Photo: Alison Ettel, Founder of Sweet Leaf, presenting at the ArcView Investor Pitch Forum in San Francisco.
Although the due diligence process isn’t exclusive to cannabis businesses, there are a few differences that can make or break your investment deal. Marijuana entrepreneurs need to understand these elements before they start pitching investors if they expect their funding to close (anytime soon). Here are seven tips to survive due diligence for cannabis entrepreneurs.
1. Bring On The Data
The due diligence process is data-driven and the first thing investors will notice about the cannabis industry is the LACK of independent data. This is a young industry–exits and IPOs are almost non-existent. There are few analysts in the space so likely the only data your potential investors will have are the reports from the ArcView Group, Viridian Capital & Research, Marijuana Business Daily, and Signal Bay (that’s a pretty short list for a multi-billion dollar industry).
Your job as the entrepreneur is to pull together as much convincing research as possible. You’ll need to look to analogous industries, such as wine, healthcare, or wellness services to corroborate your value proposition.
2. Get Your Financial Statements Ready & Independently Audited
There is currently some forgiveness of financial naiveté among cannabis entrepreneurs but that time is coming to an end. Even if your company is still in the idea stage, you need a cash flow statement. We all know that every startup’s cash flow statement ends up being wrong but its important you show that you’ve thought it through.
If you’re already operating, audited financial statements are typical in most industries but not the standard yet in cannabis. You’ll stand out to investors by having financial statements independently audited BEFORE you pitch. This can take quite a bit of time and effort to do in the midst of due diligence so get this done ASAP.
3. Make The Due Diligence Process MUTUAL
This is a common mistake of first-time founders. Although all money may be green, all investors are NOT created equal. Many cannabis companies have failed when the investors and entrepreneurs didn’t align as well as they thought they would. Just as the investor has the right to ask you for detailed information on your business, you need to learn a lot about the investor that is backing you.
- Ask for references: The investor should be able to introduce you to founders that they funded in the past and are currently working with. Even better, ask to speak to someone they invested in and the company failed. How people behave when things go bad will tell you everything you need to know.
- Figure out their REAL motivations: Every investor is different and if their motives don’t align with yours, that conflict may kill your company. If the investor wants a quick payout, make sure your project will provide that and you’re ready to align all your strategic decisions with quick returns. If your company is about providing wellness services to epileptic kids, your investor better place that mission above a monetary return. Although investors are always looking for a financial return, a survey of ArcView Group investors found that “social change” was the second most common motivation for cannabis investing.
- What is THEIR financial position?: You want your investors to be your first choice for future investment rounds and you want them to forgive you when you fall short on repayment. The investor’s personal financial position can change all of those negotiations drastically.
4. Become the EXPERT on Your State & Local Marijuana Politics
Cannabis businesses can be wiped out by changes in local regulation and policy. If you’re in the marijuana business, you are now also in the politics business. One of the first things investors should ask you is about the local regulations that will affect your business plan. The second thing they should ask you is how regulations will affect your plans to expand to more locations. You need a complete understanding of where regulations stand today and where they might go tomorrow. Make sure to include political expertise in your management team.
5. Build an Agile, Resilient & Experienced Management Team
Most early stage investments are based on the quality of the management team, not the idea. This industry moves quickly and the team must be ready to pivot with market changes. Here’s what investors are looking for in your management team:
- Parallel Experience: The cannabis industry is young but does your team have deep (read profitable) experience in a parallel industry? If you’re company is all about edibles and there isn’t a chef on your team, investors are going to wonder.
- Range of Expertise: Management teams don’t need many “generalists”. Investors want to know that you have found the top expert in all the areas where you have a competitive difference. Go for deep expertise over five MBAs.
- History of Success: Show that your team members have experience building businesses that produced high returns for investors. Having 30 years of experience in the healthcare space is great but having two previous startups that exited for millions in returns is much better.
- Focus: Does your team want to do everything? Keep that to yourself! Many investors want to know you’re going to accomplish something specific from the start. If your ideas are all over the place, the results will be too.
- Agility: You will have to pivot in this field. Can the team manage fast changes together?
- Resiliency: This industry is tough (and still includes federal prison as a potential consequence).
- Honesty: Smart investors look at HOW your team handles tough questions. Are they clear about what they do or do not know? Will they guess when they should have done more research? Will they claim that they can do it all when they don’t have the experience to prove it? You’re creating an expensive relationship based on trust and your ENTIRE team better be trustworthy.
6. Bring Up Potential Problems EARLY
This applies to every aspect of your proposal. If your idea is “grey area” today, be clear about the regulation challenges and how you plan to change them. If someone on your management team has a criminal record, expect your investor will background check and find that out. You don’t want to be caught looking like you are trying to hide something. If bringing up a problem early eliminates a potential investor then you’ve just saved both of you a lot of time and effort.
7. Understand Your Exit Strategy
Ideally your business plan scales effortlessly nationwide and can be easily acquired or go public to make huge returns for everyone involved. It’s going to be a while before businesses that touch marijuana will be able to make traditional exits so many investors will prioritize ROI in those deals. If you walk into these negotiations explaining that you’re building a business that you want to run forever, the investor will want to structure the deal so she can get out when she’s ready. Understand your exit options and align those with your investors from the beginning.