Investor’s Perspective

Cannabis investing is still the Wild, Wild West, but the right mindset and information can help you succeed as an early investor

In February, Colorado announced that total sales of medical and recreational marijuana surpassed $6 billion since the inception of adult-use marijuana sales in January 2014. A similar story of revenue generation is playing out in other states, like California, Nevada and Washington. Now that hemp is legal nationwide with the passage of the 2018 Farm Bill, things are going to get even crazier from here on out. This is a great time of opportunity for investors: getting in on a rapidly growing, exciting industry with a wide array of product categories that stretches across lifestyle and medical segments.

But reality is a bit murkier. Due to a variety of factors, such as patchwork regulation, inconsistent quality and testing standards, high operational risk and rampant misinformation, cannabis has been historically an under-capitalized sector. There’s also an element of substandard business practices, at times. I know one hemp company that had an investor who accepted unprocessed hemp biomass as collateral. When the company went bankrupt, the investor was left literally holding the bag — hundreds of thousands of dollars of unprocessed hemp, of little residual value.

Here are some core characteristics (and challenges) that are important for every potential cannabis investor to understand before getting their feet wet.

 

Fundraising constraints

Growth in startups is expensive, especially in fast-growing sectors, and cannabis is arguably the fastest growing sector in the world. Overhead in marijuana companies has been historically high. Companies on the cultivation side pay large amounts for capital-intensive cultivation operations. For processing, the required equipment is specialized and expensive. And in retail, restrictive zoning regulations result in high real estate prices.

That means they need capital, and capital is tough to acquire since most institutional investors aren’t yet touching the sector due to its federal illegality. To boot, differing regulations from state to state produce uncertainty and unpredictability that has limited most participants to angel investors and family offices.

There are a few exceptions: Constellation Brands signed a massive deal with Canadian licensed producer Canopy Growth last year; Scotts Miracle Gro has been doing deals for a few years now; GW Pharmaceuticals, more a biotech company than a cannabis player, garnered headlines with the 2018 Food and Drug Administration’s approval of a cannabis-based anti-seizure therapy.

I believe corporate involvement and institutional investment in cannabis will increase over time, but it’s hard to predict at what rate.

Another factor for investors to consider is the higher tax impact of the 280E IRS tax code on margins for companies that touch the plant. If an operator that “touches the plant” pays its entire 280E tax liability, it results in low margins, similar to grocery stores. All of this means that cannabis remains a high risk and underfunded industry, and conservative investors are staying away.

 

Takeaways:

 

The growing pains of testing

On the whole, cannabis-based products are safe, with limited potential for overdose and a lower risk of addiction compared to alcohol, but when states approved the legal use of recreational marijuana, legislators required rigorous regulations and testing. However, the testing of new biological products that aren’t yet regulated by the FDA has had its problems. Oregon’s legal marijuana industry ran into problems when the testing requirements were too stringent, for example. Yet investors need to understand that with any sort of ingestible or topical product, safety should be paramount to the producer. State marijuana regulators are continuing to improve the labeling of products for THC content, but liability remains an issue. Gummies, after all, look like candy to a young child.

There’s also the complexity of testing. Marijuana testing labs are often required by law and regulations to analyze samples for mold, mildew, metals, pesticides, pathogens, other substances and THC levels. The latter is critical for testing in the hemp sector, since to qualify as legal hemp, the product must contain 0.3% THC or less. Measuring those levels is not straightforward, and standardized methods are still in need. The measurement of THC can change depending on what part of the plant or what part of a shipping container is tested.

Take for instance the recent episode in Oklahoma, when in early December a shipment of hemp from Kentucky to Colorado was pulled over for a routine traffic violation. As of early March, it was still under debate whether the shipment is hemp or marijuana, primarily stemming from disagreement about the testing results. Adopting standard methods across different geographies has a long way to go.

 

Takeaways:

 

Confusion around marijuana and hemp

Because marijuana and hemp derive from the same species, Cannabis sativa L., one might think that you can get high from hemp — but you can’t. Investors are sometimes unaware of these differences, which creates confusion when evaluating opportunities. Some companies, funds, individuals and even cultures won’t invest in a mood-altering drug, legal or not.

The difference in THC levels between marijuana and hemp leads to a primary difference as an investment target: regulation. Because of state regulations, operating a marijuana company tends to be more expensive, with higher barriers to entry. To add to the confusion, each state has different licensing laws as well. Rolling back years of regulation won’t be a slam dunk.

Hemp no longer faces the depth of regulatory requirements in place for marijuana. The crop is quickly becoming more mainstream, with CBD being integrated into almost ever consumer product from clothing to skin care. This rapid commoditization is putting more price pressure on hemp products, reducing margins and potentially resulting in lower returns.

 

Takeaways:

 

People problems

The investor’s mantra has always been “invest in people.” You’re not just buying a product, but the people behind it. The cannabis industry is a whole different ball of wax in this regard. At the advent of legalization in 2013, talented people from analogous sectors like biotech had a wait-and-see attitude about making the move. Experienced entrepreneurs were either worried about the stigma associated with working in the marijuana industry or were waiting to get more comfortable with the risk. Many early founders were previously either small-scale illegal growers or people who needed a job or a new career track.

As a result, there are too many founders with minimal business operations experience and unfortunately, a number of charlatans and bad actors. As an investment banker, I’ve seen numerous instances of bad actors on both sides of the equation — investors and company management. One case involved a CEO who was fleecing investors to line his own pockets. Luckily, he was discovered and is now incarcerated. I’ve also talked to numerous investment groups using predatory practices and offering “toxic convertibles.”

As the industry has matured, this dynamic will continue to change and bad actors should become less prevalent.

 

Takeaway:

 

Final Takeaway

Since the advent of the modern cannabis industry in January 2014, when Colorado started offering retail cannabis, there’s been a significant amount of money lost due to investors getting caught up in the buzz and the expectation that any investment was a good investment. Nothing is a sure bet in cannabis.

With the industry poised to continue evolving in unforeseen ways over the coming months and years, being diligent, patient and flexible with your investing strategy is a sound way to get involved in a new and dynamic sector.

 

David Traylor is the founder of Golden Eagle Partners, LLC, an investment advisory firm to the cannabis and life science sectors.

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