Here’s some food for thought: 29 states currently have laws broadly legalizing cannabis, in some form. Eight of those states – Alaska, California, Colorado, Oregon, Massachusetts, Maine, Nevada, and Washington, as well as the District of Columbia – have legalized the plant’s sale, for both medicinal and recreational use. These numbers continue to grow. In fact, many studies indicate that cannabis is the fastest-rising industry in North America.
For companies to capitalize on the many opportunities this industry presents, however, they need startup and growth capital. And among the myriad questions they must address before entering the space is: What is best for my company, debt or equity financing?
Below is a primer of the pros and cons of both.
What is debt financing? Debt financing is when a company borrows money from a lender, whether institutional or non-institutional, that it will eventually pay back, in addition to agreed-upon interest. Sometimes debt may be convertible, or may also provide warrants to the lender.
What are some of the pros and cons of debt financing?
– Pros: The advantages of debt financing are many. For example, a company does not give away ownership interests to its lender, and is able to control the use of its capital. Also, other than paying back its loans, the company does not lose control of how it is run. Further, the interest that the company pays on its debt may be tax deductible, and the principal and interest are known numbers, thereby allowing for such payments to be planned in the company’s budget. Also, the business relationship ends once the loan is paid back. As a result, debt is often “cheaper” than equity, because after the repayment of any such loan, the owners are able to realize all of the company’s profits.
– Cons: On the downside, the company has to pay back the loan, plus interest, and because of the risks inherent to the cannabis industry, institutional lending is difficult to come by; therefore, companies are likely to be hit with higher interest rates and oftentimes more onerous terms and conditions. If the business relies on debt and has cash-flow problems, it will have a hard time paying the loan back, and if it carries too much debt, may be viewed as “high risk” by potential investors. In most, if not all, cases, especially in this industry, the lender will require personal guarantees or collateral to secure the loan, creating potential personal liability for the founders if the loans are not paid back.
What is equity financing? Equity financing is when a company’s initial owners exchange ownership (i.e., “equity”) for capital, commonly raised at this time in the cannabis space from family and friends, family offices, fund-investor groups, and other high-net-worth individuals.
What are some of the pros and cons of equity financing?
– Pros: Part of what makes this an attractive option is that the company does not have to pay interest on the capital it raises, does not have to pay the capital back (initially), and can access its investors’ network, which may lend it an air of credibility. Investors generally take long-term views, and most don’t expect an immediate return on their investment, and generally, equity financing is less risky than debt financing, given that there is no immediate right to repayment, except from profits of the company (if and when there are profits).
– Cons: Perhaps the biggest factor working against equity financing is that the company must give away ownership. By doing so, its founders may lose control of the business, and could need to consult with investors before making important decisions. It also takes time and money to find the right investors, who are willing and able to invest.
This only scratches the surface of these forms of financing, and the advantages and disadvantages relating thereto. It’s critical to any company’s success that its founders be educated on the lasting effects of both options. At this time, given the great reluctance of most lenders – whether institutional or non-institutional – to lend to cannabis companies, equity financing is the most common means to raise initial capital. But as the industry’s acceptance grows, there will be a wider range of investment options.