Author: T. Max Riffin
On a macro level, business transactions in the cannabis industry continue to proceed at a robust pace in 2022. In the first quarter of this year, a number of large-scale public transactions generated publicity, headlined by Cresco Labs Inc.’s $2 billion acquisition of Columbia Care Inc. and the acquisition of Goodness Growth Holdings Inc. by Verano Holdings Corp. in a deal valued at $413 million. Likewise, published announcements of deals in the fully-capitalized private cannabis markets illustrate similar trends, among them, RIV Capital’s $247 million acquisition of the Etain companies, including Etain’s vertically-integrated New York license.
Given the relative lack of transparency in the private markets, there is less visibility into the transaction activity levels of smaller businesses in the industry; certainly, among them, social equity (“SE”) and economic empowerment (“EE”) participants (collectively, “Equity”) seeking to operate in – and, at some point, potentially exit – an already highly regulated industry, yet few published data points exist outside of first-hand involvement in a deal. However, we can reasonably extrapolate based on key indicators and factors whether bullish or bearish days may lie ahead for deal activity involving Equity businesses.
As an increasing number of Equity businesses continue to come online in established legal cannabis markets such as Massachusetts, and Equity applicants launch in emerging markets with social equity programs, such as New York, Connecticut and New Jersey, ominous trends and certain critical regulatory factors intrinsic to Equity businesses persist, underscoring potential challenges Equity participants and their transaction counter-parties should be prepared to face, whether now or in the future, when contemplating any merger and acquisition, joint venture, or other business transaction.
Traditionally, fundamental characteristics of Equity programs have included eligibility qualifications, requirements mandating control and ownership by equity-eligible individuals, and restrictions on the sale or transfer of Equity licenses or ownership. Access to the capital has long been identified as a significant barrier to entry for Equity participants in the industry. In part, this likely stems from added capital-raising constraints spawning directly from ownership restrictions that are necessarily requisite elements to qualify for Equity status. Moreover, and related, as these social equity programs – and their participants’ operations – mature, it is becoming abundantly clear that Equity participants in many legal cannabis markets face heightened difficulties throughout the lifecycle of the business.
Significantly, state (and locality) imposed social equity program restrictions may deprive Equity-qualified owners of valuable business outcomes, ranging from the inability to partake in the upside of selling the business to preventing Equity owners from entering into a business combination or other transaction where they become owners in a larger (and, presumably, more valuable) post-closing ongoing business enterprise going forward.
Social and Economic Equity Participants: The Additional Layers of Regulatory Hurdles
Even within the highly-regulated cannabis industry, Equity participants face even further heightened challenges over and above the regulatory quagmire cannabis businesses already are forced to navigate when seeking to consummate various corporate business transactions. Traditionally, fundamental characteristics of Equity programs include: (i) eligibility qualifications for individuals, (ii) requirements mandating control and ownership by Equity-qualified individuals, and (iii) restrictions on the sale or transfer of Equity licenses or ownership.
As a threshold matter, Equity programs in most states identify key eligibility criteria applicants must satisfy in order to receive Equity certification under that state’s program. The criteria typically are based on the goal of promoting and encouraging participation by individuals from communities disproportionately impacted by marijuana prohibition and enforcement to participate in the cannabis industry. For example, in order to qualify for and maintain economic empowerment status in Massachusetts, the Massachusetts Cannabis Control Commission’s regulations (“CCC Regulations”) require an individual (or group of individuals) who satisfy a minimum of three of six criteria to maintain majority ownership and control of an Equity applicant.[i]
Indeed, Equity regulations commonly focus on considerations involving the following:
- Board and Officer Composition: Equity businesses likely will need to ensure they maintain a Board of Directors/Managers (as applicable) consistent with certain requisite Equity demographics.
- Minimum Ownership Thresholds: Equity businesses are generally required to issue a certain percentage of equity securities (typically, a majority) to qualifying Equity owners.
- Control: Consistent with the previous two requirements, most regulatory schemes add a further layer of requirements that the actual decision-making and management authority must be in the hands of the social and economic equity participants. While this is an issue for all cannabis business that are subject to regulatory regimes that monitor and restrict control, the requirements generally are far stricter for Equity businesses.
