We have begun to see an increase in consolidation throughout the Oregon marijuana industry. Large companies from other states are moving in, and Oregon companies are buying each other’s assets or stock and integrating to form verticals. In business parlance, we have entered the scaling portion of the inevitable consolidation curve.
Cannabis Company Acquisition
Generally speaking, there are three primary structures that acquisitions follow: (1) stock purchase; (2) asset purchase; and (3) merger. Each comes with a raft of legal and tax implications, and each is discussed very briefly below:
Stock purchases tend to be favored by sellers. In these transactions, the buyer purchases some or all of the seller’s shares (or, in the case of an LLC, its units or membership interests). Sometimes, a buyer will purchase only a majority of the shares, and later force a sale of the remaining shares by statutory short-form merger, or simply as permitted under internal company documents. Unlike a buyer in an asset sale, a buyer of stock is purchasing the target company’s assets and liabilities.
Asset purchase agreements tend to be favored by buyers. Under an asset purchase agreement, the buyer purchases the seller’s assets and assumes no liabilities, unless the parties agree otherwise. Assets can be both tangible (e.g., inventory and equipment) and intangible (e.g., intellectual property and goodwill), but generally do not include cash. Unlike with a stock purchase, an asset purchase allows the buyer to “step up” the company’s depreciable basis in its assets, within IRS guidelines. From a taxation perspective, that can be crucial.
In a merger, two entities combine to form one upon the issuance of a “certificate of merger” by the State of Oregon. The surviving company (purchaser) assumes all liabilities and receives all assets of the disappearing company (seller). We have seen fewer mergers in the cannabis space than stock purchases or asset purchases; the exception would be “downstream” mergers where the holding company absorbs its wholly owned subsidiary.
Before a transaction can be consummated, but after discussions have commenced, the purchasing entity will typically discuss its plans with counsel. The attorney will then draft a term sheet or a letter of intent, to present to the target company. Once the parties have negotiated and executed that foundational document, the purchaser will be ready to undertake the time and expense of performing due diligence on the seller and any related parties.
If the due diligence checks out, the purchaser may form a wholly-owned subsidiary to purchase the target business and to further insulate itself from the liabilities of the purchased entity. In Oregon cannabis, there are also critical state licensing strictures related to consolidation. Those conversations are important to facilitate early on: in this way, the purchaser will not find itself sitting on unproductive assets after putting a bow on the transaction.
Acquisitions can be an intense process, and the blizzard of documents and disclosures can feel dizzying at times. Ultimately, though, these transactions tend to be memorable experiences for clients and attorneys alike. And in certain instances, an acquisition is crucial for a company to achieve its ultimate goals.
Cannabis Acquisition Term Sheet
Term sheets take many forms, but in a basic sense, a term sheet describes the terms of the acquisition at hand. Because each transaction is a snowflake, each term sheet is also unique and must be carefully considered and prepared. Sometimes, the parties will skip the term sheet and simply proceed to the transaction in an attempt at “efficiency.” We strongly advise against this: it invites a substantial risk of misunderstanding as to which documents will follow, and when, and may even cause confusion as to deal points themselves.
The basic list of items for inclusion in any term sheet for an Oregon cannabis company acquisition
Binding vs. non-binding provisions
As a general concept, a well-written term sheet will be organized by binding and non-binding provisions. The binding provisions will include items like non-disclosure, exclusivity, jurisdiction, and choice of law. The non-binding provisions will include the unique deal point items, such as purchase price, payment terms and collateral agreements (e.g. consulting agreement, non-compete, lease or land sale contract, etc.). When a non-binding provision is misplaced into the “binding” category or vice versa, both buyer and seller can expose themselves to serious legal risk.
Nature of acquisition
The term sheet should clearly lay out whether the transaction is an asset sale, stock sale, or merger, and whether the purchase price will be paid via cash, debt, equity swap, or another method. This portion of the document should also detail whether the buyer will proceed in its own name, or through a newly created entity.
In nearly all acquisitions, the purchaser will assume certain liabilities of the seller. These liabilities may include everything under the sun related to the seller, or liabilities may be limited to select items, like assignable contracts. If specific liabilities are known at term sheet preparation, they should be listed, perhaps on a separate schedule.
