You may think that due diligence is something reserved for business or real estate purchases. But due diligence is also a must for lenders in cannabis loan transactions. I recently wrote a post about what borrowers can look forward to in cannabis loan transaction. Today I want to do a deeper dive into due diligence – something that lenders will need to do well, and that borrowers will need to take seriously. Below, I go through some of the key things that cannabis lenders will look for in due diligence.
Who is the borrower?
One of the first things a lender needs to know is who and what they are dealing with. This may seem painfully obvious, but we’ve seen lenders rush headfirst into transactions with less than full awareness of the circumstances. Here are some things smart lenders look for:
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Business types
Lending money to a retailer in a high-traffic area is probably a lot safer than lending to a distributor out in the sticks. That retailer will have much higher revenues, which means a higher chance of being paid.
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Org charts
Sometimes a borrower will be one entity in a larger org chart. Understanding the borrower’s place within the org chart is critical for a number of reasons, including looking for guarantors or collateral or understanding intercompany relationships that could affect the cannabis loan.
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Owners and operators
Knowing who owns a borrower can sometimes be more important than where the business sits in the org chart. Looking at an operator’s business history and experience will give a lender a great deal of insight into whether the borrower has any prospect of repayment. It also helps to determine whether a lender will ask for a guaranty from any individual owner or operator.
What is the borrower’s financial situation?
Equally important for lenders is the prospective borrower’s financial condition. Borrowers by definition need money, but their rationales for needing money vary greatly. A borrower with a strong financial condition that just needs extra money to complete expensive tenant improvements or acquire a costly asset like real estate, is much different from a borrower that needs money just to stay afloat.
Lenders evaluate some of these risks by looking at the borrower itself (see above), but a cannabis loan rarely closes without a deep dive into financial records, tax returns, and projections. Lenders use these not only to evaluate whether they should give a cannabis loan, but also to dictate things like interest rate, repayment terms, and financial covenants over the life of the cannabis loan.
What does the borrower own?
Along the same lines, a driving force in any cannabis loan is what the borrower owns. Lenders will want collateral, which is something that they can recover if the borrower defaults under its loan – so they naturally will diligence what a borrower owns. Understanding a borrower’s assets will also help a lender evaluate the financial condition of the borrower. Doing due diligence on borrower assets may sound like a relatively simple process – ask for an asset list – but in practice it can be much more complicated.
For example, a prospective borrower may have expensive equipment that’s subject to an equipment lease and can’t be further collateralized. The borrower may use vehicles or real estate under leases. It’s important for a lender to look not only at what a borrower has in its possession, but also at what it owns outright, or what it owns subject to an encumbrance in favor of a third party who probably won’t be too keen on having a junior secured party.
What kind of liabilities does the borrower have?
Another big picture item a lender will dig into in due diligence is borrower liabilities. These might include anything from tax liabilities, actual or threatened litigation, environmental liabilities, debt service or other debt-related expenses, accounts payable expenses, employee pay, other contractual liabilities, and so on.
Like with all of the other due diligence items, borrower liabilities will tell a lender about the borrower’s financial condition and the prospect of repayment. Borrower liabilities will drive the terms of a loan. So lenders will go to great lengths to understand what is on the table.
The above items are just a summary of some of the key items lenders will look for when performing due diligence in connection with a cannabis loan. Each of these items can have many subcategories that can make the due diligence process long and sometimes complicated. Borrowers with good record-keeping processes and limited liabilities will often be able to move through the process on an abbreviated time table, but it all depends on the transaction and the lender’s risk profile.
