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Looking to Invest in Cannabis? You May Be Focusing on the Wrong Companies

Newer investors in the cannabis space can experience outsized returns by setting their sights on the potential of single-state operators and ancillary services.

Opinions expressed by Entrepreneur contributors are their own.

In the past year, the regulated cannabis industry hit a turning point. Sales increased by 46 percent during the pandemic, reaching a record $17.5 billion in the U.S. alone. If this trend continues, the market will grow at a CAGR of 15 percent to $41.3 billion by 2026.  

Early investors in cannabis have already seen outsized returns based on the initial phases of acceleration within the industry. In some cases, cannabis funds— like Poseidon’s Fund 1—achieved IRRs far exceeding the industry’s growth (30 percent CAGR) on a net basis for their LPs. Now, many mainstream investors who were once wary of the risks associated with engaging with a Schedule I substance are clamoring to enter the space as it hits a new stage of rapid growth. 

Yet the question remains: How can newer investors experience the same outsized returns today that the cannabis industry generated in previous years? The answer may lie in smaller, privately held companies that will attract the interest of more prominent industry players. 

Related: New U.S. Focused Cannabis ETF Hits the Market

The untapped potential of single-state operators

While U.S. multi-state operators (MSOs) continue to report record year-over-year growth and drive investor enthusiasm, there is a limit on returns publicly-traded companies can generate. Yes, the top MSOs are a compelling choice for eager investors, considering how the global industry is projected to double in size and sales over the next five years. But early movers have already reaped the maximum ROI on these initial investments. Investors looking for maximum returns should consider targeting emerging single-state operators.

The year 2020 was an inflection point for the cannabis industry. An increasing number of states are moving ahead to expand legal access and consumer adoption at record levels. Currently, 40 percent of Americans live in a state with adult-use cannabis, and even seven of the most conservative states are beginning to embrace medical marijuana. 

Single-State Operators (SSOs) are emerging in every state where cannabis is legal and many are drawing upon battle-tested growth strategies laid out by established MSOs. The right expertise, design, technology, and execution plans were untested at scale only five years ago. Today, the top SSOs poach expertise, leverage proven design, sign-on-tested technologies, and execute from a proven playbook. 

SSOs who follow this path will likely be acquisition targets for the rapidly expanding MSOs. This was evident earlier in 2021 when Ayr, TerrAscend, and GTI acquired SSOs in Arizona, Maryland, and Virginia, respectively. SSOs are quickly becoming an attractive investment target for both established MSOs and investors who are still seeking out high-return opportunities.

Ancillary services will grow in tandem 

Cannabis business tech and services companies are growing as well. They will also likely become targets of industry consolidators, strategics, and possibly even MSOs for acquisition. In March 2021, Dutchie announced it acquired Leaflogix and Greenbits in conjunction with a $200 million capital raise. HERBL, a leading California distributor of cannabis brands, recently acquired Blackbird, a software and distribution solutions company. The acquisition strategy is not unique to Dutchie or HERBL. They are just the first to execute it.  

Blackbird, Leaflogix, and Greenbits acquisitions may be the first of many ancillary success stories in the industry. Considering how a growing number of retail transactions only recently migrated online during the pandemic, legal businesses are paying for services that allow them to provide truly modern consumer experiences to maintain a competitive edge. As the licensed operators scale, business tech and services must scale as well. Expect consolidation to keep up with growth.

Investment strategies must adapt to the market 

Cannabis investing strategies have diversified since Poseidon was founded in 2013. As the space becomes more sophisticated, investors are narrowing their focus to licenses, real estate, technology, debt, equity and convertibles. 

Additionally, the investment landscape has evolved alongside the legal industry. In 2013, investors only had access to early-stage startups and were entering uncharted territory. As the industry started to take shape, second-generation funds gravitated towards Series A and later rounds. While the returns generated by these opportunities may seem tangible, high investor demand for Series A has created a valuation bubble.

This is why a clear-headed understanding of timing and price is critical in the cannabis industry. Cannabis investors today must be more prudent with their capital and selective about the funding rounds they enter. Those who want to get in at a reasonable price, create sustainable value, and ultimately outperform the market should prioritize the private, post-seed stage companies most relevant to the needs of today’s industry. The most promising opportunities should be able to demonstrate product-market fit and early traction before their valuations balloon like we’ve seen at Series A. 

Over the next few years, the growth of the industry will serve as the engine that pulls the entire cannabis industry forward. Analysts estimate that U.S. publicly traded companies are only serving 19 percent of the total addressable cannabis market today, indicating tremendous industry expansion potential over the next few years. But the successful strategies during the earliest days of the industry are not guaranteed to produce the same results now. Investing in post-seed private companies gives accredited investors a chance at yielding the same tenfold returns experienced by early players. Investors who are adaptive and have a holistic view of the sector are positioned to maximize their returns in the industry’s next inning.