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March 17, 2022

Investing in State Law Compliant Cannabis Businesses: Part 1 - Getting Started

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Key Takeaways

  • The legal cannabis industry has been developing for years, but it is still difficult even for sophisticated investors to know where to start when thinking about investing in the cannabis industry.
  • Marijuana is still illegal under U.S. federal law, and the current Administration has been inconsistent in its approach.
  • Knowing and trusting the founders and key management is particularly important in a cannabis business.

The legal cannabis industry has been developing for years, but it is still difficult even for sophisticated investors to know where to start when thinking about investing in the cannabis industry. Stocks of publicly traded MSOs (multi-state operators like Trulieve, Cresco and Curaleaf) are down significantly from their highs of just over a year ago, but how does one distinguish between a buying opportunity and the proverbial falling knife? There have never been more ways to invest in private cannabis companies, whether through straight debt instruments, convertible debt instruments, preferred equity investments, other convertible instruments such as SAFEs (simple agreements for future equity), and there is a rapidly emerging market of private equity and venture capital styled funds servicing the sector and raising money in private placement transactions.   

As with any potential investment category, it is virtually impossible to list all the relevant issues that an astute investor should understand before making an investment decision. In this piece (Part 1) and a follow up (Part 2), we will set forth some of the list of basic considerations that every budding cannabis investor should understand before investing in a cannabis venture. 

Cannabis investing is high risk. In many markets, the easy money has already been made in the cannabis sector. There are many players trying to rapidly scale operations while navigating the awkward legal landscape, collecting, and paying high taxes and competing in an increasingly crowded sector. Many cannabis leadership teams are stretched extremely thin trying to manage their rapidly growing operations. Just as angel and venture capital investors understand they risk significant if not total loss of their investments in their search for the next technology "unicorn," cannabis investors should appreciate the downside risks inherent in a specific cannabis venture notwithstanding the overall growth projected as to the industry. 

The purpose of this article is not to caution everyone against investing in cannabis, but to make sure potential investors go into the sector with eyes open. The cannabis industry has grown significantly over the last few years, and certain areas are saturated with participants. This has compressed margins and forced operators to work much harder to make money. It is fair to say that quality management is at a premium these days.  

Marijuana is still illegal under U.S. federal law, and the current Administration has been inconsistent in its approach. The importance of this issue cannot be overstated. Because marijuana remains a Schedule I drug under the federal Controlled Substances Act of 1970, its cultivation, manufacturing, distribution, sale, possession, and use remains a violation of federal criminal law. The Biden administration has been inconsistent in its approach to the cannabis industry. While at time expressing support for cannabis reform, the Administration has not been as enthusiastic as many had hoped in promoting cannabis reform. The SAFE Banking Act, a law designed to allow cannabis companies access to the banking system, which has passed the House of Representatives multiple times in recent years, has consistently stalled in the Senate, and does not appear to be a White House priority. The White House has also expressed a willingness to revoke security clearances for persons that have consumed cannabis products, even if legal under state and local law, as well as for persons that have made investments in cannabis companies. So, investors should remember that some degree of risk will be associated with any cannabis investment. 

Knowing and trusting the founders and key management is particularly important in a cannabis business. The background, relationships and skill set of the founders and key management personnel are significant to all growth businesses, because so much of the growth of those businesses results directly from the industry know how, connections and experience of those companies' key people. In cannabis businesses, the founders and key management are even more important because those individuals are often listed as responsible parties under the cannabis company's licenses. Accordingly, a cannabis investor should get to know all the cannabis company's founders, major investors, and key managers, and should become satisfied that the individuals in charge will operate properly within the applicable regulatory framework. 

Understanding these points is important for an investor to understand and appreciate before devoting considerable time and expense going further into the due diligence process. 

In Part 2, we will follow up with more specific company specific concerns that an investor should consider before making an investment into a cannabis company. 

This article is for information purposes only and should not be construed as legal advice, business advice, investment advice or tax advice.

ALM expressly disclaims any express or implied warranty regarding the OnPractice Content, including any implied warranty that the OnPractice Content is accurate, has been corrected or is otherwise free from errors.

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