Top Three Items to Evaluate in Cannabis Due Diligence

Cannabis due diligence is essential before investing in any company involved in the emerging cannabis industry. Regardless of whether it’s a company that touches the plant, is involved in medical or retail, or operates ancillary to the industry, you must do your homework.

The scope of the due diligence an investor performs can vary depending on the business operations of the target company and the nature of the relationship, but it is often an extensive and labor intensive process that involves a large commitment of time and money. In certain instances, an investor may decide to streamline this process and only investigate certain high value diligence topics.

For investors, these would include:

1. Licensing

The Issue:

Licensing is always the primary issue when conducting due diligence on a company in the cannabis space that touches the plant. Quite simply, if a company is not properly licensed under state law, they are not just operating a business that isn’t in compliance with state or local law, they are participating in an illegal activity. Needless to say, an investor does not want to be involved in this type of situation, especially as an equity investor because they could also be subject to criminal liability.

In addition to the liability issue, many state's regulations include provisions that allow regulators to close down or suspend an improperly licensed business' operations. For an investor looking towards a healthy ROI, any shut down or suspension of business is cause for major concern.

What to Look For:

The cannabis industry is unique because the laws vary greatly by state. An investor must ensure that the target company is properly licensed under state and local law. If a company operates in multiple states or municipalities within a state, then the company will need to be licensed in each state or locality, or operate through partnerships in which the partner entity is properly licensed.

Reviewing a company’s licenses and understanding the corresponding state and local laws and regulations can be extremely complicated. It can be an expensive and time consuming process, and an investor may want to engage an outside company like Gotham Cannabis Associates, to perform this task.

2. Cash Management

The Issue:

Banking and cash management are one of the biggest hindrances to the industry’s growth. Generally, banks will not open accounts for companies involved in the cannabis industry, and as a result most cannabis companies must operate exclusively in cash. This creates a myriad of problems for companies and their investors, including tracking and security issues. Cannabis companies can be targets for criminals if they have a large amount of cash on their premises. Additionally, operating in cash makes it more difficult for companies to pay bills and taxes.

What to Look For:

Investors should start by identifying if the target company operates in cash or through bank accounts. If the business has a bank account, try to find out which bank holds the account. However, a target company may not be able to share this information until it has a signed NDA with an investor because cannabis businesses often sign confidentiality agreements with banks so they cannot share where they do their banking unless further confidentiality agreements are executed.

If the company does not have a bank account, an investor should:

  • Assess the future banking plans of the company.
  • Enquire about the target company’s banking history.
  • Examine cash management practices.

3. Real Property Issues

The Issue:

There are many due diligence issues to research and analyze related to a target company’s real property. If the target has any violations related to its real property, including operating its business in a location where legal cannabis is prohibited or problems with the premises itself, the company risks losing its license, or being forced to move or shut down.

What to Look For:

Investors should take a detailed look into various matters surrounding a target company's real property, especially if the target touches the plant. A cursory look to see if the premises are in a location that permits legal marijuana business and activity is not enough.

When conducting due diligence on a company's real property, an investor should consider:

  • The location.
  • The lease.
  • The physical premises.

Location

Investors must verify that the company's location complies with state and local laws. Even if a company's premises are in a legal jurisdiction, there are usually additional state laws prohibiting cannabis business activities within a certain distance from schools and houses of worship. Localities may have further restrictions on legal locations.

Physical Premises

Most jurisdictions require an evaluation of a specific premises when approving a license, which generally includes an evaluation of floor plans and security systems. If either of these are altered after licensing without proper approval, the company may inadvertently be in violation.

Investors should also evaluate other aspects of the physical premises, including among other things, limited access areas and security.

Lease

Investors should inspect the company's lease as part of the due diligence process. It is imperative to make sure the company has sufficient protection in the lease to account for its intended use, including flexibility if there is a change in local or state law.

There are numerous other issues to consider when diligencing a target company's lease including, but not limited to:

  • Exceptions to negative covenants about criminal activity under federal cannabis laws.
  • Landlord inspection rights.
  • Covenants related to cannabis odors.

Investing in cannabis can be risky, but with proper and thorough due diligence, an investor can attempt to mitigate some of the risks. Even if an investor does not want to engage in conducting a full-scale diligence report, evaluating these top areas of concern can provide insight in to a company’s investability.

This article was contributed by Gotham Cannabis Associates to Equities.com on August 1, 2016.