Advantages and Benefits Available to Social Equity Participants
Under most states’ Equity programs, certified Equity businesses are conferred a panoply of advantages focused on addressing past discrimination and disproportionate harm historically faced by specified communities. The types of benefits offered include:
- Expedited or priority (first-in-time) award of licenses;
- Priority (advanced) review to assist in expediting the award of the licenses;
- Access to mentoring, technical assistance and training programs that provide education, skill-based training, tools, and licensing benefits;
- Fee waivers and discounts;
- Proportion of licenses reserved for Equity applicants; and
- Exclusive availability of certain license types that are not available to non-Equity businesses.
These regulatory hurdles frequently frustrate efforts by Equity businesses not only to raise initial seed capital, but also to enter into joint venture arrangements, and/or engage in exit negotiations with prospective purchasers to ultimately consummate a liquidity event. While certainly helpful to Equity entrants, the value of the majority of these benefits to professional investors is questionable, particularly when weighing their sufficiency in light of the extra regulatory requirements to qualify in the first place. Moreover, promises of state-established Equity funds have largely fallen short to date. It remains to be seen whether certain intriguing initiatives in newly legalized states, such as New York’s proposed incubator program or grant program, or Connecticut’s proposed tax credits for certain investments into social equity businesses, will meet with success.
Throughout the Lifecyle of an Equity Business, Equity Participants and Other Parties-in-Interest Must Carefully Consider Both State and Local Regulations
Equity programs in most states explicitly restrict the sale or transfer of Equity-certified licenses or ownership interests to non-Equity purchasers, subject to a range of limitations. At the other end of the spectrum, in the rare instance (such as Arizona), Equity-qualified licenses largely are freely transferable.
A number of states have established outright prohibitions on transfer or sale, except to other Equity qualified purchasers with approval from the regulators. States such as New York have decided to impose a time-limited prohibition on the transfer or sale of licenses to non-Equity buyers. In other states, such as Illinois, for example, where an Equity target’s license was granted based on participation in the state’s Equity program, such license transfer is subject to additional conditions that the acquirer must comply with. Massachusetts and other states still permit Equity participants to proceed with seeking approval of a change of ownership or control to a non-Equity eligible owner. Of course, the acquiror simply should be aware that the post-closing business will be unable to avail itself of the Equity benefits conferred to the pre-closing Equity business.
Critically, this analysis is only relevant at the state level. At the local level, many municipalities or counties likewise have established ordinances or regulations governing Equity applicants and licensees. Consequently, even where a transaction involving an Equity business is generally in the clear at the state level, the transaction parties may nonetheless encounter restrictions or even absolute prohibitions at the county or municipality level (or vice versa).
For example, the rules and regulations promulgated by the Boston Cannabis Board (the governing body charged with granting licensure to cannabis establishments in the City of Boston) prohibit the transfer of any interests (even less than 1%) in any cannabis business without approval, and prohibit the transfer or a change in beneficial interest that would result in the social equity licensee no longer qualifying as social equity pursuant to the City’s ordinance:[ii] “[U]nder no circumstances shall an equity Licensee be approved for a transfer or a change in beneficial interest that would result in the Licensee no longer qualifying as equity pursuant to the Ordinance.”[iii]
Be Aware of Possible Consequences for Violating Applicable Equity Requirements
Consequences, and attendant penalties, for an Equity business’s failure to continue to qualify for Equity status under applicable state or local rules, regulations, and ordinances customarily span across the following range:
- Loss of eligibility for all Equity business benefits (e.g., priority treatments, access to available training programs, and economic benefits;
- Suspension or revocation of cannabis licensure entirely;
- Transferee’s payment of any outstanding amounts owed by transferor Equity business to regulatory body and any other fees or assessments determined by regulators;
- Ineligibility of violators to apply for future cannabis licensure.
