Editor's note: Cannabis Business Times originally published this article in January 2016. With input from the author, we updated several paragraphs in December 2018.
Over the last several years, we have reviewed thousands of businesses in the burgeoning cannabis industry. We have seen the gamut of cannabis entrepreneurs, their ideas and their business plans. We also have witnessed numerous trends — from the growing sophistication of entrepreneurs to more advanced business plans and increasing attempts at placing a dollar value on their businesses.
As investors and entrepreneurs, we understand the major challenges inherent to valuating a business. We view this as particularly challenging in a new industry that still has so much political overhang to navigate. Even beyond cannabis, many variables are at stake, and we will address these as we walk through the process of valuing your business.
Whether you are seeking outside investors to grow your business and increase its value, have an acquisition offer or are looking to sell your business, the following steps can help you through the art and science of placing a dollar value on your company.
Before You Begin, Get Your House in Order
Evaluate and Share Information About Your Team
If you are seeking outside investment, potential investors will want to see that you and your team have what it takes to run a profitable business and provide a return on investment. Experience, unwavering drive and determination, and knowledge are just a few factors investors will consider. Prior exits (i.e., either a sale of a business or a return on an investment) from other industries are generally favorably viewed.
If you are looking to sell or considering an acquisition offer, buyers of the business will want to ensure a positive transition and will likely request that you and your team sign a non-compete agreement, which would legally prevent you from joining or starting a competing business for a specified amount of time. They want to make sure the business’s growth stays on track, and that a dedication to see the business successfully through the sale exists and is aligned with the current business operators.
Zero in on What Your Business Does
Investors need the description of your business to be crystal clear and concise. If we do not understand your mission within 30 seconds, your value proposition needs work. The earlier stage cannabis investor is currently underfunded and oversupplied (with businesses seeking investment), so the power is in their hands. Make sure your message is clear and powerful.
Answer the Question: Why Are You in This business?
Are you passionate about the industry or its financial potential? What drew you into this space?
Why are you looking for investment or selling your company? Has the business reached a point that you don’t feel capable of handling it? Are you pursuing other interests?
Determine and Communicate Your Focus
Your business’s focus can be geographic or subsector focused, or both. An example might be: a master grower operating a greenhouse cultivation facility focused on organic practices, high-end flower in Oregon. Acquisition targets will want to know exactly where this business fits in to their portfolio during their valuation analysis.
What’s the State of Your Business?
Where is your business located? Has the business been officially established? If so, what is its structure (for example, LLC, C corporation, non-profit)? Do you have books and records, accounting support, intellectual property, litigation, etc.? This is very important to potential buyers. They will have their legal team comb through everything. Don’t hide any skeletons in the closet. If they find any skeletons on their own, it’s likely to be a deal-breaker or valuation crusher.
These initial steps are important to getting your business investment- and acquisition-ready. Putting these initial pieces in place will create value, as investors will be more confident about how serious you are about your business.
Get Your Financial Ducks in a Row
Develop or Refine Your Business Plan
Your business plan is an opportunity to wade a bit deeper into your mission. It is potentially your first major marketing piece, as it can be used to sell investors or potential buyers. There could be multiple versions of your business plan. For example, if you are pitching investors or buyers who are in the industry, they are not likely to need to see pages and pages of market statistics. Cannabis-specific investors and buyers know this information and are more interested in your business’s potential unmet need. When targeting those outside the industry, it is important to include a market analysis in your business plan. Know and outline your target audience, go-to-market strategy and use of funds so your presentation is as profound as possible.
Review and Organize Your Finances
One of the biggest factors in accurately evaluating your business, whether for an investor or for a potential sale, is having a full financial picture of your business. Make sure you have: an accurate profit and loss (P&L) statement that outlines all of your expenses and all revenue; a balance sheet, which details your assets, liabilities (debt) and capital; and a capitalization (or cap) table, detailing the business’s owners and percentage ownership for each, and any shareholders or investor equity in the company.
You should have a full financial picture available. Here are pieces of your financial picture that are important to investors or buyers.
- What is your top line revenue? (in other words, gross sales/total revenue)
- What are your gross margins? (a percentage calculated by taking the difference between cost of goods sold (COGS) and revenue, and dividing that number by revenue; COGS includes costs that can be directly attributed to the production of the product, such as materials used (e.g., soil) and labor used in production)
- What are your month-over-month and year-over-year growth metrics?
- Who are your largest customers? What percent of overall sales do they constitute?
- What are your overhead (ongoing or operational) costs? (typically fixed costs, such as insurance, rent, legal and accounting fees)
- What are your Selling, General and Administrative (SG&A) expenses? (typically non-production-related costs incurred in the selling or distribution of the product or the management of the company)
- If you have insurance coverage, what kind and what amount of coverages do you have? When did you last review your coverage?
- Is your business profitable?
- If your business is not profitable, what is your monthly cash burn rate? (the rate at which the business spends cash in excess of income, usually referring to how much a company spends in a month)
- Do you have any outstanding debt? How much? How is it structured?
- What assets do you have? What is their value?
This information will be essential to provide investors and buyers, and it comes into play for Steps 10 through 12.
Build a Pro Forma
While it may seem complicated, you do not need to be a finance guru or math genius to create a pro forma (a financial projection of the business). Many templates for basic pro formas that can do the job are available online. (This is not to say that investors are not impressed when they see a very detailed spreadsheet.)
A couple general rules of thumb:
- Investors want to see that you have put research and thought into the costs of running the business. Revenues are generally nebulous for startups, and the template will spit out a revenue run rate (an annual revenue projection based on extrapolated revenues).
