Follow the Money

Warren Buffett once famously said, “When the tide goes out, you see who’s been swimming naked.” The Oracle of Omaha offered this sage bit of wisdom in reference to companies’ ability to survive in lean times. In cannabis, the tide went out very quickly, leaving many founders blushing through a combination of hubris, inexperience, and the misguided notion that abundant liquidity was going to last forever.

“I have spent ten years in the cannabis industry, and this is the most challenging environment I have seen for raising capital,” said David Kram, a seasoned finance and capital markets executive and founder of Springfield Capital, a boutique investment management and advisory firm. “With most publicly traded cannabis companies down more than 80 percent from their highs a couple years ago and a market that appears to be in a recession, things aren’t looking good.”

Over the past two years, the industry has been plagued by a lack of growth capital and dashed hopes of changes to the rules restricting banking. The dearth of venture capital and the high cost or inaccessibility of debt financing for the vast majority of operators have created a darkening horizon across the industry as businesses burn money with no path toward profitability.

“The industry is facing major headwinds at the moment, which has made external capital scarce and expensive,” said Mitchell Osak, a Canadian consumer-packaged-goods consultant who has advised more than 200 cannabis companies globally. Osak believes rising interest rates, equity market pullbacks, and scandals like the FTX cryptocurrency exchange collapse have spooked seed investors about early-stage companies and emerging asset classes. This has exacerbated an already arduous fundraising environment.

According to Steven Ernest, vice president at cannabis lender Chicago Atlantic, the runaway inflationary environment and limited action by the federal government have made the industry appear too risky for some investors, particularly given Democrats’ failure to push through the Secure and Fair Enforcement (SAFE Banking) Act during their final days in control of the House of Representatives. “Cannabis is unique in the respect that this inflation did not benefit revenue as the industry continues to commoditize,” said Ernest. “This unfortunate confluence of macroeconomic events led to rapidly dissipating profitability.”

The result is less capital being invested as the overall financial fundamentals of companies and the general industry outlook appear worse than ever before. But for those with the capital and scale to survive, this is a good time to be conducting mergers and acquisitions. “The flip side of this is that acquisition pricing has declined by more than the cost of capital has increased,” Ernest said.

The outlook at the company level remains undoubtedly bleak, but Rob Sechrist, president of cannabis lending firm Pelorus Equity Group, believes the overall industry outlook remains optimistic—though this is clouded by a tendency for people to peg the performance of the entire industry on the valuation of the limited, low-volume public stock. “There are still tremendous tailwinds in this industry, with revenue reaching $27 billion in 2022 and sales in 2023 projected to exceed $30 billion,” he said. “Whether a publicly traded company’s market cap goes up or down or [the company] even goes out of business, people continue to buy cannabis. There will be new winners picking up market share, and the companies that mismanaged their expectations and operated like they could continue pulling equity forever are in trouble.”

With economists forecasting another challenging year ahead and cannabis companies of all stripes frantically searching for capital to survive, we assessed the fundraising landscape and tried to find some opportunities to raise money within the doom and gloom.

Venture capital

Anyone who has been trying to fundraise for a cannabis startup in the past twelve months knows there is virtually no money available, particularly for new investments.

According to Crunchbase, only $300 million had been raised by mid-2022. In its January 4, 2023, report, Viridian Capital Advisors, which tracks cannabis deals, noted total equity issuance was off 75 percent and total debt issuance was down 53.1 percent for the year. Sammi Tourish, vice president of investments and investor relations for Arcadian Capital, said not a single equity deal of more than $25 million took place in the industry in 2022.

“The general sentiment is that many of the venture capitalists are taking hard looks at their portfolios and doubling down on those companies where they think they still have an opportunity for a liquidity event,” said Springfield Capital’s Kram. “Cannabis is a nascent and fast-growing industry. It’s difficult to take swings at companies when you are dealing with limited information about a market.”

