I stumbled upon this recent post by Jason Paltrowitz titled “Lawful but Awful: The Small Cap IPO Cycle.” It contains some interesting findings and I like everything about it for cannabis companies, except the conclusion. The conclusion is that OTCQX and OTCQB markets are a good bet for small companies, because these markets “offer a simplified path with financial, corporate governance, and disclosure requirements tailored to smaller companies.”
Plant-touching U.S. cannabis companies cannot list on the senior U.S. exchanges, meaning the NYSE or Nasdaq. Still, many U.S. cannabis companies that want to raise significant capital choose to “go public.” The well-worn path is either to: 1) list in Canada or overseas, via reverse merger, or 2) head to the abovementioned OTC markets, again via reverse merger, and pursue a Regulation A offering. However, in my experience, the OTCQX and OTCQB are not good places for cannabis companies.
OTC markets are teed up for fraud
Don’t take my word for it: here’s an SEC bulletin updated earlier this year and another in the specific context of cannabis stocks– going back to 2014. Here too is a FINRA warning, a sample DOJ microcap cannabis prosecution, and an FBI case study. As you might infer, sad stories related to OTC scams abound. This is because the OTC sandbox is a huckster’s paradise, due to the susceptibility of OTC stocks to dramatic price swings and the low level of required disclosures.
Now, one could argue that none of this is necessarily bad for OTC cannabis companies: instead, it’s bad for the people who invest in them. That’s not exactly right. An OTC cannabis company, along with its management, has fiduciary and governance-related obligations to investors. Public companies are no different than private firms in that respect. In all, the level of exposure for a cannabis company grows commensurate to the amount of capital it raises, as well as how it goes about the raise.
OTC market deals are weird
I have been in and around a sizable number of OTC cannabis company listings at this point. They’re weird. In many cases, a cannabis company will be approached by an M&A advisor and/or investment banker affiliated with an OTC company. These individuals may propose a reverse merger, whereby the cannabis company delivers all of its shares (sometimes through a newly created entity) to the OTC shell, in exchange for shares in that shell. At closing, the cannabis company owners receive some combination of common and preferred shares, and maybe even warrants, in the OTC company.
In many cases, cursory diligence on the OTC company throws off obvious red flags. I’ve seen proposals where the shares offered to the uplisting owners exceed the issuable securities shown for the OTC firm. I’ve seen many OTC company shells with EDGAR information severely at odds with private disclosures. Some of these matters are deferred maintenance, to be addressed with counsel in service of a proposed transaction. Others are landmines and may be intractable.
More discomfiting than any of this, however, is the common situation where an OTC promoter approaches a cannabis business with no idea – or interest, apparently – in whether the cannabis company is even viable. The promoter will want to agree to binding terms having done no diligence on the target. Friends, if the most considered aspect of a proposed deal is the warrants a promoter gets on signing, you’re probably looking at a pump-and-dump scheme.
You may lose control on the OTC market, gaining only headaches
In an OTC listing the cannabis company “trades up” for an opportunity to be listed on a public exchange and to raise money through that vehicle. Ownership must weigh the probability of successful fundraising against the control yielded to other parties. Those parties may include legacy preferred shareholders, in addition to newly appointed directors and officers, and promoters bringing the deal.
Sometimes (not always), yielding control is required for cannabis company growth. Assuming obstacles like residency requirements are navigable in the new structure, it’s important for the uplisting owners to consider what it would mean to own a smaller piece of a potentially larger pie. This is not just a question of economics, but also decision-making. If the owners lose the ability to direct the company in any sense beyond daily operations, they may determine the prospect of additional capital isn’t so attractive.
This may feel frustratingly obvious after the closing of an uplist transaction. A standard scenario sees the OTC stock spike, dive and inevitably flatline. At that point, uplisting owners will be left wondering why they went to all the trouble. If you lose control of your company only to make some money for stock promoters, then you’ve really lost.