October 2018

The general principles of valuing enterprises apply to a cannabis company. However, the regulatory and growth attributes of the cannabis industry complicates considerably the valuation of a cannabis-related enterprise. This guide discusses unique valuation considerations for cannabis-related appraisals.

Currently, there are numerous publicly-traded companies in the cannabis area. Although there is considerable money that can be made as the market explodes, the lack of stability in terms of profitability, regulation and competition causes investments in the cannabis industry to be highly risky. For individual companies, careful consideration of the matters discussed herein is required.

Market Size and Growth

The U.S. market for cannabis products is estimated to be around $60 billion. Much of this is currently traded in the black market, so these estimates are difficult to substantiate. Worldwide, the United Nations estimates the cannabis market to be $150 billion annually.

To put the U.S. market size in perspective, the U.S. market for cannabis is around half the size as the market for beer, smaller than the market for cigarettes (but not enormously smaller), around the same size as the market for wine, and roughly twice the market size of video games. However, compared to all of these other industries, the market for cannabis is expected to grow much more rapidly, with annual growth of 20% to 30% for several years. If such growth occurs, the market for cannabis could easily double in five years.

The increase in market potential is supported by:

1. Easing consumer perceptions regarding the medical and recreational use of cannabis;
2. An explosion of the products in which cannabis and TCH (Tetrahydrocannabinol) is used; and
3. Easing regulation (see next section).

Regulation

Like most businesses and industries, a proper appraisal of a cannabis enterprise needs to consider the regulatory environment that exists. Once properly licensed, the cannabis business may face less competition than otherwise would exist, which can increase (perhaps significantly) the value of the licensed enterprise. However, the regulatory and licensing environment is changing, so the analyst needs to understand what will likely occur in the future. Absent a proper consideration of this important area, an appraisal of a cannabis company will likely be incorrect.

As of 2018, nine states and the District of Columbia have legalized recreational use of cannabis. Most states allow medical use of marijuana, although some of these place limitations on the level of THC content. Only three states prohibit cannabis for all purposes. As a result of the differences between state and federal laws, cannabis dispensaries and businesses are licensed by each state, with further regulation administered locally. Canada has legalized cannabis, and is the first major country to do so.

California (where Fulcrum is located), was the first state to establish a medical marijuana program with the passage of the Compassionate Use Act of 1996 (Proposition 215). In November 2016, California voters approved the Adult Use of Marijuana Act (Proposition 64) to legalize the recreational use of cannabis. California’s main regulatory agencies are the Bureau of Cannabis Control (BCC), Department of Food and Agriculture, Department of Public Health and Cannabis Regulatory Authority (CRA).

In contrast to the actions of the majority of states, under the federal Controlled Substances Act of 1970, drugs and certain chemicals used to make drugs are classified into five (5) distinct schedules depending upon the drug’s acceptable medical use and the drug’s abuse or dependency potential. The abuse rate is a determinate factor in the scheduling of the drug; for example, Schedule I drugs are supposed to have (i) a high potential for abuse and the potential to create severe psychological and/or physical dependence and (ii) no currently accepted medical use. Examples of Schedule I drugs are heroin, LSD, and ecstasy. Examples of Schedule II drugs (less dangerous and/or subject to abuse than Schedule 1 drugs are cocaine, methamphetamine, Vicodin, Demerol, and Oxycontin).

Currently, cannabis is classified by the U.S. government as a Schedule (Class) I drug. Multiple efforts to reschedule cannabis under the Controlled Substances Act have failed, and the United States Supreme Court has twice ruled that the federal government has a right to regulate and criminalize cannabis, whether medical or recreational. Further, the federal government criminalized marijuana under the Interstate Commerce Clause.

The discrepancy between federal and state regulation will change, most likely by having the federal government change its clearly-improper classification as a Schedule I drug. As a step towards a more accurate classification of cannabis, in June 2018, the FDA issued its first approval of a medicine derived from cannabis. Specifically, Epidiolex (manufactured by Britain’s GW Pharmaceuticals) was approved to treat two rare and severe seizure disorders (Dravet syndrome and Lennox-Gastaut syndrome). The FDA carved out an exception to the Schedule I classification of cannabis, and provided a criteria for other drugs to be similarly reclassified by the FDA.

Nevertheless, the DEA’s Schedule I classification remains at the time of this writing. Until the federal government’s position changes, the possibility of federal government action against cannabis companies (i) creates risks and uncertainties, and (ii) increases tax costs, as described in the next section.

Tax Issues

Internal Revenue Code §280(e) prevents cannabis companies from deducting normal and reasonable business expenses involving a Schedule I drug that would be deductible in other businesses. As long as cannabis is classified as a Class I or II controlled substance, only expenses classified as Cost of Goods Sold may be deducted for federal tax purposes. Cost of Goods Sold are the expenses of producing or purchasing the physical product. Costs of marketing, advertising, displaying, and selling the product, and the overall cost of running the business, are not deductible for federal income tax calculations (as would be allowed for other legal businesses). To help ensure that maximum appropriate deductions are taken, cannabis businesses, should keep records showing:

  1. The actual work being performed by employees, so that costs of growing, harvesting, curing, manufacturing and/or packaging cannabis are captured and classified as Cost of Goods Sold; and
  2. The physical space (square footage) and equipment used for the functions listed in the preceding point.

These rules disfavor dispensaries, as they are primarily involved with selling the product. However, even dispensaries may have an area in which product is received, repackaged and stored before being offered for sale.

Changes in the drug classification of cannabis will have significant positive impact on the profitability of cannabis companies becaus