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CANNABIS CONSOLIDATION Mergers and acquisitions (M&As) have taken off in the cannabis industry, as startups and larger companies alike jockey for position in the highly dynamic (and highly regulated) space.

Legal cannabis is rapidly coming of age in Illinois and a growing number of other states. Amidst fierce competition, capital access challenges and a highly complex regulatory landscape, M&As are on the rise. Three seasoned Chicago-based M&A deal attorneys with deep knowledge of the unique pressures shaping the emerging cannabis industry shared with Crain’s Content Studio what’s behind all the action—and what to expect in the coming years.

What’s fueling the recent surge in cannabis M&A activity? Do you think it will subside any time soon?

Kevin Slaughter: The surge in M&A activity has been fueled by two things: fierce competition in a highly regulated industry, and ongoing valuation compression that has dramatically slowed capital-raising. I expect the surge to continue as larger multi-state operators (MSOs) look to increase market share, enter new markets and scale ahead of federal legalization and traditional industries entering the market. Also, there are some markets that are experiencing over-saturation, which is an environment ripe for M&A activity as smaller companies look to partner to increase market share and reduce costs.

Anthony Zeoli: First, many of the larger acquiring entities are expected to create high rates of investor return. To achieve those returns, these companies need to continue to expand profitability, which necessarily leads to expansion. Second, acquisition funding is relatively cheap today—the average cost of acquisition capital across the board still remains near historic lows. But interest rates are expected to rise significantly in the near future, leading many to try to get deals done now while rates are low. Finally, in states where cannabis licenses are limited (e.g. Illinois), there is significant pressure to get acquisition deals done before the next wave of licenses are issued. I

players continue to seek out deals to increase their scope and market share, while smaller firms and new entrants search for sources of liquidity, investment capital and the safety of business combination. Continued regulatory evolution at the federal, state and local levels is also fueling transaction activity, as companies navigate the shifting sands of opportunity, and peril, in the industry.

What unique factors can make cannabis M&A transactions different from other M&As? Zeoli: Regulatory compliance, both at the state and federal level, is by far the biggest factor. Cannabis laws vary significantly from state to state, creating added complexity in deal structuring. This issue is further exacerbated by the fact that many states (e.g. Illinois) do not yet have a streamlined process for approving license transfers. Generally speaking, state regulatory approval is required prior to the actual sale and transfer of a cannabis license (or any regulated assets such as cannabis inventory).

The lack of a definitive transfer process typically creates uncertainty, leading to significant closing and funding delays.

- BILL DORAN, BENESCH

Bill Doran: The legal cannabis industry remains in its early stages, relatively speaking, so we’re seeing both rapid growth and consolidation simultaneously. Larger, established

Partner Benesch wdoran@beneschlaw.com 312-212-4970

definitely does not fit all in cannabis M&A. Slaughter: Cannabis companies often have complex organizational structures to comply with applicable regulations, which may increase

KEVIN SLAUGHTER

ANTHONY J. ZEOLI

Partner Levenfeld Pearlstein, LLC kslaughter@lplegal.com 312-476-7527

diligence costs and difficulty of transactions. At a minimum, most cannabis M&A transactions require regulatory approval. That adds a higher level of complexity to cannabis transactions relative to other M&As. For example, where sellers hold

Partner Freeborn & Peters LLP azeoli@freeborn.com 312-360-6798

conditional licenses, lack necessary capital, and regulatory approval is contingent on operational inspection, the financial exposure to buyers will increase because they will need to pay significant build-out expenses prior to regulatory approval.

Doran: The cannabis industry is highly regulated, and regulations vary by jurisdiction. Like the healthcare industry, this creates a unique overlay to traditional M&A activity because the regulatory issues influence

“CONTINUED REGULATORY EVOLUTION AT THE FEDERAL, STATE AND LOCAL LEVELS IS FUELING TRANSACTION ACTIVITY, AS COMPANIES NAVIGATE THE SHIFTING SANDS OF OPPORTUNITY, AND PERIL, IN THE INDUSTRY.”

expect the current surge will taper off significantly in the next 12-24 months as interest rates rise and the cost of acquisition funding increases.

BILL DORAN

everything from due diligence to deal structure to legal documentation.

Ownership requirements and change in control rules often influence deal timing and structure, and flexibility and creativity is required to successfully complete each deal.

