Lending money to pot businesses is a high-risk move: ‘This is not for the faint of heart’

Viewed optimistically, it looks like Kyle Kazan’s investment fund got an unbelievable deal when it loaned $2 million to Bud and Bloom.

Terms call for the recently opened Santa Ana marijuana dispensary to pay a hefty 10% annual interest rate and, once Kazan and his investors feel more comfortable, turn over a 50% ownership stake to the fund — for just $1.

Now, count the ways Kazan could lose all that cash.

For starters, Bud and Bloom could, like many small businesses, simply fail. The Santa Ana City Council could ban pot shops. State regulators could fine or shutter the business if it sells pot to minors or breaks other rules.

Oh, and one more thing: Federal authorities could raid the shop, close it down and seize its assets, as selling marijuana remains a federal crime.

“We think we got a very good deal,” said Kazan, 49, managing member of Long Beach-based AP Investment Fund, one of a handful of firms making loans to marijuana businesses. “But we’re also taking quite a risk.”

Which is why Bud and Bloom agreed to the onerous terms to begin with. A bank loan just wasn’t an option.

“It’s a very, very risky business,” said Aaron Herzberg, one of Bud and Bloom’s owners. “You don’t know how things are going to go.”

Despite California voters’ approval last month of Proposition 64, which legalized recreational marijuana, and coming ground rules for pot businesses set to take effect in 2018, it remains difficult and expensive for companies that want to grow, process or sell marijuana to borrow money.

Most banks won’t even open checking accounts for marijuana businesses, much less lend to them. And with no change in federal law in sight, that’s not likely to change, said David Dinenberg, chief executive of Kind Financial, a Los Angeles company that set out to offer loans to cannabis businesses but that instead makes marijuana tracking and compliance software.

“If everything stays the same as it is today, I don’t see the typical bank lending for some time. Access to capital is not one of the easier things in this industry,” Dinenberg said.

Neil Zick is chief executive of a bank in Washington state, where voters in 2012 legalized recreational marijuana use. Zick’s Twin City Bank is willing to open accounts for state-licensed marijuana businesses but hasn’t made any loans and doesn’t plan on it, mostly because of the threat of federal action.

The Obama administration has generally taken a hands-off approach to marijuana in states where the drug is legal, but cannabis entrepreneurs and investors fear the incoming administration will take a dramatically different tack. President-elect Donald Trump’s choice for attorney general is Sen. Jeff Sessions, an Alabama Republican who has fiercely opposed marijuana legalization.

“What if the federal government all of a sudden decides they’re going to start pushing back on the states? You don’t know exactly what the position of the next administration is going to be,” Zick said.

At issue is the way banks make most commercial loans.

Say a company wanted to buy a building and convert it into a marijuana shop. Typically, a bank would use the building as collateral, so if the business doesn’t pay, the bank could foreclose on the property, sell it and get its money back. But if federal officials crack down on the industry, they could do more than just shut down the business.

“The federal government might step in and seize the property,” Zick said. “Most banks are still not comfortable with what might happen.”

Other types of loans are off the table, too.

Marijuana businesses can’t get loans backed by the federal Small Business Administration. Unsecured business loans — think corporate credit cards or lines of credit — also don’t make sense, Zick said.

“What happens if the business owner is in jail? How will you collect?” he said.

Another twist unique to the marijuana industry: Bankruptcy courts, which are federal, won’t take cases from cannabis businesses. In a widely cited case, a bankruptcy appellate court in Denver last year ruled that the courts cannot offer bankruptcy protection to companies that are engaging in federal crimes, even if their activities are legal under state laws.

That means lenders have to know that if they lend money to a cannabis business there might not be an easy way to get even a partial repayment if the business becomes insolvent. Zick said that’s not a major concern, but nonetheless a good reason to stay out of the market.

With traditional lenders out of the picture, marijuana companies looking for cash must turn to investors willing to stomach more risk in exchange for higher returns.

For help buying real estate, some marijuana businesses have turned to so-called hard-money lenders — private lenders that offer high-interest real-estate loans.

Herzberg, the Bud and Bloom co-owner and general counsel of CalCann Holdings, a Santa Ana marijuana real estate developer, said hard-money lenders he’s familiar with will lend up to 65% of the value of real estate — less than a bank would finance — and will demand an interest rate of 12% to 18% — much more than a bank would charge.

Other workarounds for marijuana companies include raising equity by selling ownership stakes to deep-pocketed private equity and venture capital funds. A handful of marijuana firms are publicly traded — thinly traded penny stocks, mostly — and have financed their operations by selling additional shares.

Some of the funds that make equity investments in cannabis firms are also willing to lend money, but at steep rates.

Emily Paxhia, a founding partner of San Francisco investment firm Poseidon Asset Management, mostly makes equity investments in cannabis companies but has also made short-term loans, charging as much as 20% interest. A similar bank loan might carry a rate of 5% or less.

“The people we work with understand the risk we’re taking on,” she said.

Late last year, Poseidon and other investors loaned $1 million to Dark Heart Nursery in Oakland, which specializes in growing cannabis. The company didn’t have enough space to meet demand, so founder Dan Grace wanted to expand the facilities.

With that $1 million, Grace was able to add enough space to grow an additional 25,000 cannabis plants a month — doubling the 10-year-old nursery’s capacity. With each plant selling for $5 or more, that represents a potential increase in revenue of $1.5 million a year. In any other industry, Grace said, he would have been able to borrow for much less than the double-digit rate he’s paying.

“It’s a no-brainer. A bank would fund us all day,” he said. “We need physical plant and equipment. That’s exactly the type of thing banks are designed to finance. But they don’t participate.”

Kazan’s AP Investment Fund — the AP stands for “anti-prohibition” — recently raised $12.6 million from investors and plans to use that cash to buy property it will rent to marijuana retailers and growers and to make loans to marijuana businesses.

But those loans, like the one it made to Bud and Bloom, have a catch: They are what’s called convertible debt, meaning Kazan has the option to convert a loan into an equity stake in a company.

Bud and Bloom will use much of Kazan’s loan for making payroll and to cover other business expenses until the dispensary is profitable on its own. Herzberg said no ordinary lender would have given a new dispensary that kind of working-capital loan.

“There’s no such thing in cannabis at all,” he said.

Kazan, a real estate investor and former Torrance police officer, said the convertible-debt structure enables AP to be a lender now, while rules and regulations around the industry are still being sorted out, and to become a business owner later on.

“We want to enter into this business, we just don’t want to do it today,” he said. “It’s a way to invest in the marijuana industry without touching the leaf.”

If all goes well, AP will end up getting a nice interest rate on its loan and, eventually, half ownership of the business. It also bought Bud and Bloom’s building and receives rental income. Of course, if things go south, Kazan knows its entire investment could vanish.

“This is not for the faint of heart,” he said. “I’ve told every single investor: Don’t invest what you can’t afford to lose all of.”

james.koren@latimes.com

Follow me: @jrkoren

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