Cannabis Company Valuation Challenges
Valuing a company is a complex analysis. Layering on the regulatory and political uncertainty in the cannabis industry adds to the complexity for cannabis companies versus other industries.
In Canada, having a public market to compare to can help give some idea perhaps of where the future of cannabis-related valuations in the U.S. may go, but in the current Canadian public marketplace, most of these companies are underperforming on expectations and appear to be over-valued and experiencing the negative results of that.
Part of the over-valuation appears to be anticipation of a completely saturated industry that we have yet to see come to fruition with full national legalization like that of potential in the Canadian market. Canada now has a key opportunity to be at the forefront of the public cannabis marketplace with its own national legalization.
However, the performance metrics and longer-term results have yet to play out and therefore there aren’t reliable historic examples and models to serve as helpful references for valuing cannabis companies. There are operational and other regulatory challenges most companies encounter at the early stage that make for lack of clarity with respect to the company trajectory and potential. Additionally, the lack of historical financials in this new culture-shifted industry make it further difficult to rely on past example in determining valuation.
Cannabis Company Valuation Methodologies
For private cannabis company valuations in the U.S., valuations take into consideration many factors and employ a variety of different methodologies. Factors and concepts to consider when establishing the valuation of a cannabis company include, among other things:
- assessment of cannabis company’s asset value;
- the competition and general industry positioning among the competition;
- the regulations and permitting and licensing schematic and related risks involved with respect thereto, including the ability or inability to fully realize production potentials and integration structures;
- past financials, if any;
- other similar or related industry models, such as those in the regulated food and beverage industry, alcohol and tobacco industries, life sciences and agriculture industries with analogous or similar regulatory controls;
- actual invested capital into the cannabis company;
- income, if any, to date; and
- public company guidance.
Another main tool for establishing value is to look at previous arm’s length valuations in prior transactions involving the cannabis company. If the company performance or financials have improved since such prior transaction, the assumption is often that the value will have gone up from such prior transaction value. In the alternative, if the company performance or financials have declined since such prior transaction, the assumption might be that the value has gone down from such prior transaction value.
Why Valuations Matter
Valuations matter for a number of reasons. Cannabis companies need a way to assess how much a price per share of their company is worth when issuing stock; and buyers and those with transactional interest, such as investors, want to understand the value of what they are buying into and the potential upside thereof. Often valuations can be driven by those steering the deal or controlling a transaction if those are the individuals with the leverage and money to put into the business.
Down-rounds & Anti-Dilution Protection
Put simply, investors usually only invest in companies if they see upside potential. In other words, they think the value of the company they have invested in will likely go up (and not down) and so the price per share of the investment will also likely increase and not decrease.
However, sophisticated investors understand that investing is risky because there can be no guarantee that a company’s valuation will go up and not down. Such investors frequently ask for dilution protection or “price-based anti-dilution adjustment” to be built into their investment rights and documents.
This means if Investor A buys shares at a certain price, often Investor A builds in protection so that if company shares are later sold to Investor B for a price per share lower than what Investor A paid (in what’s often referred to as a “down-round”), Investor A doesn’t get as diluted by Investor B getting more shares for their money than Investor A did in their purchase at a higher price. Investor A’s shares accordingly get adjusted upwards to balance this dilution out.
There are a couple of different types of price-based anti-dilution adjustment protection that commonly get negotiated in the context of a preferred stock financing:
- the more-aggressive “full ratchet” adjustment; and
- the more-common “broad-based weighted average adjustment”.
These formulas can be discussed in more depth with our clients at the appropriate time of a financing, but the concept is to put the original investor who paid a higher price in the same position or a similar position than if the price drop on a subsequent round had not occurred (dilution reduction to the original investor).
Naturally, the result of a “down round” and anti-dilution adjustment for some preferred investors further dilutes founders that don’t receive the same such treatment or anti-dilution adjustment (or related increase in shares to make up for the dilution) and puts founders in not the best of positions with respect to their own share percent ownership interest.
A company valuation dropping is also not good because, as a general rule, investors are quite unhappy with this result and when expecting growth and development of their investments. Often investors may leverage this for more power in the company and more control rather than remaining passive. A reduction in the cannabis company’s valuation can lead to a company being bought out at a much lower price than anticipated or a lost opportunity for future investments based on poor performance history.
Cannabis companies should consider these concerns when choosing valuations in transactions and in setting share prices in transactions so that they don’t set their companies up for future down rounds. Most of the time, the best way to protect against run-away valuations (overly high valuations) is to use a third-party valuation firm to assess the company value through proven methodologies and recommended methodologies, such as Carta Valuations or Scalar Analytics.
The board of directors of the cannabis company will need to approve and confirm the valuations determined in these reports, but the professional analysis can help back the determinations made by the board of a company. Additionally, the cannabis company will need to ensure when relying on these reports that no material changes have occurred since the last completed report.
How the Corporate Transactional Cannabis Industry Attorneys at Rogoway Law Can Help
Here at Rogoway Law Group, our Corporate Transactional Legal Team can help recommend valuation firms and valuation considerations to companies and their board members. We can help educate our clients on why these considerations are critical, not only for large transactions involving third parties such as financings or acquisitions, but for equity issuances being made to employees and executives and in connection with the overall capitalization of the company. Also, when representing investors, we can help structure investment terms, including anti-dilution protection.