There are several key terms (deal points) and agreements that are typically negotiated in an investment transaction. Understanding those terms will equip you to negotiate better on behalf of your company and ultimately have a successful capital raise. As discussed elsewhere in this book, the valuation of the company is one of the key terms that must be decided early on in the capital-raising process. With a valuation set, the company can then determine the amount of stock that will be sold in the offering. In this chapter, we’ll walk through the major terms and potential agreements you need to know to successfully secure an investor. First, let’s talk about who owns your company and why that is important.
The cannabis industry is highly regulated and, as such, the ownership of a cannabis business is regulated as well. These regulations can come in many forms such as a restriction on ownership by public companies, out-of-state investors, or other license holders. While the rules and regulations in each state vary, typically an owner of a licensed cannabis business will need to have the ownership approved by a state regulator. An owner generally includes the officers, directors, managers (in the case of an LLC), and controlling shareholders (the thresholds for controlling shareholders range from 5 to 20 percent). Ownership approval generally requires an owner to submit detailed personal information, and fingerprints, and submit to a criminal background check. Additionally, a list of the owners of a licensed entity are typically publicly available.
Further, certain states, such as California, require the disclosure of any individual investor who owns an interest in a licensed entity, regardless of the size of the investment. These individuals do not need to submit fingerprints or undergo background checks, but the information provided is subject to Freedom of Information Act (FOIA) laws and may become public.
As a result of these requirements, investors may be wary to invest because of perceived or actual reputational risks of being associated with a cannabis business. It is important from the outset to inform investors of these potential disclosure requirements to avoid having investors pull out at the last minute or refuse to provide the required information to have their ownership approved.
To alleviate concerns, it is possible to limit the size of an investment or to have an investor invest through a different investment vehicle. However, the trend among regulators in the industry is to have more disclosure of all owners of a licensed entity, including those that do not hold a controlling interest. As discussed below, it will be important for the documents to clearly outline any disclosure and approval requirements related to ownership of the company.
It is important to note that even if the company receiving the investment is a holding company of the licensed operating company, the investors in the holding company will be subject to the disclosure requirements even though they only have an indirect ownership interest in the licensed entity.
In some cases, acts of certain equity holders (such as a criminal record) could compromise a company’s ability to obtain or maintain its license. In such instances, the company would need the ability to cut ties with the holder in order to preserve its license.
As such, a company should consider including something called a repurchase right. A repurchase right gives the company the right to purchase the shares from the shareholders at a particular price in the event that a holder, as a result of its equity ownership, either fails to have such ownership approved by the applicable cannabis regulator or a disqualification event occurs that compromises the company’s ability to qualify as a license holder as a result of actions taken by the individual after their ownership had been approved (e.g., a felony conviction).
The price at which the company may exercise the repurchase right will likely be subject to heavy negotiation. The investor is going to want the price to be the fair market value of the company at the time of the disqualification event. However, the company will want to fix the price at the price paid for the shares. Setting the price at the original purchase price can work as negative incentive for stockholders to avoid actions that could jeopardize the company’s license.
A dividend is the distribution of a portion of a company’s earnings paid to a company’s shareholders, which can be structured as a cash dividend or stock dividend. Dividends are one of the rights that often make a company’s equity securities “preferred” (relative to common), and, depending on the terms, are typically paid to preferred stockholders before being paid to the common stockholders.
Dividends are often stated as a percentage of the price paid for the preferred stock by the investors. In the cannabis industry, and especially in venture deals, the dividend rate will tend to be higher to reflect the risk that the investor is taking in investing in an early-state company but are often deferred or paid in stock to avoid a cash drain.
