Towards the end of 2019, it seemed that cannabis investments had all but dried up. Today, our cannabis lawyers are seeing a huge uptick in investment transactions of all kinds in cannabis and hemp businesses. With investments on the rise again, we plan to do more posts on various legal aspects of cannabis investments. At the outset, it’s best to understand some fundamentals, and the best place to start is looking at the question of debt vs. equity.
It is extremely common for cannabis businesses (and especially startups) to raise capital through issuing equity (i.e., stocks in a corporation or membership interest in a limited liability company, or “LLC”). Typically, startups seek to offer a significant chunk of equity in exchange for a large monetary investment that can be used to cover initial operating or startup costs (think of things like costly tenant improvements that virtually all cannabis licensees are required to make in order to get a permit and start operating). Generally, these equity offerings are of a not insignificant amount, and we’ve seen a lot of businesses offer close to half of the equity in the business to an investor. This makes sense from a common-sense point of view as investors in startups probably don’t want to drop half a million to get a 3% stake.
Another alternative is debt. Cannabis businesses can take out loans without issuing any equity to third parties, leaving the founders in the driver’s seat of the business. Lenders may be less willing to provide large loans to startups as they don’t get anything in return except a promise to be repaid (and there’s always a risk that repayment may never happen for a business that doesn’t even have permits yet). It’s therefore very common for lenders to ask for something additional besides just a promise to repay: a security interest in some asset of the company (like real property, tangible assets, or in some cases even things like IP). It’s also very common for lenders to require corporate or personal guarantees where third parties promise to pay the debt of the borrower in the event of a default. Debt can often be a less-attractive method of raising capital for startups. Founders may be rightfully worried about offering security interests and personally guaranteeing large debt. Moreover, loans that require immediate repayment with large amounts of interest may not be viable for businesses that aren’t yet operational.
There are some hybrid methods of fundraising that cannabis businesses commonly employ. One of the most common methods is convertible debt, which basically is a loan that converts into equity upon the occurrence of a future event. The business getting the loan will issue a promissory note that can be converted into equity. Convertible notes often include complex formulas for how debt converts into equity, and parties can freely negotiate how and when the debt can convert, and there are a lot of complex legal and non-legal terms that both investors and startups should consider when entering into a convertible note arrangement.
For cannabis businesses seeking money from third parties, serious consideration should be made as to the type of investment transaction they will use and what is best–giving up a stake in the company or taking on guaranteed and/or secured debt. Additionally, companies should carefully consider cannabis regulations that affect investments and require disclosure of investors or lenders, so as to avoid disputes by investors who gave money before knowing they had to be disclosed.