Diligence is a critical component of any business deal, and cannabis-related deals are no exception. For years, however, diligence in this area has been limited at best and nonexistent at worst. Times are changing though, and as the cannabis industry continues to rapidly evolve and mature, so too does the diligence process for cannabis deals.
Investors and acquirers who are new to the cannabis space are often unaware of the nuances that may be lying in wait to trap them. The patchwork of complex and largely unaligned state and local rules governing this nascent industry presents countless potential issues that would likely go undiscovered during routine diligence. The following list of potential diligence issues demonstrates some of the unique challenges they are likely to encounter.
One of the first steps in structuring a cannabis deal is determining whether the target cannabis business may be transferred from its original owners. While some states allow cannabis business licenses to be transferred from one owner to another by completing forms and background checks, others wholly prohibit transfers. Transferability must be thoroughly analyzed at both the state and local levels. Failure to tailor a deal to these rules could result in disastrous and costly penalties, ranging from fines to complete nullification of a license upon a deal’s execution.
2. Confirming Licenses
If a target business holds state or local cannabis licenses, the most important aspect of the diligence process is confirming its relevant licenses are in good standing. If the target business does not hold any cannabis licenses, the most important aspect of the diligence process is confirming the business does not, in fact, need any cannabis-related licenses to operate legally under state and local laws. This is not always a clear-cut answer. For example, many ancillary companies interact closely with licensed cannabis businesses but do not hold licenses themselves because they do not directly touch the plant. While this is not necessarily an issue, some jurisdictions do impose limits on the activities of such companies, and these need to be carefully assessed.
Having a license suspended or revoked can be the end of a cannabis business, so investing in or acquiring a cannabis business that does not have all required licenses in good standing may result in large financial losses.
It is no secret that access to financial services is a pain point for cannabis businesses. While some are fortunate enough to find banks or credit unions that will knowingly service a cannabis-related company, others may not have been able to be as transparent with their financial institutions. In the latter case, a target cannabis business may face the sudden closure of its accounts, especially following a large investment. Consequently, it is very important for investors and acquirers to understand the type of banking relationship a cannabis company has and the likelihood of account closure the company may face.
Loss of access to the banking system, even briefly, may suspend or altogether derail a cannabis business’s operations. Furthermore, a cannabis business that is dishonest with a financial institution in hopes of banking its cannabis proceeds, may be viewed as partaking in money laundering. Thus, it is imperative that investors and acquirers understand a potential target’s banking relationships to avoid inadvertently partaking in such illegal activity.
4. Cash Management
Because the cannabis industry has limited access to financial services, analyzing cash management practices is a key aspect of performing due diligence on cannabis businesses. Investors and acquirers must understand how a business accepts cash payments and whether all required reports are filed when required. For example, any party that receives $10,000 or more in cash must file a Form 8300 with the Internal Revenue Service, and failure to do so may subject them to costly fines and imprisonment.
Investors should also analyze the target business’s legacy cash, which is the cash it receives in payments but cannot place within the banking system. Most banks and credit unions that offer services to cannabis businesses will not take on legacy cash because it is very difficult to connect it to state-legal activities. While some cannabis businesses regularly perform internal audits in hopes of establishing state-legal origins for their legacy cash, most do not, leaving them with large quantities of non-bankable assets.
Section 280E of the Internal Revenue Code prohibits companies from deducting ordinary and necessary business expenses if they are related to the trafficking of substances classified under Schedule I or Schedule II of the Controlled Substances Act. Although cannabis is legal for medical or adult use in more than thirty states and the nation’s capital, it is still federally classified as a Schedule I substance. State-legal cannabis businesses, therefore, are subject to 280E and cannot deduct their business expenses for tax purposes. 280E’s application to ancillary businesses that provide goods and services to cannabis businesses is less clear-cut, but should not be ignored. Unfamiliarity with a target that is affected by 280E could result in costly tax implications.
Virtually all aspects of a cannabis business’s operations are highly regulated, making compliance integral to survival in the cannabis industry. Investing in or acquiring a non-compliant cannabis entity may lead not only to financial losses, but also criminal penalties. It is imperative that investors and acquirers thoroughly vet a target’s regulatory compliance practices. This vetting should include a review of the target’s standard operating procedures and an evaluation of its cannabis regulatory counsel.
Particular attention should be paid to the target’s facility and marketing. Depending on the type of operations conducted, a facility may need to comply with various fire and safety codes in addition to cannabis-specific regulations. Compliance with these codes decrease both the likelihood that a business will face regulatory enforcement and the possibility of harmful accidents. Failure to comply can result in costly consequences for the business, including fines and the cancellation of licenses. On the marketing front, advertisements can garner unwanted attention from regulators and lead to in-depth investigations. Particularly egregious cases, such as advertisements found to target children, may also trigger action from federal authorities, who have long said they will prioritize enforcement against companies that fail to comply with state laws or jeopardize public health or safety.
Reviewing a target’s insurance policies is always an important step for investors and acquirers, but conducting a thorough analysis is especially important when considering a cannabis business. A quick glance at a company’s policies and limits may suggest it has sufficient coverage. However, common exceptions and carveouts, especially those concerning federally criminal activity, may render a policy worthless. On top of this, most cannabis businesses are unable to secure adequate coverage, as many insurance companies are unwilling to work with the cannabis industry.
Failing to properly vet a target’s insurance coverage, especially with respect to cannabis-related activities and products, may result in investing in or acquiring a high-risk target that is effectively uninsured.
State cannabis regulations generally prohibit individuals with certain types of criminal convictions from having an interest in, or control or management over, a licensed cannabis business. It is very important for investors and acquirers to perform independent background checks on the owners and managers of a target and have the results analyzed with an eye toward federal cannabis enforcement priorities and each state’s regulations.
Investing in or acquiring a target whose owners or managers have backgrounds that may invite enforcement could have devastating results, including the loss of a business’s cannabis license, or criminal prosecution.
Performing due diligence on a cannabis business is deeply nuanced and requires an in-depth understanding of how the cannabis industry is governed. Consequently, investors should carefully consider every deal individually, with an eye toward all applicable state and local laws and regulations, as well as an awareness of the current tension that exists both between them and with current federal laws. The consequences of failing to do so can be severe, and a lack of attention to detail may result in financial loss and criminal penalties for an investor or acquirer. Please proceed carefully.
This column was provided courtesy of :
Charles Alovisetti – a Senior Associate and chair of the corporate department at Vicente Sederberg LLC, where he advises clients on transactions involving licensed cannabis businesses across the U.S. In addition to his corporate work, he has assisted clients with competitive licensing applications in Colorado, Maryland, Hawaii, New Jersey, Pennsylvania, and Texas. Prior to joining Vicente Sederberg, Mr. Alovisetti worked as an associate in the New York offices of Latham & Watkins and Goodwin, where his practice focused on representing private equity sponsors and their portfolio companies, as well as public companies, in a range of corporate transactions. He can be reached at email@example.com.
Sahar Ayinehsazian – an Associate attorney and co-leader of the banking and financial services department at Vicente Sederberg LLC, where she specializes in cannabis banking, corporate transactions, regulatory compliance and intellectual property. She is also a member of the National Cannabis Industry Association’s Banking Access Committee, where she works on strategy and educational advocacy to enable state-licensed businesses to obtain accounts at depository institutions. Prior to joining Vicente Sederberg, Ms. Ayinehsazian served as director of regulatory and governmental affairs at a multi-state money transmitter servicing the cannabis industry, where she developed a comprehensive understanding of credit card flow, banking and cannabis compliance. She can be reached at firstname.lastname@example.org.