Key Accounting Considerations for Cannabis Financing in the United States
Last year, M&A activity in the cannabis sector soared, with more than 305 deals completed by the end of 2021 alone. Since then, the market has seen M&A activity slow, with much attributed to the fact that the multistate operators (MSOs) that led much of the activity last year no longer have need further expansion.
During last year’s surge in M&A activity, Tier 1 companies, typically those with annual revenue over $250 million, and MSOs were the major players in the market. But sometimes, this has come at the expense of their acquisition strategy and the establishment of accurate valuations.
Now we are seeing bad acquisitions and over-promised investors being made. Investors are getting smarter and savvier, getting more realistic with their valuations, and holding their business until they see the big picture. Along with waning optimism that Congress and the Biden administration will prioritize and be able to legalize cannabis and unlist Section 280E, all of this has contributed to a slowdown in M&A activity.
That said, the U.S. cannabis sector has also seen continued M&A activity this year between Tier 2 companies — typically those with annual revenue between $75 million and $250 million — and Tier 3 companies, typically those with annual revenue of less than $75 million. While Tier 2 and Tier 3 small businesses in mature markets, such as Michigan, California, and Colorado, may not currently be looking to become MSOs, they are looking to raise additional capital. They also seek to grow into dominant players within a particular state or regional market, whether through mergers and acquisitions or stand-alone capital increases.
In the past, Tier 2 and Tier 3 small businesses could only grow by raising capital from multiple individual, private, and wealthy investors. But as they seek to grow at a faster scale and achieve dominant positions in their current markets, they realize that they have tapped into their previous sources of capital. They are getting more creative with their capital raisings, whether through increased debt financing, more private equity participation, or even bank investments through reasonable asset lending. in their various real estate entities.
For cannabis companies in the United States currently looking to raise capital through a merger or acquisition or stand-alone effort, here are some key accounting considerations. These factors can make or break the success of a transaction and the future of a business.
Get your reporting systems in order
It is essential to review existing reporting systems and confirm that they are sophisticated enough to support future growth. Suppose a Tier 3 company or startup is looking to raise capital. Startups typically spend a lot of their money on the operations side — builds, facilities, and grow lights — but spend minimal amounts on back-office needs and costs. But this is probably the most important area a startup can spend money and invest in because a strong back-office operation ensures that a business is not vulnerable to fraud and has an accurate picture of the unit cost and cash flow. Without sophisticated, streamlined, and accurate reporting systems, no business can truly know if it is profitable, if it can attract investors, or if it can secure additional funding.
The first questions investors and potential buyers often ask are what does a company’s back office look like and how sophisticated a company’s reporting systems really are. Investing in reporting systems is particularly important from a regulatory point of view. If there were to be a major regulatory move at the federal or state level for any company wishing to go public, now is the time to invest and get the back office in order.
The reality is that if 280E is de-scheduled and cannabis companies are allowed to go public on U.S. exchanges, many still won’t be able to profit if their reporting systems aren’t advanced enough to comply with SEC reports. and disclosure requirements. Once cannabis businesses also gain access to more traditional means of lending and financing, such as banks, the ability to stay compliant with a broader and more complex set of regulations will become even more important.
Look at your numbers and your projections
Before agreeing to and entering into any deal or transaction, it is of crucial importance to consider two things:
- Rate of endettement: In its initial efforts to raise additional capital, a company will need to look at its debt ratio and ask itself the following: How much capital do we intend to raise? If we were to raise additional capital, would we still be above water from a leverage ratio perspective?
- Figures and projections: A company will also need to look closely at its numbers and projections and ask itself the following questions: Are we looking at a positive projection with this specific transaction? What does this specific acquisition do for the potential combined entity?
Suppose two Tier 3 companies seek to merge to become a Tier 2 company and raise capital. Such a merger should result in increased revenue and lead to more economies of scale if the merging companies have reached an agreement based on a thorough study of the above factors. From the combination of management teams to accounting systems, these are all aspects of a merger in which economies of scale come into play as these elements are all non-deductible. Instead of keeping two CFOs on the payroll, for example, the combined entity may employ just one, allowing another to rotate and move into a different role within the board or move on, freeing up a few million dollars for the company.
All of this is factored into margins, which can make a business more attractive from a capital injection perspective. A business will be in a better position to take on additional debt and repay it without giving up equity if it has sufficient funds and cash flow to repay the debt.
Consult your professionals early on
Finally, it is essential for any company wishing to successfully complete a transaction and reap the rewards to consult with accounting and finance professionals before signing the dotted line rather than after the fact. Over the past year, numerous M&A deals have been struck in the cannabis industry only for these companies to find out that they have entered into deals that result in escalating losses, running counter to their goals. and leaving them in the red.
For any company seeking to enter into a deal or at the start of a capital raise, contacting accountants and professionals beforehand will ensure that sufficient due diligence has been carried out. It will also ensure that nothing, from cash to potential tax savings, has been left on the table, and that the transaction or deal fully aligns with and serves a strategic plan.
By getting reporting systems in order, reviewing numbers and projections, and consulting with professionals early on, cannabis companies can better ensure they are set up for success. By taking these three accounting considerations into account, cannabis companies can better prepare for sustained growth and profitability.
This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Todd Tigges is a partner of UHY LLP and is the head of the firm’s National Cannabis Practice group. He is an active leader in the firm’s tax department, based in Farmington Hills, Michigan.
We would love to hear your smart and original point of view: write for us