Financing

Private

What private financing options are available for cannabis businesses in your jurisdiction, and what are their respective advantages and disadvantages?

A startup business in any industry needs adequate funding in order to launch, fund operations, and grow. This presents unique challenges for early-stage businesses with little to no operating history. The issue is further compounded in the cannabis industry where certain traditional financing sources such as Small Business Association (SBA) loans and traditional bank loans may be unavailable. Thus, owners of cannabis businesses must get creative in their approaches to financing their businesses.

Although medicinal cannabis is legal in New Jersey, it remains illegal under federal law and cannabis remains classified as a schedule 1 drug at the federal level. The Federal Deposit Insurance Corporation (FDIC) is the primary deposit insurance provider for state and federally chartered banks. One of the FDIC's primary roles is to ensure that no banks take on any existential risks, which would include violations of federal law. Thus, under present regulations, it is nearly impossible for banks to do business with companies involved in the cannabis industry because they risk prosecution for money laundering and aiding and abetting federal crimes. Certain banks have made a distinction between companies that operate certain ancillary cannabis businesses (e.g., technology companies, testing labs, and packagers) that do not "touch the plant" as opposed to growers, processors, and dispensary operators. However, banks must file suspicious activity reports for every transaction involving a cannabis company, which creates a compliance burden which can make it unprofitable to work with cannabis companies. Several states are attempting to work out banking solutions for cannabis businesses operating in their states, but traditional banking services and loans remain largely unavailable to cannabis businesses operating in the United States.

Most startup companies raise their initial capital from personal business networks or "friends and family." Friends and family financing rounds are often the quickest and easiest ways to raise capital. They are typically small investments structured as equity subscriptions, unsecured loans, or convertible debt. It is important to remember, however, that even when raising funds from friends and family, compliance with federal and state securities laws is essential. Investments in early stage companies in evolving industries (especially highly regulated industries such as cannabis) are not appropriate for all individuals. Investors must be made aware of all risks, including the fact that they may lose their entire investment. Investors must be provided with appropriate disclosure regarding the business and the risks involved and valuation issues must be carefully addressed to avoid issues in future financing rounds.

The term "seed financing" typically denotes a company's first round of financing from third-party investors. Investors in these rounds are typically led by angel groups, venture capital funds, or other groups that regularly invest in startup companies and are structured as equity, debt, or convertible debt. The documentation for a seed round is typically less extensive than a Series A round and the restrictions on the funds and management are typically less stringent.

Series A rounds are typically used to fund growth once the company has achieved certain levels of success. Series A rounds are typically larger in size than friends and family and seed rounds and are typically led by venture capital firms. They often result in greater concentrations of investor ownership and may result in changes on the board and in management. The terms of Series A rounds are often more onerous on the companies and management and contain more restrictive protective provisions for investors. Companies operating in the cannabis space may find the terms proposed by investors to be even more restrictive that a typical Series A round due to the greater risks involved with cannabis investments.

Public

What rules and restrictions govern cannabis businesses’ listing and admission to trading on recognised equity securities exchanges? What are the advantages and disadvantages of public listing?

One of the biggest challenges facing companies in the cannabis industry is access to capital. The year 2018 has been pivotal for cannabis companies in the public markets. This was largely driven by the legalization of cannabis in Canada. Tilray, a Canadian medical cannabis company, completed its $150 million initial public offering on the Nasdaq Global Select Market in July 2018. Tilray grows and processes cannabis in Canada and Europe and sells it through a network of distributors in Canada, Australia, and Germany.

The U.S. capital markets generally remain inaccessible to U.S.-based growers, processors, and dispensary operators. All of the major U.S. stock exchanges contain strict listing requirements that prohibit the listing of businesses whose operations violate federal law. This means that companies with operations in countries where cannabis is legalized may meet listing requirements in the United States while similar companies based in the United States may not. Cannabis companies based in the United States are permitted to list on certain Canadian exchanges, but Canada's largest exchange, the Toronto Stock Exchange, has prohibited the listing of U.S.-based cannabis companies because they violate federal law in their home country.

Many U.S.-based cannabis companies have gone public through a process known as an alternative public offering, whereby a company completes a reverse merger into an inactive public company (often a shell company) and completes a simultaneous private placement into the now public company immediately following the merger. Although reverse mergers and initial public offerings (IPOs) are both mechanisms to go public, there are substantial differences between them. The costs associated with a reverse merger can be substantially lower than an IPO and the transaction can often close much quicker as it is not subject to review by the Securities and Exchange Commission (SEC) prior to closing as an IPO is. However, companies typically raise much less capital in connection with a reverse merger and it is extremely challenging to develop market support for post-reverse merger stocks, which are often microcap companies trading in the over-the-counter markets. In May 2014 the SEC issued an investor alert warning about possible scams involving cannabis-related investments, noting that fraudsters often exploit the latest growth industry to lure investors with the promise of high returns. 

A reverse merger is not the only alternative for cannabis companies looking to go public while avoiding an IPO. Companies may also go public through a self-filing process. A self-filing takes place through the filing of a registration statement with the SEC registering some shares to be resold to the market. No public offering takes place. The company seeks to register for resale shares that were previously offered in a private placement. The company avoids certain regulatory disadvantages associated with being a former shell company but will still face the challenges associated with developing market support for a non-exchange listed company. The inability to be listed on an exchange greatly limits the liquidity, analyst coverage and the potential investors that are able to purchase those securities.