Mergers and Acquisitions 101: Cannabis Market Trends and What Consolidation Means for the Global Industry
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Mergers and Acquisitions 101: Cannabis Market Trends and What Consolidation Means for the Global Industry

Dan Nicholls, director of Capital Markets Advisory Services at ELLO, discusses the past year of high-profile acquisition deals and looks ahead to 2019.

December 6, 2018

The past 12 months have seen a surge in mergers and acquisitions across the global cannabis industry. Even as widespread legalization is only just beginning in certain corners of the world, significant market consolidation is under way.

To understand those trends—and to better grasp what’s sure to be an even more active M&A season in the coming months—Cannabis Business Times and Cannabis Dispensary turned to Dan Nicholls, director of Capital Markets Advisory Services at the MGO | ELLO Cannabis Alliance.

Eric Sandy: Could you place this growing trend of high-profile mergers acquisitions in the context of the broader cannabis industry? Is this wave of consolidation happening earlier than one might expect from a young market like this, or does this track with the rapid growth that the market is seeing in general?

Dan Nicholls: I think it's a mix of both. People that are in this industry have a good understanding that at some point in the near future, in the U.S., this will become a federally legal drug. And so, once that happens, you're going to see all the big investment funds, you're going to see all the big CPG companies and alcohol companies—[they’re] are all going to get into the space, and they're going to buy out the best, most established operators. So, for operators, it's just a race to build market share, to get ready for that day.

When we look at valuations and transactions, we're seeing that they're all based on revenue. In traditional M&A, for most industries, it's about EBITDA, for profit; that's how companies are valued. If you're doing $100 million in revenue, but you're losing $50 million, that business isn’t worth a lot. But in the cannabis industry, it is. Some of the biggest players in the space right now that have the highest valuations are losing significant amounts of money. And that's just because their focus is building market share. And the easiest way to do that is M&A.

Sandy: Hence the headlines this year.

Nicholls: You're seeing massive amounts of M&A over the last six months. It's pretty incredible to watch. And it's really just companies trying to scale up and build market share as fast as possible. The biggest trend we've seen is the multi-state, vertically integrated operators. Look at any other CPG product: Brands are national. So, having scale in 10-plus states is super crucial in this stage of the game. And so, yeah, we're definitely seeing a lot of M&A. We expect that to continue.

Sandy: Could you elaborate on that multi-state component? States regulate the industry differently, and how does that fit into this idea of multi-state acquisitions, especially considering the fact that a lot of these newer state markets are capping licenses?

Nicholls: Every state’s a little different. If you look at the license holders in Florida, a lot of them are worth billions, just having one license in one state. And that's just a reflection of the licensing structure there. Every state has a different structure. Most of the states on the East Coast have very limited licenses. And those licenses afford you the opportunity to launch multiple verticals and multiple stores—much more so than in California, where a license to do one thing is just that one thing. It’s all about supply and demand at the end of the day. Oregon, Washington, Colorado: Those are relatively smaller states, and they've had relatively liberal licensing policies. As a result, there's just an oversupply of licenses. And that, as a result, pushes prices down. There's less market share per license, and it pushes valuation down.

And, obviously, a lot of this is unknown, right? You don't know if certain states could have a change in the [statehouse] or the governor and decide that, ‘You know what? We want to make it a more liberal policy and issue more licenses.’ And if you have a license in Florida, and all of the sudden they change the laws and hand out hundreds of licenses in Florida, now your valuation will drop. But I think companies understand those risks.

A good example of those risks, just one that really shocked me, was Washington banning candies a couple weeks ago. I don't know if you saw that.

Sandy: That was certainly a surprise. (Update: The Washington State Liquor and Cannabis Board later reversed that decision and continues to allow cannabis candy production and sales.)

Nicholls: That's just a crucial shock. Any companies that specialized in that area are no longer viable businesses, unless they find a workaround or move to another state. That's just a good sign of the unknowns that come with this industry. And that applies to licensing too. New Jersey is a good example where, right now, that's the hot ticket. They accepted license [applications] a few months ago. They're expected to announce six license holders, and that's a huge state for only six licenses. But you don't know, in the subsequent rounds, how many more licenses they will issue. It’s a game, and no one really knows how each state is going to play out.

