Cannabis due diligence mechanism and red flags

Over the years, our cannabis lawyers have assisted due diligence Various cannabis transactions from sole proprietorships to listed companies. Therefore, this means that we are very familiar with the mechanism of how the due diligence process handles a series of different transactions, and we have seen various hoaxes and suspicious misconduct during the due diligence process. Today, I will discuss how hard work works and some of the more common red flags we see in the process.

Not everyone is very familiar with the due diligence process, although it is inherent in most transactions. Due diligence is the process by which one party to an agreement reviews the other party or certain assets of the other party (usually by requesting information and documents). In some transactions, both parties conduct due diligence on each other. Some common examples include:

  • Investment transactions where investors conduct due diligence on the cannabis company they will invest in
  • Mergers, acquisitions or other methods to purchase equity in the cannabis company in the case of the acquirer conducting due diligence on the target company
  • Asset purchase, the buyer conducts due diligence on the purchased assets. In some cases, the owner
  • Real estate purchase where the buyer conducts due diligence on all aspects of the real estate

This is not an exhaustive list, but these are some examples where there may be obvious effort, but even in smaller transactions, there are usually some A kind of diligence. For example, if a California-licensed cannabis manufacturer signs a distribution agreement with a distributor, it may ask to see things such as its license. This is due diligence, although it certainly differs from the degree of M&A transactions.

For transactions with a more obvious due diligence process, the process is usually detailed in the letter of intent (you can read about those Here) Or as a condition of closure in the main purchase agreement (for this article, I will talk about diligence in the context of commercial purchases so that everything is consistent).

Before signing the letter of intent, there is usually a small amount of due diligence and negotiation, but in most cases this is the case:

  1. After signing the letter of intent but before signing the final purchase agreement; or
  2. Between the signing of the purchase agreement and the transaction; or
  3. Some combination of the above two.

There are many reasons for due diligence to be conducted on different trajectories, depending on the transaction. Some parties hope to implement the final purchase agreement as soon as possible and conduct due diligence before closing (in almost all purchase agreements, if the buyer is not satisfied with the due diligence, it will not be required to close). The advantage of this is that the buyer can quickly sign the transaction and lock the seller in many terms. LOIs do this to some extent, but they are usually not even as comprehensive as the main transaction, and are usually not binding, except for some terms (again, see the article I linked above).

The advantage of conducting due diligence before signing is that the buyer can determine whether time and money are wasted to negotiate the purchase price based on due diligence before signing. Consider an example. During the due diligence, the buyer discovered something that caused it to want to lower the purchase price-negotiation is easier before signing the purchase agreement, but once it is signed, it becomes more difficult. Of course, the risk here is that, given the non-binding nature of many LOIs, the buyer faces a higher risk and the seller can walk.

In many cases what happens is point 3 above-the buyer will conduct a certain level of due diligence before and after signing. In these cases, buyers will get some big pictures in advance, sign them, and then conduct detailed investigations. This method may be good because it is a balance of the above two.

Since we have talked about When Hard work happens, let’s talk how is it It happened. Usually, it starts when a conscientious party makes a request for information to the other party. Sometimes these are relatively informal, sometimes they involve sending detailed questionnaires that can be dozens of pages long (it all depends on the size and complexity of the transaction). These requests can ask for information about all aspects of the company-employment issues, litigation issues, tax issues, data security, etc.

After receiving the due diligence form or questionnaire, the seller usually responds to certain requests in writing and then provides documents. The bigger the company, the more files. The parties usually use “investigation rooms” or “data rooms”, which are virtual solutions that allow parties to upload files and classify them by category (for example, “real estate”, “intellectual property”, “litigation”) and sub-files. -Category (for example, in litigation, “Complaint”, “Settlement Agreement”, etc.).

After receiving the documents, sometimes it is a long and challenging review work. Due diligence documents are usually reviewed by some combination of the buyer’s principal, the buyer’s lawyer, and the buyer’s accountant (for financial information). For example, in a more complex and larger transaction, you may see a cannabis regulatory lawyer called in to analyze only the regulatory response and documents.

In almost any situation, there are several rounds of this. The buyer will find places where it believes it has not provided enough information or documents. Or it may have other problems. For example, it may see that a company’s lease period for its main property is about to end, and may want to ask what efforts have been made to renew the lease. This process may also take a while.

Also keep in mind that many purchase agreements will set a specific time for due diligence, which requires the buyer to act quickly, review documents quickly, and promptly ask follow-up questions. This is because at the end of these periods, the buyer may lose the ability to withdraw from the transaction because it is not satisfied with the results of the due diligence. Not surprisingly, these time caps are usually negotiated by the seller.

Okay, this is a lot of information. Now let us enter the interesting part-the red flag. Here are some of the larger ones:

  • Sellers who do not provide information or at least provide specific information. When a buyer wants to buy a business but the seller does not tell them anything, this is by no means a good sign. I have even seen multiple transactions. If buyers keep asking for information, sellers threaten to leave. If the dealer refuses to answer you asking if it is operating normally, would you buy a car? If you keep asking, what if they say the transaction is over? I do not think so.
  • The seller reduces representations and warranties. Well, this is not a real diligence question, but it is definitely related. In any purchase agreement, the seller is the one who makes the most statements and guarantees, and when they cut them in the negotiation, they always give the buyer a reason for suspension. For example, imagine buying a business and asking the seller to state that its taxes are up to date, but it does not want to make such a promise.
  • The seller closed the door hastily. Sometimes the need to complete a transaction quickly is justified, such as a government-defined timetable or (in the case of investment) the rapid need for funds to fund specific aspects of the seller’s business. But in most transactions, the date is flexible, so it can be a big warning sign.
  • Lack of organization. Hastily maintained documentation is another important red flag. Companies need to comply with many corporate governance standards when operating. If sellers cannot produce documents in a simple and readable format, this is a bad sign. How confident is the buyer in the seller’s compliance with IRC 280E when the buyer does not have a signed copy of its own company’s resolution?
  • A complete lie. Yes, this happens often! Sellers are human, and some people are not good. Unfortunately, sellers have been deceiving and deceiving buyers. This is why it is important for buyers not to accept sellers’ statements or information at face value. Although fraud in the execution of the contract may be a reason to terminate the contract, it is best to avoid signing the transaction first.

Diligence is a very important part of any transaction. Buyers really need to understand how it works and take it seriously. Be sure to follow us for more updates on cannabis trading.

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