Investing in a Cannabis Business

I am not a marijuana prude. I was in college in the 1960s.  I enjoyed it at the time but that is not a reason to invest in cannabis… or not to.

When I was in my 20’s and 30’s my closest friend was a major player in the drug paraphernalia business.  He sold high-end pipes, lighters, incense and stash boxes, wholesale, to boutiques and head shops around the US. I did a little bit of legal work for him and he, in turn, introduced me to many of the people who were active in the paraphernalia industry.

Today I can get all the marijuana that I might want. I am a cancer patient living in California where medicinal pot is readily available. I can get a card and order from a dispensary. They will deliver it to my home if I wish.

I asked my doctors about marijuana after my last round of chemo thinking that it might help me to regain some of the weight I had lost.  They offered to give me Marinol, a pharmaceutical that is a synthetic form of THC, the active ingredient in cannabis. It improves the appetite but provides no euphoria.  They offered me three  reasons:

First, they told me that the pot that I might get from a dispensary would vary greatly in terms of its THC content.  If doctors prescribe a drug, they want to be able to regulate the dosage. They told me that I could not trust the THC content on the label, as their experience showed it was not often accurate.

They also told me that much of the pot I might acquire at any licensed dispensary was likely to have been treated with pesticides.  A local TV station in San Francisco did a report where they picked up a few samples from several dispensaries and found pesticides in almost all of them.

Finally, there was the unassailable logic: “You just had cancer, why would you want to put smoke in your lungs?”  Yes, I could have ordered pot-infused brownies, but brownies are what I used to eat to come down from the high, so what was the point?

Investing in cannabis and cannabis-related businesses is a very hot item right now. There are dozens of small micro-cap companies that grow marijuana or sell it in states where pot is legal.  There are real estate funds renting agricultural land, warehouses and retail space to growers and dispensaries.  There is also a plethora of hemp and cannabis related oils, creams, dietary supplements and other products available. A hemp based toilet paper is a personal favorite of mine.

Because of my interest in investments and crowdfunding, in particular, I get a lot of questions about investing in cannabis-related businesses.  I generally tell people to invest in something else. I believe that the risks associated with a cannabis company are just too high.

Forgive me for stating the obvious but cannabis is illegal in the US both to possess and to sell.  Just because 28 states have allowed the use of marijuana for medicinal purposes, it is still illegal in those states.  State and federal penitentiaries are full of people who were convicted of selling marijuana.  Arrests are made every day.

The federal government is not currently enforcing existing federal law against small growers and dispensaries opting instead to focus US Justice Department resources on large dealers and drug cartels.  But that policy only started during the last 30 months of the Obama administration.

It is illegal for banks and federally chartered financial institutions to handle the proceeds of marijuana sales. In 2011, the federal government raided two credit unions in Sacramento, California clamping down on financial institutions that ignored that fact.

Several states in which cannabis is legal have attempted to remedy this in a number of ways.  In Colorado, state regulators permitted the creation of a state chartered credit union specifically to handle cannabis related businesses. A federal judge refused to allow the credit union to join the Federal Reserve System so transactions could not be processed.

As a practical matter, dispensaries cannot take checks or credit cards meaning that they accumulate a large amount of cash. They pay their rent in cash and their suppliers, employees, insurance and even their taxes.

Dispensaries and dispensary owners are obvious targets for thieves.  Some dispensary owners apply for concealed carry permits. Many use armored cars, private security and private depositories for the cash that they cannot store elsewhere. Customers, who must carry cash when they visit a dispensary, are also potential targets.

Some growers and dispensary owners establish holding companies or companion businesses to disguise where the cash comes from. You can imagine a dispensary supplying cash to a check-cashing business. But hiding the cash can lead to other problems.

In any business handling a lot of cash, there is always the presumption that some will get skimmed off along the way.  Most states that permit retail cannabis sales are careful to have stringent controls to make certain that they collect their sales taxes. Given that the federal government would still want all dispensaries closed, all that cash opens the door for more scrutiny by the IRS. The IRS is, after all, the way the government closed down Al Capone.

I remember the first Reagan administration when the Attorney General, Ed Meese, wanted to drug test every employee in the country. Test positive for pot and you would be out of a job and likely unemployable.

You cannot listen to the current Attorney General, Jeff Sessions, and honestly believe that he is going to look the other way while America gets high. He has been consistently on the record as being anti-marijuana.  People who believe otherwise have no basis for that belief. Anyone who thinks that the US Justice Department will continue to look the other way has not been listening.

