Always Be Prepared - Due Diligence for Cannabis Companies

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

When doing business in the legal cannabis industry, preparation is everything. Cannabis companies and their business operations are highly scrutinized—particularly regarding legal compliance and licensing requirements. As a result of this heightened level of scrutiny, you must be organized and prepared before doing anything.

The best way to prepare for a business transaction is to conduct due diligence. Almost all cannabis companies will find themselves in need of due diligence at some stage of their business.  Most commonly, companies may need due diligence when:

  • Raising capital.
  • Connecting with third parties.
  • Applying for a license.

Raising Capital

Raising capital can be difficult in any industry, but raising capital in the legal cannabis industry often proves even more challenging than most. Investors ask a lot of questions…at least the smart ones do. Sophisticated investors want as much information as possible about a target company. In addition to financial questions, investors will inquire about licensing, cash management, ownership structure, intellectual property, real property and the regulatory framework in the state where the company operates.

For a company planning to begin, or already involved in, a capital raise, this means endless hours of responding to requests for information and documentation from various potential investors. Having a detailed report on the important aspects of the company to provide to investors will save time and money.  It can also save a company from making costly mistakes by providing misinformation to a potential investor. A company can show off their preparation and legitimacy by attaching a due diligence report to a private placement memorandum when raising capital.

In preparation for this onslaught of interrogatories, a company should conduct investor-style due diligence on itself. This includes investigating, or hiring a third party specialist to investigate, everything investors want to know before making an investment.

When dealing with investors, the due diligence process serves many benefits, including:

  • Improving communication with potential investors.
  • Saving the company time and money by creating efficiencies in synthesizing all company information one time, in one place.
  • Demonstrating an organization’s preparedness and sophistication and creating a level of trust.

Due diligence can also help a company stay organized in preparation for other important business matters such as license renewal or securing cash management solutions.

Particularly as it applies to licensing, a company’s organization of its information is crucial.  Having a legal, valid license is the lifeblood of any cannabis company, and state licensing and renewal laws and regulations are often detailed and complex. By staying abreast of any important changes in company data, licensing and renewal applications are often much more manageable.

Connecting with Third Parties

It is inevitable that at some point, a company will enter into some form of business relationship with another company. This could be a partner, vendor, grower, transportation company, security company, business or legal service company, or any other type of business relationship.

While due diligence is important before entering into any business relationship, it is even more necessary in the legal cannabis industry. A company must ensure that any potential partner that they are relying on is properly licensed, in compliance with state and local laws and regulations, and takes all necessary steps to remain in good standing.

A violation by a vendor or partner can reflect poorly on the company, and depending on the relationship with that company, can jeopardize the company’s operations and licensing requirements. For example, if a company receives product from a grower that operates in a locality that has banned or restricted growing, it could jeopardize the company’s ability to operate.

The key is to conduct sufficient due diligence to ensure that you are working with a strong, safe reliable partner. This varies depending on the type of business partner, but generally includes inquiries into their business operations, ownership structure, and their real property location with an analysis of the state and local law for the jurisdiction where they operate.

Applying for a License

The licensing process is different in every state, but one thing remains constant -- time and money.  It is a long, expensive process to obtain a license to grow, sell, transport, or otherwise handle legal cannabis.

The first step is to understand the specific state licensing policies, including whether the state has an unrestricted or limited number of licenses that can be issued. For example:

  • New York issued five licenses in its medical program.
  • Maryland’s medical marijuana law installs a cap at two dispensary licenses for each of the 46 state senate districts, and a grower cap of 15 licenses.
  • Pennsylvania recently legalized medical cannabis, and will allow 50 dispensary licenses and 25 grower licenses.
  • Washington has a retail license cap of 556.

These restrictions make obtaining a license in many states both valuable and competitive.

Companies applying for licenses in some states should expect to spend hundreds of thousands of dollars to merely go through the application process—often with no guarantee of securing a license to operate.  The reward of obtaining a license will be high, but the financial risk is steep.

Due diligence by an independent third party can be a major asset to companies seeking licenses. A due diligence report can be attached to a private placement memorandum or a license application.

Thorough due diligence provides a complete look at the applying company from an organizational, operational and compliance perspective. Choosing not to conduct due diligence is like writing a novel then deciding against proof reading. Why spend the time and money to apply for a license without double-checking to ensure everything is completely ready, especially when the process can be so competitive? One mistake could mean failure to obtain a license.

In states that do not have a cap on licensure, like Colorado and Oregon, due diligence is still important when seeking a license. Not being fully prepared or compliant in a license application could delay licensure, which could be detrimental to a company’s business plans or operations.

Additionally, with constantly changing laws and regulations, states that do not have caps (or localities within the state) could implement licensure caps at any time. For example, while Colorado has no cap, the local government in Denver recently limited the amount of licenses available in Denver.

Either way, a company needs to have the complete snapshot of themselves before applying for a license, so they know if they are ready to operate as a legal cannabis business or if there are any deficiencies in their operations. Comprehensive due diligence also alerts companies to certain practical issues that will ensure smooth operations and easier license renewal, including security protocol, cash management procedure and real property issues.

As a result of the intense scrutiny facing the cannabis industry and cannabis companies, due diligence is an essential tool that companies should utilize to ensure compliance with licensing laws, connect with third parties, and raise capital.