By Steven Schain
Joining 24 states and the District of Columbia, legalized medical cannabis has come to Pennsylvania. If even less than 1 percent of its 12.8 million residents participate, the commonwealth’s medical marijuana program will be populated by more than 100,000 card holders, which leading trade publication Marijuana Business Daily estimates will generate $100 to $150 million in annual sales revenue.
While awaiting for Pennsylvania to promulgate it’s process-governing-regulations, grow and dispensary applicants must consider what funding choices exist, when ”ceding control in exchange for financing” is preferable, and whether out-of-state investing will be allowed.
Debt Versus Equity Marijuana Funding
Unlike more mature industries, cannabis ventures are predominantly “startups” differently situated in evaluating whether to seek debt or equity financing. While debt, (i.e., loans secured by assets), is preferable, equity, or convertible debt, is more common.
Because it is 100 percent violative of federal law, it is almost impossible for “plant touching” marijuana businesses to obtain a loan from a federally charted bank or credit union. Specifically, because the Comprehensive Drug Abuse Prevention and Control Act, 21 U.S.C. Section 801, Et. Seq (1970), prohibits the “manufacture, distribution, and dispensation” of cannabis. And any transfer or deposit of monies yielded from cannabis sales may be deemed “money laundering” in violation of the Currency and Foreign Transactions Reporting Act, 31 U.S.C. Section 5311-5330, most banks and credit unions refuse to provide marijuana growers, processors or dispensers with financial services.
Although startups often have assets like intellectual property, equipment or land protecting investors against default, loans often require being secured both by an entrepreneur’s home and a personally signed guaranty. Beyond the founder assuming personal risk for the debt, fixed loan payments may weaken a developing business that should be reinvesting every generated dollar. However, because it does not dilute the founder’s percentage, debt financing is usually preferable to equity, which involves raising capital in exchange for ownership.
Equity financing often requires issuing convertible notes similar to promissory notes (loans with interest, payable on or before a maturity date), but enable investors to convert the debt into equity (often preferred company stock). Because “small, closely held business investors” are most seduced by a significant equity percentage, founders must often provide 25 to 40 percent of the corporation’s shares or limited liability company’s membership interest.
For example, a business issues a promissory note with a two- or three-year term, and, if it raises more money during that period, the note holder may convert the debt to shares issued based on the company’s valuation during a subsequent raise. If no money is raised within that period, the note holder may either receive interest and principal payments or convert the note to equity at a previously agreed-upon valuation. Events triggering “conversion” include:
• Loan outstanding beyond its maturity date;
• Company raising defined capital amount in priced equity round;
• The sale of company; or
• Change in control (ie, change in entity’s effective control or ownership; sale of a large portion of company’s assets).
Business valuation is often the key to obtaining equity financing. A dispensary seeking to raise $300,000 of build-out expenses will be more successful if demonstrating the business’ $1,000,000 post-money valuation. Valuation of “plant touching” cannabis businesses often hinge on how many licenses their state has issued, the fewer of which the higher the ”pre-money value” a startup can claim.
“Alternative equity financing,” where an investor puts cash into the company then later receives stock or LLC membership in connection with a “future event,” is another equity financing method. The later event can be another fundraising transaction, or some agreed upon on target, but, unlike with convertible debt, the company never actually issues debt. Alternative equity financing imposes no maturity date or mandatory payback and often falls outside debt regulation like California’s Finance Lenders Law, 10 California Code of Regulations Section 1404.
With either convertible debt or alternative equity financing arrangements, the issuer and investor negotiate:
• A valuation cap protecting the investor from receiving a comparatively small stake in the company if a later investor values it appreciably higher;
• Providing original investors with a discount as extra compensation credit for initiative;
• What equity financing or business cycle targets will trigger conversion and stock issuance; and
• If there is conversion without an equity financing, how will business valuation be determined at that time?
Residency Requirements and Out-of-State Funding
To prevent “Big Marijuana” from hijacking the industry and preclude cannabis dollars from moving across state lines, many jurisdictions impose residency restrictions. While helping to level the playing field, residency requirements often create significant fundraising impediments unseen in other industries.
For example, adult-use marijuana state Alaska requires that anyone with a financial interest in a marijuana business be a physically present state resident. In establishing residency, Alaska’s Marijuana Control Board looks at items including home purchase, employment, voter registration and a driver’s license.
Cannabis investors may cash in on their equity in compliance with residency requirements only upon the earlier of: establishing residency for a requisite period of time within the state in which the company is located; a regulatory shift eliminating applicable residency requirements; and sale of the note to a buyer who meets the residency requirements.
In carefully structured situations, convertible notes and Simple Agreements for Future Equity (SAFEs) can be used to raise out-of-state capital without violating residency requirements or the Aug. 29, 2013, Deputy Attorney General’s James Cole Memorandum (Cole Memorandum).
Similar to convertible notes SAFEs allow investors to convert their investment into equity at some future point (when residency requirements are moot). Unlike convertible notes, SAFEs are not classified as debt, SAFE holders are not creditors and there is no maturity date or interest rate. Instead, SAFE holders receive a warrant that can be exercised if the company is acquired, raises investment capital or goes public.
Generally, SAFEs cannot be flipped (thereby assuring investors’ long-term loyalty and commitment) and because uncomplicated (often comprised of standardized terms negotiating only valuation cap) SAFE’s save startups significant transaction costs.
Upon qualified financing, SAFE holders automatically receive preferred shares based upon the valuation cap, as opposed to preferred shares based upon a higher pre-money valuation.
States are trending against residency requirements and last year Colorado amended its law to allow out-of-state financiers to fund marijuana establishments through unsecured convertible notes, warrants and options. Oregon and Washington recently rolled back residency requirements and out-of-state money is already chasing some of Nevada and California’s pending adult use legalization enterprises.
Whether pursuing debt or equity financing, retaining the maximum amount of ownership and control—along with keeping costs low and not raising unnecessary funds—are the most critical steps to a canna businesses success. •
Reprinted with permission from the July 29, 2016 edition of the The Legal Intelligemcer, ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or [email protected]