Perspectives on Growth – Cannabis Quarterly insights, Q2 2022
Growth is rampant across the cannabis industry, from companies seeking to expand their footprints to the maturation of the industry as a whole. This exciting escalation isn’t without its challenges, but the overall trend is one of opportunity for those prepared to meet it.
Here’s what we’ve been thinking about in Q2 of 2022. Click one of the links below to skip to a specific article.
- New cannabis licensees: Setting yourself up for a successful journey
- Performance improvement: Lay a strong foundation to create constant business value
- Addressing the impact of economic factors outside the control of cannabis companies: Supply challenges
- From around the industry: Insights from Simplifya
These articles are part of CannaQuarterly, our new quarterly email newsletter for cannabis industry stakeholders, developed by a wide array of CohnReznick specialists plus contributors from around the industry. Subscribe now to make sure you receive future issues, and visit these pages to explore the other articles included in Q2 2022: Technically Speaking… (Tax and technical insights) | Future of Cannabis
New cannabis licensees: Setting yourself up for a successful journey
Michael Harlow, Tara Marino
You’ve won your cannabis license. (Congratulations!) You’ve invested hundreds of thousands of dollars to get to this point. You’re about to invest (or already investing) hundreds of thousands or even millions more in building your retail store or cultivation or processing facility. How can you maximize your chances of success?
Pay special attention to these critical drivers of success to help you build a business that’s positioned to grow, and to maximize its value when you’re ready to exit.
SUCCESS DRIVER #1: FINANCING
As a successful licensee, you may have already discovered that startup capital requirements are often far more significant than an entrepreneur’s initial projections. The same can be said for operating capital.
Always be fundraising
Fundraising and managing investor expectations are critical roles for a cannabis founder. A business needs ready access to cash in order to thrive, and the journey to positive cash flow can be filled with unpredictable twists and turns. Continuously foster relationships with potential investors to keep that pipeline full and protect against a possible funding shortfall.
Set and manage realistic investor expectations
In well-established industries like technology, dedicated private equity funds have formed that understand the industry’s ins and outs. But in cannabis, your investors are likely to be a diverse mix: Along with high-net-worth individuals with sophisticated investment acumen, you likely also have friends and family who are new to investing. These inexperienced investors may have unrealistic expectations about how much and how quickly their investments will generate returns. Some may not be aware of the tax impact of Section 280E. It’s your responsibility to understand your investors and provide the information and education they need. Educate them about the regulatory environment and cash flow implications of 280E that are unique to cannabis investments.
Tap into the growing cannabis debt market
Growing any business requires a thoughtful balance of debt and equity. Thankfully, the cannabis industry now has a growing number of debt providers finding creative solutions to working with cannabis businesses. While raising capital remains a challenge for emerging operators, solid operational and financial management can help level the playing field. Have a pitch deck and financial model ready, and be prepared to support and explain your financial projections. (Check out our “Raising capital for the cannabis industry toolkit” for additional considerations and a list of materials to prepare.)
SUCCESS DRIVER #2: REAL ESTATE
Secure a lease or acquire property as soon as is practical. Even in states that don’t require a lease before you submit your application, it’s essential to identify your real estate options early in the process. However, it’s a balancing act, particularly in newer cannabis states where municipalities are still figuring out their zoning regulations related to cannabis operators.
Stay ahead of zoning laws
Unfortunately, we’ve seen hopefuls submit applications only to find out three or four months into the process that the local municipality had decided to opt out or pass exclusionary zoning regulations. To avoid this situation, make connections and work your local network from the outset. You can’t wait until it comes out in the newspaper to find out that an area where you just signed a lease has passed a law outlawing cannabis operations. Stay involved and show local leaders why you’re an asset to the community. Go to town council meetings and advisory commissions, and consider retaining an attorney who does community lobbying work.
Do thorough due diligence on the property and landlord before signing a lease. Ask explicitly:
- Does the bank holding the mortgage know that you will lease to a cannabis operator?
