Alternative Financing Options in the Emerging Legal Cannabis Industry

- October 14th, 2018

Cannabis industry financing coming from boutique lenders presents opportunities for investors.

Financing options in the emerging legal cannabis industry are proving to be varied and innovative.

One of the biggest challenges to growth in this sector has been the reluctance of American and Canadian banks to help finance cannabis companies. Understandably, North American financial institutions, especially those in the United States where cannabis remains federally illegal, have reservations about the risk posed by legal uncertainties. In this financial landscape, many cannabis companies have found it difficult to access even the basic commercial banking services such as cash deposits and operating lines of credit.

A handful of Canada’s major banks have begun to dip their toes into the cannabis industry, but the vast majority of licensed medical and recreational cannabis companies are seeking alternative funding solutions. The companies providing that alternative funding are now capturing market share in this emerging global marketplace and offering investors a way to profit on early-stage growth opportunities. According to Arcview Market Research and BDS Analytics, the legal cannabis market worldwide will reach $57 billion by 2027.

Most big banks still lukewarm on cannabis business funding

Smaller investment firms like Canaccord Genuity Group (TSX:CF) and Benchmark Capital are much less squeamish when it comes to serving the capital and business needs of cannabis companies. Vancouver, Canada-based Redfund Capital Corp (CSE:LOAN) recently opened one of the first merchant banks offering cannabis business loans and other services to medical marijuana companies.

In the US, major banks are largely barred from participating in the cannabis sector as the federal landscape has made it very difficult for US based cannabis companies to obtain financing and banking services. However, in Canada, major banks like the Bank of Montreal (BMO) and CIBC have become quite active in financing the cannabis sector.

BMO is by far the biggest player in the cannabis space. In August 2018, the major bank signed a $250 million loan deal with Aurora Cannabis (TSX:ACB) which may be the largest traditional debt facility in the cannabis sector to date, with the debt largely secured by the pot producer’s production facilities. Earlier in the year, BMO Capital Markets served as the financial advisor to Aurora on its $3.2-billion buyout of MedReleaf. These transactions followed the $200.7-million equity financing for Canopy Growth (TSX:WEED) and the arranging of a $100-million share sale for Cronos Group (TSX:CRON) earlier in the year.

CIBC World Markets was the lead alongside a handful of smaller investment firms that recently secured a $104-million private placement for Canopy Rivers, a partially owned subsidiary of Canopy Growth, in its bid to go public on the TSX Venture. TD Canada Trust has intimated that it may consider aiding in cannabis sector financings once full legalization in Canada is in effect. The banking institution recently expanded its list of cannabis stocks approved for investment advisor recommendation from three to 16 — all of which are Canadian listed companies with no prohibited US touchpoints.

The entrance of two out of five of Canada’s big banks into the nation’s cannabis industry points to increasing confidence in the sector in the infancy of legalization and helps to legitimize the industry. And yet, Canada’s large banking institutions may not be all that insulated from the US federal stance on marijuana that has kept America’s big banks from participating in the cannabis markets of states like Colorado and California.

It seems the Bush-era PATRIOT Act, meant to prevent foreign funding of terrorist activity in the US, authorizes the US government to seize what it considers illicit funds from “any foreign bank that maintains a correspondent account in the US.” That includes all 5 of Canada’s big banks — which may be the reason TD, RBC and Scotiabank have been so trepidatious about the cannabis market.

Various financing options in the emerging legal cannabis industry

In an industry where the borrower’s primary collateral is inventory of a licensed and controlled substance — not something easily liquidated if a borrower defaults on their loan — it’s difficult to find an asset-based lender who is comfortable with that risk profile. Even the specialized equipment used in cannabis cultivation and processing is not so attractive as a collateral asset given the limited resale market. However, those cannabis companies with substantial real estate assets have been successful at securing funding in recent months — making real estate assets critical to a more favorable risk profile for a cannabis company.

