Due Diligence for Investors – Don’t Fear the Great Unknown

This is part two in our three part overview discussing due diligence in the cannabis industry.

Investing in the legal cannabis industry does not have to feel like an adventure into the great unknown. With proper due diligence, an investor can understand this new and developing industry while evaluating an investment target.

In traditional industries, sophisticated investors know the right business questions to ask and the types of financial analysis required before making an investment. However, the legal cannabis industry is different for many reasons.

When investing in the cannabis space, even sophisticated and experienced investors are often left confused when analyzing the array of complicated legal implications and federal, state and local regulations governing cannabis businesses.  Add on top of that the fact that the industry is moving at lightning speed, and investing in cannabis can seem like a minefield.

There are definitely opportunities to make money in this growing industry, but it is vital to know the right questions to obtain the most comprehensive information to avoid making a bad investment, or more importantly, incurring liability in the process.

The starting point for investors looking to enter the legal cannabis industry is general industry knowledge, including an awareness of specific risks and issues. Investors must then conduct due diligence on specific target companies.

Due diligence should include both standard deal due diligence and due diligence specific to the cannabis-related aspects of the transaction, including analyzing the investment from a legal and regulatory viewpoint. Cannabis-related due diligence, however, does not only mean looking at a target’s legal and regulatory compliance— it also means evaluating the target’s practical business processes and how it manages some of the inherent challenges of operating a cannabis company. 

Industry Knowledge

Like any other type of business transaction, investors should know as much as possible about the industry they are entering. This is especially difficult in the legal cannabis industry because it is a new sector that is constantly developing and changing. 

The threshold issue continues to be that cannabis is illegal under federal law. However, the industry is investible because the federal government has allowed the industry to operate and develop in states that have legalized. Once an investor is comfortable with this initial hurdle, there are various other risks and issues cannabis businesses face that investors must be aware of, including:

  • Inability to open bank accounts. This is a major issue that invokes other important business concerns like cash management and security.
  • Federal tax issues. Section 280E of the tax code prohibits cannabis companies from making any standard business deductions, which can affect profit margins.
  • State licensing requirements. Inability to comply with license laws can be costly and ultimately result in an otherwise legally operating business being shut down.
  • Residency requirements for companies and investors.
  • Local laws. Local governments in most legal states can place additional restrictions on businesses operating in their jurisdictions. Some localities have banned cannabis despite its state legalization.
  • Real property concerns.  It can be difficult for cannabis companies to find a landlord that permits their use of the premises, and even when a company is able to secure acceptable premises, rents may be above market.

Some of these issues are a result of federal illegality, and others are a product of a growing industry that is still working out its kinks. Look for more in-depth coverage on these topics as well as many more in future posts on The Advisor.

Investigating the Target

Investors have double duty when evaluating the investability of a particular company in the legal cannabis space.  Not only does the investor need to evaluate all the typical business aspects of the company such as financials, formation and structure (particularly if investing in a cannabis fund where compliance with securities laws and regulations must also be evaluated), but a prudent investor should also conduct a due diligence investigation on the target company’s cannabis compliance, legality, and business practices.  

Conducting due diligence on a cannabis target starts with licensing. Investors must ensure that a cannabis company is properly licensed and in compliance with state laws. This includes being prepared for facility inspections and meeting requirements to maintain the license annually.

Strict compliance with licensing laws is the lifeblood of a cannabis company because compliance issues cause excess costs and decreased margins, or worse, the loss of its license, which could lead to a shut down of operations.

Licensing, however, is only the tip of the due diligence iceberg. Other legal and regulatory issues that need to be investigated include:

  • Real property concerns.
  • Compliance with local laws.
  • Advertising and marketing.
  • Product labeling.
  • Waste disposal.

In addition to the many legal and regulatory matters an investor would typically investigate, there are many practical business issues unique to the legal cannabis industry. It is equally important for an investor to understand how a company handles the unique challenges of doing business in the legal cannabis industry in order to scale its business so that investors see healthy returns.  Some of these issues include:

  • Corporate structure and indebtedness. Owners may hold their businesses through corporate entities, but they cannot use those entities to obscure ownership and control of the business. Regulators ensure that only qualified people are involved in the cannabis industry.
  • Background checks on executives and employees. In addition to criminal background checks conducted by regulators, investors should also check business and financial history, and media reports about past activities.
  • Cash management practices or banking plans. Due to banking regulations, cannabis companies must often operate in cash, which can create issues of tracking and security for the companies and their investors.
  • Security protocol. Regulations generally cover security of stored inventory, but because cannabis companies are largely cash businesses, investors must ensure that a company has the necessary focus on protection of cash and other assets.
  • Third-party contracts and relations. Investors should ensure that any vendors or other businesses the target works with are properly licensed. Non-compliance by a related third-party could have major implications on the target's operations.  

Investing in a legal cannabis business involves risk, but any investment involves risk. The most important thing is to understand the risks so you can make a smart investment, or more importantly, avoid a bad one.

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