Rising hopes for federal legalization and the potential passage of the MORE Act are stoking cannabis mergers and acquisitions in 2022 and entrepreneurs have visions of dollar signs dancing in their eyes.
As an M&A attorney and cannabis accountant with several decades of combined experience, we can tell you that those who have prepared for legalization will have a nice, profitable exit.
And those who haven’t? Well, they won’t be as fortunate.
Despite being great at cultivation, production, extraction or brand-building, many cannabis business owners are green when it comes to the nuts and bolts of preparing a multimillion-dollar business for an exit.
We regularly have clients come in and say, “I’m looking to sell, or I’ve already received a letter of intent. I know that my books are not so great, and I need you to clean things up so we can close by the end of the month.”
We go in and find that they’ve been cute with their licensing requirements and have owners who aren’t on the cap table, their balance sheet doesn’t balance, they don’t have signed contracts, and their intellectual property isn’t protected.
Often, they’ve commingled their personal and business expenses and their books and records aren’t accurate.
Unfortunately, it’s nearly impossible to get a company in that situation in order for a sale. No buyer wants to take on that level of risk, and the valuation will plummet as a result.
So what are the top five things that we want you to know about preparing for an exit?
1. Your business probably isn’t worth what you think it is – at least not right now.
There’s a lot of confusion and misinformation on valuation.
Some cannabis business owners aren’t paying attention to anything that doesn’t create profit and mistakenly believe their company is valued at many multiples more than it really is, even if their business is in a disarray.
Three to four years ago, there were buyers willing to throw gobs of money at companies without a proven track record, but now investors have more options and are pickier.
2. Better preparation = better valuation.
Today’s buyers are offering significant amounts of cash for the right to buy a company once THC becomes legal at the federal level.
Don’t get left out in the cold because you didn’t take the time to position your company as an attractive target before legalization.
Often, business owners wait to engage their accountant or legal team until a letter of intent is signed, believing it’ll take just a few weeks to clean things up.
That assumption is not based on reality. You generally need at least six months to prepare for M&A.
Be honest and transparent with your attorney and accountant, and let them help you address your weak spots before your buyer gets in there.
If the buyer’s accountants and lawyers find the issues first, you will be in a very defensive posture, and sorely lacking in negotiating power.
3. Focus your preparation on the three P’s – people, paper and profits.
First, people.
You need a well prepared and engaged management team. Buyers are not just acquiring your company. They also want experienced people who can run the business.
Get your leadership team in the same boat and rowing in the same direction by structuring incentive plans that make M&A a win-win for everyone.
Second, paper. Namely, compliance and contracts.
Compliance is especially critical in the cannabis industry, where companies have to navigate a patchwork of local, state and national laws and regulations.
You also need signed contracts covering every aspect of your business. Not generic, outdated contracts downloaded off the internet.
Experienced cannabis attorneys will update contracts regularly based upon changes in laws or regulations and cases that are decided daily in the courts.
Third, profits.
This does not necessarily mean that you’re making money today. In fact, most of the top public companies in the cannabis industry are actually losing money.
However, they have valuations in the hundreds of millions, if not billions, because their products are No. 1 in their category or geographic area. Large public companies want to buy the leaders in their space.
4. Hire an accountant who understands cannabis.
That doesn’t mean an accountant who has one or two cannabis clients. Cannabis businesses face different, far more complex tax rules and much higher scrutiny.
They also have to pay a wider variety of local taxes, cultivation taxes, excise taxes and more.
These are very tedious taxes to administer – there are a lot of them, and they have to be filed monthly in contrast to your federal taxes, which you file once a year, and then you’re done!
In addition, cannabis tax rates and rules change constantly, and errors can materially affect a deal.
If you’ve been collecting taxes incorrectly for even just a few years, you could owe hundreds of thousands of dollars – a very unpleasant surprise when a buyer opens up your books.
5. Agree on an accounting approach.
Everything involving taxes is gray. There’s not a lot of black and white.
Because of that, you and your accountant should agree on how aggressive or conservative you want to be.
Some accountants will give you the tax return you want if you pay them enough money. And although that might sound good at the time, it can put your merger or acquisition in jeopardy later.
If your taxes are found to be done incorrectly under audit, the audit assessment could be so large that instead of closing a lucrative deal, you no longer have a buyer and you’re going out of business due to the size of the tax liability you’ve incurred.
The maxim “If you take shortcuts, you get cut short” is especially true for legal and accounting matters. Don’t be penny-wise and pound-foolish.
Even if your business is still at the $1 million mark, paying attention to the small stuff now will set you up for the big offer later.
Federal legalization is coming soon. Don’t let your window of opportunity to prepare now pass you by.
