As the legal cannabis market continues to prosper and grow, sophisticated investors and sellers need to know where hidden values are in a business.
In today’s U.S. cannabis market, “proving” the actual financial statements of a cannabis business is challenging due to federal regulations restricting cash from cannabis operations being deposited into banks. Almost all businesses have reporting responsibility and possibly a certified public accountant quantifying the accuracy of the financial statements. Without accurate and trustworthy financials, it can be difficult to derive an accurate, reasonable value of the cannabis business.
Another problem in the industry is obtaining good metrics for comparable businesses in the industry. A business valuator cannot depend upon the recent metrics of cannabis businesses bought or sold because in most cases the valuation is very much over-hyped; as a result, too much is paid for businesses as has been reflected in a few purchases on national exchanges, like MedMen stock, in particular on Canadian exchanges where many transactions have occurred.
Today, a business valuator must look to other methods to produce a credible value. Valuators must keep in mind; that plant-touching cannabis businesses are subject to stringent IRS Section 280E guidelines and to more intensive federal tax versus non-cannabis businesses. For example, Section 280E penalizes traffickers of controlled substances by denying deductions from gross income for business expenses. Therefore, an after-tax discounted cash flow analysis is more appropriate for valuing plant touching cannabis businesses if the analysis has the correct segregation between state and federal taxes. It takes little imagination to discern that the denial of ordinary business deductions greatly impacts those doing business within the cannabis plant touching industry.
Find the gold nuggets
Let’s say, you, as an investor, are interested in a potential purchase of a multi-million-dollar cannabis cultivation facility. The seller is representing the facility as generating
$10 million in revenue. As an investor, there can be “gold nuggets” of information to be discovered to determine if that number is accurate or just “blue sky.”
One place to look for “gold nuggets” is in the business’s electrical bills for the most recent revenue period. Since the indoor grow facility is run entirely by electricity, the electric bill can provide some valuable information that should not be overlooked. There is a standard range of how much electricity is needed for each gram of cannabis produced (at least 1-1.5 grams per watt); however, to determine whether to use a high-end or low-end range of grams produced for each kilowatt (because the electric statement will be shown in kilowatts, not watts), the valuator would need to interview the master grower. If the yield is in the ballpark of what the seller is claiming it to be, you can likely trust the revenue numbers.
Also, when examining an electric bill, the valuator must back out the number of kilowatts that could be used for non-production of cannabis. Examples would include microwaves for cooking purposes, refrigerators for food storage, lighting of the business office, security office, etc. This could be a very small amount, but it should still be considered as a non-producing kilowatt when examining the total annual kilowatt output. Determine this estimate during your interview with the master grower.
I recently was invited to a large indoor cannabis cultivation facility, along with some team members who were interested in automating the facility to determine if they were using correct sensing devices to measure moisture content and pH of each soil potted cannabis plant.
We interviewed the master grower, asking him how many years he had been in the cannabis industry along with other cannabis-related background questions. We then tested several of their potted plants throughout the facility and found the moisture content and pH off the charts, dry soil and pH at 8.5. This test, along with the short history of this grower’s experience, convinced me that I could not assign this master grower a high range of grams per watt produced for deriving the total production, as a benchmark to what the seller is promoting.
Look beyond the harvest
Suppose, however, this cultivation facility had an efficient method of controlling the amount of light that the plants receive, or of managing the level of humidity in the grow operation. These proprietary technologies could have wide interest among the cultivation community and should be closely analyzed for the possibility of licensing. If it was determined there is licensing potential without harming the current business, this should be considered a valuable asset because of the additional source of income that could otherwise be overlooked in valuing the operation.
Do they have something unique concerning the business? For example, maybe they have selected an outstanding cannabis brand in which a trademark has already been approved by the state in which they operate? This would strongly associate the business with specific cannabis products or services. This can be extremely advantageous for marketing purposes, because it can instantly link a symbol with their company, and it will call to mind all the good qualities associated with this brand. This again adds value to the business.
Another very popular and profitable area in cannabis cultivation is that of developing new cultivars. Some cultivators are specifically developing new cannabis genetics with high levels of THC, while others are focusing on the level of CBD, which their plants contain. All the processes used in developing these new strains can become part of an intellectual property portfolio which again contains value that must be considered in the overall value of the business.
Get IP appraisal
There is a substantial need for intellectual property (IP) appraisal because of the value of rights associated with cultivation, retail, and marijuana-infused products, brands, trademarks, graphics, etc. A relatively new emerging issue relates to patent applications and whether or not individual varieties of cannabis can be patented. Following the example of expensive patent battles in places like Silicon Valley, an experienced investor would know it’s to his or her benefit to lock down cannabis’ IP in the early stages of development. If one entrepreneur has the idea, you can conclude there are others.
The IP portfolio is basically the only way to escape the horrendous taxing effect of 280E, plus actually add value to the business. When a dispensary or any other plant touching business forms the intellectual property portfolio, these are assets that are producing the revenue streams that are not subject to 280E taxation.
Gold nuggets are not always seen with the naked eye, especially IP rights, nevertheless, they are there. For example, while interviewing a prospective seller of a cultivation or dispensary business, you might ask how the day has gone for them. They unexpectedly might reply, “Oh well, I just got a letter from the IRS requesting my attendance to explain my expense deductions and my cost of goods sales profits.” The valuator would take this as a clue to further expand the subject by asking the seller, “How much of your sales are devoted to intellectual properties, like plant trademark or dispensary layout secrets?”
This is an example of why an experienced cannabis valuator will have a specific detailed questionnaire focused on cannabis, to be filled out by either the potential buyer or seller, detailed for their particular interviewing process. This is a logical path for the valuator to determine where gold nuggets can be found and considered in the valuation. Once there has been a thorough search for all critical information, then the valuator can provide a clear, trustworthy picture of the business value and how to minimize taxes, something both the potential investor and seller should have to ensure they are obtaining their money’s worth when buying or selling a cannabis business.
William Fowler and Doug Bania, Nevium Intellectual Property Consultants.