Cannabis Venture Capital: Navigating Investment Vehicles Through Uncertain Regulatory Terrain

Deal flow in California’s $2.7 billion medical-cannabis industry suffers from the state’s existing moratorium on “for-profit” operations in Health and Safety Code §11362.765(a).[1] Despite recent studies boasting cannabis as the fastest-growing industry in California, investors have no appetite for businesses prohibited from distributing passive earnings. But Assembly Bill 1575 (the Bill), which was proposed to the legislature in January 2016 as a “cleanup” measure to the Medical Marijuana Regulation and Safety Act (MMRSA), promises to change all that.

The Bill would amend California Health and Safety Code §11362.775 to allow cannabis businesses to operate for profit if the business possesses a valid Board of Equalization sellers permit and a valid local license, permit, or other authorization. If passed, it would take effect on January 1, 2018 alongside MMRSA, clearing inroads for investors to participate in an industry where the average bootstrapped cannabis dispensary generates between $500,000 to $1.1 million in gross revenue per month with 30% to 50% earnings before interest, taxes, depreciation, and amortization (EBITDA). And that’s just average.

Large-scale operations offer even greater upside. The Oakland-based Harborside dispensary, for example, generates an estimated $2.1 million per month in revenue from its 8000 square-foot facility.[2] But achieving a large-scale operation requires significant outlays of capital expenditures and early operating expenses.  The building purchase and build-out cost for an 8,000 square-foot dispensary facility might range between $2 million to $4 million before the first sale is made. Likewise, a 20,000 square-foot indoor cultivation facility might cost $3 to $5 million to fully build out – and that does not include purchasing the actual property itself. Such capital requirements, and the returns they produce, lend well to venture capital or private equity funding.

Yet therein lies the rub: how do investors participate in this period of regulatory limbo? A conservative approach might be to stay sidelined until the Bill takes effect. But under MMRSA, only businesses in compliance with local and state regulations as of January 1, 2018 will be allowed to operate until a state license is issued. All others will be left behind. Straight equity deals (e.g., stock, partnership interests, LLC membership) are complicated by MMRSA’s still unresolved disclosure and background-check requirements for passive equity holders. So that presents myriad logistical problems with limited partners in investment funds.

One investment vehicle that might be used to solve some of the problem presented by the moratorium on profits in the cannabis industry is a simple agreement for future equity (SAFE). Much like a convertible note, a SAFE converts to equity upon certain trigger events specified in the agreement. These trigger events, for example, can be tied to the Bill passing, the entity securing a license, and or the investors qualifying under state law for rightful ownership, among many other things. But unlike a convertible note, a SAFE has no maturity date or interest rate, which protects both the business and the investor against the unknown timing of passage and regulatory uncertainty. Moreover, since the SAFE is not considered equity, SAFE holders would not be subject to MMRSA’s stringent disclosure requirements. SAFE agreements are not the only solution. But they do offer a viable avenue for investors seeking to participate in a privately held industry that has already grown bigger than the National Football League.

 

[1] See, e.g., California Health and Safety Code §11362.765(a) “nothing in this section shall authorize . . . any individual or group to cultivate or distribute marijuana for profit”

[2] http://www.huffingtonpost.com/entry/harborside-health-center-case-dropped_us_5728d2d1e4b016f37893a9c2

 

 

Beau Epperly is a pioneer in structuring capitalization events and mergers and acquisitions in the cannabis industry. After earning his advanced law degree from Duke University in entrepreneurship and venture capital law, he founded the law firm Epperly | Elam, LLP with one goal in mind: use the law as a proactive measure to innovate opportunities for clients rather than just as a reactive measure to fix problems after they arise. The attorneys at Epperly | Elam, LLP adopt this forward-thinking approach to solve problems and create opportunities for clients in California’s nascent cannabis industry.

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