5 Consequences of Extending Credit in the Cannabis Industry

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Industry insiders have known for some time that most cannabis businesses struggle with cash flow problems.  This is caused by many factors such as federal illegality, high taxes and fees, including Section 280E of the tax code, a dearth of financing options, and burdensome and inefficient licensing and regulatory obligations.

Now it appears that a significant proportion of the licensed industry has begun extending credit to one another. It is easy to imagine the snowball effect of cultivators extending credit to manufacturers or distributors and manufacturers to distributors and retailers to distributors.

This article will examine some of the obvious and non-obvious consequences of market participants extending credit to one another.

First, it is important to understand one unique aspect of payments in the cannabis industry.

Armored transport delays

While many cannabis companies have bank accounts even those with bank accounts cannot make all of their payments electronically.  This means that some percentage of payments have to be made in cash. As a result, an unusual problem has come up that is tied to the industry’s reliance on armored car transport for cash payments.

Armored car companies have required that a client have a set amount of cash ready for pickup before committing a vehicle and driver to the job. This of course has the effect of slowing down the movement of funds through the entire ecosystem.

Reduction in cash flow and increase in receivables

Delays in payments will have an immediate impact on the cash flow of virtually every market participant.

This delay will make paying everyone else on a timely basis more challenging. Without available funds to pay all suppliers, vendors and service providers on time management will be forced to choose between them.

Cannabis companies’ accounts receivable and accounts payable will grow in size as receivables and payables are delayed. For larger companies having accounts receivable in the millions has become more common.

Finally, for entities looking to sell having a worsening financial condition and poor cash flow is not exactly what they were hoping for.

Material breaches in supplier and distributors agreements

Not everyone in the cannabis industry has written agreements with their suppliers, vendors, distributors and service providers. Nevertheless, a failure to pay is going to, at some point, give rise to a material breach of an arrangement even if unwritten.

In written agreements, there will be specified time for payment which under current conditions may not be satisfied.

This tension will require the parties to negotiate on alternative payment terms and conditions. Parties may have to waive their rights to pursue remedies against the counterparty in order to preserve the relationship.

Increased likelihood of litigation over non-payment

Adversity tends to strain business relationships and there is no worse strain than a failure to pay. This strain will bring any perceived or actual grievance between the parties to the forefront.

A failure of the parties to agree on new payment terms and conditions could easily escalate into litigation or threats of litigation.

Given that litigation is not a fast and efficient process for dispute resolution there is a risk that the use of litigation to resolve late payment scenarios could worsen the slow payment problem across the industry.

Financial interest holder reporting

Many state licensing regimes include the concept of a financial interest holder. In California, for example, a financial interest holder is anyone who provides a loan to a license holder. Only banks and financial institutions are excluded from this definition.

If someone is a financial interest holder, then they must be reported as such to state and local authorities. Failure to timely report a financial interest holder to regulators may result in fines, penalties and administrative proceedings against the license.

Therefore, a party that provides a loan to a commercial cannabis business is a financial interest holder.

If a cannabis company charges counter-parties interest on late payments for many months, does that constitute providing a loan to a license holder? If yes, then that would turn regulatory compliance into a total nightmare.

Violation of loan covenants

Recognizing that relatively few cannabis business have traditional debt financing this is still an issue for those fortunate few that have loans.

Loan agreements typically contain covenants that require borrowers to maintain certain financial ratios for the benefit of the lender and to do and not do certain specified things.

Loan covenants may, for example, require the borrower to make timely tax payments, maintain insurance policies, not sell any collateral, and not incur any unauthorized debt.

If the cannabis business is in financial difficulty because of delayed payments, then there is a high probability that it will be forced to violate one or more loan covenant. A violation of loan covenant will give rise to a material breach of the loan agreement which could result in the lender asking for immediate repayment in full which would be a disaster for the borrower.

Even companies that do not have traditional loans may have issued promissory notes as part of their fundraising.  Most notes require periodic payments on a monthly or quarterly basis.  Cash shortfalls caused by delays in receipt of payments will have an impact on companies required to make these periodic payments to investors.

A likely consequence of an inability to make a timely payment is a renegotiation of the investment terms with investors.  The renegotiation is not likely to be favorable for the company given the investor’s absolute right to payment.

Looking ahead

A variety of factors have caused payment delays in the industry. There is a real risk that the consequences of the ensuing cash crunch will make the problem worse. One potential bright spot, however, is the possible passage of the SAFE Banking Act and similar legislation that could alleviate some of these problems.

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