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Cannabis Industry Valuations

Mar 23, 2021

The public and political view of medical and recreational is changing at a rapid pace. Following the 2020 elections, 15 states and Washington D.C. have fully legalized the use of adult recreational marijuana and 21 states have legalized the use of medicinal marijuana. However, with the industry booming, there comes the issue of how to value business entities supporting the industry for various purposes included M&A transactions, financial reporting, and tax. The cannabis industry is a relatively new and large sector with medical and recreational stores accounting for approximately $18.6 billion in revenue1 and medical and recreational marijuana growers around $11.6 billion in revenue2, creating many questions for potential investors and the general public.

Despite the difference in legality state by state and on the federal level, cannabis entities are businesses with revenue and growth that need to be and can be valued similar to any business with some slight adjustments. There are three valuation approaches and they can all be used to value a cannabis businesses. These three approaches are as follows:

1. Asset Approach

The asset approach for valuation reviews the net asset value of the entity by subtracting the fair market value of liabilities from the assets. This approach is commonly used when it is believed that the value of the assets are the drivers as opposed to the business earnings and cash-flow stream. The two methodologies that can be used under an asset approach are:

  • Net liquidation value, which values an entity as the current value of all assets and holdings. Net liquidation value reflects what your assets are worth should you liquidate everything immediately at market price.
  • Net asset value, which adjusts assets and liabilities for their fair market value and the difference is determined to reach the value of the entity.

2. Income Approach

The income approach for valuation theorizes that the value of an entity is based upon expected future earnings, utilizing net cash flow projections, discount rates, and terminal values. The two methodologies that can be used under an income approach are:

  • Capitalized cash flow, which determines the value of an entity by reviewing a single cash flow period that is considered to be a reasonable representation of future cash flow periods.
  • Discounted cash flow, which determines the value of an entity by using projections for the earnings of the firm and discounts these projections to the present via discount rates.

3. Market Approach

The market approach for valuation considers competitors in the same industry that have similar sales and structures to the entity at hand. The two major type of market approaches used are:

  • Guideline transaction method, which considers the entity at hand and compares similar entities that have been merged or acquired within range of the valuation date.
  • Guideline company method, which considers the entity at hand and compares similar publicly traded entities.

Given that the cannabis industry in general is still in its infancy, there are some large limitation issues surrounding the valuation of marijuana businesses, including, but not limited to:

1. Federal Regulatory Issues

Cannabis is illegal on the federal level; as a result, many potential investors and operators consider it too risky for investment. This is largely due to the fact that while the current federal government allows states to self-regulate the legalization of all forms of cannabis, it is listed as a Schedule I drug under the Controlled Substances Act of 1970; this is the most restrictive class, which would permit the federal government to intervene at any given time. Due to this risk, it is difficult to properly determine the ability to raise necessary capital for start-ups and as companies try to keep up with demands and potential expansions.

2. Tax Burdens

As discussed, cannabis is illegal on a federal level and legal to varying degrees by state, putting it in a limbo-state concerning taxes. In this limbo-state, IRC Sec. 280E states that all costs except for those directly linked to production, processing and storage of cannabis must be considered non-deductible items when determining taxable burden, cutting into what is otherwise a relatively straightforward and profitable business. These complex tax filings also present a challenge as there are a limited number of tax professionals who are knowledgeable in this specialized space.

3. Rapid Industry Changes

The cannabis industry, both growers and direct sales, is in a constant state of change to the point of being considered volatile. A major player in the field must heavily invest in licenses, technology, and time in order to remain relevant, especially as more states legalize and new players enter.

4. Lack of Market Data

Market data, as discussed above, is a key factor when determining the value of an entity. Because the industry is relatively new, there are a limited number of comparable companies and transactions to calculate market multiples. Additionally, many comparable companies are in the early stages of growth, resulting in inaccurate multiples due to the instability associated with young companies.

5. Dependence on Projections

Without any market data or material years of historical data for the businesses at hand, valuations will need to rely heavily upon cash flow projections. Due to this limited operating history of most cannabis companies and the unknown future of tax burdens, projections in the cannabis industry are likely to be less accurate than those of more stable and older ones.

The cannabis industry is a constantly evolving world, changing daily with new industry players, state legalizations, and technological advancements. Though there are risks associated with the industry, the future growth potential is enormous, making the valuation of the industry a complex matter best handled by experienced professionals. Be sure to follow these articles as we delve into more complex cannabis topics going forward.

1IBISWorld Industry Report OD4142: Medical & Recreational Marijuana Stores, March 2021.
2IBISWorld Industry Report OD4141: Medical & Recreational Marijuana Growing, March 2021.

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