Much like in the mining industry, the cannabis sector is capital intensive; and much like mining companies, cannabis companies have found alternative financing solutions to help them build and grow even when the big banks would not get involved. Streaming, royalty and ownership positions have been successful, non-dilutive funding options for junior miners during the economic downturn when investment dollars were tight. And those funding options are emerging in the cannabis market as well.

Stream financing provides a cannabis company with the up-front capital needed for critical infrastructure development, with that capital paid back to the streaming company once production and sales begin. In Canada, the most active streaming investment company has been Auxly Cannabis Group (TSXV:XLY), formerly Cannabis Wheaton. Auxly has upstream partnerships with a number of Canadian cannabis companies including Beleave (CSE:BE); Lotus Ventures Inc (CSE:J); and FV Pharma, a subsidiary of FSD Pharma (CSE:HUGE).

Royalty agreements are another popular method for obtaining capital for cannabis startups and expansion activities. “The royalty model is a very attractive alternative or complement to the two typical sources of financing, debt or equity, which are largely not available from traditional sources in the US right now,” Andriyko Herchak, CEO of FinCanna Capital (CSE:CALI,OTCQB:FNNZF), told INN. “Equity can be significantly dilutive for startup companies. As a as a source of financing, royalty capital is well aligned with the economic and financial interests of great management teams that are looking to expand and grow their businesses in the licensed medical cannabis market.”

FinCanna Capital is building a diversified portfolio of royalty investments in US-based cannabis businesses. The company recently advanced US$1.25 million in an initial tranche of capital to Oakland-based Refined Resin Technologies to retrofit a large cannabis extraction laboratory. As part of the deal, royalty payments to FinCanna will equal to 11.75 percent on the first US$160 million of annual revenues.

Although legal barriers are holding back the big banks from participating in the US cannabis market, regulations in legal cannabis states do allow organizations to fund real estate or equipment.

“The lack of traditional means of lending has provided a unique opportunity to specialized financiers where the lender is able to provide the capital for land, infrastructure, equipment, and branding, all in exchange for a minority interest in the licensed cultivating operation,” Michael Yorke, CEO of CROP Infrastructure (CSE:CROP,OTCMKTS:CRXPF), told INN. “Companies like CROP have seen massive demand for these services as the legal framework is still developing in the global markets yet has strong momentum heading toward recreational legalization.”

CROP funds a real estate and infrastructure investment portfolio of projects which includes cultivation properties in California, Washington State, Nevada, Italy, Jamaica and a joint venture on West Hollywood and San Bernardino dispensary applications. There are 15 cannabis brands in CROP’s portfolio and the company has US and Italian distribution rights to a line of over 55 topical cannabis products from The Yield Growth Corp. Investments by CROP are paid back through leasing, licensing, branding, and management fees. As the legal cannabis market expands, the company plans to continue deploying its turnkey business model internationally.

Advantages for investors in alternative financing solutions

Alternative financing solutions have a lot of advantages for cannabis companies, but they also provide a host of benefits for investors as well. The companies offering these funding options are not tied to just one segment of the market but can invest in a wide variety of high-quality projects from cultivation and extraction to distribution and dispensaries, and even in auxiliary services like security and computer software companies. Such diversification mitigates the financier’s risk of exposure to the challenges experienced by just one company and allows investors exposure to the upside potential in these growing markets. Geographic reach across multiple jurisdictions also reduces the risk to business posed by legal or economic market challenges. Once the partner companies are in operation, investors benefit from a steady stream of revenue.

Looking forward

The emerging legal cannabis market is expanding rapidly, creating a competitive landscape for the numerous cannabis companies jockeying for startup or growth investment. In challenging financial climates, alternative financing options can give these companies the capital they need to move forward. With the big banks not in play, investors have the opportunity to be on the forefront of that growth as the legal cannabis market goes global.

This article was written according to INN editorial standards to educate investors.

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