What happens to public cannabis companies when promised performance doesn’t materialize?

Mid-tier public cannabis companies face a reckoning in 2022‍

SUMMARY

• Over the last several years, emerging cannabis companies rushed to the public markets in hopes of easy capital to fuel their growth.
• Lack of liquidity, public-company costs, and a deceptively competitive industry have stymied many companies in pursuit of their projected financial performance.
• While the top-tier public MSOs have built war chests of relatively inexpensive capital, many mid-tier public, and private cannabis companies find themselves burning through their cash, struggling to find additional capital, and hamstrung to grow.
• The result is a lopsided game where the divide between the “haves” and the “have-nots” gets even greater, where companies might need a white knight to rescue them or face going out of business. Beneath the shiny exterior, though, white knights can be just as predatory as some lenders.
• Options exist for these businesses, whether that is new capital, an MBO or other take-private, merging sub-scale players, an outright sale to a larger strategic acquiror, or some form of state-law insolvency proceeding.
• Just as the industry matures and experiences these natural growing pains, operators and capital are becoming more sophisticated and so too are the strategies companies may implement to survive. Best to have some honest conversations with the key stakeholders and identify an equally capable financial advisor sooner rather than later.

GROWING PAINS

We are witnessing the emergence of an incredibly unique industry. One that brings comfort and medicinal support to millions of people and will ultimately outgrow the alcohol and spirits industry for responsible recreational adult use. But these are still early days, and there are many maturation and growing pains to be had.

Not all of today’s industry participants will survive to see the industry in full bloom. Unfortunately, the evolutionary process includes false starts and failures. For some, it will require grit and the implementation of difficult decisions they didn’t necessarily anticipate for them to fight another day.

In an industry marked by an ever-changing patchworked regulatory landscape, the resulting expensive capital, a deceptively competitive market, and incredibly burdensome tax structure that inadvertently encourages illicit operators, legal companies find it challenging to thrive (or even survive) without achieving sufficient operating scale.

Scale creates better margins and potential insulation from market volatility in a wildly tumultuous market. Scale comes at a price, however. The cost of capital in cannabis is significantly higher than in traditional, federally-legal industries. The expensive capital to fuel growth coupled with a crippling tax scheme means that if scale doesn’t materialize, it can be very difficult (or impossible) to achieve the financial performance that once seemed so close.

I’ve heard “it’s easy to grow weed, but it’s hard to grow great weed” countless times. It might be “easy” to start a cannabis company, but it’s really hard to grow a successful and sustainable cannabis company.

THE PUBLIC PREDICAMENT

Given the capital constraints on our industry, many companies rushed to the public markets to access financial support from investors. Unfortunately, being public comes with significant costs, both financial and intangible. There are additional reporting and compliance costs to start. But there is also time spent away from growing the business. You must manage market expectations and messaging to industry analysts who then opine on your past and projected performance. Inevitably, attention shifts to quarterly performance versus building a business focused on the long-term future.

The MSOs that have distinguished themselves from the pack, in part through a first-mover advantage, raised the requisite capital and achieved scale. These companies are building huge war chests of relatively inexpensive capital (ex. debt at <10% rates) despite seeing their stock values decrease meaningfully in the equity markets. But they are the exception, and the result is a long tail of operators that are, what I will call, sub-scale.

A quick comparison of these two tiers (tier 1 being above $600M market cap and tier 2 being below, admittedly an arbitrary line in the sand), and the casual observer can see some stark differences in operational metrics and financial performance. With their ability to efficiently raise capital (largely debt recently), larger businesses have been able to grow more quickly while generating better margins. The result is that they trade at higher valuations and can grow out of highly-levered positions. The tier 2 companies cannot secure the same amount of capital, nor at the same price, making it harder to catch up. The limited capital available to cannabis businesses is highly concentrated in a small group of VC, private equity, and now large strategic operators.

Just as some MSOs prefer to operate in limited license states to benefit from an oligopoly, they benefit from a similar dynamic where they control most of the capital to scale or acquire other businesses. This allows them to dictate pricing and terms in M&A deals. They may appear as a “white knight” to rescue a business. Still, we must recognize the market dynamics in our industry do not presently allow for as much competition as we would otherwise desire, resulting in acquisitions priced below intrinsic values in many circumstances.

CHOOSE YOUR OWN ADVENTURE

For many businesses in the cannabis sector, 2022 is a crossroads. Some operators have been in the industry since the earliest days and are feeling the fatigue of a tumultuous and volatile industry.

There are others that still have the fire to build something lasting but are not realizing the growth they initially anticipated and now have lenders or shareholders asking tough questions. We are less than two months into 2022, and there are daily reports of substantial players potentially being delisted from major exchanges, activist investors agitating to turn over entire boards, notable brands conceding their business plan depended on regulatory changes that still have no timeline to resolution, and many companies in need of liquidity forced to evaluate any and all potential strategic alternatives.

Despite the capital constraints, some investors are still putting money to work in good businesses. To stand out, companies need to demonstrate real scarcity value, like differentiated brands, proprietary techniques or IP, a unique business model, top-tier operating metrics, or scale.

The capital that has been available to the cannabis industry via the public markets and now increasingly in the form of debt is becoming more sophisticated and discerning. Much of that capital is now in the hands of large public MSOs, having generally demonstrated those qualities of scarcity value to become a relatively safe bet for capital.

The result, however, is that the big get bigger, and the already constrained capital gets concentrated in a limited number of companies. Consequently, we have a lopsided environment where large acquirors are viewed as the white knight savior with arms open, but they hold all the leverage, and survival may only come on their terms.

I don’t mean to paint large acquirors as predatory. The fact is, if a recapitalization of a business is not an option, then a strategic sale to a larger entity might be the right move. A sale can preserve a brand and offer wider distribution through a large-scale operator. The supply/demand imbalance we see here is typical of a maturing industry. There are a lot of good companies without enough capital to go around and a limited number of buyers. There will be companies that get consolidated, and some will close their doors.

But what if the smaller guys band together? For some operators with a unique brand and significant market penetration, the right option could be a merger with an operator that has demonstrated expertise operating retail in high-value markets, for example. Or maybe you can explore a holding company model comprising a roll-up of multiple iconic brands into a unique portfolio or a horizontal combination across multiple states.

The point here is there could be a solution whereby a combination of companies creates more scale and staying power. And, potentially, it makes them an even more attractive target to a large acquiror when that time comes.

Finally, if there is no capital to support a business or take it private, and the acquirors don’t seem to recognize the value of what you have created, then creditors might push for an insolvency proceeding. For non-cannabis companies facing insolvency, one commonly utilized alternative is a chapter 11 bankruptcy process. Chapter 11 can be an effective and efficient manner to reorganize the company or sell assets.

Unfortunately, U.S. cannabis companies do not have this tool available to them as (i) their operations are still deemed illegal under the Controlled Substances Act and (ii) a federal bankruptcy court will not be used as a vehicle/venue to support, reorganize, rehabilitate or for lack of a  better term “permit” illegal activity.

That said, insolvent U.S. cannabis companies can look to other state-law alternatives, including receiverships, assignments for the benefit of creditors, etc. Insolvency proceedings are complicated and (can be) difficult processes to navigate. Businesses must identify and secure the appropriate advisors to help weather the storm.

Investment banks have the teams necessary to help evaluate the strategic alternatives available to a business and execute the plan to emerge on the other side. Operators exploring insolvency will also need legal counsel to help strategize and facilitate all the regulatory and documentation requirements. Like most things, it is best to engage help sooner rather than later. Delays in having a third-party help evaluate your position from all angles can exacerbate the problem and further limit the available options.