Uncertainty in a Time of Cannabis – Does Overregulation Risk Stifling Future Investment?.
For cannabis companies in California, 2017 is a period when neither companies nor investors are living in the moment. Everyone is looking to the future, while at the same time analyzing and evaluating the persistent grey area of the present. In addition to all of the risk factors cannabis investors need to heed, the industry is planning, or at least attempting to plan for future uncertainty because of the passage of MAUCRSA (the Medicinal and Adult-Use Cannabis Regulation and Safety Act or SB 94) in late 2016. Particularly dysfunctional and difficult to interpret are the actions of County agencies, each of which is working on its own regulations and policies that seem to shift with every public hearing held. Moreover, and in addition to the labyrinth of state and local laws, we must endure a steady stream of comments, innuendo and rhetoric from federal leadership that seems tailor-made for cooling investment into cannabis companies.
California cannabis companies, like any new entrepreneur venture, need funding now to scale up their operations in anticipation of future licensure under MAUCRSA and to appease local regulators through local licensing and permitting processes. The result of all this is that California cannabis lawyers are seeing and working on many deals involving hybrid financing structures – an element of cash investment now, with warrants, options, and convertible debt exercisable later. Each has different triggers and rights for the cannabis company and investors, but all are in essence a different form of “kicking the can down the road” to 2018.
Three big factors are driving hybridized financing in The Golden State:
1. Over Regulation that Appears Uncertain.
Investors inherently accept risk in any investment, but they do not enjoy reading the tea leaves on major issues that are out of the Company and investors’ control. This means investors are searching for creative ways to mitigate these risks, and risks abound in cannabis regulations that change regularly. Thus, many cannabis investors are uncertain whether they want to cross the 20% ownership threshold to be considered an “owner” under MAUCRSA, which ultimately requires they be disclosed to and heavily vetted by California state regulators.
2. License Transfer and Corporate Structuring.
California’s draft cannabis business regulations make clear that future licenses are not transferable. Many local governments also are making sure cannabis operators cannot transfer their permits or local licenses after-the-fact. Further, most existing medical cannabis operators are organized as non-profit entities pursuant to Proposition 215, and there is an outstanding question as to whether these entities will be able to merge into for-profits once they have their state licenses under MAUCRSA as such a move could potentially jeopardize state and local licensure altogether. Though all parties should undertake their cannabis financings with this knowledge, investors understandably still want to reduce risk by withholding some of their investment until 2018 when more of these questions will likely have been resolved by state and local governments.
3. The Size of the Opportunity.
In the past year, we have seen the situation in Nevada where despite a 33% – 37% tax on all retail sales, dispensaries simply cannot keep up with demand and are selling out of supply. In anticipation of California having a similar supply crunch, we are seeing investors in California cannabis cultivators seek warrants or options as a “kicker” for additional upside which allows for more equity if the opportunities prove even greater than anticipated.
This is not to say that investors are dictating all terms in the world of cannabis finance. Cannabis companies can and do negotiate for control of the trigger points or adjustments to the future exercise price. Some cannabis companies are choosing hybrid investment structures because they too want to feel out the size of the opportunities and many believe they will be able to demand much greater valuations and investment terms in 2018, once the initial dust settles on the regulatory sphere.
Time will tell….check back for updates.