MJBizCon2021 was as explosive as the cannabis industry itself.  The range of programs, volume of exhibits and sheer number of attendees, despite the continuing impact of the pandemic, reflected the vibrant and fast-growing cannabis space itself.

Cannabis valuation continues to take center stage in any discussion about the operational, financial or regulatory aspects of the industry.

Among the several take-aways from this conference, the prospect of federal legalization is not necessarily accretive for all cannabis valuations; it’s not as simple as concluding that national legalization is good for the space in an absolute sense, or that the status quo is bad for cannabis values.  Indeed, national legalization is not a binary equation that translates to unqualified benefit for the industry, as the analysis is multifactorial and far more nuanced.  A fully vertically-integrated MSO in Maine, for instance, will likely face exponentially higher transportation and cultivation costs if its growing operations were relocated to a more hospitable, year-round fertile climate such as California or New Mexico, and yet federal legalization may well compel that operator to so move its flower to the US Southwest to remain competitive.  In addition, even highly scaled, successful MSOs currently operating in more than one state or region may face stiffer competition and existential threats from the legacy tobacco oligarchs if national legalization were to allow those bystanders, currently sidelined, to enter – and threaten to take over outright – the cannabis market.  These considerations are just some of the factors underscoring the vagaries of any highly regulated industry, where growth prospects and assumptions about future value must reasonably capture the anticipated trends in business as well as the political arena.

Whether a dispute arises over the valuation of an entire MSO, one of its acquisition targets, its retail dispensaries or any other key assets, an operator needs to be well armed with every valuation tool and weapon available.  MJBizCon helped demonstrate, once again, that such a valuation exercise demands a seasoned blend of art as much as science, and that the unique facts and circumstances of any asset or enterprise must be fully taken into account before applying the relevant valuation metrics.

[RKS Partner Steve Hecht is currently at MJBizCon, the largest Cannabis business conference in the US.]

The diversity of businesses and business lines here at MJBizCon is one of the first things that hits you.  While cannabis itself is sometimes thought of as either an agricultural business or a retail business, the reality is it’s both and much more.  Here exhibitors ranging from agricultural machinery to varied service providers in the accounting, law, insurance and consulting space sit side by side.  What’s particularly notable is that basically every one of these businesses – those directly in the cannabis space and those serving them – sit within a regulatory grey area.  That grey area, reflecting classic federalism at its core, appears to underlie how every business here does its work.  Issues of interstate commerce (usually the stuff of law school exams) are not hypothetical but a very real, day-to-day phenomenon for these businesses.

Additionally, the energy at the convention speaks to a growing market and one that is seeing horizontal and vertical expansion.  It’s worth noting that valuation issues are front and center for the investors and business people we have met so far.

Further updates tomorrow.

See the source image

Sports teams often prize the benefits of home-field advantage, but when it comes to valuing a cannabis multi-state operator, playing in your home court does not necessarily result in the highest valuation.  As we have posted about before, different states take vastly different approaches to valuation litigation, resulting in the same MSO potentially having a significantly different valuation depending on where that litigation is brought.  Among other things, to the extent that different states select a different point in time for the valuation exercise is alone often outcome-determinative of the resulting value.  Thus, for instance, Delaware law requires the court to determine the company’s fair value as of the date that the merger closes, while California law directs a court to figure out what the fair value was immediately prior to the announcement of the merger.  In addition, the degree to which different states recognize the so-called market-out exception leads to variable availability of appraisal rights where the target company’s stock trades in a highly liquid market: states such as Arizona adopting the market-out exception to preclude appraisal of targets whose stock trades on large, liquid stock exchanges, while states such as Massachusetts have not adopted the market-out exception (although appraisal in that jurisdiction is limited to transactions presenting potential conflicts of interest).  Delaware’s appraisal statute bears the unique feature of having incorporated the market-out exception, while also yet allowing appraisal for M&A transactions where the merger price is paid in whole or in part in cash.  And focusing on these variations across the United States does not even take into account the unique attributes of Canadian appraisal, a totally different animal with a different federal/state interplay altogether.