For example, many states impose ownership rules tied to state residency or social equity status. One size

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CANNABIS CONSOLIDATION Cannabis brands don’t have the demonstrated longevity or persistence that’s achievable in other sectors. How does that shape what buyers consider when embarking on an M&A transaction?

Zeoli: I don’t personally see this as a concern to buyers in this industry.

Like it or not, the recreational use of cannabis products has been around for a very long time. While there might not be “demonstrated” longevity in terms of the legal cannabis market, the fact that the recreational use of cannabis has not only endured, but increased, over the last couple of decades evidences the sustainability of the cannabis market.

Slaughter: Currently, positive product experience rather than brand loyalty is what drives consumer choice in the cannabis industry. This is a direct result of the complex web of regulations that make it difficult to deliver consistent customer experiences across state lines. The ability of companies to develop brand awareness is also impacted by state regulations that restrict advertising and marketing of cannabis products.

MSOs that have vertically-integrated operations in states across the country are in the best position to develop national brands. Many expect 2022 to be the year of the brand. I expect an increased number of licensing deals

and joint ventures between MSOs and brands with national potential.

Doran: Investors and operating consolidators in cannabis are continuing to wrestle with the issue of brand and brand equity. An early wave of branding association with celebrity, personality and influencer status is slowly being replaced with brands associated with product, packaging, and performance. As the

Zeoli: One of the biggest issues I have encountered is having to navigate the state regulatory approval process. Each state has its own unique regulatory approval requirements and process. Many states are still playing catch-up and simply do not have a clearly documented approval process.

This often results in participants being subject to the whims and requests of the individual regulators they are dealing with.

Doran: Regulatory change in the cannabis industry is a fact of life and its impact on M&A activity varies by jurisdiction. Here in Illinois, the awarding of new dispensary and cultivation licenses remains in legal limbo more than two years after the initial rollout of adult recreational use legislation. While acquirers and investors are beginning to move cautiously towards deals in Illinois, the uncertainty has until recently

“THE CANNABIS INDUSTRY IS STILL IN ITS INFANT STAGE. WHAT WE ARE SEEING NOW IN TERMS OF M&A ACTIVITY IS SIMPLY THE INITIAL SHAKE OUT OF MANY SMALLER PLAYERS.” —ANTHONY ZEOLI, FREEBORN industry achieves more widespread legal and social acceptance, I believe that branding around products and performance will achieve longevity over those tied to personality. For the time being, as the pathway to brand development remains unresolved, I believe you will see more activity around licensing and commercial collaboration rather than outright M&A in brands.

On the regulatory front, there’s still a lot of uncertainty. What are some of the current issues both at the state level and federal level impacting cannabis M&A activity?

Slaughter: At the federal level, infighting among cannabis advocates has been an obstacle to major federal reform. Democrats have proposed legislation with broad sweeping reforms, while Republicans prefer incremental reform. I am optimistic that an enhanced version of the Secure and Fair Enforcement (SAFE) Banking Act, which reduces the tax burden on cannabis companies, opens capital markets access, and adds equity provisions and an excise tax, will pass in 2022. Until this legislation passes, cannabis companies will continue to face financing challenges, which will fuel M&A transactions.

The cannabis industry may be

regulated , but it’s anything but regular.

Rapid growth, conflicting regulations, unclear jurisdiction, inconsistent—at times nonexistent—enforcement.

Tremendous opportunity tempered by significant risk.

What was true of yesterday’s Wild West could also describe today’s cannabis industry.

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> Partner, Regulated Industries Practice Group > Advises cannabis companies of all sizes on issues of regulatory compliance; risk avoidance; company formation; contracts and licensing; corporate transactions; advertising and product packaging; and brand strategy and intellectual property protection. > 312.624.6340 | bdahlin@beneschlaw.com

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slowed the pace of M&A in this state. In other states with established medical cannabis programs that have either passed adult recreational use (e.g., New York) or are anticipated to do so (Ohio, Florida, Pennsylvania), M&A activity remains robust as investors seek to gain presence ahead of the expansion that will come from full adult use legislation.

