The maturation of the cannabis sector is presenting an array of opportunities to private producers and retailers. Not only are regulatory restrictions on ownership, operation and sales easing in certain jurisdictions but larger and more sophisticated participants continue to enter the market with targeted strategies that will elevate the sector. While this is generally a positive development, business owners may nonetheless feel surprised and overwhelmed when an opportunity to sell their business arises. The sale of a business is often the catalyst for translating a business owner’s hard work into a concrete economic benefit, but there is stress and uncertainty associated with such a transaction.
To assist potential sellers to effectively respond to an offer, this article summarizes certain steps and matters that every potential seller should consider both before and after receipt of an offer, including:
- Pre-sale preparation: Whether their company is saleable, specifically that it is properly organized and that its accounts and records are properly maintained and available for review by a potential purchaser.
- Receiving an offer: Whether they have received a binding offer and to understand what is included in the offer.
- Assessing the buyer: The specifics of the buyer, including the buyer’s reputation.
- Valuation metrics and compensation mechanisms: How contractual mechanisms such as earn-outs and other purchase price adjustments can assist them in achieving their objectives, including maximizing the purchase price for their business.
- Transaction structure: the proposed structure of the transaction and the associated implications, benefits and drawbacks.
As a preliminary measure, and prior to taking steps to solicit or encourage offers, sellers should ensure that their business is in order. This includes taking steps to properly maintain their books and records, and appropriately document those aspects of their business that are necessary for their operations. Failure to do so could lead a potential buyer to abandon a transaction during the due diligence review process or to renegotiate the terms of a transaction, including the purchase price.
Indeed, either before making an initial offer or as a condition to completing a transaction, most buyers will conduct a due diligence review of a seller’s business. This process involves a detailed review of the business’s records to identify potential issues and confirm various items, including the ownership of the business and its obligations and liabilities. For companies in the cannabis industry, due diligence will likely also involve verifying that the business has complied with the regulatory obligations and conditions associated with its license. In many cases, the license may represent one of the business’s most valuable assets and non-compliance could lead to the revocation of the license.
In addition, due diligence may also involve a review of the business’s material contracts to assess how these contracts will operate following a transaction. For example, many commercial lease contracts include what’s known as a “change of control” clause (i.e. a clause addressing the impact on the agreement from a change in ownership or control of a party to the agreement), which may provide the landlord with the opportunity to increase rent or terminate the lease. If a buyer intends to take over a business’s existing location, the buyer will likely review the lease to ensure it is able to do so, or seek pre-approval from the landlord in the face of a change of control clause.
To address these issues, sellers should take steps to ensure their business is sale ready, including:
- Having their legal and financial advisors conduct a review of the company’s minute books and accounts to address any deficiencies.
- Ensuring their capitalization table and all associated records are up to date.
- Converting handshake agreements, including distribution, marketing, consulting and employment agreements, into documented contracts.
- Carefully considering change of control and assignment provisions included in new agreements to create flexibility.
- Confirming that the business is in compliance with all regulatory requirements and obligations.
In addition to these simple preparatory steps, business owners that are actively seeking an exit may wish to conduct a comprehensive review of their business and tax planning strategy. This will allow the seller to structure their business in a manner that is not only appealing to a purchaser but also provides the seller with the best possible tax benefits from an exit.
Receiving an offer
When a business owner receives an offer or indication of interest from a potential buyer they should take time to carefully assess the opportunity, as a sale will require significant time and energy.
First and foremost, a potential seller should assess whether they are truly interested in selling their business and, if so, what they want to achieve from the sale (e.g. beyond purchase price, whether there are there any “must haves” or “deal breakers” that the seller has in mind). If a business owner is interested pursuing a sale, and assuming an offer has been received, they must then consider the offer in its entirety and truly understand what they are giving and what they are getting. To assist with this exercise, a seller should always request that an offer be put in writing. While they will not be definitive, written offers will set out the business terms and high points of what a potential buyer is offering; the price, key conditions to closing and expectations regarding the future involvement of the seller (e.g. non-competition and non-solicitation covenants, employment offers, etc.). Offers, as opposed to definitive documents, are typically non-binding and are the first, rather than the final, step in negotiating a transaction. As such, potential sellers need to be aware that until definitive or binding agreements are entered into, the terms of a transaction are not finalized and remain subject to negotiation.
