There is no shortage of arguments for investing in California's legal cannabis industry especially before valuations rise even higher. From the Orange County Register:
"If Californians legalize marijuana under Proposition 64 in November, legal cannabis sales in the state likely will climb by $1.6 billion within the first year of implementation, according to a report released Tuesday. That would put the state’s medical and recreational market on track to hit $6.5 billion in revenue by 2020 – up from $2.8 billion in 2015..."
From Bloomberg News:
“A 24 percent, 10-year revenue compound annual growth rate [for national cannabis sales] is hard to find in consumer staples, in particular one with a $50-plus billion end-point."
Very few industries ever experience this level of sustained growth. That said, potential investors need to understand that associated with this upside are enormous risks unique to the legal cannabis industry that must be factored into any investment decision. Among them:
- Risks of Federal Enforcement of the Controlled Substances Act
- Challenges presented by Federal Prohibition
- Complexities of Pre-MCRSA Business Structures
- Uncertainty of what will happen in 2018
- Uncertain tax rates going forward
- Intensive competition & dropping prices
- Potential for investor fraud
- Consumer and worker protections
- Passage of California Proposition 64
I. Risk of federal enforcement
The first thing to understand is that despite the significant legalization gains at the state level cannabis remains illegal under federal law. Twenty years after California's Prop 215, cannabis (medical or otherwise) remains illegal in the United States and yes this includes Colorado, Oregon, Washington and every other state that has "legalized" marijuana in any form. States can't change federal laws but they are not required to enforce them. During the Obama administration there has been largely a policy of "hands off" of federal enforcement of the Controlled Substances Act in states with sufficiently robust regulations. States such as Colorado and Oregon have vigorous regulations, California however does not.
California's cannabis industry currently operates under a combination of Prop 215, SB 420 and the so-called "Attorney General Guidelines." The above collectively serve more as defenses to criminal prosecution than as a proper set of industry licenses, rules, and regulations. Hence there remains a risk that the federal government could step in and enforce federal laws on individuals and companies in Californian regardless of how compliant they might be with the state's Prop 215, etc. In short, there is a difference between legality and enforcement. When it comes to federal law, the current climate is about lack of enforcement not legality.
This risk will be significantly reduced in California in 2018 (though some don't think this will start until sometime in 2019) when California's state cannabis business licensing begins under "MCRSA". Having a license issued by local government (county or municipality) is yet another mitigating factor since the majority of enforcement happens at the local level. You are not alone if you are confused by all of this. You may have read that the 9th Court of Appeals recently ruled conclusively that the DEA is prohibited from using federal funds to enforce the Controlled Substances Act against individuals and companies in California (and eight other western states) who are in compliance with state law. This certainly reduces the risk of federal intervention but, as noted above, California state law is confusing (make that convoluted) making it very easy for companies that look compliant with state law to in fact be in violation of some aspect of it. Investors need to understand that the legal risks will remain until there is a change in federal law.
II. Challenges presented by federal prohibition
The problems presented by the Controlled Substances Act go beyond DEA enforcement. Federal illegality also means that federal institutions such as bankruptcy courts, U.S. Patent & Trademark Office, and federally-regulated banks are either barred or significantly limited in the way that they can deal with cannabis businesses -- no matter how legally they may be operating in their respective states.
From Cannalawblog: "Bankruptcy courts do not allow marijuana businesses to file for bankruptcy to avoid tax liabilities by reorganizing their businesses or liquidating their assets. This means those taxes will stay with the business and may even follow you personally if you ultimately decide to shut it down. Some taxes, like state sales and payroll taxes, are always the responsibility of the business owners, which means that if liabilities are assessed, the state can come after your personal accounts and assets to collect. Tax audits in the cannabis industry often result in hundreds of thousands of dollars in tax liabilities even when tax returns are filed with the best intentions. Shoddy record keeping and reliance on poor tax advice are not excuses for failure to pay taxes due."