Exit Events: Possible Implications of Equity-Related Regulations
As and when the owners of an Equity licensee are readying to exit the business, they may find – likely much to the frustration of Equity participants and their would-be acquirors – that the regulations governing Equity participants may, in fact, substantially stymie negotiations with prospective acquirors. Indeed, stringent Equity program transfer restrictions imposing ongoing minimum Equity-ownership percentages artificially suppress marketability of the Equity business to potential acquirors.
In many cases, an Equity business’s options in the sale context are limited to the following: (x) sell or transfer a license only to Equity-qualified purchasers, or otherwise (y) sell only non-Equity-qualified ownership stakes in the company.
In the former instance, further restrictions on already limited private markets almost certainly will have a negative impact on enterprise valuation by further constraining the pool of potential acquirors. Certainly, blanket prohibitions on transfer of cannabis licensure in contravention of Equity ownership/control requirements frequently result in engendering a chilling effect upon potential sales of Equity cannabis licensure to non-Equity eligible third-parties.
In the latter scenario, non-Equity-eligible owners may be presented with an opportunity to sell, yet frustratingly, the Equity-qualified owners are prohibited from participating. In this instance, Equity-qualified owners are still the opportunity to participate at all in the deal and any attendant upside of the transaction value that non-Equity owners may pursue unfettered. As a result, a few potential possibilities present themselves from there. Subject to the business’s governance documents, the non-Equity offerees may be able to freely sell, transfer and assign their equity securities to a third-party acquiror, leaving the Equity-qualified owners behind and stuck with new owners. Conversely, many company’s governance documents frequently contain transfer restrictions and other protective provisions, allowing the non-selling owners to block the proposed sale outright and/or providing a right of first refusal to purchase the offered ownership stake. Moreover, customary and bargained-for corporate governance mechanisms, such as drag-along and tag-along rights, are often neutralized by these regulations.
Nonetheless, in the acquisition context, even where non-Equity holders are permitted (under applicable state and local regulations and company governance documents) to transfer or sell their stake in the business, few potential acquirors are interested in acquiring less than 100% of the stock or substantially all assets of a possible target. Rarer still is the case where an entity in acquisition mode might be willing to acquire less than a majority stake in a target.
In either instance, this is a confounding result, particularly where the avowed goals of such programs are to promote economic opportunities for the Equity participants, yet one of the most significant milestone events for any entrepreneur or business – selling the company – is patently unavailable to Equity businesses operating in markets with broad transfer prohibitions.
Conversely, it should be noted that the foregoing gloomy scenarios are far less likely to occur in markets where the potential consequences to closing a sale or transfer of a licensed Equity business to a non-Equity eligible acquiror are limited to less material effects — such as the loss of economic benefits, ineligibility for training programs, or even forfeiture of priority review. In such instance, would-be non-Equity acquirors are far less likely to balk at a transaction, as they will be permitted to acquire the entire business (and not merely a portion), plus the loss of benefits is unlikely to constitute a deterring factor.
Social Equity Participant Exclusivity Periods: Potential Impact and Key Considerations
Some states have adopted certain exclusivity requirements, where certain cannabis licenses are granted exclusively to qualified Equity participants for some period of time. In Massachusetts, the CCC Regulations provide for two types of delivery licenses (either a marijuana courier or delivery operator license). These delivery licenses are limited on an exclusive basis to businesses controlled by, and with majority ownership comprised of, Equity participants for a period of 36 months (or longer, if extended by the CCC at some point in the future). Accordingly, potential acquirors or joint venturers must be careful not to acquire a stake in an Equity business that would reduce Equity ownership percentage below a majority for such 3-year exclusivity period.
In a fairly typical joint venture scenario, a joint venturer providing capital to an Equity business may agree to accept a minority stake in the licensed business during the exclusivity period in compliance with applicable regulations, but frequently this capital provider will also seek to negotiate in parallel a purchase option to acquire a majority stake (or more) in the business following expiration of the exclusivity period. These types of future purchase rights are often favored by investors or other would-be acquirors, as they afford a structure that offers a certain level of comfort to a capital source when entering into a deal at the outset by removing a level of ambiguity or uncertainty at the expiration of the prescribed period.
