.  The short seller is supposed to borrow the shares to make the short, and pays a fee to the lender of the shares.  Generally, the borrow cost has been high for Cannabis stocks, due to, among other things, the demand for these stocks.)

The fund put out a report attacking Aphria’s Latin American transactions.  Aphria responded accordingly that the allegations of the short seller are “false and defamatory”.  In my opinion, this is good news.  Not for Aprhia, perhaps, but for the Cannabis public market, which is looking more and more like the rest of the stock market.

For those of you in California, today’s the day when the BCC is supposed to issue its revised proposed regs.  Something to tide us all over while we await passage of the 2018 Farm Bill.

Excelsior!

By: Marc Hauser

Capital Markets Continue to Shift and Develop in The Cannabis Space

Friends, once again, the capital markets continue to shift and develop in the cannabis space.  In other words, it’s a weekday.

In the past two weeks, we’ve seen a major public company reduce and reprice their offering in response to market movements: https://mjbizdaily.com/marijuana-firm-medmen-scales-back-financing-appoints-interim-cfo/?utm_medium=email&utm_source=mjbiz_daily&utm_campaign=MJD_20181120_NEWS_Daily_11202018&elqTrackId=A25B5812550E3D302DAE5F24E8902F66&elq=caea0b4add5e4b3a8f21e560766efe39&elqaid=834&elqat=1&elqCampaignId=543

We’ve seen one of the larger institutional players announce the upcoming launch of a second fund at US$100 million: https://www.greenmarketreport.com/altitude-investment-closes-30-million-fund/

We’ve seen a US$14 million PIPE deal by a cannabis-focused hedge fund: https://www.newcannabisventures.com/navy-capital-invests-14-7-million-in-marimed/

 What does this mean, beyond the fact that I’m pretty good at cutting-and-pasting stories that are based on press releases?  It’s probably too early to call it a trend, since the cannabis markets seem to be evolving by the minute, but these deals appear to confirm what I heard in Vegas a few weeks ago: cash is king (or, as my former boss liked to say, “Liquidity is Value”).  As speculators finally start to recover from their collective hangover and share prices react to broader market trends, operating companies taking on investment are coming to prefer cash over stock. Investors are starting to fill that need for cash by raising bigger funds to write bigger checks (just like in the rest of the private equity world).  Just wait until someone figures out how to place real leverage into these deals…..

Excelsior!

By: Marc Hauser

Juul, Cannabis, Then an Even Bigger Deal for Big Tobacco?

Friends, a report in Bloomberg today about Altria potentially investing in JUUL.  Who knows how real this is*, but if it’s true, it’s yet another example of how US companies are finding ways to establish a foothold and get exposure to the Cannabis industry (however indirect)** without causing their boards or general counsels to have a conniption.

 Excelsior!

 *(yes, some folks at Altria and JUUL know, but it’s a rhetorical question posed for editorial emphasis)

**(yes, I know that JUUL is for tobacco, not Cannabis)

Juul, Cannabis, Then an Even Bigger Deal for Big Tobacco?

Excelsior!

By: Marc Hauser

MJBizCon Recap

Friends, it was good to see many of you in Vegas for the lollapalooza that was MJBizCon.  A number of thoughts and observations from my trip:

  • Just about everyone I talked to is still mystified at the current state of the capital markets in the cannabis industry, particularly the public markets.  I heard the word "bubble" used a lot, but then I heard a lot more people counter that argument.  There did seem to be general consensus that the strategy of issuing more stock to get another all-stock deal done to issue more stock to get another all-stock deal done etc. is probably not sustainable.  What seems to me to be more sustainable is tapping the public markets for truly strategic and measured growth, not just relentless roll-ups.

  • Then again, Acreage Holdings just listed with a $2bn+ valuation.  

  • But what's interesting is that, even if this first real wave of public markets activity does correct, the industry itself is strong and growing like crazy and likely won't care, so it'll be a case study to watch how investors and buy/sell side activities adjust if/when that happens.

  • To paraphrase Rick Ross, everyday we're hustin'.  Everyone who wasn't there to look at all of the equipment on the expo floor (if you didn't go, this was a real, honest-to-goodness trade show, and the expo was mostly equipment and services, with relatively few brands) was making connections and finding deals.  Even the investor luncheon - there had to be 1000 people in the room listening to industry folks talking about investment opportunities in the industry.

