Obtaining Financing and the Inherent Challenges of the Cannabis Industry

September 25th, 2018

Following the legalization of recreational cannabis this October 17th, it is a safe bet that there will be a spike in interest in the future production market and in the number of investors wishing to take advantage of this activity sector.

Although the number of authorized producers in Canada and the number of licence applications filed with Health Canada have been on the rise for the last few years, the issuance of a licence to produce cannabis does not materialize without significant capital backing, most notably to cover the costs of preparing the licence application (time, accountants, consultants, legal expenses, etc.), and the costs of acquiring land, building greenhouses, purchasing equipment, engaging qualified personnel, and setting up security systems.

However, obtaining the necessary capital to finance the cannabis industry in Canada is not as simple as it is in other activity sectors, notwithstanding that production for medical purposes has been legal since 2001.

Financing by Banking Institutions

Some financial institutions agree to finance, while others categorically refuse to finance this activity sector. Aside from the negative perceptions the public may have of banks that finance the cannabis industry, there are also some serious queries as to whether the holder authorized by Health Canada can dispose of, assign, mortgage or hypothecate the licence, which is for a limited period of two years. The principal asset of such businesses, aside from capital property and equipment, is the licence issued by Health Canada, which can be revoked, cancelled or suspended for various reasons, such as bankruptcy of the holder or a change in the holder’s juridical form. There is nothing to indicate, under the current wording of the legislation, that a licence issued to a holder or the rights in the licence cannot be disposed of, assigned, mortgaged or hypothecated. However, the absence of any provisions in this regard and the dearth of precedents may potentially create uncertainty concerning a creditor’s ability to realize on its security. A creditor planning to take a security interest on the cannabis inventory could find itself in a delicate position if such a licence were not assignable, since the licence issued by Health Canada is notably required to produce, sell or distribute cannabis. Accordingly, the financing structure is of paramount importance and it calls for advice from counsel who are specialized in financing and the cannabis industry to make sure that a creditor can fully realize on its security.

Financing Through Private Capital or a Public Offering

Producers do have the option to look to other sources of capital to finance their cannabis operations, such as equity financing, venture capital, private capital, a public offering or the exempt market since, although “love money” may constitute a significant source of capital, it may not be sufficient to support such investments. But financing through private capital or a public offering is expensive and complicated, especially for a start-up company. Nevertheless, in the current market, that seems to be the preferred route, given that a large number of companies in this industry are listed for trading. However, implementing such a financing structure requires the assistance of various advisors in order to comply with the applicable legislation and regulations.

Equity Financing

Equity financing currently represents a significant source of capital. However, uncertainty related to the illegality of cannabis at the U.S. federal level and in the majority of U.S. states, as well as the potential risk that any person who has a financial interest in the industry may be deemed an inadmissible alien and face a lifelong ban from that country at a border crossing, turns off some investors.

It is also important to know, when it comes to equity financing, that some professionals who are governed by their professional orders may be hesitant to invest in the stock of a cannabis company. For example, the College of Physicians does not consider cannabis to be a medication, and prohibits all physicians from becoming or applying to become licensed cannabis producers. It may be necessary to take steps and make preliminary inquiries with the professional orders in order to comfort potential investors.

In addition, the Cannabis Act and its regulations (the "Regulations") refer to the concept of a "key investor". A key investor is a person that exercises or is in a position to exercise direct or indirect control over the licence holder. Any person that applies for a licence (other than a legal person the shares of which are traded on a published market) must provide, under the terms of the application, specific information about its key investors, including a description of the means by which the key investor exercises or is in a position to exercise control over the holder, potentially including whether the majority interest will or may be assigned, pledged, mortgaged, hypothecated, or sold, in whole or in part, to any person, if that fact is known. Also, to reduce the risk that organized crime might infiltrate itself into the cannabis market, the Regulations stipulate an obligation for individuals, and the officers and directors of the holder and of any company or person that controls the holder to have a security clearance. In this context, it is essential for companies operating in this industry and their investors to make a thorough analysis of the participation in the shareholding structure in order to manage the potential impact of the Regulations and make sure that the regulatory requirements are satisfied.

Financing Through the Exempt Market

Some companies in this industry are also looking to the exempt market, which allows a company to distribute securities to certain investors without a prospectus. Products on the exempt market must be offered exclusively to investors that are eligible or accredited and the costs of implementing such a structure, by way of an offering memorandum which describes to the investors, inter alia, the risks related to the investments, are definitely lower than for a public offering.

Currently, there are various forms of financing available to companies operating in the cannabis industry. To structure and implement optimum financing to facilitate their growth, advice from financing experts is essential.