Cannabis business

Cannabis business valuation

Valuing a cannabis-related business would not be much different from valuing any other business except that this business is based on a product that is illegal to grow or sell under current federal law.

When valuing a cannabis business, you can often approach the cash flow analysis with the same formula used in many other valuations: Present value of any asset is equal to the cash flow divided by the risk less growth, as shown in Exhibit:

The critical issue in this industry, though, is the lack of reliable historical cash flow information, which requires the application of a discounted cash flow analysis based on projected performance.
Where:
CF1 = cash flow expected in the next period
k = discount rate
g = growth rate (in perpetuity)
As with any business, with a cannabis retail operation or medical dispensary, you have to switch your net income to a cash flow by adding depreciation and taking away capital expenditures. You also have to add (or subtract) your working capital requirements to get to enterprise cash flow and then take away debt service and add loan proceeds. This brings you to cash flow to equity. Nothing changes in the cannabis industry other than to really understand where these numbers come from

Net income after taxes + Depreciation - Capital expenditures Working capital requirements = Enterprise cash flow - Debt service + Loan proceeds = Cash flow to equity

Given that this business has operated in the open — officially legal first in Colorado — for less than a decade and many businesses have been around for only a few months or years, it is no surprise that there are very few reliable benchmarks in the cannabis industry from the point of view of a business valuation. More information is emerging, but it is anecdotal for the most part and very jurisdictional-specific.

Business appraisers have to come up with workarounds in this situation. Look at what investors expect to receive in the public stock market, add in the additional risk of being invested in this industry, and then apply professional judgment. In a more established industry, an investor might be content with a 20-25% return; in this one — with the regulatory oversight of federal, state and municipal authorities and leasing, banking, cash and security issues — the investor might be looking for a 40-50% return (according to a 2014 interview published by Marijuana Business Daily

Thus, a cannabis business valuation is similar to any other in some ways, but the particular issues in the cannabis business can affect the cash flow. Pay close attention to vetting forecasts, taxes affecting the cash flow, the potential liability to the IRS and other risk factors unique to the industry. It is important to recognize that finding a dispensary operator with reliable projections will be unusual.

Vetting forecasts

When assessing a forecast in the cultivation sector, for example, make sure you tour the facility or the garden; so what kind of crop the cannabis growers are expecting to have in the next six months and what their annual capacity is. Get a firm understanding of the expertise involved in the growth and how much tenure these individuals have.

Various parts of the plant can be sold — not just the desirable flowers that dry into what are called the buds, but the leaves can be harvested and sold to infused products manufacturers.

Taxes

Generally, when tax affects the cash flow, you want to apply a fairly high marginal rate by taxing the gross profit. If the business has not been handling IRC Section 280E, regarding the deductibility of business expenses, in compliance with how the IRS would like to see it, you may need to book an unrecorded liability for potential IRS audits. If the dispensary has had IRS audits, ask whether they have been resolved. Remember, many dispensaries have only been in operation for a short period, so check for the possible liability of IRS audits. How is 280E handled? If the dispensaries have been ignoring 280E, consider making a valuation adjustment to record potential IRS tax assessments.

Risk factors
When considering risk in a cannabis business, never forget that the federal government considers selling cannabis illegal. You need to understand the Department of Justice memos and the IRS chief counsel’s memo, and consider how they affect your risk. Nevertheless, even if dispensaries are playing by the rules, the Department of Justice is watching. If cannabis businesses break any of the rules — for instance, if the cannabis is consumed or grown on public lands, if it gets into the hands of children or if it crosses state lines — then there is an issue. Residents can legally buy an ounce of cannabis for recreational purposes in Colorado; people from out of state can buy a quarter of an ounce. But there is no tracking of sales.
On the other hand, the cannabis industry continues to attract some unsavory types, and it is paramount that professionals working in the space always be on the lookout for client types that are not a good fit.

Competitive landscape
Consider the local area in which the cannabis business operates. A county with a large population may have only one location due to zoning restrictions, and a business there may do very well because of the lack of competition. On the other hand, for example, the South Broadway neighborhood in Denver has a concentration of dispensaries, making for a more competitive environment.

Key employees
In terms of personnel, the head gardener is very much a key employee. The best chance for success in the business is a very strong gardener working in combination with a good businessman or businesswoman. If the cannabis growers have a gardener with no business sense, this could be a problem. Owners in it just for the money, with no growing skills, are at higher risk, too.

Leases
That can happen both at the retail and the wholesale level. If the owners of a cannabis business are going to rent, ask their landlord about the debt structure. You want a building that is free and clear or has private financing. Another option, if it is financially feasible, is for the owners to purchase the real estate for growth and retail, eliminating the real estate problem.
Another issue can arise when an operation initially granted a medical license then becomes authorized to sell to the retail adult-use market. Have the lease arrangements contemplated this expansion? Anticipating and planning for such contingencies is the only way to avoid adverse consequences.

The problem of banks
One reason banks are reluctant to be involved in this industry in the current climate is that, with central bank processing, Colorado checks clear outside the state, in places that do not have legal cannabis. If the federal government stepped in and enforced the law differently, a lot of checks could bounce. Thus, banks need to know a cannabis retail or dispensary client is fully compliant with state laws and that there is complete control of the product from the grow facility to the retail and then to the bank. Armed security guards (where legal) and armored trucks that move the cannabis and cash are a must if the business wants to have access to banking.
It is very difficult for banks to do business with an industry that is making large cash deposits and operating illegally according to federal law and still comply with their own regulations under the Bank Secrecy Act and anti-money laundering rules.
If the banking problem were easy to solve, someone would have figured it out by now.
The hardest bills to pay without a checking account are taxes on payroll. You have to do an electronic funds transfer (EFT) to pay federal withholding taxes. Thus, a cannabis business needs at least one checking account — perhaps a personal checking account used just for those transactions. The rent and other bills are often paid in cash.

Speak with an Advisor

Pro Business Plans is a team of professional researchers, writers, designers, and financial
analysts. Speak with an advisor today.

GET QUOTE

Speak with Sales (646) 866-7619