In negotiating a venture deal, a company should understand the various ways dividends can be structured, and consider the likelihood that cash flow will be available to pay dividends currently and the dividend structure’s impact on its common stockholders. There are at least three common ways dividends are structured in venture capital deals:
- Cumulative dividends
- Non-cumulative dividends
- Dividends on preferred stock only when paid on the common stock
Cumulative dividends, which are the most common, are the most beneficial to the preferred stockholders and the least favorable to the common stockholders. Cumulative dividends are calculated for each fiscal year, and the right to receive the dividend is carried forward until the dividend is either paid or until the right is terminated. Even if the company suspends dividend payments, the unpaid dividends owed (known as “dividends in arrears”) will continue to accrue and will be paid to the preferred holders in a lump sum when the company liquidates or redeems the preferred stock. As a result, the accruing dividends represent a future obligation of the company to the preferred stockholders and reduces funds available for common stockholders. Cumulative dividends may be structured on a simple basis or on a compound basis, where all prior accrued and unpaid dividends are taken into account in determining future dividends.
Non-cumulative dividends refer to a stock that does not pay the investor any dividends that are omitted or unpaid. If the board of directors of the company does not declare a dividend during a particular fiscal year, the right to receive the dividend extinguishes for that year. So even though a preferred stock carries a 7 percent dividend, if the board of directors does not declare dividends in a given year, the investor will not have the right to claim any of the unpaid dividends in the future.
Dividends Paid on an As-Converted Basis
The third method of structuring dividends is to have a dividend paid on the preferred stock only if paid on the common stock. The preferred stock is treated as if it had been converted into common at the time the dividend is declared, and the preferred and common stock share in the dividend as if all shares were converted to common. This dividend structure is the least beneficial to the preferred stock and the most beneficial to the common stock.
The liquidation preference dictates the payout order in the event a company liquidates itself or in certain circumstances such as a sale (a "deemed liquidation event"). Typically, the preferred stockholders will get their money back first, ahead of other kinds of stockholders, in the event that the company must be liquidated, sold, or goes bankrupt. Liquidation preferences are typically expressed as a multiple of the price paid by the investor. For example, if the liquidation preference on the preferred stock is one time (1x) the original price paid by the investor, the preferred stockholder will be paid back 100 percent of their investment before any other equity holders.
There are three common ways liquidation preferences are structured:
- Participating Liquidation Preference
- Non-Participating Liquidation Preference
- Capped Liquidation Preference
Participating Liquidation Preference
The participating liquidation preference (also known as double-dip preferred) is most favorable to investors. Under a participating liquidation preference, the preferred stockholders will receive their liquidation preference and then will share in any additional proceeds in proportion to its equity ownership.
Non-Participating Liquidation Preference
Non-participating liquidation preference (also known as straight preferences) are the most commonly used. Under a non-participating liquidation preference, preferred stockholders can choose to either 1) receive their liquidation preference or 2) share in the proceeds in proportion to their equity ownership after converting their preferred shares into common stock.
Capped Participating Liquidation Preference
Capped participating liquidation preference (also known as partially participating preferred) are considered equally favorable to investors and the company. Under a capped liquidation preference, preferred stockholders will be paid back their liquidation preference and then will share in any additional proceeds in proportion to their equity ownership, subject to a cap.
For example, preferred stockholders with a 1x initial preference and a 3x cap on participation will receive the aggregate of: 1) a distribution equal to their initial 1x liquidation preference and 2) a pro-rata distribution along with common stock, in an amount equal to 3x the original issue price.
A conversion right is the right to convert shares of preferred stock into shares of common stock. There are two types of conversion rights: optional conversion and mandatory conversion.
An optional conversion right permits the preferred stockholder to convert its shares of preferred stock into shares of common stock, initially on a one-to-one basis.
For example, let’s assume that the preferred stockholder has a $5 million, 2x non-participating liquidation preference, representing 30 percent of the outstanding shares of the company, and the company is sold for $100 million. The investor would thus be entitled to the first $10 million pursuant to its liquidation preference, and the remaining $90 million would be distributed ratably to the common stockholders. If the preferred stockholder, however, elects to convert its shares to common stock pursuant to its optional conversion rights (thereby giving up the liquidation preference), it would receive $30 million.
A mandatory conversion requires the preferred stockholder to convert its shares of preferred stock into shares of common stock upon a triggering event, such as an initial public offering (IPO) of a pre-determined value and/or a multiple of the original price of the stock. This is typically referred to as a Qualified IPO.
