Building a cannabis enterprise requires staggering and constant fundraising and, because of the industry’s dynamic nature, any given license’s value is subjective, fluctuates with external factors beyond the licensee’s control, and may change by the minute.
Contrary to popular myth, growing, processing and selling marijuana is far from a license to print money.
Building a cannabis enterprise requires staggering and constant fundraising and, because of the industry’s dynamic nature, any given license’s value is subjective, fluctuates with external factors beyond the licensee’s control, and may change by the minute.
Whether publicly traded or closely held, a cannabis company’s value is a derived from its earning power and ability to convert that power into value as broken out into “fair market,” “investment” or “fair” valuations.
By examining New Jersey’s burgeoning cannabis program, these valuation methodologies can be harnessed to illustrate both the factors impacting a license’s worth and how a valuation figure is derived.
Legalized Marijuana’s Licenses, Products and Supply Chain
Those cultivating, processing, infusing, transporting or dispensing cannabis are deemed to be a “plant touching” marijuana-related business (MRB) and, despite being legal in the majority of American states, marijuana remains federally illegal.
The Controlled Substance Act, 21 U.S.C. Sections 801, Et. Seq (1970) (CSA) currently lists marijuana next to heroin as a Schedule I controlled substance having “a high potential for abuse” and for which there’s “no currently accepted medical use in treatment” and “a lack of accepted safety for use” “under medical supervision.” The CSA prohibits marijuana’s cultivation, distribution, dispensation and possession and, pursuant to the U.S. Constitution’s supremacy clause, state laws conflicting with federal law are generally preempted and void.
Because the CSA prevents cannabis from being sold outside of each respective legalized-marijuana state and, thus, no “interstate cannabis commerce” can occur, state regulators like New Jersey’s Cannabis Regulatory Commission (CRC), and not federal agencies like the Food and Drug Administration, issue licenses and regulate MRBs.
Whether deemed “medical” (purchasable only with state-issued card to treat resident’s statutorily defined “covered medical condition”) or adult-use (purchasable by anyone over 21 from any state with a valid identification), cannabis takes four forms: “flower” that is smoked; “oils” ingested by vaporizing; “concentrates” only consumable after being heated to a high temperature; and “infused” products ranging from eye drops to “edibles.”
Standards of Value and Valuation Methodologies
Cannabis assets are volatile and, following any legislative, regulatory, judicial and industry development, a particular MRB’s license value may soar or plummet.
“Valuation” is premised that today’s value is the present worth of expected future benefits and “earning power” means the rate of return expected for investment alternatives in light of the history, expected growth rates and risks associated with realizing the anticipated future economic benefits. Cannabis investors price an investment based on anticipated economic benefits (as opposed to what has been historically received) which hinges on the valuation’s date, what standard of value is appropriate, and what the value’s premise is.
Any MRB’s valuation standard hinges upon who the buyer and seller are and is broken out into fair market value (FMV), investment value or fair value. FMV is defined by the IRS as “the amount at which the property would change hands between a hypothetical willing buyer and a hypothetical willing seller when the former is not under a compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.” See, definition of gross estate; valuation of property, 26 CFR Section 20.2031-1.
Investment value is the value to a particular buyer reflecting its particular knowledge, expectations and assessment of the business, financial, economic and liquidity risks.
Assuming that there is neither a willing buyer and seller nor that the parties have reasonable knowledge, fair value is exclusively based on what one of the parties subjectively values the item to be which can range from a windfall to a fire sale.
After the standard is locked in, three approaches govern valuing an MRB: asset based, income and market comparative.
The “asset-based approach” measures the value of the MRB’s various assets, net of related liabilities excluding intangible assets (e.g., goodwill) and has four methods:
Net book value. Calculated by subtracting liabilities’ book value from assets’ book value.
Adjusted net asset. Modifies assets and liabilities for current market value requiring analysis of accounts receivable, inventory and fixed assets. Most appropriate if: MRB’s value rests on its tangible assets’ value; labor or intangible assets add little or no value to company’s products or services; and balance sheet reflects all of the MRB’s assets.
Excess earnings. Using net book value, adds approximation of intangible assets by capitalizing any “excess earnings.”
Liquidation value. Most appropriate if MRB will cease as a going concern within the next operating cycle.
