Legal Perspective: Corporate Due Diligence Counts

Especially in the cannabis industry, partnerships, acquisitions, and investment require thorough background research.

The cannabis industry has grown accustomed to backroom deals, evading documentation, and handshake-clad commitments. With the onset of state-specific legalization and an eye toward full federal acceptance in the next five years, cannabis businesses need to get their house in order if they are going to have any chance of standing up to, merging with, or being acquired by larger corporations. In the ever-changing legal landscape of commercial cannabis law and regulation, one thing remains constant: the need for due diligence from the outset. We typically encourage our clients to use letters of intent to outline the parameters when negotiating new business deals to ensure all parties are aware of expectations from the start.

Know the parties at the table

Do you ever truly know someone? One of life’s great mysteries. Generally speaking, people are who they present themselves to be. When we are talking about cannabis, the government’s concern typically comes down to criminal history and moral character (sort of). As it turns out, these are the primary reasons regulating authorities—state and local—tend to deny commercial cannabis applicants. Accordingly, it is imperative you know the company you keep.

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To protect against unexpected surprises, when entering into a transaction, partnership, operating agreement, shareholder agreement, strategic alliance, venture capital deal—whatever the form—ask for a background check and credit report. Individuals easily can request their own LiveScan criminal records reports and credit reports. Ask the individuals involved to do exactly that and then make the disclosure before sealing the deal.

Obviously, all of this is private information and proper protections or non-disclosure agreements should be in place. However, if you are investing your savings or are about to engage in activity that could be criminal without proper licensing, it is best to confront any potential issues head-on.

Credit plays an important role. What if the individual you have been dealing with claims to have $10 million in the bank and lives the lifestyle to prove it, yet, when credit is examined, everything is leased, nothing is owned; debt is significant; and there is a substantial history of bankruptcy and defaulted credit lines? Is this the person you want running your company and having access to company accounts? What happens when the business needs funding and the owners are asked to execute personal guarantees? Three of four owners may have assets, while the other has only debt and nothing to pledge. Lack of assets and established credit history are unattractive to lenders and may cost the business in the long run through increased interest rates or draconian financing terms.

None of this is to say that only the very wealthy (on paper) with substantial assets should be considered strong prospects. Nevertheless, you certainly should be aware of your potential partners’ true financial fitness before entering any business transaction or agreement.

Another issue that often arises, especially in the cannabis space, is the “off-the-books” investor or owner. While we discourage this sort of arrangement, in truth it is fairly common. If there are people participating in the business but they are not legally or technically part of the company, it is important to understand what agreements exist with them. Does that person expect a share of distributions from the company? Will that person be participating in the management or control of the business or some aspect of it?

In California, yes to either of those questions likely renders that person an “owner” or a financial interest holder under the state’s cannabis laws. This can be troublesome for licensing purposes, especially if the reason the person is not on the books is a criminal history. We lawyers have tools for dealing with and protecting against these issues, but it is far better to address the matter while in the early stages of a deal.

As for criminal convictions, there are only a few primary areas of true concern, at least in California: trafficking narcotics, violent felonies, and crimes involving children. For civil matters, regulators are concerned about acts of moral turpitude, meaning anything that reflects poorly on your veracity or truthfulness in business dealings. In California, this essentially comes down to unfair business practices (Business & Professions Code §17200 et seq.), fraud, embezzlement, or extortion. You also should be aware that expungements and dismissals under most circumstances still must be disclosed on cannabis applications in California; outside California, check your state-specific laws for confirmation.

Know the company history

Recycling old business entities is something we see quite often. Typically, this happens where one of the parties to a business deal has an old corporation or limited liability company that essentially functions as a shell. These companies usually are either left over from a former business line that no longer operates or has distributed all assets out of the company, or a legal entity formed for a specific purpose that never materialized. Either way, if you are not the person who formed the entity, it is important to examine the entity’s history closely.

At a minimum, you need to examine the stock ledger, capital sheet, partnership list, and any other document recording every person who ever had an ownership interest in the company. The last thing you want to happen to your million-dollar investment is to have some third party you have never heard of come out of nowhere and demand distribution because they were never properly and legally removed from the company. This can create significant issues with distributions, tax filings, voting validity, and financing—a whole lot of hassle for the nominal cost of forming a new business entity. If there are lingering owners or questions about ownership, it is best to start fresh.

You also want to review the history of filings with the secretary of state, department of corporations, or whatever authority oversees business entities in your state. Many states make those records available online for free or at a nominal cost. After making a formal records request, expect to wait two weeks to a month for documents to be returned by the regulating agency.

You also need to review documents that are not filed with state regulators, such as bylaws, shareholder agreements, partnership agreements, and operating agreements, which are the most common governing documents for businesses entities, depending on the type of business. These governing documents dictate how the business is operated, how and when distributions are made, what events may trigger dissolution, establish voting rights and procedures, and generally describe how the business is managed and by whom. If you are uncomfortable with any of the terms, you absolutely should negotiate with your future partners to set forth operational standards with which everyone is comfortable.

Subscription agreements also are extremely important. Subscription agreements are contracts that allow new parties to join the company: an agreement whereby the company promises to issue equity or ownership interest on established terms. Subscription agreements typically require the new owner or investor to agree to be bound by the governing documents and often contain restrictions on transfer as well as eligibility for becoming an owner (shareholder, member, partner etc.). These agreements also often contain tag-along rights entitling owners to sell their interest on the same terms as other owners under certain circumstances.

Make sure to assess securities registration requirements. States vary with respect to registration exemptions. The Securities and Exchange Commission regulates securities on a federal level. The SEC exempts certain offerings from registration, such as private offerings to less than thirty-five sophisticated, but non-accredited, investors; offerings that seek a total investment under a threshold amount; and intrastate offerings. As an aside, the SEC also regulates capital raised through crowdfunding. The SEC’s website provides guidance about potential exemptions from registration, but it is best to seek the advice of an attorney before making a decision.

When it comes to financials and tax returns, audited financials are always best. Understandably, many businesses do not have formal accounting practices or financials to provide, especially financials audited by an independent third party. However, there is no reason an existing operation should not have some method of tracking and projecting earnings before interest, taxes, and amortization (EBITA), which reflects the company’s potential profitability, expenses, assets, and liabilities. Startups should have a firm grasp on the cost to carry them through first-year operations, as well as tax implications. Be aware of and consider profit margins carefully.

Proper budgeting also is of paramount importance, as money management can make or break a startup. Cannabis business owners should ensure items such as permit (local) and licensing (state) fees, employee background checks, workers compensation and insurance expenses, raw materials, equipment, rents or mortgages, utilities, and transportation costs are accounted for—and more importantly, included in any budget or pro forma the company provides. Understated budgets can cause businesses owned by a small group of friends and investors to look to predatory lenders seeking significant gains from vulnerable companies trying to enter the market or sustain their existing operations in more costly, highly regulated markets. Take time to consider your options carefully.

Many people are looking to jump into the “green rush,” but sound investing in startups and new partnerships takes time and careful consideration.

 

Dana Leigh Cisneros, Esq., mg Magazine legal columnistDana Leigh Cisneros, Esq., focuses on real estate, contract, commercial, business, and corporate law. She uses knowledge and experience acquired over more than a decade to further her clients’ interests and avoid complicated legal issues in the complex cannabis industry. CannabisCorpLaw.com

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