It’s no secret that multiple state-by-state operators are building their cannabis empires through aggressive mergers and acquisitions (“M&A”). Last year, our cannabis business attorneys closed more than $100 million in cannabis company acquisitions, and that shows no signs of stopping in 2019. Cannabis M&A is not your run-of-the-mill business dealing though, and working from boilerplate, rote M&A documents is hugely dangerous. In addition, diligence is oftentimes like a regulatory spiderweb laden with liabilities that other businesses do not face. In addition, the barriers to entry in the cannabis industry are increasingly high, tedious, and protectionist, which can really torture business deals. So, if you find yourself turning into a larger multi-state operator though acquiring cannabis businesses, below are the top five things you need to know.
1. Barriers to Entry
Every state is different in how it treats would-be cannabis licensees. And the differences between states are compounded by whether the state is medicinal, adult-use, low-CBD/high-THC, or all of the above. This translates into not everyone being eligible to own cannabis businesses. And these barriers to entry may include some or all of the following: residency requirements, local control elements that vary by city and county, liquidity standards, background checks, and invasive disclosures of personal information and past conduct in business and industry. Any prospective cannabis business purchaser needs to ensure that they meet all requirements for incoming owners before even contemplating a business purchase and expending time and hours negotiating a deal that may be legally impossible. Note also that localities are increasingly implementing their own barriers to entry (like local residency, past white collar crimes and civil infractions that bar ownership, and license caps), so don’t ignore the applicable municipal code standards either.
2. Closing Can Be Chaos.
Most if not all states will tell cannabis businesses to report to them when new owners or parties of interest come into the picture. Why? Because of the federal enforcement priorities stemming from the now rescinded Cole Memo, every state must know exactly who is in control of/financing its cannabis licensees. Turning to M&A, every acquisition agreement has pre- and post-closing conditions and cannabis is no different. However, depending on the state or even the city or county in which the cannabis business operates, and due to new owner reporting requirements, conditions to and after closing will vary wildly. Ultimately, they will depend on whether state and local regulators demand that incoming owners close on business interests first so that they may be vetted and checked in that capacity, or they will depend on whether regulators must first examine the purchase agreement, approve the new owners prior to closing, and only then the new owners can take over. This is a very good reason why a one-size fits all boilerplate acquisition agreement is not going to work for your cannabis acquisitions. So, be sure to check what the subject state/locals require when it comes to closing.
3. Diligence may be a Mess.
The regulatory histories of most cannabis businesses are likely going to be chalk-full of various entitlements that enable the business to operate. And where cannabis remains federally illegal, a good amount of cannabis businesses are still operating on an all-cash basis and all of them are dealing with 280E. The diligence on these businesses then is usually more intense than other businesses. Would-be buyers need to exercise extreme care when vetting a cannabis business to look for ticking time bombs that surround state licensing compliance, local licensing compliance (which will be different depending on the local government), tax reporting (federal, state, and local) and specifically compliance with 280E (which can be a disaster). See here and here for how a cannabis business should prepare itself to sell. Also, if you’re buying a cannabis business that was operative under older, less restrictive regulations, you may face a situation where there’s little to no diligence at all because no records were kept and everything was done in cash (see Los Angeles for example).
4. Valuations are All Over the Place.
Pretty much every cannabis market in the U.S. is still emerging because they’re silo’ed marketplaces designed by state governments that continue to change as industry issues arise. Plus, the oldest regulated cannabis markets are Washington and Colorado (they’re only around 6 years old), which still doesn’t give us a ton of market data or operational history to properly value the businesses therein or in other states. Without a doubt, just having a cannabis license is valuable, but when a business is pre-revenue with, let’s say, a build-out ahead of it to satisfy local laws with constantly evolving state and local cannabis regulations in what will be a potentially saturated market in a couple of years, it’s really hard to say what the right valuation is. That hasn’t stopped certain cannabis businesses selling for pretty large sums though just based on the momentum of legalization and the prospect of market demand.
5. You’ve Probably Already Violated State and Local Law.
I cannot tell you the number of acquisitions our firm has seen after-the-fact where the parties violated state and local law from the outset of the agreement. Many folks don’t realize that, on the whole, state cannabis licenses are not transferable, so they cannot be individually bought and sold. You actually have to buy the company that holds the licenses (and all of its assets and liabilities). In addition, in most if not all states, you can’t separate licenses out from a vertically integrated company in order to sell them. And on average you can’t sell local entitlements either without them becoming void. There are also typically strict timing requirements in reporting acquisitions to both state and local regulators and parties usually violate those out of the gate because they’re either not aware or they don’t think that the reporting requirement applies to them. And if you take control of a cannabis business and do not tell regulators, your license is going to be in hot water. Specifically regarding the locals, if you’re dealing with a development agreement or other specific entitlement, assignment isn’t going to be freely allowed. The majority of the time, to get by the locals you not only have to ask for permission, you may even have to have a hearing in front of the City Council or Planning Commission to take over the entitlement. In certain states, taking over a cannabis business may even require cessation of the business and a new license application while the new owners are checked out. For the unwary or reckless buyer who may not know or care about the intensity of the regulations faced by cannabis businesses, their entire acquisition agreement may be completely illegal and grounds for license cancellation.
It’s only a matter of time before regulators begin investigating the nature of cannabis acquisitions to ensure that the transaction complied with applicable regulations. So, err on the safe side and make sure you know the regulations and your eligibility so that due diligence is smooth and compliance is less painful, and so that you don’t waste time and money on an illegal transaction.