In the first of a two-part series, learn how to do your due diligence on all aspects of a company’s financial records and licenses.
- Hire a due diligence team of lawyers, CPAs, operations engineers and any other experts to learn about the state of the company you’re purchasing.
- Use our checklist to know what to look for on a cannabis company’s balance sheet before you complete a merger or acquisition.
- Check leases, licenses, lab tests, assets and liabilities.
Speak to one of our experts for advice on mergers and acquisitions within the cannabis industry.
Mergers and acquisitions are becoming more and more popular in the cannabis industry. According to data from Marijuana Business Daily, “233 M&A transactions have been completed so far in 2019 versus 185 for a similar period last year.” M&A deals involving public buyers are an especially way for cannabis operators to grow their business and become profitable quickly in this particularly competitive market.
Closing an M&A deal successfully involves two very important actions that we will cover in this two-part series: due diligence and business integration (combining the financials, people, and culture of two cannabis businesses).
In this post, we’ll cover performing your due diligence in a cannabis M&S deal.
Due Diligence for Cannabis M&A
Due diligence is especially important in this industry. You must make sure the company that you’re purchasing is legitimate and who they represent themselves to be.
Take the time to evaluate many aspects of the business to make sure that it has the expected cash on hand, requisite licenses, records of taxes paid, and capitalized assets that are really in the building.
Due diligence is a process you must perform before you make an offer: what you find during this procedure will likely impact what and how much you offer in the merger deal.
For example, if you find certain things are not represented truthfully, or there is significantly less documentation than you expected, this will create uncertainty in your mind.
In response to that uncertainty, you may ask for a lower price than previously discussed – and the magnitude of that price break depends on the materiality of what you find.
If you’re a cannabis operator who envisions selling their business one day, there are steps you can take now to improve and preserve your business’s value. We highly suggest that you implement strict record-keeping and documentation for all aspects of your business. The more documents that you have to back up what you are claiming to be true, the stronger the case you have to ask for a price premium. The documentation you should maintain includes financial reporting documents, contracts with suppliers and buyers, granular POS data, fixed asset registers, inventory reports and more.
How to Conduct Due Diligence
Before you make an M&A offer, assemble a team to come and review the cannabis company you are seeking to purchase on your behalf (if you aren’t performing the due diligence yourself).
Typically, this team is comprised of lawyers, CPAs, operations engineers and any other experts who can help you draw insights about the state of the company you’re purchasing.
At a high level, here’s what the team will be looking for – please keep in mind that a true due diligence process is much more detailed and robust.
Understanding the Company’s Balance Sheet
Here’s a checklist of what to look for on a cannabis company’s balance sheet when performing your due diligence.
Assets
- Cash-on-hand reports: have they had any big adjustments? This could be a sign of weak cash controls. Many cannabis businesses are cash-only or primarily cash, so check to see if they keep cash logs for the business
- Is the cash log up to date? What is the frequency of the inputs…multiple times per day, daily, every other, maybe weekly? The more frequent, the better. If they do have cash logs, that’s a good first step, but now you need to verify their integrity.
- Count cash on the day you go there to make sure it correlates to the cash log input for that day. To go one step further, you will want to do a reconciliation of the accounting books to the actual cash log to see if they tie together and even out.
- What are their other assets? Go down the balance sheet and check their bank statements to see if they have other cash positions that you need to verify. This would also include merchant accounts where they process credit cards.
- Accounts receivable: how aged are the receivables? You may want to break receivables into three buckets: 0 to 30 days, 31-90, 90+. Weigh the Accounts Receivable to see your likelihood of actually collecting them. As a rule of thumb, book an expense for bad debts over 90 days and see how that affects their financials
- What is their history of bad debts? Look at their history of bad debts and use this info to estimate what the bad debts going forward are and what impact that will have on EBITDA.
- What is their inventory? See what products they have and how much of each they have on hand. Take into consideration how much effort it will take to clean and up to date the books look for inventory reports. Do they have any dead stock?
- If you really want to get deep, you could do an inventory count. If you are evaluating a cannabis grow operation, then actually walk the cultivation area to make sure they have as many plants as they claim to have. Make sure the quality of the product is coming along as you expect!
- What are their fixed assets? Sometimes businesses claim to have assets – equipment, technology, or something else – that’s not actually there. Check to see they have every asset listed, and that they have a title to those assets.
- Review the facility to see if the cannabis operator is still doing the buildout to understand if you will need to shell out additional cash to finish. If they are still constructing, quantify how much more needs to be put in.
- For example, if you are considering buying a grow operation, and they say operating space is 30k sq ft, bring your grow master and let them evaluate it.
Liabilities
Once you’ve done a full check up on the inventory, assets, and cash on hand, take the time to review the cannabis company’s liabilities.
This will let you know what risks you will be exposed to by joining your businesses together. Most companies will have some accounts payable – ask for those and make sure it’s a full and complete list. Test the list of payables by looking for unrecorded liabilities and finding those potentially unlisted payables which would be called subsequent disbursements.