At the federal level, frankly the successful passage of any regulation should have an immediate visceral uplift to deal values and deal activity. Whether it’s the SAFE Act or the Cannabis Administration and Opportunity Act proposed last year

by Senators Cory Booker and Chuck Schumer, we’d see greater amounts of capital investment into the industry, driving increased M&A activity.

How do you see the relative lack of liquidity and capital resources in this space affecting cannabis M&A in the coming year?

Slaughter: The lack of access to capital resources will present M&A opportunities in this capital-intensive industry. Until the SAFE Banking Act or similar legislation is passed, cannabis companies will continue to rely on alternative financing (with rates as high as 15%) to fund the buildout of operations and/ or expansion. While lenders are becoming more comfortable with the financial sustainability of larger cannabis companies, resulting in better terms, smaller companies still struggle to obtain financing.

Zeoli: There is certainly a lack of readily available funding in this industry. Some of the smaller players may find it harder to find costeffective capital to support expansion, possibly leading them to seek an exit altogether. That said, I believe there are a decent amount of cost-effective private funding alternatives available to larger players. Over the next year, I anticipate seeing a significant influx of additional private capital flowing into the cannabis markets, whether

through direct investment or lending vehicles.

Are there lending considerations specific to cannabis M&A? Is it relatively difficult for buyers to obtain a loan for M&A funding?

Doran: Access to traditional banking and traditional bank capital is a major problem facing the cannabis industry. It is symptomatic of a larger issue: The industry lacks consistent or meaningful access to financial products and the traditional financial system plumbing generally.

Industry cannibis regulations make it difficult to provide leaders with traditional collateral sources and structures in cannabis lending.

Many traditional lenders do not yet provide loans or banking services to the cannabis industry. A growing group of private, non-traditional lending sources do exist, but access to debt capital remains expensive and access is typically skewed in favor of larger players. This disparity in access to debt capital will tend to fuel consolidation.

Zeoli: First, given the highly regulated nature of the target entity, the general cost and level of diligence involved is significantly increased as the lender will need to be assured of the regulatory compliance of both the borrower and the target entity.

Second, the lender needs to consider what the loan collateral will be and how to properly secure its collateral interests. A target company’s most valuable assets will be its license, its inventory and its cash. Each of these assets is highly regulated in some manner, and properly securing the lender’s interest in such collateral can be complex. Given the relative lack of current funding sources in this market, lenders are being highly selective as to what deals they fund. This makes it difficult for some borrowers, particularly the smaller players, to obtain acquisition funding.

Interstate commerce might eventually drive economies of scale in certain matters.

But the timing—or even reality—of this remains uncertain. Do you think that long-term possibility is having a near-term influence on buyers’ M&A strategies?

Slaughter: Most market participants are not expecting legislation that will allow for interstate commerce any time soon and are preparing for a relatively static regulatory environment. Accordingly, I expect that companies will continue to look to M&A as a primary means to increase their market share, enter into new markets and build scale ahead of federal legalization and further consolidation expected to occur when traditional industries enter into the market.

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ABOUT THE PANELISTS Doran: Even with a rapid federal legislative breakthrough, the era of true interstate commerce in cannabis likely remains a long way off. For example, just look at how long the alcohol industry remained regionally balkanized after the repeal of prohibition. That said, longterm investments are being plotted, particularly around cultivation and logistics, for the eventual opening of commerce in cannabis across state lines.

participants to get to market is usually longer compared to larger companies. In the past year, however, state regulators have become increasingly aggressive in enforcing the requirement that licensees become operational in a timely manner.

Accordingly, some equity participants that are awarded cultivation licenses, for example, may find it increasingly difficult to raise the funds needed to build out their operations fast enough to meet deadlines.

Rules regarding cannabis delivery vary by state— it’s not allowed in Illinois, for instance, but is well established in California. How are buyers thinking about delivery-driven assets as part of their M&A and growth strategy?

Doran: Social equity programs will influence M&A activity primarily around deal structure. Licensed cannabis businesses held by social equity-based partnerships look for investment capital and liquidity, and buyers/investors look to invest in and acquire social equity-based assets to comply with the ownership rules.

The goal should be to ensure that M&A activity does not just result in short-term financial windfall for a lucky few but instead can create pathways to sustained and meaningful participation in the cannabis industry by those who have historically been victimized by illegality in cannabis. A key to enforcing social equity program legislation will be to focus not just on restrictions but on incentives.

