2023 may create the harshest conditions yet for the cannabis industry. The economy was already expected to be a challenge to profitability and now turmoil in the banking sector may further distract Congress from passing meaningful marijuana banking legislation, continuing to limit access to credit.
Yet, as the market continues its inevitable march toward federal legalization, it is possible to maximize financing opportunities, manage risks and build and protect brands.
To that end, here are some of the key factors that will influence the cannabis industry in 2023 and related legal considerations.
The High Cost of Financing
Limited Access to Credit
No one would have expected the biggest banking news to impact the cannabis industry would be a banking crisis, rather than the status of the Secure and Fair Enforcement (SAFE) Banking Act. The Act, which would create a safe harbor for banks to provide financing to state legal cannabis businesses, appears to have little chance of passing through Congress in 2023, despite widespread support.
Congressional efforts are continuing to help cannabis businesses gain access to banking in order to reduce large cash transactions, which increase the threat of crime. There is some hope that a new bill will make it to the banking committee and voted on by the full Senate later this year.
In any event, financing costs can be expected to grow higher as capital providers face their own challenges of increased costs and rising interest rates, and also tighten their underwriting and diligence standards.
A Bounceback in M&A (But Unlike the Past)
Economic conditions, including uncertainty surrounding interest rates and limited access to capital, as well as lack of clarity with respect to regulatory reform (specifically including the SAFE Banking Act) have significantly slowed the pace of deal making in the space. M&A activity in the industry reached a record high of $10.27B in 2021; that number dropped to $3.17B in 2022 and 2023 is off to an even slower pace. While the trend is likely to continue for a time, it will eventually become a buyer's market and those industry participants that maintain the ability to close deals will be well positioned to capitalize.
Preserving cash for operations is a paramount concern due to the continued burdensome tax structure the industry faces and the difficult capital markets environment for the industry. In addition, many mature recreational markets are experiencing falling prices, and at the same time, newer markets are quickly becoming saturated. The result is that licensed companies across the industry must shift into cost-cutting mode in an effort to survive. While larger/multistate companies may be in better position to weather these storms, many smaller companies may not be so successful and potentially available for purchase at bargain prices.
The result will be increased deal activity, but at much lower purchase prices than the historical norms. As deals start getting done, sellers can expect more equity consideration than in the past due to buyers' increased leverage. Additionally, in M&A markets like this one, even after the parties agree in principle, closing certainty decreases. This effect is not unique to the cannabis space, but the regulatory complexity of these deals magnifies the effect in this industry as compared to others.
Challenges for Startups
The failures of Silvergate Bank, Signature Bank and Silicon Valley Bank, all of which serviced risky emerging markets and companies, may create further funding challenges for startups. As a result, investors in convertible preferred equity, any simple agreements for future equity (SAFE) or common equity, may all engage in more stringent diligence and a greater interest to compensate for their risk and leverage.
What can be done?
Capital providers will need to adjust underwriting and diligence to reflect the increased risk of loss that comes with higher expense. Operators will need to know how to make themselves attractive to acquirers, strategic partners and funding sources and be aware of the best structures to preserve value and flexibility to operate their businesses, as applicable.
Local Real Estate Laws and Contractual Restrictions on Uses
As state and local laws continue to evolve, it is more important than ever for operators to understand the legal framework surrounding a property to guard against unexpected obstacles that could prohibit cannabis operations.
For example:
Properties may be encumbered by recorded easements, covenants, conditions and/or restrictions which prevent noxious uses, or any use that emits odors that can be detected outside of the premises.
Further, zoning restrictions may also prevent cannabis businesses from operating as fully desired.
Landlords that are not licensed to operate a cannabis business must be vigilant to ensure their rights under any leases with cannabis companies do not violate applicable laws. Their leases must provide enough flexibility to adapt to changes in the regulatory framework surrounding the cannabis industry. In guarding their interests, landlords may present leases that contain restrictions on permitted uses of the premises.
What can be done?
Operators can seek to negotiate for expansive permitted use clauses in leases so that their business is not inhibited by unnecessary restrictions and appropriate representations from their landlords that protect the operator from any prohibited use restrictions contained in recorded documents. As tenants, operators should consider ordering their own title and/or zoning reports to be certain that they are able to operate their business in the desired location.
Landlords can incorporate into their leases provisions intended to create clear boundaries between themselves and a cannabis tenant such as:
- making clear that they will not take possession of a tenant's inventory upon a tenant's default,
- avoiding collecting percentage rent from cannabis tenants (and instead collect fixed rent) as percentage rent could be viewed as having an ownership interest in a cannabis business, and
- negotiating a termination right in the lease, exercisable if any permitted cannabis use is later deemed to violate any applicable state or federal laws.
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