DNA Genetics, a global cannabis breeding brand based in California, has spent the past year working with Copperstate Farms in Arizona, honing chemovars that will soon be introduced to the state’s medical patient base.

Rez Khan, DNA’s vice president of global corporate development, says that the company’s licensing platform allows his team to provide proprietary genetics in return for a royalty on future sales. 

Copperstate Farms, which owns retail storefronts under the Sol Flower brand, fit the bill for what DNA seeks in prospective partners. Khan says that his team scouts other companies for their market penetration in a given state, conducting a business analysis on the management team and an operational analysis on the cultivation team and the facility itself. It’s part of a broad quality assurance and quality control protocol that DNA maintains in all partnerships. 

DNA Genetics

“We want to make sure that we’re at least internally setting up SOPs that we can stand by for products that are going to hit the market, so they’re not grown with stuff that we would never [use to] grow in our own gardens,” Khan says.

DNA co-founders Don Morris and Aaron Yarkoni traveled to Snowflake, Ariz., with three of their top cultivation experts to work in Copperstate’s 40-acre greenhouse.

Morris and Yarkoni oversaw the genetics selection from seed. Rather than starting with clones, this process allowed the DNA and Copperstate teams to stretch out a bit and really hone the phenotypes that would be most optimal for the genetics they were working with.

“The more space and time you have to do a genetics selection, you get better results because of the sheer numbers,” Khan says.

They cultivated a minimum of 1,000 plants per cultivar, paying close attention to different expressions that would yield the most productive, enticing profiles for Copperstate. DNA cultivars in this partnership include: Holy Grail, Skywalker Kush, Recon Kush, Citradol, Lemon OG, Kosher Dawg, 4 Prophets, 24K Gold and Tangie.

“The plant comes first,” Khan says. “Ultimately, the biology of the plant determines so much. You can’t just keep everything on the same stringent timelines or processes and not build in a margin of error or variability to account for the plant. So, when we started to actually get our hands dirty, get our boots on the ground, that’s when the fun part begins.”

Copperstate Farms CEO Pankaj Talwar echoed the sentiment in a public statement. “We are excited to debut these world-class and award-winning strains from DNA Genetics.  This has been a collaborative effort over 12 months’ time that involved starting with 12,000 seeds before narrowing this down to the exact genetics that deliver on the DNA brand as well as can function well in our greenhouse environment.”

Editor's note: This article was updated on 5/1/2020 at 1:50 p.m. A reference to an equity fund that targets distressed assets has been removed. The fund is not yet active.

The global COVID-19 pandemic and the ensuing stay-at-home orders have forced businesses to shutdown or drastically change their operations, distorted companies’ top and bottom lines, and shrunk the U.S. gross domestic product (GDP) by 4.8% in the first quarter of 2020. The U.S. GDP is expected to take an even bigger hit in the second quarter, as the Congressional Budget Office (CBO) projects the country’s economy will shrink another 35% by the end of June.

Now, experts say these market conditions might exacerbate a phenomenon that was already taking off in the cannabis industry prior to the coronavirus outbreak: vulture investing.

Vulture investment funds—investors that target “distressed assets” (companies that are near/at insolvency)—have been taking more interest in the cannabis industry, according to Hilary Bricken, attorney at Harris Bricken. These investors are “wheeler-dealer” types, she says, and take on more risk in exchange for a much larger stake in the company (in equity deals) or massive interest rates (in debt deals). They also generally attach more conditions to their investments, including taking ownership of the assets should the company continue to struggle (or, worse yet, after the company finds success).

“Their whole model is to go after these businesses that are hurting,” Bricken tells Cannabis Business Times, “and here in California, that is not going to be difficult to find because the industry was already suffering before coronavirus.”

