President Trump came through big for the cannabis industry when he issued Executive Order 14370 late last year directing Attorney General Pam Bondi and the Drug Enforcement Administration (DEA) to expedite the rulemaking process to reschedule marijuana from Schedule I to Schedule III under the Controlled Substances Act (CSA). The practical implications of rescheduling for the “state-legal” cannabis industry are (i) it removes barriers to further research on the plant and opens potential drug development and (ii) it eliminates the burdensome 280E taxation that has drained the industry of most of its cash profits since inception. Importantly, cannabis – aside from a limited number of FDA-approved cannabinoid-based medications – still cannot be legally prescribed by doctors from the Fed's perspective. But positive momentum at the federal level and the anticipated elimination of 280E has industry participants asking whether sales to Employee Stock Ownership Plans (ESOPs) are still an attractive exit vehicle. And our answer is a resounding YES!
First and foremost, industry participants need to understand that unless and until cannabis becomes federally legal or Congress passes laws exempting companies and their investors from federal enforcement whilst operating in state-legal markets (e.g., SAFER Banking Act, STATES Act), there will be FEW, IF ANY, new buyers for cannabis assets and FEW, IF ANY, new lenders or equity investors. Nothing about rescheduling the drug changes this simple calculus. And with no cash-flush irrational buyers from Big Tobacco, Alcohol, Pharma or Private Equity fueled by cheap debt and tripping over themselves to buy into the sector, one should not expect asset values to sustainably increase.
“But what about up-listing?” the masses will shout! “Well, what about it?” is our retort. It is not immediately obvious how up-listing helps the industry at large. Even if one were to believe that trading on one of the U.S. exchanges – with deep institutional pockets and vast liquidity – would drive up the share prices of the publicly-traded players in the U.S. market, so what? As it were, there are only four or five publicly-traded companies in the sector that really matter and that are likely to benefit from up-listing and, regardless of their share prices, they are precluded from being buyers for most businesses due to various state licensing caps across the U.S. geography. As for the remaining publics in the sector – “penny stocks” all – I would be hard pressed to bet on their ability to withstand the scrutiny of real institutional equity investors, in which case, up-listing may turn out to be a curse.
Oh, and let’s not forget a Sharp favorite – “perhaps we can take our company public if there is up-listing?” Our retort, “yeah...no”. First, “going public” is not a way to “exit” a business, it is a way to “fund” a business, and a high-growth, capital-intensive business at that. Ten years ago in cannabis, maybe even five years ago, a growth case could be made for raising money from the public. New markets were opening, cultivation centers and processing capabilities were being constructed, and bricks-and-mortar retail was being rolled out as consumer demand exploded in newly-legalized state markets. Is that still the case? Can you name one currently legal market that is short biomass production? Or one that needs more extraction capacity? I certainly can not. There may be a few new geographies that come online over the next decade – think Carolinas, Texas – but surely the industry can finance such projects with cash flows, particularly in light of the elimination of 280E. Public market investors do not finance the purchase of founders’ shares. They finance growth. An age-old investing adage is apropos here for all of the industry’s founding shareholders - “no one wants to buy your shares if you are selling your shares.”
So, no new buyers and no hope of going public – in other words, no world in which operating assets suddenly can fetch an exit price north of fair market value. Because let’s be honest, that is the question every business owner in the sector is asking – when and how can I sell my company for more than it’s actually worth? When can I get that banger outcome, where I sell to British American Tobacco or Southern Glazer’s Wine & Spirits at their multiple? Or sell to MariMed or some other micro cap player and take their stock and ride it up 10x because of up-listing and irrational exuberance. For what it’s worth, coming from a banker that has been selling sub $500mm businesses for the past thirty years, risking a fair market outcome today for a hope and a dream in the future is not a wise choice.
Sales to an ESOP are by law transacted at “fair market value” and it is hard to ask for more than that. Moreover, companies owned for the benefit of their employees (i.e. ESOPs) have generally outperformed their industry peers since the law creating them was passed, as employees tend to be more engaged and, as a consequence, outperform the employees of non-ESOP owned competitors. In a labor-intensive sector such as cannabis, employee engagement and performance will likely be the key competitive advantage.
So, yes, even though the forward tax advantages of selling to an ESOP will be slightly less post-rescheduling, the rationale for a state-legal cannabis business to consider a sale to an ESOP remains stronger than ever.If you are evaluating liquidity options and would like to assess whether an ESOP structure aligns with your strategic objectives, we welcome the conversation. Contact us to schedule a consultation.Best,Miles
