The cannabis industry is growing rapidly and more and more cannabis companies are raising capital, engaging in new partnerships, and executing M&A transactions. One of the biggest challenges facing these companies is: what is my company worth?
Valuing early-stage, high-growth businesses in any industry is a difficult undertaking. This is magnified in the cannabis industry given the industry’s nascent stage, regulatory risks, and lack of traditional valuation metrics. It’s both an art and a science. This article explores the various factors and methods used to analyze a cannabis company’s value.
Due Diligence is the First and Most Essential Step
Valuing any business first requires performing in-depth due diligence to understand the inner workings of the company. This includes analyzing the company’s products and services, operations, management team, market, competition, corporate governance, and more. Underlying each of these analyses is the on-going assessment of the company’s risks.
Questions driving due diligence activities include:
- Does the company have an experienced executive team?
- Are there strong operational procedures and internal controls in place?
- What advantage(s) does the company have relative to its competitors?
- Does the company have an established, popular brand?
Companies can also provide financial projections detailing their projected Income Statement and Cash Flow Statement for the next several years. Projections should utilize assumptions, which management can justify, and should be supported through due diligence efforts. Financial projections must be analyzed carefully as many companies never achieve them.
These are a sample of the sort of analyses that can ultimately raise or lower value. The specific details that emerge from focused due diligence, such as a company not being fully licensed or having a large outstanding tax liability, can have a monumental effect on valuation.
Key Factors in Valuing a Cannabis Business
The cannabis industry presents a distinct set of conditions and factors that make business valuations a complex undertaking. Key factors that guide the valuation process include the following.
Regulatory Framework – The most important factor in assessing the value of a cannabis business is understanding the federal, state, and local regulations the business operates in. Every market is unique and presents different challenges and opportunities. It is essential to understand the regulatory rules facing the business and ensure the proper operations and internal controls are in place to attain, and maintain, compliance requirements.
A notable example of this is seen when comparing public companies operating in the US compared to those in Canada. The federal illegality of cannabis in the United States limits cannabis entities’ access to capital and creates major operational hurdles. Whereas Canadian counterparts, operating in a federally legal market, have fewer regulatory hurdles and can even export their product internationally. Investors have flocked to Canada, providing Canadian cannabis companies unprecedented access to capital. As a result, valuations for Canadian companies dwarf their US counterparts. Valuations for the top 10 largest Canadian public companies are currently averaging approximately 50x 2018 revenue, compared to their US counterparts which are averaging 10x 2018 revenue.
Access to Licensing – A secondary component of assessing the regulatory framework is understanding the structure and supply of licenses. In general, the more licenses are limited, the more those licenses are worth. In many markets, including recently legal states on the East Coast, like Massachusetts and New York, regulators are issuing licenses in very limited supply. On the other hand, in Oregon, licenses have been liberally issued for years, which has led to an oversupply, driving cannabis prices and business valuations down. It is also important to consider that states and localities can always change their licensing procedures, which could potentially upend the market with new licenses.
Industry Focus – Cannabis businesses fall into one of two categories: plant-touching companies, which are directly involved in cultivating, processing, or selling cannabis, and ancillary companies, which provide products and services to support the cannabis industry. Ancillary companies are generally considered less risky, making it easier to raise capital, but also have lower barriers to entry which can limit their valuations.
There are four primary verticals in the plant-touching space: cultivation, manufacturing/processing, distribution, and retail/delivery. Depending on the regulatory framework where a business is operating, a company may have a stake in one or more of these verticals. Operating in more than one vertical can provide a company control over its product quality and supply, and increase its margins, multiplying its company value.
Ultimately, in assigning value for a cannabis company, its crucial to analyze the key value drivers for each business. For example, for retail businesses, the building’s location and local competition are key factors for assessing value. Meanwhile, for cultivators, the business’ expense profile and product quality are more important.
Management Team – In many ways, investing in a company is akin to investing in that company’s leadership team. Most startups fail, and this failure rate is magnified in the cannabis industry, which has additional regulatory, tax, banking, and other challenges. Every early-stage business will run into obstacles, and having an experienced, driven team running the business is paramount.
Having an ambitious strategic plan is one thing, but more important is whether or not the business can execute that vision. Investors putting capital into this industry look first at the leadership team in place to assess whether they have a collective history that suggests an ability, and willingness, to overcome roadblocks, make sound decisions, and ultimately sustain long-term growth.
Commonly Used Methods for Performing Valuations
While the cannabis industry may be new, the need for valuation certainly is not. There are countless methods that businesses, investors, and industry experts utilize when performing valuations. The following are the four most commonly used methods to assess value in the cannabis industry. The appropriate valuation method(s) depends on the company being valued, and will likely include a combination of approaches.
