Income Approach (Forecast Inputs) – Marijuana Businesses

Business Valuation – The Marijuana Chronicles #6

Written by: Eli C. Neal, CPA, ABV, CFF

As discussed in our previous blog post, the Discounted Cash Flow Method (“DCF Method”) relies on a management forecast for future periods. It’s important for valuation analysts to review & scrutinize management’s forecast to determine its reasonableness and gain an understanding of the likelihood that the forecast will be achieved.

We’ve compiled a list of areas for valuation analysts to consider when reviewing marijuana business forecasts to help better understand the industry, value drivers, and risks:

Understanding revenue for marijuana growers/cultivators:

• Price of marijuana – Obviously, the price of marijuana is going to be a major factor in the revenues of a marijuana and one that is unpredictable. According to the Portland Business Journal issue dated November 24, 2017, the number of cannabis producer licenses has grown from 6 in April 2106 to 848 as of November 9, 2017. Increasing cannabis supply could drive prices down from the current wholesale price of $1,000 – $2,000 per pound. A valuation analyst should understand whether the business could continue to operate at lower marijuana prices

• Plants in the ground – A marijuana grower/cultivator will know how many plants they have in the ground at any one time. A valuation analyst should have an understanding of how many plants are growing and what the historic dollar yield per plant is.

• Number of days in a crop cycle – Equally important to understanding the number of plants being grown is the number of days that a cycle takes from seed to sale. According to GrowWeedEasy.com, the crop cycle can take anywhere from 8 weeks to 7 months so it’s important to understand the subject business. This piece coupled with the plant and price information above, should allow an appraiser to “check the math” on revenue figures.

• Crop failures – An important question to ask the subject company is whether they have encountered crop failures in the past and, if so, how often. Depending on the company, a crop failure could impact anywhere from a few plants at a time or an entire cycle. Some of the most common reasons for failures include:

  • Female cannabis plants becoming males (male plants have very little THC);

  • Insect infestations;

  • Power failures; and

  • Mold development.

Depending on the size of a company, a failure of an entire cycle could be devastating – especially if crop failures have not been included in the projections.

• Testing failures – As explained in blog post #3 of our series – In late 2016, state regulators introduced pesticide testing rules which caused a marijuana shortage in Oregon. The regulation was revised due to wide spread test failures but those historic failures could foreshadow future troubles if the testing is brought back. A valuation analyst should understand if a cannabis business can comply with current and potential future regulations.

• Distribution channels – It is important to understand a company’s distribution channel and customer base. A cannabis grower that is dependent on just a few retail stores or one distributor has high risk.

Understanding dispensaries and recreational stores:

• When thinking about dispensaries and recreational stores, it is very important to understand the tax risk associated with Section 280E. Section 280E states that:

“No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”

In other words, deductions for tax purposes are limited to only Cost of Goods Sold (“COGS”) for schedule I and II drugs. For marijuana growers, the vast majority of expenses can be pushed to COGS. However, for marijuana retail stores, COGS is limited to the amount of money that the business paid for the marijuana product and most other expenses such as rent, advertising, and employee salaries are not deductible.

As a result of Section 280E, marijuana businesses could be taxed for more than their earnings! Further, we’ve heard recommendations from lawyers to organize marijuana selling businesses as C-Corps instead of pass-through entities to mitigate the risk of a huge tax assessment from the IRS. With a C-Corp organization, the owners won’t be personally liable.

The application of Section 280E to the marijuana industry is being argued in court right now by Harborside Healthcare Center. Harborside is the largest cannabis dispensary in the United States with revenues of $30 million and was given a tax bill of over $2.4 million due to Section 280E by the IRS which they are challenging. We’ll see how the case turns out as the implications are huge for the industry.

The CannaLawGroup has a nice article explaining the issue in more detail.

• Supply-Chain – An important consideration for the valuation of a recreational marijuana store or a dispensary is to understand its suppliers and how it receives marijuana. Important considerations include:
  1. The consistency of supply;

2. The suppliers’ ability to pass pesticide testing; and

3. Redundancies in the supply chain if there is a disruption in the primary supplier’s business

Both growers and selling stores:

• Form 8300 audits – A business must file Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business, if your business receives more than $10,000 in cash from one buyer as a result of a single transaction or two or more related transactions. We have heard of many audits related to Forms 8300 not being filed by both growers and sellers.

• Reliability of data – Recreational marijuana stores and dispensaries are involved in many small cash transactions that are difficult to tract. Growers are generally involved in fewer, very large cash transactions. In either case, working with cash increases the risk that not all cash is being tracked properly. A good valuation analyst will understand the company’s revenue generating ability and ask about any shortfalls to ensure cash hasn’t leaked out of the business.

These are just a few major topics that we have come across working with marijuana companies. If you’d like to know more, give us a call at 503-467-7903 and we’d be happy to have a conversation with you.

Legal support for the cannabis industry:

With this blog series, we hope to provide valuable insights into valuing cannabis businesses and show that Cogence Group can be a valuable valuation firm within the Portland cannabis community. In addition to business valuation services, cannabis businesses will undoubtedly need attorneys to help navigate various legal issues. Harris Bricken has a great blog out of the Portland area: Canna Law Blog.