In Part 1 of this series, we laid a foundation for business and intellectual property appraisal in the cannabis sector by covering fundamental financial concepts that are critical to any appraisal assignment.
In this installment, we will take a deeper dive into the use and application of an income approach to value and how to apply it to marijuana ownership interests, including interests in intellectual property such as license rights for cultivation, processing and retailing facilities.
CAPITALIZATION OF NORMALIZED EARNINGS
The basic theory behind this method is that the value of a business is based on the future benefits that can reasonably be expected. This approach uses an accepted and easily understood concept for computing value, based on a capitalization factor and the risks associated with the earnings being considered.
A major premise of this method is that the historical results of operations represent the expectations of future operations. An assumption made in this approach is that the subject company will grow at a constant rate in perpetuity. By subtracting the long-term growth rate from the cost of capital or discount rate, the growth in earnings is captured in the value indication.
The current risk-free rate of return, and other considerations, are taken into account in the development of the capitalization rate under an approach commonly referred to as a build-up method of rate determination.
As a mathematical tool, a capitalization rate is used as a divisor or a multiplier to convert an income or benefit stream into a value. The capitalization rate is usually derived from the discount rate applicable to the entity being valued, and is estimated by subtracting a company’s expected average, annual compound growth rate from its discount rate. (A discount rate represents the total expected rate of return that a prospective buyer or investor would demand on future anticipated economic benefits based on the purchase of an ownership interest in an asset or security, given the perceived risk inherent in that particular asset or security to actually receive the economic benefits in the amounts and timeframe expected.)
In selecting a capitalization rate, IRS Revenue Ruling 59-60, first published in 1959, states that the following factors, among others, should be considered in determining the appropriate rate: a) the nature of the business; b) the risk involved; and c) the stability or irregularity of earnings.
The build-up method for determining a discount rate also includes an element for specific company and industry risk, which is the opinion of the valuator, versus the other components of the discount rate which can be empirically derived from well recognized sources. The company’s stage of development, its historical and expected results, its client base, the industry within which it operates, the location of the company and other factors must be considered.
With regard to the cannabis industry, there are some unique risks to consider. For starters, marijuana is federally illegal, which means that anyone operating in the industry has legal exposure from trafficking in an illegal substance. While the U.S. government has issued conflicting messages regarding its stance toward marijuana operators over the last several years, those that have abided by state cannabis regulations have largely avoided federal intervention thus far.
Public opinion pertaining to the legalization of marijuana has also trended in a favorable direction over the past several years, causing regulators to be less inclined to interfere with operators that fully comply with state-mandated rules and regulations. However, there remains a very palpable risk that the federal government could cause a disruption in the cannabis industry at any time if it changes its position on the substance, like Jeff Sessions advocated as the U.S. attorney general when the Trump Administration took office.
One factor disincentivizing the U.S. government from removing marijuana from the Controlled Substances Act is the tax treatment that companies involved in marijuana production and distribution are subject to. Because marijuana is illegal at the federal level, marijuana companies are trafficking in a controlled substance and are essentially viewed as “drug dealers” from the perspective of the IRS, prohibiting the company from writing off any expenses other than the cost of goods sold (IRC Section 280E). Ultimately, this results in marijuana operators with relatively minimal costs of goods sold — primarily retailers — paying exorbitantly higher taxes than standard businesses in other industry sectors. Valuators should consider Section 280E either by increasing the industry-specific risk premium in the build-up of the cost of capital, or forecasting elevated taxes based on 280E to quantify its impact on value when using an income approach.
Cannabis markets in the U.S. are highly regulated, and rules and regulations vary drastically by state and municipality. Each state is its own separate market with a set of unique rules and dynamics that influence the economics of the industry. Some states have implemented licensing limits that heavily influence the supply, demand and pricing dynamics in each state. Even if a state doesn’t implicitly limit cannabis licenses, zoning restrictions may effectively limit the number of eligible locations, thereby creating scarcity for permits and impacting their market value.
In contrast to other businesses, cannabis enterprises wishing to operate most efficiently in each state must generally build a supply chain in each one to generate economies of scale and maximize profits, which is both capital (human and monetary) and time intensive. If the state “silo” structure is disrupted in any way by federal legalization, some version of an interstate commerce network could emerge, upending the artificial cannabis economics of each state. Many believe states will continue to regulate cannabis on a state-by-state basis following federal legalization, similar to the way in which states regulate alcohol currently. However, the ability to transport cannabis across state borders could have a major impact on the cannabis supply chain.
In some ways the illegality of marijuana at the federal level has been positive for some operators, while negative for others. For example, states without legacy cannabis markets have benefited from pricing power, especially in limited licensing jurisdictions, while states that compete directly with an entrenched illicit market, like California, have seen growth constrained as about two-thirds of municipalities do not allow marijuana commerce so the majority of the market remains unregulated.