In April of this year, the CCC released proposed non-binding interpretive guidance (the April Guidance) on control and ownership that, among other things, cautioned market participants that it intends to scrutinize parties’ agreements to assess egregious or depreciatory provisions.[iv] Per the CCC’s April Guidance, contractual provisions that, when considered together, are determined by the CCC to be excessively disadvantageous to SE or EE participants, may be deemed by the CCC to establish an investor as a majority owner; therefore, resultantly disqualifying a previously qualified Equity participant. Upon such disqualification as a result of deemed “excessively disadvantageous” provisions by the CCC, a delivery business may run substantial risk that its licensure will be suspended until it is brought back into compliance (requiring the unhappy situation where the Equity participant would need to rework its agreement with the joint venturer counter-party) or, in a more draconian instance, the revocation of its cannabis licensure altogether.
Importantly, in the April Guidance, the CCC highlighted contractual provisions that automatically convey ownership from one holder to another at the end of the exclusivity period, at the unilateral election of the receiving holder, as constituting “excessively disadvantaged terms.” Indeed, automatic ‘call’ rights or purchase options held by a non-Equity acquiror/investor would likely fall within the CCC’s notion of “excessively advantaged terms.” Nevertheless, the CCC apparently still leaves open other potential avenues to structure a purchase option that — perhaps — may still pass muster; thereby, possibly allowing for some level of flexibility for Equity participants and non-Equity capital sources and/or acquirors to fashion a workable path forward to an acquisition upon the end of the exclusivity period, where the parties so desire.
Social Equity M&A Deals Going Forward: Looking Ahead
In conclusion, Equity participants face clear challenges in attempts to establish joint venture arrangements with strategic partners to raise capital and then later when seeking to sell the licensed Equity business. One reasonably foreseeable outcome is that some Equity participants may ultimately determine that, on balance, the advantages conferred by obtaining Equity business status fail to outweigh the assumption of additional impediments. Correspondingly, on the flip side of the same coin, prospective joint venturers or acquirers engaged in vetting a potential deal with an Equity participant may, at least in some instances, draw similar negative conclusions on pursuing the deal, thereby foreclosing potentially fruitful and valuable paths forward for Equity participants that would otherwise have been available but for the existence of such restrictions.
Accordingly, it is critical for regulators, prospective acquirers or joint venturers, and Equity businesses, to work closely together to assure availability of capital to Equity businesses, and to carefully navigate a viable path forward without jeopardizing licensure.
We will continue to carefully monitor this space; particularly as Equity businesses and Equity applicants in Massachusetts and other states (including Connecticut, New York, and New Jersey) advance through their own respective state and local regulatory regimes.
Notes / Sources
[i] “Economic Empowerment Priority Applicant” is defined in the CCC Regulations, as follows:
Economic Empowerment Priority Applicant means an applicant who as an entity or through an individual certified by the Commission in 2018, meets and continues to meet three or more of the following six criteria, at least one of which shall be a majority-equity-ownership criterion:
(a) Majority Equity Ownership Criteria:
- A majority (more than 50%) of ownership belongs to people who have lived for five of the preceding ten years in an Area of Disproportionate Impact, as determined by the Commission.
- A majority (more than 50%) of ownership has held one or more previous positions where the primary population served were disproportionately impacted, or where primary responsibilities included economic education, resource provision or empowerment to disproportionately impacted individuals or communities.
- A majority (more than 50%) of the ownership is made up of individuals from Black, African American, Hispanic or Latino descent.
(b) Additional Criteria:
- At least 51% of current employees or subcontractors reside in Areas of Disproportionate Impact and by the first day of business, the ratio will meet or exceed 75%.
- At least 51% of employees or subcontractors have drug-related CORI and are otherwise legally employable in Cannabis enterprises.
- Other significant articulable demonstration of past experience in, or business practices that promote, economic empowerment in Areas of Disproportionate Impact. This applicant has priority for the purposes of the review of its license application.
[ii] See Section 2.00 of Rules and Regulations, Boston Cannabis Board; source: