The cannabis market in California is expected to reach $5.1 billion in market value.
As cannabis companies begin to grow and the industry becomes more mature, this sector looks more and more appealing, even to risk-averse investors. There are many investment opportunities still available; but how can investors evaluate which opportunities are winners and which are bad bets?
Our experts have a clear line into what an investor must evaluate before working with a cannabis operator. As the cannabis market stabilizes, here are the three main areas and some other factors to consider when investing in a cannabis company: the team, financials and the product.
Some companies will be pre-operational, or in the startup phase. Others will have some financial results and market traction, which you can use to assess their proof of concept and revenue growth.
The best way to assess the viability of either a pre-operational company or an existing cannabis operation is to perform due diligence into investment, its offerings, and the company behind the offering. Broadly, this means learning more about the team, the financial health of the company, and the product or service they’re offering.
Here’s what to look for when investing in the cannabis market.
Who’s on the Team?
The employees, managers, and owners of the cannabis company can tell you a lot about thstrength of the operation. If the business is pre-operational, find out more about the team’s previous business experience. Have they had any major exits? What industry do their leaders come from, and how does that experience help them succeed in the cannabis industry?
Look at their open roles and the roles they’ve already hired for. What key positions have been filled, and where are there skill gaps? Are those gaps absolutely necessary for success? Do the current team members have too many overlapping competencies?
The ideal cannabis business will have staff members who bring a range of skills and a depth of experience, both in managing a startup and in working in the cannabis industry.
Next, get a sense of how the team works together. Do they have a good rapport? Are they a group of friends, or a team cobbled together from a networking event? Is there a clearly defined leader? Too many start-ups fail because there are no clear lines of leadership and too many cooks in the kitchen. The person in charge must be empowered to make decisions – and have the experience and skillset to help them make the right decisions in a business setting.
If the company has decided to split the leadership role, how have they divided equity? A potential red flag is when the leadership team divides ownership equally: it shows that not much effort was made to calculate the value each person truly brings to the company. If the equity is not split equally, take a closer look at how they decided to divide shares.
If you’re seeking to merge two cannabis companies under one entity, it’s important to understand the people and work cultures that will be impacted by this process. Success in the cannabis industry depends largely on relationship building. Make sure you’re finding the right, well-connected leaders and experts in the field who can ensure your investment delivers the right ROI.
[Read more: Mergers & Acquisitions in the Cannabis Industry - Business Combination & Integration]
There are other employee-related things to factor in for cannabis companies that have already been operational for some time. Meet with the team members individually to see how they talk about each other. How well do they know each other? Do they believe there’s room for improvement or skills missing? Are there gaps in the team that they don’t realize? Learn more about their hiring plan and success rate. Have there been any bad firings, and what went wrong?
If the team passes your initial overview, then move onto the financials.
How is the Financial Health of the Company?
When a company is pre-operational, it’s difficult to discern if it’s financially viable. The cannabis operation may be seeking your investment for this very reason. In order to become operational, they may need a quick injection in cash. And, if you ever want to see that money again, do your due diligence to make sure they’re using your money for the right expenses.
Look at the company’s Pro Formas and financial projections. How reasonable and detailed are they? Where did they base their estimates from? Ask the founders of the company to speak intelligently about their inputs, the resulting metrics, and how results may change if some inputs change due to evolving market conditions. What is their business model, and how much funding do they need? What will they do with that funding?
[Read more: What ROI should investors expect in the cannabis market?]
For operational cannabis companies, you will get the chance to review some early financial results. Look at their revenue to see how much is recurring revenue v. one-time revenue. What are the growth rates, and how are those explained by the team? There are a number of factors that can impact growth rates, such as marketing campaigns, external factors (like the annual 4/20 holiday), and internal factors.
Another major factor to question is the cannabis operation’s tax strategy. Taxes can stifle even the most enterprising cannabis operation. How is the business mitigating the impact of federal, local, and state taxes?
Lastly, take a deep dive into the business’s cash flow. This goes hand-in-hand with how they will use your cannabis investment. What will the cannabis business use your funds to accomplish? Where have they used funding in the past? Are they cash flow positive?
Also, check their key metrics:
What’s their accounts receivable, and how aged are they? Is anything causing AR to age poorly?
[Read more: best practices for managing cash on hand
Last but not least, look at the cannabis business’s inventory turnover. Inventory management is important for staying compliant with cannabis regulations and can have a big impact on the business’s bottom line. How quickly is inventory turning over? Is the cannabis operator using track-and-trace properly, if required to do so? Do they have a plan for a worst-case scenario?
What Are They Selling?
The last set of factors to evaluate when assessing an investment opportunity have to do with the actual product or service the cannabis company offers. The market is crowded – in California alone, there are nearly 6,000 operational cannabis licenses – and there are many opportunities out there for investors.
If a company is pre-operational, learn more about what problem they are solving for their customers. Is the cannabis company addressing a true market need, or just trying to get a quick cash grab from this lucrative industry? If you determine they are solving a legitimate problem, does their solution actually work? Does the cannabis operator have a go-to-market strategy? Who is their target customer, and how detailed is this profile? Some cannabis companies think they will sell to everyone: this is a mistake. Savvy cannabis founders will have considered macro market trends and leveraged competitive research to narrow down their target audience to a specific customer.
For existing, operational companies, learn more about how the product or service has changed since it launched. If they’ve pivoted, why? What’s their product mix? Do they offer different flavors, sizes, or types of product? What opportunities are there to upsell or cross-sell? Are any products over-indexing for success, and if so, why?
Final Considerations for Investing
Every investment is a risk, but managing your risk could be the difference between making your money make money—or not. These few final factors to consider for each investment opportunity should not be discounted in comparison to the ones outlined above.
For pre-operational companies, evaluate their competitive landscape. What is their competitive advantage, and is it truly unique? Opening a cannabis business is not a novel idea, but their competitive advantage can make them stand out as a winning investment. Why are they joining the cannabis industry: for love of the product, or for cash?
For those companies already doing business, look at how well they execute their standard operating procedures. Are they compliant with local and state regulations? Do they have the necessary business and cannabis licenses? Finally, are they consistently passing lab tests?
Should cannabis turn out to be too big a risk, there are other sectors related to cannabis that are seeing growth:
Another option is to look into opportunity zone credits as a way to invest in the cannabis market and also gain some tax benefits. You can also get started with a partnership opportunity to learn more about a specific investment opportunity at a lower risk profile.
Our cannabis tax experts are here to answer all of your investment questions: get in touch by clicking the "Get Started" button below.