Conducting Due Diligence on Marijuana Companies: What the Prudent Investor Should Know

By: Michael F. Cuttitta – Hofstra Law School – Law Student Contributor

Up until this point, a dichotomy of federal and state marijuana law has inhibited a full-fledged investing spree.  Despite this, Arcview Market Research, a leading data provider in the cannabis industry, has indicated that even without legalization marijuana “can grow at a compound annual growth rate of 30% between 2016 and 2020, resulting in $22 billion in legal sales by 2020.”[1]  With investors lined up and ready to join the green rush in anticipation of a legislative overhaul on the state and federal level, it is essential to consider all of the risks associated with the possible investment of capital in the marijuana industry.  In addition to industry specific risks, there are other factors to contemplate as part of an investor’s due diligence before investing in marijuana stocks.

As part of a public company’s reporting requirements in a Form 10-K[2], Item 1A, entitled “Risk Factors”, provides information about the most significant risks to the company or its securities.  Companies tend to list risk factors in order of importance and focus on the risks themselves rather than how they are addressing those risks.  Some of the risks apply to the entire economy, while others may only apply to the company’s industry sector, geographic region, or only to the company specifically.[3]

A search of some public marijuana companies’ filings will yield industry specific risk factors including: (i) the company’s limited operating history may make it difficult to predict future performance; (ii) intense competition associated with the marijuana industry; (iii) inability to manage growth and improve operational, financial, and management systems; (iv) drop in the retail price of medical marijuana products; (v) federal regulation and enforcement may adversely affect the implementation of medical marijuana laws and regulations; and (vi) variations in state and local regulation, and enforcement in states that have legalized medical cannabis.[4]

Another concern investors should consider is that a majority of marijuana related stocks are traded on Over-the-Counter (OTC) exchanges as penny stocks.  The Securities and Exchange Commission (the “SEC”) has adopted Rule 15g-9 which generally defines “penny stock” to be any equity security that has a market price (as defined) less than $5.00 per share or an exercise price of less than $5.00 per share, subject to certain exceptions.[5]  The price of many marijuana related companies’ common stock is significantly less than $5.00 per share, and are therefore considered “penny stocks.”  Despite enhanced reporting and disclosure requirements that have developed over the past few years, many investors continue to be victimized by penny stock scams.  It is thus imperative to conduct extensive due diligence before buying a stock.  Some items to consider when conducting due diligence are the company’s management (past record, credentials, experience, accomplishments of individuals) and whether there is an employment agreement to secure the management team long term.

A thorough analysis of the company’s financial statements should be conducted as well.  Evaluate the company’s “Burn Rate.”  A Burn Rate is a measure of negative cash flow or the rate at which a new company uses up its venture capital to finance overhead before generating positive cash flow from operations.  Burn rate is usually calculated by examining the amount of cash spent per month.[6]  Virtually all of these marijuana companies have a negative cash flow.  This negative cash flow is partly due to the transience of the industry and the draconian federal tax imposed on marijuana businesses.  Determining whether a company will be able to sustain its operations notwithstanding its burn rate, while no simple task, is something the prudent investor must factor into its decision.

An additional problem plaguing the marijuana industry is found under Section 280(e) of the tax code.  Pursuant to this section, businesses that are “trafficking in controlled substances” that are prohibited by federal law may not claim tax deductions and credits available to regular businesses, such as deducting rent, utilities, and employee related expenses.[7]  Promulgated by Congress in 1982, Section 280E was enacted to prevent drug dealers from benefitting from business expense deductions on public policy grounds.[8]  Section 280E may, in some instances, require marijuana businesses to pay an effective tax rate as high as 70%, as opposed to the more traditional 30% rate.[9]  The current tax policies inhibiting the growth of the marijuana industry is something that investors should keep an eye on as well.

One last macro-issue surrounding investors is predicting the future of this industry.  In countries like Israel, medical cannabis is slated to hit pharmacy shelves in Israel in the form of cigarettes, cookies and oil.[10]  This begs the question of whether large pharmacy retailers in the U.S. will eventually be granted the same ability.  If so, small or even medium sized medical marijuana dispensaries may find themselves in a difficult position in competing with the CVS’s and Walgreens of the current pharmaceutical industry.

As evidenced by the various risks and issues surrounding the industry as a whole, investors should do their homework before investing in marijuana companies.  The prudent investor should conduct more due diligence than would typically be done when investing in other industries.  However, with some even comparing the potential investment opportunity surrounding the current state of the industry to that of the opportunity to invest in alcohol after Prohibition ended[11], the extra diligence could be worth the trouble.

[1] Sean Williams, Read This Before You Buy Any Marijuana Stocks, The Motley Fool, Mar. 14, 2016, http://www.fool.com/investing/general/2016/03/14/read-this-before-you-buy-any-marijuana-stocks.aspx

[2] The federal securities laws require public companies to disclose information on an ongoing basis.  The SEC requires public companies to submit annual reports on Form 10-K and quarterly reports on Form 10-Q, which provides a comprehensive overview of the company’s business and financial condition and includes audited financial statements.  Securities and Exchange Commission, Fast Answers: Form 10-K, (Last visited Apr. 9 2016) https://www.sec.gov/answers/form10k.htm

[3] Id.

[4] Terra Tech Corp., Annual Report (Form 10-K) (Mar. 29, 2016).

[5] Securities and Exchange Commission, Fast Answers: Penny Stock Rules, (Last visited Apr. 9 2016) https://www.sec.gov/answers/penny.htm

[6] Investopedia , Burn Rate: ‘What is Burn Rate’, (Last visited Apr. 9 2016) http://www.investopedia.com/terms/b/burnrate.asp

[7] Thor Benson, Up In Smoke: Feds Slap 70% Tax on Legal Marijuana Businesses, The Daily Beast Apr. 9, 2016, http://www.thedailybeast.com/articles/2016/02/18/feds-slap-70-tax-on-legal-marijuana-businesses.html

[8] Edward J. Roche, Jr., Federal Income Taxation of Medical Marijuana Business, 66 Tax L. 429, 437 (2013).

[9] Id.

[10] Sue Surkes, Medical cannabis set to hit pharmacy shelves, The Times of Israel, Jan. 12, 2016, http://www.timesofisrael.com/medical-cannabis-set-to-hit-pharmacy-shelves/

[11] Venture capitalist and investor Kevin O’Leary has said “he’s torn between what’s like ‘getting an opportunity to get into alcohol after Prohibition just ended’ and the possible downside of running afoul of the federal government.” Matthew J. Belvedere, Legal pot like ‘alcohol after Prohibition’: O’Leary, CNBC, Feb. 26, 2014, http://www.cnbc.com/2014/02/26/legal-pot-like-alcohol-after-prohibition-oleary.html

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