• A growing organization is a positive, but along with it usually comes increasingly complex financial accounting.
• Outsourcing provides businesses of all sizes with an opportunity to manage an array of issues — from staffing shortages or a lack of specific expertise to disorganized or unsecure financial records.
• Benefits of outsourcing include significant cost savings, direct access to specific accounting knowledge, the minimization of turnover, the ability to scale, access to tools and processes, and flexibility.

Many CEOs and business leaders are experiencing challenges in the aftermath of the COVID-19 pandemic, including changing customer trends, aggressive competition, emerging digital technologies, and the new normal of employee expectations for workplace flexibility.

These uncertain economic forces and cultural shifts are putting increased pressure on staffing for organizations of all sizes – especially fast-growing ones. While these difficulties are difficult to overcome, they are also an opportunity to change the “status quo” and level-up back-office performance.

For leaders navigating the uncertain tailwinds of the pandemic and planning to enter a new era of growth, outsourcing represents a powerful opportunity to address any staffing issues or business challenges. It empowers you to access specialized insight on a temporary basis, create value ahead of a major transaction, manage overhead costs, and modernize and revitalize business processes.

A recent study showed that 59% of all businesses utilize outsourced resources and that accounting is the most commonly outsourced function. So, how do you know if outsourcing your accounting function is right for your organization?

In this article we’ll look at five indicators that this strategy might be right for you and detail the key benefits to outsourcing or augmenting your accounting function.

Five signs your business may benefit from outsourced accounting

Here are some questions you should ask yourself to determine if your organization would benefit from outsourced accounting services:

1. Is your business growing rapidly?

If you’re experiencing a significant influx of revenue, first off, great work! Your business model is proving out and you’re on the fast-track to success. But what is happening to your expenses, profitability and working capital? Depending on your answer it could mean that your accounting needs are evolving, the risks of a breakdown are higher, and overall, there is simply more at stake. It may be time to confirm that your current in-house team is qualified and staffed appropriately to handle these new responsibilities.

2. Are you struggling to keep up with your accounts receivable or payroll?

One way to get a firm answer to whether your team is understaffed is if you’re missing key deadlines or struggling to get timely collection of cash from your accounts receivable. The inability to collect and follow-up on AR is essential to funding current and future growth and is directly connected to meeting your payroll commitments – one of the largest expenses of any business. If anything falls behind, you can find yourself in a difficult position if you do not have the ability to access cash or financing.

3. Are your financial records organized and producing usable data?

Your accounting function does more than compliance, it should help guide your organization’s financial hygiene. Organized financials tell a clear story of earnings, spending, and investment, so you can make informed decisions. An over-worked or inexperienced accounting team will be working furiously to keep up with compliance and may not have the capacity, or necessary experience, to provide guidance on your financial scorecard to accrete value to the organization.

4. Do your accounting needs fluctuate significantly throughout the year?

If your business experiences big shifts in labor productivity based on the calendar year and your taxes filings are late with significant overages from the tax preparers, or your audits have a significant number of adjustments, that may mean your accounting team lacks capability. Striking the right balance between hiring quality talent and the speed of bringing new hires up to date with company procedures can be a challenge. Outsourcing your team can deliver the resources you need, when you need them, and limit costs during the slower periods.

5. Are you concerned about financial security and checks and balances?

If your internal accounting team is one or two individuals, you may be open to hidden risks. An independent team can provide the checks-and-balances that help mitigate the risk of fraud and asset misappropriation.

If you answered yes to any of these questions, you should consider outsourcing part or all of your accounting function. With an outsourced accounting team, you gain immediate access to trained, knowledgeable staff with the knowledge you need in technical accounting. The right outsourced resources can help your business grow faster and run more smoothly — often at a lower price than building an internal accounting department.

Benefits of outsourced accounting services

1.Cost and time savings

Maintaining full-time employees can be costly — and for most organizations, labor costs are some of the highest expenses. By relying on an outsourced team, you can devote your time to growing your business and spend less time managing accounting.

2. Direct access to specific accounting expertise

Every company is different, which means every company’s needs are different. By outsourcing, you have access to the service you need when you need it. An outsourced team will bring familiarity with an array of accounting and reporting standards, including GAAP, IFRS, GASB, etc. Plus, they can provide specific experience with M&A transactions, raising capital, scaling, or downsizing operations.

3. Minimize turnover disruption

In a smaller organization, each employee is vital to the business’s success. When you lose one, the disruption left in their wake can provide additional challenges. An outsourced accounting team will never leave you in the lurch, so you can focus on what is most important: generating revenue.

4. The ability to scale

If your organization has grown quickly, you may experience growing pains when your fortunes suddenly shift. In boom times, you may need to hire more staff to meet demand. But that also means you may find yourself laying off employees in a downturn. Outsourcing allows you to handle more work without hiring additional employees or scale back if your capacity shrinks.

5. Tools and processes

No matter what your organization’s size, you should always try to keep your overhead costs minimal. By outsourcing, you can save money on specific tools or processes you might otherwise need to function. The right outsourced team will provide the know-how and equipment you need to succeed.

6. Flexibility

By outsourcing certain jobs, you can plan — and pivot, as needed — depending on your organization’s needs. This is especially relevant in the case of needing specialized guidance. If you’re planning a major transaction or other market move, an outsourced CFO can provide tactical expertise when and where you need it.

MGO can help

As your organization grows, your financial accounting needs become increasingly complex. Because your in-house accountants may be limited to handle the basics, outsourcing to professional teams with specialized knowledge and experience can provide precisely the kind of service you require — and give you the time you need to focus on the organization’s other needs.

MGO has a robust outsourced accounting team staffed by CPAs with diverse industry background and technical specialties. We’ll provide the right-size solution to your organization’s needs. Areas we support include day-to-day accounting tasks, complex financial systems projects, regulatory compliance demands, and support for M&A deals, raising capital, and other major transactions.

Whether you’re interested in simply augmenting your team with additional financial knowledge, or undertaking a complete accounting transformation, we can help you with the people, processes, and technology you need to move your business forward.

To explore your options and start along the path to organizational change, contact us.

Private organizations, while not always smaller, often have limited resources in specialty areas, including accounting for income tax. This resource constraint —the work being done outside the core accounting team — combined with the complexity of the issues, means private companies are ideal candidates for, and can achieve significant benefit from, internal controls enhancements. Thinking beyond the present, the following are five reasons private companies may want to adopt public-company-level controls:

1. Future Initial Public Offering (IPO) – Walk before you run! If the company believes an IPO may be in its future, it’s better to “practice” before the company is required to be SOX compliant. A phased approach to implementation can drive important changes in company culture as it prepares to become a public organization. Recently published reports analyzing IPO activity reveal that material weaknesses reported by public companies were disproportionately attributable to recent IPO companies. Making a rapid change to SOX compliance can place a heavy burden on a newly public company.

2. Merger and Acquisition Deals – If the possibility of the company being sold to an M&A deal exists, enhanced financial reporting controls can provide the potential buyer with an added layer of security or comfort regarding the financial position of the company. Further, if the acquiring firm has an exit strategy that involves an IPO, the requirement for strong internal controls may be on the horizon.

3. Rapid Growth – Private companies that are growing rapidly, either organically or through acquisition, are susceptible to errors and fraud. The sophistication of these organizations often outpaces the skills and capacity of their support functions, including accounting, finance, and tax. Standard processes with preventive and detective controls can mitigate the risk that comes with rapid growth.

4. Assurance for Private Investors and Banks – Many users other than public shareholders may rely on financial information. The added security and accountability of having controls in place is a benefit to these users, as the enhanced credibility may impact the cost of borrowing for the organization.

5. Peer-Focused Industries – While not all industries are peer-focused, some place significant weight on the leading practices of their peers. Further, some industries require enhanced levels of security and control. For example, cannabis companies with a heavy regulatory burden, industries with sensitive customer data like lifesciences, and tech companies that handle customer data, often look to their peer group for leading practices, including their control environment. When the peer group is a mix of public and private companies, the private company can benefit from keeping pace with the leading practices of their public peers.

