Raising Capital and Investing in the Cannabis Industry

As a result of illegality, access to capital from traditional lenders has been a major challenge for cannabis cultivation operations and other cannabis-related businesses in both the U.S. and Canada. However, given the clear path to legal recreational use in Canada, traditional lenders in Canada have begun making loans to businesses in the cannabis industry and will likely also begin to provide commercial and investment banking services. In the U.S., so long as cannabis remains an illegal substance under federal law, traditional lenders in the U.S. will almost surely stay clear of the cannabis industry unless there is clear guidance in writing that federal authorities will not enforce federal laws in states that have legalized recreational and medicinal cannabis.14 As it currently stands, federal authorities in the U.S. have the power to close a cannabis dispensary and seize its assets notwithstanding that such dispensary may be legal under applicable state law. While Canadian lenders have begun providing financing to cannabis businesses, to the extent that they have significant operations in the U.S., they may be unwilling to provide cannabis businesses with financing or basic banking services so as not to jeopardize their U.S. operations or potentially violate anti-money laundering law.

Private Equity and Venture Capital

For the reasons outlined above, until now the majority of established venture capital and private equity funds have generally been hesitant to invest in the industry. While these funds are beginning to show greater interest and are finding ways to structure around the risks of investing, most cannabis businesses have historically relied on investments by small venture capital, private equity funds and high-net-worth individuals. Smaller funds are willing to assume the risk that their portfolio companies could be subject to changes in regulation in exchange for the value proposition that their portfolio companies will have a head start compared to other companies or will be merged, acquired or partnered with other companies in the supply chain.

Mainstream venture capital and private equity funds looking to invest in the cannabis industry should consider ways to structure cannabis investments to address the concerns of their institutional investors.

Such venture capital and private equity funds will typically invest through fund investment vehicles which are structured like traditional private equity funds and established for the purpose of investing solely in cannabis or cannabis-related businesses.15 A survey of such funds shows that targeted capital commitments currently range from US$25 million to US$125 million with capital being sourced from high-net-worth investors or family offices, often through cannabis specific investment funds.16 Venture capital and private equity funds are using innovative branding and marketing tools to tackle the stigma associated with cannabis to attract investors. These firms should be prepared to address stricter confidentiality requests from investors who may have reputational concerns associated with investing in the cannabis industry.17 A survey of cannabis-sector investment funds shows that investments are being made across numerous verticals within the cannabis industry, including cannabis and related accessories, medical cannabis, technology platforms and software and cannabis information resources.
Some venture capital and private equity funds making equity investments in cannabis businesses will also provide loans, but at relatively high interest rates. In some cases, the loan has been structured as convertible debt allowing the fund to convert the loan into an equity stake in the company at a future date. In the U.S., it should be noted that to the extent a cannabis business’ activity violates U.S. federal law, such business has no entitlement to federal bankruptcy protection (even though its operations may be legal under applicable state law), meaning lenders may have difficulty obtaining repayment.

Large mainstream U.S. and Canadian institutional investors, including pension funds and endowments, are among those investors largely evaluating the cannabis industry from the sidelines. While there have been some early-mover institutional investors in this industry, for many others, investments in cannabis may not be consistent with their investment mandates, particularly as it relates to risk tolerance. In addition, it is not uncommon for institutional investors to be prohibited from investing in portfolio companies that derive revenue from activities such as gambling, pornography, tobacco, alcohol or munitions. Institutional investors will generally negotiate excuse rights with respect to investments in portfolio companies that contravene such investment policies, which are typically set out in the side letters that investors negotiate alongside the limited partnership agreement of the fund.

Mainstream venture capital and private equity funds looking to invest in the cannabis industry should assess whether their institutional investors are subject to internal investment policies that would prohibit them from investing in cannabis and consider ways to structure cannabis investments to address the concerns of their institutional investors, including through the use of side letter provisions to address confidentiality, reputational risk and other concerns (and, where necessary, by granting excuse rights).