Since January, she has seen a handful of new equity funds pop up that are targeted toward distressed assets. In a March 4 interview with CBT, Joe Caltabiano, former president of Cresco Labs, stated his interest in working with distressed assets after resigning from the company he helped launch

Since January, Bricken says, “very aggressive vulture investors and funds based around only debt buy-ups [have] come to me not for representation—they already have attorneys—but asking ‘Do you have deals? Do you have deals that you can bring to us? Do you know anyone that’s dying or hurting?’

“There has been an uptick, it’s not rampant, but it’s starting to become the finance vehicle of the year, and it’s probably not going to stop in the wake of the pandemic,” she adds.

The biggest effect the pandemic brings to the market, according to Canaccord Genuity analyst Bobby Burleson, “is the potential for other industries to start to compete with cannabis companies for access to capital.”

Burleson highlights how the cash crunch prior to the pandemic forced many investors to look at debt financing instead of equity financing in order to generate cash flow. With that cash crunch spreading across the economy thanks to the supply chain gridlock accompanying the COVID-19 outbreak, investors have more options to make similar returns in less volatile markets. “I think the types of rates that cannabis companies were paying for their debt, up in the teens interest in some cases, you might start to see debt investors have opportunities in other sectors where they can get really high rates simply because there’s going to be so much distress,” he says.

Burleson adds this will make it more difficult for cannabis companies to access capital when they might need it most. This sets the table perfectly in favor of vulture investors.

“Normally, a vulture investor is going to take a first position security interest and will align themselves up to be the number one creditor in the event of bankruptcy or liquidity if the business doesn’t turn around,” Bricken says.

It’s in the nature of vulture investors to take risks, but those risks are exponentially higher when dealing with cannabis companies, as bankruptcy is not an option for those federally illegal businesses. Combining current market conditions with a potential acquisition target’s poor performance means vulture investors generally will be setting the conditions to the deal with little to no room for negotiation.

“There’s definitely a buyer’s market today as opposed to a seller’s market where valuations were through the roof and there was just a lot of money being thrown at the industry,” says Hershel Gerson, CEO and Managing Director at the MGO | ELLO Cannabis Alliance, a professional services company offering financial, tax and advisory services to the cannabis market.

Hemp vs. Cannabis

Investors evaluate cannabis (meaning THC-rich) and hemp (meaning cannabis containing a maximum of 0.3% THC) companies differently for a variety of reasons: different federal statuses, access to national a market vs. locked in single-state markets, and available biomass all play into how analysts and investors look at each market. While the fundamentals of evaluation remain the same, Burleson says, these market forces (along with others such as state license caps) weigh heavily into company valuations and projections.

Despite hemp companies having access to federal bankruptcy (thanks to the 2018 Farm Bill legalizing the crop), Gerson believes THC companies in general are in a better position to negotiate with vulture investors compared to their low-THC counterparts. While sales remain steady—or have risen—for THC companies, “what we’re hearing in [the hemp] industry is that the demand is way behind the relative biomass and extraction capacity that is currently in the market,”  he says.

Another issue with the hemp/CBD side of the marketplace making it difficult for those companies to navigate debt or equity markets, according to Gerson, is CBD tinctures can be expensive: a 30 ml bottle of Premium Jane tincture with 1,000mg CBD retails for $124.00 on the company’s website, for example. “In a recession market, that discretionary spend isn’t there,” Gerson says.

Colin Kelley, operating partner at Merida Capital, a cannabis investment fund, puts the current situation for hemp companies a bit more bluntly. “Hemp and CBD companies are not only managing through the current COVID-19 environment, they are also navigating a national market where true commoditization is occurring,” Kelley says. “Capital will be difficult to acquire for companies that do not have a solid plan and a team who can execute.”

Attractive Assets

Different parts of the supply chain bring different value to vulture investors. For example, dispensaries generally have more consistent cashflow than a cultivation company as they are public-facing, Bricken says. Likewise, distributors (where such licenses exist) that try to become brand houses with exclusive access to products and retailers can better assure product movement, increasing their value to investors.

Cultivation operations, on the other hand, might not be as attractive to vulture investors because “it’s extremely expensive to run a cultivation site, especially if it’s indoors because of all the environmental factors that go on, the electricity and other utilities,” Bricken says.