Private companies are not immune from the intense scrutiny of numerous stakeholders over accountability and risk. Companies with a clear understanding of the inherent risks that come from negligible accounting practices demonstrate their ability to think beyond the present, and to be better prepared for future growth or change in ownership.

When planning to sell your cannabis or hemp operation, a core value driver is your willingness and execution in preparing for the transaction. Early preparation will motivate you and your team to undertake improvement activities that will appeal to potential Acquirers and ease the M&A process. There are numerous benefits to this preparation stage, with a little elbow grease and strategic planning you can: maximize the value of your organization during the valuation process; optimize the due diligence reviews, saving both time and money; and finally, convey to the Acquirer that you have firm control over your organization, instilling confidence and comfort.

Additionally, all the improvements we recommend improve efficiency and performance enterprise-wide, and provide additional controls and documentation to support on-going regulatory compliance – all essential to thriving in the competitive cannabis and hemp landscape.

It’s never too early to begin preparations

All too often, a Target company’s leadership team decides it is time to sell, begins networking and marketing, and only after the pieces are in motion, or potential acquirers are kicking the tires, the improvement processes begin. The next stages – valuation, preparing a data room, due diligence, etc. – are often a rush. Improvements to operations come too late and don’t positively impact the valuation. When hurried, mistakes can be made preparing appropriate documentation of finances, controls, and regulatory compliance, and the valuation and due diligence processes are delayed. Meanwhile, the market is moving and the growth curve may have changed or flattened out. Ultimately, valuations are suppressed or, in the worst case, Acquirers move on.

Considering the volatility of the cannabis and hemp landscapes, this is a reality that must be faced. Rather than wait until the market timing feels right, Target company leadership need to be planning well ahead of time. We recommend AT LEAST a 90 day window of preparation for an M&A transaction. Depending on the complexity of the operation, even more time may be needed. The good news is that by preparing ahead of time, the Target company gains the upper hand in most negotiations. You can wait to go to market when the timing is perfect, and then when you introduce your company or assets, you have extra confidence knowing everything is in order and you’re putting your best face forward.

Audit preparedness is the name of the game

A common issue plaguing cannabis and hemp operations is inadequate documentation of finances, operations, and controls. Many operations have been founded by expert growers, scientists or sales persons who are leaders in their respective fields, and who’ve bootstrapped themselves every step of the way to seizing their respective market share. In these circumstances, documentation is often limited to the bare minimum to maintain tax and regulatory compliance. While this may be enough to continue operating, in the case of an M&A, an Acquirer is likely to need much more.

Especially if the Acquirer is a publically-owned company or SPAC (special purpose acquisition company), which will have robust financial/accounting teams and will conduct thorough due diligence. They’ll need to have clear visibility into all of the core areas of your operation, and confidence that internal controls exist, are adequate, and properly documented.

Preparing for this level of due diligence ultimately amounts to audit preparation. This is a stage that public companies are all too familiar with, and consider routine, but private companies may find onerous and time-consuming if they haven’t undergone the process before.

Know thyself – approach to M&A preparedness

Once you understand that M&A preparation is roughly akin to audit preparation, you can begin the process. To outline what to look for, we will take the perspective of an auditor, and describe what they will be reviewing and looking for, and what you should be doing to meet their needs.

Operational Assessment: The first thing an auditor will do is examine your operating procedures and internal control environment. They will review all operations and seek to establish that you have appropriate financial personnel, processes, and controls in place.

In even the most high-functioning organizations, there are often opportunities to improve operational efficiency. Following are a couple questions to ask:

• Are you losing cash? Do you have adequate capital on hand? – In the cash-heavy, but capital-poor, cannabis marketplace, an Acquirer will closely examine your financials. If your internal control environment isn’t continually assessing margins to find opportunities to tighten things up, now is the time to do so. There are relatively simple actions that can be taken to improve your bottom line and make your operation more desirable to an Acquirer.
• What is the strength of your internal controls? Is documentation appropriate? – While the numbers visible reviewing financials are helpful to an Acquirer, the knowledge that internal controls are sufficient lends validity to those numbers. If you aren’t getting detailed financial information from your control environment, it is never too late to strengthen this area. Whether selling now or in the future, clear visibility, and checks and balances, will improve efficiency.
• Have you tested, and documented, cash and inventory controls? – An Acquirer (just like an auditor) is going to want to see verifiable, periodic integrity for both cash and inventory. Quarterly counts are the minimum for good accounting practices. If you’re not doing this yet, start now, the stronger your history the better. The process of reviewing cash and inventory controls will likely also produce opportunities for improvement. Inventory controls, for example, may uncover opportunities to write off obsolete or spoiled inventory, boosting your bottom line.

Getting your papers in order: During the due diligence process, the Acquirer and their team of lawyers, bankers and accountants, will want to see… well, just about everything. Cannabis and hemp companies often have incomplete information on existing contracts, stock options, cash logs, corporate records, etc. A buyer will insist on seeing all financial data, important contracts, and much more, and you must be prepared to build a data room and deliver that information quickly and efficiently.

If you’re unsure whether your books and financial data are adequate, here are some questions to ask:

• Have you reconciled all accounts? – Ahead of the M&A deal, you’ll need to ensure all of your accounts are as up-to-date as possible. This includes paying any bills and collecting any invoices. This will help make sure your financial information supports accurate projections and analysis.
• Are your books clean? – We don’t mean free of fraud (that goes without saying), but are your cash counts and logs up to date? Can you properly track all cash going in and out? Can you provide receipts for all purchases and sales? And finally, and most importantly, are you categorizing expenses appropriately? IRC 280E is a major point of concern for all cannabis M&A transactions, as the Acquirer will be prodding for any potential 280E tax exposure.
• Are your employees categorized correctly? – A common mistake for cannabis companies is related to employee categorization and compensation. Also tied directly to 280E, it is essential that your full-time and part-time employees are in the appropriate categories, you have documentation (time sheets) supporting their work, and all 1099s are in good order.

Showing your best in the Quality of Earnings report

A standard part of the M&A due diligence process will be the Quality of Earnings (QOE) report. If you, as the Target Company, don’t provide one, it is a near guarantee that the Acquirer will request one. It is our recommended best practice to take the lead and have an independent accounting firm provide a sell-side quality of earnings report.

You can think of this as a practice run for the due diligence process. The team you bring in will dig deep into your financial statements and other documentation to analyze the findings. If all is well, the QOE will validate your financials and projections, providing significant validation to the Acquirer. If the QOE comes up with red flags, it is better that you’ve uncovered those yourself and you can make whatever adjustments needed.

The QOE report will examine the impact of events and activities outside your business’ normalized performance and cash flow. These can include management decisions, accounting methods, business environment, etc. It will also assess the condition and value of both tangible and intangible assets. And finally, measure the strength of operations and controls on a comparable basis for industry, product type, etc.

Building a data room

The final preparation step will be establishing a data room as the M&A process proceeds from initial discussions, as both the Acquirer and the Target company will need to exchange information in order to assign value to the deal, assess interest, and conduct due diligence. The data room is an essential tool for ensuring easy, secure access for confidential information and financial transactions.

Typically set up by the Target company, the data room provides a space where the Acquirer and the Target company – and their teams of advisors, attorneys and accountants – can meet and access confidential financial and operational data, including contracts, employee information, disclosures and other sensitive information. It is our recommended best practice that the data room is established separately from the day-to-day work activities of the Target company, to both ease access and limit risk.

Even before the COVID-19 pandemic, digital data rooms were preferred to physical data rooms. But now in the post-COVID-19 world, this is essentially a requirement. Significant improvements in digital access and security technology allow Target companies to maintain complete control over confidential data while still providing access globally.