The hemp industry offers another glimpse into the impact that federal legalization may have for marijuana operators. The price of hemp and hemp-based derivatives cratered following federal legalization, as operators rushed into the industry to capitalize on perceived “easy money.”
There is much debate about whether the cannabis industry will remain contained by state or open to interstate commerce — or even global commerce — in the event that legalization progresses.
Some of the risks inherent in a cannabis business could be captured in the anticipated cash flows of a business. For instance, if you believe prices will fall as a result of federal legalization, the impact can be modeled within the projected cash flows. However, for any uncertainty left over, the unsystematic risk premium can be increased to account for it.
Discounted Cash Flow Method
The basic theory behind the Discounted Cash Flow (DCF) method is that the value of a business is based on the benefits that can reasonably be expected to be generated in the future. The use of this method involves two steps. First, the present values of the projected annual earnings over the life cycle of the business are added together. Next, the present value of the terminal value is calculated by capitalizing the earnings stream in the final year of the projected enterprise life cycle. These two values are then added together to arrive at the entity value. This method is best used when companies have not achieved stabilized earnings, are expecting volatile results of operations, or have only recently begun operations.
In many cases, a DCF methodology is used to “size up” the anticipated cash flows of a cannabis business to ascertain a value indication, given the lack of market data within this nascent industry. Many privately held companies in the cannabis industry are early-stage companies with limited operating history to gauge future performance.
Many early-stage investors consider the DCF method to be of limited use given the extreme uncertainty surrounding assumptions, as well as its susceptibility to manipulation or bias. The DCF method is very sensitive to the assumptions selected. One side of a negotiation might assume a higher growth rate than another, or that a particular investment contains a greater degree of risk than another, which can result in drastically different values. However, we believe the exercise of modeling the realistic financial possibilities and required rates of return of a cannabis company to be informative and useful if only to develop a reasonable range of possible valuation outcomes. Using a best case, worst case and most-likely case scenario analysis can also assist in evaluating the range of values that are in play for any specific enterprise or license right.
The purposes of the valuation and development stage of the company has a major bearing on the valuation opinion and methodology used, and therefore the appropriateness of relying on the DCF method to value the company. For instance, if a company is raising $1 million dollars to build a cannabis company that has not begun operating in a newly legalized market, it may be appropriate to utilize a discounted cash flow to justify a valuation of, let’s say, $5 million. The ultimate goal is that the investors will own 20-25% of the business following the investment round — a fairly typical “give-up” percentage of equity in pre-revenue investment rounds, historically. However, the moment after the $1 million of capital is raised, in our example, does that mean a pre-revenue cannabis company that is highly illiquid is truly worth $5 million dollars for the purposes of a founder buyout at this stage? Essentially, the business at this early stage consists of investors, founders, ambition and cash. Suppose that one of the founders of the company wants to be bought out immediately following the investment round but before the store is even operating or licensed? In our view, the value hasn’t necessarily been created in the investment round, in this example, but the new capital infusion and price has been established as an opportunity to “grow into” the valuation implied in the investment round.
Therefore, context and reasonableness should mean a great deal in any valuation and methodology selected. The DCF method gives the valuator the ability to quantify the anticipated economic benefits of a cannabis asset under varying assumptions to establish a specific value, or range of values. By going through this process, the analyst gains an understanding of the magnitude that different assumptions have on value and establishes a range using both aggressive and pessimistic assumptions. Armed with this knowledge, the analyst can then compare the market price paid for, and multiples implied by, similar business transactions identified in the jurisdiction to the range of values derived from DCF analysis to determine whether a “comp” falls inside or outside of this range and what the motivations for the price may have been.
This process will help refine the analysts’ view as to the comparability of the subject enterprise to the “market” and where the company fits into the value spectrum in any given market (distressed or competitively advantaged). Like golf, the DCF is another method (club) that allows the analyst to reach a value closer to the proverbial pin.
For a cannabis company with some length of operating history, a DCF method or capitalization of cash flows method to value becomes a more reliable calculation because the quality of earnings has been proven and are less subjective. In the early stage of development, the DCF method should be considered a broad stroke of the valuation process that should be carefully considered along with other methodologies and conceptualization of value.
About the Authors:
Ron Seigneur is the managing partner of Seigneur Gustafson LLP, a nationally recognized firm for its expertise in the marijuana and hemp/CBD sectors with respect to business and intellectual property appraisal, economic damages and lost profits assessments and related consulting and tax planning and compliance. He is a certified public accountant, accredited in business valuation, and a certified valuation analyst. Seigneur and his partner Brenda Clarke are co-authors of “The Cannabis Industry Accounting and Appraisal Guide,” published by LuLu in May 2018.
Ryan Cram is a certified valuation analyst who has worked as a financial analyst with Seigneur Gustafson LLP since 2016.