The Highest Return

To build a viable business and attract the best investments, start by asking the right questions.

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There is no denying the harsh reality of the current economic climate, or that the flow of investment dollars into the cannabis industry has slowed to a trickle. Viridian Capital Advisors reports that year to date through Dec. 2, capital raises are down more than 65% compared to the same time last year. For those of us who were in the industry during 2017, we may recall the previous tight capital market. However, this feels different than previous economic cycles, particularly coming off the highs (pun intended) of 2021.

While this downturn can elicit a sense of fear, it is important to remind ourselves that the industry is growing and companies are maturing along the way. Nearly half of the U.S. population lives in a state where cannabis is legal. These markets require infrastructure, operators, and investment to fuel the fire.

Cannabis is treated as a high-risk investment, and because most cannabis companies are private (not publicly traded stock), those investments are typically illiquid—thus requiring a premium return. In fact, Viridian data shows that U.S. cannabis equity funding is down 96.3% this year, and debt funding overall has dropped 28.1%. But debt funding for private cannabis companies increased during 2022. There are, of course, more companies vying for these loans than ever before. The supply of capital is guarded, and the demand continues to rise, making it easy to recognize the funding crunch prevalent in the industry. The result: only the best opportunities at the most attractive valuations are being funded.

As an example, Michigan retailer NOXX secured $15 million of debt financing in Q3. NOXX CEO Tommy Nafso presented a robust business plan and highlighted his team’s experience in and outside of the cannabis industry. NOXX now has two dispensaries open in Grand Rapids and a partnership with rapper and entrepreneur Berner’s cannabis brand Cookies in the works.

So, how can a cannabis business best position itself to attract investors?

Take and build on Warren Buffett’s advice: to invest better, read better.

Similarly, I say: To be a better investment partner, ask better questions. Know thyself and thy business.

Tactics matter. Asking the right questions about where to focus and how to execute will put you on the right path. Knowing these building blocks of your company will also make the day-to-day simpler.

Consider this example: Cultivation business plans often focus on pounds per light (or grams per square foot) and assume the market can absorb 100% of production (flower, distillate, etc.) at current wholesale prices. Often, when asked, they cite quality, genetics, and branding as reasons for commanding a higher price. This unfortunately does not always hold true, as we have seen in Oregon, California, Michigan, and even newer markets like Missouri. Instead, a business plan that conservatively models demand and the production levels needed to meet demand—and assumes wholesale price compression—is more attractive to investors. This also reduces the required amount of start-up capital. Once you are executing flawlessly, by all means, grow high quality plants, use the best genetics, and launch the most innovative products.

This is all to say that good questions develop self-awareness in operators. Yes, investors want to know that you have a strategic vision. They also want the vision focused and to trust that you can execute it tactically.

Building on the questions that sharpen your vision, start with the foundation of your business—the nexus of people key to operations and the entity itself. Ask yourself the following:

What do I want from this business? How do I interact with it today and in the future?

  • The answers will create the guardrails you need to determine your optimal mix of equity and debt. With debt playing a bigger part in cannabis funding currently, it may make sense to include it in the mix, or to offer equity coverage for your debt where you had not been open to do so in the past.

What is happening in the local market, and what is my company’s place in that market?

  • Realistic valuations are built from fundamentals, not a pie-in-the-sky market share calculation. Price compression of wholesale cannabis should not be a surprise. Consider where your local market is going, how much revenue can be generated, and at what velocity.
  • While national sales data can be useful, more insight can be found from your state-market dynamics and local trends.
  • Find out what a consumer adoption rate is, or might be, for your state. Compare that with licensed square feet of cultivation to get an idea of biomass supply and demand dynamics.
  • Similarly, dispensaries should look at number of locations in a metropolitan area, and know that tourists often make smaller purchases than locals.

Once those questions are answered, you can now go deeper into your business. Be willing to shed parts of your initial vision if they don’t make economic sense anymore. Consider the following:

Are all the parts of my business plan viable?

  • The business may need to look different than originally planned. Companies that can adapt and provide a compelling value to the market will win.

Is the way I have been doing business sustainable?

  • For companies seeking growth capital, taking a close look at how they plan to scale is important. Everything from brand placement, pricing strategies, and product line-up can come into play here.

What strategic partnerships could reduce my need for capital?

  • Focus on being a vital part of an ecosystem. There will be other companies that can take over execution of certain areas of the business, develop additional sales channels, and provide outsourced services that can help reduce overhead. This requires a detailed look at the value creation process from seed to sale. Make the decision to build and own parts of that process and to buy the remaining through partnerships.
  • Examples here could range from simple, like outsourcing accounting, digital advertising, IT, security, or transport, to more complex, like partnering with existing brands to manufacture their products instead of investing in your own brand or purchasing biomass/distillate instead of making your own.
  • In essence: If you don’t need to take on fixed costs to build or develop something, don’t do it. Every investment dollar is hard-won and often expensive.

The time has come for cannabis companies to be selective in their spending and seek the highest return on that capital allocation. Likewise, investors will remain selective and seek the highest return on capital contributed.

Colin Kelley is an operating partner for Merida Capital Holdings.

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