Written by Steve Schain
Unlike more mature industries, cannabis ventures are often “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% violative of federal law, for “plant-touching” marijuana businesses obtaining a loan from a federally charted bank or credit union is almost impossible. Specifically, because the Comprehensive Drug Abuse Prevention and Control Act, 21 U.S.C. §§ 801, Et. Seq (1970) prohibits “manufacture, distribution, and dispensation” and any transfer or deposit of monies yielded from cannabis sale may be deemed “money laundering” in violation of the Currency and Foreign Transactions Reporting Act, 31 U.S.C. §5311-5330, most banks and credit unions refuse to provide marijuana growers, processors or dispensers with financial services.
Cannabis and Intellectual Property
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 25-40% of corporation’s shares or limited liability company’s membership interest.
For example, a business issues a promissory note with a 2 or 3-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;
- sale of company; or
- change in “control” (ex, change in entity’s effective control or ownership; sale of a large portion of company’s assets).
Cannabis Business and Equity Financing
“Business valuation” is often the key to obtaining equity financing. A dispensary seeking to raise $300,000 of buildout expenses will be more successful if demonstrating business’s $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 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 §1404, et seq…
With either “convertible debt” or “alternative equity financing” arrangements, the issuer and investor negotiate:
- a valuation cap protecting investor from receiving a comparatively small stake in 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.
Copyright ©2020 by Steven M. Schain, Esquire