Cannabis Industry Valuations

The public and political view of the use of medical and recreational cannabis continues to evolve, and laws continue to change across all 50 states. More states are amending their laws to allow for the use of cannabis in some format: medical, recreational, or just decriminalizing its use. In fact, 37 out of 50 states now allow either medical or recreational use and, in some cases, both. While the states are changing their laws to be more favorable to the cannabis industry, the federal government and industry regulators continue to pose an issue for full acceptance nationwide.  

Cannabis continues to be classified as a Schedule 1 controlled substance under the Controlled Substances Act, passed as part of the Comprehensive Drug Abuse Prevention and Control Act of 1970. That said, there have been echoes in Washington, D.C., that this stance may be softening due to the possibility of downgrading cannabis at the federal level within the foreseeable future.    

Regardless of the current federal restrictions, the cannabis industry continues to grow. While this industry is relatively new, medical and recreational marijuana retailers already account for approximately $36.1 billion in revenue,1 and medical and recreational marijuana growers account for approximately $23.8 billion in revenue.2 With this upward growth trend, issues surrounding determining the value of industry players (both direct and supporting) for M&A transactions, financial reporting, tax, and even litigation, among other purposes, have begun to receive more scrutiny, creating many questions for potential investors and the public. 

Despite differences in legality by state and at the federal level, cannabis entities are businesses with significant revenue and growth that need to be, and can be, valued similarly to any other business—with certain adjustments and considerations. There are three approaches that can be used to value cannabis businesses: 

1. Asset Approach 
   The asset approach considers the net asset value of the entity by subtracting the fair market value of liabilities from the fair market value of assets. This approach is commonly used when it is believed that the tangible assets are the drivers of value as opposed to the business’s earnings and cash flow stream. The two methodologies that can be used under the asset approach are: 
   
   Net Asset Value Method - Assets and liabilities are adjusted to fair market value, and the difference reflects the value of the entity.  
   
   Net Liquidation Value Method - Net liquidation value reflects what the assets are worth should you liquidate everything immediately at market price. 
2. Income Approach 
   The income approach considers that the value of an entity is based upon expected future earnings, utilizing net cash flow projections, discount rates, and terminal values. The two methodologies that can be used under the income approach are: 
   
   Capitalization of Cash Flows Method – This method determines the value of an entity by utilizing a single cash flow period that is considered to be a reasonable representation of future cash flow periods. This single-period cash flow is capitalized at a rate that reflects the risk inherent in the cash flows. 
   
   Discounted Cash Flow Method – This method determines the value of an entity by utilizing projections of the company’s future cash flows, discounting these projections to the present value via a rate that reflects the risk inherent in the cash flows. 
   
   
3. Market Approach
   The market approach considers other industry comparable (public and private) to determine market-based pricing multiples that can be applied to the subject company. The two primary methods of the market approach are:
   
   Guideline Transaction Method – This method calculates pricing multiples based on comparable companies that have been recently acquired in merger and acquisition transactions.
   
   Guideline Public Company Method – This method involves determining a set of publicly traded companies comparable to the subject company and analyzing multiples based on trading price ranges of the guideline group. Oftentimes, multiples must be adjusted for differences in size, profitability, and other company-specific risk factors between the subject company and the guideline group.
   
   As mentioned, there are certain issues and considerations surrounding the valuation of cannabis businesses, including, but not limited to: 

Federal Regulatory Issues 

Cannabis is illegal on the federal level. As such, many potential investors and operators consider it too risky for investment. This is largely because while the federal government currently allows states to self-regulate the legalization of all forms of cannabis, it is still listed as a Schedule I controlled substance under the Controlled Substances Act. This is the most restrictive class, which would permit the federal government to intervene at will. Due to this risk, it is difficult to properly determine the ability to raise necessary capital for startups as companies try to keep up with demands and potential expansions. 

Tax Burdens 

As discussed, cannabis is illegal on a federal level and legal to varying degrees by state, putting it in a limbo-state concerning taxes. In this limbo-state, IRC Sec. 280E states that all costs except for those directly linked to production, processing, and storage of cannabis must be considered non-deductible items when determining taxable burden. These complex tax filings also present a challenge due to the limited number of tax professionals who are knowledgeable in this specialized space. 

Rapid Industry Changes 

The cannabis industry is in a constant state of change to the point of being considered highly volatile. A major player in the field must heavily invest in licenses, technology, and time to remain relevant, especially as more states legalize and new players enter. This affects not only growers but direct sales and indirect support entities.  

Lack of Market Data 

Market data is a key factor when determining the value of an entity. Because the industry is relatively new, there are a limited number of comparable companies and transactions to calculate market multiples. Additionally, many comparable companies are in the early stages of growth, which results in unreliable multiples due to the instability associated with young companies. Since the market is in a rapid growth phase, one has to be careful not to misinterpret the data or market analysis. 

Dependence on Projections 

Without any market data or material years of historical data for the businesses at hand, valuations need to rely heavily upon cash flow projections. Due to the limited operating history of most cannabis companies and the unknown future of tax burdens, projections in the cannabis industry are likely to be less reliable than those for companies in more stable or mature industries. Current industry growth rates cannot be expected to continue indefinitely. This is an important factor to consider when reviewing projections and forecasts or offering a prospectus. 

The cannabis industry is constantly evolving, with new industry players, state legalizations, federal considerations, and technological advancements. Though there are risks associated with the industry, the future growth potential is enormous, making the valuation of the industry a complex matter best handled by experienced professionals.