The “income approach” determines the net present value of an MRB’s expected future cash flows utilizing a discount rate reflecting the risks inherent in receiving those cash flows using methodologies including:
Capitalization of normalized earnings. Computes value whereby a selected benefit stream is capitalized by a factor to determine the price that would be required to be paid to yield a return commensurate with the risks associated with the earnings being considered.
Discounted cash flow/discounted future earnings. Most advantageous when there are sufficient data points available to reliably forecast future earnings and cash flow. Due to industry’s startup nature and absence of historical operating data, often used in valuing development-stage MRBs.
The “market comparative approach” includes the market value of MRBs similar to that which is being valued (either in publicly traded companies’ trading price or similar companies’ purchase price) relative to those MRBs’ earnings and cash flow. The ratios, or market multiples, are applied to the target’s normalized level of expected gross revenue, earnings or cash flow to derive an indication of value. When sufficient market data is available, traditional market-based methodologies include:
Guideline public company. Correlates various valuation multiples of guideline companies with the closely held MRB being valued. Given the disparity between Cannabis markets, the range of operational scales, and that most publicly traded MRBs are outside of the United States, making a direct comparison of an early stage, private MRB to a public one is difficult.
Guideline merged and acquired company. Tracks “guideline public company” approach but derives data from nonpublic companies that have been merged or acquired. Although private business withhold sensitive financial data, acquisition prices, company details, financial metrics and other key items can be harvested from securities filings, court documents and press releases sufficient to construct a “comp” table.
Industry. Seldom exclusively relied upon for MRB’s valuation, information is gleaned from published compilations, industry sources, business brokers, trade associations and industry members.
What’s a New Jersey License Worth?
Forming the Eastern seaboard’s most dynamic cannabis program, New Jersey is a key bellwether to illustrate factors impacting both a license’s worth and how that figure was derived pursuant to these valuation approaches.
With a population of 9,242,109, the New Jersey medical marijuana program is comprised of 130,000 patients/caregivers serviced by 12 vertically integrated medical marijuana grower/processor dispensaries comprised of 23 dispensary location, (13 of which, on March 21, 2021, were authorized to also dispense adult-use cannabis).
Between Oct. 15, 2021, and March 24, 2022, New Jersey issued: 10 grow, five grow-processor and 30 dispensary conditional medical licenses; and 50 grow and 18 manufacturers conditional adult-use licenses (hereafter, collectively referred to as conditional licenses).
Under the provided valuation approaches, the following factors impact the amount for which a license can be sold. First, what is the jurisdiction and is it a limited license? Based on its proximity to 44 million New York, Pennsylvania, Delaware, Maryland and New Jersey “adult-use access lacking” consumers, New Jersey’s adult-use program is first-to-market in the Mid-Atlantic region. Thus, based on its positioning, any New Jersey adult-use license exceeds the value of that in an equivalently populated state. However, similar to how diamonds’ pricing is driven by that gemstones’ scarcity, the value of any license is driven by it preciousness. For example, although capping adult-use grow licenses to 37 over ensuing two years, New Jersey imposes no limit on dispensary licenses. Thus, based on scarcity alone, a New Jersey adult-use grow license’s value exceeds that of a commensurate New Jersey dispensary license.
Second, is license “paper” (meaning recently issued to an unbuilt, nonfunctioning MRB) or a “going concern?” Although a functioning business is seemingly more attractive because it automatically gets the buyer to market, paper licenses involve fewer assets and are less costly, are devoid of any operating issues (e.g., lawsuits, taxes, employee woes) or poor choices (lousy buildouts, weak products, negative buzz) that may have hobbled the seller. Conversely, as New Jersey issued a glut of conditional licenses, and the impending federal legalization’s impact on state programs is unclear, a functioning cannabis business ensures not missing the market entirely.
Third, how is the deal structured? Is it a “lump sum all cash deal,” is the buyer paying all or part of the purchase price in stock, or must some key performance indicators (KPIs) be achieved to trigger layered purchase price payment? Because many public cannabis companies issued stock in acquisitions at the pinnacle of their market capitalizations, the value actually received by the seller was considerably diminished when calculated in today’s dollars.
Fourth, who is the purchaser? Is it a multi-state operator with operating MRBs in numerous states or an aggressive stand alone cannabis company? Tracking the “paper license versus going concern” analysis, a startup offering a big bag of cash might justify a lower purchase price against a moribund MSO’s KPI-driven gradual payout.
Reprinted with permission from the April 28, 2022 edition of the Legal Intelligencer © 2022 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.
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