Most business purchase transactions we see in the cannabis space are structured to have a concept of “closing”, which I’ve described before here. Essentially, this means that the parties sign, there is some gap of time for them to take care of certain things, and then the business is sold.
Today, I want to examine those things that need to get taken care of in order for a deal to close, which are commonly referred to as closing conditions. Each party will specify its conditions to closing in the purchase agreement. If it turns out that one of them does not occur, then the party can either choose to waive the condition and proceed to closing, or walk away.
A lot of times, parties will implement what we call “drop-dead dates.” These are deadlines by which, if the closing has not occurred for any reason, one or both sides can terminate. This puts pressure on both sides to act quickly to get their closing conditions taken care of as soon as possible. In my experience, these dates can often end up getting pushed back a few times if the parties are doing their best to close and some condition beyond their control stops it from happening, like a regulator taking their time issuing approval. I want to stress though that getting a drop-dead date moved during the pre-close period, while routinely common, is by no means guaranteed. Smart parties will just assume the date will be inflexible and negotiate a date as far out as possible.
To make things simpler, I’m just going to list out many of the common pre-closing conditions that you’ll see in the typical cannabis M&A deal. Note that while a lot of these contingencies may be taken care of during the pre-closing period, there are some (like payment of the purchase price) that will likely end up happening at the time of closing. Here’s that list, in no particular order:
In order to close a cannabis business purchase transaction, there are usually at least a few different third-party approvals that need to be sought. First, if the business is leasing property, the lessor will almost certainly require that changes of ownership of the lessee be pre-approved by the lessor (see here). For California cannabis businesses, prior to closing, approval from the local jurisdictions where the business operates is usually a prerequisite to closing. In more complicated transactions, there may be a host of other third parties and government agencies that need to approve various aspects of a transaction prior to closing.
No Restraints on Closing
If there is a government order prohibiting the parties from closing, nobody wants to close. So the parties will usually put language in a purchase agreement stating that the absence of such an order or restraint is a condition to closing.
Absence of Material Changes
When someone is buying a cannabis company, they want to make sure that the company and its assets are in substantially the same shape at closing as they were at signing. Since this can take several months, buyers might insist on closing conditions that require that no event occurred that would cause a material adverse effect on the business or its assets. These can often be highly negotiated — buyers will want these conditions to be as broad as possible, while sellers will want them to be narrow. Sellers will want to define the condition to not include things like changes in market conditions that may make a deal less desirable (such as a poorly performing economy) but only to include truly unforeseeable events that change the business.
Cannabis businesses often desperately need to clean up their corporate governance documents or other third-party or internal contracts. Some buyers are willing to proceed with a purchase even knowing that the business has been less than spectacular when it comes to internal governance, but may condition the purchase on the company cleaning up some or all of these documents (and usually will want a say in how they are drafted) prior to or as part of closing.
Satisfaction of Indebtedness
Believe it or not, a lot of buyers actually enter into purchase agreements to buy cannabis companies with massive debt (including tax debt). Buyers will often condition the purchase on some or all of the debt being satisfied prior to close, or out of the closing proceeds.
Due Diligence Completion
In almost all deals, buyers do at least some diligence before signing. Sometimes, they will have the right to continue doing diligence for some or all of the pre-closing period. As a condition to closing, they will want to ensure that they are satisfied with the results of that diligence. For example, if they find out in diligence that a company hasn’t been paying its taxes, they’ll want an out.
Inventory/Working Capital Target Verifications
When buying an operational business, buyers will often want the business to have some amount of inventory and working capital at closing so the business can continue operating seamlessly without infusion of additional buyer capital or purchasing new inventory (I wrote a piece on inventory and working capital adjustments, which you can read here).
Generally, the parties will set a target amount or value of inventory and working capital and have some kind of adjustment to the purchase price at or after closing depending on how far away from that target the numbers end up being. But in some cases, buyers may actually condition closing on inventory/working capital being a specific value. Think about it this way — if the buyer wanted $100,000 in inventory at closing but there was only $1,000, that buyer may want to just walk as opposed to adjusting the purchase price, since acquiring $99,000 worth of replacement inventory may not be very easy.
Execution of Contracts
At closing, there are usually at least a few contracts that are drafted. For example, there may be a bill of sale in an asset purchase or assignment in a stock purchase that reflects the closing of the transaction and sale of assets or stock, as it may be. Sometimes, the target company may be required to execute employment agreements with key employees of the buyer, or to execute separate IP assignments to a buyer’s IP holding company. Also, it’s almost guaranteed that there will be a lease assignment executed, and possibly even a brand new lease. All of these will be conditions to closing for at least the buyer, but often both sides.
Receipt of Legal Opinion
Sometimes, and especially for the more complicated transactions or transactions involving public companies, larger companies, or foreign companies, one or both sides may want a legal or tax opinion concerning some part of the transaction before closing. These opinions are used to assess a risk going into the transaction and the party seeking the opinion will usually note that the condition to closing is an opinion expressing favorable views of the transaction or aspect of the transaction for which an opinion is sought.
Just like with buying a house, some buyers may not have all the cash they need up front to pay for the purchase price, so they may condition the closing on their receipt of financing for all or part of the purchase price.
Compliance with Terms of Purchase Agreement
This sounds like a no brainer, and it is. Parties want to make sure that they are not obligated to close if the other side has breached the purchase contract or some obligation under a related transaction document.
Accuracy of Representations and Warranties
Purchase agreements require the parties to make a lot of promises to one another, called representations and warranties. Sellers always make more of them than buyer — things like promising that the company has no debt and has paid its taxes. Since there will be a delta between signing and closing, buyers will want to ensure that all reps and warranties made on signing are still accurate as of closing.
Related to reps and warranties, there may be a number of disclosure schedules attached to a purchase agreement. These will do things like list out the physical assets, real property, intellectual property, material contracts, vendors, employees, etc. of the company. Other disclosure schedules will relate to reps and warranties and potential carveouts for them. For example, you might see a rep and warranty that says something to the effect of “Except as disclosed in Schedule X, Company has paid all of its taxes”, with Schedule X listing unpaid taxes. Like with reps and warranties, buyers will want to make sure these are updated at closing.
Delivery of Purchase Price/Funding of Escrow
The most important thing to a seller is getting paid. So they will always want a condition that the purchase price is paid and, if escrow is going to be used post-closing for any purpose (such as a holdback for indemnification), that the escrow account is funded at closing.
This is a pretty comprehensive list, but it’s far from everything. Some deals may have very narrow conditions to closing, while others may have pages and pages of conditions. The number of conditions depends on the complexity and value of the deal. For more on cannabis M&A, please stay tuned. You can also read some of our other posts below: