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M&A Field Guide

Fundamentals of an Effective Cannabis M&A Strategy

By Scott Hammon, CPA

Welcome to the Cannabis M&A Field Guide from MGO. In this series, our practice leaders and service providers provide guidance for navigating M&A deals in this new phase of the quickly expanding industries of cannabis, hemp, and related products and services. Reporting from the front-lines, our team members are structuring deals, implementing best practices, and magnifying synergies to protect investments and accrete value during post-deal integration. Our guidance on market realities takes into consideration sound accounting principles and financial responsibility to help operators and investors navigate the M&A process, facilitate successful transactions, and maximize value.

There are as many reasons to seek out a merger and acquisition (M&A) deal as there are companies engaging in these transactions. Through our extensive experience conducting M&A deals in cannabis, and related industries, we advocate a fundamentally sound approach that puts companies on the path to a successful deal.

In the following, we will discuss a general approach to M&A strategy and the unique conditions of the cannabis industry that must be taken into consideration.

In any deal, focus and strategy are the keys

Whether on the buy- or sell-side, a successful M&A strategy must adhere to the same logic that informs a cannabis operation or fund’s long-term strategic goals. Any deal should be the means for achieving these goals. Below are the basic stages of a successful M&A strategy.

Stage 1: Develop Strategic Business Plan and Key Drivers

What are the long-term goals of the organization? Common goals include: increasing revenue/lowering overhead, achieving economies of scale, new product offer/market entry, expanding operations, acquiring technology/Intellectual Property (IP). When it is determined that the goals stakeholders agree on cannot be achieved expeditiously through internal channels, M&A deals should be considered to accelerate timelines.

Stage 2: Understand Financial Limitations

On the acquisition-side, assess the funds or assets available for the deal, this can include cash on hand, stock/debt issuance, and sales of tangible/intangible property. Once known, the blend of what makes up a consideration for a purchase can have a large effect on what bid a seller is willing to take.

For sellers, you must understand your financial position, what you need to achieve your goals, and the market value of your assets. They must align within reasonable expectations before moving forward.

Stage 3: Develop List of M&A Targets

This can be a complex but essential step. Acquirers must perform deep analyses of the market and licensing conditions of the region where they are considering a deal. Sellers need to connect with potential buyers. Involving an investment bank can prove beneficial in identifying targets/sellers and supporting the valuation stage that follows.

Stage 4: Build Valuation Models

At this stage, it is important to lay out the market and financial realities that will drive acquisition costs. Both sides must also account for the returns necessary to provide a positive outcome. Using the valuation models, you also can begin to prioritize candidates based on business impact and deal feasibility.

Stage 5: Review and Approve Strategy

With the previous stages complete it is time to step back and make sure a potential deal aligns with business goals and confirm that critical stakeholders will approve the potential deal.

License acquisition at the center of M&A deals

The regulatory complexity of the cannabis industry in the U.S. has created a unique set of circumstances that add fuel to the drive for M&A deals. While cannabis remains illegal at the Federal level, states and territories are acting to implement state and local laws regarding the lawful use of medical and or/adult-use cannabis.

In the absence of a Federal regulatory framework, a patchwork of state and local regulatory regimes, each with their own complex set of rules and regulations, has emerged. The process of applying for and receiving a license to operate in most of these markets is expensive, time-consuming and subject to unpredictable factors. As a result, licenses have emerged as a type of commodity in the cannabis market. But unlike other intangible property commodities (i.e. intellectual property), most cannabis licenses are inextricably tied to the business unit that holds it. While there are some workarounds, including management agreements, in most markets M&A deals are the most direct way of acquiring licenses.

Considerations for Buyers

The process of seeking to gain new licenses must begin with extensive market research and growth projections for the targeted market. To fully understand the value of a license, you’ll also need to understand the licensing process and ascertain how many are issued per year, whether current caps on licenses exist (or are planned), and whether your competitors already have a foothold in that market.

Once a target company holding licenses is identified, the details of those licenses become paramount. Considerations should include: expiration date of license, process for re-certifying licenses, and whether any conditions the license was issued under would change upon acquisition and potentially invalidate or block the recertification of that license. In many markets, the change of ownership or equity stake in a cannabis business is contingent upon regulatory approval.

Considerations for Sellers

Understanding the real market value of all licenses held is the name of the game. All previously listed factors must be considered. Since, in the majority of cases, you’ll be selling a business unit along with the license, you must also have a firm understanding of the value of that unit and all its tangible and intangible property. The acquirer will also be performing extensive due diligence on you and your business units, so it is best to have financial statements prepared, all regulatory issues up-to-date, etc.

Complexities surrounding increasing operational capacity

Considering the relatively early stage of the cannabis industry, many companies are a long way from their planned operational capacity. Establishing new operations, whether as a cultivator, manufacturer, retailer, vertically integrated operation, requires extensive planning for zoning, licensing and regulatory concerns, a major initial capital outlay, and a long timeframe to build and establish operations.

For many fast-growing companies, the quickest route to expanding operations is to acquire or partner with cannabis companies with already established operational scale.

Considerations for Buyers

A common motivation for acquiring operational capacity is the desire to achieve scales of economy through vertical integration. This is when, for example, a retailer acquires cultivation and manufacturing operations to bring product development under the same roof. By controlling more steps along the supply chain, a great number of financial and operational efficiencies can be achieved. However, these advantages must be weighed against the burden of managing greater regulatory complexity.

Considerations for Sellers

Overextended cannabis operations can achieve greater operational efficiency by off-loading under-performing assets. As related to the sale of licenses, understanding the true value of both tangible property, and the attached license, is key to getting a fair price.

Distressed assets provide buying opportunities

The cannabis industry has endured significant volatility over the past 12-15 month period. One of the results of the turmoil has been a significant dip in valuations, which has limited the capital-raising potential for many operators. A number of organizations that were aggressively expanding their presence during 2017-18, now find themselves overextended with portfolios burdened by under-performing assets. These circumstances have resulted in a “buyer’s market” for cannabis operations and funds with sufficient capital flexibility to be acquisitive in this environment.

Considerations for Buyers

For the first time in the legal cannabis industry’s history, difficult economic conditions can be advantageous for companies with access to capital. The overall dip in valuations and growing number of distressed assets presents a unique opportunity to gain licenses, expand operations, and enter new markets. While we always preach caution and emphasize due diligence in executing M&A deals, now may be one of the rare times it is advantageous to swim against the current and move quickly in acquiring assets and establishing a solid foundation for when economic conditions improve.

Considerations for Sellers

In the absence of other forms of capital-raising, carrying under-performing assets may prove to be a lifeline for many cannabis operations. Finding a buyer for operations in, for example, a market that haven’t yet matured, could provide a “reset” button for over-extended operations. It is essential to take a strategic view and make difficult decisions about the validity of existing operations and business plans.

Final thoughts

The motivations and circumstances surrounding M&A deals are so diverse there is simply no one-size-fits-all approach. What remains consistent is that when a strong business case matches market realities and ultimately produces an M&A deal, the outcome is most likely to be favorable. Stopping at every step to confirm proposed deals align with the overall business strategy will help keep your plan on track.

Catch up on previous articles in this series and see what's coming next...

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