Your VDR can be set-up to allow access to all documents or subsets of documents, and only to pre-approved individuals. A primary benefit of VDRs is that Acquirers can have access to new or amended documents instantly, without visiting a physical location. Meanwhile, the Target company, and their advisors, can review who has been in the data room and the dates of entry.

It is important to keep in mind that technology solutions are useful in so far as the human judgement using and safeguarding access. That is why it is critical for the Target company to dedicate qualified personnel to uploading and maintaining documentation, and monitoring and controlling VDR access and related tasks.

Final thoughts

In an M&A deal, early preparation is essential for the Target company. Not only can you save time and money by easing the M&A process, but you also maximize your potential in a valuation. While the process can be onerous, extra benefits come in the form of improved operational processes and financial controls. You’ll gain a better understanding of your organization, while significantly improving its value.

Catch up on previous articles in this series and see what’s coming next…

Special Purpose Acquisition Companies, or SPACs, have been steadily rising in prominence over the last year, earning headlines with a number of eye-popping capital raises and making acquisitions that took high-profile companies public, including Virgin Galactic and electric carmaker Nikola. Previous, a relatively niche investment vehicle, many cannabis and hemp industry operators are still not clear as to how these investment companies operate, and what one should do if approached by a SPAC for an acquisition. In the following we will lay out the basics of SPACs and provide key considerations for cannabis operators and entrepreneurs approached by, or courting, investors.

The fundamentals of SPACS

Simply defined, a SPAC is a shell company formed by founders/sponsors in order to raise investments through an IPO to acquire an existing company/companies. The key players involved are:

• Founders/Sponsors: Generally subject matter experts in their industry fields with credible market reputations.
• IPO Investors: Typically include institutional investors, equity funds, and the general public.
• Target company: A private company in the industry/sector stated as the SPAC’s focus during the IPO process.

As a regulatory stipulation, the Target company cannot be identified at the time of the IPO, and investors pour money into this instrument mainly on the basis of the founders’ reputation and the sector of investment – thus SPACs are also known as ‘blank check’ companies.

SPACs have many safety criteria for protecting investor interests. For example, investor money is generally kept in escrow in an interest-bearing trust account, and can be used only for acquisition purposes. The interest is used to cover certain operational SPAC costs until a transaction closes. Also, SPACs are time bound – a SPAC typically has two years to complete an acquisition or face liquidation, in which case the money is returned to the investors. (However, this period is extendable upon meeting certain conditions.) And finally, for the M&A transaction to be regulatory admissible, the fair market value of the target company must be 80% or more of the SPAC’s trust assets.

SPACs are generally beneficial to all parties concerned: sponsors/founders get liquidity to implement their ideas as well as ‘founder shares’ for their efforts; investors get an ‘expert’ backed investment platform to invest in; and the target company gets sound management expertise and liquidity. The IPO process is also faster for SPACs compared to traditional IPOs due to simplified documentation and listing procedures.

SPAC Structure

History and growing popularity of SPACs

SPACs have been in existence since the 1990s, but they became more popular in the early 2000s when entrepreneurs and mid-market public investors started seeking out private equity alternatives, more direct market options for raising funds, as well as suitable risk return options. Nowadays, SPACs are increasingly being used in various industries, to take companies public, and in situations where financing is scarce. At the moment, SPACs are having a major impact in technology and other high-growth sectors, exemplified by transactions involving DraftKings, Virgin Galactic, and Nikola. In the United States, the SPAC public offering structure, like many other financial instruments, is governed by the Securities and Exchange Commission (SEC).

Source: SPAC Research

SPACs as a force in cannabis and hemp

On May 1, 2020, founder and former CEO of Canopy Growth, Bruce Linton, rang the Nasdaq’s opening bell on the day he took his new venture public – a SPAC called Collective Growth Corp. – raising $150 million. While not the first SPAC to enter the cannabis space, Linton’s high-profile in the cannabis and hemp industries introduced the idea of SPACs to many industry operators and investors.
According to analysis provided by ELLO Capital, cannabis SPACs raised over $3 billion between June, 2019 and July, 2020. Not all of the funds have been utilized to date, so the clock is ticking on the ~two year window following the initial capital raise.

Considering the proliferation of distressed assets and companies struggling with the cash crunch, general economic turndown, and other complexities inherent to today’s cannabis industry, SPACs are likely to offer lifelines to a significant number operators – building new market leaders and reshaping the cannabis industry in the process.

Source: ELLO Capital

Guidance for cannabis industry companies

When a SPAC makes an acquisition, it can follow any of the standard transaction structures – asset acquisition, stock/share purchase, or merger – and the resultant entity combines the SPAC and the Target company into a publicly traded operating company.

So, what should cannabis and hemp operators and entrepreneurs do if approached by a SPAC for an acquisition? Of course, it’s a personal decision whether to go public or not, but for companies in need of liquidity or seeking an exit, merging with/selling to a SPAC can be quite advantageous, especially in the present market context. For one, a SPAC acquisition can help to raise the Target company’s sale price, due to increased competition as private equity and SPACs compete for the same targets. Furthermore, SPAC founders’ reputation and their choice of your company can also bring increased attractiveness/investor interest and richer valuations.

Since SPACs are traditionally led by experienced founders, the IPO process often runs smoothly and efficiently. Because there is typically no roadshow or series of investor presentations, the timeline and resources are more optimal than an IPO. And finally, for companies without experienced management, SPAC control can help provide the requisite expertise and talent.

It is important to note that SPACs listed on US exchanges, including Linton’s Collective Growth Corp, are necessarily focused on the legal hemp sector, since SEC regulatory guidelines prohibit adult-use and medical cannabis companies from going public in the US. However, several SPACs are listed on Canadian exchanges, which creates the potential for investments in US-based cannabis businesses.

Final thoughts

In the last year, broad market conditions have elevated the importance of SPACs across all industries. The cannabis and hemp industries are no different and SPACs represent a welcome investment source in these tough times. SPACs are bringing investment back into the industry, importantly from ‘so far on the bench’ institutional investors, which is particularly important for companies who want liquidity at a time when other avenues are drying up.

Catch up on previous articles in this series and see what’s coming next…

Proactive tax planning during the M&A process is one of the key methods to drive value before, during, and after the transaction. In the cannabis and hemp industries, tax planning takes on a special importance due to the various regulatory concerns at the federal, state, and local levels and the overwhelming impact of IRC Section 280E.

In the simplest terms, the crux of tax discussions at the deal structure level are based on the competing interests of the Acquirer and the Target company’s owners – the former seeking to maximize future tax benefits, and the latter seeks to minimize or defer the tax liabilities relating to the gain from the transaction. In the following, we lay out the tax fundamentals guiding optimal value for both sides of an M&A transaction.

Target company tax classification

A key element to the discussion between the Acquirer and the Target’s owners is the tax classification of the Target company, since this affects a number of transaction structuring decisions. The most common tax classification types are the following:

C Corporation – This is the general form of a corporation. A C Corporation is taxed at the entity level. In addition, distributions to shareholders are typically subject to a second level of tax.

S Corporation – This is a corporation with an S Election. An S Corporation is generally treated as a passthrough entity for income tax purposes, although certain items may be subject to entity level taxation.

Partnership – A partnership is treated as a passthrough entity for income tax purposes. Taxation occurs at the partner level.

Disregarded (as separate from its tax owner) – All income is taxed to the tax owner of the disregarded entity. A common legal form for a disregarded entity is a single-member limited liability company (LLC).

Asset vs. stock acquisitions

This topic was addressed in our article focused on transaction structuring but represents such an essential touchstone that a more in-depth examination is warranted.

Broadly speaking there are two fundamental structures to an M&A transaction, each with its own tax implications: asset acquisition and stock acquisition.

Asset acquisition

The Acquirer purchases some or all of the Target’s assets. The Acquirer can also assume some, all, or none of the Target’s liabilities. (Note that certain successor liabilities can also transfer over.) Target may then either continue operations or liquidate following the transaction.

