Four Lessons from Five Years of Cannabis Due Diligence

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Note: After more than five years of conducting due diligence on executives and companies operating in the state-legal cannabis industry, I spent some time in January 2020 reflecting on what I’ve learned. This post was originally published on LinkedIn.

My first cannabis-related due diligence project landed on my doorstep in late 2014. It looked straight-forward: vet the CEO of a group of dispensaries who had come to cannabis via a real estate investment (a fairly typical path for many early investors in the industry). They weren’t transitioning from the illicit market, which I assumed at the time was likely to be the biggest risk to my client. As I dug into my research, however, I found some patterns of litigation involving the executive in their pre-cannabis life that raised red flags, which brought me to…

Lesson One: Check your assumptions at the door.

Since that first case, I’ve delivered due diligence investigations on dozens of cannabis companies and executives across Canada, the US, Latin America, and Europe. The majority of these companies were led by executives who were never involved in the illicit market, which seemed to make them more attractive to many investors.

But not having participated in one category of illegal (now legal) activity does not guarantee that an executive is trustworthy. Right now, cannabis has more than its fair share of fraudsters, people who see an opportunity to capitalize on the “green rush” mentality in the same way that they’ve capitalized on rushes in other emerging industries. In this industry, insurance fraud, sexual harassment allegations, multiple bankruptcies, and penny-stock shenanigans are bigger red flags than a conviction for cultivation in the 90s.

(Of course, you need check state regulations to make sure that an individual with a cannabis-related conviction is permitted to participate in the regulated industry, but the current trend among regulators is not to disqualify applicants on this basis alone, while a prior fraud conviction will almost always derail an application.)

Lesson Two: Use of due diligence is way behind media hype and market capitalizations.

I confess that, based on the amount of media coverage, investment, IPOs, and M&A activity in the cannabis industry between 2015 and 2018, I was convinced that someone, somewhere, must being doing a lot of investigative due diligence.

I was wrong.

My assumption was based on my experience with more mature industries, where investors and operators have mostly already learned (the hard way) that failing to do due diligence is a bad move that leads to litigation. In the US, when a company goes public on one of the major stock exchanges, there is almost always a firm like Galen Diligence vetting the company’s senior executives and board of directors on behalf of underwriters.

With the exception of a handful of top investors and operators, investigative due diligence that includes thorough background investigations of executives and directors, an understanding of state regulatory contexts, and verification of license status/ownership is still not the norm in the cannabis industry. This includes publicly-traded companies, especially on the CSE.

In several instances, investors and operators have effectively outsourced their due diligence to state regulators: “They have a license, so hasn’t the diligence been done?” To which my response has always been, “They have a license, if they can keep it.”

A regulator can revoke a license at any time and for a host of reasons, including new information that might come to light about owners and officers, questionable contracts, or compliance failures. There’s also a real risk that an operator bribed a regulator or municipal official along the way to win a license, and will lose that license when the crime comes to light.

Cannabis may be turning a corner on the due diligence front, as investors get more cautious, shareholders get more litigious, and spectacular compliance failures are revealed. We’ll see.

Lesson Three: Keep an eye out for future risks.

The risks that come up constantly in conversations about the cannabis industry include security and money-laundering risks from operating in cash, and the risk of product diversion to the illicit market. These are important, of course, and we need to take steps to address them, but while we’ve been talking about the same familiar risks for the last five years, there has been a general failure to look toward the horizon for the risks that are coming.

Two years ago, we began flagging license acquisition-related issues for our clients. Specifically, when our clients asked us to look at some of the US multi-state operators, we set out to confirm that they had the licenses they claimed to have on their websites, and that the licenses were in good standing (this should be a fundamental step of any due diligence). What we discovered was that most “acquired” licenses hadn’t actually changed hands as far as the regulators were concerned. This in turn raised questions about these companies’ claims about how many licenses they “controlled” – would regulators eventually approve these changes… or not? How might this affect valuations?

Cannabis regulators are becoming savvier enforcers, updating their regulations in response to the hijinks of some operators. Licenses get suspended and revoked, and announced mergers fall apart under scrutiny or stock market pressure. Management teams’ commitment to compliance is more important than ever. Managing the risks that everyone is already talking about should be the bare minimum that we expect.

Lesson Four: The timelines are longer than they feel.

Folks in the post-2011 cannabis industry like to joke about living in "dog years," by which they mean that the speed of the industry makes it feel like one year in cannabis is equivalent to several outside the industry. I agree that the pace of change is fast, and it can be a challenge to keep up, but the way things feel and the actual maturation of the industry are completely different. Confusing the pace of press releases and the size of market capitalizations with sustainable growth or maturity is a recipe for irrational exuberance.

It can be very challenging to hang on to a sense of "real time" when press releases, investor conferences, and (some) industry enthusiasts are beating the drum of "you’re already almost too late." All of this noise is designed to create a sense of urgency that leads people to make deals they wouldn’t under other circumstances, and to skip the risk management steps they would have applied if it were anything but cannabis. The truth is that this perceived urgency serves fraudsters and stock pumpers far more than it serves investors, employees, or consumers.