When the new year began, the North American cannabis industry already was reeling from a chaotic 2019. The first year of Canada’s legal market was anemic, plagued by supply problems, heavy regulatory burdens, and an inability to compete with illicit markets. In the United States, even bipartisan lawmaking couldn’t get needed banking reforms approved. The deadly vaping crisis in the latter half of the year revealed serious industry-threatening risks at all points along legal supply chains in North America and worldwide. As if all that weren’t bad enough, a series of high-profile cannabis company takeovers and closures left many wondering whether the industry’s green rush of optimism was beginning to fade for 2020.
And then the COVID-19 crisis hit.
The cannabis industry—all aspects of it: hemp, CBD, and marijuana, both medical and adult-use—now is facing immediate economic uncertainty as the world responds to coronavirus concerns. As tempting as it might be, it’s really too early to forecast what the long-term financial implications of COVID-19 may be on the industry, specifically when considering the pursuit of capital in the sector. Capital will be in even greater demand the longer the economy suffers.
For example, how the novel coronavirus outbreak possibly affects the long-term supply and public demand for cannabis is yet to be seen. Already, though, many public-health experts are predicting COVID-19 will affect public life globally through the summer months and, perhaps, even into the fall.
As states order their residents to shelter in place, cannabis has been viewed as an essential service in many parts of the country. Denver recently moved to shut down recreational dispensaries before rolling back that decision a couple of hours later. No doubt similar decisions will be considered in other metropolitan areas as the duration of the pandemic goes on.
Meanwhile, reported cases in the United States multiply, along with deaths attributed to the virus. As numbers rise, it’s easy to surmise that if the flow of venture capital was at risk of slowing at the start of the year, COVID-19 slowed it even more substantially before the official start of spring. And the longer the pandemic goes on, the more it will affect funding plans in the cannabis sector just as in all others.
Venture capitalists are adopting a cautious approach to the future like the rest of us. That means many cannabis companies probably will find themselves having to look elsewhere for capital investment in 2020. Two of the most immediate potential options are initial public offerings (IPOs) and mergers and acquisitions (M&As). Both are tried and true, yet both have some risks not always fully considered.
More M&As? Maybe
If there is a prolonged economic downturn due to COVID-19, we may see more M&A activity and deal-making because many cannabis businesses simply will need to consolidate to survive. In a long-lasting slowdown, it’s easy to envision well-positioned national players most likely would continue to acquire regional and smaller brands, especially if other forms of venture funding are harder to come by in a down economy.
It’s also probably safe to say most company founders look favorably on having their business creations targeted for either merger or acquisition. It’s recognition, of sorts, for their companies’ profile in the industry. More importantly, though, it’s a lifeline for cash-strapped organizations caught in any kind of low earnings period.
So, while many founders seek a merger or acquisition along with a new role in the merged operation, it’s often easy to overlook some potential risks. One of the biggest challenges a founder faces can be earnouts affecting a continued role with the company.
Earnouts most often are tied to revenue targets or specific earnings before interest, taxes, depreciation, and amortization (EBITDA) benchmarks. If earnout clauses aren’t structured soundly in the beginning of any merger or acquisition, some founders can find themselves struggling early to achieve the financial benchmarks required. That means they are at greater risk of being contractually forced out of the company they created. Unfortunately, many of them are.
It’s too early to forecast what the long-term financial implications of COVID-19 may be on the industry, specifically when considering the pursuit of capital in the sector. Capital will be in even greater demand the longer the economy suffers.
Another note about M&A deals in 2020: At the end of 2019, the U.S. Department of Justice (DOJ) appeared to be using the Hart–Scott–Rodino Antitrust Improvements Act to delay a sizable number of pending cannabis M&A proposals. The use of the HSR law—and the delays it can bring—prompted a concern in the industry that the lags were becoming more common…and costly. Fortunately, the postponements haven’t continued as stringently as before, but companies should take care to have a legal review conducted before any planned M&A activity. Such a review can indicate if there may be a need for companies to divest any particular operations before mergers take place.
Coincidentally, in March the Federal Trade Commission announced that, because of coronavirus concerns, DOJ will accept HSR filings only via a new electronic filing system.
What about IPOs? Well, perhaps
Some cannabis companies could turn to another favored form of raising money often seen as equally prestigious as acquisition by a larger company: an IPO. In economic downturns, there are heightened risks and uncertainties associated with going public. Yet many companies still do, especially those with a lot of debt and a need to leverage balance sheets.
For anyone holding stock in a company that has yet to go public, the possibility of an IPO is enticing. But in the cannabis industry, perhaps more than in any other, private-placement stock often is used as a way to compensate employees, vendors, and contractors of all kinds.
When the companies eventually do go public, these kinds of stockholders get paid. But many of these private-placement stockholders often forget their ownership stake in companies comes with restrictions to quick profit-making, thanks to applicable securities laws.
That rule is part of the U.S. Securities Act of 1933, the landmark investor-protection law that emerged in the wake of the stock-market crash of 1929. Rule 144 is a safe harbor for transactions in restricted securities, and it provides a way for individuals holding these kinds of stocks eventually to sell them to the public.
When a company is private, it can issue stock in what’s known as “private placements.” The shares in private placement are considered restricted. They aren’t registered with the U.S. Securities and Exchange Commission (SEC), and they can’t be publicly traded. The stock certificates of such shares even are stamped with a legend denoting them as being banned from sales or trades.
However, restricted stock can be resold to the public if the holder can attain an exemption to securities laws. That’s where Rule 144 comes in.
The rule stipulates a mandatory holding period for restricted securities. For a public company reporting to the SEC (for at least ninety days), that period is six months. For private companies under no such SEC reporting constraints, the hold is for one year. For any restricted-stock holders, the period is identified as beginning when the securities are fully purchased.
If a company relies on Rule 701 for issuances to employees or consultants who are individuals, stocks can be sold with no holding period (after the ninety-day reporting period).
Aside from the holding-period requirements of Rule 144, holders of restricted stock also need to be aware of the rule’s requirements concerning restriction labeling on stock certificates. Even if all other requirements of the rule are met, shareholders still will need to have any restriction warnings removed from the stock certificates before they can be traded. For public companies, only so-called “transfer agents” can make this happen—meaning it’s a requirement for companies to get a legal opinion to confirm the stock is “freely tradeable” under Rule 144.
The cost of coronavirus, human and otherwise
This year’s initial pullback on venture funding was at first an acknowledgement that no market—even a wildly popular and profitable one like cannabis—can support endless quarters of negative company earnings, regulatory uncertainty, and legal challenges. Now that COVID-19 has shaken the world, it’s clear the cannabis industry will have to respond in unique ways to finding capital, too, as investors remain cautious.
Otherwise, COVID-19 threatens to be just as deadly to some businesses as it can be to many human populations. There’s no comparison between the two costs, of course, but both will be hallmarks of the year ahead.
Julie Herzog is managing partner and head of the corporate/securities practice at Fortis Law Partners and Full Velocity Consulting