Last week, the Department of Health and Human Services (HHS) recommended rescheduling cannabis from schedule I to III under the Controlled Substances Act (CSA). My colleagues already covered various implications of the proposed cannabis rescheduling (see here and here). Today, I want to talk about one of the most important consequences of the announcement other than 280E reform: the effect on cannabis investments.
What’s been happening with cannabis investments?
Some stage-setting is in order. In the earlier days of cannabis legalization, cannabis startups typically did fundraising via equity investments. Everyone and their grandma wanted to own a piece of a cannabis company, and many of these people were willing to pay top dollar for a piece of the pie. I don’t have an exact statistic, but early on it seemed like debt finance was pretty uncommon, whereas equity finance was the norm.
At the time, cannabis investors and businesses alike thought that if they could pay a lot up front, get their feet in the door, and expand market share, they’d succeed. A lot of this rested on the false assumption that federal legality was around the corner – and that federal legalization would end 280E, allow interstate commerce, and so on. Obviously, that never happened. Lots of businesses bet big and lost bigger. Over the years, equity finance slowed down and debt finance, with hyper leveraged deals and massive interest rates, spiked. Up until a few days ago, most cannabis businesses would be hard pressed to find meaningful sources for cannabis investments.
Flash forward to last week. Within a few hours of the cannabis rescheduling news, publicly traded stocks began to shoot up. It looks like they are still going up as the Biden Administration has announced (still pretty tenuously) support for reform. This is obviously good news for publicly traded cannabis companies. But most cannabis companies are not publicly traded.
Over the years, our corporate cannabis team has represented countless companies doing equity and debt financing, as well as potential investors in negotiating and diligencing these transactions. Today, I want to talk about many of the things we have seen over the years and how cannabis rescheduling is likely to change things.
What’s actually happening?
If you want to really understand the ins and outs of the cannabis rescheduling announcement, read my colleague, Vince Sliwoski’s, recent post here. In a nutshell, the government has not yet rescheduled cannabis. If/when that happens, it will be on schedule III, meaning state-legal programs will still violate federal law. However, section 280E of the Internal Revenue Code would no longer burden cannabis companies. Section 280E has, bar none, been the biggest roadblock to financial success in the industry. If it goes away, expect to see a massive influx of capital in the form of investments, as one of the biggest expense sources will be lessened. 280E reform won’t change regressive state taxation, but that’s often much less impactful than federal reform.
At the same time, nobody really knows what will happen if cannabis is placed on schedule III. Technically, schedule III means a host of DEA and FDA regulations could apply. But it seems less than likely that the federal government would virtually ignore state-level cannabis programs during the schedule I era, reschedule cannabis, and then enforce state-level programs out of existence via enforcement of healthcare regulatory requirements. I tend to think that the status quo will prevail, but at the end of the day, nobody knows yet. And we won’t know until rescheduling happens and the DEA and FDA provide guidance on the matter.
Investors and companies beware!
Given that cannabis is still on schedule I, companies doing fundraising need to be very careful. Since nobody knows if cannabis rescheduling will even occur, let alone whether it will lead to drastically different federal interventions, companies making promises about the future could be in for a wild ride in terms of securities fraud litigation. We’ve seen cannabis companies make sketchy or untenable claims in investment offering materials many times in the past, and this announcement is almost certain to kick that into high gear in the future. All those companies are doing is rubber stamping future litigation and a bad time.
By the same token, cannabis investors need to be doubly vigilant when it comes to diligencing prospective investments. Over the years, we’ve worked with tons of investors to do basic diligence projects prior to investments. We’ve seen just about every conceivable skeleton in the closet over the years. The difference between then and now is that we used to have a fundamental understanding of the interplay between federal and state laws.
In the wake of this announcement, there are tons more unknowns regarding what cannabis rescheduling will do in the long term. This makes cannabis investments much more difficult from a diligence perspective. Investors who are unfamiliar with the market or regulatory structure and try to do diligence on their own may be in for a rude awakening.
Are the wonky structures going away?
One of the most annoying things about the cannabis industry is the org charts. In any other line of business, org charts are clear and make sense. In cannabis (and now psychedelics), you see some of the most wonky and bizarre org charts imaginable. See here for a good summary by my colleague, Vince Sliwoski. In a lot of cases, cannabis companies try to take what should be one company, and split it into two, or three, or five, or ten, often in an attempt to mitigate 280E impacts. Even though the tax courts can and for years have disregarded lots of this stuff, it’s still pervasive.
With 280E potentially going away, I predict a lot more sanity in cannabis org charts and corporate structuring. Without a need to find “creative” ways to deduct costs otherwise prohibited by 280E, businesses are going to see the light of day and realize that simplicity is key. This is good not only for good corporate governance, but also for cannabis investments. It is much easier for companies to bring in capital if investors understand the org chart – i.e., what they are specifically investing in.
There are still a lot of unknowns about what cannabis rescheduling will do. But we already can see a tangible uptick in public company stock prices, which naturally will lead to investments in non-public companies. Stay tuned to the Canna Law Blog to learn more about cannabis investments in the coming months.