Guest post by Erik Ott, Partner at KO Acquisitions
The latest news on cannabis M&A transactions in the US might make one wonder if more deals are falling apart than are closing. In Q4 2019, over US$1 billion in M&A deals were terminated by Multi-State Operators (MSOs), including:
- Cresco terminating the $120m acquisition of VidaCann
- Green Growth Brands terminating the $310m acquisition of Moxie
- Medmen terminating the $682m merger with PharmaCann
- Harvest terminating a deal to acquire Falcon International as well as a massive downsizing of their planned acquisition of CannaPharmacy.
Countless other deals across the US involving private companies were also terminated, and, while it may be easy to blame these failed transactions on the capital market, the truth is more nuanced. The reasons for failed deals in the cannabis market are as complex as the industry itself. KO Acquisitions has identified five factors that cause deals to collapse and how buyers and sellers might plan for these situations to keep deals on track.
- Licensing/Regulatory Issues: M&A negotiations in most industries are between the buyer and the seller. Only in the cannabis industry do local and state regulatory agencies have the proverbial “seat at the table”. Many CA jurisdictions don’t allow the buyer to own more than 49% of a company, necessitating complex deal structures and work-arounds. Further, changes to a local tax code can make a jurisdiction untenable overnight.
- Poor Corporate Hygiene: Can sellers produce accurate financial information? Are they auditable? Have they properly accounted for 280e? Can their corporate records withstand the scrutiny required of a public company? Often, the answer to these questions is no.
- Seller Risk Exposure: Cannabis is rife with disputes — perhaps it is part of the industry’s DNA. What will buyer due diligence uncover about the decisions the seller made in the years leading up to the transaction? Perhaps the buyer will discover shareholder and partner disputes, messy cap tables, or other undisclosed liabilities. In addition, many operators lack trust in the folks “wearing suits”, which is certain to impact the ability to close.
- A Protracted M&A Process: It can take nine months or more from LOI to close, so it is not uncommon for deal fatigue to set in. Further, this period gives buyers time to look into the seller’s business, and often the pro-forma returns that sellers promised to deliver do not materialize. This can lead to a valuation re-trade that can kill even a deal with strong mutual alignment and cultural benefit.
- Capital Markets Challenges: If a buyer’s access to cash has dried up and CSE valuations have shrunk, the buyer will be left with little structural wiggle room. Many sellers with strong operations want cash to be significant percentage of their compensation. The lack of a cash component in M&A transaction can make many deals harder to close, not to mention the difficulty in selling the buyers stock.
To see what matters most to buyers, KO surveyed the M&A teams at the large MSOs. Not surprisingly, the collapse of capital markets was the #1 reason given for deals falling through. One MSO rightly noted that valuations in the public sector came crashing down in the second half of 2019, yet private seller expectations have only very recently begun to reset.
The second and third reasons given were poor corporate hygiene and high seller risk exposure. Almost all of the MSOs bemoaned the due diligence process, noting how many “skeletons in the closet” were identified and lamenting the need to solve problem after problem. Other MSOs took some of the blame themselves, stating that more due diligence should occur prior to executing a Letter of Intent (LOI). They opined that LOIs were being treated as “options to buy” in the cannabis market, resulting in astonishing fail-to-close rates relative to other industries where LOIs seem to be taken more seriously.
Of course, the story is completely different when interviewing sellers who have been left at the altar by large conglomerates — the reason most often cited is “they don’t have cash and/or I can’t sell their stock”.
Closing M&A deals is difficult. There are many variables at play – some that can be controlled, others that cannot. One thing sellers can do is to invest the time on the front end to get the house in order and be more conservative in your growth projections before you initiate buyer engagement. Once in the process the best advice is to focus on the areas that you can control, be transparent with your data (particularly the bad news), and pick a partner where the alignment and cultural fit runs deep.
About the author:
Erik Ott is a Partner at KO Acquisitions, Inc. a boutique investment bank specializing in cannabis mergers and acquisitions. KO provides sell-side and buy-side advisory to companies looking to scale up their business through transaction with strategic partners. Erik can be reached at O@KOAcq.com.
