The cannabis market is young, fragmented, and growing fast. While the U.S. continues to hedge on federal guidelines and states slowly adopt standards for legalization, the mergers & acquisitions marketplace is incredibly active. Owners and investors with an eye on an exit should ensure they have the right infrastructure in place to present themselves as an attractive purchase.
The trend is clear, with 2021 showing a record pace for acquisitions. The Wall Street Journal points out that $5.5 billion worth of cannabis M&A transactions have closed (as of September 6), with more on the horizon due to an excess of cash on hand. “After strong cannabis sales throughout the pandemic and recent capital raises, large growers also have cash on their hands. By the second quarter, the 10 biggest U.S. cultivators had $193 million in cash on average, nearly triple the figure a year before.”
It is not just the value of the deals that has increased – the pickup in volume is also stunning. Analysis by Viridian Capital Advisors shows a 400% increase in the number of cannabis M&A transactions, jumping from 39 deals in the first half of 2020 to 166 deals in the first half of 2021.
Who’s leading the charge? There is a healthy mix of strategic acquirers and private equity. On the U.S. side, for example, multi-state operator Cresco recently acquired Cultivate for a potential net purchase price of just over $150 million. The move provides a Massachusetts footprint and opens the door to a better stronghold for Cresco in the Northeast.
The IPO route invites further complexity and opportunity. A rash of filings from cannabis companies seeking to go public via Special Purpose Acquisition Companies (SPACs) signals that the heavy buying activity is likely to keep its momentum.
Cannabis operators that want to capitalize on the sector’s appetite for acquisitions need to think through these three keys to preparing for an exit:
- Get ready for real scrutiny
The industry is still in its early stages, with normally routine operations complicated by regulatory shifts and a reliance on cash transactions. Combine that with fast growth, exit opportunities or both, and the result is often a financial house in disarray. The most common buyers are publicly traded companies and sophisticated investors, and they will be looking closely at the financial history of the company. Income tax filings, sales tax filings – everything will be on display.
When an acquirer shows interest, it will be too late to pull together an orderly picture. Ideally sellers should consider having audits done two or three years in advance of an anticipated exit. Audits not only create a more stable, clear understanding, they also bring credibility to the organization.
By contrast, confusion on the financial and tax side can lead to less favorable deal structures and, in some cases, deals that get abandoned altogether.
- Predict your profit
Starting a couple years early not only helps shore up the financial presentation, it may also present opportunities to maximize your position in a deal.
For example, elevating earnings before interest, taxes, depreciation, and amortization (EBITDA) is critical to increasing a payout, which is likely to be based on historical profit margins. While in a non-exit strategy, we work with companies to control tax exposure by decreasing their margins; whereas the opposite approach comes into play during a sale. Sellers should maximize EBITDA to show the healthiest bottom line possible.
Looking past the sale, accurately forecasting EBITDA is just as important. Deal terms often call for an earnout period, during which sellers will be responsible to hit profitability targets. Having solid projections in place helps prevent a buyer from changing the targets dramatically, thereby setting up a more difficult path for the earnout.
- Structure the business for a better deal
Often overlooked fact: your entity structure plays a significant role in the deal. Being taxed as an LLC or a C Corp makes a difference, and any changes to the structure need to take place at least one year before an acquisition is explored.
Much of the M&A activity is currently driven by Canadian public companies looking to break into different geographies. That means that an exchange of stock is frequently part of the deal; if a seller is a C Corp, the acquisition can be structured as a reorganization, and the stock is tax-deferred until it is sold. This is a tremendous benefit for sellers that is lost under different structures. With LLCs, the exchange is considered liquidity and triggers a tax event.
Much will continue to change across the cannabis sector – and it will likely change quickly. The U.S. continues the steady (but slow) march towards legalization, which will open more fluid opportunities for expansion. We remain heavily involved as the sector shifts and encourage you to reach out to us with any questions.
If you have questions, please contact David McManus, CPA, CGMA at 774.512.4013, firstname.lastname@example.org; Joshua England, JD, LLM at 774.512.4109, email@example.com; or your AAFCPAs Partner.