  • Cash is back.  More vehicles are being formed and raised to put cash out the door, as operators are coming to realize that stock consideration comes with risk, and as more traditional (non-Cannabis) PE investors come into the market and want to write bigger checks and don't want to hold SAFEs (because, why would they?).

  • That's also because Series A/B rounds are on fire.  Operators in the industry are now large enough that they've grown past the seed capital stage and hitting up friends and family. (hence the real need for sophisticated/experienced charming deal/capital markets counsel such as yours truly to help them develop, structure, and make that pitch...)

  • PE funds being raised are still being funded by individual investors, not really yet with any traditional institutional investors (unsurprisingly).  One fund I spoke with noted that they've got 99 people in their new fund - they have to stop at 99 for boring securities law purposes - and the average check isn't relatively (to traditional PE funds) large.

  • Lots of focus on Senator McConnell and the 2018 Farm Bill, which (if you believe what a politician says before they actually do it) is now almost certain to include industrial hemp. Investors are very much eyeing the potential in hemp-based CBD with the anticipated passage of the Farm Bill, particularly if it really does, once and for all, clarify that it's legal (few operators seem to appreciate and/or care that the legality of hemp-based CBD is not as certain as they think it is).

  • Lori Ajax, Chief of the CA Bureau of Cannabis Control, finally gave some public guidance (after relentless public questioning) that the newly-proposed regulations weren't intended to eliminate white label products. We'll see what happens there, but she suggested that no one should change their current practices yet (this is not legal advice).

  • I personally didn't see any dreadlocks or tie dyes at the expo, and instead saw lots of khakis and sensible shoes. Another example of the fact that cannabis is moving towards being like any other business with a giant trade show and people doing regular business things. (not a judgment on dreadlocks or tie dyes - more likely to be found at The Emerald Cup)

  • That being said, Vegas brings out some odd ones.  Waiting for coffee at a stand at NYNY, an older gentleman in front of me asked if they could grill his bagel. No, not toast it (that was an option he declined) - grill it.  I'm 99.99% certain this was a sincere request.  

Looking forward to seeing you all there next year, and definitely sooner than that. 

Excelsior! 

By: Marc Hauser

Cannabis and the Three-Tier System?

Friends, an interesting report published in Marijuana Moment a few days ago (yes, I’m behind) about NY State liquor stores advocating for direct sales of cannabis.  Reading their website, they’re worried about cannabis cannibalizing (alliteration!) their sales.  It’s related to the same point that I’ve been hammering for a while, that the wine and spirits industries need to be finding ways to play along, not bury their collective heads in the sand.  The idea of selling at liquor stores makes sense to me, particularly once you’ve got companies with nationwide distribution.

It also raises what to me more is the interesting question, which is: how does alcohol’s three-tier system fit into all of this?  We’re already seeing Southern Glazer and Breakthru Beverage working in the Canadian markets.  When Federal legalization occurs, are they able to persuade legislators to replicate the three-tier system for cannabis?  I imagine they’ll try.  On the other hand, I can think of a few companies that wouldn’t like that.  It’ll be an interesting fight to watch when it arrives.

Also, a sort-of correction.  In my last email, the one about SPACs, I noted that I couldn’t find any other cannabis-focused SPACs.  Well, it’s true that I couldn’t find them, but there are plenty of others out there.  I need to hone my Google skills.

Excelsior!

https://www.marijuanamoment.net/new-york-liquor-stores-want-to-sell-marijuana/

https://savethelaststore.com/

Written by: Marc Hauser

Cannabis Professionals

Friends, passing along an article from Bloomberg this morning as another sign of the professionalization of the cannabis industry.  The trend that the article discusses, of bankers and other financial professionals moving into cannabis up in Canada, looks a lot like what happened with the first dot-com boom, when investment banks (and then law firms, accounting firms etc.) couldn’t compete with startups for talent. 

My point isn’t that cannabis is in a dot-com-like bubble, though – instead, my point is that cannabis companies know that they need expertise in multiple disciplines to grow and survive (finance, marketing, sales, distribution, etc.), and certainly to position themselves to succeed through legalization.  This certainly isn’t news for those following the industry, and it isn’t just happening in Canada. 

Yet another sign that running a cannabis business is like running any other business (well, almost), and that’s a good thing.      

Bankers Are Flocking to Canadian Cannabis Startups

Excelsior!

