As the legal cannabis industry continues to pick up momentum, safe investments remain tough to find. Investing in any nascent industry carries risk even when you're dealing with honest operators, but if there's a scam artist on the other side of the phone line, then your prospects are even worse.
But with California, Canada and Massachusetts rolling out recreational-pot sales this year and other states such as New Jersey ready to possibly follow suit, the legal cannabis trade offers huge growth. So, brace yourself for more opportunities than ever to step up and place your bets on legal weed -- either through small funding rounds, penny-stock purchases or buying Canadian pot stocks that have recently been in the spotlight.
Recent history serves as a good teacher on how to avoid weed scams, because 2018's flash of interest in pot stocks really amounts to "Green Gold Rush 2.0." The first Green Gold Rush came around 2012, when Colorado and Washington State voters first OK'd legal cannabis sales to adults.
At the time, a plethora of weed-related penny stocks went public through reverse mergers. These names took investors on a wild ride by at first rising many times over, but then losing a collective 97% of their value from peak to trough.
Along the way, the U.S. Securities and Exchange Commission announced trading suspensions in 2014 against five penny stocks for claiming they had operations related to the marijuana industry. Questions had arisen regarding the accuracy of publicly available information about the companies, with two of the five suspected of market manipulation and unlawful securities sales.
The SEC also issued an investor alert with advice that's still relevant today, recommending that investors beware of:
- Trading Suspensions. Beware of any stock with past SEC trading suspensions.
- Promotional 'Spam.' Watch out for any stock recommended via spam showing up in your inbox or fax machine.
- Heavy Insider Ownership. Large holdings by insiders could represent a red flag.
- Laudatory News Releases. Beware of exaggerated press releases about a company's current or future success.
- Do they file with the SEC?
- Do they generate any revenue?
- Do they have sufficient cash or the ability to raise it to fund operations for a year?
- Is management heavily promoting the stock?
Also try to read the company's SEC filings, such as 8-K statements and quarterly reports, to check for any threatening developments.
And remember that as with any penny stock, you might lose your entire investment or have trouble finding a buyer when you want to sell a small weed stock.
Folks looking to buy and hold OTC stocks for years and follow the listing to the Nasdaq or New York Stock Exchange will usually be disappointed. A very low percentage of OTC stocks ever graduate to the large exchanges, although some might eventually merge with a larger player.
Warning Signs for Private Placements
High-net-worth individuals either doing business with cannabis executives or pondering a private placement or ownership stake in cannabis companies also need to be on their guard.
Experts see the riskiest private placements as ones that directly "touch" the plant, such as growers and retailers, as recreational cannabis remains illegal on the federal level and in most states.
Big institutional investors are mostly absent in this space, aiming to avoid any potential violations of U.S. money-laundering laws. Many big investors instead focus on companies that provide services or technology to the space.
Be sure to check online databases maintained by the SEC or state-securities regulators to see if a cannabis business you're thinking of investing in has registered its securities offering.
If the listing isn't registered, red flags to avoid include:
- Big Promises. Watch out for any claim of "guaranteed" high returns.
- Social-Media Contacts. Unrequested solicitations through social media to buy private stock could be suspicious.
- High-Pressure Tactics. Beware of pressure to invest right now, or requests for information about your finances.
Know Your Business Partners
David Feldman, a partner at Duane Morris who helps cannabis companies raise money and go public, said it's key to avoid doing business with the wrong people.
"I've been on Wall Street as a securities lawyer, and so my Wall Street radar is good, [but] my cannabis radar is still developing," he said. "I was surprised by the people I have met who turned out to be shady. Since the business is so new, everybody comes from somewhere else."
Whether the cannabis pros you deal with come from Wall Street, family offices, private-equity firms or someplace more questionable, insiders recommend thorough scrutiny.
"You want to carefully check their backgrounds -- if they have had regulatory problems in the past and what kind of companies they worked for," Feldman said.
Still, the expert said he's been seeing more legitimate investment bankers doing private offerings for cannabis companies, with some bigger players such as family offices writing $25 million checks.
Some high-net-worth investors and family offices will agree to provide funding in the form of debt secured by a weed company's real-estate holdings, like farmland for growing weed. That way, the lender can still get the real estate if the cannabis business itself goes sour.
"That's your downside protection," Feldman said. "You can secure the debt with the real estate."
The Bottom Line
With plenty of potential upside to the weed business, accredited investors continue to circle the space -- but success may not come to all.
"People want to roll the dice and think they'll win," Feldman said. "But it's not a 'golden ticket.'"