Due Diligence in Cannabis Transactions: Mechanics and Red Flags

I don’t know how it came to be, exactly, but I’ve spent countless hours of my adult working life assisting with due diligence on cannabis transactions. These transactions involve all kinds of companies, from sole proprietorships to public companies, and a variety of deals–from leasing, to financing, to good old M&A. Today, I’ll cover how diligence works in the regulated cannabis world, and some common red flags we see during the process.

What is due diligence in a cannabis transaction?

Due diligence in a cannabis deal is like diligence in a non-cannabis deal, with some nuance and regulatory overlay. Simply put, due diligence is a voluntary process where one party vets and investigates another, or some asset or obligation of the other. This is principally done by requesting information and documents, which may be housed in a data room or exchanged in some other way. A purchaser or investor, or their agents, may also conduct public records searches, including FOIA requests to government bodies. In-person visits and inspections are also typical.

Who does what, and when?

In some deals, diligence goes one way. In others, each side perform diligence on the other. Some common examples of transactions requiring diligence include:

• Investment deals where investors perform diligence on a cannabis company they may fund
• Mergers, acquisitions, or equity plays in a cannabis company where the acquirer performs diligence on the target
• Asset purchases where the buyer performs diligence on the assets being purchased, and in some cases, the owners of those assets
• Real estate transactions where the buyer performs diligence on various aspects of real property, or where a landlord vets a tenant

This isn’t an exhaustive list, but it hits some of the high notes. Note that even in smaller deals, there is usually some kind of diligence.

For larger deals with a pronounced diligence process, the process is usually spelled out in a letter of intent (you can read about those here) or in the main purchase agreement as a condition to closing. (For this post, I’m looking at diligence in the context of a business purchase, for ease of reference.)

Usually, a small amount of diligence and negotiation occurs before a LOI or term sheet is signed, and the real legwork comes:

1. After executing the LOI but before signing the definitive purchase agreement; or
2. Between signing the purchase agreement and closing; or
3. During both periods, to some extent.

There are many reasons why diligence proceeds on different trajectories– each deal is a snowflake.

Some parties want to execute definitive purchase agreements quickly and conduct diligence before closing (in almost any purchase agreement, the buyer won’t be required to close if it’s not satisfied with diligence). The benefit here is that buyer can get the deal signed quickly and lock the seller into a lot of terms.

In other deals, significant diligence is done pre-signing. This allows a buyer to figure out whether or not to waste time and money negotiating a purchase price based on limited information before “getting married.” Consider the classic example where, during diligence, a buyer discovers something that causes it to want to lower the purchase price. Before a purchase agreement is signed, a discount will be easier to negotiate; afterward, not so much.

What happens in many cases is set forth in number 3 above–the buyer will do some degree of diligence pre-signing, and some post-signing. In these cases, buyers will get some of the big picture stuff up front, sign, and do nitty gritty diligence while “in contract.” This approach can be good because it’s a balance of both of the above.

How is diligence conducted?

Now that we’ve talked about when diligence occurs, let’s talk about how it occurs. Generally, it’s started when the inquiring party makes written requests for information to the other side. Sometimes, the requests are relatively informal; in other cases, they involve sending detailed questionnaires that can be dozens of pages long–it all depends on the size and complexity of the deal. Due diligence requests can ask for information about every aspect of the business–employment matters, litigation matters, tax matters, data security, contracts, etc.

After receiving a diligence checklist or questionnaire, the seller will usually respond to certain requests in writing, and provide documents and other data. The bigger the company is, the bigger the pile of documents. For this reason ,it’s common for parties to use “diligence rooms” or “data rooms” which are virtual solutions that allow the parties to upload documents and sort them by category (e.g., “Real Estate”, “Intellectual Property”, “Litigation”) and sub-category (e.g., within Litigation, “Demand Letters”, “Settlement Agreements”, etc.).

After receipt of documents comes the sometimes long, sometimes challenging task of reviewing them. Diligence files are usually reviewed by some combination of the principals of the buyer, attorneys for the buyer, and accountants for the buyer (for the financial information). In more complicated and larger deals, you may see a cannabis regulatory attorney hired to analyze just the responses and documents in the regulatory section, for example.

In almost any case, there are several rounds of this. The buyer will find places where it believes it hasn’t been provided sufficient information or documents. Or it may have other questions. For example, it may see a seller lease that is near the end of its term, and may want to ask what efforts have been made to renew the lease; or whether the landlord will consent to an assignment, as is typically required. This process can take a while.

Keep in mind too that many purchase agreements will set specific times for due diligence. This necessitates the buyer to act quickly, review documents quickly, and ask follow-up questions quickly. At the end of these periods, the buyer may lose their ability to walk away from closing on the grounds that it was not satisfied with the results of diligence. Not surprisingly, these time caps are usually negotiated by the seller.

Okay, that was a lot of information. Now let’s get to the fun part.

Red flags in cannabis due diligence

Sellers who won’t provide information, or at least concrete information.

It’s never a good sign when a buyer wants to buy a business, but the seller isn’t telling them anything about it. I’ve even seen multiple deals where the seller threatened to walk if the buyer kept asking for info. Would you want to buy a car if the dealer refused to answer when you asked if it was functioning properly? What about if they said the deal was off if you kept asking? I don’t think so. Run!

Sellers unreasonably cutting back representations and warranties.

This is not squarely a diligence issue but its certainly related, and often ties into disclosure schedules in definitive agreements. In any purchase agreement, the seller is the one making the most representations and warranties, and of the most consequential variety. If and when sellers push back on certain reps and warranties during negotiations, it should give the buyer pause. For example, imagine buying a business and asking for the sellers to represent that it was current with its taxes, but it didn’t want to make that promise.

Sellers rushing closing.

Sometimes there are legitimate reasons why closing needs to occur quickly, such as government mandated timelines or (in the case of investments) when money is needed quickly to fund a specific aspect of the seller’s business. But in the majority of transactions, dates are flexible. Undue pressure to close can be a big warning sign.

Lack of seller organization or records.

Sloppily maintained or missing documents is yet another big red flag. Businesses need to adhere to numerous corporate governance standards while operating, and if a seller can’t produce documents in an easy, legible format, that’s a bad sign. How confident can a buyer be that the seller complied with, say, IRC 280E, when it doesn’t have a signed copy of its material corporate resolutions?

Outright lies.

Yes, this happens–a lot! Sellers either are people, or they’re controlled by people; and, in the immortal words of Nick Cave, people they ain’t no good. Unfortunately, sellers lie to and defraud buyers all the time in cannabis land. As an unfortunate corollary, a LOT of litigation happens in M&A deals, big and small. It’s important for buyers to not take seller representations or information at face value. While fraud in the execution of a contract can be grounds for unwinding it, it’s better to avoid inking a bad deal in the first place.

___

Diligence is a hugely important part of any cannabis business transaction. Buyers need to be aware of how it works and take it seriously. Please make sure to follow us for more updates on cannabis dealmaking.