- Have you done your due diligence to make sure that we won’t have any zoning issues?
- Is there any reason why you can’t lease to us?
SUCCESS DRIVER #3: OPERATIONAL MANAGEMENT
Success in the cannabis industry requires both knowledge of the cannabis product and experience in relevant business operations. It will be important to balance the two as you build your team and operations. For example, a cannabis cultivator might start with the idea that they should hire the best growers, but a better priority might be seeking out top-notch facilities managers from retail or manufacturing. This section isn’t to say that good cultivation isn’t important, and the grow process definitely should not be ignored; it’s just not the only expertise you need.
Hire interim operational leaders (e.g., CFO)
It is critical for cannabis applicants to put a management team in place many months before the business is operational. In some cases, the license application requires bios of key managers. In most cases, investors and lenders will expect resumes of the people running the operations.
During these early stages, consider outsourcing critical operational functions. For example, some outsourced CFOs work on an interim basis, taking on a handful of early-stage clients before helping each client transition to a full-time CFO.
Build a cash flow model
Although it’s a well-worn trope, the saying “cash is king” holds true for cannabis companies. Since success depends on accurately forecasting sources and uses of cash, one of the essential jobs for the interim CFO will be building a realistic cash flow projection. Top factors to incorporate will include any price compression as markets mature, supply chain inflation, and tax costs related to 280E.
Invest in inventory management
Cannabis inventory is highly regulated in terms of how much companies can keep and have available for sale at any given time. Given this complexity, inventory management is a crucial area of operations that is best handled by someone with inventory management experience in the retail or manufacturing sector. Make sure you have adequate technology in place to provide that person with accurate, real-time inventory data, too.
SUCCESS DRIVER #4: COMPLIANCE
The one aspect of the cannabis industry that most sets it apart is that it is highly regulated at the state and local/municipal levels. You should have at least one person whose primary focus is state and local regulatory compliance, whether you hire an experienced compliance officer, develop that expertise in-house, or seek out an outsourced compliance solution.
Corp, S-Corp, or LLC?
If you haven’t already, choose a corporate structure as soon as possible. Identify attorneys and accountants who have worked in the cannabis space and understand the state regulatory environment. The interim CFO should be familiar with the structure of cannabis companies and the factors that impact the decision, such as your license (or licenses) and your investor demographics.
SUCCESS DRIVER #5: EXIT PLANNING
Be prepared to entertain a sales offer when your business is operational – or even during the application process.
Be ready to sell
While a sales offer might not happen right away, you could miss out on a potentially lucrative opportunity if you’re not ready when it arrives. Be constantly prepared for a buyer’s due diligence checklist. Keep your loan documents, capital table, and financial statements organized and readily accessible.
Prioritize working on (rather than in) your business
As much energy as you direct into your operations, the same amount of energy should go into the business side. While your customers might appreciate a beautiful, well-designed dispensary, potential investors or acquirers will want to see clean, organized, and readily accessible financials.
Build your ecosystem
And remember, amid all these best practices, that part of the fun and the challenge of cannabis is that it is an emerging growth industry where it often feels like we’re making up the rules as we go. Thankfully, plenty of resources exist to help you learn and navigate the industry’s complexities. Consider attending national, state, and local industry events to network with industry capital providers and professional advisors.
YOU TELL US
Help us decide which topics to explore more in-depth in future issues of CannaQuarterly. As you’re embarking on your cannabis business journey, what success driver has been the biggest struggle for you? If you’re well-established, where did you have the biggest growing pains? Send your thoughts to Jessica Timmerman.
Michael Harlow, CPA, Partner
Performance improvement: Lay a strong foundation to create constant business value
Valued at $28.3 billion in 2021, the global cannabis market is expanding at a compound annual growth rate (CAGR) of 32% and expected to be worth nearly $200 billion by 2028. Driven mostly by growing demand for legal cannabis, the market is attracting a large number of multi-state and single-state operators that are focused on serving the mainstream marijuana consumer.
