How Risky Is Your Cannabis Business?
Free Book Preview Cannabis Capital
Risk is inherent in all aspects of every business — it’s an expression of the uncertainty of future outcomes. It’s this exposure to known and unknown threats that investors evaluate when defining the risk specific to each individual investment. The cannabis investing market, and private company markets, in particular, are populated by entrepreneurs and investors who have a very high tolerance for risk.
Cannabis investors view their investments in the context of putting their capital at risk at the outset of an investment, compared to the potential to create a return in the future. Cannabis investors desire to take as little risk as possible in an investment for the greatest return. This is the risk-adjusted rate of return that’s acceptable considering that the investment is illiquid, meaning there’s no readily available marketplace to sell the shares and liquidate the investment, as you can with a publicly-traded stock. The result is, there’s little to no ability to convert the investment to cash until an exit event at some future point in time.
One unique aspect of cannabis businesses is that despite being very early stage, many companies achieve positive cash flow quickly, which is unusual in other investment markets. This can be a beneficial situation for investor and entrepreneur alike; however, it can also be a threat to the business as revenues and profitability can hide operational deficiencies and regulatory risks.
Investors will continually strive to identify risk in all aspects of any investment opportunity by asking such probing questions as:
- Does the company have outstanding lawsuits?
- Do they get sued a lot?
- Does the company need any regulatory approvals they don’t have?
- What’s the probability they don’t receive those approvals and what’s the contingency plan?
- Do the founders work well together?
- Has the company taken on too much debt and is struggling to service that debt?
- Does the company have a concentration of sales with one customer?
- What happens if that customer goes out of business?
As you can see, opening up any discussion around risk can take the investor down a seemingly endless path of exploration and identification of market and company specific risk. How an investor views the perceived risk of a proposed investment will inform their negotiations and create a structure for moving forward in the process. It’s the job of the entrepreneur to help the investors fully understand the risks of the investment, but also to put those opinions in context and explain the mitigation strategies and planning for any unforeseen eventualities that are contingent to the company’s business plan.
Private company risk
There’s some level of risk to investing in any company, public or private. Macroeconomic trends can impact the largest, most stable businesses, and unforeseen natural disasters can happen. When they do, there’s little a management team can do other than have contingency plans in place. When investors evaluate the risk of a private company specifically, there are several categories of risk that investors will focus on:
Management team risk
When evaluating a management team, investors look for people who clearly work well together, have some track record of success, and ideally have a history of producing financial returns for investors in the past. An example of this is that many early-stage venture capital investors will prioritize an investment with a team of individuals who have successfully built and exited a company in the past over an investment in a first-time entrepreneur.
As investors define the addressable market and industry of the specific company under review, they’ll also be evaluating the overall market, sector and global cannabis economy risk. This includes consolidation trends, competition, international market trends, customer buying trends and sector maturity. For example, in a mature market with larger, more established competitive businesses, is there room for innovation or new developments? Will that innovation be a threat to the business or create an opportunity?
This is the area investors are most likely to focus on when considering a cannabis investment. The regulatory issues in this industry are broad, complex and changing rapidly. Fifty percent of investors surveyed over a recent two-year period identified regulatory issues as the number-one consideration when investing in a cannabis company.
Product or service risk
Does the company have a product or service that’s unique and addresses a major point of pain for its customers? Is the company’s solution difficult to replicate or compete against? Is the product in a decline due to new offerings, which requires the company to invest heavily in research and development? Will heavy spending also be required to bring new products to market, not all of which will succeed? You’ll need to ask yourself if you’ve evaluated your direct and indirect competition, unique selling proposition, and costs in line with a competitive product.
Operational/Strategic execution risk
Execution risk is a common theme across the cannabis investing spectrum and in venture capital. The key concept is that all companies have operational risk with varying degrees. Cannabis investors will need to spend a lot of time understanding this risk and determining if the management team can identify and execute against a defined strategic plan to reach the milestones and goals for the business.
When determining the financial risk of a cannabis investment, investors will take a 360-degree approach to the financial structure of the company. This full scope view will take into account everything about the business that flows though, or is managed by, the finance department. Does the company have the appropriate alignment of financial resources, structure and operational controls? This is increasingly complicated in cannabis venture investing in that many companies may not be able to have traditional bank accounts or have to comply with 280E federal tax requirements.