A company in any space may wind up with substantially divergent values depending on the jurisdiction hearing its valuation litigation, but the inherent vagaries of cannabis valuations only magnify the already significant differences that valuation disputes may experience across different jurisdictions.

What is the IRS 280E Tax Code and Why is It Killing the Marijuana Industry  Right Now?

Players in the cannabis space already understand that federal tax law as currently structured extracts a far greater tax bite from marijuana businesses than corresponding companies, as cannabis companies are prohibited from deducting their business expenses from gross income.  Of course, with U.S. cannabis sales expected to grow by nearly 2.5x from 2018 to 2025, the excessive tax liability still leaves lots of room for cannabis companies to experience outsized profits.  Clearly, navigating the perils of the tax code is a critical step in any cannabis valuation.

Internal Revenue Code Section 280E

Because marijuana is classified as a Schedule I controlled substance under the Controlled Substances Act, the production, distribution and possession of cannabis is illegal, even where marijuana is legal under state law.  As a result, Section 280E prevents taxpayers from taking any tax deductions or claiming tax credits attributable to marijuana businesses.

This short overview by the Congressional Research Service, The Application of Internal Revenue Code Section 280E to Marijuana Businesses: Selected Legal Issues, frames the issue well: “Under federal law, all income is taxable, including income from unlawful activities.  In contrast, not all expenses are deductible from a taxpayer’s gross income.”  Consequently, given this imbalance in the tax code, all cannabis businesses, “from farmers and processors to distributors and retailers, are prohibited from writing off many of their day-to-day expenses and overhead costs, such as rent, utilities, compensation, costs of administration, and charitable gifts to promote goodwill.”  In limited cases the tax courts have shown some leniency to multiple-service facilities, allowing the deduction of expenses for that aspect of a community center that provided caregiving services for sick members, while prohibiting the deduction of expenses incurred by that community center in dispensing medicinal marijuana.  But wherever multiple activities within a single enterprise “share a close and inseparable organizational and economic relationship,” the tax court will not find the operation of more than one trade or businesses, precluding that business from taking deductions.  Likewise, Section 280E prohibits deductions even for unrelated activities if they are “ancillary” to the cannabis business.  While a marijuana company can reduce its gross receipts by the cost of goods sold, no deductions that reduce gross income are permitted.

Legislative Proposals to Limit or Eliminate Section 280E

The CRA compiled an array of legislative proposals that would render Section 280E inapplicable to cannabis businesses by recasting marijuana as a Schedule III controlled substance, or by entirely de-scheduling it altogether.  Short of making cannabis federally legal, other legislative efforts have sought to create an exception to Section 280E for marijuana companies operating legally under state law.  There are a number of proposals under consideration and the legislative landscape is far from settled.

So what does all this mean for cannabis valuation?  Under current conditions, marijuana companies owe outsized federal tax liabilities given their inability to deduce expenses.  While it is beyond the scope of this post to analyze the extent to which the IRS has actually been enforcing these laws and pursuing cannabis companies for taking improper deductions, any appraisal of marijuana companies and their assets must take into account the lack of deductions under current US tax law.  This factor alone doesn’t necessarily sink cannabis valuations – cannabis sales in the U.S. are expected to reach $25 billion by 2025 according to the CRS report, well beyond the $11 billion in sales experienced in 2018 – nor does it fully take into account the extent to which a single cannabis operation can be divided up into multiple activities, permitting some or even most of the non-cannabis facets of the business to take deductions.  In any event, the tax environment surrounding any cannabis business poses a unique valuation exercise requiring creativity and a fresh set of eyes, one that is not readily solved with a one-size-fits-all formula.

IRS & Business Taxation of the Cannabis Industry

The Association for Corporate Growth of Los Angeles hosted a panel on Trends & Transactions in Cannabis Middle Market M&A.