With major mergers making headlines, many cannabis operators are preparing for potential acquisitions by other entities. As they manage the day-to-day and state-specific regulatory issues while finding their way in this emerging market sector, companies also need to implement initiatives that drive value creation across the enterprise.
The latter, also known as performance improvement, can be a challenge for operators that are very good at selling, growing, or distributing, but aren’t as well-versed in setting up a business to scale or maintaining efficiencies as a business grows. For example, human resource management, financial reporting, sales and marketing, and/or operational management may all be short-changed when a company is focused narrowly on production and distribution. These challenges usually surface once a company starts preparing for an acquisition, IPO, or other significant financial event, when they might find the market value to be less than they expected or hoped for.
The good news is that when you create a business with the right people, processes, systems, and products in place, you’ll always have value to sell. That’s the ticket to driving and creating business value, versus adopting the day trader mindset and hoping to time the opportunity right.
Focus on the underlying fundamentals
By focusing on the underlying fundamentals of running a good business and implementing performance improvement strategies, cannabis operators can count on financial, operational, and human capital benefits. A good starting point is to leverage the “fresh eyes” approach to identifying issues and actions to drive performance and enhance value. Some of the easy wins typically include supply chain and cost optimization, followed closely by process efficiency, leadership/workforce effectiveness, and technological upgrades to automate business operations.
Top-line improvements – increasing wallet share, capturing market share, and/or infiltrating adjacent markets – are often the best way to realize the long-term value that cannabis companies are working toward. And while implementing change comes with its own set of challenges, performance improvement initiatives can create significant enterprise value for all cannabis operators that deploy such strategies.
Because there is no one-size-fits-all approach to performance management for this industry sector, the focus should be on the areas of the business that would most benefit from upgrades in people, processes, and systems. For example, an organization that still has a bookkeeper handling the financials on spreadsheets (or by hand!) would benefit from an automated, unified system that streamlines this process and produces data timely that management can rely on for visibility and decision-making. This would not only take some of the pressure off the company itself, but also create a more accountable, auditable financial trail for future investors or acquirers (and help the companies manage compliance and regulatory requirements).
Alternatively, an operator may be excellent at growing its products, but fall short with sales and marketing – which can create a disadvantage for a newer company competing for customer attention against very large, established players, not to mention the illicit market. Addressing this challenge is less about cost management (trying to be the low-cost provider) and more about understanding who your target customer is and then positioning your company to attract and serve them.
Lay down a strong foundation first
For growing cannabis operators that are preparing for a transaction, the keys include maximizing revenue (expanding market share and share of wallet) and optimizing cost (getting the most value for every dollar spent) so that margins increase and growth produces additional, rather than less, profit. This is generally best accomplished by implementing value creation strategies to improve your workforce effectiveness, process flow, and system integration and innovation.
As a cottage industry that’s now experiencing massive growth, the cannabis industry presents significant opportunities and challenges for the companies operating in it. The same goes for the firms that are acquiring other entities in this space, where performance improvement initiatives can create positive impacts across all of a firm’s functional areas, including strategy, sales and marketing, finance, human resources, technology, and operations.
To most successfully go public, be acquired, or expand into new geographic areas or customer segments, a cannabis company must create a solid foundation that supports profitable growth. While cost optimization and reduction, supply chain optimization, process reengineering, organizational redesign, or systems overhauls can work, there is a limit to what these measures can achieve on their own; they must be part of a broader, well-thought-out business plan that continually drives toward optimizing overall performance and creating value.
The bottom line is that you can’t grow effectively along with demand if your firm’s underlying foundation isn’t solid. It’s a lot like trying to construct a building on a rocky foundation versus one made from solid cement: The building settles, and it can’t be expanded and it can’t grow. It works the same way in business; cannabis operators that put performance improvement initiatives in place can lay that solid floor to continually create long-term enterprise value.
