The cannabis industry currently looks a lot like a combination of the1940s advent of gambling in Las Vegas and the repeal of prohibition in the 1933. The status of the industry at this point in its evolution has added significant challenges and complexity to valuing cannabis businesses.
Arguably the biggest challenge in the cannabis sector from a valuation standpoint is assessing risk versus return, a practice that due to the unique nature of the cannabis industry, requires a thorough understanding of the industry and its inherent risks.
The following issues should be considered in any cannabis business appraisal engagement; they make industry experience critical to a meaningful and supportable valuation:
- Internal Revenue Code Section 280e
- Banking and cash management challenges
- A relatively new industry
- Jurisdictionally driven
- Regulatory environment
- Lack of reliable market data
- Lack of reliable financial forecasts
- Risk/return challenges in developing cost of capital and market multiples
Internal Revenue Code Section 280e
U.S. Tax Code Section 280E states that, “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.” 1
Cannabis is currently classified as a Schedule I controlled substance. Only cost of sales can be deducted for income tax purposes. The inability to deduct general and administrative expenses leaves cannabis businesses compromised in value compared to other businesses that are allowed to deduct those expenses.
Banking and cash management
As of June 30, 2020, of the nation’s 12,000 financial institutions, only 553 banks and 162 credit unions were servicing cannabis businesses. Because cannabis is a Schedule I substance, any transfer or deposit of money yielded from the sale of cannabis may be deemed “money laundering” in violation of the Bank Secrecy Act (BSA). The Treasury Department has provided guidance on providing financial services to marijuana-related businesses and due diligence practices to follow to avoid prosecution, but many financial institutions have decided it is not worth the cost of compliance. Operating with large amounts of cash creates numerous problems, including greater operating costs and risk of theft.
Traditional sources of capital are rare. Banks are unwilling or unable to lend due to the continuing federal constraints stemming from the Controlled Substances Act, leaving cannabis firms to investments by venture capital and private equity firms. When cannabis businesses find financing, they are often forced to pay significantly greater interest rates than non-cannabis businesses.
A relatively new industry
Dynamic changes continue to take place. Public company cannabis stocks are extremely volatile, as evidenced by the following:
For a smaller non-public company, fluctuating values are a significant factor in making a sound valuation.
The mere location of a cannabis business poses multiple challenges. What are a certain jurisdiction’s requirements and limitations? Are there residency requirements? What are the restrictions on transferability? Can a license holder also hold other licenses or be involved in ancillary enterprises? What are the reporting provisions and how well is the enterprise positioned to comply?
Location. How many competitors are in the area and what is the outlook for new competitors? Can the facility be expanded or redesigned if needed to accommodate license requirements (e.g. medical and adult use sales in the same facility)?
Lease. How solid is the lease arrangement and relations with the landlord, if not operating in owned space? What are the restrictions on hours of business, signage, parking and the like? Who are the surrounding tenants and have they “bought in” to having a cannabis operation as a neighbor? What is the term of the lease and what are the renewal options?
Local, state, and federal laws and pending legislation require cannabis and their advisors to maintain a close watch on all this regulatory. What is the current and prospective outlook for regulatory change in the subject jurisdiction?
Lack of reliable market data
As opposed to fair market value, industry transactions made at investment or “synergistic” value where the buyer will pay more to get into a specific market, to acquire a competitor, or for another non-financial reason. The premium paid is difficult to quantify because the business may be worth different amounts to different buyers.
Lack of reliable financial forecasts
The anticipation of future legalization for adult use purposes and the unknown effect on prices adds several degrees of difficulty to forecasting. Knowledgeable industry appraisers understand how to develop realistic forecasts based on analyses of similar markets.
Risk/return challenges in developing cost of capital and market multiples
The greater the risk, the lower the value of a business. To illustrate: The value of a business deemed stable with a cash flow of $100,000 and a 15 percent appraiser-assessed rate of return is $667,000. A second appraiser considering the business riskier than the first and assessing a 17% rate of return results in a value of $588,235. Due to the lack of reliable forecasts, among other factors, cannabis businesses are assessed a much higher rates of return than established businesses in other industries.
Due to these challenges alone, it is crucial for owners and management of cannabis businesses to work with financial professionals with deep industry experience.
HBK Cannabis Solutions is a dedicated team of cannabis industry subject matter experts within HBK CPAs & Consultants, an Accounting Today Top 100 CPA firm. We were among the first accounting firms to specialize in the cannabis industry and have worked beside entrepreneurs in all industry segments—cultivators, processors, retailers—from single facility to multi-location and integrated operations. We counsel owners, management and investors in multiples states and countries, helping them with key financial activities: from planning start-ups to connecting operators with investment bankers to facilitating M&A; from pre-offering projections, state applications and licensing to management planning and operations.
1 – 26 U.S. Code § 280E – Expenditures in connection with the illegal sale of drugs