The panel addressed appropriate valuation methods for cannabis companies, with one speaker suggesting that a valuation based on a multiple of EBITDA alone would likely not be sufficient if that were the only method, given the outsized effect that the current tax laws have on cannabis companies.  That speaker suggested that a DCF using a five-year projection could be more helpful, where the cash flows are projected on an after-tax basis.  Of course, as we’ve posted before, a valuation of any cannabis asset is a highly fact-specific exercise that is not subject to any one-size-fits-all formula and depends on the facts and circumstances presented in each case.

As a practical matter, the panel also cautioned M&A buyers to go beyond the written financial statements and do a walk though of the facilities, a critical step for cannabis companies to ensure that half the plants aren’t dead, for instance.

Marijuana Business Opportunity Cannabis Business Start Marijuana Business Cannabis Events

Cannabis valuation issues will continue to grow in importance as the macro industry grows and as market participants continue to engage in transactions that refine the inputs for any valuation analysis.

This piece by Bloomberg BNA [sub] highlights the 34 states that have now legalized cannabis for medicinal use (along with the 19 states allowing recreational usage); the projections put US market growth at 21% annually, reaching $41.5 billion by 2025, with the worldwide legal market for cannabis forecast to reach $91.5 billion by 2028.  These estimates have room to the upside, as further legalization pushes may increase the addressable legal market, while reduced criminal penalties and diminishing stigma may also spur additional innovation.

First Department of New York Loosens the Standard for “Piercing the Corporate Veil”

Delaware law generally respects corporate separateness, but in rare cases will disregard the corporate form to prevent fraud or injustice.  Earlier this year, in Manichaean Capital, LLC v. Exela Technologies, Inc., 2021 WL 2104857 (Del. Ch. May 25, 2021), Vice Chancellor Slights issued the first Delaware decision recognizing reverse veil-piercing, in which liability is imposed on an entity for the liabilities of its owners, in allowing the claim of plaintiffs attempting to collect an appraisal judgment from the subsidiaries of the recalcitrant entity.  This decision provides investors and creditors another tool in their arsenal to prevent potential abuse of the corporate form.

Background.  Plaintiffs were equity holders in SourceHOV Holdings (“SourceHOV”) prior to its acquisition by Exela.  Plaintiffs dissented from the merger and brought an appraisal action, obtaining a $57.6 million judgment against SourceHOV, which did not pay the judgment.  Plaintiffs brought suit asking the court to pierce SourceHOV’s corporate veil downward, so that plaintiffs could enforce the judgment against the company’s solvent subsidiaries.

Decision.  The court denied defendants’ motion to dismiss and permitted plaintiffs to proceed on their reverse veil-piercing theory.  The court explained that “[a]t its most basic level, reverse veil-piercing involves the imposition of liability on a business organization for the liabilities of its owners.”  Opinion at *9.

(Reverse veil-piercing can be invoked by an insider—where the request to disregard the corporate form comes from the entity owner itself—or an outsider—where the request comes from a third party.  The court’s decision addresses only outsider reverse veil-piercing.)

The court began by holding that the “[r]isks that reverse veil-piercing may be used a blunt instrument to harm innocent parties, and to disrupt the expectations of arms-length bargaining,” “while real” do not “justify the rejection of reverse veil-piercing outright.”  Id. at *11.  Given that Delaware law, while respecting corporate separateness, will not permit “the use of the corporate form as a means to facilitate fraud or injustice,” the court found that “there is a place for a carefully circumscribed reverse veil-piercing rule within Delaware law.”  Id. at *12.

The starting point for reverse veil-piercing is the same as traditional veil-piercing:  the alter ego factors of “insolvency, undercapitalization, commingling of corporate and personal funds, the absence of corporate formalities, and whether the subsidiary is simply a facade for the owner.”  Id. at *13.  The court should then ask whether the owner is using the corporate form “to perpetuate a fraud or injustice.”  Id.  The court provided eight illustrative factors in this inquiry, including impairment of shareholder expectations, public policy, harm to innocent third-party creditors, and the extent and severity of the wrongdoing.  Id.  In sum, reverse veil-piercing, “like traditional veil-piercing, is rooted in equity, and the court must consider all relevant factors . . . to reach an equitable result.”  Id.