By: Marc Hauser

Cannabis SPACs

Friends – so yesterday, I made a comment in my email that exits are getting done these days with paper.  Well, that’s not totally true. Another short, fun lesson in capital markets.

https://www.newcannabisventures.com/5-u-s-cannabis-companies-with-projected-c261-million-sales-in-2019-join-forces-to-go-public-in-canada/

Cannabis Strategies Acquisition Corp. just announced a roll-up of five different cannabis assets, closing simultaneously.  Cannabis Strategies is a SPAC, an acronym that’s fun to say and stands for “special purpose acquisition company”.  SPACs are publicly-traded companies that are formed to raise money in an IPO without any assets, and a mandate to acquire assets within a specific period of time and (sometimes) with a specific industry focus.  It’s a blind pool, and the investor is betting to get in early at a discount in exchange for tying up their capital, in exchange for the hope that the sponsor managing the SPAC will find good assets.  It’s sort of a publicly-traded private equity fund, sort of.

Here, Cannabis Strategies raised a pile of money in December 2017 on the Canadian Stock Exchange, and has now put together a parcel of somewhat different assets to spend some of that money.  I did some quick searching, and didn’t seen any other cannabis-focused SPACs out there. It’ll be interesting to watch how Cannabis Strategies integrates these differing assets, and also if anyone follows suit with raising capital and buying up assets this way for cash.

Excelsior!

By: Marc Hauser

Cannabis and the Capital Markets

Friends, another dive into the world of complex capital markets transactions.  This time, an analysis of Tilray’s announced $450 million convertible bond offering, noting that the annual interest payment is more than 2017 revenues (although the author sort of elides over the fact that the company will now be sitting on nearly half a billion more of cash to pay that coupon), and the 15% premium to the (then) current stock price. 

In my opinion (which, by the way, is not the opinion of Gaw Van Male, LLP or its employees), the author’s breathless concern about this offering seems to have less to do with the bond itself and more with how the market has been bidding up Tilray’s stock price. https://ftalphaville.ft.com/2018/10/08/1538971201000/Tilray-s--450m-game-of-chicken/

Excelsior!

By: Marc Hauser

Cannabis - The Pains of Going Public

Friends - passing along a noteworthy review by the Canadian Securities Administrators (which coordinates securities regs across the provinces) about the general lack of appropriately sufficient disclosures by cannabis companies in their public filings.

Remembering that cannabis companies have really only been going public on the CSE for not very long, eventually I imagine this will shake out and investors will demand disclosures that are more in line with market expectations and customs (see, for example, WeWork’s very-short-lived attempt to report “community-adjusted EBITDA” (which isn’t a thing)).  Nonetheless, it does remind companies that, even when listing on a smaller exchange like the CSE, getting access to public capital means comes at a price.

https://www.bcsc.bc.ca/Securities_Law/Policies/Policy5/PDF/51-357__CSA_Staff_Notice___October_10__2018/

Excelsior!

By: Marc Hauser

Cannabis Meets the Public Markets

Friends, an interesting article today from Bloomberg about public cannabis company Hexo Corp. (f/k/a The Hydropothecary Corp.)  They’re the ones that announced the deal with Molson Coors in Canada a few months back.

What I love about this story is that it’s showing how quickly the public cannabis markets are maturing.  They’ve now got activist investors!   As the story notes, Hexo is up 95% since mid-August and is trading 13x enterprise value to forecast (!), but because that lags the 26x EV to forecast of the rest of the industry (minus Tilray, which skews the results!), an activist investor sees blood in the water.  Another sign that finance is treating cannabis like any other industry (see, also, Goldman and BofA lending into the Constellation deal).

Welcome, cannabis, to the public markets. 

Excelsior!

By: Marc Hauser

Material Adverse Effect in M&A Transactions

One of the major deal negotiation points in mergers and acquisitions transactions is whether the buyer can walk if something happens that causes a “material adverse effect” (MAE) on in the target’s business.  The MAE closing condition shows up in deals where the buyer is locked up for a period of time between signing the agreement and closing (say, for regulatory approvals or financing).

 

From the buyer’s perspective, it seems logical and fair that it should be able to terminate and get its deposit back if the target’s business declines materially.  From the target’s perspective, MAE is vague and subjective – what does “materially” even mean?  Deal lawyers and well-meaning law professors have tried to solve this problem over the years by trying to tie “materiality” to objective tests, such as a specific decline in EBITDA, but even those tests are somewhat unsatisfying.  The meaning of MAE is such an unknown that even the Delaware Court of Chancery (which is, nationally, the key court for M&A law) had never found a case where the buyer was justified in terminating because of a material adverse change in the target’s business.  Until now.