Tax Impact on Target/Target Owners:
C Corporation: Gain on the asset sale should be subject to tax at the entity level. In addition, any distributions of the proceeds from the transaction should generally be subject to a second level of taxation at the shareholder level.

S Corporation: Gain on the asset sale should typically be subject to tax at the shareholder level. However, certain built-in gains originating from a prior C Corporation conversion could be taxed at the entity level.

Partnership: Gain on the transaction should be subject to tax at the partner level.

Besides the general tax impact by entity type, there are also different classifications of the gain from the transaction:

• Capital Gain – This generally results from the sale of capital assets and assets used in a trade or business.
• Ordinary Gain – This can result from the sale of ordinary income assets (e.g., accounts receivable, inventory) and from depreciation recapture from previously depreciated assets. The amount of ordinary gain can have an effect on a number of tax attributes, as well as how much of a sale can be deferred through installment sale treatment. In addition, for Target Owners that are taxed on the gain as individuals, this gain can result in a higher effective tax rate than capital gain.

Tax Impact on Acquirer:
The Target’s assets that are acquired are typically stepped-up to fair market value, which may potentially generate additional depreciation and amortization deductions, subject to any Section 280E limitations.

Stock acquisition

An equity transaction involves the sale of equity by the Target company’s owners to the Acquirer. Generally, all assets and liabilities of the Target company are transferred in the process. This often includes the Target’s tax liabilities and uncertain tax positions (although there are certain exceptions for partnerships).

As such, the Acquirer may find itself liable for tax audit adjustments.
This is especially relevant in the cannabis industry, where Section 280E audits can result in significant tax liabilities. As part of the diligence process, Section 280E exposure should be identified and quantified. In addition, indemnifications, representation & warranties, and tax representation responsibilities should consider the impact of Section 280E.

Tax Impact on Target/Target Owners:
C Corporation: Gain on the equity sale should be subject to tax at the Target owner level, resulting in a single level of taxation. If the stock meets the qualifications for Qualified Small Business Stock and the requisite 5 year holding period is met (i.e., the Section 1202 exclusion), up to $10 million of the gain can be excluded by Target owners that are not corporations.

S Corporation: Gain on the equity sale should be subject to tax at the shareholder level. S Corporation shareholders do not qualify for the Section 1202 exclusion.

Partnership: Gain on the equity sale should be subject to tax at the partner level.

Usually, gain on the sale of an ownership interest is characterized as capital gain. This is especially important for individuals who have held the equity for more than a year, since they may qualify for preferential tax rates. However, note that partnerships with “hot assets” will have a portion of this gain recharacterized as ordinary gain.

Tax Impact on Acquirer:
An Acquirer purchasing a corporate Target’s stock does not obtain a step-up in the basis of Target, resulting in the Acquirer typically not being able to take the additional tax deductions described above for an asset purchase. However, depending on the circumstances, an IRC 338 election ((g) or (h)(10)) or an IRC 336(e) election may be available to treat the stock acquisition as an asset acquisition for US tax purposes. Tax modelling is often recommended to determine whether making such an election is advisable, especially considering that the election may result in adjustments to purchase price to reflect any additional tax costs or to reflect a premium for allowing the election.

An Acquirer purchasing a partnership Target’s equity also generally does not obtain a step-up in the basis in assets, unless a Section 754 election is in place or the Acquirer is acquiring 100% of the Target’s equity. As a result, a Section 754 election is often made in order to step-up the inside basis of the partnership’s assets to match the outside basis of the ownership interests held by the partners.

Tax attributes (e.g., net operating losses, credits) of the Target company transfer over in an equity transaction. However, they may be subject to limitations due to the ownership change (e.g., Section 382). As a result, a review of the availability of tax attributes post-transaction is often factored into the transaction structuring considerations.

Cash vs. stock vs. debt: the perfect storm of tax-free acquisitions

The other major determinant of the tax implications of an M&A equity deal is the form of consideration paid by the Acquirer. Consideration typically comes in some combination of cash, stock, or debt.

In the notably cash-poor cannabis and hemp industries, equity consideration is commonly used to lower the cash flow needs in M&A. However, the proliferation of distressed assets and over-extended operations have made debt assumptions an emerging and increasingly common form of consideration as well. Consequently, an Acquirer willing to pay in cash is relatively unique and brings significant advantage to the M&A negotiation table.

As the percentage of equity consideration in the transaction increases, the opportunity to have at least a portion of the transaction be tax-free also increases:
Corporations – The transaction may be able to be structured as a reorganization (and sometimes a contribution) if the equity consideration is at least 40%. This usually results in no gain recognition for the equity portion of the consideration. The cash/debt portion would still be taxable.
Partnership – The transaction may be able to be structured as a part-sale/part-contribution. This would result in the contribution portion being nontaxable (subject to certain exceptions).

Navigating tax credits

A thorough review of the potential tax benefits and credits available to a Target can influence the structure of an M&A deal and increase the appeal for the Acquirer. Tax credits and incentives in particular can result in significant tax savings. Even cannabis operators subject to Section 280E can qualify for significant credits and incentives at the state & local levels. For instance, cannabis operators have been able to qualify for job creation credits, social equity incentives, and reduced local tax rates.

International transactions

One final consideration to take into account with M&A is the potential for an international transaction. This can occur in a foreign “go public” transaction or an expansion into international operations. These types of deals add an additional (and possibly unfamiliar) layer of tax considerations to a deal structure. Often, US tax planners familiar with the US tax intricacies of the transaction coordinate with their foreign counterparts to iron out the details of the transaction to ensure that the transaction is tax efficient in all of the respective jurisdictions.

As part of an international transaction, some form of Acquirer structuring usually occurs in order to take advantage of various tax incentives (e.g., treaty benefits) while mitigating exposures such as Subpart F. This can be as simple as forming a new holding company and as complicated as a detailed international structure that considers IP placement, supply chain, and transfer pricing.

Final thoughts

Ultimately, any M&A deal will require careful tax planning to minimize tax burdens and maximize the value of the deal. As an important aspect of the M&A process, tax planning is one of the best ways to ensure that both sides of the transaction get the best deal possible.

Catch up on previous articles in this series and see what’s coming next…

The due diligence process is one of the most important stages of an M&A transaction. Carefully verifying the financial and operational information provided by the Target company helps ensure the quality and fairness of the deal and reduces the risk of inheriting liabilities that could put the Acquirer at risk. The resources and effort invested in due diligence act as a form of insurance against surprises following the transaction.

The financial and regulatory complexities inherent to the cannabis and hemp industries make the due diligence process particularly important. There is tremendous risk in not knowing the full details of the Target company’s tax liabilities, contract obligations, intellectual property issues, licensing terms, litigation risks, and overall operational processes.

Every due diligence process will be unique to the involved parties. In the following sections we will lay out the fundamental steps and provide guidance for potential issues and opportunities unique to the cannabis and hemp industries.

What does M&A due diligence involve?

Due diligence is an in-depth investigation into a Target company’s financial, operational, and strategic initiatives. It is the act of looking at key issues of the business, including profits, financial risks, legal issues, and examining historical records and future projects. The process not only reviews financials and projections, but must also provide an accurate view of the Target company’s business model, including operational details, strength of internal controls, customer relationships, vendor contracts and relationships, skill-levels of current employees, and competitive status within the market.

Benefits to a robust due diligence process include:

• Improved negotiation process — Performing due diligence can facilitate better negotiation of the terms of the deal, including those pertaining working capital targets and definitions, net debt definitions, and optimal allocations of tax benefits.
• Risk analysis — Due diligence may uncover exposures to liability due to faulty products, regulatory compliance, tax exposures, environmental concerns, and other issues that can escalate to the point that the Acquirer’s operation may be at risk.
• Inherent bias — Both Acquirers and Target companies can be either intentionally or unintentionally biased. Due diligence puts analysis and confirmation behind core concepts, including integration potential or projections of sales and profits.
• Inability to seek restitution — It is essential to uncover any issues/liabilities before a transaction is complete, as opportunities for restitution are limited after a deal is closed.

