This year is primed to be the cannabis industry’s biggest yet. Almost $3 billion of capital was raised in the first quarter of 2018, more than four times the amount raised in the first quarter of 2017. With the increase in capital investment comes an increase in the sophistication of investors, including institutional ones like venture capital and private equity sponsors.
As more institutional money pours into the cannabis industry, entrepreneurs are being held to higher standards of professionalism, and are now expected to understand basic venture finance and equity structures. Part of this understanding includes preferred equity, which is a general term used to describe any class of securities (e.g., stock, limited liability company [LLC] units, limited partnership [LP] interests, etc.) that has higher priority for distributions of a company’s cash flows or profits than common equity.
In its simplest form, the “preferred” component of the equity represents additional rights and privileges investors receive in return for their investment beyond owning a percentage of the company. In most instances, when a company takes on outside investors, it will have at least two classes of securities: common equity and preferred equity. The common equity will be that owned by the founders of the business, and possible additional employees and service providers. The preferred equity will be owned by the investors. Since the investors are providing capital to the company in order for the enterprise to operate, the investors generally receive preferential treatment as it relates to certain activities of the business. For example:
1. Liquidation Preference – Typically, all cash flows and profits remaining after required payments to a company’s lenders are distributed to the preferred equity holders, until they receive the full amount of a previously agreed-upon return (e.g., 1X, 2X, or even 3X), before any other funds are distributed to the common equity holders. Under the 1X scenario, the preferred equity holders would receive their invested capital back, and then any additional proceeds would be distributed pro rata based on the percentage ownership of both the preferred and common equity holders. This particular liquidation preference is known as participating preferred equity. Under the 2X scenario, the preferred equity holders would receive 2X of their invested capital, and share pro rata as described above. And so on.
2. Information Rights – Preferred equity holders are generally entitled to certain rights in order to gain access to the company’s information, including the rights to receive (i) annual, quarterly and even monthly financial statements; (ii) annual operating budgets; and (iii) periodic capitalization tables.
3. Protective Provisions – Preferred equity holders may also be granted certain protective rights, whereby the company would be forbidden to take certain actions without the approval of the preferred equity holders. In most cases, the approval threshold would require the vote of at least a majority of the preferred holders. Such protections may include:
- Liquidating, dissolving, or winding up of the company, or any sale, merger, consolidation or other deemed liquidation event;
- Amending, altering or repealing any provision of the company’s charter (in the case of a corporation) or LLC agreement;
- Creating or authorizing a class of equity senior to the preferred equity;
- Creating a debt security exceeding a certain amount, which would generally exclude equipment lease or bank lines of credit; or
- Increasing or decreasing the size of the board of directors (in the case of a corporation) or board of managers (in the case of an LLC).
4. Pre-emptive Rights / Anti-Dilution – Preferred equity holders may also be granted the right to purchase securities offered by the company in a subsequent financing round. Such purchase rights by the preferred equity holders would be limited to the preferred equity holder’s pro rata ownership percentage of the company, prior to such equity issuance. This is a form of anti-dilution that preferred equity holders generally benefit from, so that their percentage ownership interest is not diluted by future securities offerings by the company.
There may be other benefits/rights granted to preferred equity holders, depending on the stage and size of capital investment, but these represent some of the basic feature of preferred equity.