The interpretation and enforcement of social equity program rules should be designed to incentivize mentorship, training, and long-term participation.

Zeoli: Some states are behind the curve in terms of allowing for cannabis delivery, but I believe that eventually all states that allow for the sale of cannabis will also allow for its delivery. By way of example, there are at least three Illinois bills now pending focused on cannabis delivery. Interestingly, the existence of COVID-19 accelerated legislative action to permit delivery in many states. Many states decided to open up delivery since in-person sales were curbed by the pandemic.

Doran: I agree that delivery will likely expand to be present in many, if not most, legal markets in the midterm. Investment and M&A activity in delivery assets, licenses and logistics technology is not where everyone will focus, but a select subset of investors in the cannabis industry will continue to explore and exploit opportunities to establish themselves in what will ultimately become a vital industry component.

Zeoli: I believe many cannabisrelated social equity programs are well-intended but often very poorly executed—in particular, Illinois’ social equity program. Having done a deep dive into the program, I can say there are several loopholes in the current regulations that can be easily exploited, ultimately defeating the intended benefits of the programs.

“WHILE LENDERS ARE BECOMING MORE COMFORTABLE WITH THE FINANCIAL SUSTAINABILITY OF LARGER CANNABIS COMPANIES, RESULTING IN BETTER TERMS, SMALLER COMPANIES STILL STRUGGLE TO OBTAIN FINANCING.”

BILL DORAN is a partner in Benesch’s Corporate & Securities Practice Group. He focuses his practice on M&A’s, general corporate and commercial transactions, private equity, and debt and equity finance. Doran’s diverse industry experience includes advertising and digital media, cannabis, wealth management and financial services, technology, food and health care services. He is a seasoned deal attorney with over 30 years experience helping clients successfully complete a variety of public and private transactions.

KEVIN SLAUGHTER is a partner in Levenfeld Pearlstein’s Corporate Practice Group. He is a go-to attorney for clients in the cannabis industry, advising them on a range of issues including license applications, corporate governance and funding. Slaughter also assists cannabis clients with organizational structure, real estate matters, branding and licensing agreements and supply agreements. His broader experience includes complex commercial transactions such as M&As, financing agreements, joint ventures and private offerings.

ANTHONY ZEOLI is a partner in Freeborn’s Corporate Practice Group and the leader of its Emerging Industries Team. He concentrates his practice in the areas of M&As, banking and commercial finance, securities, real estate and general corporate law.

Zeoli is an industry leader in the areas of crowdfunding, blockchain, securitiesbased cryptocurrency/token offerings, peer-to-peer (P2P) lending, and Regulation A+ offerings. He was named to the National Law Journal’s inaugural list of Cryptocurrency, Blockchain and FinTech Trailblazers.

industries, such as pharmaceuticals and alcohol, entering the market.

As consolidation continues and the current MSOs become more dominant, I also expect smaller companies will find it increasingly difficult to survive and will partner with other smaller

companies to increase market share and reduce costs.

Zeoli: The cannabis industry is still in its infant stage. What we are seeing now in terms of M&A activity is simply the initial shake out of many

smaller players. This will most likely continue while there are still licenses to be acquired. Once markets are a bit more saturated, I believe you will start to see the larger regional, or even national conglomerate entities, pick off competitors.

Growing and Nurturing Success

— KEVIN SLAUGHTER, LEVENFELD PEARLSTEIN

What are your thoughts on how social equity programs and goals set by Illinois and other licensing jurisdictions might influence cannabis M&A activity?

Slaughter: I expect more M&A activity (including joint ventures) between larger companies looking to expand and social equity participants that have a license but lack funding.

Despite the best intentions of the Illinois legislature and other state legislatures, the reality is that social equity participants typically have limited access to capital—yet cannabis is a capital-intensive industry. The amount of time it takes social equity

If the regulations are properly tightened, I believe Illinois’ program could significantly increase equity within the state’s cannabis markets.

Until then, however, I unfortunately see the program more as a political talking point than a significant vehicle for change.

How do you see current and near-term M&A activity shaping the cannabis industry going forward?

Slaughter: I believe that over the next couple of years, larger MSOs will continue to rely on M&A to increase their market share, enter into new markets, and build scale ahead of federal legalization and traditional

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