Investing in Cannabis: Five Due Diligence Red Flags

Our cannabis team has performed due diligence on countless business purchases, investments, loans, and just about every other kind of transaction you can imagine. As you can imagine, we’ve seen some pretty bad and even sketchy things over the years. With rescheduling on the horizon (see here and here), we expect to see an increase in loans, investments, and other transactions. And so we thought it might be time to look at five of the biggest due diligence red flags.

#1 No cooperation in due diligence

Hands down, the biggest red flag in due diligence is when the seller, borrower, etc. refuses to participate in the process. I don’t mean getting fatigue when the buyer or investor’s lawyers ask too many questions – I mean refusing to participate in the basic process. We’ve seen people refuse to provide basic information. Or walk away from a deal when basic questions were asked. Or say that other people did similar deals without information, so you should too.

This is all incredibly suspect behavior. Someone who is selling a business or seeking a loan or investment needs to be completely open. Obviously, diligence periods can get off the rails and become too long, but failure to provide basic information is a red flag that something bad lurks beneath the surface.

#2 When the pitch doesn’t match reality

One of the next big red flags is when due diligence reveals facts that grossly contradict pitches or early disclosures. The due diligence process usually begins once a client decides a deal is worth pursuing enough to pay lawyers or financial advisors. That means that the client will expect that what was disclosed to them initially is true. But often, once attorneys start to look under the hood, things can change quickly. Imagine a company saying it has X amount of licenses, when really it has half of that and has simply applied for more – stuff like that.

I can’t tell you how upset clients can get when they figure this out. A deal can just die on the spot. If a buyer or investor fails to do proper diligence, it may not learn the truth until after the deal closes. While the buyer or investor could sue for fraud, that money could just disappear. It’s much better to know this up front, before wasting time and money.

#3 Bad or crazy business structures

Another big thing to look for in due diligence is the target’s business structure, plans, and organizational chart. In our experience, the more complicated an org chart or business structure is, the bigger the chance that things won’t work out (my colleague, Vince Sliwoski, wrote a pretty good post explaining some of the wackier business structures we’ve seen over the years). In some cases, over-complexity is used in a misguided attempt to reduce tax burdens or avoid other problems. But it can also be used to straight up confuse and defraud potential investors. Again, due diligence is critical.

It’s not just bad or crazy business structures that a buyer or investor should look out for. They also need to understand fundamentally what the target’s business plan is. We’ve seen more than a few cases where a target claimed to have found some hidden loophole in the law that meant its business would be able to corner the market. Sometimes, a target will even get a law or accounting firm to give an opinion letter in support. But these kinds of pie-in-the-sky promises rarely come to fruition.

#4 Byzantine governing documents

Investing in a cannabis company means getting stock (of a corporation) or membership interests (of an LLC) and becoming an owner of the company. An even moderately well-governed company will ask its investors to sign on to existing governing agreements. In cases with smaller companies, an investor may have the chance to negotiate new governing agreements, but that’s by no means a guarantee. So one of the most important thing an investor can do with respect to due diligence is to look at the target’s governing agreements.

This is something that can trip up lots of lawyers and almost any lay person. I’ve seen investment transactions with 80 or 90 or even more than 100 pages of corporate documents slipped into the deal. If you are not intimately familiar with corporate law, you may miss key provisions that dramatically affect you.

For example, I’ve seen transactions where an investor thought they were going to have the same rights as other owners, but the governing agreements gave them non-voting stock with no management rights and a lower place in the distribution waterfall. This kind of thing can be buried deep within an operating agreement and couched in language that is incredibly dense and tough to understand. This is just one area where working with good corporate counsel can pay dividends (no pun intended).

#5 Ownership disputes

One of the most important things to look for is ongoing or threatened litigation. It’s relatively easy to find out if a business is involved in active litigation (court records are public after all, even though they may not be easily searchable). But finding records of things like private arbitration, mediation, or demand letters may be impossible unless the sellers or target company discloses that information to the buyer’s representatives. A step beyond that, sometimes there may even be a potential for a dispute, for which no demand letter has been served. Again here, a buyer will need to rely on a seller to disclose those facts.

This is a bit of a digression, but the point is that it’s critical to perform due diligence on a target’s litigation profile. One area where litigation can lead to disasters involves ownership disputes in an M&A (business purchase) transaction. Imagine a person is trying to sell you their business while they are currently embroiled in a lawsuit with an ex-partner who says they were illegally forced out and own half the business (we’ve seen this!).

If a buyer fails to figure out that an ownership dispute has or is likely to arise, or does learn and proceeds with the deal anyway, it is virtually begging to be named in that lawsuit. If money was handed over to the seller, that money may be as good as gone.

Above are five of some of the biggest red flags we have seen in cannabis transactions when performing due diligence. This list is by no means exhaustive, and there are countless other things that could tank a deal or lead to litigation. We’ll continue to blog about all kinds of corporate law mishaps for the cannabis industry, so stay tuned.