Information about Cannabis Industry Mergers and Acquisitions
Mergers and acquisitions (M&A) between privately held corporations involve a variety of complex business and legal considerations. In order to effectively navigate this terrain, it’s important to understand some of the underlying dynamics and some of the issues that may arise.
This is especially important in the cannabis sector. As an industry in its infancy, there is a great amount of volatility, dynamism, and hype along with a scarcity of information surrounding the M&A process which makes for significant opportunity, but also significant risk. In this article, we lay out several things that any prudent businessperson should keep in mind when contemplating an M&A opportunity.
Challenges in the cannabis regulatory environment
In every industry, the regulatory environment is a factor that needs to be understood and appreciated when considering an M&A opportunity. This is especially important in the cannabis industry, for several reasons:
- First, the industry is relatively young. This applies to the Canadian national industry as well as the 10 American States where cannabis is legal. This means the business and legal landscape is constantly changing as new laws and regulations are passed and legislators try to figure out what works and what does not. More and more States adjust the legality of cannabis in their jurisdiction every year, meaning there is a high amount of volatility in the regulatory environment.
- Furthermore, there is a fragmentation of the regulatory environment. For example, in the United States, cannabis is legal in some states, illegal in others, partly legal in some, and illegal at the federal level. In Canada, there are varying regulations across provinces that might need to be factored in when considering M&A activity.
- Finally, the industry itself is complex. There are different stages in the cannabis pipeline, with different rules governing each stage, each emanating from one of several different sources. For example, there are cultivators, processors, distributors, retailers, marketers and accessory manufacturers all at different niches in the cannabis pipeline, each dealing with their own regulations and the regulations of other niches they interact with. To further complicate things, there are a variety of products in this space such as hemp, combustibles, edibles, oils, and topicals. The rules are varied for each of these products at each of the stages of the cannabis pipeline.
All these factors combine and interact to create a kaleidoscope of rules, a house of mirrors of legislation and regulation. Without an understanding of these variables in the regulatory landscape, a company contemplating an M&A in this space could quickly have the sand shift beneath their feet. At the very least, they could expose themselves to significant legal and business risk down the road which sufficient foresight could have prevented. We have seen some highly publicized cases of companies running afoul of the regulators early in the creation of this industry.
How are companies valued in the cannabis sector?
In an M&A, everything is negotiable.
Since we are discussing M&A’s between privately held companies, benchmarks to follow are less available (or in some cases, not available at all). This is compounded in the cannabis industry where there are significantly fewer private transactions which might allow you to calibrate your deal based on historical data. Even if there are available models, you will unlikely be privy to all the relevant information.
There are several key factors to contemplate to help you to work towards an agreeable price for both parties:
- Market comparables (if available)
- Financial or strategic buyer (who may buy at a higher price due to synergies)
- Trends in the company’s time sequenced financial performance
- Strategic alliances and partnerships
- Projected financial growth
- Proprietary technology
- Legal risks
- Experience/quality of management and key employees
- Multiple bidders or a single interested party
If a purchase price cannot be agreed upon, contingency clauses such as “earn-outs” can be drafted as a way of bringing the parties together. For example, with an earn-out, payment of a certain portion of the purchase price is contingent upon the purchased business meeting specific targets. This is helpful when the parties differ on the valuation of the business.
However, earn outs should be used with caution; these clauses can entail a fair amount of risk for a selling party, as the seller will have to depend on the business stewardship of the purchaser to actually meet those targets and if the targets aren’t met, the seller will be out a portion of the purchase price. Of course, carefully drafting can also help protect the seller in an earn-out situation. A seller also exposes itself to the risk of a buyer not paying the earn-out when due in the event a dispute arises relating to the target being met. For that reason, a clear dispute resolution clause in the agreement is paramount. It is equally important for the seller to obtain some form of security from the buyer in the event the buyer does not pay the earn out when due. This security can take the form of a registered general security agreement or personal and corporate guarantees.
Before buying an asset, a prudent purchaser will need to ensure that it knows exactly what it is buying and what kinds of obligations and liabilities it is assuming. This can mean worrisome contracts, litigation risks or intellectual property problems.
The seller should ensure all its records, books and contracts can withstand a buyer’s in-depth review. Some issues that may arise are:
- Amendments to contracts that are not fully signed
- Director and shareholder resolutions that are unsigned or misplaced
- Material contracts that are not assignable by the seller in the event of a sale of the company
- Existing and previous employees or contractors not having signed confidentiality agreements or intellectual property assignment agreements
- Employment or contractor agreements that should be in place but are non-existent
- Financial statements will be intensively vetted
- Existing litigation or other claims that may effect the seller and the assets being sold
To avoid these along with other unforeseen problems, it can be pragmatic to undertake a due diligence on your own company before a buyer does their own.
Multiple bidders enhance the seller’s position and can drive up prices
Due to the lack of available information about comparable deals in the cannabis sector, having multiple bidders can be extremely useful to a seller. Not only does it help the seller calibrate what a realistic price might be, it also can drive up that price as a result of competition between the buyers. Sellers should use this to their advantage, be patient, and bring multiple bidders into the process if possible. However, sellers should also be mindful of any contractual terms that may restrict them from entertaining other offers or bids during a period of time. Of course, industry conditions will heavily influence whether it is a buyers or a sellers’ market.
Beware letter of intent traps
A common oversight by sellers in the M&A process, in their eagerness to get a buyer into the deal flow, is to sign a letter of intent without considering this a key part of the negotiation process.
These agreements might be nonbinding, but sellers need to realize that their bargaining power is greatest BEFORE they sign a term sheet. Once the term sheet has been signed, the leverage shifts over to the buyer, since letters of intent often include provisions relating to exclusivity. Treat these documents like they are legally binding on all terms and the extra effort will be rewarded as the deal progresses.
Some key terms in a letter of intent can include:
- Price and payment structure
- Scope and timeline of exclusivity provisions
- Conditions to be met or waived prior to the agreement becoming binding on the parties
- Decisions as to which terms are binding, which are nonbinding
Employee and benefits issues
The difficulty and sensitivity of these issues can vary across industries. For example, in the tech industry, you’ll typically see a number of highly important employees with complicated stock option plans. These potential issues are certainly worth paying attention to in the cannabis industry. These are some questions to consider:
- How will stock options and equity issued by the seller be incorporated in the M&A?
- As a result of a deal, do any of the unvested options or equity accelerate in their vesting?
- Might the buyer ask for non-compete agreements for key employees as a condition for completing the transaction?
- Are there any issues with employment agreements or dismissals that could potentially cause a problem for the buyer?
- Have all current and past employees signed confidentiality agreements?
- Have all current or past employees signed invention assignment agreements?
- Will key management/employees be retained? If so, under what terms?
You need a great legal team
M&A agreements in any industry are complex, multi-dimensional and can be contentious. They are fast moving and involve difficult legal issues. Because of this, buyers and sellers need lawyers familiar with these deals. Not only do lawyers need to be competent with respect to the substantive law, but it is also imperative they be skilled advisors and negotiators with an intimate knowledge of the cannabis industry. For more information or to connect with one of our lawyers, please feel free to reach out at 604-629-5400 or [email protected].
Article co-written by Alon Segev, managing partner; David McHugh, lawyer; and Eric Kroshus, 2019/20 articling student.
***The above blog post is provided for informational purposes only and has not been tailored to your specific circumstances. This blog post does not constitute legal advice or other professional advice and may not be relied upon as such. ***