A few days ago, I was talking with someone about raising capital and, in particular, the merits of different sources of investment, so thought it might be useful to outline some benefits and drawbacks from taking pre-IPO capital from various types of investors.
- Friends and Family – typically where the startup company raises capital, passing the hat to a close circle of friends and family who are willing to accept the risk of backing an entrepreneur with a dream. In some ways, we can think of this as “dumb money”, which I do not mean to characterize the merits of the investment, but rather the knowledge of the investor in cannabis. These kinds of investors typically put their money in through a SAFE or a convertible note, which gives them very few rights, and they typically are not expected to ask many questions. For early-stage companies, this kind of “dumb money” is quick and easy and appropriate.
- Individual High Net Worth Investors – I think of this group from the Friends and Family as a category of investors who have more money to invest and have a history of making early-stage investments in high growth companies (although, depending on the capital raise, securities laws will likely require minimum net worth or income tests for both). The benefits of this kind of investor is that they typically will be able to write a larger check and can move quickly, since it is their own money (compared to, say, a fund). On the other hand, since they are less likely to have the personal relationship with the principal, they are harder to find (which is where the investment banker earns its fee), will likely ask more questions about the investment, and almost certainly will have more demands for their money – better economic terms, governance rights, and protections. Additionally, given the regulatory nature of non-hemp cannabis, they may have personal reasons for not investing while non-hemp cannabis is still federally illegal.
- Venture Capital/Private Equity Funds - generally, the typical route for a company that has made it past the very early capital round and is ready for a preferred-style investor that is ready to invest a lot more capital. Compared to “dumb money”, this capital is very “smart money”, in that the fund is likely going to be only investing in cannabis (particularly, for regulatory reasons, when investing in non-hemp cannabis), so it is going to be very knowledgeable about the industry, the business, the market, and the company’s prospects. The fund is going to do extensive due diligence on the company and expect a high level of compliance, and more stringent governance and control rights are de rigueur. This is not cheap capital either – valuations will be heavily scrutinized and negotiated, and the money will come in on a preferred basis, as these are professional investors who know the market deeply. So why take this money? A fund investor can add a level of sophistication and discipline to a company, and potentially open the door to business synergies and partnership opportunities, particularly in such a small industry as cannabis. Most importantly, they will typically have access to a lot of money and can write large checks.
- It is worth noting that the cannabis private equity market has changed in the past twelve months. In early 2018, with public market valuations hitting new highs and equity capital flowing briskly, funds were much quicker to write checks for small investments in a lot of companies, without much diligence or long-term visibility (very much in the style of a venture capital fund, even though funds generally characterized themselves as private equity). With the valuations crash of later 2018, funds have become more selective, as they have raised more money in order to write larger checks into developed companies. The frenzy of venture-style investing by funds seems to have passed, and, based on my conversations, their focus seems to be shifting generally to distressed opportunities.
- Strategic Investors – this category is meant to mean one cannabis industry operating company investing in another, where a merger or acquisition is not the right result. The fundamental benefit of taking capital from another operating company is the synergy – the partnership could mean shared access to markets, products, technology, know-how, or ideas. Given the highly fragmented nature of non-hemp cannabis in the US, with the current lack of interstate commerce, this is also typically a way for a larger operator to gain access to another state’s market without having to buy in completely – this happened a lot in the frenzy of early 2018, with MSOs making a lot of seed-level investments in small non-hemp cannabis companies to get a toehold in another state, but that kind of venture-style investing has all but vanished as MSOs have shifted to protecting their cash stores. The downside to this kind of investment is that, while it could open up new opportunities, it could also shut off others by hitching a wagon to one particular company.
This is definitely not an exhaustive list (for example, I ignored asset lenders, real estate sale/leaseback, and other forms of non-equity-ish capital), and I recognize that I am making a number of generalizations in order to get to the point that, for each company, at each stage in its growth cycle, there is no one-size-fits-all answer. Working with the right kinds of advisors (investment bankers, CFOs, and, yes, even lawyers) can help assess the right kind of investor for the right situation.