Are you ready for an exit?

Consolidation is a defining aspect of the cannabis industry in its current stage. Mergers and acquisitions are mounting at a breakneck pace: Viridian’s Deal Tracker counts 265 North American transactions YTD in 2021, compared to 71 in the same period last year. Nearly 200 of those deals involved U.S. companies.

It is not just the volume of deals that demonstrates the trend – the value of transactions is also stunning. Average deal size has skyrocketed from about $20 million in early 2019 to over $70 million as we approach the end of 2021.

Who’s leading the charge? There is a healthy mix of strategic acquirers and private equity. On the U.S. side, for example, multi-state operator Cresco recently acquired Cultivate for a potential net purchase price of just over $150 million. The move provides a Massachusetts footprint and opens the door to a better stronghold for Cresco in the Northeast.

The IPO route invites further complexity and opportunity. A rash of filings from cannabis companies seeking to go public via Special Purpose Acquisition Companies (SPACs) signals that the heavy buying activity is likely to keep its momentum.

Cannabis operators have found themselves – or placed themselves – in a feeding frenzy. There is great potential for growth and a healthy sale, however neither of those goals are easy to achieve. Those who want to capitalize on the sector’s appetite for acquisitions need to evaluate three key considerations if they are poised for an exit:

When you first established the company, your exit strategy may not have played a role in the legal structure you chose. Launching as an LLC often makes the most sense in a startup phase, however a C Corp provides a different set of advantages – and the decision has a significant role in how tax efficient a sale might be.

Much of the current M&A activity is being driven by Canadian public companies looking to break into new geographies. That means that an exchange of stock is frequently part of the deal. If you are structured as a C Corp, the acquisition can be considered a reorganization and the stock may be tax-deferred until it is sold. This is a tremendous tax benefit for sellers that is lost under different structures. With LLCs, the exchange is considered liquidity and triggers a tax event.

It is possible to change structure in anticipation of a sale, however you’ll want to tackle that at least one year prior to exploring your acquisition.

Cannabis operators are burdened by complexity that makes normally routine operations much more difficult. Regulatory shifts and a reliance on cash transactions, fast growth, and exit opportunities can result in a financial house that appears disorganized and unreliable.

Buyers in the space, however, are quite the opposite. Publicly traded companies and sophisticated investors are geared for financial clarity, responsibility, and transparency, and they look closely at the financial history of any potential acquisition candidate. Income tax filings, sales tax filings – everything will be under the microscope.

Sellers should stay ahead of this reality by commissioning audits two or three years in advance of an anticipated exit. Audits not only create a more stable, clear understanding, they also bring credibility to the organization.

By the time an acquirer shows interest, it will be too late to pull together an orderly picture. Confusion on the financial and tax side can lead to less favorable deal structures and, in some cases, deals that get abandoned altogether.

While financial clarity is being established two to three years prior to an exit, owners should also begin changing their perspective on profit. The right treatment of net income can present opportunities to maximize your position in a deal.

For example, elevating earnings before interest, taxes, depreciation, and amortization (EBITDA) is critical to increasing a payout, which is likely to be based on historical profit margins. In a non-exit strategy, accountants often aim to manage tax exposure by decreasing margins. The opposite approach comes into play during a sale. Sellers should maximize EBITDA to show the healthiest bottom line possible.

Looking past the sale, accurately forecasting EBITDA is just as important. Deal terms often call for an earnout period, during which sellers will be responsible to hit profitability targets. Having solid projections in place helps prevent a buyer from changing the targets dramatically, thereby setting up a more difficult path for the earnout.

Much will continue to change across the cannabis sector – and it will likely change quickly. Banking regulations may soon shift in operators’ favor, and the U.S. remains on the steady (but very slow) march towards legalization. Both developments will open more fluid opportunities for expansion. Operators and their advisors should continue to be vigilant about how developments affect their business and what steps will lead to the best outcome.

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