Accordingly, before determining whether or not to proceed with an offer, and expending time and energy, sellers are encouraged to seek legal and financial advice to help them assess the merits and risks of an offer.
Assessing the buyer
Sellers need to know much more about a prospective buyer than the price they are willing to pay and are often benefited from conducting sell-side due diligence. A seller’s diligence should address and explore possible issues that can arise in respect of the buyer and events that could result in a buyer failing to proceed with a transaction.
Assessing how serious a buyer is about their offer is an important early step in any transaction. A serious offer will generally come from an established entity and provide a level of specificity surrounding what the buyer is seeking and willing to provide, beyond simply proposing a purchase price. Once a serious offer has been received, or once a seller has begun to engage in discussions with a potential buyer, an important next step for the seller should be to research the buyer. Information about a buyer’s past operations, history of prior transactions and key management team can be very helpful in a decision to move forward.
Some buyers may have a tendency of making offers but not closing transactions, they can rely on conditions included in their offers to explore a variety of opportunities while only intending to proceed with one or two. Understanding a buyer’s past behavior and patterns may shed light on how they will act once they make an offer and during the negotiation.1
Further, it is important that sellers find out how a prospective buyer intends to finance the transaction. Understanding whether a buyer has its own capital or is seeking external financing is significant in determining the likelihood of the transaction closing.2 Knowing the source of financing can also provide sellers with valuable information about the buyer and their negotiating tactics, including whether there are items that the financer requires.
Sell-side diligence is especially important where the parties have agreed to the deferral of portions of the purchase price, including through earn-outs, purchase price adjustments or equity participation. Prudent sellers will conduct comprehensive diligence on the buyer, as the value they will receive for the sale of their business is intrinsically tied to the buyer’s operations. While this process will potentially be more expensive for sellers, they will receive the benefit of greater certainty that any deferred compensation will retain its value and be paid in accordance with the agreed upon terms.
Valuation metrics and compensation mechanisms
Generally, the quickest and easiest approach for payment when selling a business is for the buyer to make a one-time cash payment to the seller on closing. This approach is typically adopted where the valuation of a business is relatively simple and the buyer and the seller agree on the value of the business.
However, given the emerging nature and volatility of the cannabis industry, buyers and sellers of cannabis businesses may disagree on a business’s value. Valuation in this space is relatively new and complex, evolving rapidly and often involves a high degree of speculation.3 To bridge the gap between any disagreement as to valuation, buyers and sellers may wish to consider alternatives to one-time cash payments on closing, such as earn-outs and post-closing price adjustments.
An earn-out is an agreed amount payable to the seller after the transaction closes that is based on the achievement of certain operational targets or milestones, such as revenue.4 Similarly, a post-closing price adjustment is an agreed amount payable that is based on certain established financial targets such as working capital.5 In short, earn-outs and post-closing price adjustments are a means of deferring the question of what a business is worth at the time of sale. The downside of these alternatives and other deferral mechanisms (such as equity participation) is that sellers are required to be more aware of, and often involved in, how the business will be run following the sale. This often leads to the negotiation and implementation of an agreement between the buyer and the seller setting out certain restrictions, controls, acceleration events and approval rights in respect of the operation of the business following the sale to ensure that the buyer cannot reduce the amount payable to the seller.
By considering alternative compensation mechanisms, buyers and sellers can be better equipped to negotiate the terms of a transaction acceptable to both parties. Sellers should be aware that earn-outs, post-closing price adjustments and other deferral mechanisms are complex and must be carefully evaluated, negotiated and documented to ensure that the targets and effective periods to perform any calculations are properly set forth in the transaction documentation, together with appropriate exclusions, protections and dispute resolution mechanisms.
