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Entrepreneurs looking to build a company in the cannabis space often wonder what’s the best strategy for raising capital, and that includes setting up the right capital structure, also known as a capital stack.
This structure takes into account all forms of equity and debt invested in the company.
“You do need to start off with the foundation of your capital stack, which is the equity stack”, says Steve Ham, managing partner at Altmore Capital, a lender for the cannabis industry that has closed over two dozen deals since launching in 2017, to the tune of about $350 million in senior lending.
A first step towards building the capital stack involves finding a strong equity partner that can move with the startup as it finds its best strategy.
Secondly, Ham advises meeting a “great lending partner” and developing a strong relationship with them to be able to have straightforward conversations if bad times arrive.
“Because this is a growing industry, it changes very quickly, so you want to have a deep equity stack, and a modest amount of leverage,” says Ham.
Ham spoke live on Wednesday at the Benzinga Capital Conference in Chicago, in a conversation moderated by Irina Dashevsky from Greenspoon Marder LLP, along with other expert cannabis investors.
Aim For A Real Estate Play
In the current state of the industry, equity investors are not easy to come by, and companies are having to turn to debt investors more and more.
Judy Rinkus, founder and CEO at Seed to Sale Funding, explains that she operates as a “loan broker,” hired by companies to find them a lender. She calls her business a “one-stop shop” for borrowers looking to close a loan transaction.
Since 2018 her company has placed over $85 million in loans, which are primarily real estate-based.
For startups and very early-stage companies, Rinkus says that the only way she can secure a loan is by taking real estate as collateral and “at a well-margined basis.”
That’s because these companies have not generated any cash flow yet.
“By no means, can any of these lenders lend you 100% of what you need. You’re going to have to do that friends and family round, you’re going to have to put a good portion of your own money to it, and then the debt capital can top that off,” she says.
For companies that have been in business for a number of years, and are generating a solid cash flow, the situation becomes easier to manage. Lenders are going to make their lending decisions based on the history of cash flow, rather than on the hard assets held by the company.
The Cost Of Capital Today And Tomorrow
In the current market, the cost of capital has increased extensively for cannabis businesses.
Kevin Stone is director of investment banking at Seaport Global Securities LLC, a NY-based firm that has placed north of $1.5 billion in cannabis since 2019.
He says that the “minimum acceptable rate of return” —also known as a hurdle rate— has been raised for generalist investors like hedge funds, taking the cost of capital higher.
In recent years, investors have become more savvy in the cannabis space, and many are dubious about investing in cannabis, due to expensive operating costs, because of high regulation and high taxes.
Angus Rogers, managing director and head of fixed income at Canaccord Genuity Group Inc. says that a lot of the generalist lenders that were lending to cannabis businesses in the past have now pulled back.
“That’s not surprising, they’re doing this in all kinds of markets,” says Rogers.
Hedge funds are pulling back because they’re not seeing a good free cash flow conversion – a ratio that measures a company’s ability to convert its operating profits into free cash flow.
For this type of lender to come back to the space, on the macro level, Rogers says that interest rates need to arrive at their terminal rate, which is expected to park at 4%. He expects the rate increase to help inflation begin to moderate.
Simultaneously, Rogers hopes legislation can give some headwinds to the industry.
In anticipation of any type of federal legislative action around cannabis, the equity markets should act, bringing stock prices up by 2x or 3x.
At that point, the debt markets should re-open, says Rogers.
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Image and article originally from www.benzinga.com. Read the original article here.