California, Licensing

California Cannabis Applications: Debt Got You Down? Consider the SAFE Route

Best not to confuse your local regulators.

Across California local jurisdictions are opening licensing windows and evaluating commercial marijuana license applications. Often the scoring process is conducted by the staffs of city councils, zoning boards and planning commissions, working on a compressed timeframe, and giving scores for various categories using a scoring matrix: “Location,” “Safety & Security,” “Community Benefit,” are common categories, for example. There is typically a “Financial Stability & Capitalization” category, as well, where companies disclose their balance sheet, and their business plan going forward.

The scoring of these categories is unpredictable. Typical requests from the local regulators may be:

  • A budget for construction, operation, maintenance, compensation of employees, equipment costs, utility costs, and other operation costs. The budget must demonstrate sufficient capital in place to pay startup costs and at least three months of operating costs, as well as a description of the sources and uses of funds.
  • Proof of capitalization, in the form of documentation of cash or other liquid assets on hand, Letters of Credit or other equivalent assets.
  • A pro forma for at least three years of operation.

As we’ve previously written, early-stage companies are often raising early capital using convertible notes, as a means of kicking the valuation can down the road into 2018. Although notes are much more akin to equity investments, they show up on a balance sheet as debt. The impact of an applicant having outstanding debt is uncertain, but one can imagine that an applicant that has almost all of their cash on hand through issuing debt may be viewed unfavorably. And that can be a problem.

To a city staffer unfamiliar with a convertible promissory notes, the debt may appear to be nothing more than a short-term loan, and with a balloon payment set at a 12 to 24 month maturity date, the company may look like it needs a moonshot to survive. In reality, though, the company will have no payment obligations, so long as it achieves a priced round equity financing within that timeframe. In that case, investors will convert to equity, the debt is extinguished, and no debt service payments are made. However, in a competitive licensing application environment, explaining the intricacies of a convertible note to a city staffer means you’ve likely already lost the battle.

Rather than carry debt on the balance sheet through the application process, an alternative instrument for early-stage financing can be borrowed from the tech world: the SAFE (Simple Agreement for Future Equity). This instrument was developed for early company financing by startup accelerator Y Combinator. It serves the same function of a convertible note, and will often convert to equity on nearly identical terms. But is explicitly NOT a debt instrument. It’s a more company-favorable means of raising capital, as compared to the convertible note: the investor loses the security of holding a debt instrument, and the leverage of having a maturity date.

To the local regulator – likely unfamiliar with either instrument – the SAFE would appear to be much more like a letter of intent to issue equity in the future. And the SAFE investment received by the company appears on the balance sheet as cash on hand and unencumbered, making the company appear much better capitalized than a company whose capital all comes with a corresponding debt obligation.

SAFEs are not for everyone, and an investor familiar only with convertible notes but not SAFEs will almost always prefer to hold the convertible debt. However, for companies that can raise funds with a SAFE, there are a few potential advantages: 1) these companies may find their applications get a critical boost in their “Capitalization” score; and 2) they are easy to put together, as a SAFE is just a standard agreement with few negotiable terms – the Cap, the Discount, the Most Favored Nation Clause. If the terms are right, companies planning to navigating multiple local cannabis application processes would be wise to consider taking the SAFE route.