Ever since the SEC cracked down on marijuana-related investments in 2014, potential investors have been painfully aware of the need to conduct adequate due diligence on the early-stage companies that come courting. Last year’s crisis focused on thinly-traded penny stocks.
This June the private company situation may become especially complex, when changes under SEC Regulation A will permit more widespread crowdfunding. According to Sara Hanks of CrowdCheck, “The intersection of two industries and one school of people is chaos doubled or cubed. Both online early stage fundraising and cannabis are highly regulated while entrepreneurs focus on the business they have to run. It’s a recipe for anarchy.”
On April 20, 2015, Hanks and Alan Hawkins, Executive Director of the Association of Responsible Cannabis Public Companies, co-hosted a session on Risk Management, Best Practices and Due Diligence at the Marijuana Investor Summit.
Private Company Due Diligence
Hanks outlined several basic lines of inquiry for the investor considering investing in early-stage private companies. A careful investor will need to know:
- Whether the company is properly incorporated and whether it operates in compliance with its organizing documents.
- What the tax arrangements are, specifically if it is being taxed as a subchapter S corporation or a partnership.
- What rights will the investor receive? In a subchapter C corporation, there may be both preferred and common shares. In an LLC, the investor’s package of rights may be less well defined contractually.
- What are the financial arrangements? Is there a bank? Is there an escrow account? How does the investor’s money actually get to the company?
- How are records kept of ownership interests in the company, and how accurate are those records? Do they go beyond an Excel spreadsheet?
- What exemption from SEC registration requirements does the company rely on? What are the conditions of that exemption?
- Is the company selling shares through a broker/dealer?
- Has the company put together proper disclosure statements that are qualified with legally required language?
According to Hanks, “The ability to go online totally changes the dynamics for early-stage investors because the business needs to be in compliance before the investor becomes involved.”
CrowdCheck focuses on performing due diligence for investors interested in early-stage businesses and walking entrepreneurs through the complicated compliance process, so that they know they meet all the legal requirements prior to seeking investment.
Public Company Due Diligence
Although the challenges for early-stage public marijuana companies are similar, ARCPC’s model is somewhat different. It is a non-profit self-regulatory organization, whose members are publicly-traded companies in the cannabis industry that adhere to the organization’s Code of Practice. According to Hawkins, they expect “four or five companies in by the second quarter and maybe a dozen by the end of the year.”
ARCPC’s Code of Practice requires:
- registration under either the Securities or Exchange Act,
- compliance with reporting requirements,
- a class of securities actively trading on either the OTC Markets or a national exchange and
- management with a demonstrated track record in cannabis or general business activities.
ARCPC doesn’t recommend companies for investment, but membership is contingent on compliance with standards that may address many investors’ due diligence concerns.
Reverse Merger vs. S-1 Registration
To date, the marijuana companies that have gone public have generally done so through reverse merger. As Hawkins noted, the process may be relatively quick and easy. However, because the acquiring private company relies on the dormant public company’s registration, the new entity need not immediately demonstrate compliance with Financial Industry Regulatory Authority regulations. A reverse merger thus provides relatively little assurance to investors about the new entity’s capital and financial structure.
He foresees that more emerging growth companies in the marijuana industry will choose to go public through S-1 registration, which requires the issuer to disclose basic business and financial information. The advantage for investors is that they may then use the prospectus to evaluate the merits of an offering and make an educated decision. The advantage for entrepreneurs may be an increased ability to attract professional investors and greater capital.
Chaos doubled or cubed, for all the challenges it presents, is a hallmark of emerging industries. It is an exciting prospect that calls for careful investor review.