Introduction

We are seeing what I believe is the end of global prohibition around cannabis consumption, with more and more countries around the world legalizing cannabis in some shape or form. This has resulted in a “green rush” to capitalize on a global opportunity that is estimated to currently be US$10–12 billion and expected to grow ∼10× to US$100–140 billion by 2029.

For many, this space presents a once-in-a-lifetime opportunity given the potential size and reach of the market. Cannabis is commonly associated with the recreational consumer acting as a social lubricant. At the same time, the potential wellness and medical opportunities of cannabis (including anxiety, anti-inflammation, weight loss treatment, natural sleep aids, seizure management) presents a potentially massive market and many believe the larger f inancial opportunity.

The broadness of the cannabis industry touches many traditional markets, including beverage alcohol and tobacco, medical and pharmaceutical, and wellness, and not surprisingly the major global companies in this space are beginning to take a stake in cannabis, including investments and/or partnerships by household names such as Constellation Brands, Altria Group, ABInBev, Molson Coors, and Imperial Brands (as of August 2019).

What is unique about this emerging industry is how it has been financed early on, which has resulted in some atypical characteristics of this space. Canada was the first major economy to legalize cannabis usage. However, the Canadian economy has a relatively modest private capital infrastructure (relative at least to the United States). Consequently, many of these cannabis companies turned to public equity markets, which together with an insatiable retail investor appetite for cannabis investments, resulted in hundreds of start-up cannabis companies financed by public equity markets.

At the same time, cannabis remained federally illegal in the United States (even though numerous states have legalized), which placed significant limitations on the ability of federally regulated banking and capital markets to fund U.S. cannabis companies; this only exacerbated the flood of capital into the Canadian cannabis companies.

This perfect storm led to a plethora of early stage public cannabis companies with easy access to capital, but with inexperienced boards and management teams, generally poor governance and oversight, and virtually no institutional shareholders to serve as a check and balance. Not surprisingly the cannabis space has not been held as a beacon of good governance or proper stewardship of shareholder capital—this has not been helped by several high-profile scandals of major cannabis companies that have been accused of activities including selling cannabis to the black market in a federally licensed facility, inappropriate related-party dealings, and growing cannabis in unlicensed rooms and hiding that from federal authorities. Unfortunately, these are not likely to be the last black eyes for this space.

By no means should this deter directors looking to serve on a board of a cannabis company—the sector will evolve and mature and the potential opportunity is immense. That being said, the following are some tidbits of advice for current or prospective directors—albeit given the speed at which the space is moving, this advice may very well be dated by the time this is being read.

In These Early Days, There Are More Stocks Than There Are Companies

Before joining the board of a cannabis company, do your homework. There is a saying in the cannabis space: There are more stocks than there are companies. The evolution of the space has attracted a wide range of entrepreneurial individuals, including stock promoters and other like-minded capital markets participants. Not surprisingly, you will find a fair number of cannabis companies that appear to be more focused on near-term share price than on building a strong operating business. Moreover, in a space where valuations are relatively outsized, it can be difficult to assess a company based on its market value or share performance.

For prospective directors, particularly those being asked to serve on an earlier stage cannabis company, it is important to satisfy for themselves that there is a meaningful operating business or there is a thoughtful and well-laid strategy to get there. It is highly recommended that you vet the employment history of the management team and existing board—look for actual operating and successful business experience. Also closely scrutinize communiques to the public in the form of press and media releases: Are they of substantive nature or are they largely promotional in nature, and has the company met the statements and commitments they have set out to shareholders?

Getting Underneath the Canopy

Directors new to the cannabis space may feel daunted by the perceived complexity of this nascent industry. While there are certainly elements of this space that are different than traditional consumer packaged goods (CPG) or agriculture, it is not a complicated business to understand—at least not in these early days. In the most simplistic form, these companies grow a plant, they create a product from that plant, they brand and market this product, and they sell the product.

Once directors understand the basic building blocks of the cannabis industry, they'll be in a better position to assess the business and performance of the management team. As a recent example, a cannabis company was found to be growing and selling unlicensed product, leading to a public relations crisis and potentially the business being shut down by the regulators. The key takeaway of this scandal for directors in this space is the importance of understanding the “math” behind the cultivation element of the business.

Boards and particularly audit committees should have an undertaking to understand the cultivation metrics of a cannabis business, for example, how many crops per square foot, yield per plant, how are yields dependent on strain, what is the wet-versus-dry ratio of the plants, how much flower versus trim is produced. Those who understand this math will be best positioned to identify potential irregularities as they arise; for example, when output or revenue in licensed cultivation spaces is so far above or below industry norms it should raise the question of why the business is such an under- or outperformer.