When presented with an offer, sellers should also evaluate the proposed structure of the transaction and the implications, benefits and drawbacks to the seller. Three potential structures to consider are:
In a share transaction, a buyer generally acquires all of the business’s securities. Along with the securities, all rights, benefits and liabilities of the business remain with the business, including the business’s contracts, permits and licenses. Sellers of private Canadian companies often prefer share transactions over asset transactions because of the potential beneficial tax treatment and clean exit.6 From a seller’s perspective, a share transaction is highly beneficial as all of the business’s liabilities are retained by the business and become the indirect obligation of the buyer. Share transactions can also be desirable for buyers because they may pose minimal disruption of the business and may negate the need to obtain third-party consents. Share transactions may also offer benefits to buyers of cannabis companies from a regulatory perspective as it may become easier for existing market participants to transfer operating businesses, together with licenses, to new market participants by way of a share transfer, as regulatory frameworks governing the cannabis industry continue to develop.
In an asset transaction, the buyer is able to selectively purchase specific assets of the seller. The buyer does not acquire the seller entity itself and is afforded the opportunity to pick and choose what assets will be transferred and what liabilities will be assumed. An asset transaction provides the buyer with more certainty with respect to what is being purchased and the opportunity to leave some of the less advantageous aspects of the business behind.
Unlike a share transaction, the contractual arrangements entered into by the existing business will not automatically be retained by the business. Instead, the seller and the buyer will be required to identify key agreements to the business and to assign those agreements to the buyer. Indeed, buyers will often expect landlords, key suppliers, key customers and secured parties to consent to the assignment of their contractual relationship. Unfortunately, this process can provide counterparties with the opportunity to refuse (or condition) their consent or renegotiate the underlying arrangements.
An asset purchase may also result in disadvantageous tax consequences to the seller. For example, certain assets might be subject to recapture, which is fully included in the seller’s income. On the other hand, buyers often prefer asset transactions because they do not automatically assume all of the seller’s liabilities and receive beneficial tax treatment with respect to the actual assets. In Canada, when depreciable capital property such as equipment is sold, proceeds are allocated towards assets, which can give rise to future capital cost allowance and cumulative eligible capital deductions.7 On the other hand, asset transactions do not generally afford buyers with any regulatory benefit as a buyer will often need its own licenses in order to operate a cannabis company, posing a potential complication for new market participants.
In the Canadian cannabis space, regulatory restrictions on the transfer of licenses and authorizations may impact the way a transaction is structured. For instance, one creative structure used to address regulatory restrictions involves the use of franchises to enable a single brand to retail cannabis through an existing retail license holder. Pursuant to law in the Canadian province of Ontario law, a corporation is ineligible for a Retail Operator License if a licensed producer owns or controls more than 25 percent of the corporation.8 However, franchises are independent businesses that license a brand rather than transferring control. Because the franchisor does not generally own or control the franchise, the regulation does not preclude a franchisee from obtaining a Retail Operator License on the basis that its franchisor is a licensed producer of cannabis.9 Therefore, by employing this structure, cannabis can be both produced and retailed under the same brand, and profit from the sales can be passed back to the franchisor through royalties.
Each of the above structures has potential benefits and drawbacks and will be the subject of negotiation between the buyer and seller. An additional point for negotiation, relevant to any emerging industry, is the ability of the buyer to terminate the agreement in the event of market developments. The cannabis industry is largely speculative, as both shareholders and companies themselves are speculating on future yields and capacity, product demand, and even how safe products are for public consumption. Furthermore, even slight underperformance can cause investors and the market to lose confidence in a company or the industry as a whole. Unsurprisingly, buyers may (and have) tried to back out of transactions in market downturns, so accounting for such circumstances in the negotiated agreement should be of significant importance to sellers.
M&A activity in the cannabis sector is experiencing exponential growth as the industry continues to mature; however, as with many business opportunities, timing is a key factor in the success of any transaction. New participants in the cannabis sector are now looking for opportunities to accelerate their entrance into the market, and one of the most common mechanisms for acceleration is to acquire an existing operation. As a result, business owners who are interested in or tempted to explore opportunities to sell their businesses will benefit from considering the matters and steps raised above. In addition, such efforts will also help with the day-to-day operation of a business and provide owners with the opportunity to analyze and reflect on what aspects of their business are most in need of adjustment and improvement.
With a special thank you to Brandon Schupp and Tegan Raco, both articling students in Toronto, who helped to write this article.