When a company issues additional shares of equity securities, the additional issuance has a "dilutive" effect on the ownership percentages of all the company’s existing stockholders. An anti-dilution provision protects a preferred stockholder and if shares are issued or sold below the price they paid by issuing the holder additional shares.
An anti-dilution provision protects a preferred stockholder from equity dilution resulting from later issues of stock at a lower price than the price paid by the investor. Total shares outstanding may increase because of new shares being issued due to a round of equity financing or perhaps because existing option owners exercise their options.
The two common types of anti-dilution clauses are known as "full ratchet" and "weighted average." The company will prefer to use "weighted average," and an investor would prefer to use "full ratchet." Here’s why.
In a full ratchet anti-dilution provision, the conversion price of the preferred shares is adjusted downward to the price at which new shares are issued in later rounds. For example, an investor who paid $2 per share for a 10 percent equity ownership in a company would get more shares in order to maintain that stake if a subsequent round of financing were to come through at $1 per share. The investor would have the right to convert its shares at the $1 price, doubling their number of shares.
The weighted average anti-dilution provision is a little more complex. Under weighted average anti-dilution, the conversion price is determined using the following equation:
C2 = C1 x (A + B) / (A + C)
In this equation, the variables equal the following:
C2 = new conversion price
C1 = old conversion price
A = number of outstanding shares before new issue
B = total consideration received by the company for the new issue
C = number of new shares issued
The weighted average anti-dilution formula adjusts the rate at which preferred stockholders convert into common stock based upon two things:
- The amount of money previously raised by the company and the price per share at which it was raised, and
- the amount of money being raised by the company in the subsequent dilutive financing, and the price per share at which such new money is being raised.
Thus, a new reduced conversion price for the preferred stock is obtained, which results in an increased conversion rate for the preferred stock when converting to common stock.
Protective provisions are typical in venture deals and provide the preferred stockholders the right to approve certain decisions made by, or with respect to, the company. These approval rights are of critical importance to a company and its investors and often involve significant negotiation. Protective provisions will address key issues such as:
- A liquidation, dissolution, or wind-up of the company’s affairs; or the effect of any merger or consolidation or any other deemed liquidation event;
- Amending the company’s certificate of incorporation or bylaws so as to alter or change the powers, preferences, or special rights of the shares of preferred stock so as to affect the holders adversely;
- Increasing or decreasing (other than by conversion) the total number of authorized shares of preferred stock or common stock;
- Authorizing or issuing of any equity security with a preference over, or on a parity with, any series of preferred stock with respect to dividends, liquidation, or redemption;
- Redeeming or purchasing shares of preferred stock or common stock (subject to certain exceptions);
- Any declaration or payment of any dividends or any other distribution on account of any shares of preferred stock or common stock; and
- Any change in the authorized number of directors of the company.
When an investor owns shares in a private company, there are restrictions for the company and the investor that govern how they can sell their shares to third parties or transfer ownership through a transaction.
Drag Along Rights
A drag along rights gives majority investors the ability to sell a company to a third party without consent from minority shareholders. In a sale of the company, the minority shareholders agree to sell the entirety of the stock they own. In a merger, the minority shareholder agrees to vote in favor of the merger.
Tag Along Rights
Tag along rights, also known as "co-sale rights," are similar to drag along rights, except they guarantee minority shareholders the right to sell their shares in the company at the same time and under the same conditions as the majority shareholders. In sum, tag-along rights require the majority shareholder to include the holdings of the minority shareholders and gives such shareholders the ability to capitalize on a deal that a larger shareholder is able to identify and negotiate.
Rights of First Refusal
Under the right of first refusal (ROFR), in the event that a founder wants to sell any of their shares to a third party, the ROFR requires them to first give the company the right to purchase the shares on the terms and conditions offered by the third party. If the company elects not to exercise its ROFR, the preferred shareholder then has the right to purchase the shares on the same terms and conditions offered by the third party. If neither the company nor preferred shareholders exercise the right, then the founders may proceed to sell their shares to the third party.
