Investing in Cannabis: Understanding Risk Management & Due Diligence

MJINews |

Why talk about due diligence? Two words: Bernie Madoff.

So what does Bernie Madoff have to do with investing in cannabis? Everything! The Madoff funds looked like the perfect investment. The trading strategy made sense and the returns were consistent—nothing to make you think he was taking unnecessary risks.

Madoff ran a wildly successful brokerage firm that had been repeatedly declared “clean” in multiple SEC audits. The man himself was smart and charming—the former chairman of the Nasdaq, he was prominent socially and generous philanthropically. But it wasn’t a perfect investment. It was a perfect fraud. And a lot of smart, sophisticated investors got their checkbooks caught in his trap.

If Madoff didn’t exist, it would be probably be necessary to invent him. His story is the perfect cautionary tale and demonstrates why due diligence—both pre-investment and ongoing—is so important. You have to go beyond Google and learn what it really means to do your homework.

Risk Parameters for Cannabis

Legal cannabis is an exciting frontier market and there are precious few frontiers these days, let alone one with solid opportunities for early adopters. It’s easy to follow the shiny things and write a check because we don’t want to miss out. It’s not so easy to wait or to walk away. There are things you need to know before you greenlight an investment; wait and see; or run like hell.

Due diligence is an ongoing process and also involves developing and continually re-evaluating your own risk parameters and tolerance. These risk parameters are extremely personal and no one can decide them for you except you. If you’re not comfortable with something, move along.

The first decision you need to make is whether you’re comfortable with a business that touches the plant—such as a dispensary, grow or edibles company—or would feel better with something a bit more distant, such as greenhouse equipment, lighting, irrigation or packaging companies. Each carries its own risk/reward profile. The next thing to consider is public versus private markets, or perhaps a combination of the two; medical versus recreational companies or a combination is another individual choice.

Special Challenges Facing Legal Cannabis

First and foremost, cannabis is a Schedule I drug, which means that it is federally illegal and while it may be “legal” in 23 states for medicinal use and a handful for recreational use, this means it is theoretically possible for you to lose your entire investment if the feds crack down. Legislative risk is perhaps the greatest threat to this industry. If you’re not prepared to take that risk, walk away now.

Another factor regarding Schedule I is that if the feds should change the scheduling, will the company you’re invested with be able to cope with the compliance burden of dealing with as many as 5-8 federal agencies, plus the additional state-level agencies? Compliance is a heavy burden and an expensive one. Make certain in your pre-investment and ongoing due diligence that the company is ready, willing and able to adapt quickly to a new regulatory environment.

Another legislative risk involves individual towns or counties going “dry” in a state where cannabis is legal. Currently the town of Vail is considering forbidding the sale and use of recreational marijuana inside of city limits in spite of its being legal in Colorado. There’s some headline risk here as a prominent ski town is essentially saying that it isn’t comfortable with cannabis consumption in its town, and it also reduces the potential consumer base in Colorado. From an investor standpoint, these can and should be red flags.

It’s also difficult for cannabis businesses to scale because for the most part, companies that touch the plant cannot cross state lines. Dixie Elixirs, a Colorado-based firm, recently opened in California, but product cannot be transported across state lines.

Banking and taxes are next on the list of extraordinary challenges cannabis businesses face. Because the wire system used by banks belongs to the feds, most banks aren’t interested in opening accounts for cannabis businesses. This means the legal cannabis industry is largely a cash business and unlike mutual funds, owners of cannabis firms can’t manage cash by keeping a constant rolling stream of treasuries to pick up a few basis points.

Before you make an investment, understand how the company manages its cash and make it a point in your ongoing post-investment due diligence to be certain its adhering to what it says. The same is true for tax issues. If the company you’ve invested with is subject to the IRS regulations surrounding 280E, make certain it’s compliant.

The Due Diligence Process

Once you’ve determined where your comfort level lies and you’ve found a few companies that pique your interest, the real work begins.

When I was in journalism school, one of my professors continuously said, “If your mother says she loves you, check it out, and your brother isn’t a reference.” That’s as true in due diligence as it once was in journalism.

The Internet is a wonderful tool and Google is a gift, but remember that Bernie Madoff looked really good on paper. Who would have believed that a former chairman of a major exchange and noted philanthropist would be the master of the world’s largest Ponzi scheme? By all means, use Google, just remember to “trust but verify.”

Scrutinizing the business plan as you would in any other investment is critical, keeping in mind the special issues that accompany the cannabis industry, but the team is where you need to pay real attention.

Things you need to know about the team before you invest: Who are they and how much experience do they have running a business? Have they previously run a business? If so, what happened to it? If not, what makes them think they can? How much experience do the key people have with cannabis?

Check references and consider spending the money to do a background check. Be aware that background checks may reveal felonies. This is cannabis, folks. Know beforehand if a key team member has a conviction and think through whether you are ok with that.

For a list of questions and an excellent due diligence questionnaire focused on the cannabis industry, visit the ARCPC’s website. The Association for Responsible Cannabis Public Companies has done extensive research into the subject and its questionnaire is comprehensive. While it focuses on public companies, the basic issues facing both public and private companies in this space are much the same.

Due diligence doesn’t—and shouldn’t—stop when you write the check. This is an ongoing part of your investment. Most people who invest in frontier markets consider themselves to be strategic investors and most entrepreneurs want that involvement. Define your terms and expectations clearly before you write the check and then make sure that all parties adhere to them.

If you’re investment is large enough or you have multiple investments in the space, you might consider hiring an outside firm to monitor the companies. If you’re monitoring your own investments, visit the company regularly. Watch for style drift—is the company doing what the plan calls for? If not, why not? Style drift kills.

Are key staff members paying attention, or are they distracted? One hedge fund investor I know always says he won’t invest in a fund if the portfolio manager is building a new house, buys a red Ferrari or is getting a divorce. It’s good advice. A distracted CEO isn’t paying attention to your investment.

Ultimately, you need to decide for yourself what your risk profile looks like, but the more information you have, the better your decisions will be.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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