7 Potential Pitfalls in Cannabis M&A Deals—And How to Avoid Them
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7 Potential Pitfalls in Cannabis M&A Deals—And How to Avoid Them

While buyers and sellers are eager to close deals, both parties should perform their due diligence before signing off.

January 24, 2019

M&A activity is heating up in the cannabis industry, and while many are eager to achieve their business objectives through buying or selling assets, it’s critical that parties on both sides of the table perform their due diligence before signing off on the deal.

Oftentimes, sellers liquidate their assets to solve a problem, whether they no longer want to work with a partner or they have a cash crunch, according to Sabas Carrillo, founder, managing partner and CEO of Adnant Consulting, a Los Angeles-based accounting and consulting firm with 10 years’ experience in the cannabis space. Other reasons for an exit plan include operations stretching themselves too thin over a large geographic area, as well as smaller operators looking to grow and join a larger team, Carrillo adds.

Buyers, on the other hand, are often looking to acquire as much ground as possible in this emerging industry, but before opening their wallets, they should learn as much as they can about their targets and have a plan in place that includes business objectives and how to integrate a new team into their operations.

Here, Carrillo outlines potential pitfalls buyers and sellers may face when negotiating an M&A deal, and how they can be avoided through careful planning and due diligence.

1. Fraudulent Transactions

As recent as last year, the green rush brought in many individuals without industry knowledge, who fell victim to fraudulent transactions, Carrillo says.

In L.A., for example, the city would close a dispensary that may have had a temporary license, and then someone would open a new dispensary in the same location under the same company name and lure a buyer into acquiring the fake business.

“The buyer would come in and, because of the frenzy, they would buy the dispensary and then do a hurried-up diligence process and then find out later on that actually the permit that they bought was either not active [or] not real, and they just bought a retail location that was not permitted to operate,” Carrillo says.

Although he has not seen any recent cases, Carrillo cautions buyers to perform deeper due diligence to confirm that the target is indeed real before entering into an M&A transaction.

2. Temporary Permits

Some municipalities issue temporary permits for cannabis businesses, and buyers should not mistake these for final, permanent licenses to operate, Carrillo says.

“People come in and they acquire those businesses and see that the permits are there,” he says. “They look on the city website or municipal website and then they’re like, ‘Oh, OK, this is legit,’ but they fail to connect the dots that a temporary permit doesn’t mean a long-term permit.”

Potential buyers should take the extra step to confirm that even if a cultivation or dispensary has a temporary permit, there is a caveat clause or some provision in the agreement indicating that a certain amount of the consideration will be escrowed until the temporary permit becomes a final license to do business within the city, Carrillo says.

3. Undisclosed Liabilities

Sometimes, sales tax underpayments or debts to service providers may not be disclosed, or a dispensary generally has bad bookkeeping. It is the buyer’s responsibility to uncover this information and determine whether it is a deal-breaker, Carrillo says.

“If there are undisclosed liabilities, that’s certainly something that I think buyers should be wary of,” he says.

Buyers should be prepared to appoint one of their team members to do the clean-up work necessary to remedy any financial issues.

4. Poor Community Relations

An establishment that doesn’t have good standing in its community should be another red flag for buyers, Carrillo says.

“You want to make sure that the business has good ties to the community that they operate in, especially with the local police [and] any kind of council in the district,” Carrillo says. “You also want to make sure that they’re not too friendly with the city council because, as we’ve seen in some cities like Santa Anna and Oakland, people can get in trouble because they were greasing the wheels too heavily to get a permit. You don’t want to come in and inherit those kinds of problems.”

5. Complicated Terms

An easy-to-digest, easy-to-read letter of intent (LOI) laid out in layman’s terms is a must in M&A deals, Carrillo says. Sometimes, when larger, publicly traded companies try to buy assets from smaller mom-and-pop shops, they lead with attorneys and legal lingo that the sellers simply don’t understand, which can lead to problems later.

“If you come in with legal language and too complicated a set of terms, you’re going to turn people off simply because to do a deal with you, they put themselves in a weakened position by not being able to understand some of the deal terms,” Carrillo says.

On the seller’s side, it’s important to have trusted service providers, such as attorneys and business accountants, who have M&A experience and a deep understanding of negotiations and terms.

6. A Poor Fit

Sometimes, the chemistry between the buyer and seller just isn’t there, and this can backfire on both parties, Carrillo says.

Many publicly traded companies that are ripe with capital will rush to acquire dispensaries or cultivation businesses without doing the financial analysis to determine if it will be a good long-term investment. Buyers should ask themselves if the region, market or permit they want to acquire will be lucrative to them, weighing factors such as sales tax and how operational costs will impact their bottom line.

“Some of the higher sales tax counties, you may not want to operate in there,” Carrillo says. “Even if you can get a permit or even if you can get an operating business in that county, it might not make sense because of sales tax.”

The cultural fit is also an important factor, he adds. If a buyer intends to keep the seller’s team in place, both teams’ priorities and visions should be aligned so they can easily be integrated.

“Sometimes there are different operators operating different dispensaries, for example, and bringing two teams under the same brand can become impossible because of legacy issues,” Carrillo says. “If an operator’s been in the industry for 20 years, they may have pre-existing relationships that are deep-rooted. Let’s say, for example, you bring in an operator from the San Diego area to the Oakland area and your vendors in that area don’t like that guy. That’s going to impact your ability to do business.”

7. No Long-Term Plan

Sometimes, a larger publicly traded company may not have a long-term plan for the assets it has acquired, and sellers should be wary when selling to inexperienced and unprepared operators, Carrillo says.

“Some [public companies] are great at raising capital and they can go raise $100 million, but that’s it, and they stall out,” he says. “[Sellers] want to make sure that … the corporate team can remain a publicly traded company and has the people and the teams in place to be able to comply with the regulatory requirements of being a publicly traded company, but that [it] also has a plan to operate the company, how they’re going to grow the company [and] what else are they going to do after they acquire your business."