Another important federal institution for entrepreneurs and their investors is the USPTO, which can provide protection for intellectual property such as trademarks and patents. In general, because of the CSA the PTO will not issue trademarks or patents for cannabis goods. As a consequence, companies will sometimes try to gain at least a little protection for their brand by getting a trademark for an ancillary good and/or getting a state issued trademark. Neither of these are true substitutes for federally recognized protection of a company's primary brand and even state level trademark protection is not currently available for California cannabis companies.
With regard to possessing a bank account, there are significant challenges for businesses that deal with cannabis. The Financial Crimes Enforcement Network ("FinCEN") puts onus on the banks to insure that their customers (and thus the source of those customers' deposits) are fully legal. The banks are expected to preform due diligence on their customers, including:
- Customer identification and verification;
- Beneficial ownership identification and verification;
- Understanding the nature and purpose of customer relationships to develop a customer risk profile; and
- Ongoing monitoring for reporting suspicious transactions and, on a risk-basis, maintaining and updating customer information.
Since there are harsh rules for violating these most banks don't want to take the risk by opening an account with a cannabis company. Consequently many if not most cannabis-related businesses conduct the majority of their business completely in cash. Since these businesses can do millions of dollars of revenue, it means that large sums of cash are being shuttled back and forth to vendors, employees, and even tax authorities. It is both costly and risky to be dealing with such large sums on a regular basis.
III. Challenges of pre-MCRSA business structures
When investing in a typical (that is non-cannabis) company, investors can look to hundreds of years of laws to clarify rights, responsibilities of every aspect of conducting business from forming entities to shutting them down. Investors still have to try and pick the winners from the losers but at least the rules of the game are well understood. Not so in the cannabis industry. Instead of operating with typical corporate structures (C-Corps, S-Corps, LLCs, etc.), cannabis business in California operate as "mutual benefit corporations," agricultural cooperatives, and other such non-profit structures. While the goal of typical (that is non-cannabis) businesses is to generate a profit for its founders and investors, cannabis businesses in California are prohibited from making profits. This is obviously an issue for investors since why would they invest in a company that is barred from making money?
From the Cannalawblog: "When dealing with nonprofits, there is no concept of equity, period. Nonprofits do not have owners, partners, or shareholders. They can though have directors, officers, and salaried employees. This means that it simply is not possible to invest in or buy or sell a nonprofit entity. But because of shoddy legal advice or straight up shady dealings, we have seen (and we are continuing to see) all sorts of “deals” involving the buying and selling of California nonprofits."
The Cannalawblog notes that despite these restrictions investments and purchases are still being made. However, they typically involve a combination of for-profit management entities, IP holding companies, side deals, and other mechanisms intended to navigating the profitability prohibitions. If this sounds confusing and potentially risky, it is.
There have been efforts to fix the profit issue (including a recently vetoed bill by California's governor) and most expect that it will be corrected in the coming year. However until this happens investors will have to rely on very clever attorneys and accountants to figure out ways to construct layers of intertwined companies with side letters, licensing agreements, and so forth. Far from ideal.
It's worth noting that the above issues relate only to businesses that "touch the plant." Companies that provide technology or other services that are not involved directly with marijuana creation or distribution have far fewer obstacles and are not barred from seeking a profit. However even these companies face possible legal risks (including prosecution) and business hassles (e.g., losing a bank account) for their involvement with an industry still viewed illegal by the federal government.
IV. Uncertainty of what will happen in 2018
Even though MCRSA lays the groundwork for state licensing and regulations (see our analysis here), the specific implementation of MCRSA has yet to be determined. Above we talk about the risks of investors operating under pre-MCRSA, however a potentially greater risk is what happens after MCRSA. What happens to a company that fails to obtain a state license? (Answer: It will close). What happens to businesses that can't afford to comply with state regulations that haven't been established yet? (Answer: They will be forced to close.). For example, cultivators could find that the type of equipment they have been using for years is no longer permitted under MCRSA. They either make the necessary investments to implement the changes or they close.
Besides all of the questions about licensing and compliance, there are also questions about distribution under MCRSA. MCRSA establishes a "three-tiered" distribution model putting a third party distributor in-between organizations that grow and/or make cannabis products and the dispensaries that sell them. But the specific implementation of this is still far from clear. At a recent "pre-regulatory" meeting with incoming state regulators on MCRSA licensing, there were far more questions than answers. Since distribution is one of the most vital aspects of a supply chain, this is far from comforting.
