Welcome to the latest installment in our series on Oregon cannabis company acquisitions. In Part I of this series, we wrote about the general deal structures these acquisitions tend to take. In Part II, we wrote about how those structures are outlined at a high level, through term sheets. Today, we offer additional details on a topic we have covered before, for purchasers: due diligence on the target company.
If you are the type of person who enjoys sifting through large stacks of files and correspondence, or more likely, wandering around online in a virtual data room, you will love due diligence. If you are not that type of person, well, you get to do it anyway. The good news is that a corporate cannabis lawyer skilled in acquisitions can start things off with a comprehensive due diligence checklist, and begin looking under rocks on your behalf. Note that the form of checklist provided will vary, depending on whether the acquisition of the cannabis company is an asset purchase agreement, stock sale, merger, or other form of agreement.
Because due diligence occurs after a term sheet is executed, but before an acquisition is final, the due diligence period is the parties’ last big chance to walk away from a deal. On several occasions over the past few years, we have spotted show-stopping issues during the due diligence period, on either side of a transaction. If the issues cannot be fixed, these deals tend to die. Other times, the due diligence period will turn up nothing remarkable at all. And that is what you want, because in the world of due diligence, turning over rocks and finding nothing is progress.
When we covered this topic in March, we wrote that too often cannabis deals involve two sides rushing to complete a transaction without having done adequate due diligence on the potential cannabis company purchase. We offered a top five of due diligence items for purchasers, including some of the big ones: state and local law compliance, state law procedures for ownership changes, corporate authority, real property, and financial liabilities. We recommend you revisit that post, and today offer five more crucial items to look for during the diligence period.
Funky financial statements. Oregon cannabis companies tend to be new companies, and businesses with three or four years worth of financial statements, or even tax returns, are almost unheard of. Many cannabis companies stuff their skinny financial statements with unreasonable assumptions, under-estimates of working capital requirements, misleading margins, etc. If you are not comfortable auditing this type of information, enlist someone who is, and do not be afraid to ask lots of questions as you attempt to read the tea leaves.
Intellectual property. In an ordinary business transaction, a purchaser will be very interested in the target’s intellectual property. In the Oregon cannabis trade, brand power is important, but formally registered IP is less common than in other businesses, given the nature of federal law. That said, do not overlook: trade secrets (particularly for cultivators and processors), state trademark filings, and licensing agreements, to start.
Sales and Clients. Before investing in or purchasing a marijuana producer, processor or wholesale business, a buyer should understand who its top 5 or 10 clients are, whether these clients (who are usually other Oregon cannabis businesses) are loyal to the company, whether their operations will cause fluctuations in company revenues (common with producer clients, for example), and other factors. This means that in addition to doing diligence on the target company, it’s worth looking into the target company’s clients, at least in a cursory way.
Contracts. Like most businesses, a cannabis business will be party to numerous material contracts; and if the target business has no contracts for review, RUN. Types of contracts worth a close look include: customer and supplier contracts, equipment leases, real estate leases and purchase agreements, employment agreements, loans and credit agreements, and non-competes. Internal company contracts are also key, beginning with charter documents like shareholder and operating agreements.
Disclosure Schedules. As a part of any large or mid-sized acquisition, the target company will prepare a disclosure schedule addressing due diligence items, and identifying any exceptions to the representations and warranties requested by the buyer. If you are a target company, this will be the most important and laborious portion of the sale: so, it’s wise to start early, involve key employees and work with an attorney. If you are the buyer, this is the document you will cross-check against everything requested in your due diligence checklist.
If you make it through this vetting period, and are satisfied with what you have seen, congrats! It’s time to close the sale.