How We Got Here: The Financial Evolution of Commercial Cannabis

Features - Business

This special three-part series reflects on legislative, financial and regulatory developments that have altered state-legal cannabis programs during the past decade. Part II looks at how capital and investors shaped today’s market, and what that trajectory might mean for the industry’s future.

July 23, 2020

Editor’s note: This article contains profanities.

When David Bonvillain launched Elite Botanicals in 2013, he financed it by selling all his valuable assets, including his IT security company, Lamborghini and motorcycles. After taxes, he was left with roughly $1 million to invest in something new.

Bonvillain, now an industry veteran, believes the path he took to enter the cannabis industry wouldn’t be possible today. The cost of entry and other financial demands of the industry have simply changed too much.

Part I of this special “How We Got Here” series, published in CBT’s June issue, looked at how the legislative landscape has changed since the dawn of the era of commercial cannabis. Here, Part II explores how the financial market has evolved for cannabis, how different groups have benefited or have been left behind as a result, and what the past five years can tell us about what’s coming in the years ahead.

Tracking the Rise of the Public Markets

When Poseidon Asset Management, a cannabis investment fund created by siblings Emily and Morgan Paxhia, started back in 2013, the market was “primitive,” Morgan tells CBT. “Capital flow, companies, investment opportunities available, legal markets … it was basically at the beginning of all of them.”

In the early years, capital-starved startups accepted aggressive loan terms. Poseidon could close debt deals with up to 20% interest rates, Paxhia details. The regulatory costs were much less than what they are today, he says, leading to more cash-flow-positive businesses able to take on that debt.

Cost of entry into the cannabis industry has dramatically risen across most legal markets in the past five years. For example, application fees for a compassion center in Rhode Island were $250 in 2015 and renewal fees were $5,000 every two years. By 2019, Rhode Island’s application fee ballooned to $5,000 and annual licensing fees can reach $80,000, depending on canopy size.

Investors like Poseidon were few and far between in those early days, says Bethany Gomez, managing director for Brightfield Group, a cannabis and hemp market research group founded in 2015. She describes those early financiers as “[mostly] all on the private side of things: some enthusiastic high-net-worth individuals or some enthusiastic entrepreneurs that were able to put a limited amount of money into the industry and see if they had something.”

Early medical markets were structured to support small businesses, Gomez says, with limitations on canopy size, caps on the number of licenses a company could hold and on out-of-state investors, and, in the case of California’s early regulatory models, requirements to operate as non-profits.

Those non-profit models limited the participation of bigger investors in the space, according to Paxhia. When states like Washington, Colorado and Oregon launched their for-profit adult-use markets between 2014 and 2015, and California voted to legalize adult-use sales in 2016, the cannabis investor market took off along with them.

Hollingsworth Photo by Jake Gravbrot; Paxhia headshot courtesy of Paxhia; Gomez headshot courtesy of Gomez; Bonvillain headshot by Brian Kraft

Canada’s movement to legalize adult-use cannabis also played an outsized role in the development of the cannabis industry’s financial outlook. As licensed producers (LPs) moved from over-the-counter (OTC) markets to the Toronto Stock Exchange, investors had a legitimate avenue to trade cannabis stocks from plant-touching companies. LPs took advantage of those capital opportunities and swapped stock for cash to expand their international footprints and fund large developments or expansions.

What ensued from the middle of 2016 through the start of 2019, both Paxhia and Gomez say, was a period of “insane” spending and growth. In those days, investors had little understanding of the cannabis industry because there were no other markets to compare it to, nor was there a long financial history to track within the industry. “If you’re trying to invest in a company, how did you know what the valuation should be?” Paxhia asks. The rise of multi-state operators (MSOs) coincided with this flood of capital, as a handful of large American companies rushed to acquire licenses and properties, often promising big returns on those undeveloped licenses and projects.

