-By Caleb M. Zobrist, Esq., Glenn H. Truitt, Esq. & David J. Housey
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Investors – especially those unfamiliar with the cannabis market – have traditionally been hesitant to invest in an industry the federal government views as illegal. While this still holds true for most institutional investors, smaller firms and groups of wealthy individuals are becoming increasingly interested in cannabis.1 However, the majority of information surrounding these investments still lies somewhere between rumor and nuance, and the dizzying array of so-called cannabis “experts” can lead one to the conclusion that there is no such thing (there is, but they’re hard to spot).
The Cannabis industry has a lot in common with business in general. The industry includes agricultural, commercial processing, retail and laboratory businesses – each of which has a broad market of comparable enterprises for comparison. The maturity of these sectors also means that traditional accounting and financial reporting is more than adequate for business analysis purposes.
So, you’re looking to invest in marijuana. You’re not alone. Billions of dollars of private equity are flowing into the cannabis business – with billions more flowing into the rapidly growing public market for marijuana securities. However, if you have even a remote connection to this sector – you’ve likely been solicited (or know someone who has) with a private equity opportunity. Despite the federal illegality of the cannabis industry, in general (owing to the classification of marijuana as a Schedule I drug, as governed by the federal Controlled Substances Act), federal securities laws still apply to investment in marijuana businesses. Here’s a quick guide to what to do next.
The Supreme Court has adopted a flexible and liberal approach in determining what constitutes a security. In its famous decision of SEC v. W.J. Howey Co., 328 U.S. 293, 90 L.Ed. 1244, 66 S.Ct. 1100 (1946), the Court held that land sales contracts for citrus groves in Florida, coupled with warranty deeds for the land, and a contract to service the land, were “investment contracts” and thus securities. The Court stated that
[a]n investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party. 66 S.Ct. at 1103.
In general, all securities offered in the U.S. must be registered with the SEC or must qualify for an exemption from the registration requirements. Registering securities (as publicly traded companies do) is an exceptionally expensive undertaking, and requires the full-time support of an experienced securities law firm. It is critical for the success of the issuance of private securities that they avoid registration by qualifying for a Regulation D exemption and properly documenting that exemption.
No matter what you are told by a cannabis company seeking investment, if you give them money, with an expectation of return on your investment without any material effort on your part: you are being issued a security. As a result, you should be provided with a private placement memorandum (“PPM”; a prospectus and required legal disclosure statement) and a Subscription Agreement (providing the terms of your investment – and your qualification as an accredited and/or sophisticated investor). The PPM must include information regarding its qualification for a Regulation D exemption.
One of the greatest challenges facing investors in new markets is proper valuation of marijuana enterprises. Speculation and short supply can drive equity valuations into inflated multiples based on rapid growth expectations. Conversely, perceived risk can be overestimated and drive equity valuations into substandard positions. No matter what, the one valuation you should be skeptical of is the one provided by the issuing company. The offer, itself, represents a valuation (e.g. if you get offered 10% of a company for $100,000 investment – that’s a $1,000,000 valuation), but may also include detailed analysis to highlight the valuation discount or premium.
Nevertheless, you should have the pro forma financials reviewed by an independent financial professional – including an independent valuation, for perspective. The resulting quantitative analysis will provide important information on the nature of the offer you’ve been provided.
For the amateur investor, legal compliance is likely your biggest concern. For professional money, the regulatory environment is just another variable in the valuation. While compliance risk has always been a material element of cannabis investing (and will be until marijuana is legalized at the federal level), it has become particularly sensitive in light of Attorney General Jeff Sessions rescinding the 2013 Cole Memo, which had directed US attorneys not to pursue properly-licensed marijuana businesses in marijuana-legal states.
If this repeal had gone unmentioned or unopposed, the increased risk would materially depress valuations and chill investment. However, opposition to the repeal was swift and widespread, including (at the federal level) U.S. Congressmen Polis of Colorado, Rohrabacher of California, and Blumenauer of Oregon sponsoring an amendment to the House’s next budget bill prohibiting the Justice department from spending money on the prosecution of legally-compliant cannabis businesses.
Additionally, Cannabis-legal states have indicated they will aggressively fight back any federal action taken to shut down state-legal Cannabis businesses. Many industry analysts cite the expected tax revenues that have already been budgeted, and the increase in local economies via job creation and the deep political unpopularity involved in eliminating or even reducing those revenues.
The bottom line is that cannabis investment remains at record levels with stable valuations and public sentiment strongly in favor of legalization (across both parties). Eventual legalization is all but inevitable.
It’s a great time to invest in cannabis, despite what you may have heard in the news. When it comes to investment, follow the money – and with little or no money exiting cannabis companies, it remains a bull market. However, once you’re ready to invest:
Make sure private securities offers are properly documented; and
Secure your own independent valuation.
Because a good investment can still be a bad (or illegal) deal.
Glenn H. Truitt, Esq. is a managing partner at Ideal Business Partners (www.idealbusinesspartners.com), a multidisciplinary professional services firm serving healthcare professionals with state-of-the-art legal, financial compliance and strategic advice, working together to lift up their practices. IBP consults with ComplyPro (www.mycomplypro.com), a HIPAA compliance services company, serving Nevada and southern California, and employing both traditional and digital compliance tools to develop comprehensive, customized compliance solutions for any size practice.
Malvika Rawal, Ph.D., J.D., is a law clerk at Ideal Business Partners. She received her Master of Science at the University of Delhi in Biomedical Sciences and her doctorate degree in Free Radical and Radiation Biology at the University of Iowa. She then received her Juris Doctor at the University of Iowa College of Law in May 2016. Rawal is deeply involved with ComplyPro, a HIPAA compliances services company.
1 Marijuana Business Daily. Marijuana Business Factbook 2017. p.6. https://mjbizdaily.com/wp-content/uploads/2017/05/Factbook2017ExecutiveSummary.pdf