Discounted Cash Flow Method
The Discounted Cash Flow (DCF) method states that the value of a company is the present value of all future projected cash flows. The DCF method requires developing a multi-year projection of the company’s future cash flows, along with identifying an appropriate discount rate.
Strengths: Theoretically, the DCF method is the most accurate method for valuing a company, if the assumptions are accurate. This method allows the appraiser to adjust the financial forecast for different operating outcomes and assumptions to analyze the impact of value.
Weaknesses: The DCF method requires making a myriad of assumptions about a company’s future performance and risk profile – and the valuation is only as good as the assumptions used. “Garbage in, garbage out.” For young, fast-growing cannabis companies, identifying realistic assumptions is a complex process.
Market Transaction Method
Building on the old business adage of “something is worth what someone will pay for it,” the Market Transaction Method analyzes the valuation metrics, or comps, of similar privately-owned enterprises or properties that have been sold or have raised capital. The most common valuation metrics utilized are Enterprise Value / Revenue and Enterprise Value / EBITDA. By examining similar transactions, an approximate value can be determined by adjusting for company size, growth, and other factors.
Strengths: Based on actual valuations achieved by companies in the market, the Market Transaction Model is an excellent gauge of what valuations are truly being achieved in the market.
Weaknesses: While the market may say one thing, the realities of a business and its operations ultimately determine value. This method requires access to data for similar companies, which can be difficult to obtain given that the majority of transactions completed are private and there are few industry valuation metrics available. Also, as the market evolves, valuations change, so the older the data the less relevant it is.
Guideline Public Company Method
The Guideline Public Company Method values a company by analyzing the valuation metrics of comparable publically-traded companies. Similar to the Market Transaction Method, adjustments must be made to account for differences between the subject company and the comparable companies.
Strengths: The price of publically-traded companies are based on market data and easily accessible. Additionally, quarterly earnings reports and other investor reports can provide detailed financial and operational information.
Weaknesses: Utilizing this method requires identifying public companies that have comparable business operations, which can prove difficult for smaller companies. There has been an exponential increase in the number of companies going public, which is making this method more accessible. However, public company valuations are very volatile and can swing heavily due to market factors independent of the company’s fundamentals. For instance, the Marijuana Index, an index tracking the top cannabis stocks, increased more than 200% in the three months leading into California going legal in January 2018.
Adjusted Net Asset Approach
The Adjusted Net Asset Approach values a company based on the fair market value of its assets less its liabilities. Assets include tangible assets, such as equipment, licenses, and staff, as well as intangible assets such as brand name and a loyal customer base.
Strengths: This approach establishes a fundamental baseline of value based on the company’s owned assets. If the company goes bankrupt, investors are at the least able to recover the fair market value of these assets.
Weaknesses: As this approach does not consider a company’s income-generating potential, which is significant for most cannabis companies, this approach is generally reserved for distressed and capital-intensive companies.
Every Valuation Represents a Unique Case
Valuing a cannabis business is a complex process that is generally done on a case-by-case basis. Many businesses in Canada and the US are earning sky-high valuations as the outlook on market growth is currently bullish. The key right now is keeping one’s valuations rooted in reality and not to get caught up in the “green rush.”
There is no one answer to the best way to value a business. Landing on an accurate valuation requires in-depth due diligence to analyze the quantitative and qualitative factors driving the company. Ultimately, meetings with the leadership team and visiting the company’s facilities to see the business in action can speak volumes about underlying operational strength and long-term potential.
In an industry as new as cannabis, valuating businesses is a difficult undertaking. This makes it all the more essential to consult with a specialist when seeking to understand a company’s value, whether you’re seeking to raise capital, acquire or invest in another business.
About the Author:
Dan Nicholls, CFA, Director of Capital Markets Advisory Services, ELLO: Dan is the leader of ELLO’s Capital Markets Advisory Services practice, providing financial advisory services to cannabis companies including capital raising, M&A, valuations, forecasting and strategic guidance. The MGO | ELLO alliance has served over 500 cannabis industry clients across the world and has provided assurance, financial and capital markets advisory services for many of the industry’s largest public filings and capital transactions.
Dan has extensive experience providing investment banking and capital raising services to hundreds of cannabis companies. Before joining ELLO, he was the Vice President of MJIC, where he advised cannabis companies on raising investment capital and provided outsourced CFO services. He also analyzed and completed numerous investments in the cannabis industry. Previously, he worked at a boutique investment bank where he led $1 billion in healthcare M&A transactions.
Dan is also the creator of the Marijuana Index, a stock index that tracks the top cannabis stocks in the U.S. and Canada, which has been featured in the Washington Post, CNBC, Forbes and over 100 other publications. He is also the co-founder of CannaEvents, a Los Angeles-based cannabis events company.