Cannabis M&A: Protecting Against Undisclosed Liabilities

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When someone buys a cannabis business, and not just that business’s assets, they essentially inherit all of its liabilities. And there are usually a lot.

If the business is in the midst of a lawsuit, owes back taxes, is behind on rent, etc., the buyer will need to deal with those problems on its own–unless the purchase agreement requires some form of assistance from the seller.

Smart cannabis business buyers spend a lot of time doing “diligence” on the target business either before signing a purchase agreement or before closing, in large part to flag potential liabilities. But in some cases, buyers fail to ask the right questions or sellers (whether intentionally or not) fail to disclose material information about the business.

We call these “undisclosed liabilities,” and if they are not properly addressed in the purchase agreement, they can lead to serious problems for the buyer. Below, I’ll identify a few common ways that buyers protect themselves from undisclosed liabilities.

Conducting thorough due diligence

You probably wouldn’t buy a car without test driving it, making sure title was clear, and maybe even having a mechanic check it out. So would you buy a business without making sure you weren’t walking into a minefield first? You’d probably be surprised at the amount of folks who would.

The first and best way to avoid undisclosed liabilities is to thoroughly diligence the target business. The diligence process usually involves lawyers sending written questionnaires to the seller’s counsel, seeking a host of information about the business.

A good diligence questionnaire will include information about its finances, debt, real estate, employment matters, litigation, corporate structuring and governance, intellectual property, owned and leased assets, licensing and regulatory matters, and so on. Increasingly they will include things like privacy law compliance and other “newer” legal concerns.

This is really only the start — the buyer’s counsel and tax/financial advisors will review many of the documents and flag concerns for the buyer. Buyers may also do things like physical inspections of the business premises or assets.

Concerns raised in the diligence process will drive negotiations with the seller and in some cases necessitate changes to the deal structure. In more extreme cases, a buyer may walk altogether.

In the next few parts of this post, I’ll address tools sophisticated buyers use to proactively mitigate liabilities that were not disclosed in the due diligence process.

Indemnification

One of the most common risk-mitigation strategies in business purchases is requiring the seller to indemnify the buyer in the event that the buyer suffers harm as a result of certain identified acts or omissions of the seller. These usually include inaccuracies in representations by the seller or breach of the purchase agreement by the seller.

For example, a purchase agreement may state that the seller must indemnify the buyer and company (as well as their affiliates) against harm they may suffer as the result of seller’s breach of a representation. Say there was a representation by the seller that the company owed no back taxes, when in fact it did and the tax collector came knocking, the buyer could require the seller to pay the back taxes and defend it in any tax proceeding.

Indemnification provisions can be incredibly complicated and heavily negotiated. For example, sellers will often push for a cap on their indemnification obligation, since after all, a seller wouldn’t want to end up responsible for paying more than they were paid in the deal to cover the buyer’s expenses. Buyers on the other hand may push for carveouts to seller caps in cases of fraud or concealment of material undisclosed liabilities.

Additionally, indemnification provisions only really work to the extent that the seller has money to actually indemnify the buyer. A good rule is to assume that once the seller is paid, it (and its money) will vanish from the face of the earth, leaving the buyer left holding the bag regardless of how well it negotiated an indemnification provision. Still, buyers have a few options to protect against this.

Offsets and holdbacks

One easy way (in theory at least) to protect against a disappearing seller is to ensure that money will be tied up post-closing. There are two main ways this typically happens.

First, buyers may establish a holdback of part of the purchase price to be held in a neutral escrow account for some period following the closing. For example, if the purchase price is $5mm, the buyer may insist that $750,000 is held for a year in an escrow account post-closing, and that any liability that arises during this time may be satisfied out of the escrow fund.

Second, where any part of the purchase price or consideration will be paid or granted post-closing, the buyer may include an offset provision similar to the escrow holdback. Rather than having a pot of money held in escrow, the buyer could simply deduct future payment. Where part of the purchase price is paid via a seller note or post-closing installments, offset provisions are common. But they can also be used against things like post-closing options, warrants, or earnout provisions.

Conclusion

Undisclosed liabilities are the bane of any sophisticated buyer’s existence. Thinking proactively about mitigation strategies early on can save buyers headache and financial misery down the road. Cannabis M&A is no easy task and buyers who address undisclosed liabilities head on will be in a lot better position down the road.

For more on cannabis M&A, check out some of our other posts below: