Securing Funding for Your Cannabis Business Through Preferred Stock Financings

Types of Financings for Cannabis Businesses

Financings for cannabis businesses can take different forms. There are debt financings and equity financings.

Debt Financings

Debt financings often are documented in instruments such as promissory notes (whether simple loans with interest that accrue and mature, or loans convertible into equity on certain events or otherwise mature).

Equity Financings

Equity financings often are documented in share or stock purchase agreements, whether for common stock or for preferred stock (if the entity is a corporation). If the entity is a limited liability company, the equity financing instruments generally used are membership interest purchase agreements or operating agreements with amendments thereto. 

This blog focuses on preferred stock financings as one form of equity financing in the corporate context. 

Factors in Determining Structure 

The approach as to what type of financing should be conducted by a cannabis business is dictated by a variety of considerations, including:

1. investor sophistication and preference;
2. cost of raising the capital in connection with the financing;
3. amount of funds to be raised;
4. timing and efficiency needs; and
5. market preference.

Often early stage cannabis companies with little operating history conduct debt financings (sometimes referred to as “bridge financings”) since debt instruments are generally straightforward and reasonably easy to prepare, and since most early stage cannabis companies have little corporate history for determining a valuation related to equity and often desire to buy time to achieve certain initial short-term goals.

Cannabis companies further along in maturity and looking to raise more significant amounts of funding often conduct equity financings in the form of common stock financings or preferred stock financings. Sophisticated investors investing larger sums of money sometimes will require that they receive preferred stock in lieu of common stock for their investment and since preferred stock generally carries special preferences over the common stock. 

Common Stock and Preferred Stock

Common Stock is the simplest form of equity investment in the corporate context and investors who acquire common stock typically receive the same class and type of equity security with the same rights, preferences and privileges as the startup founders hold or as employees or consultants hold, as applicable (with certain exceptions). 

In a preferred stock financing, a series of preferred stock is created and authorized under the certificate or articles of incorporation to sell to investors and such document and other investment documents in connection with such preferred stock provides for such stock to have preferred rights, preferences and privileges typically senior to the common stock.

The preferred stock is generally considered more valuable than the common stock, in part, because of these special preferences the stock carries.  The price per share of preferred stock is generally based on, and takes into consideration, the entire valuation of the company on a pre-financing basis and in respect of the fully diluted outstanding equity in connection with the company. Investors will consider the cannabis company’s assets and other market factors and conduct diligence to determine a “pre-money” (pre-financing) valuation of the company. The cannabis company and investors will negotiate to ultimately come to an agreed per share price for the preferred stock to be acquired in the financing. 

Key Terms for Preferred Stock Financing

There are certain standard terms that tend to be more highly negotiated in the context of a preferred stock financing. The following are certain of those key terms:

• Control:
  • Board: The individuals that will be on the Board of Directors and how many seats the preferred stock will have the right to elect.
  • Shareholder: What special protective voting rights the preferred stock will secure (protective provisions and veto rights for certain corporate actions requiring the vote of the preferred stock).
    
• Liquidation Preferences:
  • The preferences paid on a liquidation event (e.g. company sale) to holders of series preferred stock, often prior to and in preference to holders of common stock.
    
•  Dilution Protection (price-based and other adjustments):
  • Protection of investor pro rata holding from dilution on subsequent issuance of additional shares of stock at a lower price per share than the investors paid in the financing and adjustment on certain reorganizational events such as stock splits, stock combinations and the like.
    
• Pro Rata Rights and Rights of First Refusal:
  • Right to maintain ownership percentage/ability to participate in future securities offerings to maintain investor “pro rata” share. 
  • Right of first refusal on sales of shares by other shareholders (e.g. key common stock holder transfers/founder transfers).
    
• Dividends:
  • Often a set percentage of the original issue price of the preferred stock to be paid on annual basis to the shareholder in connection with their shares if and when declared by the Board of Directors and often prior in preference or pari-passu to the common stock.
  • If, as and when declared by the Board (in practice, dividends are not often declared). The declaration of dividends is subject to fiduciary duties of the Board and subject to applicable corporation law.
    
• Drag Along:
  • Provisions where if the preferred desire to sell the company and vote to sell the company, the common holders can be “dragged” along (required to vote in favor of such sale and to sell their shares). Typically, there are certain triggering votes required to trigger the drag along and protections negotiated for the “dragged” shareholders.

Here at Rogoway Law Group, we have the experience of having collectively consummated hundreds of financings. We can advise as to what’s “market” and provide feedback and insight into what these key terms mean for cannabis businesses that need to consider the long-term impact of the preferences they provide to investors in the context of these financings. Please contact us so we can assist with inquiries ranging from very simple to very complex when it comes to financings. We are happy to provide both business and legal advice in connection with these important business decisions for your cannabis company.