But I think the hope is that if you're one of those early adopters, and you build your name, you build your brand, your operations, even if they issue more licenses, you can also buy more licenses. If you're looking to do acquisitions in multiple states, you definitely need resources on your team—people who understand the licensing structures in those states, and that's what can make some of these multi-state deals very difficult.

Sandy: Getting into the due diligence required to determine the valuation of a company and possibly position a company for an acquisition—is that an active, leaning-in kind of process? Or is a company interested in ultimately being acquired meant to just sit back and wait to be approached by a larger company?

Nicholls: In traditional M&A, there are really two types of processes. There's a targeted process, where, if you have a couple parties in mind, you want to limit your search to just those parties. It's a shorter process, because there are these two names or these five names, [and] we're just going to target those. Ideally, you already have relationships with those parties, and that will help make the process smoother.

The alternative side is a broad auction process. And a lot of M&A deals in larger industries are done this way, where you'll hire an adviser, [and] they'll work with you to prepare the company to sell, which includes everything from building your financial model, assessing your valuation, performing due diligence—because you want to find the skeletons in the closet before a potential acquirer does—putting up a data room, going through all the steps that a buyer would, but doing it internally. The second phase is the marketing and outreach phase. And that's where, if you're doing a broad auction process, a lot of companies will reach out to everyone and anyone. When we used to do sell-side deals, we reached out to hundreds of potential buyers, and, obviously, 90-plus percent of them aren't going to be interested. But you start with a very wide net, and then you narrow it from there. You set up an auction process where there's an initial round of bidding, you collect the bids, you pick maybe the top five or 10 to go on to the next round of bidding, you provide them a little more information. It's a very structured process, and it takes more time. But if the goal is to extract the highest value possible, oftentimes a broad auction process is the best way to go.

I think next year will be probably a big year to see a lot of existing investment banks move into the space.

- Dan Nicholls

But it also depends on your motivation as a seller, right? Do you want to just cash out completely and have nothing to do with the business? Or do you still want to be involved in the business? Do you care about the employees? Do you want them to stay involved with the business? A lot of transactions like this, it's about understanding the motivations of the buyer and seller, and trying to find a structure that works for both parties. And oftentimes, for sellers, maybe that additional 10 percent of value isn't worth it if you can still have a stake in the business: Be on the board, or get an earn-out provision—benefits down the road, if this does become the next billion-dollar company. There are a lot of considerations. That's why cannabis is an interesting industry, because there's such a wide range of companies, but they're all technically startups. Even some of these billion-dollar companies, they're growing so quick. A lot of them will see their revenues double or triple or quadruple over the next few years. They’re still startups. And when it comes to buying startups, it’s a whole different can of worms.

Sandy: That startup point is a good backdrop to the whole conversation here. And in some ways, you always have state regulators in a sense sitting at the table with these companies. How do they fit into the transaction process? Is it just taken for granted that the license will be part of that deal, and the state will be OK with this?

Nicholls: I think it depends on the state, certainly. I think the understanding is that most states are fine with licenses transferring owners. Now it's understood. There are obviously different processes, depending on the state, and also just the transaction structure in general: You can either buy the stock—the equity, where you're buying the existing company—or you can buy the assets, where you're just buying the license, the brand name, and the IP and all that. So, the structure of the transaction matters, as well as the state.

At the local level, especially here in California, the local level is the harder license to get. One of my clients is really well-established in their local community. They've been there for decades. They worked with the City Council to put in place a licensing program; as a result, they got one of the licenses. And now, they just turned around and sold it. And they were concerned, ‘Well, you know, we built this long relationship with the city, selling them on our vision for this store and how it's going to look. We’ve built a good relationship with the city. And now, before the stores even open, we're selling it. That looks bad, right?’ They were afraid of some blowback from the city. So, as a result, the way they structured that transaction was that they're still going to be involved in the next two years. They're going to the city and saying, ‘Look, for us, it made the most sense to sell this off to another party. But we're still going to be involved in every step of the process. We're going to be on the board, we're going to be doing all the build-out, we're going to make sure everything adheres to all the codes and regulations that we had agreed on originally, just to give some comfort to the city.’

Sandy: Switching gears a little bit, as far as your company but also just firms, in general, that are facilitating these kinds of deals, are these very much cannabis-facing firms? Or are you seeing more and more just traditional M&A facilitation firms getting into the cannabis space?