Addressing the impact of economic factors outside the control of cannabis companies: Supply challenges
Heather Carter, Benny Herman
The cannabis industry is an amalgamation of many other industries: agriculture, manufacturing, fulfillment, transportation, retail, technology, and real estate, to name a few. As supply chain disruptions, labor shortages, and other external factors continue to plague businesses of all types, cannabis operators must face not only their own unique challenges, but also the challenges inherent in each of these component industries.
As new states open markets and existing states continue to expand, higher numbers of cannabis businesses are tapping the same finite resources for their needs. Supply and labor shortages are inevitable, and in response savvy operators are shoring up channels and proactively planning for disruptions as critical components of their overall business strategy.
This article is part of an ongoing series to address economic factors that impact the cannabis industry, and offer potential solutions. While the economic factors may introduce challenges beyond a company’s control, the good news is that there are ways to soften the impact while maintaining a competitive advantage in the market.
Current conditions compounding supply challenges
Supply and product lead time
At the core of the cannabis supply chain are the cultivation, processing, and packaging materials needed to ultimately get product on the shelves. Competition for necessary items such as fertilizer, lighting, machinery, batteries, and cartridges is increasing the cost and difficulty to obtain them. Frequently these are imported items, which adds further risk and time to delivery. Companies are left vulnerable to large-scale events or disruptions, such as the current sanctions on Russian exports because of the conflict in Ukraine or factory closures due to COVID-19 in Asia.
- Diversify your supply base where possible. Remember the old proverb, “Don’t put all of your eggs in one basket.” A multisource strategy decreases the likelihood of supply disruptions, and may also drive vendor competition to influence better pricing. Consider maintaining a mix of relationships with both domestic and foreign vendors in the event you need to implement supply chain substitutions. With new providers coming online to support the industry all the time, watch for opportunities to work with small, diverse, local businesses, too.
- Learn from the experiences of others. Familiarize yourself with the ways that agriculture, manufacturing, transportation, and other mature industries respond to market and supply challenges. For example, the operational methods adopted by process manufacturing firms are especially well-suited to serve as a starting point for cannabis best practices; determine which may be applicable to your own needs, and implement them within your operation. Additionally, some industries obtain contractual commitments to secure future deliveries from suppliers, and consult with transportation brokers to make sure they have access to timely shipping resources. Others are trending away from just-in-time delivery and increasing reserve supply, while carefully monitoring trends to avoid being caught with unusable product.
Inflation has increased the costs of products across the board. Raw materials are driving up overall prices, with items like ammonium nitrate and urea, which are sourced heavily from eastern Europe, in high demand and low supply. With so much instability in the global market, forecasts on future pricing are impossible to predict.
Inflation will certainly have an impact on consumer behavior, and economic uncertainty will likely compel many to rework budgets to de-prioritize discretionary spending. Some buyers consider cannabis a luxury item and may opt to curb their spend or trade down from branded products, while others deem cannabis medically necessary and will prioritize those purchases. This unique influence on the market could have the potential benefit of lessening the severity of inflationary impacts on revenue.
- Optimize your product mix. Conduct research in your market to assess what is popular and where your products face strong competition, and adjust your production mix accordingly. Augment your mix with new products and strains so you don’t lose out on potential sales, and remove slow-moving items and items sold by too many competitors. We have observed cultivators testing new strains to generate premium pricing as markets become saturated with supply of older strains.
- Put the right people behind the counter. The employees behind the dispensary counter are the face of the operation – it is critical that they be equal parts experienced, knowledgeable, and personable. Many green cannabis consumers rely heavily on recommendations from budtenders, and how they feel about their buying experience will influence whether they return. A positive experience may also increase revenue per transaction. Implementing continuous training programs for dispensary staff will help ensure they stay current on the latest knowledge of this mysterious and misunderstood plant.
