Key Accounting Considerations for Financing Cannabis in the U.S.

Last year, M&A activity within the cannabis sector soared, with over 305 transactions completed by the end of 2021 alone. Since then, the market has seen M&A activity slow, with much of this attributed to the fact that multi-state operators (MSOs) that drove much of the activity last year are no longer in need of additional expansion.

During last year’s surge in M&A activity, tier 1 companies—typically those with over $250 million in annual revenue—and MSOs were the biggest players in the market. But at times, it was at the expense of being strategic about their acquisitions and settling at accurate valuations.

Now we’re seeing the realization of bad acquisitions and over-promised investors. Investors are becoming smarter and savvier, getting more realistic with their valuations, and holding on further activity until they see the bigger picture. In addition to waning optimism that Congress and the Biden administration will prioritize and be able to legalize cannabis and de-schedule Section 280E, this has all contributed to a slowdown of M&A activity.

That said, the U.S. cannabis sector has also seen M&A activity continue this year among tier 2 companies—typically those with $75 million to $250 million in annual revenue—and tier 3 companies, typically those with under $75 million in annual revenue. While smaller tier 2 and 3 companies 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’re also looking to grow to become dominant players within a particular state or regional market, whether through mergers and acquisitions or standalone capital raises.

In the past, smaller tier 2 and 3 companies may have been able to grow solely through raising capital with several individual, private, wealthy investors. But as they look to grow at a more rapid scale and achieve dominant positions in their current markets, they are realizing that they have tapped out their previous sources of capital. They are getting more creative with their capital raises, whether through more debt financing, courting more private equity interest, or even investment from banks through reasonable asset lending in their various real estate entities.

For cannabis companies in the U.S. currently looking to raise capital through a merger or acquisition or standalone effort, here are some key accounting considerations. These factors can make or break the success of a transaction and the future of a company.

Get your reporting systems in order

It is of paramount importance to look at existing reporting systems and confirm that they are sophisticated enough to support future growth. Say a tier 3 company or startup is looking to raise capital. Startups typically spend much of their cash on the operations side—the build-outs, facilities, and grow lights—but spend minimal amounts of money on back-office needs and costs. But this is probably the most important area a startup can spend money and invest in, as a solid back-office operation ensures a company is not susceptible to fraud and has an accurate picture of cost per unit and cash flow. Without sophisticated, streamlined, and accurate reporting systems in place, no company can truly understand whether it is profitable, whether it can attract investors, or whether it can secure additional financing.

The first questions investors and potential buyers will often ask is what a company’s back-office looks like and how sophisticated a company’s reporting systems really are. Investing in reporting systems especially matter from a regulatory standpoint. Should there be any major federal or state regulatory movement for any company hoping to go public, now is the time to invest in 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 American stock exchanges, many still won’t be able to take advantage if their reporting systems aren’t advanced enough to comply with the SEC’s reporting and disclosure requirements. Once cannabis companies also gain access to the more traditional means of lending and financing, such as banks, the ability to remain compliant with a broader and more complex set of regulations will become even more important.

Look at your numbers and projections

Before taking on and completing any deal or transaction, it is of crucial importance to look at two things:

• Debt-to-equity ratio: In its initial efforts to raise additional capital, a company will need to look at its debt-to-equity ratio and ask the following: How much capital are we intending to raise? If we were to raise additional capital, would we still be above water from a debt-to-equity ratio standpoint?
• Numbers and projections: A company will also need to look closely at its numbers and projections and ask the following: Are we looking at a positive projection with this specific transaction? What does this specific acquisition do for the would-be combined entity?

Say that two tier 3 companies are looking 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 made a deal based on a close study of the above factors. From the combination of upper management teams to accounting systems, these are all aspects of a merger in which economies of scale come into play because such items are all nondeductible. Instead of keeping two CFOs on the payroll, for example, it might be the case that the combined entity now employs just one, allowing another to pivot and transition to a different role on the board of directors or move on, freeing up a couple million dollars for the company.

This all factors into margins, which can make a company more appealing from a capital needs infusion perspective. A company will be in a better position to take on additional debt and repay it without giving up equity if it has sufficient funds and enough cash flow to repay the debt.

Consult your professionals from the beginning

Finally, it is essential for any company hoping to successfully complete a deal and reap the benefits of it to consult accounting and financial professionals before signing the dotted line rather than after the fact. In the past year, many M&A deals have been struck within the cannabis sector only to result in those companies finding that they have struck deals that are resulting in increasing losses, working against their objectives and leaving them in the red.

For any company looking to strike a deal or at the beginning of a capital raise, reaching out to accountants and professionals beforehand will ensure that sufficient due diligence has been conducted. It will also ensure that nothing, from cash to potential tax efficiencies, 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, looking at the numbers and projections, and consulting professionals from the beginning, cannabis companies can best ensure they are set up for success. In taking these three accounting considerations into account, cannabis companies can best set themselves up for sustained growth and profitability.

Written by Todd Tigges. Originally published by Bloomberg Tax.