Is cannabis going mainstream? The legal cannabis industry continues to see strong growth as it gains broader acceptance. And yet, the regulatory landscape remains uncertain and highly complex with significant effect on how cannabis companies grow and operate. As a result, cannabis M&A deals continue to present unique challenges before and after closing. As the post-closing sellers’ representative on numerous cannabis deals, SRS Acquiom has seen firsthand how these challenges play out after the deal closes. The uncertain legal status of cannabis, the atypical structure of cannabis companies, and unique licensing requirements for cannabis deals are explored below, as well as suggestions to help protect deal parties engaged in your next cannabis M&A deal.
Cannabis Remains Legally Uncertain
The cannabis industry has experienced strong revenue growth even as legal uncertainties persist. According to Business Decision Data Service, Inc. (BDSA), a cannabis market research firm, legal cannabis sales in the U.S. reached $17.5 billion in 2020, a 46% increase from $12.1 billion in 2019. Global cannabis sales reached nearly $21.3 billion in 2020, an increase of 48% over 2019 sales of $14.4 billion. BDSA estimates by 2026 legal cannabis sales will reach $41.3 billion in the U.S. and $55.9 billion globally.1
Cannabis legality varies widely among states
Currently, cannabis is now fully legal in 17 states and the District of Columbia. It remains fully illegal in five states and is subject to partial or mixed legality (such as for medicinal purposes) in remaining states.2
Cannabis remains illegal under federal law3
But the risk of federal enforcement is in part dependent upon the company’s compliance with applicable state laws. In 2013, the U.S. Department of Justice issued guidance commonly referred to as the Cole Memorandum providing that given its limited resources, the DOJ would not enforce federal prohibition in states that “legalized marijuana in some form and implemented strong and effective regulatory and enforcement systems to control the cultivation, distribution, sale, and possession of marijuana.” The Cole Memorandum was officially rescinded in 2018 but still appears to guide DOJ enforcement decisions.
Cannabis companies face challenges in accessing financial services
A company conducting legitimate cannabis operations within a state where cannabis is fully or partially legalized may have limited access to banks, lenders, insurers, and other financial institutions because of the institutions’ concern about federal punishment.
Continuing federal disapproval means insurers, banks, and other financial service providers often will not serve the cannabis industry to avoid risking their own licenses or regulatory approvals. The travails cannabis providers commonly experience without access to simple depository account and payment-processing services are well documented. The inability to access financial services also distorts key M&A deal characteristics when the cannabis provider is acquired.
In recent years, the SAFE Banking Act has been introduced in Congress to bridge the gap between the federal and state regimes. The Act is designed to prohibit federal regulators from punishing financial institutions for the sole reason that they choose to provide services to the cannabis industry. The Act has yet to pass both houses of Congress.
Cannabis Companies Are Not Typical
In some important ways, the legal grey area in which they operate affects the way in which many cannabis companies grow and mature. Most traditional investors and lenders like venture capital firms and banks have avoided the cannabis industry altogether. Indeed, a typical cannabis company’s capitalization table is often a list of individual investors with an exceedingly high tolerance for risk.
- Limited Prior M&A Due Diligence
The lack of professional investors deprives cannabis companies of more than startup capital. When a venture capitalist or bank invests or lends, there is a significant amount of due diligence that takes place. Shortcomings and idiosyncrasies are identified and addressed. Many cannabis companies do not undergo the kind of scrutiny other startups have. This dynamic is challenging for M&A deal lawyers tasked with due diligence in a cannabis deal; definitive agreements that are amended and restated to address what counsel turned up are not unusual.
- Lack of Professional Leadership
Once the investment is made, a professional investor will often join the board of directors or advisors and act as a formal or informal mentor to the executive leadership. The presence of sophisticated investors can add a level of professionalism to the company’s management and operations that otherwise might not exist.
Even with extensive due diligence, problematic practices and discrepancies may continue to materialize after closing. Purported investors holding options or warrants not appearing on the capitalization table, employees compensated in nontraditional ways, customer and vendor contracts never reduced to written form, and other idiosyncrasies may result in post-closing indemnification claims alleging breach of the sellers’ representations.4
It’s All About the Cannabis License
State and local jurisdictions where cannabis is legal require a license to market and sell cannabis products. The requirements to obtain a license vary widely between state and even local jurisdictions and may feature unusual requirements. For example, the City of Oakland, California expressly favors license candidates who have formerly run afoul of cannabis trafficking laws.
The heightened importance of the license creates a dynamic where the licensee becomes a ripe target for acquisition…
This license cannot be sold or transferred in most jurisdictions, making it difficult for cannabis retailers to enter new markets if obtaining a new license directly is too tedious. A well-capitalized cannabis company may find it easier to acquire a local retailer to gain entre, effectively acquiring the retailer for its license. The heightened importance of the license creates a dynamic where the licensee becomes a ripe target for acquisition simply as a vehicle for the buyer to obtain a subsidiary licensed to sell cannabis in a particular jurisdiction. The sellers’ representations concerning the license often receive extensive treatment and are treated in the vein of “fundamental representations” with extended survival periods and expansive rights to recover indemnified losses beyond the amount escrowed, held back or subject to earnouts. The sellers’ representations may also include compliance with Cole Memorandum principles.
Issues or problems with the license post-close may accordingly assume outside significance relative to other breaches of representations. A buyer’s claim for indemnification arising from a license that turns out to be unenforceable or otherwise flawed after closing may represent a significant share of the total consideration paid for the acquired company.
Perspectives for Your Next M&A Cannabis Deal
As illustrated above, the evolving environment for cannabis deals brings a host of issues not usually encountered in mainstream M&A deal scenarios. Deferral of deal- party consideration payments, the avoidance of banking services (given their spotty availability), and third-party claims are frequently making an appearance in these kinds of deals. Perspective is offered below on how M&A cannabis deals are unfolding to help your next deal be successful.