- Investigate whether future buying is an option for critical materials. To stabilize pricing and secure supply, many producers make use of future buying techniques such as hedging and forward contracts. These purchasing vehicles enable suppliers to ensure they have a predictable stream of revenue, and buyers love them because they reduce risk exposure beyond the near term. These methods provide the most opportunity with commodities, such as fertilizer, electricity, gas, and other products with developed, competitive markets. It is important to view them through the lens of cost certainty as opposed to “beating the market.”
Increased market competition
The race to market is fiercely competitive, and aspiring entrants are vying for a limited number of available licenses, materials, consumers, and spaces. Facilities, for example, pose one particular challenge in this area, as new operations rely on construction of specialized facilities to enter the market. In this respect, cannabis operators are competing not only among themselves, but also with construction projects across industries.
- Consider proactive and creative purchasing strategies. Strategies like category buying and collective buying could help mitigate the cost of and competition for materials; consider collaborations with providers in your upstream or downstream value chains. Plus, look for ways to tie your sourcing to your environmental, social, and governance (ESG) goals. For example, the local supply chain can be a great opportunity to build new vendor connections, support smaller businesses, and even reduce your environmental footprint, if goods don’t have to travel as far. Investments in ethically, sustainably produced materials from ethical, sustainability-minded businesses can not only get you the supplies you need but also drive value, as ESG is increasingly important to stakeholders across the business community.
- Cultivate strategic vendor relationships. Shortages and competition are inevitable. Find ways to extract additional value from current suppliers, while also building relationships with new suppliers. Depending on your leverage, you may be able to defer price increases, take advantage of “most favored customer” status, or obtain value beyond price from key relationships.
- Consider other ways to break into the market. Being part of a nascent market means frequent review and optimization of your go-to-market strategies. The cannabis consumer audience is growing, diversifying, and becoming more demanding – operators must be ready to optimize their sales channels, evaluate product pricing and packaging and waning popularity of older strains, and even take on entire new customer segments in response to the change in demand.
From seed to sale, cannabis requires specialized labor, and finding quality and qualified workers in a general market is challenging enough without the complexity of this industry. Employees need specialized knowledge of the product and comprehensive understanding of regulations as well as the ability to perform assigned duties. Due to the relative immaturity of the industry, the skillsets needed are in short supply, and again, cannabis companies within a given market are competing to recruit the same finite workforce. Labor shortages put workers in the power seat, enabling them to pursue opportunities with higher wages and better benefits and putting organizations at risk of high turnover. Employers should act now to develop strategies that reward and retain existing employees to avoid losing them, especially amid the “Great Resignation.”
- Invest in employees, particularly in learning and development. Many people want to break into the cannabis industry, but not everyone is skilled in its nuances. It is important to ensure that the employees hired know the plant and the industry, and that management understands the real costs involved in employee turnover to realize the ROI on training investments.
- Incentivize employees to remain at your company. Other companies want your workers. Don’t train employees for your competition. Offer them a wide range of reasons to stay, such as competitive benefits, retention bonuses, ample opportunities for new skills development, and the chance to grow beyond their current role. Remember, retaining existing employees is far less costly than recruiting new ones.
Drive performance and plan for the future – in any environment
Absorbing and solving all of the issues presented here may feel like a lot to unpack. Don’t try to take them on all at once; instead, prioritize the efforts based on their greatest potential value for your organization. To start, you’ll need to define the top goals for your business and identify the inefficiencies that create the greatest obstacles to your success. Quantifying the costs and impacts of each goal will be critical. You’ll also need to determine the systems, data, and processes necessary to address these issues and be prepared to support cross-functional change management that will be necessary for stakeholders from all areas of the production chain.
Like with most problem-solving, the trick is to conduct thorough research, identify and explore multiple options, and have clarity on how a decision will impact your business. If unsure how to approach this journey, seek advice from experienced professionals who can help you navigate your approach to this ever-changing marketplace.
Benny Herman, CPA, Director
Heather Carter, Technology+, Global Consulting Solutions