After raising money for their original funds in more optimistic days, venture groups largely are sitting idle at the moment, using what capital they have to support existing investments as opposed to placing bets on new entities. “If you’re a new brand or company, raising money from this industry is extremely difficult,” said Roie Edery, founder of direct-to-consumer platform Ginger and infused spray Click. “It’s expensive and margin-erosive to play in competitive markets like California, and a lot of companies have been chasing topline revenue no matter the cost. The problem is, when the VC [venture capital] money dries up like it has now, the party’s over.”

There is an argument that low capital cost, outlandish projections, and optimistic valuations in the industry’s early days contributed to today’s challenges. Many companies that were able to raise considerable capital have failed to meet expectations or disappeared entirely, calling into question the wisdom of the gatekeepers of the industry’s much-needed growth capital. “I think the VCs are under a lot of pressure right now to lock in returns in an environment where [mergers and acquisition] deals are drying up, cash already has dried up, and the public markets essentially are closed off for new cannabis offerings,” said Kram. “In this environment, it’s especially hard for VCs, because they almost have to manufacture [mergers and acquisitions] within their portfolio in order to generate enough liquidity.”

Kram pointed out that, as in the music industry, it takes only one or two winners per fund to return capital to investors and post strong performance. But as long as VCs continue to struggle to find investors themselves, they will be sitting mostly on the sidelines.

The venture landscape inevitably will improve with time, but how many of the current crop of cannabis VCs will be around to participate in future booms remains to be seen. The sage advice we repeatedly heard? Reach out to VCs that fit your company’s profile, arrange opportunities to pitch, but don’t get your hopes up.

Equity crowdfunding

A growing number of companies both inside and outside the industry are starting to take advantage of a new-ish fundraising opportunity called equity crowdfunding.

Sometimes referred to as “crowd investing” or Regulation A+, equity crowdfunding allows companies to raise funds from retail investors keen to get in at the seed or pre-initial-public-offering stage. The fundraising method involves offering a company’s securities to a wide pool of potential investors via a platform like SeedInvest, Wefunder, or Republic in exchange for capital. Members of the general public may invest as little as $100 to buy equity or convertible debt in early-stage companies, an opportunity that otherwise would be available only to a founder’s friends and family or accredited investors plugged into angel opportunities.

“Equity crowdfunding enables early-stage companies to have their funding cake and eat it too,” said Osak, who has helped cannabis companies strategize crowdfunding campaigns. “It allows firms to tap millions of social-media-powered retail investors, many of whom consume cannabis, invest on Robinhood, and previously have not had access to early-stage cannabis investments.”

The benefits to fledgling companies are numerous. Not only can entities tap a far broader range of investors for smaller dollar amounts at high valuations, but they also can build a significant customer base of people who are invested in the success of their products, making them devout advocates for the brand.

“Equity crowdfunding is a low-cost, high-impact way for a small firm to build their awareness, community, and new product buzz while also driving sales and channel distribution,” said Osak. “It has been proven in a variety of sectors like consumer goods and tech. Why wouldn’t it be successful in a sexy and medically beneficial sector like cannabis?”

Among the more high-profile or successful companies that have crowdfunded are High Times, Click, and California beverage brand Uncle Arnie’s, which recently launched a campaign to raise $1.2 million at a $20-million pre-campaign valuation.

According to Uncle Arnie’s co-founder and vice president of sales Ave Miller, raising money while turning customers into impassioned shareholders was a key selling point of equity crowdfunding. “We wanted everyone to have the chance to own a piece of Uncle Arnie’s. This is the dream,” he said. “Uncle Arnie’s is a brand for the consumer. With the community’s help, we’ll be able to reach our national growth goals.”

By January 2—technically still pre-launch—Uncle Arnie’s had raised $200,000 from $1,010 minimum investments on SeedInvest. Miller said the funds came from a combination of the platform’s built-in network, the brand’s existing audience, and “a lot of budtenders, buyers, and the general public. We haven’t even started marketing the campaign yet.”

