Earlier this year, Dan Nicholls, leader of the MGO | ELLO Cannabis Alliance Capital Markets Advisory practice, sat down with Eric Sandy, Digital Editor for Cannabis Business Times, for a Q&A that touched on merger and acquisition trends in the cannabis space. An excerpt from their discussion is included below.
Eric Sandy: Getting into the due diligence required to determine the valuation of a company and possibly position a company for an acquisition—is that an active, leaning-in kind of process? Or is a company interested in ultimately being acquired meant to just sit back and wait to be approached by a larger company?
Dan Nicholls: In traditional M&A, there are really two types of processes. There’s a targeted process, where, if you have a couple parties in mind, you want to limit your search to just those parties. It’s a shorter process, because there are these two names or these five names, [and] we’re just going to target those. Ideally, you already have relationships with those parties, and that will help make the process smoother.
The alternative side is a broad auction process. And a lot of M&A deals in larger industries are done this way, where you’ll hire an adviser, [and] they’ll work with you to prepare the company to sell, which includes everything from building your financial model, assessing your valuation, performing due diligence—because you want to find the skeletons in the closet before a potential acquirer does—putting up a data room, going through all the steps that a buyer would, but doing it internally. The second phase is the marketing and outreach phase. And that’s where, if you’re doing a broad auction process, a lot of companies will reach out to everyone and anyone. When we used to do sell-side deals, we reached out to hundreds of potential buyers, and, obviously, 90-plus percent of them aren’t going to be interested. But you start with a very wide net, and then you narrow it from there. You set up an auction process where there’s an initial round of bidding, you collect the bids, you pick maybe the top five or 10 to go on to the next round of bidding, you provide them a little more information. It’s a very structured process, and it takes more time. But if the goal is to extract the highest value possible, oftentimes a broad auction process is the best way to go.
But it also depends on your motivation as a seller, right? Do you want to just cash out completely and have nothing to do with the business? Or do you still want to be involved in the business? Do you care about the employees? Do you want them to stay involved with the business? A lot of transactions like this, it’s about understanding the motivations of the buyer and seller, and trying to find a structure that works for both parties. And oftentimes, for sellers, maybe that additional 10 percent of value isn’t worth it if you can still have a stake in the business: Be on the board, or get an earn-out provision—benefits down the road, if this does become the next billion-dollar company. There are a lot of considerations. That’s why cannabis is an interesting industry, because there’s such a wide range of companies, but they’re all technically startups. Even some of these billion-dollar companies, they’re growing so quick. A lot of them will see their revenues double or triple or quadruple over the next few years. They’re still startups. And when it comes to buying startups, it’s a whole different can of worms.
Sandy: That startup point is a good backdrop to the whole conversation here. And in some ways, you always have state regulators in a sense sitting at the table with these companies. How do they fit into the transaction process? Is it just taken for granted that the license will be part of that deal, and the state will be OK with this?
Nicholls: I think it depends on the state, certainly. I think the understanding is that most states are fine with licenses transferring owners. Now it’s understood. There are obviously different processes, depending on the state, and also just the transaction structure in general: You can either buy the stock—the equity, where you’re buying the existing company—or you can buy the assets, where you’re just buying the license, the brand name, and the IP and all that. So, the structure of the transaction matters, as well as the state.
At the local level, especially here in California, the local level is the harder license to get. One of my clients is really well-established in their local community. They’ve been there for decades. They worked with the City Council to put in place a licensing program; as a result, they got one of the licenses. And now, they just turned around and sold it. And they were concerned, ‘Well, you know, we built this long relationship with the city, selling them on our vision for this store and how it’s going to look. We’ve built a good relationship with the city. And now, before the stores even open, we’re selling it. That looks bad, right?’ They were afraid of some blowback from the city. So, as a result, the way they structured that transaction was that they’re still going to be involved in the next two years. They’re going to the city and saying, ‘Look, for us, it made the most sense to sell this off to another party. But we’re still going to be involved in every step of the process. We’re going to be on the board, we’re going to be doing all the build-out, we’re going to make sure everything adheres to all the codes and regulations that we had agreed on originally, just to give some comfort to the city.’