Part 4: Confirm Deal Terms

In the series “Marketing a Cannabis Company for Sale,” Dena Jalbert, walks through the nuances and intricacies involved in preparing a business for sale in the cannabis industry. This article, “Part 4: Confirm Deal Terms,” is part four of a five-part series. 

At this point in the process of marketing your cannabis company for sale you have laid the groundwork for finding the ideal buyer for your company including mapping out your strategy, assembling a strong M&A team and identifying profitability and financial trends. Now it’s time to determine how well-aligned you and a potential buyer are on deal terms.

A letter of intent (LOI), sometimes called a memorandum of understanding (MOU), outlines key deal terms and is an initial expression of intent by you and the buyer to move forward on the deal. A LOI is essentially non-binding and acts as a framework that describes how the deal will proceed.

Given the legal, regulatory, tax and valuation complexities of the cannabis industry, less is not more when it comes to LOIs. A LOI that is vague and does not cover key terms can endanger a deal when you and your buyer realize you didn’t agree on principal terms. By contrast, a LOI that is very detailed will help hammer out key terms, saving you time and money in the process of arriving at a definitive agreement.

Getting to the LOI stage of the M&A process is often described as an engagement signaling that both parties are committed to a marriage.  Confirming deal terms in a LOI is an important step in the process to ensure that there is agreement on these terms before entering into the lengthy and costly process of performing due diligence and negotiating final contracts.

Your M&A team, including attorney, CPA and advisor, will work with you to understand the proposed material terms outlined in the LOI and ensure there are no deal-breaker issues.

Some of the terms spelled out in a LOI include:

Structure of the Sale

The LOI defines what is being purchased – assets or stock. An asset sale is the purchase of individual assets and liabilities, while a stock sale is the purchase of the owner’s company shares.

If you are selling your company in an asset sale, you would retain possession of the legal entity, while the buyer would purchase individual assets of your company, such as equipment, fixtures, licenses, trade secrets, trade names and inventory

In a stock sale, the buyer purchases the selling shareholders’ stock directly, obtaining ownership in your legal entity and assuming all of the known and unknown liabilities of the business. In other words, instead of choosing specific assets and liabilities to acquire, the buyer purchases an ownership stake in your entire business.

Many cannabis businesses are purchased for a mix of stock and cash, and it is important for you to understand the implications of the stock part of the deal. Because valuations are currently highly inflated in the cannabis industry, there is a real risk that the shares issued as payment for your business will devalue in the future. However, if the market remains strong, you could realize a big payoff. Your payoff will depend on the market, so understanding the terms around when and how you can sell those shares is important. Your M&A advisor will make sure you are clear on terms, so you know what to expect from a worst case/best case scenario.

Purchase Price

The LOI will include the amount that the buyer proposes to pay for your business as well as the timing and manner of payment (how much will be paid at closing versus post-closing and whether any post-closing earnout payments are contingent on future events and/or performance targets).

It is important to work with your M&A team to understand what these earnout events and/or performance metrics are and what autonomy and resources you will have to hit those metrics.

Management/Employee Roles

A LOI can also include a description of the buyer’s intentions for key employees to remain with the company after the deal closes, including defining roles and compensation levels for these employees. In cannabis M&A, it is common for the buyer to specify that deal closing is contingent on certain employees signing employment contracts and noncompete agreements. Buyers want to retain top talent, recognizing that the cannabis industry is a young industry with a scarcity of experienced employees.

Regulatory Approvals

A description of any regulatory approvals or third-party consents that will be required will also be included in a LOI. As the seller you will need to provide representations and warranties about all consents and approvals, as this will be a condition to the transaction closing. It is particularly important that your M&A team have experience in the cannabis industry in order to advise you on the developing regulatory landscape in the industry and what approvals and third-party consents should be part of the LOI.

Indemnification Framework

A high-level summary of the scope of your indemnification obligations to the buyer is also often part of a LOI. These terms allocate risk between the buyer and seller. The complex legal environment in the cannabis industry impacts the allocation of this risk with buyers sometimes requiring that losses from representations made about your business not be subject to regular caps, deductibles and other indemnification. You should work with your M&A team to gain a clear understanding of the indemnification obligations outlined in the LOI, including the amount of time you will be liable for these representations.