- If you own an existing business (vs. a startup), you should have a good understanding from previous months, quarters and years of P&Ls, and possibly even audited financials.
- At this point in the cannabis industry, we prefer to see three-year, forward-looking projections. Though five-year projections are standard in other industries, we feel they are less relevant to our industry; this is mainly because the growth rate for the industry is so great that it causes the pro forma to overly inflate projections, especially after 3 years.
- We also like to see at least some margin for the unplanned. It’s inevitable that unforeseen costs will arise, and it’s better to account for these expenses up front. For those of you with existing businesses, you are probably painfully aware of the unexpected.
A pro forma is known to be, essentially, your best guess, especially if you have limited operating history. However, it is helpful in that investors and buyers want to see your commitment to understanding your business.
Know Your Market
Gauge Market Sentiment and Perception
Understanding investor willingness to invest or buy is a study in sociological behavioral analysis. This can be evaluated by exploring the market’s current state of investor risk tolerance. In positive financial market environments, people take risks and are more willing to pay to play. However, when markets are rocky, the economy is weak, etc., people pull in the reins. Take some time to get a feeling for people’s perception of current and future markets. This will help you determine whether your business value may be too high or too low, depending on market fluctuations.
Do a Discounted Cash Flow Analysis
A discounted cash flow (DCF) analysis is a common tool used for establishing initial valuation. This analysis allows a company to look at potential business metrics for cash flow in three to five years, and then “discount” it back to a valuation today. (The “discount” is applied because cash projected to be made in the future has less value than cash today. In the simplest terms, you could draw a parallel between discounted cash flow and the adage, “A bird in the hand is worth two in the bush.”)
The discount rate is a percentage, which is used to compensate the investor or buyer for buying today. The greater the percentage, the greater the risk compensation to the buyer. However, a word of caution: Investors are not going to buy into a DCF that shows a business that is expected to generate $100 million in five years as being worth $10 million today. It’s just not a realistic expectation for 99 percent of businesses. Early stage investors are taking on the riskiest part of the investment and will want to be met with a valuation that reflects that versus a rosy, five-year outlook.
We have seen a wide range of discount rates applied to the cannabis industry. However, we currently put less emphasis on this analysis than other industries might. Our sentiment here is similar to what was discussed at the end of Step 8. The pro forma and DCF rely on future business metrics that get quite inflated the longer you look out. We believe DCF could become a more useful tool in the future, but right now, we tend to analyze companies using proprietary metrics. Still, DCFs can be useful to help you arrive at an estimated, current value base for your business.
Like with pro formas, plenty of excel templates are available for building a DCF. This will be easy if you have gone through all of the previous steps, as you already should have your finances in order.
Explore Private Company Comparables
The cannabis marketplace continues to grow at a very fast rate. As a result, more and more startups are entering the market. Competition is rising, which means entrepreneurs need to have their ducks in a row from the outset. One benefit of the industry’s growth is the growth in comparable valuations (aka “comps”). Entrepreneurs are better able to track competitors’ or similar businesses’ valuations and capital raises from seed money and beyond. Here is one source you can reference: https://angel.co/marijuana/investors.
Review Public Market Comparables
Public markets “should” offer another form of comparables you could review. In the cannabis industry, the vast majority of the public market trades via the U.S. OTC (over the counter) markets or in Canada on the Canadian Securities Exchange, or Toronto Stock Exchange Venture. Many of these public names, however, have limited business prospects (revenues, assets, business plan, intellectual property, go-to-market strategy, etc.), which is worsened by the fact that they are artificially supported by gratuitous press releases.For the last several years, public companies have commanded a significantly greater valuation than private companies. It is normal for a “liquidity premium”, meaning investors have ability to buy and sell public stock. However, the premium has been pretty significant at times and can skew valuations for private companies. For example, private plant touching companies may be valued at an annual revenue multiple of 2-5x but public companies are valued 10x up to 1000x revenue.
Under Promise, Over Deliver (UPOD)
UPOD has to be one of our favorite acronyms, though it’s more applicable to those seeking investors versus buyers.
While under promising is advised (vs. over promising/under-delivering), don’t sell yourself short. You are taking a major risk to pursue your dream. However, investors want to feel confident that they will see not only a return of their money, but also a return on their money. Showing some reserve relieves the pressure to execute on every level, while setting yourself up to beat your own projections. That’s a strategy to take to the bank!
Value in a Growing Industry
Valuation is one of the hardest objectives in business. The steps above, however, should be useful in helping you prepare to engage with business suitors. Keep in mind that hindsight is generally the only way to know if you were “right” in your valuation. Because of the difficult nature of assigning a value to your company, it can be helpful to speak with professionals/an independent third-party during the process, before potential buyers are at your door.
The emerging cannabis industry offers opportunity to a wide variety of skill sets. We strongly believe that cannabis will be a major, global economic driver, and it’s already happening here in the United States. Jobs are being created, new technologies are being deployed, and capital is starting to flow. The opportunity to get a toehold in this market is potentially bigger than what most of us have experienced or will experience in our lifetimes, and along with the burgeoning industry, our bullishness continues to grow.
About the Author: Morgan Paxhia is a founding partner and managing director of Poseidon Asset Management LLC (PoseidonAssetManagement.com), a California-based Investment Advisor. He is the key navigator at Poseidon, guiding the fund through the cannabis industry's uncharted waters. With a degree in Applied Mathematics, Paxhia draws on his years of experience along with a blend of instinct and innovation in crafting leading-edge investment strategies for the portfolio he stewards.