Enforcing marijuana laws also furthers the Attorney General’s policy of rounding up undocumented immigrants. If the police kick down your door without a warrant because they “smelled marijuana as they approached” found no drugs but a cache of stolen property, there is a fair chance that the search might be quashed because you would get your day in court.  If they do the same and find an undocumented immigrant in the home, that immigrant will likely be deported without a day in court or any due process.

There is also the fact that the cannabis business has some nasty competition. Just north of where I live in California, in Humboldt and Mendocino counties there are a large number of pot farms. Some are run by Californians; some are run by drug cartels.  At some point the cartels are going to burn out their more legitimate competitors, or worse.

Finally, there is that fact that many of the cannabis products, oils, creams, etc. are making claims that would make the patent medicine salesmen of the 1880s blush. Cannabis does not cure cancers, autism or hemorrhoids. Call me when a peer reviewed study by a major medical school says otherwise.

One thing that might change the federal government’s thinking about legalization is the amount of tax revenue it might generate.  In states like Colorado, if the sales tax is only 7%, the state gets $70,000 on every $1 million of pot that is sold.  That is roughly the equivalent of the salary of one grade school teacher or one highway patrol officer for a year. Most states that have legalized cannabis charge a higher than 7% sales tax on purchases.

If and when Congress gets around to “fixing” the cannabis market, it is reasonable to assume that high priced lobbyists from the alcohol, tobacco and pharmaceutical industries will cut up the market between themselves.  If Congress approves marijuana sales and production it is likely to do so in a way that large companies will produce packs of 10 or 20 uniform marijuana cigarettes with a US excise tax stamp affixed to every pack in the same way alcohol and tobacco products are sold and taxed.

None of this, not the continued illegality of marijuana, the continued competition from the cartels or the legalization to the large corporations bodes well for the small micro-cap companies that are in the industry now or that are likely to get into the industry in the foreseeable future.  That is why I don’t think investing in one of these small companies is a good idea.

If you really believe that marijuana use will grow substantially in the next few years with 10 or 20 million new users entering the market, I suggest that you consider investing in Pizza Hut, Nabisco or Frito-Lay or perhaps Weight Watchers.  That way no matter which way the cannabis industry grows, your investment portfolio is likely to grow with it.



Crowdfunding- Waving the Red Flag

There are lessons to be learned by crowdfunders from mainstream brokerage firms.  Just about one year ago, when Reg. A+ offerings were just beginning, I wrote two blog articles in which I questioned whether two of the earliest offerings that had been approved by the SEC, Elio Motors and Med-X, were kosher. The Med-X offering was subsequently halted by the SEC for failing to disclose required financial information.  Elio Motors, which was applauded by the crowdfunding industry for separating $17 million from small investors, is teetering on the brink of bankruptcy because it cannot get the government loan it promised but for which it never qualified.

In the ensuing year, a lot of people have told me that these two patently lousy offerings were a result of the immaturity of the crowdfunding industry; just “growing pains”.  So I thought that I would take a look around at some of the current offerings and see if the industry has gotten its act together. Sorry, not yet.

I recently finished preparing the paperwork for a solar energy fund that is conducting an institutional private placement.  I am a fan of renewable energy and I was pleased to see that a crowdfunding portal dedicated to that industry, Gridshare, had opened for business.

Two of the first three offerings listed on that portal are from a company called Pristine Sun.  The company is run by a gentleman named Troy Helming.  Mr. Helming was the subject of two cease and desist orders by the State of Missouri in 2002 and 2005.

The portal is aware of these past transgressions but chose not to require Mr. Helming to disclose them.  Mr. Helming’s biography in the offering covers this time period and leaving out the disclosure is misleading to investors. There were some other questionable things about Mr. Helming’s disclosures that I brought to the attention of the attorney who runs this portal.

The attorney told me that Mr. Helming was a personal friend who “agreed to put an attractive offering on Gridshare to assist us.  Pristine is an outstanding developer of quality projects, notwithstanding Troy’s legal problems in the past.”  I have no reason to doubt this attorney’s word but I still question the non-disclosure.

What he meant by “attractive” was that investors are being paid 20% interest on the loan that they are making to fund one of these projects.  Pristine Sun claims to have over $80 million in assets and cash flow from its over 200 solar projects that generate electricity and money whenever the sun comes up.  I read the 20% return as a red flag. It is significantly higher than the rate that junk bonds pay.

This offering is being made under the new Reg. CF meaning that the securities are being offered to smaller, basically uneducated investors.  If an investor asked my advice, I would wave them off any loan paying 20% interest as a matter of course.  To me, a return that high, coupled with the questionable disclosures about Mr. Helming’s past, is a clear “red flag” from a  due diligence perspective.