A signed LOI is a significant milestone in the M&A process, confirming understanding, expressing commitment to the transaction, and setting ground rules for future negotiations.

Once you have a signed LOI, you are well on your way to selling your cannabis company.

Part 3: Identify Profitability and Financial Trends

In the series “Marketing a Cannabis Company for Sale,” Dena Jalbert walks through the nuances and intricacies involved in preparing a business for sale in the cannabis industry. This article, “Step 3: Identify Profitability and Financial Trends,” is part three of a five-part series. 

At this point in your journey of marketing your cannabis business for sale, you should have progressed through step one – mapping out your strategy – and step two – assembling a strong M&A team. The next step in the process is to identify profitability and financial trends.

Profitability

Profitability is the goal of any business, and is a critical component of making your business an attractive target for acquisition.

When you are positioning your cannabis business for sale, you will need to have a complete financial picture of your company, including past and current profitability, as well as projections of future profitability. Potential buyers want to know how your company is currently performing and look at its historical performance prior to an acquisition, assessing whether your profits are trending up or down. If your company is underperforming – not growing revenues and not controlling costs – you will find it challenging to attract a buyer willing to invest the time and attention needed to turn it around.

Many companies in the cannabis sector struggle to become profitable, hedging their success on future distribution and sale of their product as rules and regulations related to cannabis are solidified. The most profitable cannabis companies are those that are committed to staying in the black as they expand their product portfolio, have a focus on organic growth and/or a strategy for growth through strategic partnerships. A focus on successfully executing on your business plan to achieve profitability will position you to take advantage of the increase in consumer spending on cannabis products and will attract the most interest for your company as a target for acquisition.

Trends

Timing is critical in terms of your company’s profitability, but also important in this timing are trends that impact the financial health of the cannabis industry. As a business owner, you should have your finger on the pulse of what is happening in the industry in order to strategically adjust your business plan to take advantage of these trends and potentially adjust the timing of putting your business up for sale if needed.

Two of the most significant trends currently impacting the cannabis industry include the legislative climate and the development of new cannabis products.

Legislative Climate

One of the key drivers of growth in the cannabis industry is increased legalization. Exponential growth in the industry is already being seen in states where cannabis is currently legal and will only increase as markets open up in more states. According to New Frontier Data, in states where cannabis is legal, medical and adult use sales are forecast to grow from $12.9 billion in 2019 to $26.3 billion in 2025.

Lawmakers in states where cannabis is not legal are seeing the success of the industry in states with legalization and want to bring this revenue stream to their states. Recreational marijuana is now legal in 10 states and the District of Columbia, and medical marijuana is legal in 33 states and D.C. The New York and New Jersey state legislatures are considering legalization of adult recreational use of cannabis in their states this year, and momentum for legalization is building in Pennsylvania and Illinois.

The legislative climate should be a significant factor in deciding when the time is right to sell or buy. As more states legalize marijuana, the markets will continue to open up and provide an even more favorable climate for M&A.

New Cannabis Products

Another key driver of industry growth is cannabinoid, or CBD, which is making significant inroads in consumer products. CBD can be found in everything from food, to skin care, to pet and fitness products. Consumer interest in these products is increasing as many of these brands are touting the wide-ranging health and wellness benefits of CBD. CBD products are bringing mainstream market opportunities to the industry with the development of innovative consumer products, and is expected to be a key driver of industry market growth moving into 2019.

The growth in market opportunities generated by the continuing increase of cannabis legalization and the development of new cannabis consumer products has attracted interest from large corporations in a wide range of sectors including food, tobacco and alcohol. These corporations are strategically entering the market by acquiring small cannabis companies, providing an excellent window of opportunity to position your company for acquisition. This window of opportunity will begin to close as the industry matures. Fragmentation as the result of the entry of many new players, a dwindling availability of seed capital and an increasing squeeze in profitability will all inevitably occur when the market has met this maturity.

The bottom line is that timing in terms of where your company is in its drive toward profitability, as well as industry trends impacting the financial health of the industry, will be key determining factors in the success of the sale of your company. Get the full picture of both as you determine the right timing to position your business for acquisition.