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How we #duediligence

About a year ago, when I entered the cannabis industry as an investor and professional, there was no shortage of questions from my friends and family. One of the most common questions was about how to navigate the noise and make informed investment decisions. 
Specifically, with the hundreds of deals that are out there, how does a prospective investor separate the good deals from the bad to make prudent investment decisions?
Due diligence on investment opportunities in the cannabis industry takes a different flavor than in a mainstream industry. However, some of the same basic principles apply.  Investment decisions should be made based on the expected risk-adjusted return on your capital.
Several topics should be considered when evaluating a potential cannabis investment.  In general, as fundamental economic valuations are not readily available in this industry, investment decisions tend to rely more heavily on intuition and qualitative aspects of the opportunity.  As the industry matures and evolves, investors will eventually have access to formal company valuations, traditional financial and economic models, and more robust documentation, but for now, we have to focus on the following:

Team

For me, the number one factor in evaluating investment opportunities is the team.  Given the rapidly evolving nature of the industry, organizations are sure to encounter twists and turns.  It is absolutely imperative that you invest in a team that is well suited for their roles, highly resilient and adaptable, open to feedback, compatible with one another, and incentivized to stick around through the ups and downs.  

Evaluation

Next is the evaluation of the product or service being offered by the target company.  The offering needs to solve a real problem or fill a glaring gap.  The problem or gap needs to be profound enough that customers are willing to pay a price that will yield a profit for the company you are evaluating. 
For B2B offerings, it needs to meet a core need or pain point of the industry, as operators in this sector are not yet ready for the “nice to have” offerings.  There has to be a core, strategic importance to their business and their ability to operate and it must be priced at a level that works with their business model. 
The solution has to be proven, and the company must demonstrate that they will be a stable presence and able to service their customers on an ongoing basis. The solution must be unique and protectable from an IP perspective as there are scores of aspiring cannabis entrepreneurs waiting in the wings for copycat opportunities. 
For B2C offerings, if I am in the target demographic I sometimes find it useful to reflect on the brand and the product.  Many operators are happy to give out samples if you ask – you can determine if the branding and product live up to the hype!

Traction

For me, the next step is a careful evaluation of the company traction. Has the operator made progress against their plan, pivoted when necessary, shown an ability to raise capital, execute on their business model, and provide appropriate documentation for investors?  As a related consideration, how much cash is being burned each month?

Legality

Legal and regulatory concerns are important as well. The current regulatory environment is complicated, and local, state and federal regulations should be considered. It is critical to understand the requisite licensing and then confirm the company’s status or progress towards attaining the necessary licenses to operate.  Furthermore, it should be acknowledged that cannabis is still a schedule 1 drug according to the DEA.  Unless you are willing to sign a contract that says something to the effect of “without regard to federal law” then you may be more interested in “ancillary” or “non-plant touching” opportunities.  
These companies represent the “picks and shovels” of the industry. Products and services that are sold to operators or consumers because of their relevance to the industry, but without any contact with the federally banned substance.  Many of the deals out there are “plant touching,” most notably cultivation and retail. These can be very compelling offerings, but you have to be willing to stomach the inherent contradictory legal paradigm. That said, the regulatory paradigm is what has lead to the imbalance of supply and demand for capital, so the returns on these “plant touching” deals are often very favorable.

Deal Terms

Deal terms are the final point of evaluation.  Operators in this industry generally need to be made aware that the supply and demand for capital are not tilted in their favor at this time. Traditional capital sources are typically unavailable, and even private investors may be risk-averse or morally opposed to cannabis.
As such, viable capital sources are limited. Operators need to be willing to compensate investors for their willingness to toe the legal boundaries and understand that their financial projections will not translate into valuations at the same multiples that they would command in a mainstream industry.  In addition to valuation, investors should review evidence of governance, liquidation preference, dilution protection, and other financial and non-financial terms.
The bottom line is that there are great deals to be had in this industry.  There are also many many bad deals.  With a comprehensive, thoughtful, and open-minded evaluation, there can be great strategic partnerships that are fun, lucrative, and will form the building blocks for this important industry.

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