Industry Deep Dive: Cannabis and Investing

Investing in the cannabis industry is not the same as investing in mainstream industries. Navigating where to put one’s money in any start-up, stock, or established company is challenging. Cannabis concerns are especially challenging in a federally illegal designation. However, 36 states have either medical and/or adult use laws that make investing in cannabis attractive to entrepreneurs, investors, and ancillary businesses.  The upside and future for the cannabis industry is what is attractive for investors. 

This deep dive takes a look at cannabis investing, the challenges surrounding it, and some of the ways cannabis businesses are securing the capital funding they need to grow despite these obstacles.

What is the investment landscape in cannabis?

Unlike other industries, such as the tech sector, investing in cannabis is not usually as simple as buying and selling stocks on a stock exchange like NYSE or NASDAQ. While there are some big companies that have been publicly traded in this way, the majority of the cannabis industry cannot access this space in the U.S.

However, that doesn’t mean investors can’t get involved in the industry in other ways. Whether relying on private investment firms or alternative methods of indirectly investing in the growth of cannabis, there’s no shortage of opportunities to get involved in the space.

“There are lots of ways people can invest in cannabis,” said Sumit Mehta, CEO of investment firm Mazakali. “Cannabis is a market I would think about in five categories: plant-touching businesses from retail to cultivation, non-plant-touching ancillary businesses, hemp and CBD, real estate, and international markets.”

Internationally, Canada is the only country to have a fully legalized stock market for public cannabis businesses, said Mehta, who is also a strategy and finance consultant for the Arcview Group. However, he added, people who want to invest in the domestic market can still do so despite the lack of a robust public market.

“You can’t get a stock price every day and trade out, [but you can] go directly into private companies all over the country,” Mehta said. “The other way is to invest in real estate funds, which are a sound investment because they can be repurposed and are enjoying high rents from cannabis tenants.”

Challenges facing cannabis investors

While cannabis is predicted to grow immensely as an industry — eclipsing $40 billion by 2030 according to Grandview Research — there are some challenges that investors should be aware of. Cannabis is an industry that faces a lot of restrictions, so despite the estimated growth projections, investors should be aware that there is no such thing as a sure bet, especially in cannabis.

IRS Section 280E

One of the biggest obstacles to profitability for cannabis companies is IRS Section 280E, a tax code which disallows state-legal cannabis businesses from taking federal tax deductions that businesses in other industries claim all the time. Instead, cannabis businesses are only allowed to deduct the cost of goods sold (COGS) from their federal tax liability. 

“Very simply, 280E means the difference between revenue and profitability is greater for cannabis businesses than those in any other industry in the U.S.,” Mehta said.

The result is that many high-revenue cannabis businesses have much thinner margins than they would otherwise, which means a lower rate of return for investors. The code may even impact a business’s ability to turn a profit altogether, even if the business model and fundamentals seem sound.

Banking restrictions

Cannabis businesses face limited access to the U.S. banking system, meaning many have to deal with cash and are unable to process debit and credit card transactions. Those who do have bank accounts and merchant processing accounts are susceptible to sudden closures leaving them without a banking solution, in some cases overnight. In addition to these business disruptions, cannabis businesses often don’t have access to conventional bank loans and lines of credit. When this is the case, the lack of capital can restrict the growth of a business and delay the return on investment to a company’s investors.

Lack of interstate commerce

The state-by-state legalization of medical and adult-use cannabis has led to isolated state markets that need their own supply chains. The lack of interstate commerce has not only slowed the growth potential of the industry as a whole, but has led to a proliferation in the total number of cannabis businesses operating in these fragmented markets, making it difficult for investors to identify the future winners.

“Because cannabis is federally illegal, you cannot transport it across state lines,” Mehta said. “The industry is massively different from others in that you have seed to sale supply chains within state lines, and if or when the federal government drops Prohibition, it will be a massive change for the industry.”

The result, Mehta said, is that there are 80,000 licensed businesses in cannabis throughout legal states and 160,000 more unlicensed businesses competing for the same market share without the same restrictions. 

Will federal legalization resolve cannabis investing challenges?

Federal legalization would likely get the ball rolling on the changes Mehta predicts for the industry, but he doesn’t anticipate it happening quickly. Instead, over the course of years, Mehta expects a gradual rollout of a regulatory framework and the subsequent slow adaptation by the industry based on those rules.

“I would expect that even if the federal government takes action, it would take north of five years for the government to adopt their own regulations to even begin controlling the industry,” Mehta said. “Hopefully, in the meantime, the IRS effectively takes away 280E to allow companies with healthy revenue to show a healthy profit.”

“The second thing that would happen is, hopefully, these state border walls will fall,” he added. “We grow spinach in California and ship it to Arizona, so why don’t we do that with cannabis? But the states will fight this tooth and nail; they now have industries, jobs, and tax revenue that would leave the state.”

While optimism around the prospect of federal legalization fixing cannabis challenges may be mixed, that doesn’t mean the industry isn’t still rife with opportunity. However, it does mean that the capital flowing into new businesses is not as readily available as it once was. 

“There was a lot of euphoria for legalization and the expectation that banking and tax issues would be lifted,” he said.

Funding options for cannabis businesses

Despite reticence on the part of many investors due to the restrictions surrounding the cannabis industry, there are still several options for entrepreneurs when it comes to funding their ventures. These are the most common ways businesses are funded in cannabis:

  • Bootstrapping: In many cases, founders use their personal funds to start their cannabis business and get it off the ground. Of course, bootstrapping a company comes with certain limitations that could restrict the growth of the business. However, it’s a good option to get the foundation in place and begin generating some revenue to prove the viability of your business model.
  • Friends and family: With limited conventional lending options, many new cannabis businesses seek investment or loans from friends and family. While this may be ideal for new businesses or those that only need to hire an employee or two, an informal friends and family capital raise might not be suitable for businesses that are trying to scale up significantly.
  • Line of credit or business credit cards: Some banks are willing to work with cannabis businesses, although it can be a challenge to find them. If you do, though, you may qualify for a line of credit or business credit card that can be used to help grow your business. Unlike a bank loan, you’ll only pay for the credit you use. However, be sure to check the terms and interest rates of any line of credit or credit card you accept, as these sometimes include restrictive requirements.
  • Private investors: Most cannabis businesses won’t go public even when the public markets are unrestricted to the industry. Instead, those that court investors will likely do so through one of three avenues: Reg CF, Reg A+, or Reg D capital raises. Reg CF enables equity crowdfunding, allowing many accredited investors to purchase a small stake in a private company, which could be useful for smaller, growing companies that need to raise capital to expand. Reg A+ and Reg D allow for private placements to investors for larger scale capital raises.

Exploring opportunities for investors in cannabis

With the right guidance and know-how, investors can identify and fund lucrative opportunities within the cannabis industry. One way to do so is at the CannaVest East Institutional Capital Forum, held alongside CWCBExpo at the 2023 conference. This forum has been created specifically with the needs of the family office and sophisticated accredited investor in mind. Qualified attendees will get an in-depth look into the opportunistic cannabis industry and explore a broad range of investment opportunities. Visit the CWCBExpo website to see qualifications and learn more about this year’s conference, held June 1-3, 2023 at the Jacob K. Javits Convention Center in New York City. 

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