Looking beyond the valuation of a cannabis business to create a valuable relationship.
George has an aptitude for making the best concentrate he has ever tasted; all his friends agree. Jean had grown up gardening with her mom in Humboldt, and has been growing cannabis for a living for over a decade. When they met, the two realized that together they could create a vertically integrated commercial cannabis business. They came to an agreement, worked hard, and got cultivation, manufacturing, and distribution licenses from the state of California. Their products were a hit and flew off the shelves of dispensaries. With their growth came a need for an investor so they could continue their trajectory.
Sarah is a marketer and has been for her entire 30-year career. She has run multiple nationwide marketing campaigns and is generally considered to be an expert at branding. Sarah has recently become an avid supporter of cannabis legalization and use because it helps her with her back pain from years in front of a computer and it helps her with insomnia. She decided to enter the cannabis space to promote a line of products she thinks would be well received by an older generation of professionals like herself.
George and Jean met Sarah at a cannabis conference. They all hit it off and decided to try to work together. Sarah wanted to enter a partnership with an established cannabis business like George and Jean’s. George and Jean made Sarah an offer to invest in their business, which they arbitrarily valued their business at $12 milion, and they asked Sarah to invest $4 million for a 25% interest. (Remember that after the investment the post-money valuation is $16 million, so $4 million is 25%.)
Sarah had sticker shock. She had the capital to make that kind of investment but the valuation seemed arbitrary and quite high to her. She was much more interested in a smaller investment that would put her in a situation where she could quickly get her products to market and use her marketing skills to bolster the business she was investing in.
George and Jean wanted a $4 million investment so they could each pocket a million. They were master growers and manufacturers, and had worked hard for years building their business. The other $2 million would be used for building out a new greenhouse and expansion of their distribution network (inventory, employees, and delivery vehicles). George and Jean also wanted to use some of their money for their first vacation in years.
Sarah didn’t know what to do, she wanted to be an investor and strategic partner for the brand, but couldn’t get over the valuation that they had set. Further, she was worried that if she began their relationship by haggling over price, George and Jean would feel like Sarah didn’t value them. On the other hand, Sarah didn’t want to make a bad investment or start the relationship off by being a weakling.
This fictional scenario highlights several common issues that occur among cannabis businesses seeking investment and investors seeking to invest in cannabis businesses.
Determine what is valuable, not what the value is.
Whether you are the investor or the company looking to raise capital, taking the time to understand what is valuable to you in the relationship is crucial to ensuring that the relationship is successful. There are broad categories that can be considered in this process, but ultimately what is valuable to a given individual or company is particular to that person. I look at the broad categories as follows: 1) Financial Arrangement, 2) Control, and 3) Ancillary Value.
There are some of the general terms that I find to be commonly important to one side or the other in an investment; however, there are many other terms that may be important to you based on what is valuable to you.
I find that many cannabis investors and companies seeking investment are looking to establish relationships with each other as strategic partners, not just silent partners. With this in mind, I often advocate that a strong relationship between the two parties is top priority–if the parties both aren’t willing to work towards this it is unlikely a good match. Using the process of raising capital or investing capital as a means to develop strategic partnerships within the cannabis industry has added value because most companies are on a trajectory to grow and many investors want to be more than just silent partners. This means that creative relationships can be developed so long as both sides are open to finding ways they can maximize the value of their potential relationship.
Generally, people focus on the valuation here. For instance, if the pre-money valuation is $9 million and the company is looking to raise $1 million, then the company is selling 10% of its equity. However, there are other financial arrangements that can be very important to both the investor and the company. For instance, an investor may be willing to accept a higher valuation if they are getting a preferred return. If you promise to pay $2 million of dividends to the $1 million investor before any other dividends are paid, then the investor may be more likely to agree to a high valuation. Terms regarding a preferred payback can become even more investor-favorable if the dividend payment becomes mandatory based on profit or revenue. (For example, the company will pay the $2 million preferred return using a minimum of 75% of the profits the company earns.) The more beneficial the investor demands the preference to be, the more likely it is to hamper the company’s ability to grow, which, in turn, diminishes the equity investment. Ultimately the company and the investor have to find a balance that works for everyone. Often the balance is not only found using financial arrangements but it is offset using other aspects of the agreement.
Another aspect of financials to consider is how the money is to be used. This does overlap with control but again the buckets are just broad categories. Allowing an investor to dictate how their investment will be used often leads to more comfort with the investor. An investor needs to have some level of control so they are comfortable with the investment, but too many restrictions on how money can be used can hamper the growth of the company to the detriment of both the company and the investor. Again both parties need to seek a balance that works for them.
One of the touchiest subjects that can come up in an investment is how much of the money being invested will end up in the pockets of the founders. What is fair in a given situation is highly dependent on the particulars. However, both the investor and the company should have clarity about what their intention is and why.
Other topics that frequently come up in this category are dilution protection, rights of first refusal in future investments, and salaries.
Control is often an important issue. Will your investor have any control over the company? Is the company willing to give the investor a board seat? Does the investor want to participate? I won’t go into detail on this topic here, however, it is often wrought with disagreement. I find that placing yourself in the other side’s shoes, looking at what is fair, and then striking a balance often leads to the creation of more value rather than a fight over control. Think back to the anecdote above–could it not be good for everyone if the investor had control of marketing?
This is where you get to be creative. What is valuable to the partnership you are creating? It is in this big bucket that the strategic partnership can work together to find added value. In answering questions about value, people often look at what was valuable to “each side,” but this mentality is fundamentally mistaken if your goal is to establish a strategic partnership. I encourage the potential strategic partnership to think in terms of what will add value to the partnership as a whole, not just what is good for “each side” of the partnership.
Ultimately I counsel my clients to think about the terms surrounding an investment, and not just the valuation. It is often easier to get to “yes” if the negotiations initially focus on pieces other than valuation, as these can add value for the strategic partnership (both sides) rather than creating a zero-sum game
By Mathew Auric
Attorney, Hoban Law Group