Spectre of California Legalization Hangs Heavy Over Early Adopter States

In November 2016, California will have a least one ballot initiative for the legalization of adult use of cannabis. If passed (as expected) it will be a nice benefit for the other states who have adopted similar measures (Alaska, Colorado, Oregon and Washington) in maturing the industry. However the downside to having the country's most populous state (and largest marijuana producer) go legal is that it could easily suck up the majority of the available investment dollars coming into the legal cannabis industry. This is an understandable concern for the following reasons:

1. Investment is very much needed. Legal cannabis is a growing industry (Inc. Magazine calls it the fastest growing industry in the country). Growth industries require capital. This is particularly true in legal marijuana because of the problems with banking (due to federal prohibition) and because of IRS 280E which eliminates most normal business deductions thereby squeezing the margins that could otherwise be reinvested.

2. The amount of available investment capital for marijuana related business is exceedingly small. It's not usual to see a press release trumpeting a new cannabis-focused fund where the capital commitment is in the tens of millions of dollars. Compare this to non-marijuana industries where a fund raising of even a billion dollars (e.g., Technology Crossover Ventures' last several funds) barely earns a press mention and even individual companies can raise hundreds of millions of dollars (e.g., Uber and Spotify).

3. Why would someone invest in a company serving a small market such as Oregon or Alaska when they could invest in a company serving a much larger market (e.g., California)? This is not to say that these states can't be good markets nor that big, successful companies can't be built in them. But investor psychology can be tricky and as we get closer to full legalization in California, companies seeking investment capital will be increasingly forced to explain their "California strategy."

Complicating all of this is the fact that the legal cannabis industry is currently very regional with many limitations on out of state investments or licensing. According to the Cannabist, marijuana business residency ownership requirements began in the early days of regulated pot as a safeguard against investment by foreign drug cartels. And though such fears have largely dissipated, many believe that states are continuing to implement residency requirements because they believe it keeps the industry small and easier to manage. 

There is an additional benefit to states for blocking out-of-state competition (and with it investment) which is to make it easier for the existing industry participants in the black / grey market to succeed as legitimate, licensed businesses. One of the many goals of legalization is to get rid of the black market. However, if the majority of a state's licenses were to go new, out-of-state ventures then one of the most important benefits of legalization (taxation and control) would be lost. 

Of course there are multiple reasons that individuals and companies on the fringe might want to remain so (with overly burdensome taxes and regulations being the primary ones cited), but putting up barriers on interstate entrants is certainly an easy way to manage too much competition coming on too quickly. Washington state officials estimate that approximately 28% of marijuana sales are happening through the black market. In an attempt to reduce that they are planning on opening up new recreational licenses.

All of this leads to the question of whether regulators would be better off to open their states up to outside investment prior to California's recreational legalization allowing the necessary expansion capital to flow into their states. Again from the Cannabist:

“There’s only so many people willing to invest in this risky and new industry, so allowing people from out of state to become investors in this business … seems like a good idea,” said Colorado Sen. Chris Holbert, R-Parker, and sponsor of a bill to allow out-of-state ownership of marijuana businesses.

By the way, are residency requirements unconstitutional by being a restraint of trade? It may not matter. In the words of one attorney we were talking to about this topic, "Who are you going to call to complain about this, the feds?" In the end, these types of restrictions are likely going to play themselves out over the next several years as the cannabis industry becomes more and more mainstream.

By: Wesley