Cannabis companies that need more money than they can generate through sales generally have two options: borrow money (debt) or solicit investments (equity). Over the years as the industry has constricted, equity finance became less of an option. I recently predicted that equity investment will reignite when cannabis is rescheduled. But that hasn’t happened yet, which means that cash-hungry cannabis companies need to borrow money. And because of high taxation, overregulation, the illegal market, and so on, many if not most cannabis companies need cash.
Not surprisingly, over the years I’ve seen massive increase in debt transactions as investments decreased – both original financings and refinancing. Today, I want to look at some of the things that cannabis companies should expect when looking for cannabis loans.
Traditional lenders won’t work with cannabis companies
Cannabis companies can’t just walk into a big bank and draw a commercial cannabis loan. Many banks (especially the big ones) and institutional lenders are still too skittish to do business with cannabis companies. You can read about that here. This may change if cannabis is rescheduled, but probably not too much. Unless federal law changes to unequivocally treat cannabis as a federally legal commodity, the bigger banks will hesitate.
Because of this, expect to see private lenders, hard money lenders, and all kinds of servicing agreements with companies that loan specifically to cannabis companies.
Expect high interest
Cannabis companies that borrow money can expect to see high interest rates – often higher than “normal” businesses would be required to pay. Lenders justify higher interest on cannabis loans because of the increased risks they incur while (a) lending to an illegal business, and (b) lending into a highly volatile industry where businesses seem to go under left and right.
Except for very small loans or loans with related parties, I can only think of a handful of times where I’ve seen completely unsecured debt in cannabis loans. A security interest is a right that the borrower or an affiliate of the borrower grants to a lender to secure payment and performance of loan. It gives a lender recourse in the event the borrower stops paying or goes under, by allowing the lender to swoop in and take the asset that is collateralized. Think of a car loan – if you stop paying the bills, the car will get repossessed. It’s the same thing with cannabis, though on a much larger scale.
The types of security interests I see most in cannabis deals are:
Real property – Real property means real estate. If a cannabis company owns real estate, expect a lender to ask for a security interest in that real estate as part of a cannabis loan. These are granted pursuant to mortgages, deeds of trust, trust deeds, etc. (the exact type of instrument will change from state to state). But because lots of cannabis businesses don’t own property outright, that means cannabis loans are often secured by other types of collateral.
Physical assets – Security interests in physical collateral are probably the most common form of collateral we see in cannabis loans. This may include vehicles, equipment, machinery, office equipment, racks, lights, you name it.
Equity interests – Another very common form of collateral is equity, such as stock of a corporation or membership interests of an LLC. Very frequently, the owners of a borrower entity are asked to grant security interests in their stock in the borrower as collateral. These agreements are called pledge agreements, and are also very common.
Other intangibles – Intangible assets, such as intellectual property, rights under contracts, future accounts receivable, and so on, may be pledged as collateral to secure a loan.
Keep in mind that cannabis regulations play a huge role in determining the scope of security and pledge agreements. Some assets can’t be pledged under state law (depending on the state), such as cannabis licenses or cannabis inventory. Cannabis companies need to be fully aware of what they can and can’t collateralize so they don’t risk their licenses.
Lastly, security interests in general are complicated and can be subject to myriad requirements under Article 9 of the Uniform Commercial Code (UCC) in each state. Security interests in real estate are often doubly more complicated. So it’s key that cannabis businesses understand the law of security interests before seeking out cannabis loans.
Corporate and even personal guarantees
Lenders also frequently ask for guarantors on a cannabis loan. A guaranty is an agreement by someone other than the borrower of the borrower’s obligations. Guarantees by natural persons (usually officers or major stockholders) are often called personal guarantees, and guarantees by entities (usually parents or affiliates of the borrower) are often called corporate guarantees. They can also have multiple guarantors and be hybrid personal/corporate guarantees.
Guarantees can be a tall ask because a guarantor will be forced to step into the shoes of the borrower. If the borrower fails to make payment, the lender can simply demand that the guarantor make the payment in its place. And guarantors usually waive a host of defenses to performing on behalf of a borrower.
Personal guarantees are obviously much riskier than corporate ones, because a person risks their own personal assets (cars, houses, art, etc.) if the borrower entity doesn’t perform. Expect a lot of negotiation by cannabis companies concerning who must serve as a guarantor, the term of any guaranty, and related issues.
Lots of filings and third-party issues
A common misconception is that loans are purely between a borrower and lender. But that’s rarely the case. Expect to see one or more of the following in most commercial cannabis loans:
UCC filings are filings made with a state agency like the secretary of state that put third parties on notice that the lender has a security interest in certain assets of the borrower. Lenders often do UCC lien searches prior to loaning money to be sure of what a borrower has agreed to grant in the past. UCC lien forms will be filed at the inception of a loan, and terminated upon repayment.
Mortgages/deeds of trust/etc. are recorded with the county recorder where the real property is located.
Borrowers often must give regulatory notice to cannabis regulators, and make some disclosures, in connection with cannabis loans. Some states may even require preapproval.
Borrowers and persons offering collateral to support a loan must also often get preapproval from a host of third parties. For example, if an affiliate of the borrower offers equipment as collateral, and that equipment is located in a leased building, the lender will often ask that the lessor consents to the lender’s entry of the property on default to take the property.
The above is a summary of some high-level things that cannabis companies can expect when trying to borrow money. As you can see, lenders really do have the upper hand in these transactions. That said, there are always grounds for borrowers to negotiate for better (or at least more palatable) terms in cannabis financings. We’ll be sure to keep writing about these topics, so stay tuned for more updates.