When establishing a cannabis business, the lists of “things to consider” and “best practices” available on the internet can leave would-be cannabusiness owners scratching their heads. While there is a myriad of factors that can, and should, influence those aspiring to become legal cannabis operators, one consideration that applies to all businesses – and remains a significant source of problems across the cannabis industry in particular – is business financing. To shed some light on the subject, we have assembled a brief overview of several common investment structures as well as the instruments used to effectuate them that we have been seeing and using here in New Jersey. Additionally, we have included several hypothetical business fundraising scenarios to assist readers in applying these concepts in their own cannabusiness journey.
Increased cost or diluted ownership?
When considering raising money through debt or equity financing, an aspiring cannabusiness entrepreneur should be aware of the largest drawbacks of each approach and their implications for future business operations.
Raising money through debt financing, or taking out a loan, will come with significant extra operating cost. While borrowing money will not dilute the founder’s ownership stake in the business, the loan must be repaid to the lender, including significant (sometimes usurious) interest and monthly payments. An important note: a lender is not an owner, but rather a creditor, of the business. This means that if the business goes belly up, the lender gets in the front of the line to take whatever value is left of the business, whereas the equity owners only get to split any leftover value. Thus, debt financing is more secure for the investor, but the investor does not get the benefit of the potential upside.
On the other hand, equity financing does not need to be repaid the same way a loan would; the investor puts in its money for a share of the equity and has no right to be repaid. An equity investor buys shares in the company, which come with two primary rights: a share in the profits and some control over the business (or at least voting power). Equity investing is riskier than debt investing but comes with chance for a higher return and more say in how the business is operated.
The choice between debt and equity is not black and white, however, as many debt-equity hybrid investment vehicles have been developed over the years to seek the best of both worlds. The following is a brief overview of two common hybrid investment instruments.
Common Fundraising Instruments
- Traditionally (but not exclusively) used as a “bridge” to enable company to fund operations before larger equity fundraising.
- Permits parties to delay valuation of the company, which is necessary for an equity offering but takes time and money to assess and agree upon.
- Permits parties to delay negotiation of full set of investor rights, resulting in a faster and cheaper investment.
- Risk of early investment is rewarded with a conversion discount and or a valuation cap (operators should familiarize themselves with these terms when reaching out to potential investors).
- Convertible debt bears interest and has maturity date
- Some convertible notes allow the lender to decide whether or not it wants the debt to convert to equity (better for the investor), whereas in others, the conversion is automatic (better for the operating business).
- If the investor decides not to convert, it remains a creditor with a prioritized right to repayment.
- Convertible notes offer a way to comply with ownership restrictions for diversely owned businesses and social equity businesses while still honoring the business deal among the founders and their investors.
- SAFE = Simple Agreement for Future Equity
- No interest rate or maturity date
- More standardized, therefore even cheaper and faster than convertible notes – standard forms are available online.
- Created by institutional investors; rights slant towards investors (especially when it comes to founder equity dilution)
Common v. Preferred Equity
- Founders have “common” equity.
- Investors often require equity with certain rights and preferences that are superior to common equity, including
- Payment priority and minimum rate of return
- Special approval rights
- Gives investor some of the benefits of debt but with the upside of equity
Do Not Forget that Securities Laws Apply to Fundraising
Whether an investment instrument qualifies as a security, making it subject to state and federal securities laws, is the topic of an entire lecture series, but understand that the definition of securities is very broad, and securities laws are very strict. Here are just a few basic points about security law compliance:
- Securities offering must be registered with the federal and state securities regulators or be exempt from registration (99.99% of start-up financings are done via exempt offerings)
- Speak to an attorney before publicly soliciting investment (do not ask for money or solicit investors via social media or another public platform!)
- Disclosure and transparency with investors is key, so if anyone has an interest in the business when an investor is considering cutting a check, make sure they have the full picture of the existing ownership and financing.