Someone asked me to look at the offering for the GreenLeaf Investment Fund (GLIF). This is a Reg. A+ offering that is listed on a platform called CrowdVest. The fund intends to purchase commercial warehouses and rent them to the cannabis industry in states where cannabis is legal.  The website says: “When industrial properties are retrofitted for cannabis cultivation they have shown an increase in value by 5 to 10 times.”

The only research I could find suggested that, in Colorado, re-purposing a warehouse for cannabis cultivation might increase the value by 50%, not 500%. But I am willing to assume that CrowdVest asked the fund to provide support for its advertising.

There are other cannabis related, real estate funds available that are not suggesting that renting to the cannabis industry will increase the property value 5 or 10 times.  Most of those funds are structured as LLCs so that the income that is generated from rents can flow directly to the investors.

The GreenLeaf Investment Fund is structured as a corporation, specifically as a penny stock offering.  There is nothing inherently wrong or illegal about this, but neither is there any obvious reason that this fund should deviate from the norm and not pass the income it will receive to the investors.

The fund certainly spent more on legal fees for a Reg. A+ offering than it would have for a Reg. D offering and I do not believe that it was money well spent.  “CrowdVest shall be entitled to receive an administration fee of $10,000 per month and a one-time consulting and due diligence fee of $125,000 from GLIF that will be due upon completion of the offering.” If CrowdVest did not question the penny stock structure for this offering, I do not think that money was well spent either.

When I wrote about both Elio Motors and Med-X, I was of the opinion that I was looking at two companies that were intent upon scamming investors. That is not the case with either Pristine Sun or the GreenLeaf Investment Fund.  I am not questioning their integrity, just their approach to corporate finance.

When a company is paying 20% to borrow money it is telegraphing the fact that it is not a creditworthy company.  When a company structures itself as a penny stock, a market that has been full of fraudsters over the years, it is saying that it could not structure itself better.  In both cases, the crowdfunding “professionals” at the portal and platform should have set these issuers straight before they released these offerings to the public.

Please do not tell me that the JOBS Act prohibits Title II platforms from giving “advice” to issuers.  As counsel for a platform, I always have a conversation with the attorney representing the issuer and I always ask a lot of questions about the company and the structure of the offering.  The issuer and the platform share a desire to see that all appropriate disclosures are made and that the offering is structured to be well received by investors. Attorneys are always charged with acting to further their clients’ interests.

There are really 3 levels of responsibility in crowdfunding. A registered portal (and the Title II platforms and the issuers) are in the business of selling securities.  They need to appreciate that this is a highly regulated process and they need to take their responsibilities as sellers of securities seriously.

In the first place, there is compliance with the federal securities laws and the myriad rules and regulations that have been enacted by the SEC and FINRA. The primary rule is to not offer securities without full and fair disclosure. The only way that compliance is possible is with a comprehensive due diligence investigation. The portal or platform should also take care to ascertain that the company’s website and other advertising comply with the rules.

Next, offerings need to have practical business plans. FINRA was clear about this when it expelled a portal called uFundingPortal.  FINRA specifically questioned the business plans and the valuations of the companies that listed on this portal.  A portal should be able to evaluate a company’s potential for success at least with the money that they are raising. If a company suggests that they are going to raise $1 million and can cure cancer with that amount of money, I would not expect the offering to be listed on any crowdfunding website.

Finally, an offering should make sense from a corporate financing perspective, which is where the two offerings I discussed above fall short. The portal or platform should appreciate that the size, structure and terms of the offering are important to both the issuer and the investors.

An offering for a real estate fund, a restaurant, a film, a tech company and a company selling consumer products would all likely be structured differently. Companies rarely have the expertise to fashion an offering that investors find attractive which is why many are having trouble selling the offerings and raising the funds that they want.  Portals and platforms should have that expertise available for every offering.

I am constantly amazed how many people operate portals without any real experience dealing with investors.  A Title III portal, because they are dealing with small, inexperienced investors, should always have an experienced broker/dealer compliance person either on staff or on call.  They should also be able to assist companies in structuring and pricing their offering.  They should have marketing people available who understand what excites investors, which is not always the same thing that will excite the end user of the company’s product.

Complying with the rules, funding companies with a better chance of success and structuring offerings in such as way as to benefit both the issuers and investors will lead to more success for the industry and happier investors. This will never happen unless and until the industry steps up.  The way in which the mainstream brokerage firms would approach the same offerings should be a model for the crowdfunding industry.

The mainstream brokerage firms are already beginning to appreciate that they can sell securities to investors from a website without paying sales commissions and make a lot of money doing so.  Unfortunately, until that happens or until the current participants up their game, issuers will continue to have difficulty raising the funds that they need and thousands of investors will lose tens of millions of dollars to bad deals that could have been made better if only the crowdfunding industry would hire people who knew how.