The latest buzz in the growing cannabis industry, a form of alternative financing which is familiar in the mining world, is creating high expectations for companies and their investors.
In April 2017, the Trudeau government announced its intention to legalize and regulate access to recreational marijuana in Canada, with a target date of July 2018. While the details have yet to be fleshed out, the result is expected to be that Canadian adults will be able to legally purchase and consume cannabis, and it will be lawful for licensed producers to grow, produce and sell cannabis. The existing regime governing access to medical marijuana will remain unchanged.
Estimates of the likely size of the Canadian recreational cannabis market indicate it could be lucrative. A 2016 Deloitte study estimates the market as between $4.9 billion to $8.7 billion annually, which at the upper end of this range would rival the size of the Canadian beer market. This does not include the market south of the border in certain U.S. states, such as Colorado, Washington, California and Maine, where the cultivation, sale and use of marijuana is now legal under state law (although still technically illegal under federal law).
With stakes this high, companies in the cannabis industry have been rushing to secure financing for the construction or expansion of production facilities in anticipation of legalization. To date, the equity markets have been their principal source of financing, since banks have been reluctant to lend funds to companies whose activities would until recently have been considered criminal. In addition to these reputational concerns (which have led certain Canadian banks to refuse to even offer deposit accounts to cannabis companies), since the ownership and transfer of production licenses is restricted by applicable laws, there are concerns about lenders’ ability to take, enforce and realize upon security over a cannabis company’s assets in the event of a loan default.
For companies which either have difficulty accessing equity markets, or have done so previously and do not wish to further dilute shareholders with additional equity offerings, financing can be a challenge. As a result, an increasing number of cannabis companies are utilizing a product which has become familiar in the mining industry as a means of financing mine development - the streaming transaction.
A stream is essentially a financing technique structured as a long term contract for the purchase and sale of a commodity. In the mining context, in exchange for an upfront cash deposit, the stream purchaser is granted the right to buy an amount of refined metal, representing a percentage of production from time to time at the seller’s mine, at a significant discount to the market price. The deposit is often used to finance construction or expansion of the mine, and is generally non-refundable once the mine commences production. While the mine is producing, the purchaser pays the seller the discounted cash price per ounce or pound of metal, and the difference between this cash price and the spot price of the metal is notionally applied to reduce the amount of the upfront deposit. Once the upfront deposit has been fully amortized in this manner, the seller’s revenue from sales to the purchaser is equal to the discounted cash price for the remaining life of the stream.
Recent streaming deals in the marijuana space have featured similar terms, including the use of the upfront deposit to fund construction of a particular cultivation facility; purchase by the streamer of a percentage of marijuana production over time for either a fixed price or cost-of-production plus a markup; and sometimes concurrent equity subscriptions by the streaming purchaser. As in the mining world, a small number of streamers are seen as occupying the field, including Cannabis Wheaton, PannCann Streaming, The Green Streaming Finance Company, and recent entrant Canopy Rivers (a subsidiary of marijuana producer Canopy Growth Corp.)
The application of this form of financing to marijuana should not be overly surprising, given some of the characteristics shared by mining and cannabis companies:
- Substantial upfront capital costs to production;
- Output of production which is often predictable (within a reasonable range) but sold at market prices so that revenues may fluctuate;
- A desire to maintain operational control and flexibility by keeping financial and other covenants to a minimum;
- Particularly for junior issuers, the reputational benefits they gain from validation of their business model by an established streamer; and
- Difficulty at times in obtaining equity and/or debt financing, and shareholders averse to dilution through repeated equity financings.
The commercial, accounting and legal issues raised by streaming in the cannabis industry can be similar to those involved in mining streams, and include:
- From an accounting perspective, achieving deferred revenue treatment of the upfront deposit;
- Tax structuring, which again includes ensuring deferred revenue treatment, and also allocating potential ongoing tax risks such as withholding or recharacterization;
- Issues relating to the taking of security over the production facilities being financed;
- Balancing the desire of the streamer for ongoing information regarding production with the producer’s need for operational flexibility; and
- Ensuring the streamer is protected in the event of a sale of the facility or an insolvency event affecting the producer.
For those with previous experience with metal streams, these issues and the means of addressing them will be familiar territory. For others, the long term nature of these streams, which can be for a duration of many decades, and their potential impact on the long term revenues and commercial flexibility of the producer, require that all participants in this budding area get the necessary legal, financial, accounting and tax advice on these and other issues.