By Diana Novak Jones

Law360 (May 29, 2020, 5:32 PM EDT ) A Santa Cruz, California, cannabis manufacturing company was about to receive $10 million from an investment fund when the coronavirus' spread accelerated in the United States.

In a panic, the fund's investors pulled their money, leaving nothing for the company's planned investment.

"You can imagine a company that was expecting to have a $10 million infusion ... to be without that was dramatic," said Lorenzo Nourafchan, CEO of Northstar Financial Consulting Group, which works with the company and many others in the cannabis industry.

The Santa Cruz company's setback is just one of several canceled investments Nourafchan said his cannabis clients have faced since the pandemic took off in the U.S., leaving them forced to consider cuts instead of expansion.

Nearly three months after the stay-at-home orders began, cannabis companies already facing a capital crunch are encountering fewer investors, more questions and harsher terms as they fight to raise the money to stay in business beyond COVID-19.

Largely shut out of traditional bank loans, the cannabis industry is reliant on private investment. That reliance has already been tested by a capital drought caused by last year's dramatic drops in stock prices and valuations. And now, the dire headlines about a likely recession caused by the pandemic haven't helped.

Most states that have legal marijuana businesses have designated them "essential" and able to stay open during pandemic closures, which has kept some investors interested in the industry. But they're taking their time, asking for new information and forcing companies to accept less, experts told Law360.

Nourafchan sees the worsening capital crunch as a dividing line between businesses that will be able to survive and those that won't.

"At the end of the day … those companies with immature or not-best practices when it comes to operating from a financial perspective, a lot of those are going to be weeded out," he said.

"What is going to start to emerge are going to be larger companies that will have grown even larger, through acquiring these companies."

Deal-Making in the Time of COVID-19

Cannabis retail technology company Green Bits was just closing a $23 million round of financing when the stay-at-home orders began popping up around the country, CEO Barry Saik said.

The investors had been cautious, concerned by the struggles the industry was dealing with at the end of 2019, Saik said. But the round was successful, closing in April.

At that point, the company turned to recruiting some follow-on investors, usually smaller outfits that trail behind the larger money, he said.

"Normally there's a dynamic of getting in on a good deal," Saik said of the investors that come after a big raise. "A venture capital firm, they hire analysts, they're doing a bunch of due diligence, and so there's a lot of work that has been done. There is an opportunity to piggyback on that, [but] you have to act quickly."

Instead, Saik said those followers had their own demands before they joined up. They wanted to do their own due diligence, asking questions about Green Bits' fundamentals, revenue and customer attrition, he said.

Total capital raised by the cannabis industry dropped nearly 70% in March compared with January and February of this year, according to Viridian Capital Advisors, a cannabis capital and transactions advisory firm that tracks deals in the industry.

And total capital raised is down almost 60% from the first quarter of 2019, according to the firm.

Recruiting investors interested in cannabis has been hard since the middle of 2019, said Marc Hauser, co-vice chair of the cannabis law team at Reed Smith LLP.

"It's only gotten worse since then," he said.

But Hauser and other attorneys working on the investor side say the current situation presents a unique opportunity for investors accustomed to risk.

For one thing, the industry has long been home to a wide variety of investor-friendly deal structures, such as asset-backed loans that come with equity, warrants and high interest rates, Hauser said. Investors may also be given control over major company decisions.

"[In] deals I've been working on lately, on the investing side, the investor has a lot more ability to dictate control rights," he said.

"I think this will allow investors to be even more opportunistic than they were already."

Samantha Gleit, a partner focused on debt and equity financing at Feuerstein Kulick LLP, led a deal for investors in cannabis company 4Front Ventures that saw the company raise $5.8 million through a private placement of convertible debt earlier this month.

Gleit said deals she had in the works before the pandemic have gone through as planned.

"They've closed because the companies have demonstrated that they were able to withstand what has happened in the last three months now," Gleit said.

New deals are still happening, she said, but going forward, lenders are going to want updated projections, and they'll have questions about what the company has done to weather the pandemic, she said.

"Because these companies have been operating, a lot of investors are really interested," Gleit said. "They have accepted some risk profile if they're already somebody who was in the game, so to speak. So my belief is those same investors are continuing to look opportunistically."

That's true for investor Michael Auerbach.

Auerbach, who invests in the cannabis industry through his firm Subversive Capital, said he made a few seed investments in cannabis startups in the first months of the pandemic. They were done at what he calls post-COVID-19 pricing.

"In cases where companies were valuing their pre-revenue company at $10 million, we'll look to put in half a million at a $3 million valuation," Auerbach said. "Valuations have come down significantly."

He said there aren't too many investors looking to put new money into cannabis, and an investor who put money in previously is going to have a different take on the company's value now versus before the pandemic.

Nourafchan said that just before the pandemic began, one of his clients was in negotiations for more funding from existing investors who had put money in when the company was valued at $40 million.

Right away, the investors wanted to talk about investing based on a lower valuation, Nourafchan said. Instead of the $10 million they had originally planned, they invested $2.2 million based on a valuation of $12.5 million, he said.

Auerbach said that type of situation is becoming more frequent.

"If you're going after existing investors, they're going to want to take a pound of flesh," he said.

Who's Left?

The struggle to raise money is going to be life or death for many cannabis businesses, and it will likely leave the industry in a very different place at the end of this year than at the beginning, experts said.

Nourafchan and Auerbach think dropping valuations will eventually bring in more investors, but prices will have to go even lower.

"I think people are waiting for the bottom," Auerbach said. "I don't think we've seen the bottom yet."

Nourafchan said the interest in cheap assets will be there because the possibility of legalization is looming.

"The bubble can burst in some sense, [but] this is going to be federally legal soon," Nourafchan said. "These are going to be legit businesses."

Auerbach also thinks the squeeze the pandemic put on government budgets could push more states and localities to legalize, or loosen regulations on their existing cannabis businesses. Cities have allowed their dispensaries to do curbside service and delivery to get through the pandemic. If those policies stay after the economy fully reopens, it could give the industry a lasting boost, he said.

And some businesses have seen something positive come out of the pandemic. With many dispensaries open for business, some have seen a marked uptick in sales.

Saik, whose company Green Bits runs point-of-sale software for dispensaries, said his clients have seen a sustained 35% increase in sales over this time last year.

Industry analyst Headset Inc. has said that markets less reliant on tourism are seeing increased sales, while places like Nevada have taken a hit.

The pandemic has come at a time when many in the industry expected to see the competition for shelf space and dispensary licenses force struggling companies to shutter. But it's really the competition for cash that will be the deciding factor, Nourafchan said.

"We knew [2020] was going to be a year of consolidation in the cannabis industry," Nourafchan said. "We thought it was going to be based on success-driven valuation. What is actually happening is a consolidation due to distressed assets."

--Editing by Aaron Pelc.

This year already promised to be a tough one for the cannabis industry, before the coronavirus compounded the many problems businesses have been facing. In this series, Law360 looks at the specific impact the virus is having on the nascent industry as it fights for a foothold in the U.S.

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