The court first addressed the alter ego factors, finding that the complaint adequately alleged that SourceHOV was insolvent and undercapitalized and did not follow corporate formalities.  The court then concluded that it was “evident” that certain of SourceHOV’s subsidiaries were actively diverting assets away from SourceHOV to other Exela entities to shield those proceeds from the appraisal judgment.  Finally, the court briefly addressed the other fraud/injustice factors, including that there was no basis to find that reverse veil-piercing would harm innocent creditors of SourceHOV’s subsidiaries.  Notably, the court explained that reverse veil-piercing here would serve public policy by allowing plaintiffs to receive the compensation awarded to them in the appraisal action.

Takeaways.  The decision recognizes reverse veil-piercing for the first time under Delaware law and provides a road map for its use.  Where appropriate, investors and creditors should thus consider a reverse veil-piercing claim if an entity (or owner) is improperly using subsidiaries to, for example, evade liability or frustrate a judgment.

CoinDesk: Bitcoin, Ethereum, Crypto News and Price Data

In a federal court ruling from earlier this year, Vogel v. Boris, the New York federal court refused to toss out a claim by an LLC member, Vogel, against his two other business partners, alleging that they violated a restrictive covenant in the LLC’s operating agreement prohibiting any member from forming a new SPAC aside from the existing SPAC they had explicitly agreed to be working for: their violation consisted of forming a sponsor for a second SPAC and closing a $250 million IPO, all while squeezing Vogel out of the new SPAC.  The court ruled that the allegations sufficiently stated a legal claim to allow the case to proceed further, without deciding the substance of those claims.

First off, in the course of its analysis the court provided a succinct summary of the SPAC process:

The first step of the typical SPAC process, according to Vogel, is for those managing the SPAC to create a company to control it, usually a limited liability company, referred to as the “sponsor.” The sponsor receives a percentage of the shares raised in the IPO as a fee and puts the shares aside in escrow or trust pending consummation of a potential merger. Once a successful merger has occurred, the sponsor will distribute the shares to the SPAC’s managers and/or members based on certain contractual triggers such as, for example, termination of a lockout period or the reaching of a particular share price.

Second, however unusual this set of facts may be, it makes the point that some of the background activity underlying a SPAC transaction is often a creature of contract.  Here in Vogel, that contract was an LLC operating agreement, while in other situations, the operative contract may be a subscription agreement underlying a PIPE transaction relating to the SPAC deal.  In all events, investors considering their rights in connection with a SPAC transaction should be sure to consider any contractual remedies in addition to any federal securities fraud or state fiduciary duty and common law claims.

As reported here in Law360 [$$], Sustainable Opportunities Acquisition Corp. — a SPAC planning to mine the seafloor for metals to be used in electric vehicle batteries — has sued two potential investors for failing to fulfill their purported obligation to provide funding under a PIPE deal.  The investors had signed subscription agreements committing them to fund $200 million to the SPAC but ultimately refused to do so by the stated funding deadline.  The SPAC is seeking specific performance, asking the court for a judgment requiring the investors to fund their PIPE commitment.  The newly filed complaint does not indicate what the investors’ reasons were for refusing to fund.

Delaware Supreme Court Adopts Limited Practice Privilege For 2020 Bar Applicants – First State Update

When can an investor bring an action against corporate directors and officers directly – i.e., on behalf of the investor herself, rather than derivatively, i.e., on behalf of the company?  In a September 20, 2021, decision, the Delaware Supreme Court clarified a split in authority over whether corporate overpayment claims are direct or derivative by overruling a prior precedent – Gentile v. Rosette.  While the impact of Gentile (and thus, its overruling) is limited, the result is a caution to minority shareholders that when faced with oppressive tactics by a controlling shareholder, you must consider the full suite of potential claims and tactics available.  The fact that a transaction is unfair on its face will not necessarily be enough for a harmed investor to recover directly.