Infused spray brand Click ran a campaign on SeedInvest in early 2022, raising $820,000 in sixty days. Like many other brands last year, Click encountered issues raising money from VCs and was attracted to the idea of turning to retail investors, whose only exposure to the industry was investing in public multistate operators on the Canadian exchanges. “Cannabis has arrived at the point where you can talk about the benefits of your products to people all over the country and court their willingness to write a check,” said co-founder Edery. “We had been pitching the same old VCs just like all the other cannabis brands had, but through equity crowdfunding, we could bring a unique story to a grandma in Kentucky who could get excited about a cannabis spray that helps you sleep, and she could then invest $500 in our company.”

Edery considers the campaign a success but added his team had to do a lot of heavy lifting. “It’s definitely not a case of getting the platform to list you and then the money just starts flowing in,” he said. “You need to invest in marketing, build your landing pages, expand your email list, et cetera.”

Equity crowdfunding isn’t without its detractors. “It was rife with fraud in the early days,” said Kram. “There have been numerous cannabis companies that have launched and run successful Reg A+ offerings, but not all of them were transparent or even followed through with what they said they were going to do with the money.” He added the sentiment toward equity crowdfunding is becoming more positive, and more quality companies are opting to supplement their traditional fundraising efforts or completely replace them with the method.

To ensure a successful campaign, companies must get their data room in order, carefully pick the platform, and be realistic about the upfront marketing investment. But when capital is as scarce as it is right now, why not try pitching to a big pool of small-dollar investors in parallel with a traditional fundraising round, particularly when negative sentiment hasn’t poisoned the average person’s perception of the industry’s potential?

“Small retail investors and consumers still see considerable upside in the cannabis industry, both in North America and around the globe,” said Osak. “And for high-growth firms, cash—from anywhere—is king.”

Angel investors

Angel investors have played a key role in the developmental stages of businesses across the economy, and cannabis is no different. Today, they present a good opportunity to tap fresh, untarnished funds from those inclined to look at the bigger picture around the industry’s long-term potential.

An angel typically is an accredited investor (defined by the U.S. Securities and Exchange Commission as someone with a net worth of $1 million or more in assets, or someone who has earned $200,000 per year for the previous two years) who participates primarily in the early rounds of a startup. The investments often will range from $25,000 to $500,000 and are considered to be high-risk, as angels often bet on companies with a limited track record but high potential for future upside.

Angel investing has become increasingly common over the past twenty years as the tech boom generated enormous wealth for savvy investors who bet early on the next big thing. Stories of startup savants like Peter Thiel cutting a young Mark Zuckerberg a $500,000 check for a 10-percent stake in Facebook in 2004 continue to ignite the imaginations of bold investors. When you’re courting angel capital, selling a big dream of a “disruptive” company in the making is part of the dance. The bigger and bolder the better.

While “go find some rich people” isn’t exactly the most constructive or sophisticated advice, it’s essentially the first step in the path toward securing angel investment. If you have high-net-worth individuals in your network who are interested in alternative investments like early-stage companies, get your pitch deck in order and invite them out to coffee. Investment vehicles like simple agreement for future equity (SAFE) notes, an elementary form of convertible debt created by startup incubator Y Combinator, are becoming increasingly popular for angel investment in the early rounds, so have a copy of your note ready to send to interested parties along with your data room.

There are a number of angel investing groups and syndicates around the country fielding pitches from founders, and some quick Google searching will pull up lists and contact information. That being said, very few of these groups are interested in plant-touching companies at the moment, so be prepared for a fair amount of rejection.

One cannabis-specific investment event is hosted by The Arcview Group, which has been running Shark Tank-style pitch events for the industry since 2010. The group pairs accredited investors and money managers with early-stage brands and companies looking to raise capital and in twelve years has facilitated more than $600 million in funding.

“We hand-pick attendees, speakers, panelists, and companies from across every vertical in the industry,” said Joe Derr, national director of business development. “If you go to a typical industry event, you often find yourself speaking with twenty people who do the same thing you do. We strive to bring the best of the best. We do our due diligence, look at their investor decks, and really get into the details. The standards for participation at an Arcview event are very high.”

Arcview boasts a strong attendance of “decision-makers and board members,” Derr said. Companies that have participated successfully in the past include Eaze, MedMen, and 4Front Ventures.

