Recent reports have shown that many cannabis businesses are struggling with the current market situation. However, a down market can provide clever entrepreneurs with an opportunity to break into the industry. If that is you, or if you are already in the industry and looking to raise capital for the first time, there are some options when looking to raise seed financing for your startup.
The most common are convertible notes, simple agreements for future equity (“SAFE”), convertible preferred stock, and common stock. Below we provide a high-level introduction to each financing instrument along with some pros and cons of each.
Convertible Notes
These are the most common instruments used when cannabis companies are raising capital. Convertible notes are a form of debt security, which may turn some people away from using them. However, rather than collecting debt payments, the investors’ goal is to convert the note into the same preferred equity security issued at the time of a conversion event, which would be defined in the note.
Being a debt security, the common terms for a convertible note are (i) principal amounts that are due at a maturity date; (ii) a fixed interest rate; (iii) definition of the conversion events; and (iv) a claim on the cannabis company’s assets that is senior to all equity-holders and typically pari passu with all other unsecured non-senior debt.
Pros
- Familiarity. As mentioned above, they are the most common instrument when raising capital.
- Simplicity. They are typically relatively short and have few negotiated terms.
- Cost. Preparing and issuing convertible notes can be cheaper than more complex equity transaction documents.
- Equity Incentives. Convertible debt typically does not negatively impact the fair market value of the cannabis company’s stock, which keeps the cannabis company’s equity incentives more attractive and valuable.
Cons
- Uncertainty. Conversion prices are typically based on a future value of the cannabis company, which can create uncertainty for founders and investors regarding the percentage of the cannabis company they will own upon conversion.
- Maturity and Interest. If the convertible notes have not been converted before the maturity date, the investors can gain significant leverage over the cannabis company to extract a better deal.
- Unintended Outcomes. Some basic-looking notes can provide noteholders with full anti-dilution protection or liquidation preference which is several times the purchase price of the notes, which would not be market in a seed equity deal.
SAFEs
A SAFE is similar to a convertible note but they are not a debt security as there is no maturity date or interest is accruing. Otherwise, they are substantially the same as a convertible note.
Pros
- Simplicity. These tend to be form documents and are typically shorter than convertible notes.
- No Maturity or Interest. Founders do not have an impending maturity date or accruing interest over their heads using SAFEs.
- Similarity to Convertible Notes. Carries the same mechanisms and economics as convertible notes, which are the most common instrument.
- Cost. Issuing SAFEs typically costs less than issuing convertible notes.
- Equity Incentives. Similar to using convertible notes, SAFEs have minimal impact on equity incentives.
Cons
- Uncertainty. There is the same pricing uncertainty found with convertible notes.
- No Maturity or Interest. Investors may prefer convertible notes with a maturity date and accruing interest.
- Unintended Outcomes. Some of the same unintended outcomes can occur with SAFE as with convertible notes.
- Tax Treatment. There is still uncertainty with tax treatment for SAFEs.
Convertible Preferred Stock
Rather than having the investors’ investment convert into equity at a later date, the cannabis company can sell convertible preferred stock. Preferred stock is a class of stock in the cannabis company that entitles the holders to defined rights that typically include (i) priorities in payment over the common stockholders, such as a right to receive dividends or a right to specified distributions on the cannabis company’s dissolution, liquidation or deemed liquidation; and (ii) different or additional voting rights, such as approvals on mergers, dividends, and equity issuances.
Pros
- Certainty for Investors. Investors have control over negating the price and terms of the stock at the time of the investment rather than waiting for a convertible event as with a SAFE or convertible note.
- Certainty for Founders. Founders will know exactly how much of the cannabis company they are selling.
- Simplicity of Next Financing. Without having to worry about outstanding SAFEs or convertible notes converting as part of a financing round, the next financing will be less complex.
- Familiarity. There are form documents sophisticated seed investors use as a starting point and many are familiar with such type of equity.
Cons
- Complex Documents. Documenting this type of investment typically takes longer than other forms of investment.
- Cost. Due to the greater length of documentation, there is typically a higher cost associated with such investment.
- Equity Incentives. These typically have an adverse effect on the fair market value of the cannabis company’s common stock for equity incentive purposes.
Common Stock
This is the simplest form of equity investment where investors purchase the common stock of the cannabis company, which is typically the same security that the founders hold. Common stockholders generally have the right to (i) vote for the cannabis company’s board of directors and on other stockholder matters; (ii) receive dividends, if and when declared by the board; and (iii) receive their proportional share of the cannabis company’s remaining assets if the company is liquidated.
Pros
- Simplicity. This is the simplest of the seed investment instruments. There is no uncertainty caused by later conversions and they typically do not include any special rights, preferences, or privileges.
- Cost. The documents the founders used to acquire their stock can be retooled for this type of investment.
- Equality. Founders and investors will have the same type of security.
Cons
- Equality. Some investors may want privileges, special rights, and/or preferences when making an investment.
- Equity Incentives. Typically has the most adverse effect of all the seed investment instruments on the fair market value of the cannabis company’s common stock for equity incentive purposes.