To summarize the recent decision overruling Gentile:

Under Delaware law, stockholder claims can be derivative (i.e., on behalf of the corporation) or direct (i.e., a personal claim of the stockholder).  Whether a claim is direct or derivative determines, among other things, whether the claim survives a merger (derivative claims do not).

In 2004, in Tooley v. Donaldson, Lufkin & Jenrette, Inc., the Delaware Supreme Court held that whether a claim is direct or derivative “must turn solely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?” 845 A.2d 1031, 1033 (Del. 2004).

Under Tooley, claims of corporate overpayment are usually derivative.  But two years after Tooley, in Gentile v. Rossette, the Delaware Supreme Court held that there was one type of corporate overpayment claim that is both derivative and direct:  a claim challenging the corporation’s overpayment in company stock for assets of its controlling shareholder, thereby diluting minority shareholders and increasing the controller’s stake.  906 A.2d 91, 100 (Del. 2006).

In the years since it was decided, Gentile faced criticism.  Indeed, in his concurrence in El Paso Pipeline GP Co. v. Brinckerhoff, 152 A.3d 1248 (Del. 2016), Justice Strine urged overruling Gentile.  On September 20, the Delaware Supreme Court did just that in Brookfield Asset Management, Inc. v. Rosson, No. 406, 2020, slip op. (Del. Sept. 20, 2021).

Decision Below

Defendants conceded that the facts fit the Gentile rule, but urged Vice Chancellor Glasscock to overrule Gentile.  He declined to do so.  On interlocutory appeal, Defendants asked the Delaware Supreme Court to scrap the Gentile exception.

Supreme Court Decision

 The Delaware Supreme Court agreed with Defendants and overruled Gentile.  The Court discussed the following factors:

  • Gentile Conflicts with Tooley. Although Gentile was decided after Tooley, the Court concluded that “certain aspects of Gentile are in tension with Tooley,” including whether and how stockholders were injured independent of the corporation, Gentile’s reliance on the “special injury” test contained in a prior case, In re Tri-Star Pictures, Inc. Litigation, 634 A.2d 319 (Del. 1993) (a test whichTooley rejected) , and Gentile’s focus on the alleged wrongdoer—the controller—rather than who was injured and who would receive recovery.  Slip op. at 27-43.
  • Gentile Not Needed. The Court gave minority shareholders a roadmap for non-Gentile claims.  Finding that there was “no practical need” for the Gentile doctrine, the Court highlighted that “[o]ther legal theories” gave stockholders a basis to address fiduciary duty violations in a change of control context,” and that stockholders have “the right to challenge [a] merger itself as a breach of the duties they are owed” by arguing that “the seller’s board failed to obtain sufficient value for the derivative claims.”  Slip op. at 43-44.  Shareholders facing a harmful merger can look to this discussion in future cases.
  • Stare Decisis Does Not Save Gentile. Finally, the Court held that stare decisis concerns did not compel upholding Gentile.  The Court explained that Gentile was decided fifteen years ago and that time has proven that the decision “is more of a departure from the then-recent Tooley than the continuation we perceived it to be at the time” and that El Paso “further muted” any reliance on Gentile.  Slip op. at 49.

Impact

 Given Justice Strine’s decision in El Paso urging that Gentile be overruled, the Delaware Supreme Court’s decision doing just that was not surprising.  The death of Gentile means that minority shareholders must consider alternative routes to challenge a controlling shareholders’ extractive transaction.  As the Supreme Court discussed, minority shareholders may have other non-Gentile claims, and thus should explore all of their legal options if faced with a controller who has effectively expropriated both economic and voting power via a related-party stock transaction.