Arcview focuses on bringing new angel investors, VCs, and family offices to the table, acknowledging most existing cannabis investors are “either underwater or they’ve been burned by some less-than-excellent operators.”

Debt

The final path toward raising money is debt. While debt financing has been rising steadily in the industry, it isn’t viable for all companies. To be a good candidate for taking on debt, a company needs to have hard assets—like real estate or valuable licenses—and a track record of generating cash flow. This rules out the vast majority of startups.

“Debt increasingly has become the top choice for capital deployment in cannabis,” said Ernest, whose role with Chicago Atlantic involves sourcing and executing due diligence on new opportunities for the firm. “This is largely the result of collapsing equity markets leaving venture capital and private equity with very poor track records raising additional capital.”

Ernest explained private companies need to offer downside protection to compete for limited dollars. “Lenders have tightened the reins on leverage as the macroeconomic situation has deteriorated,” he said. “At Chicago Atlantic, we look for a one- to two-times EBITDA-to-debt ratio, and that has dropped from two- to three-times [EBITDA] a year ago.” EBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization.

For startups, this pretty much takes debt financing off the table. According to Ernest, the fundamental difference between equity and debt is that equity looks at forward upside and debt looks at historical financials and hard assets to protect downside.

According to Sechrist, Pelorus Equity Group is open to working with any cannabis-related business, public or private, that owns commercial real estate, shows strong financials, and possesses ample experience and expertise in its sector. The firm’s “sweet spot” typically is offering loans ranging from $10 million to $30 million, but Pelorus will go as high as $100 million and as low as $5 million. “We’re most interested in lending to companies with a competitive edge, whether that means they offer unique, high-quality products, demonstrate operational excellence, or have a unique position within the markets where they operate,” said Sechrist. “But regardless, it’s imperative they really understand their own project, have the required equity raised to completely fund the project, and have all local approvals to begin construction.”

Profitability, or at the very least a demonstrable path toward it with solid cash flow, is essential, and Ernest believes this typically is found in vertically integrated multistate operators who are expanding into markets that have experienced less commoditization. “Delivery and standalone retail are largely unprofitable thanks to [Internal Revenue Code Section] 280E. Cultivation makes money in early years and loses money as markets commoditize,” he said. “Thus, it’s vertical integration that reigns supreme as the best candidate for lending.”

What those seeking funding should know

To be blunt, it’s a dire moment to start a cannabis business and a daunting time to be fundraising for an existing business, particularly if that business is bleeding money and in desperate need of a cash injection.

“A few years ago, you could be successful at raising money with a polished pitch deck with the word ‘cannabis’ written on it. Those days are long gone and never coming back,” said Springfield Capital’s Kram. “The bar is much higher today, with most investors looking for those who have extensive experience in the space, have a demonstrated history of running a lean, mean cannabis business, and are good stewards of other people’s money.”

Osak added today’s macroeconomic climate makes raising equity or debt financing difficult for any company, let alone cannabis companies, which continue to face investor stigma, federal illegality, and low or zero profitability. However, there is hope for well-run companies that can get their proverbial ducks in a row.

“Good cannabis firms do get funded,” Osak said, adding those companies tend to be profitable and have strong cash flows, good governance mechanisms in place, and some kind of sustainable advantage such as licenses in limited supply or desirable retail locations. “To attract equity or debt investment, I would make sure my business is investment-ready,” he said. “This includes putting my financial records and cap[italization] table in order, showing ambitious yet attainable profit and revenue-growth projections, and having a strong, committed management team in place.”

As for new founders—who face the tough, capital-intensive challenge of getting their business off the ground when institutional-investor sentiment has been tempered severely—Kram implored them to be modest and realistic.

“Raise just enough money to get you to your next milestone, whether that be a successful harvest, cash flows, or the launch of a brand,” he said. “Don’t get greedy. Be extremely honest with yourself and your prospective investors about your business. Understand your financials. Have a robust financial model to share. Be able to answer questions before they come up. Have a best-case, base-case, and worst-case scenario for raising capital.”