We’re in the midst of earnings season, and although growth seems positive across the board, losses are widening for some while changes in market dynamics – due to the capital market reset and regulatory complexity – are forcing both investors and management teams to rethink strategies. In early November, Columbia Care, a multi-state-operator with licenses across the U.S. and Europe, announced the intent to acquire The Green Solution, a Colorado-based vertically integrated cannabis company, for $140 million. This deal is one of many announced in 2019, which have ranged from Green Growth Brands’ acquisition of Spring Oaks Greenhouses for almost $55 million, to the merging of 4Front Holdings and Cannex Capital Holdings for a valuation just shy of $500 million. If the Columbia Care and The Green Solution acquisition goes through, Columbia Care’s position in the $1.68 billion Colorado market will be significantly elevated, giving it a more defensible competitive advantage in that market. This type of consolidation had become the cannabis industry’s new normal by mid-year 2019, though the growth of these types of deals has slowed in the latter half of the year, begging the question of which industry constraints are downshifting the speed of such deal activity.
No Guarantees For Even The Biggest M&A Deals
With so much consolidation at the top and an increasingly competitive market all-around, cannabis companies must now pursue even more strategic M&A in order to strengthen fundamentals and scale operations. Early October saw MedMen’s intended $682 million acquisition of PharmaCann fall apart due to market pressures, regulatory hurdles, and MedMen’s desire to continue an ongoing push into existing markets. When the year-old deal was announced, MedMen’s shares were trading around the $5 range. Once the acquisition fell apart, shares dipped below $2. Even though MedMen’s revenue continues to ramp up 227% year on year in fiscal 2019, the company still lost $79 million on $130 million in income. Consequently, the company had to borrow from Gotham Green Partners at a 6% rate to keep operations afloat. Further consequences for MedMen’s leadership included making changes to the company’s board and amendments to the size of both Tranche 3 and Tranche 4, “in order to minimize dilution given the current capital market environment”.
Cannabis Industry Challenges Make An Impact
Increased consolidation makes existing structural market changes more visible. First and foremost, federal illegality continues to limit bank participation in the industry which, in turn, provides additional challenges to obtain traditional financing. This challenge might be on the wane, as a bill to approve a federal safe harbor for banks (SAFE Banking Act) has passed the House of Representatives, with bipartisan support, and is currently on the floor of the Senate. On the flip side, this conflict also trickles down to legal products such as hemp and hemp CBD, as state and federal regulators have yet to create a uniform test to ensure hemp being grown does not exceed the 0.3% THC limit (in a recent Senate Committee, Sen. Dianne Feinstein highlighted the issues stemming from the difficulty in classifying the plant). This leaves financial institutions unsure of how to legally service the industry, leading to thousands of companies being unable to open bank accounts as well as accept credit cards from customers.
Foreign investment is even more complex. Most obviously, cannabis is still fully illegal in many an investor’s home country. And once that is solved for, they have to navigate the different state regulations here in the US. California, for example, requires foreign purchasers to have Social Security Numbers (SSNs) or Individual Taxpayer Identification (ITINs); ITINs can take months to obtain. Furthermore, there are immigration concerns. According to the most recent BCC regulations, “if an entity is considered an owner, then anyone with a financial interest in that entity must be disclosed to the BCC and may be considered an owner.” This requires “ownership” disclosures, which could affect a person’s legal status, as according to the U.S. government, direct or peripheral involvement in the cannabis industry is incompatible with immigration laws. This applies to everyone who is not a U.S. citizen, including green card holders, those living, studying and/or working, and even those visiting the country.
Another matter is the potential tax liabilities not readily transparent in deals due to the lack of standard business tax benefits. U.S. Code Section 280E states that a business engaging in the trafficking of a Schedule I or II controlled substance is barred from taking tax deductions or credits. This means cannabis enterprises must pay federal taxes on all of their revenue without the benefit of deducting business expenses. To prevent constitutional challenges, Congress added an exclusion that allowed a deduction for the cost of goods sold even where the goods are illegal under federal law. “Costs of goods sold” includes the cost of the product, shipping and any related expenses. Even though such costs are now deductible, the IRS is stricter on cannabis companies. Ultimately, working with sophisticated tax, accounting and legal advisers will help to create a solid legal structure and then use transparent record keeping to prove that businesses are operating as stated.
The last tricky hurdle associated with these deals is the fact that many of the target companies weren’t set up with an acquisition in mind. That means their financial record-keeping and other corporate practices might make due diligence particularly challenging. Combined with the above noted challenges, along with more traditional issues of streamlining different technology platforms and corporate cultures, means that striking a successful deal and integration requires some precise tightrope walking.
On The Horizon
The good news is that antitrust concerns seem to be renegotiated. In recent weeks, a number of cannabis companies have announced that the U.S. Department of Justice’s antitrust review of their proposed acquisitions had been completed, or was near completion. Cresco Labs is among them, stating in late October that their $800 million merger with Canada-based Origin House had cleared a key hurdle after the “waiting period” for federal antitrust review of the deal had expired under the Hart-Scott-Rodino law.
While this is encouraging from a legal standpoint, the time it took to get here had an impact on stock valuation, requiring a renegotiation partly because the acquisition price has since been reduced. Harvest Health & Recreation also has two significant deals awaiting closure, one to acquire CannaPharmacy (valued at $90 million), and the other to acquire Verano Holdings ($850 million). Harvest shares now trade at about half of what they were trading at the time those deals were struck.
A strong M&A market is vital to continue fostering a robust and innovative entrepreneurial spirit within the cannabis industry, as well as attract new capital. With the possibility of a clear exit plan, entrepreneurs, operators and investors will likely be more prone to new investment, and less risk averse when it comes to new ventures. These deals, when executed well, should help to bolster the fundamentals of the business, create efficiencies and enhancing the scale of operations. The result is more diversity in terms of products, ideas, and people.
For a new industry like cannabis, consolidation doesn’t necessarily mean that growth will be stifled. In fact, the consolidation of capital, innovation, and infrastructure can offer a level of legitimacy, security and robust operations with a focus on financial performance that the industry has yet to see.