Cannabis Due Diligence Mechanics and Red Flags

For years and years, our cannabis lawyers have assisted with due diligence on all kinds of cannabis transactions from sole proprietorships to public companies. So that means we are intimately familiar with the mechanics of how the due diligence process works on a series of different transactions, and that we have seen all kinds of shenanigans and shady misconduct during due diligence. Today, I’m going to talk about how diligence works, and some of the more common red flags we see during the process.

Not everyone is intimately familiar with the due diligence process, even though it’s inherent in most transactions. Due diligence is the process where one party to an agreement vets the other side or some asset of the other side (usually by requesting information and documents). In some deals, both sides perform diligence on the other. Some common examples include:

  • Investment deals where investors perform diligence on the cannabis company they will invest in
  • Mergers, acquisitions, or other purchases of equity in a cannabis company where the acquirer performs diligence on the target company
  • Asset purchases where the buyer performs diligence on the assets being purchased and in some cases, the owners
  • Real estate purchases where the buyer performs diligence on various aspects of the real estate

This isn’t an exhaustive list but these are some examples where there may be pronounced diligence, but even in smaller deals there is usually some kind of diligence. For example, if a California licensed cannabis manufacturer enters into a distribution agreement with a distributor, it will probably ask to see things like its license. This is diligence, though certainly not to the same extent as in, say, a M&A deal.

For deals that have a more 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’ll talk about diligence in the context of a business purchase just so it’s all consistent).

There’s usually a smaller amount of diligence and negotiation that take place before a LOI is signed, but the majority happens:

  1. After executing the LOI but before signing the definitive purchase agreement; or
  2. Between signing the purchase agreement and closing; or
  3. Some combination of the two above.

There are a lot of reasons why diligence proceeds on different trajectories and this depends on the deal. Some parties want to execute definitive purchase agreements soon and do diligence before closing (in almost any purchase agreement, 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. LOI do that to some degree, but they are usually not even a fraction as comprehensive as the main deal and are usually non-binding with the exception of a few provisions (again, see my article linked above).

The benefit to doing diligence pre-signing is that a buyer can figure out whether or not to waste time and money negotiating a purchase price based on the diligence before signing. Consider an example where during diligence, a buyer discovers something that causes it to want to lower the purchase price–before a purchase agreement is signed, this is easier to negotiate, but once it’s signed, it becomes more difficult. Of course, the risk here is that given the non-binding nature of many LOIs, the buyer is at a higher risk that the seller could walk.

What happens in many cases is 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 then do the nitty gritty diligence. This approach can be good because it’s a balance of both of the above.

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

After receiving a diligence checklist or questionnaire, the seller will usually respond to certain requests in writing, and will then provide documents. The bigger the company is, the bigger the pile of documents are. 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, then comes the sometimes long and 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 brought in 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 company lease for its main piece of property that is near the end of its term and may want to ask what efforts have been made to renew the lease. This process can also take a while.

Keep in mind too that many purchase agreements will set specific times for due diligence which necessitates the buyer to act quickly, review documents quickly, and ask follow-up questions quickly. That’s because 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–the red flags. Here are some of the bigger ones:

  • 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.
  • Sellers cutting back representations and warranties. Okay, this is not really a diligence issue but its certainly related. In any purchase agreement, the seller is the one making the most representations and warranties, and when they cut them during negotiations, it always gives the buyer reason for 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 and so it can be a big warning sign.
  • Lack of organization. Sloppily maintained 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 own corporate resolutions?
  • Outright lies. Yes, this happens–a lot! Sellers are people and some people are not good. Unfortunately, sellers lie to and defraud buyers all the time. That’s why it’s important for buyers to not take sellers’ representations or information at face value. While fraud in the execution of a contract can be grounds for unwinding it, it’s a lot better to just avoid inking a deal in the first place.

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