The summer of 2019 is when “the rose-colored glasses came off for investors in the cannabis industry,” Gomez says. Disappointment in the performance of LPs as the Canadian adult-use market kicked off spurred a near-collapse of the publicly traded cannabis market. The market “was not showing the returns that companies were hoping for,” she says.

As stock prices fell, “capital started to retreat,” Paxhia says. He explains that this capital crunch, an ongoing problem since last summer, has created a bifurcation between what he calls the haves and the have-nots in the publicly traded side of the industry. “If you’re doing well, if you’re operationally strong, if you’re showing good growth, you’re in the haves column where you can access cash, you can raise capital,” he says, adding “the have-nots are the ones that [had] just poor management teams, poor intentions, maybe a combination of the two, and they’re falling apart.”

While raising capital might be more expensive for the haves today than in the past as valuations are down and volatility is up, institutional investors eyeing the cannabis industry are looking at company fundamentals, Paxhia says. Earnings before interest, taxes, depreciation and amortization (EBITDA), cash-flow and bottom lines matter more today than they ever have.

But where does this leave private companies?

Joy Hollingsworth, COO of The Hollingsworth Cannabis Company (THC Co.), says her small family operation has been surviving, not thriving, since its launch in 2013.
Photo by Jake Gravbrot

Smaller Operators (Mostly) Left Behind

For smaller companies that don’t have access to capital markets—like The Hollingsworth Cannabis Company (THC Co.) in Washington State or Elite Botanicals in Colorado—the capital market growth has largely left them behind.

Small-scale farmers—the craft growers, the family-run operations and their ilk—have mostly struggled in the cannabis space, says Joy Hollingsworth, COO at THC Co. “When I think about our family farm, I think we’re continuing to survive,” she says. “I think other families, our partners are trying to survive.”

THC Co. has been trying to find its niche in the marketplace since its launch in 2013, trying different models nearly every year. “We tried everything you could possibly think of for the first three to four years of operating, trying to figure out which business model works for us. As the market constantly changes and it’s highly volatile, you have to be quick with being able to change up on the drop of the dime or switch up your business model at certain points to adjust to what the demand is, what the consumer wants, what laws and regulations are,” she says.

THC Co.’s 30,000 square feet of canopy is not the advantage that some might think it is, either, Hollingsworth says. Companies need people and money, too. “It’s more about the resources you have access to, the capital you have access to, the labor you have. … That, to me, is characterized [by] some of these larger [MSOs], they have access to that.”

Raising capital has been a struggle from the beginning for Bonvillain. And he doesn’t blame the investors for being skittish: “It’s like, why would I risk my metric shit tons of cash on the potential of making a little bit more when there’s other, safer investments that may not have quite as high of ROI, but they are a lot fucking safer?”

Thinking back to the early days of his company, Bonvillain can’t help but chuckle at the mistakes he made, including burning through his cash reserves too quickly. “Nobody really knew what they were doing,” Bonvillain says. While a $1 million startup would have yielded a solid business in 2008, he adds, it was barely enough to hang on with in 2013, when the market got more crowded.

Bonvillain managed to navigate his company through an equity-less landscape and is in a stronger position today than he was then. But while many early cannabis companies got their start using personal savings and funds from family and friends, he doesn’t think what he did is as feasible in today’s financial landscape.

“I think we’ve evolved from what we saw five or six years ago,” he says. Adventurous investors still are “willing to continue to take aggressive risks and whatnot. But [as the industry moves] toward more institutional investors and more folks that have serious capital and are willing to risk some of that capital because they feel like legalization is coming, … it really changes the landscape dramatically to the detriment, largely, of the smaller businesses and people that can be even somewhat successful in the current market.”

sophon | Adobe Stock

California’s micro- licenses are entry options for less-well-capitalized startups, Bonvillain says, but those also come with limited revenue generation and expansion opportunities, as well as the continued issue of increased rent and property valuations in “green zones,” designated areas zoned for cannabis companies.