Cannabis M&A Deals: Much of the Deal Consideration Is Deferred
Buy-side representation and warranty insurance (RWI) is used on many deals as a mechanism to provide buyers with protection against breaches of representations and warranties from the seller. However, this trend has not been present in the cannabis industry because, in the experience of the SRS Acquiom team, RWI insurers will not cover cannabis deals. As a result, at least 10% of total consideration— and often more—is withheld at closing in the form of an escrow or holdback to protect against unknown liabilities and shortcomings in the sellers’ representations. Cannabis industry sellers also normally retain a substantial expense fund to litigate disputes with the buyer or third parties because they are directly exposed to indemnity claims. The result is a significant portion of the deal consideration is deferred and contingent upon post- closing claim activity on many of these transactions.
Closing and Deferred Compensation Are Designed to Mitigate Need for Banking Services
Most M&A deals involve a paying agent to facilitate document collection and cash payments to the sellers, and an escrow agent to hold cash and/or buyer shares as the buyer’s security against indemnification claims. These services are largely not available, or available only in limited form, in cannabis M&A deals. In the experience of the SRS Acquiom team, cannabis acquisitions usually involve stock-only compensation to sellers, or a mix of cash and buyer stock. This is in stark contrast to traditional M&A; among deals where SRS Acquiom was engaged, 79% involved cash-only payments to the sellers, 18% included a mix of cash and buyer stock, and only 3% were stock only.5
Deferred consideration in cannabis deals is often retained by the buyer as a holdback instead of deposited with an escrow agent, although some escrow agents will hold buyer shares in escrow. The use of a holdback in place of an escrow puts the sellers at a disadvantage often not well understood. Funds held in escrow will remain in place until the buyer and sellers’ representative agree to their disbursement, or a court orders the release. Both sides are motivated to resolve any dispute so they may recover funds.
But the buyer has unfettered control over a holdback it may choose to retain unless the sellers’ representative obtains and enforces a court judgment. If the buyer’s only incentive to settle is to avoid the threat of litigation, which it may not find credible if the sellers’ representative lacks the resources to litigate or the amount at stake is relatively small, the sellers could struggle to get such funds released. At worst, the holdback, unlike the escrow, may disappear altogether in the event the buyer is insolvent or files for bankruptcy protection, leaving the shareholder’s representative with nothing more than an unsecured claim.
Third-Party Claims Are Common
Merger agreements generally provide for indemnity where a third party asserts a claim against the acquired company for some action or omission that would constitute a breach of the sellers’ representations. The sellers may also specifically indemnify the buyer for third-party litigation that is threatened or ongoing at closing.6
- More post-closing claims, higher value
Third-party claims are not unusual. But as the sellers’ representative,
SRS Acquiom has found cannabis deals produce more claims of high value that can be especially difficult to resolve. This trend is rooted in several dynamics particular to the cannabis industry. One is most cannabis targets are consumer-facing, giving rise to consumer class action litigation regarding the product, related advertising, and more. In fact, cannabis providers are particularly susceptible to consumer litigation because the product is highly regulated, offering ever more opportunities for entrepreneurial plaintiffs’ counsel to find and exploit a compliance shortcoming.
- Legal uncertainties drive third-party claims
Ongoing legal uncertainties are at the root of many third-party claims. A claim SRS Acquiom handled as the sellers’ representative particularly illustrates this tendency. The sellers represented that the cannabis company was a tenant in good standing under a real estate lease. After closing, the landlord threatened to bring an eviction action because the landlord was apparently in breach of a covenant with its mortgage lender prohibiting commercial cannabis at the property. SRS Acquiom successfully contested indemnification, but the issue would not have come up in the first place if the company were in a different industry.
- Nature of industry is high risk, high reward
Another dynamic behind third-party claims is more nuanced. The investors, venders, brokers, suppliers, and others who partner with cannabis companies tend to be comfortable operating in a high-risk, high-reward industry of uncertain legality. When a dispute occurs, cannabis partners are often more willing—eager, even—to aggressively pursue the up-side potential rather than negotiate a quick resolution for less.
Cannabis M&A Is Evolving
The cannabis industry remains characterized by a certain “Wild West” element even as it becomes more broadly accepted. Often, the result is an unusually eventful M&A post- closing period. The systemic effects of the lack of federal approval, inconsistent application of laws across state borders and unavailable mainstream financial services continue to slow the development of cannabis companies. Yet the cannabis industry is evolving as cannabis becomes legal in ever more jurisdictions and the SAFE Banking Act appears to gain traction in Congress. Even as this journey progresses, cannabis M&A deal parties must remain aware of the industry’s unique characteristics and how they may affect deal characteristics and post-closing challenges.
1 https://www.globenewswire.com/news-release/2021/03/02/2185408/0/en/BDSA-Reports-Global- Cannabis-Sales-Exceeded-21-Billion-in-2020-Forecasts-55-9-Billion-by-2026.html
2 DISA: https://disa.com/map-of-marijuana-legality-by-state
3 Hemp was legalized under U.S. federal law in the 2018 Farm Bill.
4 Across all M&A deals where SRS is engaged as the sellers’ representative, 38% of deals had at least one claim for indemnification (excluding purchase price adjustment), and of deals that had at least one claim, 54% had at least one claim totaling at least $1 million. 2020 SRS Acquiom M&A Claims Insights Report, slide 13.
5 2021 SRS Acquiom Deal Terms Study, slide 15.
6 This sub-set of third-party claims is sometimes called “scheduled litigation” because it appears in a schedule of specifically indemnified matters. See this whitepaper for the SRS Acquiom perspective regarding handling scheduled litigation matters before and after closing.