Limitations on both seller and buyer liability can be a heavily negotiated portion of any term sheet. The term sheet should deal with any potential claim that may arise out of the parties’ pending agreements. It should also address claims existing prior to the transaction, the possibility of breaches of representations and warranties, issues of title to assets, tax obligations, employee benefits, claims arising out of marijuana’s status as a controlled substance, etc.
Every term sheet should deal with the seller’s employees. Will they stay, or will the seller be required to fire them? What happens with regular employees versus executives? When can employees be apprised of the transaction? Failure to address employment can cause serious headaches for both parties.
Conditions to closing (contingencies)
This list may be long and varied, and include items from the acquisition of third-party financing, to approvals by the shareholders and/or directors of the purchasing and selling entity. The satisfactory completion of due diligence by the parties is always a crucial item, and in the cannabis context, licensing (see below) is a critical issue.
Like other adult-use states, Oregon requires its cannabis companies to maintain state licensure. In certain areas, a local license may also be required. The administrative protocol for changes in license ownership can be complex and time-consuming and may take on a unique character, depending on the type of acquisition. The licensing update or transfer protocol must be carefully thought through and delineated in the term sheet.
If you made it this far, congratulations; but please note that the above list is not at all exhaustive. There are many nuances to a letter of intent or term sheet beyond the deal points highlighted here. Once a term sheet is negotiated and signed, the parties can move into the formal due diligence phase mentioned above, and ultimately, to closing.
If you are the type of person who enjoys sifting through large stacks of files and correspondence, or more likely, wandering around online in a virtual data room, you will love due diligence. If you are not that type of person, well, you get to do it anyway. The good news is that a corporate cannabis lawyer skilled in acquisitions can start things off with a comprehensive due diligence checklist, and begin looking under rocks on your behalf. Note that the form of the checklist provided will vary, depending on whether the acquisition of the cannabis company is an asset purchase agreement, stock sale, merger, or another form of agreement.
Because due diligence occurs after a term sheet is executed, but before an acquisition is final, the due diligence period is the parties’ last big chance to walk away from a deal. On several occasions over the past few years, we have spotted show-stopping issues during the due diligence period, on either side of a transaction. If the issues cannot be fixed, these deals tend to die. Other times, the due diligence period will turn up nothing remarkable at all. And that is what you want because in the world of due diligence, turning over rocks and finding nothing is progress.
Five crucial items to look for during the diligence period
Funky financial statements
Oregon cannabis companies tend to be new companies, and businesses with three or four years worth of financial statements, or even tax returns, are almost unheard of. Many cannabis companies stuff their skinny financial statements with unreasonable assumptions, underestimates of working capital requirements, misleading margins, etc. If you are not comfortable auditing this type of information, enlist someone who is, and do not be afraid to ask lots of questions as you attempt to read the tea leaves.
In an ordinary business transaction, a purchaser will be very interested in the target’s intellectual property. In the Oregon cannabis trade, brand power is important, but formally registered IP is less common than in other businesses, given the nature of federal law. That said, do not overlook: trade secrets (particularly for cultivators and processors), state trademark filings, and licensing agreements, to start.
Sales and Clients
Before investing in or purchasing a marijuana producer, processor, or wholesale business, a buyer should understand who its top 5 or 10 clients are, whether these clients (who are usually other Oregon cannabis businesses) are loyal to the company, whether their operations will cause fluctuations in company revenues (common with producer clients, for example), and other factors. This means that in addition to doing diligence on the target company, it’s worth looking into the target company’s clients, at least in a cursory way.
Like most businesses, a cannabis business will be party to numerous material contracts; and if the target business has no contracts for review, RUN. Types of contracts worth a close look include: customer and supplier contracts, equipment leases, real estate leases and purchase agreements, employment agreements, loans and credit agreements, and non-competes. Internal company contracts are also key, beginning with charter documents like shareholder and operating agreements.
As a part of any large or mid-sized acquisition, the target company will prepare a disclosure schedule addressing due diligence items, and identifying any exceptions to the representations and warranties requested by the buyer. If you are a target company, this will be the most important and laborious portion of the sale: so, it’s wise to start early, involve key employees and work with an attorney. If you are the buyer, this is the document you will cross-check against everything requested in your due diligence checklist.