Be Realistic About What Governance Is in This Space

Consistent with the evolution of this industry, corporate governance is also in its infancy—with few exceptions, the boards and management teams of cannabis companies do not have extensive governance experience.

The board processes and reporting that are second nature in more established and mature industries are generally nonexistent in the cannabis space. These are improving rapidly, but it remains early days. Directors joining this space should recognize this and manage their expectations accordingly—working with the board and management team to enhance corporate governance while recognizing the need to be nimble and flexible in a rapidly evolving space.

Notwithstanding, the highest priority for boards in this space should be to bring in “been there and done that” corporate directors to help guide the board, and particularly to help chair key board committees.

At the same time, the demand on directors in this space can be significantly higher given the speed at which the space is moving, the relative inexperience of many management teams, and the highly regulated nature of cannabis. Directors in this space should expect and demand a significantly greater involvement in the business than would be typical for a board. For example, a traditional board and committee meeting schedule (e.g., quarterly board and committee meetings) is less suited for cannabis companies. In the cannabis space, a fiscal quarter is a lifetime—it is recommended that directors have more regularly scheduled meetings and calls to stay on top of the business. Directors will also find it useful to have regular reporting from management on capital spending and other activities to have a pulse on the business, which can go sideways very quickly in this space.

Board and Management Need to Keep Each Other Focused

The cannabis sector is moving at breakneck speed—new geographic markets are opening up regularly, there are numerous form factors coming to market, global supply chains are starting to form, and major global players (CPG, beverage alcohol, tobacco, and pharmaceutical) are also entering the space.

There appear to be endless opportunities for companies to pursue and in the early days there has been an abundance of cheap capital that has fueled a climate of being something to everybody, together with a global “land grab.”

There has been a belief in the cannabis space that the old business adage that you have to be good at something doesn't seem to apply to them. Not surprisingly, at the time this list was prepared, we are seeing growing signs of market skepticism and concern surrounding some cannabis companies' ability to meet outsized expectations they had previously set, including the ability to generate any meaningful profits in the medium term.

This issue of focus is further compounded by the unique shareholder landscape for cannabis in these early days. A lack of understanding of the cannabis business, an industry born in stock markets, the perceived social stigma of cannabis, and federal prohibition of cannabis in the United States has led to a shareholder environment that is almost entirely retail driven and devoid of any traditional long-term asset managers. This has resulted in a climate highly sensitive to momentum, shareholder temperament, and headlines.

Consequently, companies can feel pressured to make more noise and hype to attract retail attention. Directors need to help management find the balance between making the right business decisions and ensuring that it is properly communicated to the market—versus making decisions you believe the market wants to see. It is important that the board oversee management in developing and executing on a clear strategy—at the same time supporting management and shielding them from criticism they may receive for not pursuing businesses or market segments that their competitors are.

Setting Pay in This Space

The cannabis industry shares similarities with traditional consumer packaged goods and agricultural industries, but the “speed” of the space is more akin to technology. A relatively young, talented, and dynamic workforce, a dearth of cannabis industry experience, a growing global marketplace, and constantly new and emerging opportunities has created a market for talent that is very competitive and dynamic. It should be noted that experience in the cannabis space is currently measured in months—an “experienced” executive has been in the space for a little over 12 months.

Consequently, companies may find that the traditional remuneration programs found in general industry are not adequate to attract, retain, and motivate the talent required to be successful in this space. Directors and those on the compensation committee may wish to look to the technology space for design specifications and ideas for remuneration.

Specifically, look to increase the impact and perceived value of compensation through shorter and more rapid performance and vesting periods. For example, instead of traditional annual or cliff-vesting share awards, companies may wish to consider awards that vest quarterly or even monthly.

Remuneration plans with built-in traditional annual key performance indicators (KPIs) or balanced scorecards are also difficult to set and assess as the speed of progress and change in this space can render the strategic priorities and any KPIs set at the beginning of the fiscal year quickly moot. It may be more effective to set quarterly or biannual objectives with broad goalposts of what success looks like. It is also just as critical to ensure underperforming executives and employees are quickly removed—again a page from fast-moving technology companies.

In an industry that consists almost entirely of publicly traded companies, boards will want to consider the use of full-value shares as remuneration versus traditional options—the volatility in this space can create significant overhang on options and create a perverse incentive for executives and employees to join competitors to “reload” at lower levels.

