Cannabusiness Risks: Due Diligence and Disclosure

bud and moneyBy Andrew M. Walsh

Private equity investments in cannabis businesses have totaled more than $100 million over the last two years, according to CB Insights. The opportunity for investors and entrepreneurs is unique — and so are the risks. Sophisticated investors will ask about them, and cannabis-related businesses need to identify them early on, and manage them. The following is a quick outline of the salient risks.

Strict Enforcement of Federal Law

As states continue to decriminalize cannabis in a variety of ways, cannabis remains a Schedule 1 controlled substance, right alongside heroin and methamphetamines, under the federal Controlled Substances Act. Accordingly, businesses that engage in various forms of commerce in the cannabis industry and individuals who purchase and use cannabis-derived products remain subject to federal prosecution and seizure of assets. Federal enforcement could lead to dissolution and total loss of investment.

While the Department of Justice indicated in mid-2013 that it would not direct resources to block recreational and medical marijuana in “legal” states, that position could change at any time. Newly-confirmed Attorney General Loretta Lynch has testified that she does “not support the legalization of marijuana.”

Many bills that would ease cannabis businesses’ path have been introduced in Congress, including, most notably, the CARERS Act that would classify cannabis as a Schedule II drug, alongside legal opiates. However, there is no guarantee that any of these bills will ever become law. The risk of federal prosecution for business that is legal under state law remains.

No Adequate Banking Solution

Most banks are not yet willing to take deposits, issue credit cards, open checking accounts, or assist with payroll services for cannabis businesses. They fear violating federal law and being accused of money laundering. After Oregon-based MBank was contacted by federal banking regulators, it promptly ceased welcoming customers from Colorado, and announced in April that it was closing all of its cannabis-related accounts, citing extraordinary compliance costs. In November 2014, another banking institution, Fourth Corner Credit Union, received its state charter from the Colorado Division of Financial Services, but it is still waiting for approval from the U.S. Federal Reserve while it seeks insurance from another department, the National Credit Union Administration.

For now, cannabis businesses are handling lots of cash, which presents numerous risks, including inability to secure and invest funds, manage cash flows and pay taxes. Other facets in play are safety/security risks and expenses, as well as crimes such as theft, assault, burglary, employee skimming and tax evasion.

Compliance with State Regulations

Companies are subject to changing laws and regulations in their home states and in the states in which they do business. Rapidly changing laws can create numerous expenses for a growing business and enable “fast-followers” to gain a competitive advantage by learning from the early entrants’ mistakes. Increased regulatory compliance costs could result in lower gross margins or higher retail prices, or both, while competition from the black market looms.

A prospective investor should understand whether the company is in compliance with state law and should ask questions about this. For example, Colorado requires a person to have been a resident of the state for two years before applying for a license, and it requires equity investors (and holders of convertible debt) to be residents. Washington State also has a residency requirement for the entrepreneur. The penalties for violations of these regulations are unclear, and an investor should insist that the company represent in transaction documents that it is in compliance with state laws.

Federal Tax Law Challenges

Except for “cost of goods sold,” IRC 280E prohibits cannabis businesses from taking tax deductions for numerous ordinary and necessary business expenses. This should not be a surprise to the cannabis entrepreneur who is seeking capital from investors. A company’s inability to take advantage of deductions for ordinary business expenses significantly hurts profit margins and may cause investors to think twice about investing. A business’ financial statements and projections of after-tax profits should take this into account. How the target handles this issue in its solicitation materials could help a prospective investor gauge an entrepreneur’s sophistication or naïveté.

Product Liability Claims

Insurance law for cannabis-related risks is not developed, and product liability lawsuits against manufacturers of cannabis products are a top concern. Accordingly, investors and companies should review their insurance policies with counsel and understand that coverages may be limited or challenged by insurance carriers.

Background checks

An investor should not be surprised if a cannabis entrepreneur developed his or her interest and expertise long before legalization. It is therefore wise to conduct criminal background checks on the founding team. An arrest for possession at a frat party a decade ago may be overlooked, but if a member of the founding team, for example, served time in prison for numerous violations, the investor should seriously consider passing on the opportunity.

Market Acceptance

Even if a majority of voters support adult non-medical use of cannabis products, retailers and distributors may be reluctant to carry them for a variety of reasons. One common mistake that entrepreneurs make is the belief that their product is so good that it will sell itself. Cannabis products are no exception, and have the added challenge of convincing retail partners to carry their products.

Conclusion

These are only a scattering of some of the risks that a prospective investor should consider. Risks may also arise in connection with oversupply, intellectual property  (inability to register a federal trademark), lower-priced competition from the black market, labor issues, and of course, more general risks arising from agricultural, supply chain, employment and economic/market conditions. Many more risks that prudent investors should be aware of and companies should disclose will certainly develop along with the industry and changing law. Identifying and anticipating such risks is essential in this very green field.

Andrew M. Walsh is an attorney in Anderson Kill’s Stamford office and a member of the firm’s corporate and securities, regulated products and captive insurance groups. He advises entrepreneurs, emerging companies and private equity investors, including those in cannabis-related ventures, in company formation, capitalization, mergers and acquisitions, commercial transactions and corporate governance.

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