It is important to understand that the value of an interest in a company or intellectual property asset is a derivative of the earning power of that company or asset and the ability to convert that earning power into value.
This economic principle is valid regardless of whether the ownership interest is in a publicly traded company or a closely held business. It is also not industry dependent.
This series will focus on the valuation of interests in closely held businesses and intellectual property rights in the marijuana industry, including cultivation, processing and retail. We will also provide insights on how to establish the value of regulatory and patent-related license rights, brand and trademark rights, recipes and strains, and related intangible assets.
Valuation is based on the fundamental premise that value today is the present worth of expected future benefits. Earning power is related to rates of return expected in the financial markets for various types of investment alternatives, with consideration given to the history, expected growth rates and the risks associated with realizing the anticipated future economic benefits. This concept seems easy to grasp on the surface, but like many financial challenges, the devil is in the details.
Put another way, astute investors will typically price an investment based on what they anticipate they will receive in economic benefits prospectively, as opposed to what has been received historically, particularly for growth investments like cannabis assets.
From the viewpoint of the valuation analyst, there are three fundamental questions that must be addressed at the initial phase of any appraisal assignment:
– What is the date of the valuation?
– What standard of value is appropriate?
– What is the premise of value?
Given how dynamic the marijuana industry is and how rapidly it is changing, the date that the value is being determined is paramount for any appraisal analysis, given the volatility inherent in cannabis assets. For example, the date of a particular license right may change dramatically over a short time based on industry developments and legislative, regulatory, competitive and judicial events.
The appropriate standard of value is also critical to establish, and the following section will highlight the three basic alternatives, each of which may result in a different conclusion, all else held equal. The premise of value is typically assumed to be a premise of “going concern,” which essentially means the business will continue to operate the same as it has in the current and prior environment. The alternative to going concern is a premise of liquidation, either on an orderly basis or potentially by an auction.
These concepts are highlighted here only in a summary fashion and readers are encouraged to consult with one of the recognized valuation treatises, such as “Valuing a Business: The Analysis and Appraisal of Closely Held Companies” (Shannon Pratt and Ron Seigneur, 6th edition, McGraw-Hill, 2021) for a more in-depth understanding.
Standard of Value
In business valuation, there are many different standards of value. In some situations, the standard of value is legally mandated either by law (or interpretation of case law) or by binding legal documents or contracts. The standard of value reflects the assumption of who the buyer will be and who the seller will be, whether hypothetical or actual.
– Fair market value (FMV) is defined by the IRS in Section 20.2031-1(b) of the Estate Tax Regulations as: “the amount at which the property would change hands between a hypothetical willing buyer and a hypothetical willing seller when the former is not under a compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.”
– Investment value, by contrast to FMV, is defined as the value to a particular buyer or prospective owner. Unlike FMV, investment value reflects the buyer’s particular knowledge, expectations and assessment of the business, financial, economic and liquidity risks. Perceived synergistic benefits are often a key consideration for investment buyers in the cannabis sector.
– Fair value does not assume that there is a willing buyer and seller, as in the case of FMV, or that all parties have reasonable knowledge. Often there is a willing buyer but an unwilling seller. The concept of “fairness” replaces the assumption of an arm’s-length transaction that is used in FMV. From a practical standpoint, the major difference is often the application of discounts for lack of control and/or marketability in valuations utilizing an FMV standard, whereas under a fair value standard, these discounts are not applicable.
There are three primary approaches to consider when valuing a business interest or intellectual property rights — asset, income and market — and multiple valuation methodologies available under each of these approaches. The methods used for any specific assignment are dependent on the specific circumstances and valuation purpose of a particular business or ownership interest therein.
– The asset-based approach to business valuation measures the value of the various assets in the subject interest, net of related liabilities. In this approach, intangible assets, such as goodwill, are included in total assets.
– The income approach involves determining the net present value of expected future cash flows to be generated by the business interest utilizing a discount rate that reflects the risks inherent in receiving those cash flows.
– Market comparative approaches consider the market value of business enterprises similar to the subject interest being valued, as observed either in the trading price of publicly traded companies or in the acquisition price of public or private companies, relative to the earnings and/or cash flow of those businesses. The ratios, or market multiples, are applied to the subject business interest’s normalized level of expected gross revenue, earnings or cash flow to derive an indication of value.
The following methods are most often employed in the appraisal of operating entities within the cannabis sector.
The asset-based approach to business valuation measures the value of the various assets in the business, net of related liabilities. In this approach, intangible assets, such as goodwill, are included in total assets. A summary of asset-based methodologies includes:
– Net Book Value Method: Calculated by subtracting the book value of the liabilities from the book value of the assets. This is normally a poor indicator of business value, because it reflects accounting policies that can be different for individual companies and often does not consider intangibles such as goodwill.
– Adjusted Net Asset Method: A method that adjusts assets and liabilities for current market values. This sometimes requires an analysis and/or valuation of accounts receivable, inventory and fixed assets. This method is an improvement compared to book value. It is appropriate mostly in situations where: a) the company’s value depends heavily on the value of its tangible assets; b) there is little or no value added to its products or services from labor or intangible assets; and c) the balance sheet reflects all of the company’s assets. This method is also appropriate in combination with other valuation methods.