“When they do allow a green zone, the property values just go through the fucking roof because all of a sudden these landlords are going to go ahead and retire based on cannabis coming in, to the detriment of the [cannabis] company being able to be successful unless you just have massively deep pockets,” he says.

It’s one of the many reasons why he compares the grind of running a cannabis company to a “daily kick in the nuts.”

However, there are ways to avoid skyrocketing rents and other challenges, he says, such as offering the landlord equity in the company.

Another way small growers have made advances is by banding together through co-ops, distribution companies or mutually beneficial partnerships. That’s where THC Co. has positioned itself, operating as a wholesaler to other producer-processors in Washington state, leveraging their market access to offload THC’s biomass. “It just makes sense for us financially, at this moment in time, to be 100% dedicated to wholesale,” Hollingsworth says. “That doesn’t mean that we’re not going to do retail ever again, but right now it feels great just being a producer … and then selling it off wholesale for other people then to either repackage for their brand or process for different edibles or oil. That’s our lane right now.”

Left: Elite Botanicals’ farm. Launching a cannabis company in 2020 is vastly different, and more difficult, than it was in 2008 or even 2015, according to Elite Botanicals’ David Bonvillain, due partly to the increased capital costs. Right: Investors, who once struggled to evaluate cannabis companies as investments, have returned to looking at business fundamentals as this remains a “consumer-packaged-goods industry,” says Brightfield Group’s Bethany Gomez.
Photo Courtesy of Brandon James

What Does the Future Hold?

Paxhia believes that more and more companies are going to have to learn how to operate nimbly, like THC Co. Specifically, he says, “You cannot be set in your ways. You got to stay open-minded because … the next five years are likely going to see even more massive changes than we saw the previous five years.”

Federal legalization and interstate commerce are two factors that could drastically change the landscape for all players, from small farms to large MSOs and LPs with international footings. “What does [interstate commerce] do to markets that are enjoying very rich, high prices?” Paxhia asks.

Access to banking, Paxhia predicts, will level the playing field between large and small companies. As cannabis companies gain access to traditional banking services, “their cost of capital plummets,” he says. Once 280E is removed, “these become almost like blue-chip-like companies that are multi-billion-dollar enterprises.”

Gomez says she predicts the industry is going to continue to normalize and investors are going to continue to look more and more at company fundamentals. When commercial cannabis started taking off, “There was this mentality that ‘Everything you know is wrong, this is cannabis, this is a once-in-a-generation industry, this is different. Everything you know from past lives is wrong or doesn’t apply here,’” Gomez says. “And what companies are finding right now is that’s not true. This is a consumer-packaged-goods industry … and most of the fundamentals apply.”

Bonvillain sees a lot of companies adapting to the coming reality of investors looking at fundamentals instead of the quality of leadership teams and number of licenses. “It’s making a lot of those companies step back, tighten their belts, [and] actually run a productive and profitable business and put quality products on the shelf,” he says. Therein also lies an opportunity for third-, fourth- and fifth-wave entrants to get into the industry, he adds, as those who rushed in and ran poor operations either go bankrupt or exit the industry by selling their businesses/licenses.

Hollingsworth, for her part, sees a lot more consolidation on the horizon, as the cannabis industry goes down a similar path as post-prohibition alcohol companies, “where you just have a bunch of distributors, but you might have one company and they own like 20 brands … I think we’re going to start seeing that with [the] cannabis industry,” she says. Hollingsworth also notes, “We’re seeing people partner up together to streamline [processes].”

Investors, ultimately, will yield a lot of power in selecting who the haves and the have-nots are. Well-established companies will get the lion’s share of the early investors who come back to the industry in the coming months and years, “but as those start getting bid up again,” Paxhia says, “the natural cycle would be to see that capital start … to try to get in earlier and get a better entry point in the hopes of seeing that kind of [big investment] return.”

Brian Maciver is senior editor for Cannabis Business Times and Cannabis Dispensary magazines.