The Board and Overseeing the Capital Expenditure Budget

A hallmark of the early cannabis industry has been vertical integration of companies, which has required major infrastructure needs from cultivation, extraction, production, and R&D facilities.

Unique to this space and in large part due to the access to cheap capital via equity capital markets is the fact that infrastructure spending is driven largely by equity and not traditional debt financing. As a result, this has spared companies from the typical robust rigor and oversight required by debt financiers in their due diligence, including careful examination of capital spending and budgets. This issue is compounded by infrastructure designs that are relatively new and not well understood, and as a result the risk of major cost overruns or inefficient capital allocations is very high.

As such, it is critical that boards are involved in the capex budget and development of major infrastructure projects. Boards should make use of external consultants and other third-party expertise as required to ensure that they satisfy themselves that there is a prudent deployment of shareholder capital.

Boards will also want to work with management to develop KPIs to ensure the board has a clear line of sight to the performance of infrastructure projects (e.g., cost to completion).

Challenge Management on Big Bets by Looking to the Informal Market

As noted, the cannabis space is one where there appear to be endless opportunities—product segments, geographies, and so on. This has manifested itself in early days through various product markets, including cannabis drinks, edibles, oils, concentrates, and other infused products.

The challenge with pursuing many of these opportunities is the significant capital that tends to be deployed—again in these early days, the ecosystem of established contract manufacturers and specialists is in its infancy so companies may have to invest heavily to enter these new segments.

This puts the board in a position to approve or support capital projects that could significantly deplete reserves and divert senior leadership resources—capital projects that effectively support a quasi-start-up business and the risk associated with it.

Consequently, boards should be challenging management to demonstrate the viability of these new businesses. While this is a nascent industry and data is limited, there are meaningful indicators for the boards to consider. This includes data from mature U.S. markets (e.g., California and Oregon), but also just as important, anecdotal information from the informal markets—markets that have existed for a very long time and offer lessons on evolving consumer tastes and preferences, consumption methods, and so forth.

Too often, the excitement to chase the herd into new opportunities overrides thoughtful discourse on whether that opportunity is a viable one and represents a satisfactory return on capital.

Mergers, Acquisitions, and Consolidation Present Unique Challenges for Cannabis Boards

Lastly, similar to many early stage industries, the cannabis space has and will continue to see significant merger and acquisition (M&A) and consolidation activity for years to come.

The combination of the factors previously discussed, including the priorities of some of the management teams in this space, can put directors in challenging situations to assess deal terms and valuations. A number of cannabis companies have faced scrutiny for deals where the deal value represented valuations that some may perceive to be grossly inflated. The modest governance structures and processes in place at many cannabis companies only further compounds the challenges for the boards in determining whether a deal is in the best interest of their shareholders.

Nonetheless boards should ensure they are fully made aware of any related-party interests, receive detailed pro-forma forecasts for the businesses with sensitivity analysis, and carefully review all the key assumptions being put forward. In the cannabis space, nothing is easy—assume everything is new. For example, the process of moving products and ingredients from one market to another is relatively straightforward for pharmaceutical and CPG companies where export channels are clearly defined and the regulatory framework accepted by all the key stakeholders. However, in cannabis, moving product or ingredients is no easy proposition with numerous international narcotics treaties and regulations—in addition, individual countries could insert additional regulatory hurdles.

In addition, for relatively significant transactions, directors would benefit from sending members to have a look and evaluate firsthand the facilities and businesses they are acquiring—including spending time and speaking with the employees to assess the credibility of the team and business. If it is too good to be true—it is certainly the case in the cannabis space.

About the Author

Steve Chan is vice president, corporate affairs and corporate secretary at The Supreme Cannabis Company. He previously served as the head of investor relations and corporate communication, as well as chief human resources officer of the company.

He serves on the board of MG Health Ltd., a medical cannabis company in Southern Africa, on the board of Green Rush Ventures, a CBD investment fund in the United Kingdom, and on the advisory board of Asia Horizons, a Sino-American fund focused on investing in CBD products and brands in China. Prior to joining the cannabis industry, for more than 12 years Steve served as an advisor to major corporate boards in the United States, Canada, and UK on strategic performance, governance, remuneration, and shareholder matters. Steve is also a course director at York University.

Mr. Chan graduated from Wilfrid Laurier University with a Master of Arts in business economics and a Bachelor of Arts in economics from McMaster University. Mr. Chan is also an adjunct faculty member at York University, teaching corporate governance.