Opportunities abound for today’s cannabis producers, but any business seeking to sell a cannabis operation is likely to face a steep learning curve and numerous unforeseen obstacles. In a three-part series, Erik Ott of investment bank KO Acquisitions will lay the groundwork for those contemplating a sale to US or Canadian buyers. In Part 1, Ott will focus on the requirements necessary to engage in serious discussions. Part 2 will cover early engagement between buyer and seller up to and through the LOI, and in Part 3 Ott will examine the due diligence process and chart the path to a successful closing.
Part 1 – M&A Readiness – Corporate Hygiene
Mergers and acquisitions have long been a strategic growth tool for companies looking to enter new markets, expand a product portfolio, and/or acquire talent to scale the buyer’s business. Cannabis, despite its limited legal operating history, is no different in this regard as market leaders GTI, Curaleaf and Cresco have utilized M&A to close more than a dozen deals creating over $10b in shareholder value. While the tightening of the capital markets in 2020 has reduced M&A activity in cannabis, there is hope that 2021 will be good year for the industry and that “cash on the sidelines” will flow into cannabis.
So the question becomes: if an MSO or well-funded private company comes knocking, and you like the valuation and terms, can you close the deal?
Over the past 2 years, MSOs have refined their ability to make an offer (a Letter of Intent, or LOI) quickly and with limited due diligence. However, the path to closing a transaction is much longer, often taking 9-12 months (if it closes at all). One common reason for this is that during due diligence the seller cannot provide comfort to the buyer that the transaction has a manageable risk profile. So if you are a seller and you wish to entertain M&A either today or in the future you must focus on your corporate hygiene. Consider that in order to sign a Definitive Agreement the buyer will typically review 150-200 documents. These will include three years of financial statements, shareholder information, vendor and employee agreements, facility leases or real property agreements, and much more. Operators who are ill-prepared to provide this information will struggle to close a transaction that passes the reporting requirements of publicly traded companies on the CSE or the TSX.
How can a cannabis operator go about shoring up corporate hygiene?
Let’s take financial statements. Given the complexity of cannabis regulations, it is rare to see a cannabis seller with audited financials. In fact, it is more likely that a company is virtually un-auditable. Most cannabis entrepreneurs see the time and expense associated with an audit and choose to “kick that can down the road.” This is understandable, but fortunately there are other less expensive and time-consuming options that can provide a buyer with comfort. Options include having your financial statements “reviewed” or “compiled” by an independent CPA; this process will likely flag a number of potential areas of concern that can be addressed prior to engaging in an M&A process. Reviewed or compiled financials do not require the auditor to verify the information — consequently, there is no guarantee of accuracy. However, it will give a buyer more confidence when evaluating a company.
Of course, corporate hygiene extends to all facets of the business. One particular focus of buyer analysis is compliance and licensing. Cannabis operators are all aware of the challenges thrust upon them by local and state regulators. Suffice it to say, these regulations are works in progress that can change quickly – often every two years as newly elected officials implement their cannabis policies. The most challenging aspect to closing a transaction is transfer of the license(s). Some states are known to take 6-9 months after the Definitive Agreement is signed (often a 6-month process in itself) to process a license transfer. Sellers must assume that a buyer will hire the top legal compliance teams with domain expertise to dig into all the nuances of license transfer, and sellers should therefore be intimately familiar with local and state agencies, their processes, and their requirements. Complex license transfer may not completely derail a deal, but there is little reason to entertain an M&A transaction if your compliance and licenses are not stable.
While financials and compliance are the key areas, or table stakes, to closing a deal, evaluation of corporate hygiene can extend into numerous complex areas. Many companies have multiple entities for strategic purposes, but those entities must have well defined cost allocations and policies when money is being moving around. Inventory is often overvalued as many products may be bordering on obsolete or subject to a substantial write-down. These may seem like minor issues, but once the buyer does its due diligence there may be ample reason for a purchase price reduction if these issues are identified and resolved. Issues like these will rear their ugly heads near closing in the form of working capital adjustments, and can often have a significant impact on the compensation received by the seller.
Investing in corporate hygiene will put you in a position to entertain offers from buyers, confident that you can actually close. The length of time it takes to sell your business and the kind of deal you structure will be a direct function of how well you’ve prepared your business for sale and the degree to which you’ve made the acquisition process easy for the buyer. Put another way: if you make your business attractive to the right buyers and “smooth the path” to buying by removing obstacles, you’ll be far more likely to sell for agreeable terms and close the sale quickly and successfully.
Stay Tuned for Part 2 – Negotiating the LOI