Look Beyond the Valuation of a Cannabis Business to Create a Valuable Relationship

By Mathew Auric, Hoban Law Group

Many cannabis investors and companies seeking investments are looking to establish relationships with each other as strategic partners, not simply silent partners. A strong relationship between the two parties should be a top priority — if the parties aren’t willing to work towards this common objective, it is unlikely a good match. Using the process of raising or investing capital to develop strategic partnerships within the cannabis industry has added value since most companies are on a trajectory to grow, and many investors want to be more than just silent partners. It means that creative relationships can be developed so long as both sides are open to finding ways of maximizing the value of their potential relationship.

Whether you are an investor or a cannabis company looking to raise capital, taking the time to understand what is respectively valuable in the relationship is crucial to ensuring that it is successful. There are broad categories to be considered in the process, but ultimately what is valuable to a given individual or company is particular to the entity. Thus, though highly subjective, there are three broad categories to be considered in the process:

1) Financial Arrangements

Generally, people focus on the valuation. For instance, if the pre-money valuation is $9 million and the company is looking to raise $1 million, then the company is selling 10% of its equity. However, there are other financial arrangements which may be very important both to the investor and the company. For instance, an investor may be willing to accept a higher valuation if receiving a preferred return. Say, with a promise to pay $2 million of dividends to the $1 million investor before any other dividends are paid, the investor may be likelier to agree to a high valuation.

Terms regarding a preferred payback can become even more investor-favorable if the dividend payment becomes mandatory based on profit or revenue (e.g., the company will pay the $2 million preferred return using a minimum of 75% of the profits earned by the company). The more beneficial that the investor demands the preference to be, the likelier it is to hamper the company’s ability to grow, which in turn diminishes the equity investment. Ultimately, the company and the investor must strike a mutual balance. Often, such balance is found not only by using financial arrangements but also offset by using other aspects of the agreement.

Another aspect of financials to consider is how the money is to be used. That may overlap with control, but again the buckets are just broad categories. Allowing an investor to dictate how their investment will be used often reinforces their comfort. An investor needs some level of control to make them comfortable with the investment, yet too many restrictions on how money can be used may hamper the growth of the company to the detriment of both the company and the investor. Again, both parties need to establish a balance that works for them.

One of the touchiest subjects that can come up in an investment is how much of the money being invested will end up in the pockets of the founders. What is deemed fair in a given situation is highly dependent on the particulars. However, both the investor and the company should have clarity about what their intention is, and whether it is being fulfilled.

Other topics that frequently come up in this category are dilution protection, rights of first refusal in future investments, and salaries.

2) Control

Control is often an important issue. Will the investor have any control over the company? Is the company willing to seat the investor on its board? Does the investor want to participate? The topic is often fraught with disagreement. Placing oneself in the other’s shoes, finding what each finds fair, and then striking a balance often leads to the creation of more value than would any fight over control.

3) Ancillary Value

This is where you get to be creative. What is valuable to the partnership? It is in the formational big bucket that the strategic partnership can work together to find added value. In answering questions about value, people often look at what is valuable to “each side,” but the mentality is fundamentally mistaken if the goal is to establish a strategic partnership. A potential strategic partnership should be devised in terms of what will add value to the partnership as a whole, not just what is good for either side in the enterprise.

Ultimately, thought should be given to the terms surrounding an investment, not just the valuation. It is often easier to strike an agreement if the negotiations initially focus on pieces other than valuation, as such can add value for the strategic partnership (and both sides) rather than creating a zero-sum game.

Mathew Auric is Counsel to Hoban Law Group with extensive corporate and transactional experience, including corporate structuring, capital raises, acquisitions, and contract drafting.

This article has been prepared for informational and general guidance purposes only; it does not constitute legal or professional advice. You should not act upon the information contained herein without obtaining specific professional advice. No representation or warranty (express or implied) is made to the accuracy or completeness of the information contained in this publication. Hoban Law Group, its members, employees, and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based thereupon.