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Raising Capital for Your Canna-business

Have you ever taken a tango lesson? If so, then talking about starting in an “open embrace for traveling ochos” will mean something to you. To the rest of us, it’s Greek. And just like the tango, raising capital is a dance that is built around a unique language. Speaking with investors requires an understanding of the language of investment finance and, like all forms of communication, the key to success is being a good listener.

Raising capital from investors is one of the single most difficult tasks an entrepreneur has to manage. One of the key challenges is negotiating with investors who most likely have much deeper experience in structures and investment terms. Three key terms that form the language of raising capital that every entrepreneur needs to be proficient in are:

1.  Term Sheets

2.  Valuation

3.  Due Diligence

1. Term Sheets

A term sheet is a non-binding document (meaning that it is unenforceable and the terms are not binding until the definitive agreements are executed) that investors present to a company that outlines the structure of the transaction they are interested in pursuing. The term sheet is the first major inflection point to moving a deal forward and should be heavily scrutinized with your legal counsel. The term sheet will outline the key terms that both parties will agree to when the transaction closes and it typically includes the major key deal points such as assignment of board seats, valuation, types of securities (preferred or common equity), investment amount, timing of the deal, anti-dilution, transfer restrictions for selling the company, and other key governance rights and voting rights.

It is advised for both the investor and the entrepreneur to negotiate and agree to a term sheet as soon as possible if they desire to consummate a deal together. This ensures that neither party spends an inordinate amount of time on due diligence if the terms under which they will close are not aligned. There is no benefit to spending months on due diligence with an investor if they want to own 51 percent or more of the company and you are not prepared to sell an ownership stake.

2. Valuation

When raising capital, the investor and current owner need to agree to what the value of the company is today. A valuation is needed to strike a share price for the investment that correlates to a percentage ownership. Private companies do not have a market for their shares and therefore, unlike public companies, do not have any way to liquidate their investment.

This also means that without a market for the securities, the valuation of the company in a private transaction is ultimately negotiated. The ownership of the company through the investment is communicated through a “pre-money” and “post-money” valuation. Pre-money valuation is just that, the agreed value of the company before the investment closes and then what the value of the company is when you add the money from the investment to the calculation. This is important because it also implies what the shareholders will each own in the event of the company selling or some other liquidity event in the future. The below chart is a simple calculation of pre- and post-money valuation:

To get to a valuation for the transaction, the parties must agree to what the company is valued at today. Valuation is tricky because there is a combination of standard business metrics that are normally used, but with a private company those metrics may not be entirely applicable. For example, when a company has several years of profits measured in Earnings Before Interest Taxes Depreciation and Amortization (EBITDA), an investor can apply a multiple to that measurement to value the implied cashflow benefits of the company in the future. A five-time multiple, for example, implies that the company is valued today at five times the current EBITDA. Implied in multiple calculations are the assets and liabilities of a company and therefore a proxy for current and future enterprise value.

What happens when a company does not have any profits to speak of? In this situation, the investor and the company need to come to a shared belief as to what the company will be worth in the future if it is successful. The valuation of the company becomes more about quantitative metrics such as intellectual property or addressable market and management. The projected future performance is emphasized over past performance. As we know, nothing is guaranteed in the future, so more times than not the company and the investor have such varying views as to what the performance will likely be that a deal cannot be achieved. This is why there can be such a massive disconnect on valuation for an early stage company where the investor perceives greater execution risk than the founders.

3. Due Diligence

Due Diligence (DD) is the term for the deep analysis that an investor performs to understand all the elements of the business they are planning to invest in. DD starts from the very first interactions when an investor starts evaluating the strengths and weaknesses of the founders and management team and continues into an in-depth process that is completed before the transaction closes. With a term sheet agreed to, the investor will look at every aspect of the company from all the contracts and communications, to third party independent studies on any technology or intellectual property and a very deep analysis of the financial performance of the business.

This can be a very intense phase of the process, because essentially the investor is trying to find any reasons not to complete the transaction. They are looking for risk factors that will contribute to the business not performing in the future. It is often overlooked that this is also a time for the current shareholders to do their own DD on the investors. DD is a bilateral process and entrepreneurs should also seek references for the investor and talk to other management teams they have invested in.

At the end of the day, both parties are agreeing to a meaningful financial relationship through an investment, and the stakes are extremely high. It is therefore critical to speak the language in order to manage the communication to a mutually beneficial outcome. Now that you know how to dance the tango with a partner, are you ready to enter into marriage and form a long-term investment partnership?

Author

  • Ross O’Brien is the Founder of Bonaventure Equity, a late stage cannabis venture capital fund that provides investment capital, regulatory access, and an operational platform for leading entrepreneurs. Ross is also the founder of the Cannabis Dealmakers Summit, a series of invitation-only events, and the author of the forthcoming book Cannabis + Capital on Entrepreneur Press.

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