If an Acquirer is entering the due diligence process, it has already completed some analysis of the risks and rewards. Too often, Acquirers approach due diligence as a high-level analysis limited to a search for red flags and fatal flaws. While this is an appropriate starting point, a comprehensive approach includes more detailed analysis of the target’s information, industry, and economic prospects.

Overview of key stages of the due diligence process

Stage 1: terms of the engagement

Terms of the engagement are discussed and agreed-upon by both parties, this will include a list of all financial information, contracts, licenses, and other documentation to be provided by the Target company. A non-disclosure agreement is signed, after which the review process may commence.

Stage 2: operational due diligence

Operational data and documentation is gathered and provided to the Acquirer’s due diligence team, typically via a data room. The Acquirer’s team then reviews and analyzes the data. This stage should also include on-site reviews of assets/property within the purview of the engagement.

The key here is to understand the effectiveness of the Target company’s operating model. This should include a market analysis that looks outside the Target to identify competitive advantages, market specifics, and the investments necessary to scale operations.

Stage 3: financial due diligence

All relevant audited financial statements, tax documents, records, and projections are reviewed. Emphasis here is on confirming both past performance and the viability of future projections. The process should also include interviews with the Target company’s financial management team and external auditors.

Findings in this stage will provide important information on tax and debt exposures and capital expenditures, while also informing post-transaction net working capital needs.

Stage 4: regulatory/legal due diligence

This stage is focused on identifying any legal exposures or risks, with special focus on the status of licensing and regulatory compliance. This will include a review of licenses, leases, purchases agreements, regulatory reviews and all contracts. Of particularly focus here is the documentation of regulatory reviews and compliance.

Stage 5: reporting of observations

After the review processes are complete, the Acquirer and Target company will meet to discuss the results of the review and the Acquirer will have the opportunity to ask follow-up questions and request more information/documentation.

Specific areas of due diligence for the cannabis and hemp industries

Every industry has unique operating models, financial structures, and legal considerations that must be taken into account when conducting due diligence. In the following we will address some key points that should be examined for transactions in the cannabis and hemp industries.

Enhanced regulatory compliance

The validity of licenses and a company’s ability to meet and maintain regulatory compliance is of the utmost importance when considering an M&A deal in cannabis and hemp. Just because a company is operating, it does not mean it is doing so legally.

There are multiple layers of compliance necessary for operation: including State, Local and Federal. Maintaining compliance with one does not mean the other conditions are met. Diligence relating to state and local law compliance must be tailored to the legal and regulatory specifics of the states and localities where the Target company operates.

Quality of financial documentation

A roadblock encountered in many cannabis transactions can be traced back to an overall lack of accuracy and detail for financial statements and reports. Many smaller cannabis operations simply do not have the back-office resources to produce documentation in accordance with accounting principles and standards.

These circumstances do not necessarily represent an effort to obfuscate or mislead – but all precautions should be taken to avoid potential misrepresentations of transactions. In instances of poor financial documentation, the responsibility of securing and analyzing appropriate documentation falls on the Acquirer.

Contract review

Due to the often times unclear legality of cannabis enterprises, all business relationships demand extensive scrutiny in the cannabis context. These include property leases, vendor and supplier contracts, and insurance policies. Any standard-issue contracts and agreements, which do not explicitly acknowledge and conform to the legality of cannabis operations, often require follow-on agreements.

Ownership transparency

Many cannabis operations have complex corporate structures comprised of affiliates and subsidiaries, especially in the case of multi-state operators. Ownership and control are typically directly tied to the licensing arrangement of a cannabis operation. It is important to conduct diligence to confirm the ownership formation provided by the Target is both accurate, and that the transfer of licenses will not be negated by a change of control.

For example, if a license is issued under “Social Equity” guidelines, those conditions may not apply to the new ownership group, which can cause a variety of post-transaction issues.

Banking and insurance relationships

The fraught legal status of cannabis at the federal level has made access to banking and insurance extremely difficult. When reviewing these relationships, it is important to ascertain that financial services and insurance providers are fully aware of the business conducted by the Target company and the contracts and coverage are appropriate.

Oftentimes, financial institutions and insurance providers will have conducted their own regulatory diligence before entering a relationship with a cannabis company, and their input/assistance can provide valuable insight during your own diligence procedures.

Tax exposure

With the cannabis industry continuing to exist in a legal gray area at the federal level, tax issues are of the utmost importance. Some cannabis operations take a “creative” approach to managing tax exposure, specifically in regards to 280E. When examining financial statements it is important to identify the accounting methods used and confirm whether they are appropriate. All too often cannabis operations are audited and found to be short in tax payments to the tune of millions of dollars. As the Acquirer you do not want to inherit this kind of liability.

Final thoughts: do the homework

Developing and implementing a thorough due diligence process before acquiring a business is simply smart business. While due diligence will not necessarily make a transaction successful, it can help reveal potential threats and risks, and support informed pricing, valuations, or other adjustments later in the transaction process. An extra benefit comes from the ways the information gained during due diligence, especially related to operational specifics and corporate culture, can ease the transition and drive efficiencies during post-transaction integration process.

Catch up on previous articles in this series and see what’s coming next…

Assessing the value of a cannabis/hemp operation will ultimately be the foundation of any M&A deal. The Acquirer will seek the lowest “fair” price for the Target company and its assets, whereas the Target company will value itself at the highest possible price. The truth will fall somewhere in between and it is of central importance that both parties feel that risks are acknowledged, and that the value brought to the table is recognized.

In most cases, a third-party valuation expert will be brought in to conduct an impartial assessment. To recognize the true value of an operation, it is essential that this valuator is not only an expert in the cannabis and/or hemp industries, but also specializes in the appropriate verticals. For example, when assessing a cultivation facility, the valuator must have the skill to go beyond standard benchmarks, like yield/sq. ft. and grams/watt, and be able to interview the head of cultivation, understand the specialized skills they are bringing (or lacking) and also assess intangibles like the value of unique cultivars. Similarly for a retailer, revenue and expenses provide a baseline, but a valuator must also understand nuances, like the socio-economic details of operating markets and consumer attitudes to proprietary brands.

Valuation in any industry is a complex process, but like all things cannabis and hemp, shifting regulatory and market conditions present another layer of complexity that limit the use of traditional metrics and values. This makes cannabis and hemp valuations as much art as science. In the following, we will lay out the quantifiable fundamentals behind a valuation and provide some key considerations for intangible aspects that lift (or depress) the real value of an operation.

Key factors in valuing a cannabis business

Regulatory Compliance – Every legally-operating cannabis or hemp business in the U.S. is necessarily licensed and compliant with state and local regulations. Since every market is unique and presents different challenges and opportunities, it is essential to both understand those rules and confirm that a Target company has the proper operations and internal controls in place to maintain compliance. In the best case scenario, the failure to maintain compliance will result in fines, penalties and temporary cessation of operations. In the worst case scenario, the entire operation can be permanently shut down.

License Terms, Supply and Demand – The broader conditions driving regulatory compliance are the structure and supply of licenses. In many jurisdictions, including California, many operators are working under temporary licenses, as approval processes for permanent licenses have been delayed. Temporary licenses are tenuous and provide no guarantees that a permanent license will follow. The value of an operation is largely dependent upon the ability to operate legally – excepting some cases of asset sales – making it essential to understand the specifics of how each license was attained and all relevant terms and conditions.
In general, when access to licenses is limited, those licenses are worth more. Many markets, whether at the state or local level, have strict caps on issuing licenses. In states with well-established markets, licenses have been issued for years, leading to an oversupply that can lower both cannabis prices and business valuations. It is also important to consider that states and localities can change their licensing procedures, which could potentially upend the market with new licenses or drive up value by limiting new issuances.

