The global outbreak of COVID-19 has created alarming headwinds with no clear end in sight for nearly every industry. In the coming months, businesses spanning all sectors will need to find intelligent solutions for growth, logistics, and funding challenges as more states and countries restrict business and travel. Although most businesses feel blindsided by the countless obstacles brought on by the coronavirus pandemic, cannabis entrepreneurs, arguably, have spent their entire careers preparing for these strenuous and unpredictable circumstances.
The political and economic challenges mainstream industries currently face are common occurrences that cannabis founders navigate on a monthly, if not daily, basis. Cannabis has always been a volatile industry to operate in due to its shaky legal status and social stigma, forcing founders in this space to be nimble in their businesses and be more financially judicious with their capital.
Political and economic uncertainty is part of the business
Mainstream industries are currently scrambling to access capital and navigate political regulations to save their businesses, but for cannabis companies, these are expected idiosyncrasies of working in the space. Cannabis founders are extremely familiar with operating in a tightly regulated market that can change instantly depending on shifting political and social trends.
When it comes to financing, cannabis startups have seen limited access to institutional investors and have raised less capital compared to mainstream companies due to stringent federal banking regulations. While large tech startups like Uber had the luxury of high burn rates from having raised massive amounts of capital, many cannabis companies learned to be disciplined with their lean balance sheets from the beginning. The discrepancies in their spending habits is especially visible during this pandemic—while several unicorn tech companies are struggling to generate revenue and reduce costs, cannabis startups are tuning their business strategies with relative ease.
How COVID-19 will change key industry structures
Although cannabis companies are well positioned for continued growth after the pandemic subsides, founders must stay proactive and prudent during these unprecedented circumstances. While cannabis is fortunately considered an essential business in many states, this does not make the industry impervious to serious existential threats. Social distancing guidelines have suddenly forced brick-and-mortar retailers to move their businesses and dispensary experiences online. At the same time, recreational retailers in Massachusetts are struggling to stay afloat after Governor Charlie Baker only classified medical retailers as essential businesses. There will also be considerable supply chain disruptions in the coming months due to international travel and business restrictions that will severely impact consumer product output.
In the next year, the industry will likely see a consolidation of cannabis companies and supply chains. Stronger and well-funded companies will likely acquire or strike licensing agreements with companies that have promising ventures but are struggling to raise capital or to manage cash flow. Product companies that manufacture items like edibles and vapes are likely to undergo major consolidations in order to streamline their supply chains and maximize resources. It is more important than ever for companies to create strategic partnerships with complementary businesses in the industry, evaluate liquidity, and preserve at least eighteen months of cash to ensure future growth and longevity.
To raise or not to raise?
To be frank, this is not the ideal climate to raise capital. Early stage cannabis companies—or those that were in the middle of a funding round before the outbreak—should first try bootstrapping and accessing internal resources to create synergies and generate as much revenue as possible.
If that is not possible, companies should reach out to their team of internal equity investors. These investors are familiar with the company’s goals and behaviors and are more likely to have the company’s best interests in mind. They are also already on the cap table and are aligned in the shared interest of surviving and thriving. Companies in this position should create an investment structure that is strategically aligned with downside protection.
Another funding approach startups might consider are warrants that can be exercised or ‘cured’ at certain milestones. This can help to gain alignment on valuations. Also, exercising warrants will infuse the company with additional capital if the milestones are not met. Businesses with access to banking should explore financing through revolving lines of credit, as long as it works for their cash flow. Taking this path prevents the company from acquiring more costly debt and can insulate them from changing interest rates.
In general, taking on debt can be a precarious decision and companies must exercise extreme caution before pursuing debt instruments. It is imperative for founders to stress test their models and make sure they can cover the debt expense even in the worst financial scenarios. Creditors are increasingly exercising their right to seek control over various aspects of the company when startups default on payments or covenants. Companies ultimately should refrain from making risky fundraising decisions with toxic structures that will impair their ability to raise productive capital in the future.
Like all periods of economic downturn, this period of uncertainty is temporary and likely will expose areas of the industry that can be streamlined and improved. From my experience, forward-thinking cannabis investors will have their eye out for companies that are making an effort to preserve cash, stay relevant, and show signs of growth during this pandemic. Entrepreneurs must take this period to further demonstrate their business prowess and show mainstream industries how to stay flexible. The companies that emerge as breakout opportunities for investors in the next year will be the ones that embrace the turbulent roads of this time.
Emily Paxhia is co-founder and managing partner at Poseidon Asset Management. She has reviewed thousands of companies in the cannabis industry and has worked with countless founders in many capacities. She has shaped founders’ pitch preparations, their go-to-market strategies and product launches, and advised on day-to-day business operations. Extremely active in the investment decision making and ongoing investment oversight processes, Paxhia works closely with her partners to create meaningful deal structures, ensuring proper governance is carried out at the company level. Further, she has dedicated time and energy to supporting policy groups and has served on the board of directors for the Marijuana Policy Project. She also currently serves on the boards at Athletes for CARE and The Initiative.