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Venture Capital Perspectives on Navigating Cannabis Investment Risk

by Nic Easley

CEO and Managing Director, Multiverse Capital

The legal cannabis industry is global, making it all the more crucial for investors to understand all of the applicable laws influencing the space at each level of government. At Multiverse Capital, we have watched many investors jump on opportunities in the cannabis industry only to have regulations shift, decreasing the value of their investments. Diligence and compliance can make or break your investment, so keeping abreast of these fluctuating regulations and having a thorough knowledge of the law is well worth the time and effort. Family offices and high net worth individuals have a unique advantage in the cannabis sector as regulations in many parts of the world are forcing institutional capital to remain on the sidelines. The time is now for this unique investment opportunity to secure early positions before the proliferation of institutional capital and the wave of M&A transactions. However due to the inherent risks, we recommend finding expert advisory prior to investing capital.

Domestic Cannabis Markets

Starting in California in 1996 with Proposition 215, cannabis legalization has spread consistently state-by-state. Today, 33 states have legalized some form of medicinal cannabis, and 10 states including the District of Columbia, the Northern Mariana Islands, and Guam have legal recreational programs. Cannabis regulation across the United States is complex and changes at each level of government, but businesses that directly handle cannabis are also faced with numerous operational challenges unique to the industry as a result of the plant's U.S. Schedule 1 drug status. For example, Internal Revenue Tax Code 280E prohibits businesses that touch the plant from deducting any operating expenses except for the cost of goods sold (COGS), making profitability nearly impossible without the correct business formation strategies. Operators also lack access to traditional debt financing and banking services, producing an adverse effect on the business. Additionally, since interstate commerce is prohibited, each state is required to produce and distribute their own products. These are just a few of the numerous challenges faced by U.S. cannabis businesses.

Domestic medicinal and recreational cannabis markets each have their own unique structure. Some are based on a free market approach, while others have limited licenses. Medical markets have varying qualifying conditions which often place tremendous restrictions on patients. While cannabis is still illegal under federal law, there is a spending bill rider in place that prohibits the Department of Justice from using any money to prosecute medical cannabis companies that are compliant with the laws of their state. Recreational cannabis businesses have inherent risk because they are not included in the same federal protections. To minimize tax liabilities and protect assets from potential legal issues, we find that it’s best to compartmentalize investments based on plant-touching or non-plant-touching and medicinal or adult-use operations.

Canada

Canada has been a hot topic for anyone watching the cannabis industry over the last year. When recreational cannabis became legal, numerous companies went public on Canada’s exchanges. Valuations of these companies soared as Canadian firms raised over $9 Billion USD in 2018 alone. Many companies rushed to go public in hopes of cashing in on the craze. The Canadian cannabis industry is projected to produce a surplus of 2 million kilograms per year by 2020, which will need to be exported. However, as foreign cultivators come online with lower production costs, Canada will experience substantial oversupply issues. We foresee the collapse of the per-gram price of cannabis, ultimately putting pressure on Canadian businesses.

While Canada was the first developed nation to legalize recreational cannabis, they were a little premature in this regulatory leap. Considering the regulations laid out in the UN Single Convention on Narcotic Drugs of 1961, Canada’s legalization of recreational cannabis is in direct violation of international law. Canadian companies that have built their entire business models on the export of medicinal cannabis products may soon be banned from doing so. Market caps in the cannabis sector have exceeded 300x revenue, putting them above the 100x market caps of the dot-com bubble.

European Union

Estimated to be worth $140 billion by 2028, the EU cannabis market is experiencing steady and impressive growth, albeit slower when compared with Canada and the United States. Over the next five years, however, it is anticipated to become the world's largest medical cannabis market. According to the recent 2018 International Narcotics Control Board (INCB) report, “the legalization of nonmedical use of cannabis contravenes the international drug control treaties," directing the focus of European commercial cannabis businesses on medicinal products and patients.

The EU’s medicinal cannabis markets are structured differently than the United States and are more closely related to the pharmaceutical industry. In Europe, cannabis is treated as a medicine and doctors are able to directly prescribe specific formulations to their patients. In comparison, in the U.S. patients receive doctor recommendations and then purchase their own medicine, but are often left searching for high quality and efficacious products. Europe’s pharmaceutical model requires domestic producers and importers to adhere to Good Manufacturing Practice (GMP) standards. When vetting operations that intend to export to the EU, it is important to verify that the business meets or exceeds all applicable GMP Standards.

Summary

In summary, a cannabis company’s location, team, potential scalability, and international reach are some of the essential factors contributing to its overall worth. The laws and regulations that influence these factors are changing constantly, making it equally difficult for companies to adapt, and investors to manage risk. It’s important to arm yourself with information and invest in professional teams, and companies with scalable futures, to avoid as much of this risk as possible. In order to vet an opportunity correctly, you must spend a great deal of time cultivating a deep understanding of both local regulations and the universal landscape. Or, invest through a firm like Multiverse Capital where we have over 13 years of cannabis knowledge and experience with over 300 cannabis operators.

Nothing will educate you more quickly on the industry than working directly with cannabis operators, like we have. Experience has taught us to pay close attention to industry regulations, the global markets, potential legal issues, and the best legal business structures and practices required to protect capital. If you approach the cannabis industry too narrowly, focusing on a single state or country, or a single investment opportunity, you will likely make investment mistakes and miss out on the majority of the upside that this industry has to offer.

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