Cannabis Business Value

28 Jan Cannabis Business Value

I spend a lot of time with business owners discussing their cannabis business value. Often, they come to me when they realize they have a problem with their current or former business partner. We all like to assume our business relationships will continue indefinitely as the venture increases in value and the owners see eye-to-eye on everything.

In many startup business ventures, but especially in the cannabis context, it is not unusual for founders to have a falling out. Sometimes the falling out occurs very early in the relationship and the co-founder disappears for months or years (see here). The statute of limitations in each U.S. state means that your long-lost business partners may be out of sight but should not be out of mind until the statute of limitations period lapses (often ~6 years).

Determining cannabis business value: from a valuation expert

In an ideal world, the formula and criteria for determining your cannabis business value is clearly set forth in your operating agreement or shareholder agreement. You can be as creative as you like, including using multiples of gross or net earnings, valuation discounts, and flexible payment structures and timing.

I recently asked a friend who is a cannabis valuation expert for his recommendation on language to use in an operating agreement to avoid fights about business value. He said that a “battle of the valuation experts” never reflects the entity’s true value or leaves either buyer or seller satisfied. Choosing a single valuation expert and putting the buyer and seller owners in a room together for their interviews cuts out a lot of ambiguity, uncertainty, puffery, and obfuscation.

Things get very messy when there is no operating agreement. The following is an amalgamation of our advice regarding how to value a minority cannabis business interest and deal with a problematic minority owner where you have no operating agreement or no valuation methodology in your operating agreement.

Determining cannabis business value: a case study

I think offering him $XYZ is a good starting point. You know his temperament better than I do. Based on what I know about his track record, you may end up paying $XYZ or something more.

Keep in mind that a negotiated settlement with him is much cheaper than a fight in court or even hiring one or more valuation companies to agree upon the value of his X%. Also keep in mind that you’ll need to disclose his ownership interest if you decide to shop around the company for sale if you cannot buy him out before then.

Having multiple entities involved complicates this analysis, but we should discuss further what was explicitly promised and documented in an email to him. Then we need to consider what kind of assumptions he may have made about his investment in this subsidiary entity vs the group of entities.

Think about it this way. If an investor gave you $XYZ at the beginning of a business venture in exchange for X% of that business entity, they would expect to receive the full benefit of that X% ownership and everything the business does from that point on.

They would also have some voting rights (presumably X%) from the outset that would give them some input into how the company is operated, as well as access to company information. At X% they would get notice and participation rights in meetings, financial oversight, and probably veto rights on major company issues (like whether to engage in a merger, sell most of its assets, change the business’ focus, etc).

He has not had the benefit of any of those normal investor rights for the past Z years. All of these “normal” investor rights – including any unexpected deviations (like lack of voting or information rights) – would have been detailed in both an initial investment contract (we call this a subscription agreement) and the company’s operating agreement. You had none of those agreements in place with him.

Without these agreements in place, some of these terms are governed by the LLC Act, but other terms are undefined or at least indeterminate. They can only be concretely determined by your recollection and his (which as you can guess are often drastically different).

We can confirm the terms of his ownership by an exhaustive review of emails and text messages that you can locate. You can see how this could spiral out of control into litigation if you cannot reach an agreement now about what you agreed to Z years ago regarding his investment and ownership rights – or at least what is fair to him now.

You need to think about what kind of input he would have provided over the past Z years if he had been involved, even as a passive owner. If I am his creative transactional lawyer, then I am going to argue this:

• He is entitled to Z years’ worth of X% of your parent company’s net profit that is attributable to this company’s operations.
• He is entitled to X% of this company’s value, including assets that have been transferred over the past Z years.
• To determine the full extent of his ownership value, we need a full valuation of all related entities. This valuation needs to be done by an appraiser acceptable to him and paid for by the parent company. This is because the proper valuation must be based on ongoing enterprise value rather than the bare asset value of this entity alone. It does not make sense to value the company only as the value of its assets sold as part of an entity liquidation (balance sheet value or lower) because that does not reflect the vibrant and profitable conglomerate value, of which this company is a part.
• We also need a full financial audit of all related entities for the past X years, paid for by the parent company, to see if any other company assets or revenue have been diverted to related entities.

Cannabis business value: conclusion

It is very easy for cannabis business valuation issues to spiral out of control, requiring expensive competing valuations and potentially more expensive litigation (see here). Owners who prioritize putting a comprehensive operating agreement or shareholder agreement in place at the beginning of the relationship will thank themselves later when the invariable business dispute arises among the founders.

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