HEF Finance

How to use Debt to Obtain Equity Financing for your Cannabis business

Raising equity for a startup can be a painful experience. Investors have their own timeline, and sometimes the ups and downs of their deliberation can make you feel like you are on the one-yard line, or you are facing a fourth and long. We’ve all been there for the jubilance of the post meeting glow from an enthusiastic investor only to meet the reality of their inexplicable disinterest in the project shortly thereafter. Or the classic “yes yes yes” investor who says they have the means and intent to move quickly to take out a good chunk of equity, but either misinformed about their intention or their means, or both. But, for many investors, staying on the sidelines until your capital stack nears completion is common, and they often do.

While huge gains may remain to be realized by investors in the cannabis sector for sure, it’s more challenging to raise capital now than in years past. But with the fairly large number of flops in private equity cannabis investments over the years, investors are no longer jumping in at a fever pitch to participate in the “green rush”. Rather than guzzle the green Kool-Aid, they’re more often asking about what can go wrong, and not always asking the issuers of the offering.

Getting momentum in large capital stacks in particular is critical. The first investors always take the highest risk in a capital raise because they are not just contending with the risk of investing in a startup business, but they are also coming in at a point where the completion of the capital raise itself is a risk. What happens if I put in my money and the capital raise takes 2 more years or never gets completed at all? That’s how you get a number of big investors on the edge, waiting for the other guys to jump first. Well, debt, as a part of the capital stack, might help achieve the momentum necessary to help the edge dweller’s motivation to jump before the opportunity is missed.

How can Debt help momentum in a capital raise?

Answer: Legitimate term can help sway the decision of the equity to a confident yes in many cases.

Let’s say for example your startup capital raise is asset intensive. You have potentially real estate acquisition, construction, and equipment components assuming it’s a grow operation, extraction lab, or cannabis testing lab. Assuming the principals of the project look pretty strong and the property valuation is in line with reality, a startup, with the right underwriting and sources, could acquire a bone fide term sheet for 60% or more of the finished cost of the project from a lending source. To do that, a firm that underwrites these credit facilities would need to be retained to acquire that financing option which means there will be a cost associated with doing it. Of course, the cost of the capital stack not having momentum may far outweigh the cost of acquiring a term sheet. Just do the math when putting those numbers side by side. In 99% percent of the cases, it’s probably a no-brainer.

It’s important to note that selling equity, particularly if the startup anticipates high profitability, is in the long term is usually the most expensive financing possible. In a business that could generate millions of dollars a year in revenue with 20-40% returns, I would fight for every point as a sponsor who truly believes in the future success of their project. Taking on “Partners for forever” are far more expensive than high cost debt partners for a couple of years. Of course, that assumes that the partners have put together a plan that they themselves believe will have a very high likelihood of success. Debt, even high cost cannabis debt, can save the principals who built the model precious points. Using a term sheet to get momentum may make the difference between finishing and not finishing a capital raise, or at least speed up the process, while offering the sponsors a long-term higher reward for putting it all together.