Trouble Brewing? A Look at the Cannabis Industry’s Signs of Distress – and Resilience

“If you build it, they will come.” These were the words spoken from above to Kevin Costner’s character, Ray Kinsella, in Field of Dreams, as he walked through an Iowa cornfield and envisioned Shoeless Joe Jackson standing in what would become a beautiful ballfield. And this vision did come true. Like Ray, countless entrepreneurs have walked through farmlands, warehouses and retail shops alike – dreaming of building state-of-the-art cannabis facilities.

The cannabis industry is home to some of the hardest working, gritty, thoughtful, and passionate entrepreneurs in the world, and there are plenty of success stories out there. However, the industry at large is quickly experiencing a difficult truth: it’s not as simple as if you build it, they will come. The saying for the industry, at this point, should probably be something more along the lines of if you build it, and build it in a great location, and are well capitalized, and execute effectively, with a great team that provides customers with a consistent product, then they will come.

Yes, there is momentum from 2021’s state legislative victories that resulted in Connecticut, New Mexico, New Jersey, New York, and Virginia all legalizing adult use. But the reality today is the cannabis industry is in a state of hypergrowth – and distress.

 

How Did We Get Here?

The largest publicly traded cannabis multistate operators (MSOs) have experienced significant stock price decreases over the last twelve months, experiencing declines of over 50% of their trading prices on average. The public market pricing reductions have cooled equity valuations for private companies as well, generally speaking.

In a capital-intensive industry such as cannabis, these equity valuation compressions have resulted – for many companies – serious working capital deficit issues. And now, we are beginning to see cannabis businesses starting to go out of business or liquidate. This month, cannabis operators closed their doors on more than ten dispensary locations in Michigan and Colorado. Meanwhile, wholesale prices continue to plummet in many of these mature markets, causing additional pressure on cultivators and manufacturers faced with margin compression.

There is much speculation about why cannabis stock valuations rapidly decreased. One theory is that many investors in publicly traded MSOs speculated that by now, Congress would have at least passed a bill to decriminalize the plant or would have passed the SAFE Banking Act to ease cannabis businesses’ access to banking services. After all, in 2020, the country elected a unified Congress and a President that promised to “work to reform the criminal justice system, improve community policing, decriminalize marijuana, and automatically expunge all prior marijuana convictions.” Almost two years later, Congress has passed neither such bill. Many early investors expected federal legislation, to no avail. And as a result, there are certainly investors that lost patience.

 

Why is it so Challenging for Cannabis Businesses to Succeed?

The cannabis industry – at its core – is highly capital intensive. It takes a lot of money to build and operate a cannabis business.

  • In addition to the burden of capital expenditures required to launch a business, the reality is that in a heavily regulated industry, there are significant costs and expenses associated with complying with state and local regulations.
  • As cannabis remains illegal at the federal level pursuant to the Controlled Substances Act, operators still struggle to find adequate banking services.
  • Section 280E of the tax code is probably the most significant handicap on operators (particularly retailers) – as this tax provision prohibits plant-touching cannabis companies from deducting any of their business expenses other than Cost of Goods Sold. Should 280E get removed through legislation, cannabis businesses would face significantly less burdensome tax requirements.
  • Compounding these issues is the fact that, as of now, cannabis companies are prohibited from obtaining bankruptcy relief in Federal Bankruptcy Courts because cannabis remains illegal under Federal Law. This has made it more challenging for cannabis companies to restructure their businesses. They are generally limited to state court insolvency proceedings and receiverships, which offer fewer protections for potential acquirers, lenders or other capital sources than would otherwise be provided in a typical Chapter 11 bankruptcy proceeding.

So, if you combine the fact that cannabis companies need more capital — much of which is seemingly drying up (at least for the moment) – with the practical challenges companies face to effectively restructure, the marketplace is presented with a condition of distress.

 

Where Do We Go From Here?

All is not lost. According to a study by New Frontier Data, the cannabis industry grossed $27 billion in sales in 2021 and is expected to reach $32 billion this year. This plant is not dead; it will continue to grow. And more Americans (and people abroad) will consume the plant. According to that same study, annual legal sales of cannabis in the U.S. are projected to grow at a compound annual growth rate (CAGR) of 11% between 2020 and 2030 and reach beyond $57 billion. In states where it is currently legal, annual sales of medical cannabis are projected to grow at a 7% CAGR through 2030, from $8.5 billion in 2020 to an estimated $16.7 billion by 2025. During the same period, adult-use sales are projected to grow at a 13% CAGR, from $11.7 billion to $40.9 billion (New Frontier Data).

For effective operators and shrewd investors, the distressed market conditions present compelling opportunities. Creative companies and investors alike have an opportunity – which we are already seeing take place in the market – to obtain assets and invest in businesses at favorable valuations that were not previously available and may not be available in the future.

Here at Burns & Levinson, we are at the forefront of the industry – hard at work helping our clients navigate and weather these challenging times. We are also working with our seasoned investor clients that see the present market conditions as an opportunity to expand, while also helping new investors jump into cannabis, recognizing now as the perfect time to enter the industry.

Be sure to come back for our upcoming post, where we look at how this distressed market is playing out for both investors and operators.