The past two years have been a whirlwind for cannabis companies looking to raise capital, going from boom, reaching stratospheric heights, to bust, leaving the industry cash-strapped well before the onset of the coronavirus pandemic. This cycle is the direct result of the myriad of federal, state and local regulatory challenges to doing business and attracting investment in the state-legal cannabis industry. (For purposes of this article, "cannabis" does not include industrial hemp (Cannabis Sativa L. with not more than 0.3% THC)—with industrial hemp no longer a federal controlled substance, most of these issues no longer apply).

As the state-legal industry began to escalate, particularly after California legalized adult use in 2018, the industry turned to a number of non-traditional investment sources and firms to raise capital, since more traditional financial have, for the most part, refused to do business with cannabis. Private equity and venture capital funds were set up to invest specifically in cannabis, but they were funded by risk-tolerant, high net worth individual investors and family offices, since the traditional fund investors (pension funds, insurance companies) would not invest.  More so, US companies looked north to the Canadian Securities Exchange (CSE) to sell equity— unlike U.S. exchanges, and other Canadian exchanges, the CSE will list companies operating in violation of U.S. federal cannabis laws.  Public and private valuations skyrocketed as a result.

Cannabis companies used this influx of investment to build an industry; however, the cost of doing business is extraordinarily high—compliance and security is expensive, the lack of traditional banking services (lines of credit, ACH and treasury services) stifles the cash flow cycle and imposes additional fees, and high state and local cannabis-specific taxes eat into gross margins.  Most notably, when paying their federal income taxes, Internal Revenue Code Section 280E does not allow cannabis operators to take most of the operating deductions that other businesses enjoy (other than cost of goods sold), resulting in very high effective tax rates.

At the same time, cannabis companies operate in a unique marketplace. State cannabis laws prohibit licensed operators from crossing state lines, prohibiting them from selling into other states. Although highly questionable from a dormant commerce clause perspective, these laws have resulted in national fragmentation of consumer markets. Companies that operate in multiple states have to build entirely separate supply chains, infrastructure, and brands within each state, making scale and brand building even more capital-intensive than usual. Combined with the higher cost of doing business in cannabis (Section 280E, etc.), it is extraordinarily difficult for a cannabis operator to generate positive cash flow, even with scale. The result is a perpetual need to raise capital.

In March 2019, the speculative stock bubble peaked and prices on the CSE began a steady climb downwards. Individual investors began to sour on the industry as valuations plummeted, for both public and private companies, resulting in a dearth of equity capital. To fill that need, new sources of debt capital began to make significant headway into the cannabis industry. Real estate investment trusts began to form to conduct sale/leasebacks of the vast amounts of real estate held by larger operators (real estate is frequently owned outright many (landlords do not want to rent to cannabis companies) and without leverage); non-bank lenders started to lend against real estate, hard assets, and receivables; and specialty lenders started to finance equipment. As equity pulled back to a trickle in mid- to late-2019, cannabis operators turned to these sources of leverage to try to handle the dual challenges of scale in a fragmented industry and the difficulty of generating positive cash flow.

However, cannabis companies face a particular challenge in borrowing. Generally, state and local cannabis licenses, which are required to possess cannabis (let alone sell it in a foreclosure), require the licensing authority's permission to transfer. So, although a lender might take a lien on an operator's license and cannabis assets (namely, the inventory), foreclosing on that lien is not a reliable remedy, since the lender will have to work with a state agency to take action (only a few state laws even have a statutory procedure for dealing with secured lenders in foreclosure, and those laws have not yet been properly tested). As a result, licenses and cannabis assets are challenging to underwrite as reliable and saleable collateral, meaning that lenders instead look to other assets—real estate, equipment, receivables, personal guarantees—to lend against, which small operators may not have to offer.

Since the beginning of 2020, valuations for cannabis companies have remained low and investors are approach the industry from a distressed perspective. A number of special purpose acquisition companies (also sometimes referred to as "blank-check companies") have raised over $1 billion in public equity, but being acquisition vehicles, SPACs cannot inject much-needed cash into the space. New cannabis-focused distressed credit and equity funds are being raised, but, similar to older vintage funds, they are having to rely on individual, high net worth investors.

Further, traditional distressed investing techniques do not clearly translate to cannabis.  Regulatory approval requirements for cannabis license transfers make vulture and roll-up strategies difficult and time-consuming to execute. More importantly, federal bankruptcy courts have made it clear that cannabis operators cannot file for protection under Chapter 11 of the U.S. Bankruptcy Code, forcing companies to face unpaid creditors without the benefit of the automatic stay.  State receivership statutes vary widely, but generally do not offer distressed cannabis companies or investors the powerful tools of bankruptcy.

So where does this leave the cannabis industry from a capital markets perspective? Unfortunately, the outlook is hazy at best. Valuations remain depressed, even with the consumer buying spree as people went into quarantine. Capital-raising activities have mostly gone into lockdown as the broader markets have been roiled by the pandemic. The cannabis industry is left with few options to deal with the current situation, short of federal reform.

Some operators will survive this downturn, and consumer demand continues to grow as more states open up to legalization. In the meantime, cannabis companies and their service providers will have to continue to utilize every tool available to navigate through the storm.

Marc D. Hauser serves as vice chair of the cannabis practice team at Reed Smith. He currently dedicates his entire practice to the cannabis industry. His clients include public and private single- and multistate operators, market-leading ancillary businesses, real estate investment trusts, investment banks and other financial services providers, private equity funds and other investors, testing labs, cultivators, processors and entrepreneurs.