Does vertical integration make sense for the cannabis industry?
When you select a perfect peach at your local grocery store, it’s a safe bet that the shop owner didn’t grow or harvest it. When you buy a tube of name brand toothpaste from the drug store, it probably wasn’t made by the retailer, and when you upgrade to the latest iPhone, it wasn’t manufactured by your service provider.
In Washington, the same goes for cannabis at state-licensed retailers: shopkeepers don’t grow their own product. State law prohibits license-holders from being involved in both retail and production, but other states have taken a wide range of approaches to vertical integration.
When Colorado initiated regulations for the marijuana industry in 2010, the state adopted the 70/30 rule, which required retailers to grow 70% of the product they sold.
The newly-enacted Medical Marijuana Regulation and Safety Act prohibits most cannabis businesses from vertically integrating. In order to be exempt from this ban, licensees must satisfy three specific criteria:
– The business must be operating in a city or county with an ordinance that permits vertical integration;
– The business was vertically integrated and continuously operating prior to July 1, 2015;
– The business has been registered with the Board of Equalization.
Vertically integrated licensees are restricted to two license types, and some combinations of licenses are prohibited. All vertical integration will be prohibited after Jan. 1, 2026.
Marijuana business attorney Warren Edson says several factors played into the implementation of the 70/30 rule, including the fact that many of Colorado’s medical marijuana dispensaries were already open when the rules were being drafted. It was easier for regulators to monitor dispensary storefronts than hidden grow operations, Edson says.
In 2014, the New York Times published a monumental, six-part editorial series supporting the end of marijuana prohibition and addressing the structure by which the drug should be regulated.
“States should keep the production and retail sales of marijuana separate to ensure that the industry does not evolve into a group of politically and financially powerful vertically integrated businesses,” the New York Times story said.
The Times suggested that future states should follow Washington’s lead in separating retail and cultivation businesses.
Proponents of mandatory vertical integration claim it would make enforcement simpler for regulators and prevent diversion. But the logic behind Colorado’s original model wasn’t completely clear.
“It was just nuts,” says Edson. The model for alcohol regulation, he says, was completely different — vertical integration was prohibited.
In the fall of 2014, Colorado regulators ditched the onerous 70/30 rule in favor of a system that made vertical integration an option, but not a requirement.
Washington took a very different path from the get-go. Initiative 502, the framework that legalized marijuana in the Evergreen State, forbids business owners from holding both retailer and producer licenses.
Ian Eisenberg, owner of Uncle Ike’s Pot Shop in Seattle, says if the state allowed him to produce, process and sell his own cannabis, he’d do it — and he suspects many other retailers would, too.
“More than anything, the tax ramifications are huge,” Eisenberg says. “A grower can deduct all the costs of goods sold.”
Some well-capitalized growers say they’d benefit from expanding into retail. Clarence “Cip” Paulsen III, owner of the Spokane, Washington company GrowState, says he would “absolutely” be retailing his own product if he were allowed. Many Washington growers have struggled to gain a foothold in the market, partially because the state hasn’t issued as many licenses as it had planned. There have been about three times more producers licensed than retailers in Washington. This gives retailers the “pick of the litter” when it comes to product, Paulsen says.
If vertical integration were an option, “we’d be able to charge fair prices,” Paulsen says. “Right now we have to produce it, process, package and deliver — and we make less, get less than the retail person does. We charge $10, and they sell it for $20, $30, $40.”
Paulsen says it would be a lot easier for him to open and operate a retail shop than the huge warehouse with a $47,000 monthly electric bill where he grows his product.
But even with some growers and retailers expressing support for vertical integration, Eisenberg says he doesn’t see the law bending to allow it in Washington in the near future. Those interested in integrating vertically may look toward Oregon.
“We’ve been trying really hard not to make the same mistakes in Oregon as in Colorado and Washington,” says Leland Berger, an attorney with the Oregon CannaBusiness Compliance Counsel. “Ballot Measure 91 allows — but does not require — vertical integration, and I don’t expect the Legislature to change that during their short session this February.”
The law also doesn’t have residency restrictions for license applicants, but the Legislature is projected to repeal that allowance, Berger says.
Not everyone would benefit from the option to vertically integrate, though. In states that allow vertical integration, businesses that can afford to expand will put mom-and-pop outlets at a competitive disadvantage. In some cases, smaller operations will be put completely out of business.
Industries where vertical integration has long been standard are tough for new players to enter. Take the oil industry, for example. Shell extracts oil from the ground, processes it into gasoline and sells it to consumers at fuel stations. Very few companies have the capacity to compete in the oil game because the capital required to enter is staggering and the few entrenched major players already have a stranglehold on the market.
Moving forward, it’s likely that more states will allow vertical integration as an option.
However, California — long one of the nation’s thought leaders regarding cannabis — is a notable exception.
The recent overhaul of California’s medical marijuana regulations prohibits most forms of vertical integration. One specific set of qualifications allows some businesses to remain vertically integrated through 2026 (see sidebar). After that, all vertical integration will be prohibited.
At a glance: Vertical integration by state
Each state with legal marijuana is a crucible for economic research. The variety of regulations and licensing structures makes each program unique, and it will take years to truly understand the impacts of different rules.
There are a few states, like Hawaii, Michigan and Montana, that have either remained unregulated or are still in the process of formulating rules for dispensaries and grow operations. But the vast majority of states with some form of legal marijuana have rules about vertical integration that fall into one of three categories: allowed, required or prohibited.
Allowed: Alaska, Arizona, Colorado, Maryland, Nevada, Oregon, Washington, D.C.
Required: Connecticut, Delaware, Maine, Massachusetts, Minnesota, New Hampshire, New Jersey, New Mexico, New York, Rhode Island, Vermont
Prohibited: California, Illinois, Washington
Could this be a harbinger of things to come? Marijuana Policy Project spokesman Morgan Fox says it’s too early to make explicit predictions about states that are currently on the road to legal cannabis.
“Most of the initiatives that will likely be considered in the 2016 election mandate the Legislature to determine the licensing system. I suspect that they will end up with separate licenses for cultivation, processing and retail,” Fox says. “Some states with such systems will allow the same person or organization to have more than one type of license.”
In a perfect world, Edson says, his grower and retailer clients would be vertically integrated, as the potential benefits for individual businesses are huge. Those that have the capacity to integrate vertically should be allowed to.
“My clients who have their acts together can deal with all of it — go vertically integrated and maximize profits,” he says.
But he opposes mandatory vertical integration, such as Colorado’s model from 2010 to 2014.
“The libertarian in me hates forcing anyone to do anything; it screws my growers who don’t want to run a store,” Edson says.