Cannabis Investing: Can Regulation Turn Your Investment Into Smoke?

By John Downs

This article originally appeared in mg magazine.

 

Any discussion about investment risks in the cannabis industry must, of course, start with the fact that cannabis is federally illegal. Beyond the risk to personal freedom (which I believe is remote if one is an honest operator – see: COLE MEMO) marijuana’s status as a Schedule 1 Drug of the Controlled Substance Act inhibits access to traditional banking, levels onerous taxation through IRS 280E, and is creating a patchwork of fragmented markets that are regulated at the state level. This greatly increases complexity for investors and operators, yet despite these persistent challenges, I’ve noticed that investors’ concerns have largely shifted away from “Am I personally at risk?” to “what are the risks to my capital?”

As with any investment, there are many types of risk that must be faced: business risk, execution risk, team risk, market risk, liquidity risk and more. Cannabis today carries the additional burden that an investor must also deal with significant regulatory risk and uncertainty. Lawmakers are grappling with what the regulatory framework for legalized marijuana should look like, and their decisions directly impact investors. Federal illegality notwithstanding, the nature and implementation of state regulations should be a principal concern for cannabis industry investors and operators.

For example, because cannabis remains federally illegal, traditional banking is off-limits, creating a constant need to physically secure large amounts of cash. Sophisticated security systems or old-fashioned security guards are the industry standard; security firms are doing brisk business guarding the industry’s cash. In addition to those methods, cash management systems enable secure accounting of every dollar while eliminating the possibility for diversion and employee theft. One company, C4Ever Systems, has developed a kiosk that serves as a kind of reverse ATM where the customer inserts cash and receives a ticket to hand to the budtender. An astute investor considering how changing regulations will affect these businesses might wonder what would happen if banks begin accepting deposits from cannabis companies or credit card companies begin processing cannabis transactions. It’s likely that the industry’s demand for physical security or cash management systems would decline. Investors should ensure the company has a plan to adapt to changing regulations, such as C4Ever Systems’ expansion into credit and debit card processing as banking access is eventually eased.

To help California lawmakers anticipate key issues surrounding legalization in California, a Blue Ribbon Commission (BRC) on Marijuana was formed when it became likely the issue would appear on the 2016 ballot. The BRC recently released a Pathways Report outlining policy options for legalization. Rightly noting that designing sensible regulations is an ongoing process and not a singular event, the BRC calls for regulators to collect and evaluate comprehensive industry data to draft, and then fine-tune regulations as necessary based on market feedback. Indeed, regulators, investors and entrepreneurs all need quality information in order to make informed decisions. Coinciding with the creation of legal markets are companies that collect the data and crunch the numbers to provide information and transparency lacking in the black market. After decades of little to no data being available on the illicit marijuana market, companies such as New Frontier Financial that are focused on data collection and analyses have plenty of room to grow because the cannabis market is finally regulated, not in spite of it.

Poorly designed or overly restrictive regulations are a hazard that can delay or impede a cannabis business, or in some cases eliminate entire sub-sectors of the industry from operating where such regulations exist. For example, Meadow is a mobile application that facilitates cannabis delivery between medical dispensaries and patients. Meadow has scalable technology that can be easily and quickly implemented in any legal market. Popular around the San Francisco Bay area where they operate, Meadow is unable to facilitate medical cannabis delivery in Los Angeles County due to Proposition D, which only allows collectives to distribute to their own patients, and disallows third party delivery services. Washington State, Colorado and Oregon currently ban delivery services—and the potential for more states, counties or cities to follow suit and eliminate potential markets for delivery applications cannot be discounted. Despite the continued expansion of state legal cannabis markets seemingly being a “sure thing,” the ability of governments below the federal level to enact restrictions that hinder cannabis operations remains a significant regulatory risk.

The good news is that regulation is not necessarily an impediment to business; there are many instances in which regulation is welcome by the industry and creates the opportunity for new cannabis businesses to prosper. Mandated lab testing of cannabis serves the public interest by assuring safety as it creates investible business opportunities for testing facilities. Marijuana purchased on the black market isn’t tested for potency, cannabinoid content, mold, fungus or pesticides. Assuring that marijuana is safe and free from harmful molds and pesticides, and that customers know what strain and potency they are purchasing, is a fundamental benefit of legalization. Testing is a win-win for regulators, the industry and the public. Along those same lines, seed-to-sale tracking systems that guard against cannabis being diverted into the black market are a universally accepted monitoring tool for regulators, and a fact of life within legal cannabis markets. With regulators in states coming online likely to mandate their use, testing labs and seed-to-sale tracking companies should continue to present intriguing investment opportunities.

