There is a segment of the investment community that wants to invest in the cannabis industry in the worst way, and that is exactly how some are doing it. Over the past several months our firm has reviewed a number of private placement memoranda (PPM) for clients, and while some appear to be solid and well written, others remind us of the early days of the internet boom when business plans were sometimes written on napkins. Deficiencies we have found in PPMs include confusing descriptions of business plans, lack of financial projections, lack of basis for valuations, inadequate disclosure of risk factors and vague discussion of management compensation and/or equity holdings.
If you are planning to invest in a cannabis company, here are a few factors that you should consider before making a decision.
What are you investing in? Does the company touch the plant? In other words, is it a grower, processor or retailer of marijuana, or is it a software or service company that services the industry but has no actual contact with the plant? Companies that touch the plant have different legal, banking and tax challenges.
For companies that don't touch the plant, are they providing services or software that is actually useful? The cannabis industry is growing fast and changing on a daily basis. Many start-up companies provide services that are needed today, such as management services for small growers, and others are building for the future, i.e., bank compliance software.
Will the company buy out the promoter? In at least one PPM we reviewed, the promoters started companies in different states with the intent of operating dispensaries. These companies were being sold to the company funded by investors for valuations that bore no relationship to reality, or at least none that we could see. One of the companies had been denied a license but was still valued at several million dollars. There was no mention of how the valuation was determined, or whether any neutral third party had reviewed or determined the valuation.
Valuation. As the last point illustrates, "irrational exuberance has unduly escalated asset values," to borrow a phrase from former Federal Reserve Board chairman, Alan Greenspan. Many of the PPMs simply do not address valuation. For start-up companies, this is understandable, but for companies with a history, even a brief one, it is important to discuss valuation. One refreshingly honest PPM simply stated what is true in many PPMs in this industry–"the offering price for the [interests] has been arbitrarily determined by the Manager."
Banking. This is critical for companies that touch the plant. As most readers of The Blunt Truth are aware, it is extremely difficult for a cannabis company to establish a banking relationship, so it is important to understand how the company will deal with its cash and account for its income and expenses. Several PPMs we reviewed do contain a statement to the effect that it is difficult for a cannabis business to establish a banking relationship but do not discuss how the company seeking the investment will deal with the issue.
Tax. Again, critical for companies that touch the plant. Companies that touch the plant cannot deduct ordinary, necessary and reasonable business expenses and, as a result, pay what is, in effect, a gross income tax, not a net income tax. Obviously this affects the bottom line. Is this adequately disclosed?
Financial Information. Is there any? A good PPM should contain some basic financial information to give the investor some idea of what to expect, assuming all things go as planned.
Founders Ownership and Management Compensation. Are the founders making a capital contribution to the company? If not, what percentage interest, (i.e., carried interest) will they own? In most companies, the maximum carried interest should be 20%. Also, does the PPM adequately disclose the nature and amount of compensation the founders, as managers of the company or their affiliates, will receive?
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.