Nicholls: I have not seen a lot of traditional firms getting into the space. From my contacts in the investment banking industry, I've seen a lot express interest. This year, there's been a handful of big deals. We're seeing more and more come along. I think a lot of those are being facilitated by either Canadian banks or a few of the smaller, middle-market firms that are getting into the space—but the vast majority still don't touch it.

A big part of that is they don't have experience in the space, right? If you’re a bank that has a 30-year history in health care, they're just not going to jump over to cannabis yet. The money's not there. I think next year will be probably a big year to see a lot of existing investment banks move into the space. But right now, there are not a lot. It’s definitely something we've seen, and we've had a lot of clients try to do it on their own, which can be a very, very difficult process. If you don't have any expanding experience in M&A, it is a it is not a fun process. I think a lot of people like to think M&A is sexy and fun, but it is a lot of work—structuring the deal, executing the deal, pricing the deal, negotiating the terms, as well as the integration.

Sandy: “Integration,” meaning the blending of internal procedures and structures?

Nicholls: I would say most acquisitions that fail, honestly fail because of the integration phase. It’s often overlooked. But it's not that easy. It does depend on what type of acquisition it is, right? If you're a California company, and you go buy an Ohio company, the Ohio company will more or less operate autonomously. There will obviously be some involvement with management, and maybe you take over their HR functions and their finance functions, but most of the operation itself will maintain autonomously. But for a lot of acquisitions, integration is everything, because you're merging two companies and companies have—you know, it's like a living being, right? You have the finance function, the IT function, the HR function, right? How are the employees compensated? Transitioning the employees over is a very difficult topic. Integration is something where it takes a lot of empathy as the acquirer: You really need to connect and understand the company and how it works. How can we structure this transaction successfully?

One of the most important things to do in M&A is identify the value drivers. So, if Company A is buying Company B, why are they doing the deal? It's good to identify three, four or five key reasons why they're doing the deal. Whether you want to bring the management team on board and you want them part of your team, or you just want the license or it’s a market share grab or it can help you lower your costs—there's a number of different reasons you can complete a deal. But, as the acquirer, it's really important to identify those value drivers.

And then on top of that, what are the risks behind those value drivers? What are the key risks that could eliminate any gains from the transaction, and then try your best to mitigate those risks. That’s kind of like M&A 101, and integration is such a crucial part of it. If you buy a company and you don't integrate it successfully, you can lose half its staff. Or if you don't do the due diligence behind the license, and you come to find out they're not properly licensed, well, you just kind of a whole bunch of money on something that isn't licensed.

Sandy: In terms of the integration part of this transaction and laying that plan out, to whom is that being communicated? Meaning: Is this a conversation between management teams? Or is this a conversation with the firm?

Nicholls: It’s members from both management teams. The acquirer, they select a few key individuals to oversee the transaction, and it's pretty much the M&A team, and they'll have weekly calls, they'll set a plan in place. Oftentimes, closing the deal in the integration phase can take three to four months. So, putting in place a timeline and goals that you have to make sure you hit: making sure there's proper communication between the acquirer and the target, and weekly calls and status updates to make sure everything is on track. If issues come up—not if, when issues come up—[make sure] that you have the right individuals in charge of those areas to assess and eliminate those risks.

One other thing I'll point out, and this is just really from my background in M&A that's really interesting to me, is almost all the deals I've seen in cannabis involve an earn-out provision, where a portion of the purchase price is paid out over time, based on meeting performance goals. And that's something that makes complete sense to using cannabis. Pretty much every deal I've seen has this, and that's because every company in this industry is growing substantially. So, their current valuation is based a lot on the future growth. And that future growth, there's a lot of significant unknowns with that. One of my clients right now that's raising capital, they have $50 million in revenue this year, projected to grow to $200 million next year. Their revenue may quadruple, so if they were to sell—they're not selling, they’re raising money—but if they were to sell, they want to be valued based on that future growth. But an acquirer—you know, there's a lot of uncertainty. What if they only hit $80 million next year? And they thought they're getting $200 million? So, earn-outs are a big part of these deals. I’ve seen a lot of deals, where half of the purchase price is paid out in the future based on meeting those goals. And that's actually a very good bridge to help eliminate any concerns between the acquirer and the target. As a target wants that value, the acquirer wants to mitigate risk that they don't achieve their goals. That’s a good way to bridge that gap.