Traditional VC funds are governed by the terms of their partnership agreements. These agreements between the general partner (GP) and the limited partners (LPs) contain the terms under which the GP is allowed to invest the LPs’ capital. These terms include adherence to an established investment thesis, required reporting and compliance, and something called a moral clause, which is a clause that prohibits funds from investing in companies that are in the tobacco, firearms, or pornographic industries. And as long as cannabis is a federally illegal Schedule I narcotic, those clauses will continue to prohibit traditional VC investors from investing in cannabis businesses.
When this does change — and it will over time as many funds are already ramping up to start exploring cannabis investing — it’s plausible that they’ll stay focused on the industries they’ve invested in historically. For example, a health-care fund will have the systems, relationships and teams in place to invest in health-care companies and may, at some point, open up to cannabis health-care businesses.
The cannabis economy will impact the industries that venture investors have historically invested in, and once they are clear to invest in companies that are in those industries, they will look at companies that leverage cannabis in their business model. We can think about them as “industry first, cannabis second” investors.
According to the National Venture Capital Association (NVCA) and research firm PitchBook, there are approximately 125 explicit venture capital funds in the U.S. today investing exclusively in companies in the cannabis economy. Given the restrictions for traditional VC, the financing void is also being filled at a meaningful level by family offices and private investors that invest in deals directly.
As the industry matures, a group of cannabis-committed funds are coming into the mainstream as well. Examples of some of the leading funds that are making significant investments are Gotham Green Partners, Altitude Investment Management, Tuatara Capital, Phyto Partners, Merida Capital Partners, Casa Verde Capital, Lerer Hippeau, Privateer Holdings, Poseidon Asset Management, Treehouse Global Ventures, T3 Ventures and Hypur Ventures. Each has distinct investment strategies and invest across segments and companies at various stages of scale.
In addition, there are a number of firms that started as funds but migrated into holding companies and consolidated groups of operating businesses. This is how Canopy Growth Corporation, TILT Holdings and Acreage Holdings started out.
The year 2018 represents a banner time in financing with 149 deals collectively securing more than $1 billion in CVC backing. Comparatively outside of cannabis, the PitchBook-NVCA Venture Monitor research tracked 8,948 VC deals closing in 2018 with total investments topping $100 billion in value for the first time since 2000. This would indicate that although CVC is expanding and many funds are raising their second-round funds already, there are still very few deals being funded in the cannabis sector. This is despite the explosive growth and significant legalization momentum, with medical use now legal in 23 states and recreational use permitted in 10 states.
The types of transactions that CVCs are consummating is also coming into view. As the sector matures, both early-stage investing and late-stage investing will increase as companies stay private and secure follow-on rounds of funding and investment funds secure more capital to deploy.
As the markets continue to expand, there will also be more companies seeking CVC for both first financings and subsequent financings. Financings in private companies are described as “series,” and the first institutional or VC round is commonly referred to as the “Series A” round. This round usually comes after you’ve requested funding from any friends and family or angels. Each subsequent round is given the next letter, so round two is a “Series B” round, and so on. Late-stage CVC are those companies that have closed multiple series and continue to open up new series of investments. The year 2019 is projected to be the first year that late-stage investment will exceed early-stage investing.
When you hear investors talk about “syndicating” a deal or a “club deal,” this means that a group of investors are working together to invest in the transaction. This is most common in investments that are under $20 million and almost always the case for seed rounds and Series A and B rounds. What this means is that one investor will typically take a “lead” on the transaction, set the terms and quarterback managing the transaction on behalf of a group of investors who’ll invest less than the lead.
It’s common practice to set up something called a special purpose vehicle (SPV), a legal entity set up for the sole purpose of collecting a group of investors to invest in the company. This means that one investor (the SPV) will own a portion of equity of the company and that SPV may have several investors in its own right. Having one entity investing in your company reduces the management of the investors significantly. Typically, the SPV will nominate one person to interact with the company on behalf of the syndicate.
The role of the SPV is vital—they have to understand and manage the nuances of those relationships. The syndicate should be managed so you don’t end up with a whole group of investors who want to be actively involved in your company. At times, it may make better sense to negotiate directly with the individual investors one-on-one. But syndicates are very common and a structure you should be familiar with.