One of the most important factors to investors is brand recognition. “There are definitely brands out there that we feel are quality brands that are going to be available that are distressed,” Gerson says. That doesn’t necessarily mean that recognized brands are in any better negotiation position with vultures, however.

“The problem with unlocking that distress is that a lot of these brands are [owned by] equity holders that are still coming to terms with the fact they are in a bad spot,” Gerson says. The question surrounding those companies’ survival, he poses, is, “Can they activate an investor quick enough to protect them and be rational enough to understand that they’re coming from a position of vulnerability?”

On the hemp side, farms are likely to be less attractive to vultures given the current supply glut. Hemp seed breeders and specialty processors (those who manufacture more than isolate and distillate) are “the two ends … where people want to play and there’s value added and margins to be had,” Gerson continues.

Ultimately, however, the pandemic and economic turmoil that has ensued places nearly everyone in the same unenviable negotiating position, Burleson says. “I don’t really see any particular segment of the supply chain escaping this [market].”

What Cannabis and Hemp Companies Can Do

While investment terms might be onerous, cannabis companies should remain open to vulture investors, especially in critical times like these, Bricken advises. “The name is a bit of a misnomer. It’s gotten that name for obvious reasons in that no other money is going to touch these companies,” she says, adding, “The good thing about the vulture is … they’ve been in distressed markets before, they likely know how to turn business around, and this is not their first rodeo.”

Cannabis companies looking for an urgent cash-infusion “should be looking for seasoned vulture investors who would be more open to a more middle-of-the-road restructure where the target still gets to participate at the end of the day even after there’s been success,” Bricken says. “And the seasoned vulture is going to be more likely, probably, to agree to something like that because they’ve been around the block with various entrepreneurs.”

Cash-strapped companies looking to find the best terms for financing deals (debt or equity) are going to be hard-pressed to find favorable terms, according to Burleson. “I don’t know that you can artificially put yourself in a better bargaining position,” he says. “Being organized, having all your ducks in a row probably counts more than ever.”

In the end, some companies seeking capital will simply have to accept unfavorable terms, Kelley says. “My advice is to do so with capital partners who want you to weaponize the cash; not somebody just angling to flip their investment when the market ‘returns.’”

Tax relief is hard to come by in the cannabis industry, to say nothing of broader financial assistance at all. In California, however, State Treasure Fiona Ma tells CBT that a sales tax extension and a $50,000 bridge loan are available to small business owners working in the cannabis industry.

Gov. Gavin Newsom signed the 90-day extension into law last month, giving small business owners until late July to file and pay their first-quarter sales taxes. At the state level, cannabis sales tax comes in at 7.25%.  

On top of that, Ma says that small businesses may keep up to $50,000 of their sales tax payments for a year, effectively using the cash as a no-interest bridge loan between now and next summer. The $50,000 would need to be paid back in installments by June 30, 2021. This bridge loan is available to businesses will less than $5 million in annual revenue.

Ma is clear: This isn’t part of the typical tax refund process. It’s a separate plan that business owners must opt into with the state’s taxing authority.

For more information on how to sign up for this bridge loan program, visit the California Department of Tax and Fee Administration’s website. 

“This is pretty much the only relief besides the 90-day extension and payment requirement for our federal and California income tax returns,” Ma says. “But for California, unlike the federal government with 280E, California cannabis businesses can deduct their ordinary business expenses—not just cost of goods sold.”

Ma says she’s unsure whether the second-quarter tax deadline will be moved at all, but it seems unlikely. Newsom’s executive order was an emergency measure provided in the early days of the coronavirus outbreak and its attendant economic pressures. But the ripple effects are compounding, and delaying sales tax payments any further could have significant effects on other areas of the state.

“Right now, the federal government is not really helping these smaller cities with the municipal liquidity financing program,” Ma says. “If we push back another 90 days, that’s going to severely continue to impact local governments.”