In the third of a 3-part series, Erik Ott of Investment Bank KO Acquisitions examines the due diligence process and shares advice on how to drive a transaction to a successful conclusion. In Part 1 Ott focused on the requirements necessary to engage in M&A discussions, and Part 2 discussed early engagement between buyer and seller up to and through the LOI.
You’ve signed the LOI and shaken hands and now the work begins. The best way to describe due diligence is that everything that you have (or haven’t) done since founding your company will now be analyzed by the buyer. Many transactions in cannabis are stock deals, so when the buyer acquires the shares they are also acquiring all of the risk that goes with those shares. In assets transactions, buyers can more easily disassociate themselves from risk as they can choose to acquire only those pieces of the business that they want. In either case, you should expect a deep dive into every “decision” your management team and Board of Directors has ever made.
A cannabis due diligence checklist covers hundreds of documents and the process typically requires 3-4 weeks if the buyer is fully engaged. The key areas of focus are:
- Finance and taxes
- Corporate operating agreements and shareholder data
- Regulatory and licenses (may include real estate)
- Human resources
The buyer’s review requires the seller to respond to instances where information is deemed missing or incomplete. Once complete, the analysis will roll up into an assessment of the buyer’s potential exposure to litigation and/or future disruption of operations. Suffice it to say that seller transparency is critical, as most buyers are willing problem solvers and will create an environment that helps to address any issues. Given that cannabis has a history of being litigious, it is far better to lay bare all the challenges before the deal closes than to end up litigating things that were hidden or misrepresented during due diligence.
Perhaps nothing is of greater importance during due diligence than 280e. It is rare to find a seller that has a) properly estimated their 280e exposure and b) paid or set aside funds to cover their liability. More often than not, the seller underestimates their exposure and has “sticker shock” when the buyer pegs the liability at an order of magnitude higher than expected – which of course is deducted from the purchase price. This has blown up more than a few cannabis deals, so it is prudent for the seller to enter negotiations with an accurate picture of potential exposure to avoid surprises during due diligence.
Details around any proposed earn out are also very important during this phase. The key to successful earn out is alignment with the goals and objectives of the buyer. Revenue is an easier metric to track than EBITDA, given that the latter is more susceptible to manipulation once the seller controls the company. However, due to increasing pressure on cannabis companies to turn a profit, EBITDA is becoming more popular. The key requirement becomes the development of a pro-forma financial plan that takes into consideration multiple budgetary factors including capex investment, hiring and marketing spend. This jointly developed plan should become part of the final agreement.
As we noted in Part 2, transactions can take a long time to close – often six months or more will pass between the seller’s initial presentation and the closing date. A note of caution: negotiations will be much more challenging if the monthly revenues that were “projected” six months ago are not being achieved. This has occurred in a few of the largest M&A deals in cannabis; it led to a very difficult period during which the buyer wanted to renegotiate the deal terms. Therefore, sellers should not be overly aggressive in the development of pro-formas as it can come back to haunt them vis-à-vis a smaller up-front payment and a larger earn out, or perhaps jeopardizing the deal in its entirety.
The final phase of the definitive agreement is the drafting of representations and warranties. The purchase agreement will contain a comprehensive list of representations that the seller is asked to give. Often, there will be 20 to 30 different sections covering various areas of the seller’s business, and the depth to which the management (and shareholders) wish to indemnify the buyer is often surprising to sellers. This phase is when an entrepreneur will become acquainted with terms like “knowledge qualifiers” and will learn the nuances of “joint and several” representations. A seller may discover that if they made a verbal stock offer to an employee, the seller may still be liable for that commitment – even if that employee has since left the company or been fired. There are many topics that can come up during this process, and the entrepreneur should to lean heavily on advisors throughout.
Last but certainly not least, license transfer requirements are a huge issue in all cannabis deals. Often it can feel like there are three people at the M&A negotiating table; buyer, seller and a local/state government official. It is not uncommon to see local laws and amendments written in real time. Further, “owners” of the surviving entity must be vetted by regulatory agencies prior to close. This can result in a protracted period between “signing” and “closing” (enter “deal fatigue”) while both sides deal with legal interpretations, clarifications, and the typically slow pace of a bureaucracy. Sellers must remember that the buyer cannot take control of operations until the deal closes, and this can be an awkward time while the parties await governmental approvals but it is critical that the seller refrain from turning over the reins.
Selling a company is a time consuming and emotional process. Cannabis entrepreneurs need to be well organized and assemble a team of experts well in advance of a transaction in order to see a sale through to a successful conclusion.
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