2018 saw a flurry of investments, mergers and acquisitions. Altria invested in Cronos for $1.8B and Juul for $12B(!), MedMen purchased PharmaCann for $682M, Constellation Brands invested $4B in Canopy and the list goes on. We all hear about these big deals but in terms of volume, investments in and acquisitions of, smaller cannabis company deals far outnumber these highly publicized ones.
Acquisitions or investments in small to mid-size cannabis companies in 2019 are on track to far outpace the previous year which is natural as these companies allow smaller investors the chance to get in on the industry as well as having a potential for more upside. However, this also comes along with more risk.
Risk that the target company:
- Is unable to execute on their plan
- Is non-compliant with regulations
- Have projections that are wildly inaccurate
- Has erroneous financial statements
Companies like Altria (Marlboro, Chateau St. Michelle) and Constellation (Corona, Svedka) are highly sophisticated with years of experience operating as well as making investments and acquisitions. They have teams of analysts, CPAs, attorneys and operations experts to properly evaluate potential investments. In many cases, deals between the smaller players do not. In fact, I suspect it may even be more often than not.
Often these investors are ignorant of the risks or willfully ignore what should be warning signs of a questionable investment. What contributes to this fast and loose investment environment? FOMO, lack of resources and valuations.
There is so much hype surrounding the cannabis industry, many are in fear of missing out, or FOMO. With lack of operating history, there are all kinds of estimates and projections for the cannabis market and the profits to be made which will likely turn out to be wildly inaccurate. Many of these projections are leading to valuations that are in the stratosphere and bear no relation to fundamentals or reality but still expected to rise. Combine unrealistic valuations with FOMO and you have a recipe for disaster.
Unfortunately smaller investors/companies have fewer resources and therefore many times have less expertise necessary to mitigate the various risks. I will say this once, due diligence MUST be priority #1 in a cannabis investment. Due diligence validates what you are buying and in turn supports the value of your investment.
There are many things you will want to validate but since we are an accounting firm, we'll stick to discussing those items related to our expertise.
- Have the financial statements been audited, and for how many years?
- Does the company have projections and are they realistic?
- How much working capital will be needed to operate the business going forward?
- Are any future capital raises planned (dilution)?
- Is there any ongoing or potential claims (litigation) against the company?
- Are there any customers that make up more than 15% of total sales?
- Review all contracts and agreements to ensure all potential liabilities, restrictions or commitments are accounted for or disclosed.
- Evidence of filing of all tax obligations including income, payroll and sales taxes.
As you can see many of the items I mentioned previously relate to validating assets held and liabilities owed by the company. This equates to the necessity of having complete and accurate financial statements which include a balance sheet which lists all of a companies assets and liabilities. You want to ensure the assets claimed are real, the company has title to it and the condition it is in. Likewise, you will want to ensure that if the company owes any money on that asset, it has been accounted for or that there is a clear title.
Failed diligence in an investment generally results in either needing to invest more just to keep your investment alive or worse a total loss. Believe me, I've been there and it is a terrible situation to have gotten into. I've seen many situations where undisclosed liabilities appear and the new owners are left holding the bag.
So in a nutshell, make sure you do your due diligence and know what you're paying for.
If you're an operator looking for capital and need help developing sound financial statements or are an investor needing assistance to ensure your investment is worthwhile, we can help. Give us a call at (775) 525-1398 or e-mail to firstname.lastname@example.org.