In 2017, as Canada and California both hurtled toward their first legal adult-use cannabis stores, there was no hotter investment than cannabis. Investment articles teased “game-changing” investments, while others touted the coming of the cannabis “green rush.”
Five years later, there are many sour attitudes from cannabis investors who saw some of their stocks slide to 1/20th of their peak even as the stock market was enjoying a broad rally. The sell-off is even more perplexing as states like New York and New Jersey prepare for commercial sales, with the prospects of Ohio and Florida not too far behind. According to recent projections, the market could reach $72 billion by 2030. There must still be value here, right?
In short, there are still massively good investments in cannabis. However, evaluating a cannabis venture is tricky. An investor should consider all of the standard metrics for making a good investment (EBIDTA, TAM, churn, etc.). Still, cannabis businesses exist in a tricky landscape. Arguably no other investment is as connected to a shifting regulatory landscape as cannabis.
Before investing in a cannabis, the investor should consider whether the business has what I will refer to as “regulatory resiliency,” which is the ability of a business to survive under multiple regulatory scenarios. To answer whether a company has regulatory resiliency, I ask the following questions:
1. Does the business model require specific regulatory permission to operate? Worse, is the model betting that the regulatory system will require its services? Many good ideas in cannabis fail because they are reliant on the regulatory system to actively endorse its business model. Eaze, one of the first cannabis delivery companies in the nation, relied on a specific way of delivering cannabis. Essentially, it needed the “ice cream truck” delivery system. Drivers would pick up thousands of dollars worth of cannabis and drive around neighborhoods waiting for customers to use the app.
When the state finally started regulating delivery services, it sought to allow only for an “Amazon model” of delivery. An item is ordered, and the driver can pick it up and deliver it to the customer. Eaze would eventually get its way in California, but the weakness in the model was clear. It would be challenging to scale Eaze from state to state, as it required a very specific regulatory system to thrive. Eaze has pivoted its business model.
Some ideas are even more fragile. More than once, when I was Colorado’s cannabis czar, I was approached by fintech companies about mandating a closed-loop monetary system for all cannabis purchases to solve the cannabis banking problem. The frustration was palpable from these as I told them the myriad reasons why I was not going to mandate their technology. With a few exceptions, it is unlikely that the government will require any specific technology.
If the business model requires regulatory permission to operate, it is not likely to have the regulatory resiliency it needs to survive.
2. Can the company modulate its burn rate depending on the environment? For a while, many cannabis companies believed they were in a “winner take all” or “winner take most” model. They would spend massive amounts to gain regional footprints or be first to market. Then, most of those companies failed. MedMen, once thought to be the powerhouse operator of the cannabis space, watched its fortunes quickly dwindle as the C-suite “aggressively” spent money to try to dominate every market.
The rollout of regulated cannabis is bumpy at best, even in states that pass legalization. California, for instance, has seen regulatory delays, failure to capture the illicit market, and burdensome regulations and tax rates. Illinois spent years in litigation over its licensing process. As states work their way through these growing pains, businesses continue to burn through capital. The pace of legalization and commercialization will remain unpredictable. Smart investors will need to seek out ventures that can modulate their burn (headcount, marketing budget, etc.) based on the current landscape. Otherwise, the venture may not have the regulatory resilience to overcome the fits and starts of cannabis legalization.
3. Does the business model succeed with interstate commerce and legalization? Does it succeed without it? Finally, every investment should be evaluated under two models — one in which legalization and interstate commerce do not come in the next 10 years, and one in which it happens in the next three years.
As it exists today, state-legal cannabis operations must remain in the state. In some cases, that’s a positive for the business model. Having one of the 22 medical cannabis licenses available in Florida, for instance, will likely be lucrative if there is no interstate commerce. In other cases, the lack of interstate commerce may be prohibitive. Many of the operations on the West Coast are having trouble competing against their neighbors who are illegally selling across the country. Even technology is not immune from the effects of interstate commerce. There may be a great fintech that allows for banking cannabis today, but will that model survive when cannabis is legalized federally and a specialized fintech is less necessary? The best investments will have the regulatory resilience to be profitable in both worlds.
Maybe investors were inadvertently right to see cannabis as akin to the gold rush, where many lost their life savings following rumors and dreams. Still, cannabis remains a potentially lucrative opportunity, and there is a rational way to mitigate risk here. Companies that can survive and thrive as the regulatory system goes through its infancy should be great investments when the market matures. Some should even be unicorns.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.