The Cannabyss – Factoring as a Cannabusiness Lifeline

While there is still a long way to go before it is fully legalized, the cannabis industry has been growing rapidly in recent years. Due to the many challenges surrounding the sector, factors have an opportunity to win business with cannabis operators, but there are important considerations to understand before doing so.

BY ROBERT HOBAN, MEMBER, CLARK HILL

Cash flow is king in any business and the ability to ensure the timely payment of expenses balanced against incoming revenues is always a tricky maneuver. The cannabis industry is no different. Companies that have managed to attract loyal clientele and which generate recurring revenues still face the possibility of insolvency if the rate at which they take in dollars fails to outpace the expense payments that are required to maintain their ongoing operations.

When one is operating a startup, as many “cannabusinesses” are, lines of credit are often hard to find, resulting in cash flows that can become stretched thin as a company is forced to pay for expenses (the costs of goods sold) and other key supplies up front, while customers tend to take their time paying for the goods or services that the company has rendered. Cash flow challenges tend to be the most visible when a company is growing quickly or if it participates in an emerging industry.  Cannabis industry businesses tend to feel this challenge on a regular basis.

Financing Challenges

Cultivation of cannabis is a time-consuming process, even under modern standards. I cannot tell you how many times I have heard a client tell me (or a third party) that ‘harvest is only a few weeks away,’ as if the dollars that are derived from the freshly cured cannabis flowers, or derivatives processed therefrom, will magically cover all pending expenses. And many states require (or did require) vertical integration, meaning even retailers had to be connected to a cultivation operation in some form or fashion.  Hence, the cash flow issue exists across a large portion of the cannabis industry, as cannabis cultivators/operators must make payroll, cover rent, pay extensive power/energy bills, maintain their crop cycle, process, or move to retail all while paying expenses. The dollars are almost always right around the corner, and while they do actually tend to be, this gap between revenue flow and expenses obligations remains a substantial challenge.  Thus, cannabis companies require solutions — creative, normalized or otherwise. 

I reference “creative” options because most banking institutions will generally not provide lines of credit, or other forms of short-term (or even long-term) financing solutions, to cannabis companies because marijuana is unequivocally a Schedule I substance under federal law. As such, options can seem relatively limited. Consequently, these operators require short-term relief in the form of invoice financing or invoice factoring alternatives. But we have not seen this concept utilized widely in the cannabis industry, at least not yet. 

As stated in the previous paragraph, marijuana remains a federally controlled narcotic in the most restrictive schedule of drugs under the Controlled Substances Act (CSA). It is situated under Schedule I of the CSA, which indicates no medicinal value and a high potential for abuse. While there has been lobbying, legislative and litigation efforts to reclassify marijuana under the CSA, the law remains the same, and while the overwhelming scientific data says marijuana is indeed highly beneficial to human beings (and all mammals, really) from a medicinal, therapeutic and wellness standpoint, the authorities have not yet been persuaded, even in a day and age when ‘science’ effectively controls our daily lives on a global level, but I digress. 

Industrial Hemp

Now, industrial hemp is another topic altogether. In the most sweeping cannabis policy reform in U.S. history, Sen. Mitch McConnell led the effort to define industrial hemp as different than marijuana and to remove it from any sort of CSA controls. The difference between the two is the percentage of tetrahydrocannabinol (THC), specifically Delta 9 THC. Any cannabis plant containing less than 0.3% THC by dry weight (which is similar to the amount of caffeine in a decaffeinated cup of coffee) can be defined as lawful hemp under the law (with appropriately enacted state law). Anything above that threshold is deemed marijuana. Thus, there is a distinction as to the risk spectrum for lenders and factors deciding whether to potentially work with hemp or marijuana operators, and that distinction is significant. In sum, hemp is 100% legal under federal law; marijuana is not. 

Legalization and Regulation

More and more markets around the world are legalizing some form of cannabis and there is indeed a global cannabis economy that exists outside of the United States. This will tend to ratchet up the pressure for the United States to reform its laws surrounding the cannabis plant. And even the United Nations (with U.S. support) voted to substantially reclassify cannabis to reflect these changes in global mores and beliefs (and science!) surrounding the cannabis plant.  

Despite these basic legal facts, and the international momentum surrounding cannabis policy reform, marijuana businesses operate across the United States but only engage in intrastate commerce. And each state that allows commercial regulated cannabis has enacted very stringent rules and regulations, which tend to be strictly enforced. 

Thus, regulatory issues tend to make a cannabis business’ license its most valuable asset.  But under current rules and regulations, these licenses tend to be closely guarded and, often times, not transferrable or able to be collateralized in some manner. There are alternatives in various jurisdiction by way of disclosure, registration, etc. at the state level in the event that one seeks to secure payment/repayment through this valuable business asset, but these rules vary in every state and specific guidance is essential. 

Furthermore, engaging in any sort of finance with a marijuana business can be complicated by state-agency-based enforcement, operator compliance and other factors that are somewhat unique to the cannabis industry. After all, this industry has only recently been moved from the dark into the sun, and legacy operating standards often remain, so be wary and proactive. 

Further Considerations

As alluded to earlier, companies in the marijuana space tend to have stacked debt. This is due to onerous regulatory requirements, the lack of efficiencies associated with interstate commerce, vertical integration laws or practices and the fact that marijuana businesses cannot deduct ordinary business expenses under the IRS tax provisions known as Section 280e. As a result, even though these companies tend to generate large sums of revenue, their margins are very slim and they tend to have a series of large and overlapping debt obligations. 

Furthermore, while banking can be available to these companies, it is typically at a high cost through depository accounts only with local, regional or community banks, adding another layer of complexity to those seeking to work with the industry.     

There are several other issues that one must fully understand before working closely with a cannabis operator. Bankruptcy is an unavailable option to marijuana businesses under the law, causing the rise of receiverships to fill out the role of asset liquidation or reorganization. This is both good and bad but comes along with a wide range of challenges.  

First, liens are seldom used because the actual cannabis plants cannot typically be liened under a UCC filing statement or otherwise, although this landscape has been changing,

Second, there are a large number of other significant issues related to foreclosure mechanisms in the cannabis industry, the rampant use of licensing agreements which complicates technical ownership of any potential collateral and the fact that compliance tends to be a moving target (and one that you cannot rely on the cannabis business to completely align with because of its challenges).

Thus, in the event that one seeks to engage with a cannabis business, it is absolutely essential to seek professional legal advice from an attorney with significant cannabis industry expertise and factoring experience. To that end, it is also necessary to contract for the ability to perform compliance audits, and it is recommended that you first perform industry-specific due diligence through the use of tools such as those offered by Gateway Proven Strategies (and its proprietary COMPASS tool).

At the end of the day, there is no simple road to navigate working with the cannabis industry. And if you go, no one may follow, meaning the path is for your steps alone. 

To learn more about factoring and the cannabis industry, make sure to check out the International Factoring Association’s recent webinar on the subject. The recording can be found here.

Robert Hoban is a member at Clark Hill. He can be reached at rhoban@clarkhill.com. You can learn more about Hoban’s background and experience here.