– Excess Earnings Method: Also considered an income approach, this method uses Book Value (or Net Asset Value as described above) plus a method to approximate the value of goodwill (and/or other intangible assets) by capitalizing “excess earnings,” if any exist. In the absence of reasonably comparable public market-based data, we might use this method as a “reasonableness check” as some entrepreneurs may use similar measures in developing their personal opinion of a “floor value” of a company.
– Liquidation value: While this is not considered a valuation methodology, a liquidation premise should be used when there is a presumption that the business will cease as a going concern, within the next operating cycle (or year) and/or when its results exceed other methods (such as “highest and best use” value).
Income or discounted cash flow methodologies involve determining the net present value of expected future cash flows to be generated by the business, utilizing an appropriate risk-adjusted discount rate that reflects the various risks inherent in receiving those cash flows in the amounts and time frames anticipated.
Recognized income methodologies include:
– Capitalization of normalized earnings: Uses an accepted and easily understood concept for computing value whereby a selected benefit stream is capitalized by a factor to determine the price that would be required to be paid to yield a return commensurate with the risks associated with the earnings being considered. The current risk-free rate of return and other factors 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.
– Discounted cash flow/discounted future earnings: This is best used when companies have sufficient data points available for reliable forecasts of future earnings and cash flow. On the other hand, the discounted cash flow method is often employed in valuing development-stage cannabis businesses due to the startup nature of the industry and the lack of solid historical operating data to draw from. The key here is working with competent management to develop financial forecasts that properly embrace the realities of the specific opportunity, including jurisdictional and regulatory rights and limitations, market trends and competitive forces.
Market comparative approaches consider the market value of business enterprises similar to the subject company being valued, as observed either in the trading price of publicly traded companies or in the acquisition price of public or private companies, relative to the revenue, earnings and/or cash flow of those businesses. The observed market multiples are then applied to the subject company’s normalized level of expected revenue, earnings or cash flow. The following is a description of traditional market-based methods that can be considered when sufficient market data is available:
– Guideline Public Company Method: This method correlates the various valuation multiples of guideline companies with the closely held company being valued. It is often difficult to make a direct comparison of an early stage, private cannabis company to a public cannabis company given the disparity between cannabis markets, the scale of operations and the fact that most publicly traded cannabis companies are based outside the U.S.
Nonetheless, public cannabis “comp” tables do provide a sense for cannabis investor sentiment at any given time, especially if the valuation multiples are compared over time. For example, are multiples expanding or contracting? Some investors may use public company valuation multiples as a means to project a hypothetical exit value for a privately held company they are considering investing in. However, this approach must be used with caution and may not be a prudent approach to value a smaller cannabis company whose prospects for IPO or acquisition are minimal or far into the future.
– Guideline Merged and Acquired Company Method: The basic principles of the Guideline Public Company Method are used, except the data is derived from non-public companies that have been merged or acquired. Obviously, finding valuation data from private companies is a challenge because private businesses intentionally conceal sensitive financial data for competitive reasons. Despite this challenge, private company “comp” tables can often be constructed by scouring press releases, securities filings and court documents to uncover acquisition prices, company details and financial metrics such as sales or earnings to build a “comp” table from the ground up. The deal structure, and any updates on the transaction post-deal are also critical components of the valuation multiples being calculated. This can be a painstakingly slow process but we believe market comps are a critical aspect of any cannabis valuation to the extent that a reasonably comparable set of company transactions can be identified.
– Industry Method: Sometimes referred to as a “rule of thumb,” the industry method should be reviewed but is seldom relied on exclusively for the valuation of a subject company. Sources for this type of valuation include published compilations, industry sources, business brokers, trade associations and industry members. A major disadvantage of using an industry method is that the appraiser often does not have detailed information to evaluate and verify the data provided, including any synergistic motivations involved in the underlying transactions.
We have reached out to cannabis companies that have been focused on expanding their footprint in particular jurisdictions to inquire about their acquisition strategy and valuation methodology. This technique has helped us understand the buyer’s assumptions, motivations and thought process behind a rule of thumb industry multiple. Generally speaking, a rule-of-thumb multiple would be reserved for established businesses with brand awareness, experienced management teams and tangible financial metrics for which to measure value.
The significance of deal structure
A buyer paying 100% of the purchase price in stock or debt is not the same as an all-cash deal due to the volatility inherent in equity values, particularly in emerging markets such as cannabis. The valuation multiple realized to date may be drastically higher or lower than the headline price based on the acquirer’s stock performance after the deal was consummated and/or the terms of debt.
For example, many public cannabis companies issued stock in acquisitions at the pinnacle of their market capitalizations over the last several years, compressing the valuation multiple if calculated in today’s dollars. As a result, there have been no shortage of asset impairments found in securities filings of cannabis companies to date. As a general rule of thumb, valuation multiples increase as more stock or debt is used to finance the deal. Also, the deal may involve contingent payments based on earn-out provisions which stipulate that a seller is to be paid a certain amount only if specific milestones are achieved such as revenue or EBITDA targets. Analysts will want to examine the deal structure carefully and understand the impact it has on value.