In a venture deal, the shares that are purchased by investors are considered restricted shares. In other words, they cannot be transferred or sold by the shareholder without being registered with the SEC or pursuant to an applicable exemption from registration. A registration right is a right that entitles an investor who owns the ability to require a company to list the shares publicly so that the investor can sell them. There are two types of registration rights: demand registration and "piggyback" registration.
Demand registration rights allow the holders of a certain percentage of registrable securities to require that the company register its shares after a certain period of time, typically three to five years after the investment or six months after an IPO. The number of times the investors can make this demand can be negotiated; one or two is usual.
Piggyback registration rights, as the name implies, enable holders of registrable shares to participate in the registration of any other class of shares by the company.
Depending on the size of the investment, certain investors may ask to have a board seat with the company. The company would agree to nominate a director proposed by the investors each year. The right to the board seat will usually terminate upon certain events, such as the investor holding less than a specified percentage of stock (common or preferred) in the company, the completion of an IPO, or the mutual agreement of the parties. As discussed above, the board member is likely to be subject to regulatory approval. Therefore, any right to a board seat should include provisions that require the investor to nominate only individuals who will not be disqualified from being a board member of a licensed cannabis company.
Information rights are rights that a preferred stockholder has to demand to receive regular updates from the private company about its financials and operations, such as:
- the right to receive quarterly financial statements;
- the right to receive annual audited financial statements;
- the right to receive any periodic reports required by securities laws;
- the right to receive documents, reports, financial data, and other information as reasonably requested;
- the right to visit and inspect the company’s properties, including books of account;
- the right to discuss company’s affairs, finances, and accounts with the officers; and
- the right to consult with and advise management on all matters relating to the company’s operation.
The terms discussed above are going to be included in several definitive documents that will set forth all the rights and obligations of the parties. These documents will likely include a stock purchase agreement, the certificate of incorporation, investor rights agreement, right of first refusal, and co-sale agreement and voting agreement.
Stock Purchase Agreement
The stock purchase agreement is the document by which the investors agree to pay the purchase price for, and the company agrees to sell, the preferred stock. The stock purchase agreement will contain representations and warranties of the company and the investors. The investors will make representations that include, among other things, they are accredited investors and have the ability to purchase the shares under applicable securities laws, and that they will not be disqualified from owning an interest in a cannabis company. It will also contain the closing conditions for the investment.
The stock purchase agreement should also contain an exhibit that an investor can complete that will ask for the relevant information needed to provide to the cannabis regulators for approval of such ownership interest by the investor. The agreement will also contain a corresponding closing condition that the exhibit must be completed prior to closing.
The company can include additional covenants that require the investor to cooperate in good faith with the company’s cannabis regulators both in connection with the approval of the investor’s investment, with periodic reports, and with any license renewals.
Certificate of Incorporation
Immediately prior to the closing of the investment, the company will need to amend its certificate of incorporation to include several of the key terms discussed above, including the liquidation preference, the dividend, the mechanics of conversion, if any, the anti-dilution provisions and certain voting matters such as protective provisions and director seats.
Investor Rights Agreement
The investor rights agreement is an agreement between the company and the investors that typically governs the registration rights, lock-ups, and information rights. If there is a lead investor, the investor rights agreement may also contain additional provisions regarding matters requiring the lead investor director’s approval and board observation rights.
Right of First Refusal and Co-Sale Agreement
This agreement will contain the rights of first refusal, drag-along rights, and co-sale rights, if any.
The voting agreement is an agreement to be entered into by the company, the investors and all pre-existing stockholders of the company. This agreement requires all the parties to vote their shares in accordance with the agreement and generally includes obligations regarding the size of the board and voting for director designees.
This was excerpted from Cannabis Capital: How to Get Your Business Funded in the Cannabis Economy by Ross O’Brien. Reprinted with permission of Entrepreneur Media, Inc. ©2020, Entrepreneur Media, Inc. All rights reserved. Available where books are sold.