Key Due Diligence Issues for Cannabis Investors

[Thanks to Wendel Rosen business attorney Karen Balderama for this post.]

More than a year after legalization of recreational cannabis in California, the maturing California cannabis industry has seen an exponential increase in capital raising and M&A activity. Sophisticated investors and established companies are jumping in and making deals happen, infusing operators with capital and betting on even more growth if and when federal legalization occurs. Investors from Canada, where recreational marijuana is legal, are particularly interested in the California market. California cannabis companies are a popular target because they represent a foothold in the largest legal cannabis market in the world.

Before jumping in, however, investors should conduct thorough due diligence to uncover any potential landmines. The cannabis industry is unique in that many companies are emerging out of the illegal “black” or semi-legal “gray” market and may be operated by individuals who are not familiar with conventional business practices. Investors should be aware of the unique issues they will encounter when reviewing companies newly subject to complex and quickly evolving rules and regulations. In this environment, the potentially high upside is tempered by significant risk.

Investors who are new to the cannabis industry should be aware of the key areas that may require increased focus during the due diligence process. Along with my colleague, Rob Selna, I will be discussing these key due diligence issues and how investors can address them at the O’Cannabiz Conference in Toronto on April 27, with real-life examples from recent financing and M&A transactions.

1. Local and State Licensing

Without a local permit and state license to operate, a company cannot do business in the legitimate California cannabis market. While this sounds like a no-brainer, investors must ensure that any company they review has all the proper required state and local permits it needs to operate. Given the new and untested California licensing process, an investor must ask some basic questions, such as: If the company does not have a permanent license, is it in the process of obtaining one? Is there any risk that it can be denied a local permit or a permanent license?

2.  Capitalization and Corporate Records

One particular problem for cannabis companies, is that they may have been started and operated without legal help. While some disorganization can be accommodated, a company ready for investment or acquisition should have some level of basic corporate housekeeping. Due diligence questions may include: Have corporate actions been properly documented and approved? Is the company in compliance with its own articles of incorporation and bylaws? Are there risks of other “founders” coming out of the woodwork to claim ownership in the company?

3.  Tax and Financials

It’s common knowledge that cannabis companies are taxed heavily. Some companies may have come up with creative solutions to try to get around this, or they may have handled tax issues themselves without getting sound advice from accounting professionals. Questions to ask include:

  • What banking arrangements, if any, does the company have in place?
  • Has the company filed accurate tax returns?
  • Has it paid all of its local, state and federal taxes?
  • Is it at risk for an IRS audit?
  • Could there be a large tax liability?

Like corporate records, companies also may have neglected to keep complete and proper financial records. Investors should engage accountants well-versed in the cannabis industry to review a target company’s tax returns and financial information so they understand the risks involved.

4.  Intellectual Property

After it obtains a license to operate, a company’s intellectual property (trademarks, trade secrets, patents, etc.) may be some of the most valuable assets that a cannabis company has. An investor should examine how well the company’s IP is protected, understanding that federal registration of certain intangible assets may not be available for an “illegal” business activity. It is also critical for investors to know whether any other parties (such as employees or partners) have a valid claim of ownership on the IP, or whether the company’s IP infringes on another party’s intellectual property.

5.  Business Operations and Agreements

Investors should carefully examine how the business has been operated to assess other possible risks. This bucket includes employment issues (such as proper classification of employees, wage and hour issues, etc.); lease agreements and other real estate matters; contracts with customers and suppliers; adequate levels of insurance coverage; adoption of and compliance with internal controls, policies and procedures; compliance with environmental laws; and compliance with other rules and regulations that may apply. Noncompliance in each of these areas could present a risk of liability to investors.

Ideally, once due diligence on a cannabis company is completed, there are no significant issues that present a heightened risk of liability. If there are issues, it is best to uncover these issues and address them early in the process. If the company presents too high a risk of liability, investors can negotiate better terms and demand certain protections, or they might decide to pass on a particular opportunity altogether.