Management Team – Depending on the structure of an M&A deal, and post-integration plans, the skills and experience of the management team of the Target company can help determine a business’s value. The Target company’s leadership will have played a key role in achieving current performance, and will provide projected revenue and long-term strategic plans. Ambitious strategic plans are rarely worth the paper they are written on if the leadership team does not have potential to achieve them. Taking stock of the collective history of the Target company’s leadership will help put projections into perspective.

Even an M&A deal is focused on acquiring assets or integrating Target company operations without keeping senior management, the experience of the team that built the Target company will provide another metric for the viability of existing operational and financial processes and controls.

Operator categories and considerations

In the many verticals of cannabis, businesses fall into one of two broad categories: plant-touching, which are directly involved in cultivating, processing, or selling cannabis, and ancillary, which provide products and services to support the cannabis industry. Going beyond standard financial and operational metrics, each vertical has unique circumstances and considerations that will play a role in valuing the business.

Vertical integration is a key value driver across all plant-touching operations. Having a stake in more than one vertical provides control over product quality and supply, increases margins, and multiplies company value when executed correctly.

Commonly used methods for performing valuations

The following are four commonly used methods to assess value in the cannabis and hemp industries. The appropriate valuation method(s) depends on the company being valued, and will likely include a combination of approaches.

Discounted Cash Flow Analysis (DCF) – DCF measures the value of a company as the present value of all future projected cash flows. The DCF method is dependent upon multi-year projections of future cash flows, adjusted by an appropriate discount rate.

Strengths: Theoretically, if all assumptions hold true, DCF is the most accurate method for valuing a company as it provides an intrinsic valuation. This method allows the appraiser to adjust the financial forecast for different operating outcomes and assumptions to analyze the impact of various scenarios.

Weaknesses: DCF requires making assumptions about future performance and risk profile – and the valuation is only as good as the accuracy of those assumptions. The complexity of the cannabis market makes identifying realistic assumptions difficult.

Precedent Transactions Analysis – Building on the business adage of “something is worth what someone will pay for it,” Precedent Transactions Analysis analyzes the valuation metrics of similar businesses or assets that have been sold or have raised capital. The most common valuation metrics utilized are Enterprise Value / Revenue and Enterprise Value / EBITDA. By examining comparable transactions, an approximate value can be determined by adjusting for company size, growth, and other factors giving a relative valuation range.

Strengths: Based on actual valuations achieved by companies in the market, the Precedent Transactions Analysis can be an accurate gauge of the market’s perspective on value.

Weaknesses: There are a multitude of intangible qualities that ultimately determine value, including changes in leadership and shifting market conditions, the latter of which is completely outside the control of a business. There is limited amounts of data for cannabis/hemp industry transactions, and broader economic and social changes have essentially thrown out the comparisons used in previous years.

Public Comparable Company Analysis – This method values a company by analyzing the valuation metrics of comparable publically-traded companies. Similar to the Precedent Transactions Analysis, adjustments must be made to account for differences between the subject company and the comparable companies.

Strengths: The price of publically-traded companies are based on up-to-date market data and easily accessible. Additionally, quarterly earnings reports and other investor reports can provide detailed financial and operational information.

Weaknesses: This method is more useful in well-established industries with a multitude of comparable companies. Additionally, public company valuations are volatile and can swing heavily due to market factors independent of the company’s fundamentals.

Adjusted Net Asset Approach – The is approach values a company based on the fair market value of its assets less its liabilities. Assets include tangible assets, such as equipment, licenses, and staff, as well as intangible assets such as brand name and a loyal customer base.

Strengths: This approach establishes a fundamental baseline of value based on the company’s owned assets. If the company goes bankrupt, investors can hopefully at least recover the fair market value of these assets.

Weaknesses: As this approach does not consider a company’s income-generating potential, which is significant for most cannabis companies. This approach is generally reserved for distressed and capital-intensive companies.

Everything begins with thorough due diligence

Valuing any business first requires performing in-depth due diligence to understand the inner workings of the company. This includes analyzing the company’s products and services, operations, management team, market, competition, corporate governance, and more. Underlying each of these analyses is the on-going assessment of the company’s risks.

Companies should provide financial projections detailing their projected Income Statement and Cash Flow Statement for the next several years. Projections should utilize assumptions, which management can justify, and should be supported through thorough due diligence efforts. Recent events have shown that financial projections must be analyzed carefully as many are based on assumptions that no longer hold true – making achieving those projections impossible.

We provide more detail about the due diligence process in our dedicated article (COMING SOON).

Every valuation represents a unique case

Valuing a cannabis business is a complex process that is generally done on a case-by-case basis. There is no one answer to the best way to value a business. Landing on an accurate valuation requires in-depth due diligence to analyze the quantitative and qualitative factors driving the company. Ultimately, meetings with the leadership team and visiting the company’s facilities to see the business in action will speak volumes about underlying operational strength and long-term potential.

Catch up on previous articles in this series and see what’s coming next…

Deal structure can be viewed as the “Terms and Conditions” of an M&A deal. It lays out the rights and obligations of both parties, and provides a roadmap for completing the deal successfully. While deal structures are necessarily complex, they typically fall within three overall strategies, each with distinct advantages and disadvantages: Merger, Asset Acquisition and Stock Purchase.
In the following we will address these options, and common alternatives within each category, and provide guidance on their effectiveness in the cannabis and hemp markets.

Key considerations of an M&A structure

Before we get to the actual M&A structure options, it is worth addressing a couple essential factors that play a role in the value of an M&A deal for both sides. Each transaction structure has a unique relationship to these factors and may be advantageous or disadvantageous to both parties.

Transfer of Liabilities: Any company in the legally complex and highly-regulated cannabis and hemp industries bears a certain number of liabilities. When a company is acquired in a stock deal or is merged with, in most cases, the resulting entity takes on those liabilities. The one exception being asset deals, where a buyer purchases all or select assets instead of the equity of the target. In asset deals, liabilities are not required to be transferred.

Shareholder/Third-Party Consent: A layer of complexity for all transaction structures is presented by the need to get consent from related parties. Some degree of shareholder consent is a requirement for mergers and stock/share purchase agreements, and depending on the Target company, getting consent may be smooth, or so difficult it derails negotiations.

Beyond that initial line of consent, deals are likely to require “third party” consent from the Target company’s existing contract holders – which can include suppliers, landlords, employee unions, etc. This is a particularly important consideration in deals where a “change of control” occurs. When the Target company is dissolved as part of the transaction process, the Acquirer is typically required to re-negotiate or enter into new contracts with third parties. Non-tangible assets, including intellectual property, trademarks and patents, and operating licenses, present a further layer of complexity where the Acquirer is often required to have the ownership of those assets formally transferred to the new entity.

Tax Impact: The structure of a deal will ultimately determine which aspects are taxed and which are tax-free. For example, asset acquisitions and stock/share purchases have tax consequences for both the Acquirer and Target companies. However, some merger types can be structured so that at least a part of the sale proceeds can be tax-deferred.

As this can have a significant impact on the ROI of any deal, a deep dive into tax implications (and liabilities) is a must. In the following, we will address the tax implications of each structure in broad strokes, but for more detail please see our article on M&A Tax Implications (COMING SOON).

Asset acquisitions

In this structure, the Acquirer identifies specific or all assets held by the Target company, which can include equipment, real estate, leases, inventory, equipment and patents, and pays an agreed-upon value, in cash and/or stock, for those assets. The Target company may continue operation after the deal.
This is one of the most common transaction structures, as the Acquirer can identify the specific assets that match their business plan and avoid burdensome or undesirable aspects of the Target company. From the Target company’s perspective, they can offload under-performing/non-core assets or streamline operations, and either continue operating, pivot, or unwind their company.
For the cannabis industry, asset sales are often preferred as many companies are still working out their operational specifics and the exchange of assets can be mutually beneficial.

