September 2016 | Updated
Investing in the Legal Marijuana Industry: Opportunities, Risks and More Risks
Our engagements in connection with Colorado
Arizona marijuana businesses offer a first-hand confirmation of the cannabis industry’s business opportunities and unique challenges.
A Growing Industry (Pun
Regardless of your personal stance on the morals and
practicality of legalizing marijuana, there is no denying the nationwide trend
toward legalization. In the wake of the November 2016 elections, eight states
and the District of Columbia allow (or will soon allow) recreational use, and
passage of California’s ballot measure could be a “tipping point,” prompting
other states to follow California’s lead.
The cannabis industry is on a pace to grow from
virtually nothing to tens of billions of dollars in revenues in just a few short
years. In contrast to other rapid-growth industries, the projected explosive
growth in recreational marijuana is not the result of any technological
innovation or discovery, but simply the result of changing societal attitudes.
Kotzin Valuation Partners is familiar with the
cannabis industry, having been engaged on various assignments to offer appraisal
or consulting services for dispensaries and ancillary businesses. Our experience
suggests that the industry is unique in many respects, offering challenges that,
from the perspective of a business owner, investor or valuation professional,
are both frustrating and intriguing.
If you provide professional services to clients
in Arizona but have not yet had any dealings with the cannabis industry, that
will likely change in the coming years. This article explores the unique issues
associated with legalized marijuana (both medical and recreational), especially
from the perspective of estimating the value of an operation or considering an
investment opportunity in a marijuana business.
Opportunities, Risks and Value Drivers
According to a February 2016
Fortune magazine article, legalized marijuana in the U.S. will reach $6.7 billion in revenues in
2016 (up from $5.4 billion in 2015) and, according to one industry resource, is
estimated to reach $21.8 billion by 2020. Expressed in those terms, the business
and investment opportunity speaks for itself.
However, some perspective is in order, from both
ends of the opportunity spectrum.
First, the ability of any individual or entity to
be directly involved in the sale of the product will be governed largely by
state licensure. While some legalization opponents contend that licensed
marijuana businesses will have a “monopoly,” the merits of such an argument are
dubious at best, as few people would accuse an owner of a similarly licensed
bar, liquor store or pharmacy of monopolistic practices.
Additionally, many people assume that having a
license to operate a marijuana dispensary is a “golden ticket” to automatic
riches. That assertion, too, is flawed, as profitability and ultimate business
success will still be subject to adequate capitalization, sound business
practices and, as we are seeing in Colorado, the law of supply and demand.
Examples. In Colorado (population 5.4 million in 2014),
where Kotzin Valuation Partners has performed valuation analyses of marijuana
businesses, the ratio of citizens to marijuana dispensaries is approximately
7,700 to 1. Marijuana is legally sold at approximately 700 establishments – more
than the number of McDonald’s, Starbucks and 7-Eleven stores combined – with
many dispensaries struggling to make a profit.
In contrast, Washington State (population 7.1
million), which also has legalized recreational marijuana, has a significantly higher
citizen-to-dispensary ratio, of about
17,200 to 1, providing a more favorable competitive environment for that state’s
licensed sellers and investors.
an industry's prospects and risks are an important part of the valuation
process. No business can be valued in a vacuum, as the performance of a business
is dependent on industry trends and other external factors. This is especially
relevant in the marijuana industry, as a myriad of industry-specific risks and
uncertainties need to be incorporated into the valuation process.
Beyond competitive issues, several factors need
to be considered when valuing or considering an investment in a marijuana
Under federal law, marijuana (recreational or
medical) remains classified as a Schedule I substance – technically illegal. The
Obama administration has publicly stated its policy of not enforcing the federal
law in states that have legalized its use, but this policy could change under
the next president.
In an odd twist, the illegality of the product at
the federal level also provides some benefit to current and prospective growers
and dispensary owners, as it discourages the major national pharmaceutical
and tobacco companies and national retailers from entering the industry. If the federal
government lifts its illegal classification, the small-time operator in the
cannabis industry may be forced out by Big Drug
or Big Tobacco. Just one more risk to think
However, for now, the continued classification as
an illegal drug under federal law is a catalyst for a host of other risks.
First, most banks and credit card issuers want to
have nothing to do with the industry, due to concerns over enforcement at the
federal level and fears that they will fall victim to charges of money
laundering or other alleged felonies. Consequently, most dispensaries operate in
an “all cash” environment, which makes each operation more susceptible to crimes
by employees or outsiders.
Further, the banking industry’s reluctance to
accept this industry makes it harder for potential marijuana businesses to
purchase real estate, due to a shortage of lenders. Similarly, it is often
difficult to persuade a potential landlord to lease space, as the landlord may
worry about seizure of his or her property. The good news for operators is that
limited banking options are reportedly evolving, although at a slow pace, in
both Colorado and Washington.
The illegality of marijuana at the federal level
also presents serious problems with respect to paying income taxes. Internal
Revenue Code Section 280E disallows deductions incurred in the trafficking of
controlled substances prohibited by federal law. Presently, the only expenses
that are deductible for income tax reporting purposes are those costs directly
involved in producing the product. Any costs related to the sale
of the product (e.g., dispensary rent, retail labor, advertising, and operating
costs) are not deductible. As a result, dispensary owners that abide by these
regulations can end up paying taxes at a rate of 80% or more of their actual
Advertising is another concern, as options are
limited. Even social media sites such as Facebook do not allow dispensaries to
post company sites or otherwise advertise. At the time this article was written,
only two major online resources – Weedmaps and
– allow dispensary owners to advertise their products and promotions, and having
a presence on those sites can be very pricy. That may change as the industry
continues to evolve and new options emerge.
This article touches only the surface of the
unique factors the pose challenges to would-be participants in the cannabis
industry, and to investors and valuation professionals seeking to establish
The marijuana industry is rife with both
opportunities and risk. For small business owners that can tolerate risk,
significant tax bills, heavy regulatory scrutiny, and a lingering moral stigma,
an efficient operator with good locations can make significant returns.