I’d like to talk briefly about the importance of due diligence. The term is thrown around a lot, but what does it mean and why does it matter?
Due diligence is, at heart, learning. Whether you’re an investor or a buyer, you’re asking questions to learn about the target (the company you’re buying or in which you’re investing) and make sure you’re getting what you expect, you’re getting what you’re being told you’re getting, and you’re satisfied with it. If any of those aren’t true, you can reduce the amount you pay, you can be indemnified (like a guarantee) for the risk, you can walk from the opportunity, or you can accept the risk as-is.
But, you may ask, I’ve got an investment or acquisition agreement full of pages and pages of densely-worded representations and warranties telling me all about the target, so why do I need to also spend time and money reviewing information about the target? Chiefly, you’re better off finding out about the target’s defects before you send them money or acquire them – it’s much harder (and more expensive) to deal with the fact that you were lied to (a “breach” of the representations) after the deal closes. Also, you may not be in a position to evaluate the strength and breadth of the representations, let alone negotiate them.
Why am I raising this point now? Well, the U.S. Securities and Exchange Commission just filed a complaint accusing a group of fraudulently raising $25 million from investors in alleged cannabis operations. (link) Among other things, the SEC is alleging that the defendants failed to disclose key facts about existing liens on the assets and loans taken out, as well as relevant facts about the operators. Securities law generally requires disclosure of material facts to potential investors (note: I’m grossly oversimplifying the rule here).
I don’t know whether the investors here were offered or conducted due diligence, and I’m not suggesting that they didn’t. I’m instead using this news to highlight the broader point that asking questions and getting answers are always fundamental to doing deals, perhaps even more so in an industry that operates in the quantum mechanics-like duality of illegality and heightened regulation (link). Due diligence can be expensive and is typically thankless, but it’s sort of like insurance – you don’t need it except when you do, and you can’t predict when you’re gonna need it.