Marijuana Industry

Investing in the Legal Marijuana Industry: Opportunities, Risks and More Risks

Our engagements in connection with Colorado and Arizona marijuana businesses offer a first-hand confirmation of the cannabis industry’s business opportunities and unique challenges.

A Growing Industry (Pun Intended)
Regardless of your personal stance on the morals and practicality of legalizing marijuana, there is no denying the nationwide trend toward legalization. In the wake of the November 2016 elections, eight states and the District of Columbia allow (or will soon allow) recreational use, and passage of California’s ballot measure could be a “tipping point,” prompting other states to follow California’s lead.
The cannabis industry is on a pace to grow from virtually nothing to tens of billions of dollars in revenues in just a few short years. In contrast to other rapid-growth industries, the projected explosive growth in recreational marijuana is not the result of any technological innovation or discovery, but simply the result of changing societal attitudes.
Kotzin Valuation Partners is familiar with the cannabis industry, having been engaged on various assignments to offer appraisal or consulting services for dispensaries and ancillary businesses. Our experience suggests that the industry is unique in many respects, offering challenges that, from the perspective of a business owner, investor or valuation professional, are both frustrating and intriguing.
If you provide professional services to clients in Arizona but have not yet had any dealings with the cannabis industry, that will likely change in the coming years. This article explores the unique issues associated with legalized marijuana (both medical and recreational), especially from the perspective of estimating the value of an operation or considering an investment opportunity in a marijuana business.

Opportunities, Risks and Value Drivers

According to a February 2016 Fortune magazine article, legalized marijuana in the U.S. will reach $6.7 billion in revenues in 2016 (up from $5.4 billion in 2015) and, according to one industry resource, is estimated to reach $21.8 billion by 2020. Expressed in those terms, the business and investment opportunity speaks for itself.
However, some perspective is in order, from both ends of the opportunity spectrum.
First, the ability of any individual or entity to be directly involved in the sale of the product will be governed largely by state licensure. While some legalization opponents contend that licensed marijuana businesses will have a “monopoly,” the merits of such an argument are dubious at best, as few people would accuse an owner of a similarly licensed bar, liquor store or pharmacy of monopolistic practices.
Additionally, many people assume that having a license to operate a marijuana dispensary is a “golden ticket” to automatic riches. That assertion, too, is flawed, as profitability and ultimate business success will still be subject to adequate capitalization, sound business practices and, as we are seeing in Colorado, the law of supply and demand.
Examples. In Colorado (population 5.4 million in 2014), where Kotzin Valuation Partners has performed valuation analyses of marijuana businesses, the ratio of citizens to marijuana dispensaries is approximately 7,700 to 1. Marijuana is legally sold at approximately 700 establishments – more than the number of McDonald’s, Starbucks and 7-Eleven stores combined – with many dispensaries struggling to make a profit.
In contrast, Washington State (population 7.1 million), which also has legalized recreational marijuana, has a significantly higher citizen-to-dispensary ratio, of about 17,200 to 1, providing a more favorable competitive environment for that state’s licensed sellers and investors.
Other Risks
Knowledge of an industry's prospects and risks are an important part of the valuation process. No business can be valued in a vacuum, as the performance of a business is dependent on industry trends and other external factors. This is especially relevant in the marijuana industry, as a myriad of industry-specific risks and uncertainties need to be incorporated into the valuation process.
Beyond competitive issues, several factors need to be considered when valuing or considering an investment in a marijuana dispensary.
Under federal law, marijuana (recreational or medical) remains classified as a Schedule I substance – technically illegal. The Obama administration has publicly stated its policy of not enforcing the federal law in states that have legalized its use, but this policy could change under the next president.
In an odd twist, the illegality of the product at the federal level also provides some benefit to current and prospective growers and dispensary owners, as it discourages the major national pharmaceutical and tobacco companies and national retailers from entering the industry. If the federal government lifts its illegal classification, the small-time operator in the cannabis industry may be forced out by Big Drug or Big Tobacco. Just one more risk to think about.
However, for now, the continued classification as an illegal drug under federal law is a catalyst for a host of other risks.
First, most banks and credit card issuers want to have nothing to do with the industry, due to concerns over enforcement at the federal level and fears that they will fall victim to charges of money laundering or other alleged felonies. Consequently, most dispensaries operate in an “all cash” environment, which makes each operation more susceptible to crimes by employees or outsiders.
Further, the banking industry’s reluctance to accept this industry makes it harder for potential marijuana businesses to purchase real estate, due to a shortage of lenders. Similarly, it is often difficult to persuade a potential landlord to lease space, as the landlord may worry about seizure of his or her property. The good news for operators is that limited banking options are reportedly evolving, although at a slow pace, in both Colorado and Washington.
The illegality of marijuana at the federal level also presents serious problems with respect to paying income taxes. Internal Revenue Code Section 280E disallows deductions incurred in the trafficking of controlled substances prohibited by federal law. Presently, the only expenses that are deductible for income tax reporting purposes are those costs directly involved in producing the product. Any costs related to the sale of the product (e.g., dispensary rent, retail labor, advertising, and operating costs) are not deductible. As a result, dispensary owners that abide by these regulations can end up paying taxes at a rate of 80% or more of their actual profits.
Advertising is another concern, as options are limited. Even social media sites such as Facebook do not allow dispensaries to post company sites or otherwise advertise. At the time this article was written, only two major online resources – Weedmaps and Leafly – allow dispensary owners to advertise their products and promotions, and having a presence on those sites can be very pricy. That may change as the industry continues to evolve and new options emerge.
Conclusion
This article merely touches the surface of the unique factors the pose challenges to would-be participants in the cannabis industry, and to investors and valuation professionals seeking to establish business value.
The marijuana industry is rife with both opportunities and risk. For small business owners that can tolerate risk, significant tax bills, heavy regulatory scrutiny, and a lingering moral stigma, an efficient operator with good locations can make significant returns.
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