The U.S. cannabis industry’s predicted growth trajectory is extraordinary. New Frontier Data predicts that annual legal sales across the U.S. medical and recreational markets will increase to nearly $43 billion by just 2025 — an extraordinary leap from the projected almost $25 million in 2021. As you’d expect, this projected growth has piqued the interest of investors, both locally and internationally. However, as with anything related to cannabis, legal compliance issues are significant when it comes to buying a cannabis business.
Anyone looking into purchasing a cannabis business needs to be well versed with the financial and compliance issues that the industry faces. The federal illegality, difficulties relating to access to traditional financing and potential immigration issues for international cannabis investors have all received significant attention. However, as the legal market slowly matures, further due diligence requirements are emerging.
Purchasers should analyze whether the cannabis business has any existing tax liabilities before agreeing on a purchase price.
We’ve seen examples of cannabis business purchases where existing tax liabilities have been overlooked during the due diligence process. The tax landscape for cannabis businesses is complex, with federal, state and local tax obligations. And the reality is that the businesses being sold often have poor management and a poor track record of compliance, including tax compliance.
Purchasers should look closely at the tax records for any business they are considering purchasing. Where tax compliance has been poor or where outstanding tax liabilities can be identified, purchasers can (and should) use this to negotiate a lower purchase price.
Any due diligence on a potential cannabis business purchase should explicitly include licensing and operational compliance.
The web of local and state laws relating to opening and operating a cannabis business is incredibly complex. It is within your interest as a purchaser to ensure that the business is currently operating in line with the legal requirements to limit the potential for future enforcement action, or even license revocation.
First, assess whether the business holds permanent licenses at all levels required by law. In California, this means the business must hold local and state licenses, though these requirements may vary by state.
Again, using California as an example, the business may be operating on a provisional license. If this is the case, the risks associated with a purchase are significantly higher. It is possible that regulators may not agree to issue a permanent license, especially if there have been issues with compliance in the past. There will also be significant post-purchase costs associated with the permanent license applications. This process is painstaking and may involve the purchaser needing to jump through further hoops, like the California Environmental Quality Act (CEQA) permitting requirements, which mandate that cannabis permit applicants in California must undertake environmental impact assessments. The purchase price for a cannabis business operating on a provisional license should be lower to account for the time, money and uncertainty of applying for and receiving a permanent license.
You must also take steps to ensure that the paperwork submitted by the license holders accurately reflects how the business is currently operating; everything is overseen by the regulators — from what is being sold to the physical layout of the store to how the products are being stored. If the standard operating processes submitted don’t reflect what the business is doing, you risk future enforcement action. So look closely at what the current licensee says the business is doing and request that they make appropriate changes, or adjust the purchase price before you go ahead with the transaction.
Finally, check whether there are any current or past enforcement actions or warnings from the regulator relating to the cannabis business you’re considering purchasing. Request details of any official enforcement correspondence with the regulator and/or inspections (and the findings) to cover all bases.
Purchasers need to be aware of the legal and practical issues caused by the non-transferability of cannabis licenses.
In California and in many other states, cannabis business licenses are technically not transferable. This means that a seller cannot simply transfer the business outright. Instead, you must go through a staged purchase where the current license holders add the potential purchasers to the license.
In the California context, the potential purchaser must undergo significant disclosure to the regulators, including a criminal background check. As such, regulator approval of the purchaser being added to the license should be a condition of the sale in any state where licenses aren’t immediately transferable.
Another issue that purchasers must be alert to is that licenses are tied to the specific physical location. If you wish to move to another location, you will need to go through the licensing process again for that location. In practical terms, this means that, unless you own the business premises, your business is at the relative mercy of the landlord. Since the landlord will be aware of this, you should be aware that your position as a tenant is more precarious than it may be in other circumstances. In some instances, we see landlords asking for above market rent rates, while in others, landlords may push back about tenant improvements required by licensing regulators.
While these issues can typically be resolved through negotiations, it is yet another area where cannabis operations tend to be more expensive than what you’d see in other industries.
Purchasing a cannabis business is more expensive and more complex than traditional business sale-purchase agreements.
The costs of purchasing a cannabis business are going to be significantly higher than those you’d expect to see across many other industries. You still need to consult transactional attorneys with experience in business purchases. However, it is critical that you involve regulatory counsel with specialized knowledge of the cannabis industry in that state, too. Your accountancy costs may also be higher since they will deeply analyze tax compliance.
All that said, the cannabis industry is undergoing significant growth. With proper management and strong compliance, there is plenty of room for cannabis businesses to operate profitably. And, further down the line, we would expect potential profitability to increase — especially when it is legalized at the federal level.