Counter-intuitively, the inevitability of certain regulations may limit investor returns. A “sure-thing” entices investors to overvalue an investment, and brings more participants to the market, increasing competition and lowering profitability. Established leaders in these areas—like Steep Hill Labs, or seed-to-sale software company MJ Freeway—may end up retaining dominant market share, though innovators such as handheld testing device MyDx (OTCQB: MYDX), or MassRoots-backed (OTCQB: MSRT) Flowhub could also ascend to the top of the heap. However these markets shake out, the eventual winners will have earned it, because there is no shortage of companies seeking to exploit these sectors. Understanding and adapting to the regulatory landscape plays a significant role, but is only part of the equation for successful investing.

While some regulations are necessary, the burden of complying with them increases costs, lowers profits and increases prices for consumers, all of which sustains the black market. Regulators must strike a balance between a highly regulated and free market, learning as they go. In Colorado and Washington, regulations have already been changed in order promote the public interest of a well-functioning legal market. Washington recently overhauled their entire regulatory structure to combine the recreational and medical market, and changed their system and structure of taxation for cannabis to make the legal market more competitive. These modifications are viewed as net positive for the industry, but other changes being considered in Colorado are not. Regulators there may require even more stringent warning labels on marijuana-infused edibles packaging despite already forcing the industry to comply with increased packaging and labeling restrictions that just went into effect in February.

When evaluating an investment into an edibles manufacturer, therefore, an investor would be wise to consider the cost of compliance with unforeseen packaging regulations—costs not likely to be in an entrepreneur’s financial projections. California currently has no statewide packaging and labeling requirements for its medical market, which will undoubtedly change when marijuana is legalized for adult-use, a potential boon for companies that specialize in designing and manufacturing compliant packaging and labeling for the cannabis industry.

Advertising restrictions are another form of regulation that impose a significant impact on the cannabis industry. The inability to leverage mass media to build consumer awareness and recognition is a significant challenge for upstart cannabis brands. This creates significant opportunity for celebrity-driven brands that benefit from preexisting awareness and positive associations in the minds of consumers. Willie’s Reserve is an excellent example of a marijuana brand backed by an iconic celebrity who has been a household name for nearly 50 years. Willie Nelson’s name is nearly synonymous with cannabis, and every media appearance or musical performance he makes gives consumers another chance to reaffirm the association.

Cannabis is a new market that is highly fragmented and crowded with new brands clamoring to stand out from the rest. In this environment, the strategy of investing in a celebrity-driven brand in not unlike investing in sequels to a major motion picture franchise rather than betting on an upstart independent studio—there is no guarantee of success, but the risk is greatly mitigated.

Navigating the quickly growing and heavily regulated cannabis industry requires careful research and focused attention to a rapidly changing landscape. Nonetheless, forward thinking investors should be eager to join the historic and ongoing process that is the end of marijuana prohibition. The ambiguity surrounding what form regulations will take as marijuana is legalized does not diminish significant demand from consumers. Black market marijuana sales are estimated to exceed $50 billion a year, while the legal market comes in at less than $4 billion! In no other industry does there exist such a discrepancy between proven demand, and the meager legal means to supply it. This means enormous opportunity as an entire (legal) industry is literally being created from the ground up.

If (or rather, when) cannabis is removed from Schedule 1 of the CSA, many investors waiting on the sidelines will be lured to jump into the industry because of the magnitude of demand from consumers. Today’s cannabis industry pioneers will likely have seeded the investments that those newcomers pursue—and at higher prices than in today’s quasi-legal world. Legal and regulatory risks keep valuations lower than they would otherwise be in a federally legal and well regulated industry. Mindful investors appreciate that recognizing and managing regulatory hurdles is necessary to realize investment profits. And so, while regulatory complications can be a hindrance, they are a fact of life within the cannabis industry. By taking regulations into account and staying informed on how they affect a portfolio, investors can find success in today’s cannabis industry.

 

John Downs is Managing Director at MJIC, a holding company focused exclusively on the Cannabis Industry. MJIC seeks to position its shareholders to earn significant returns as cannabis matures into a legal and regulated industry nationwide. For more information, visit www.mjic.com or email john@mjic.com.

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