For example, if the M&A transaction happened in July, check the August bank account statements to see what cash went out. If the transaction is not on your list of payables, then you need to inquire and ask the company to explain what it is including as a full liability amount and frequency of that payment. Another quick way to find out about debts is to scan through bank statements to look for massive debt payments.
Next, you need to understand the company’s debt arrangements.
To do this, you will need to work closely with their in-house legal counsel – and potentially outside legal counsel, since these are huge contracts which surely the lawyers helped negotiate and execute on behalf of the company.
Check the company’s leases; these expenses typically will not be found on a balance sheet, as it’s an expense every month that comes out of the company’s bank account automatically or is paid in cash.
You should gather all of their lease agreements to see what the company is obligated to pay and how the leases are structured. If the company can’t produce lease agreements, this is a big red flag you can use to reduce the price of the acquisition.
Speak with the lawyers to see if there are any legal claims against the company. Claims you might ask about include employee wage disputes, customer issues, contractor issues and anything else that may pose a legal threat to the company’s assets. This is a risk assessment you must account for, as you are liable for any outstanding issues the company has once you make an M&A deal. For that reason, we also suggest you meet with HR to see if there have been any questionable terminations since the company started.
The last part of liability review? Taxes.
Review that all taxes applicable for that jurisdiction have been filed. Check taxes at the local, state, federal levels. Get the returns for all of the taxes paid, as far back as possible. They may owe back taxes that you may be on the hook for if the M&A goes forward.
Understanding the Company’s P&L
Once you’ve completed your liabilities review, dive into the P&L sheet. The goal of reviewing the P&L is to understand the trends of the business.
Start with Revenue
There are usually two types of revenue (recurring and non-recurring). You should find any non-recurring revenue, which you will then back out or discount from the total revenue numbers. Non-recurring revenue is not dependable – so it’s shouldn’t be include in valuing the deal.
Examples of non-recurring revenue could be large one-time buys of product that were for a specific event and surely not going to be a periodic buy. Plus, you want to understand the composition of the company’s customers and their behavior.
For example, if you are buying a manufacturing business, you want to learn the number of customers, the average transaction size, and the trends of each of these numbers. Are things trending up or down, and why is that happening?
It may be helpful to chat with the sales team to see how they think things are going. This can also give you context and background information if the team of employees is a group you would like to work with if/when you do buy the company.
Breakdown Their Costs
Understand the gross margin by product. In most cases, especially in these early years of the cannabis industry, most businesses don’t keep solid records of costs at a product level. Most cannabis operators aggregate their costs at a business level, or sometimes at a product line level.
If the business you are buying doesn’t keep these detailed records, say to them: “We are taking huge risk which is creating a higher level of uncertainty and we want a discount on the purchase price of the product.”
Bottom line: the better the records, the higher the purchase price.
Check a company’s recurring expenses.
If they claim an expense is non-recurring, you need to take the time to check it out and verify. Delving into each of these categories may seem tedious, but it’s important to get a clear picture of what it actually takes to operate this business in totality.
One note about private companies: sometimes owners will include personal expenses into the business books for one reason or another. We are not here to say that is right or wrong, but make sure that when you are reviewing expenses, the things you see are part of the business and not the CEO’s rent payment, food bill or other misc expenses.
Once you understand the entire balance sheet and P&L, take the time to understand what the business will look like going forward.
Use what you found to create financial projections for the next few years of business operations. This can help you make a decision whether to walk away from the deal, or argue for lower purchase price.
Other Aspects to Understand
Lastly, let’s look at some other miscellaneous items you need to include in your due diligence assessment.
Entity Type & Structure
Consider the overall structure of the business:
- Is it an LLC, S-Corp, nonprofit, or something else?
- Is it just one entity, five entities or is it monstrous and set up as 20 entities?
We suggest that you make a visual chart of how all of the entities are connected and see which entities owns what assets and which other entities. The business you are buying should supply you with operating agreements and bylaws to confirm what you are drawing is actually true. This exercise also helps you understand how funds flow around the entities as well.
Proper Licensing
Of course, make sure to verify their licenses.
Look for their expiration date or if the company has permanent, temporary or provisional licenses. Make sure you know the fees associated with maintaining the license agreements and any other pertinent information regarding the licenses, especially who owns them or if there’s a revenue share agreement associated with them.
Lab Tests
Last but not least, check lab tests on the products.
These tests will help you understand the integrity of the manufacturing process and understand if they are experiencing any issues. It’s understandable that sometimes things go wrong and a business will fail a test, but you need to know how frequently and how severe the failures are.
Tying It All Together
Between balances, liabilities, inventory, and profit/loss statements, it’s possible to get a relatively clear picture of how a cannabis company operates before the M&A deal.
In our next post, we will cover what it looks like to combine two cannabis operations together, including the how to consolidate your financials and integrate people and company cultures.
If you have questions or need help with your cannabis company’s M&A Deal, then please reach out to us.
