While the last few years could reasonably be described as chaotic for our industry, we are looking at the coming months and years as the time for cannabis companies to establish more organized and structured practices and focus on the fundamentals of running their businesses. One good reason for greater focus: an increase in the role of private equity, venture capital, and family offices within the cannabis industry.
Last year, we watched public stock prices fluctuate like a roller coaster in anticipation of favorable legislation and the prospect of expansions. In the short term, the federal government’s stance on the legalization of cannabis is likely to be unchanged. Given the amount of federal stimulus spending and income tax revenue being generated by IRS Section 280e, it would be surprising to see the Biden administration walk away from 280e into a scheduled environment without some industry-specific tax or fees.
With the influx of capital into the industry, we are seeing a greater number of cultivation and processing facilities moving from the developmental stages into partial or full production . These scenarios are in contrast to the historic environment of companies wheeling and dealing but without sufficient capital for making serious deals or executing their strategies. Investors and stakeholders are showing an increased interest in an industry that boomed during the COVID-19 pandemic as many states determined cannabis-related businesses to be an essential business. This essential business status enabled them to remain open and profitable as well as provide medical field workers primary access to dosages of the vaccines. The pandemic strengthened the already strong companies, kept others afloat that were on the brink between being successful and imploding, and put others out of business. These factors, combined with the increase in merger and acquisition (M&A) activity and an infusion of capital, has created an industry ripe for explosive growth.
Focusing on the Fundamentals
Industry growth in 2021 will be fostered by enhanced access to the “big three”: banking, capital, and human capital. Taking advantage of those opportunities will require companies to shift their focus to business fundamentals. The stronger companies typically already have a higher level of self-awareness. They realize that documented processes, procedures and financial modeling meant something in their license application stage but are also things to pay attention to in their operational stage due to the role of cash. Cash is king in the cannabis industry. Companies in the cannabis industry have the opportunity to position themselves as acquirers or as potential targets to be rolled into another company’s platform. Both sides of that equation still need to focus on fundamentals.
Cannabis is a commodity. That fact will change in the future as true national brands are developed over the next few years. In any commodity market, those with economies of scale are aware that the lowest cost producers typically win. Many companies functioned throughout 2020 without knowing their costs, or if those costs were truly aligned with their business strategy. While focused on their immediate opportunities for growth, most companies didn’t invest in their back offices and recruiting employees with an understanding of the fundamentals of accounting and finance. Internal and external financial reporting drive everything for a business, especially in this new era of the cannabis industry where the expertise and sophistication of investors is increasing daily within the competitive capital market.
Companies and their investors must understand their true production costs and contribution margin. For example, when flower is selling for $2,500 per pound and production cost is $1,000 per pound, that is an acceptable model for a profitable outcome. This spread needs to be tracked and adjusted as the market determines the price. But as a commodity in most state legal markets, cannabis prices will fall when there is more supply than demand and additional supply is becoming available daily. The hope is consumers will want to do buy goods from a legal company as opposed to from the black market due to products being consistently of a higher quality and priced fairly. As stabilization of prices within state legal markets continues over the next few years, we will see more roll-up, merger, and acquisition opportunities—and a maturing industry over the next three to five years.
Additionally, stronger companies will focus on refining their current cost models, not so much to be the lowest cost producer, but the lowest cost within the demographics they target. In many ways, cannabis is like wine. Both industries offer a selection of products to satisfy different palates. In cannabis, there is a small market of consumers of ultra-high THC content; much like hundred-dollar-a-bottle wines. However, the sweet spot, the much bigger market, is the twenty-dollar-a-bottle cabernet or chardonnay crowd. Strong companies can focus on the larger market, focus on the cost model, and create huge profits. That tipping point is when cannabis consumption becomes an acceptable social activity—like a bottle of wine with dinner on a Friday night.
More Sophisticated Capital
The sophistication of the capital coming into the market over the last five years has increased exponentially. Early on, companies were getting money from friends and family-like investors and deals were done with a handshake. Now we have more options: venture capital, private equity, and family office groups. Where you once needed 30 or 40 investors to raise $20 million, that amount of capital is now available from one source.
Private equity groups are comprised of experienced financial professionals looking for a business that understands its industry, its local market, and its financial condition and operational metrics. Younger cannabis entrepreneurs with less experience with high-level finance will need the support of a professional with industry experience to bridge that gap.
Most cannabis entrepreneurs understand operations. They do not necessarily understand supply chain management, finance or other key business areas. To be more competitive, businesses will need more knowledgeable human capital. It is difficult to attract skilled people to a federally illegal start-up that doesn’t offer traditional fringe benefits like a 401(k), incentive compensation models, executive bonus plans, or cafeteria plans. These skilled professionals enjoy the stability associated with traditional industries; they see the cannabis business as too risky a career choice. Greater compensation for an open position alone does not necessarily bring in a more qualified candidate. Companies may have to review their compensation packages to attract high performers who require both higher compensation and a benefits package to remain motivated, let alone make a career move from a low-risk to a higher-risk business.
Systems, Processes, and Procedures
An environment characterized by greater access to capital, a path to de-scheduling in three or four years, and the potential for interstate commerce will lead to increased M&A activity. M&A professionals will want to see documented and implemented procedures and systems implemented internally to make their due diligence process more in-depth, efficient, and effective.
Many professionals have shifted their focus recently to building national brands. Most joint venture and M&A activity has focused on branding. Building a mature brand is a five-to-ten-year process. When management’s attention is diverted to brand building, it runs the risk of losing focus on the operation’s effectiveness and the financial results.
To thrive, cannabis companies should focus on the fundamentals when operating their businesses. Being proactive about growth and staying focused on what keeps a business successful are not just necessary, they are essential. Business owners need to monitor production costs and their yields while providing the products being demanded by consumers at a competitive market price. Otherwise, what looks like a profitable and growing cannabis company from the outside to some, might soon deplete its resources and be forced to close its doors.
About the author:
Nick Odille is a Principal in the Youngstown, Ohio office of HBK CPAs & Consultants. Since 2015 he has specialized in financial consulting and services to business owners and operators in the cannabis, industrial hemp and CBD industry. In addition to, he has provided assurance, tax, accounting, due diligence and consulting services encompassing the feasibility, structuring, application, startup phases and post revenue operation consulting for clients in the US, Canada and European markets.
About HBK Cannabis Industry Group:
The HBK Cannabis Industry Group is a dedicated team of CPAs within HBK CPAs & Consultants, an Accounting Today Top 100 CPA firm. We serve businesses in all cannabis industry segments—cultivators, processors, retailers—from single facility to multi-location and integrated operations. We counsel owners, management and investors in multiples states and countries, connecting operators with investment bankers and helping them with key financial activities: from planning for start-ups to facilitating M&A; from pre-offering projections, state applications and licensing to fund raising to management planning and operations.
This article was originally published as part of Lido Consulting's Spring 2021 newsletter.