The end result is that anyone investing in a cannabis business needs to understand that many of the assumptions made in any financial model are going to be subject to significant change. For example, a cultivator who raises money on the basis of their current financial performance could, in coming years, find themselves having to turn their sales over to a third-party distributor (who then takes a significant cut of revenues) as well as being subjected to significant compliance investments as mandated by future regulations. Even tax rates (see below) are evolving and likely to only go up.
IV. Uncertain tax rates going forward
One of the strongest arguments for legalization is the revenues that will be generated by new taxes. How much these taxes will end up being (at both the state and local level) is anyone's guess. (There are a reported 62 marijuana-related ballot initiatives throughout California this November with many of these involving taxation. Because taxes require voter approval, this is a process that will be played out over the next several years. It is possible that one could invest in a company expecting one tax rate and then a few years later be subjected to a much higher one. Worse one could invest in a company with a local tax rate of 15% while the competitor down the road finds themselves in a jurisdiction with a local tax rate of 5% putting your company at a significant competitive disadvantage.
V. Intense competition / dropping prices
It'd be natural to think that the silver lining of all of the risks and impediments listed above would be to scare off potential competition. This is true, but that is not to say that the cannabis industry isn't already a very competitive market on its way to being an extremely competitive market. Despite its risks and challenges essentially every aspect of the cannabis industry is seeing a flood of new entrants and investment dollars. Yes the industry is growing quickly but so are the number of people trying to get their slice of it. A result of the increase in competition is dropping wholesale prices. Both Washington State and Colorado are experiencing price drops of roughly 25% per year (see our analysis here). The result will require managers to navigate two difficult trends: increasing costs (& taxes) and dropping prices.
Much like the dot-com era of the late 1990s / early 2000s, while a great deal of value and wealth will be created in the cannabis industry much of it will go to a small group of winners with more people losing money than making it.
VI. Potential for investor fraud
Due to a variety of factors would-be cannabis-business investors need to be wary of being duped. Reasons include: a) Lack of established investors who can take lead in doing due diligence, b) Desire of participants to rush into deals to avoid missing out on the "green rush"; and c) Unscrupulous individuals seeking to capitalize on the above.
Some of the most notorious fraud has been with public securities. ("pump & dump") but with privately-help business fraud is likely much greater. Investing in any kind of private business will involve risk. But with a popular market like marijuana, fraud is going to be even more prevalent. In 2014, the SEC suspended five marijuana-related tickers for fraud, stating that "fraudsters often exploit the latest innovation, technology, product, or growth industry—in this case, marijuana—to lure investors with the promise of high returns."
VII. Consumer & Worker Protections
For a variety of reasons, cannabis businesses have not experienced the level of scrutiny afforded other businesses on regulatory matters such as working conditions of their factories & farms (Cal OSHA), labeling (FTC), and product liability (think several thousand attorneys only too happy to file class action lawsuits for faulty products). Consumer and worker protections have lagged but will catch up. Cannabis businesses who to date have largely worried about police raids will increasingly need to worry about the Department of Health not to mention selling products that are making false claims and/or are improperly labeled. These are all significant positives for the safety and growth of the industry but given the general absence of best practices for dealing with such things (not to mention a general lack of product liability insurance), entrepreneurs and their investors must consider this as a very real risk factor.
VII. Passage of California Proposition 64
On Tuesday November 8th, Californians will vote on Proposition 64, which would legalize adult use of marijuana in the state. Like MCRSA, there are many questions about how it will be implemented and the impact on existing cannabis businesses (so much so that many current medical cannabis business owners say that they will vote against it). One significant example is that Prop 64 is essentially silent on distribution. Said one state regulator on what this means, "It's anyone's guess."
It is true that the legal cannabis industry is creating one of the most attractive investment and business opportunities in decades. But with such an opportunity come significant and unique risks that must be weighted into any investment decision. Don't skimp on due diligence. Caveat emptor.