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Cap-Table Risk in Cannabis M&A – Top 5 Pitfalls

Focussing on sound governance at all stages of corporate development is a primary step any cannabis company can take to build strong ESG+ foundations and increase the probability of investment, raise valuation, and generally present itself as investable. 

The cannabis industry, with its continuing emergence from legacy regulatory frameworks, is more susceptible to pragmatic organizational and governance structures. This is especially true when it comes to funding and capitalization. With cannabis being locally regulated but federally illegal in the United States and other nations struggling to find regulatory balance, there is ample risk sensitivity to deter institutional practices from entering the space.

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Building Solid Foundations

Traditional banking and financing options are largely closed to cannabis entrepreneurs, requiring creative approaches to reaching funding objectives. These often include tier II and tier III venture capital, private equity, and angels willing to provide support, when institutional backing falters. Those angel relationships are often, in hindsight, predatory and do not account for the true value of the company at the time of its funding shortfalls or service needs. Over time, these relationships grow increasingly asymmetric as the value of the company grows disproportionately to the original contribution of the angel.

Looking at the sector’s private equity ownership structures, it’s common to see multiple owners having little to do with the ongoing operations and support of the business. Some may have provided a small loan during a period of price volatility, others may have helped build the manufacturing facility for equity, and some may be there to make a business seem more legitimate than it actually is. While this phenomenon is less of a concern for local family-run businesses, it becomes an increasing risk when venturing into public markets and dealing with institutional investors using generally accepted due-diligence protocols.

Thinking of the cap table and the overall governance model of the company first is a forward-thinking approach that mitigates multiple avenues of risk down the road. These risks can be broadly classified as an outward perception of being “un-investable” but are multifaceted in their expression. It is important to understand that investors place value on the 4-pillars of logic, reason, equity, and value. If your cannabis startup or scale-up doesn’t meet those expectations in its most, basic, exhibitable form – the cap table – the negotiation may be finished before it has even begun.

Top 5 Pitfalls

Avoiding these top 5 cap table pitfalls will increase efficiency within your organization, set a strong foundation for continued ESG+ adherence, allow for greater internal and external transparency, and endear investors, customers, and stakeholders to your way of doing business.

1. Giving away equity for one-time services or transactions 

Case Example: an option for a cultivation property was paid for in cash and equity putting the original owner of the property firmly on the cap table of the new venture for the foreseeable future.

 

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2. Equally sharing equity with a group under vague circumstances

Case Example: a cultivation license was awarded to a group comprised of several individuals with differing opinions and needs, forcing future capital negotiations to be conducted with all of them and their respective legal representatives, instead of one unified team.

3. Issuing non-dilutable shares

Case Example: a founder created two different types of shares, protecting his own stake in the company but deterring all institutional investors.

4. Not vetting shareholders

Case Example: a medical pharma company appointed a CEO with non-vesting equity awarded on day one. The company did not know the CEO had a criminal conviction for violation of the controlled substances act and would be legally prohibited from applying for the needed narcotics license in the present jurisdiction as part of his new appointment.

5. No transparency on previous valuation records

Case Example: multiple conversations were had with investors as part of a scale-up’s fundraising campaign. Some of the shares offered were directly by the founder, others were from a communal pool.  Two private transactions occurred at different prices/valuations and institutional investors walked away from the “shady” deal

Conclusion

The path to full ESG+ implementation and adherence is never-ending. With the targets for Environmental, Social,  Governance, and Innovation continuously expanding, the game is less about winning, than it is about starting! Case studies show that ESG+ adherence starts with strong governance – the internal change agent of every business. Focussing on creating a pathway for transparent, inclusive, and equitable governance is a sure-fire way to build the necessary frameworks for sustaining long-term, adaptable growth in the cannabis industry. 

Please contact us for more information on sound governance practices, workshops, and strategies for ESG+ transformation.

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