 

On October 1, 2018, the Delaware Court of Chancery ruled in Akorn, Inc. v. Fresenius Kabi AG et al. that Fresenius properly terminated its merger agreement to acquire Akorn because of a material adverse change in Akorn’s business.  This case is noteworthy because it is the first time, after many prior cases considering the question, that the Delaware Court of Chancery has allowed a buyer to terminate an acquisition because of an MAE.  The Court makes it very clear that the MAE was very fact-specific and company-specific.  In particular, the target’s EBITDA had fallen 86% year-over-year, the stock price had plummeted, the target had materially breached its regulatory and compliance obligations, eroding value, and, after signing, the target did nothing to resolve its serious compliance problems, breaching its covenant to operate in the ordinary course of business between signing and closing.

 

This decision most likely will not change the deal landscape – indeed, the Delaware Court of Chancery declined to find an MAE in landmark cases coming out of the 2008 recession.  However, it will likely affect the negotiation of closing conditions in transaction documents – no longer can deal lawyers argue that “the Delaware courts have never found an MAE, so it doesn’t matter” – with MAE definitions more specifically tied to the target’s business and operations.  Akorn also serves as a reminder to targets that the pre-closing obligation to keep operating the business in the ordinary course is a real one.  Finally, this case could result in more buyers testing the limits of the Akorn decision in the courts, but, as the Delaware Court of Chancery seems to have made clear – those limits are still fairly narrow.

 

If you have any questions, please feel free to reach out to your GVM lawyer.

This information is only a summary and provides only general information about fiduciary duties and corporate law.  It does not constitute legal advice, and you may not and should not rely on it.

By: Marc Hauser

Control Rights and Fiduciary Risk

Don’t overplay your hand – that’s what the Delaware Court of Chancery is suggesting in a recent and important case for investors. If you own equity with control rights, “hardball” tactics like forcing “oppressive” financing terms could expose you to a breach of fiduciary duties.

Georgetown Basho Investors LLC, a fund led by Chester Davenport, began investing in data company Basho Technologies, Inc., in 2010. After a series of preferred stock financings, Georgetown gained the right to block outside capital raises. In 2014, Georgetown and Davenport forced a final preferred round that gave them control over the company and fairly egregious economics (including a 3x liquidation preference). Georgetown and Davenport took active steps to thwart outside financing pitches (including offers that the investment bankers found were more favorable to the company), controlled the negotiations with potential investors, and pushed aside management who opposed their terms. The Board of Directors rejected Georgetown’s offer, but then Georgetown refused to further fund a bridge loan, throwing the company into a liquidity crisis, and Georgetown gave the company one day to accept its final preferred round terms. After three board members resigned, Georgetown appointed a majority of the board and moved forward with the financing. Needless to say, this didn’t end well – the company later ran out of money and liquidated in 2017.

The Delaware Court of Chancery (which is, nationally, the key court for corporate governance issues) found that Georgetown and Davenport breached their fiduciary duties for self-dealing both in the preferred round and afterwards – Davenport as a board member and Georgetown as a shareholder.

Notably, and an important point for investors to remember, even though Georgetown didn’t own a majority of the stock, the Court reminded that a shareholder still owes a fiduciary duty if it exercises “control over the business affairs” of the issuer.

So is this the end of private equity investing? Well, the Court took pains to make it clear that this case is very fact-specific, pointing out that its decision doesn’t mean that there’s a “heightened risk for venture capital firms who exercise their consent rights over equity financings. … If Georgetown only had exercised its consent right, that fact alone would not have supported a finding of control. … Georgetown and Davenport did far more.”

This decision shouldn’t chill investing activity or the ability of investors to exercise their well-negotiated blocking rights. But, like in other areas of law (e.g, equitable subordination, lender liability), courts don’t like it when investors take too much advantage of their rights for their own benefit, to the exclusion of other stakeholders.

If you have any questions, please feel free to reach out to your GVM lawyer.

This information is only a summary and provides only general information about fiduciary duties and corporate law. It does not constitute legal advice, and you may not and should not rely on it.

By: Marc Hauser