Advantages/Disadvantages

Transfer of Liabilities: One of the strongest advantages of an asset deal structure is that the process of negotiating the assets for sale will include discussion of related liabilities. In many cases, the Acquirer can avoid taking on certain liabilities, depending on the types of assets discussed. This gives the Acquirer an added line of defense for protecting itself against inherited liabilities.

Shareholder/Third-Party Consent: Asset acquisitions are unique among the M&A transaction structures in that they do not necessarily require a stockholder majority agreement to conduct the deal.

However, because the entire Target company entity is not transferred in the deal, consent of third-parties can be a major roadblock. Unfortunately, as stated in our M&A Strategy article, many cannabis markets licenses are inextricably linked to the organization/ownership group that applied for and received the license. This means that acquiring an asset, for example a cultivation facility, does not necessarily mean the license to operate the facility can be included in the deal, and would likely require re-application or negotiation with regulatory authorities.

Tax Impact: A major consideration is the potential tax implications of an asset deal. Both the Acquirer and Target company will face immediate tax consequences following the deal. The Acquirer has a slight advantage in that a “step-up” in basis typically occurs, allowing the acquirer to depreciate the assets following the deal. Whereas the Target company is liable for the corporate tax of the sale and will also pay taxes on dividends from the sale.

Stock/share purchase

In some ways, a stock/share purchase is a more efficient version of a merger. In this structure, the acquiring company simply purchases the ownership shares of the Target business. The companies do not necessarily merge and the Target company retains its name, structure, operations and business contracts. The Target business simply has a new ownership group.

Advantages/Disadvantages

Transfer of Liabilities: Since the entirety of the company comes under new ownership, all related liabilities are also transferred.

Shareholder/Third Party Consent: To complete a stock deal, the Acquirer needs shareholder approval, which is not problematic in many circumstances. But if the deal is for 100% of a company and/or the Target company has a plenitude of minority shareholders, getting shareholder approval can be difficult, and in some cases, make a deal impossible.

Because assets and contracts remain in the name of the Target company, third party consent is typically not required unless the relevant contracts contain specific prohibitions against assignment when there is a change of control.

Tax Impact: The primary concern for this deal is the unequal tax burdens for the Acquirer vs the Shareholders of the Target company. This structure is ideal for Target company shareholders because it avoids the double taxation that typically occurs with asset sales. Whereas Acquirers face several potentially unfavorable tax outcomes. Firstly, the Target company’s assets do not get adjusted to fair market value, and instead, continue with their historical tax basis. This denies the Acquirer any benefits from depreciation or amortization of the assets (although admittedly not as important in the cannabis industry due to 280E). Additionally, the Acquirer inherits any tax liabilities and uncertain tax positions from the Target company, raising the risk profile of the transaction.

Three types of mergers

1: Direct merger

In the most straight-forward option, the Acquiring company simply acquires the entirety of the target company, including all assets and liabilities. Target company shareholders are either bought out of their shares with cash, promissory notes, or given compensatory shares of the Acquiring company. The Target company is then considered dissolved upon completion of the deal.

2: Forward indirect merger

Also known as a forward triangular merger, the Acquiring company merges the Target company into a subsidiary of the Acquirer. The Target company is dissolved upon completion of the deal.

3: Reverse indirect merger

The third merger option is called the reverse triangular merger. In this deal the Acquirer uses a wholly-owned subsidiary to merge with the Target company. In this instance, the Target company is the surviving entity.

This is one of the most common merger types because not only is the Acquirer protected from certain liabilities due to the use of the subsidiary, but the Target company’s assets and contracts are preserved. In the cannabis industry, this is particularly advantageous because Acquirers can avoid a lot of red tape when entering a new market by simply taking up the licenses and business deals of the Target company.

Advantages/Disadvantages

Transfer of Liabilities: In option #1, the acquirer assumes all liabilities from the Target company. Options #2 and #3, provide some protection as the use of the subsidiary helps shield the Acquirer from certain liabilities.

Shareholder/Third Party Consent: Mergers can be performed without 100% shareholder approval. Typically, the Acquirer and Target company leadership will determine a mutually acceptable stockholder approval threshold.

Options #1 and #2, where the Target company is ultimately dissolved, will require re-negotiation of certain contracts and licenses. Whereas in option #3, as long as the Target company remains in operation, the contracts and licenses will likely remain intact, barring any “change of control” conditions.

Tax Impact: Ultimately, the tax implications of the merger options are complex and depend on whether cash or shares are used. Some mergers and reorganizations can be structured so that at least a part of the sale proceeds, in the form of acquirer’s stock, can receive tax-deferred treatment.

In conclusion

Each deal structure comes with its own tax advantages (or disadvantages), business continuity implications, and legal requirements. All of these factors must be considered and balanced during the negotiating process.

Catch up on previous articles in this series and see what’s coming next…

There are as many reasons to seek out a merger and acquisition (M&A) deal as there are companies engaging in these transactions. Through our extensive experience conducting M&A deals in cannabis, and related industries, we advocate a fundamentally sound approach that puts companies on the path to a successful deal.

In the following, we will discuss a general approach to M&A strategy and the unique conditions of the cannabis industry that must be taken into consideration.

In any deal, focus and strategy are the keys

Whether on the buy- or sell-side, a successful M&A strategy must adhere to the same logic that informs a cannabis operation or fund’s long-term strategic goals. Any deal should be the means for achieving these goals. Below are the basic stages of a successful M&A strategy.

Stage 1: Develop Strategic Business Plan and Key Drivers

What are the long-term goals of the organization? Common goals include: increasing revenue/lowering overhead, achieving economies of scale, new product offer/market entry, expanding operations, acquiring technology/Intellectual Property (IP). When it is determined that the goals stakeholders agree on cannot be achieved expeditiously through internal channels, M&A deals should be considered to accelerate timelines.

Stage 2: Understand Financial Limitations

On the acquisition-side, assess the funds or assets available for the deal, this can include cash on hand, stock/debt issuance, and sales of tangible/intangible property. Once known, the blend of what makes up a consideration for a purchase can have a large effect on what bid a seller is willing to take.

For sellers, you must understand your financial position, what you need to achieve your goals, and the market value of your assets. They must align within reasonable expectations before moving forward.

Stage 3: Develop List of M&A Targets

This can be a complex but essential step. Acquirers must perform deep analyses of the market and licensing conditions of the region where they are considering a deal. Sellers need to connect with potential buyers. Involving an investment bank can prove beneficial in identifying targets/sellers and supporting the valuation stage that follows.

Stage 4: Build Valuation Models

At this stage, it is important to lay out the market and financial realities that will drive acquisition costs. Both sides must also account for the returns necessary to provide a positive outcome. Using the valuation models, you also can begin to prioritize candidates based on business impact and deal feasibility.

Stage 5: Review and Approve Strategy

With the previous stages complete it is time to step back and make sure a potential deal aligns with business goals and confirm that critical stakeholders will approve the potential deal.

License acquisition at the center of M&A deals

The regulatory complexity of the cannabis industry in the U.S. has created a unique set of circumstances that add fuel to the drive for M&A deals. While cannabis remains illegal at the Federal level, states and territories are acting to implement state and local laws regarding the lawful use of medical and or/adult-use cannabis.

In the absence of a Federal regulatory framework, a patchwork of state and local regulatory regimes, each with their own complex set of rules and regulations, has emerged. The process of applying for and receiving a license to operate in most of these markets is expensive, time-consuming and subject to unpredictable factors. As a result, licenses have emerged as a type of commodity in the cannabis market. But unlike other intangible property commodities (i.e. intellectual property), most cannabis licenses are inextricably tied to the business unit that holds it. While there are some workarounds, including management agreements, in most markets M&A deals are the most direct way of acquiring licenses.

Considerations for Buyers

The process of seeking to gain new licenses must begin with extensive market research and growth projections for the targeted market. To fully understand the value of a license, you’ll also need to understand the licensing process and ascertain how many are issued per year, whether current caps on licenses exist (or are planned), and whether your competitors already have a foothold in that market.

Once a target company holding licenses is identified, the details of those licenses become paramount. Considerations should include: expiration date of license, process for re-certifying licenses, and whether any conditions the license was issued under would change upon acquisition and potentially invalidate or block the recertification of that license. In many markets, the change of ownership or equity stake in a cannabis business is contingent upon regulatory approval.

Considerations for Sellers

Understanding the real market value of all licenses held is the name of the game. All previously listed factors must be considered. Since, in the majority of cases, you’ll be selling a business unit along with the license, you must also have a firm understanding of the value of that unit and all its tangible and intangible property. The acquirer will also be performing extensive due diligence on you and your business units, so it is best to have financial statements prepared, all regulatory issues up-to-date, etc.

Complexities surrounding increasing operational capacity

Considering the relatively early stage of the cannabis industry, many companies are a long way from their planned operational capacity. Establishing new operations, whether as a cultivator, manufacturer, retailer, vertically integrated operation, requires extensive planning for zoning, licensing and regulatory concerns, a major initial capital outlay, and a long timeframe to build and establish operations.

For many fast-growing companies, the quickest route to expanding operations is to acquire or partner with cannabis companies with already established operational scale.

Considerations for Buyers

A common motivation for acquiring operational capacity is the desire to achieve scales of economy through vertical integration. This is when, for example, a retailer acquires cultivation and manufacturing operations to bring product development under the same roof. By controlling more steps along the supply chain, a great number of financial and operational efficiencies can be achieved. However, these advantages must be weighed against the burden of managing greater regulatory complexity.

Considerations for Sellers

Overextended cannabis operations can achieve greater operational efficiency by off-loading under-performing assets. As related to the sale of licenses, understanding the true value of both tangible property, and the attached license, is key to getting a fair price.

Distressed assets provide buying opportunities

The cannabis industry has endured significant volatility over the past 12-15 month period. One of the results of the turmoil has been a significant dip in valuations, which has limited the capital-raising potential for many operators. A number of organizations that were aggressively expanding their presence during 2017-18, now find themselves overextended with portfolios burdened by under-performing assets. These circumstances have resulted in a “buyer’s market” for cannabis operations and funds with sufficient capital flexibility to be acquisitive in this environment.

Considerations for Buyers

For the first time in the legal cannabis industry’s history, difficult economic conditions can be advantageous for companies with access to capital. The overall dip in valuations and growing number of distressed assets presents a unique opportunity to gain licenses, expand operations, and enter new markets. While we always preach caution and emphasize due diligence in executing M&A deals, now may be one of the rare times it is advantageous to swim against the current and move quickly in acquiring assets and establishing a solid foundation for when economic conditions improve.

Considerations for Sellers

In the absence of other forms of capital-raising, carrying under-performing assets may prove to be a lifeline for many cannabis operations. Finding a buyer for operations in, for example, a market that haven’t yet matured, could provide a “reset” button for over-extended operations. It is essential to take a strategic view and make difficult decisions about the validity of existing operations and business plans.

Final thoughts

The motivations and circumstances surrounding M&A deals are so diverse there is simply no one-size-fits-all approach. What remains consistent is that when a strong business case matches market realities and ultimately produces an M&A deal, the outcome is most likely to be favorable. Stopping at every step to confirm proposed deals align with the overall business strategy will help keep your plan on track.

Catch up on previous articles in this series and see what’s coming next…

In the past 18 months, the cannabis and hemp industries endured a series of seismic upheavals that have changed the game for mergers and acquisitions (M&A). In 2019, a combination of market shifts, regulatory issues, and corporate governance scandals, resulted in 95 cannabis industry M&A deals, worth more than $2.4 billion, being cancelled or unwound. In 2020, the global health crisis, and subsequent economic fallout, has nearly brought a halt to cannabis M&A, with only 42 deals completed year-to-date, compared to the 215 deals completed during the same period of 2019.

Today, entrepreneurs, operators, and investors must navigate a new market reality defined by uncertainty created by the COVID-19 pandemic, the fallout from lower-than-expected financial performances from market leaders, and increasingly tight capital markets. In this environment, traditional business fundamentals reign supreme. Investors and markets that once rewarded the size and breadth of a company’s footprint, are now laser-focused on margins, EBITDA (“Earnings before interest, taxes, depreciation, and amortization”) and cash flows.

As a result, acquirers are more selective in their targets and working to emphasize greater operational, regulatory, and management efficiency by building out a presence in their core geographic footprint. In instances where buyers look outside their core markets, they are focused on assets that are distressed or expected to generate at a minimum positive EBITDA. The ultimate goal is to build on positive cash flows.

The buyer pools for sellers is limited and growing pressure has contributed to a broader range in valuations as sellers are more likely to be rewarded or punished for their specific strengths or weaknesses than in the past. These changes have also increased the number of companies that are simultaneously buying and selling assets as they reshuffle organizations to execute a more focused strategy. This reset is spurred, in most cases, by public equity pressure, and is welcomed by many as a positive change from the old “Green Rush” model.

Throughout the Cannabis M&A Field Guide, we will provide a variety of perspectives as we examine best practices, common pit falls, and other considerations that will make or break cannabis M&A deals in this new normal. But first, in order to ably navigate this new environment, we must understand how we got to this point – and where we are headed next.

Understanding the fallout from the “Green Rush”

2018 will likely be remembered as the original boom year for legal cannabis. California opened the largest adult-use market on January 1, and later that fall, Canada followed closely behind by becoming the first North American nation to legalize cannabis for adult use. Investor optimism was high as large numbers of both Canadian and U.S.-based cannabis companies went public on Canadian stock exchanges, and the first Canadian companies went public on U.S. exchanges. At the time, revenue projections were ambitious and companies traded at elevated valuations.

A number of cannabis companies, flush with cash from both public and private capital raises, engaged in a race for market share, acquiring operations and licenses across North America. A series of eye-popping M&A deals resulted, with acquirers shelling out millions to gain operational capacity and secure licenses in competitive markets.

The cannabis “Green Rush” continued into early 2019, as the Global Cannabis Stock Index hit its 2019 peak in late March, but the tone began to shift after disappointing Q1 financial results were released. Over the following months, a number of market difficulties were made apparent. In Canada, where many of the largest cannabis companies (by market capitalization) are based, a number of issues – including slow market roll-outs, regulatory hurdles, operational miscues, and supply chain problems – resulted in lower-than-projected revenue numbers and substantial losses. Adding to the bitter mix were high-profile regulatory violations, and emerging corporate governance concerns. As a result, the risk profiles of many organizations were altered and ambitious revenue and profitability projections were exposed as premature, at best.

U.S.-based cannabis companies endured similar issues and additionally had to navigate the punishing impact of IRC 280e, which creates excessive tax burdens for companies in a complex and evolving environment. With few exceptions, valuations cratered across the industry, mainly dragged down from the fall in the Canadian names. These changes, and increased scrutiny from anti-trust regulators, dramatically slowed down the process of completing transactions. Additionally, continued market and regulatory uncertainty resulted in high-profile M&A deals being revalued or unwound.

Where cannabis M&A stands today

As the glow of the “Green Rush” fades, gone also are casual attitudes toward easy access to capital and operating results. This overall shift in the market perception has been exacerbated and accelerated by the unprecedented socio-economic impact of the COVID-19 pandemic, which caused capital raises and M&A deals to slow down to a trickle.

From our perspective, the tone has shifted throughout the cannabis sector: operators and investors are going “back to the basics.” New M&A deals are being inked, but now at much lower valuations that are adjusted to market realities and prioritize operational efficiency and cash flow.

The purpose of the Cannabis M&A Field Guide is to empower buyers, sellers, and companies engaged in both activities, as they maximize value and build stronger organizations in the emerging industry landscape of cannabis, hemp, CBD and related products and services.

Catch up on previous articles in this series and see what’s coming next…