A fellow cannabis investor and I exchange ideas and pitch decks we receive from operators seeking capital – approximately 10 per week that make it to each other’s inboxes. Ninety percent of the deals we see have the same overarching business plan: Be everything to everyone, and take over the industry.
In media and content deals (WeedMaps, Leafly, Herb.co, HighTimes, The Fresh Toast) that we receive, in broad strokes, companies aim to start with content aggregation or creation, grow a base of eyeballs, start facilitating orders online for in-store pick up and home delivery, and then go up the value chain in interesting states, becoming vertically integrated. In products and branding, entrepreneurs begin with an idea for a new delicious treat, slap on a name and a logo, get into 50 stores in the state of origin, begin looking across state lines, and before you know it, seek to become vertically integrated in the new geography.
“Second-mover” entrepreneurs in a legalizing state seeking to distribute cannabis have their own route to world dominance. These adventurers read the news, envision a fountain of profits, and set out to be “The Starbucks of Cannabis”. They tell their friends of their newfound alignment of profits and purpose. They seek real estate, conjure a cheeky name that would make any respectable punster wince, and assemble a straw-man business plan. At some point along the journey, they learn about the 280E Tax Code, which brings their effective tax rate from 30% to 70%. An accountant, attorney, or more experienced cannabis company operator will undoubtedly inform them that with proper accounting strategies, if you are vertically integrated, you can reposition many of your normal business expenses into the cultivation side of your operation and avoid astronomical tax rates.
“A no-brainer! Let’s go up the value chain, capture more of the margins by growing, processing, manufacturing our own products, and wind up saving a ton on taxes!” says the entrepreneur.
While the entrepreneur’s math and logic are sound on the surface, they have entered a complex world. When one initiates a vertically integrated cannabis company, they are effectively starting seven businesses at once, each with amplified risk, from being federally illegal, discouraged by many communities, and early in its genesis of existence in general.
Here are the seven businesses you will need to become expert in, create, fund, staff, manage, and excel at in order to achieve vertical integration, ultimately realizing a greater net profit for yourself and the dozens, if not hundreds, of investors you’ll have to attract to get out of the gate.
Middle Market Financing Company
The magic combination for an entrepreneur seeking vertical integration is an MBA, a CPA, and a minimum of 200 friends with liquidity greater than $5,000,000. (Why that many people with that much money? Because about 10% of investors will bite, and they’ll likely not put more than 20% of their liquidity into any single enterprise.) Vertical integration is incredibly expensive and to retain even a small slice of your own company, financial structures over time become increasingly complex, beginning with equity at a low valuation and evolving into multi-tiered debt and equity hybrid structures guaranteed by everything and anything investors can get their hands on. Think of a few of these line items:
Acquisition of the cultivation: $1M-$5M. You do not want to skimp here because at a minimum you’ll need to pay more to retrofit your facility if it is a relic, or, if you buy too small, you will need to start from scratch elsewhere and harm your operational efficiencies if you need to move to expand. Advice: Over-purchase.
Build out of the cultivation: $5M-$25M to start. Business plans often estimate they will generate $30 - 60M in cash in the first full year of operation. Forgetting the fact that they are bold-faced lies, do you think that could possibly occur with a couple of rooms of light bulbs from CVS? Every piece of equipment you buy is part of an intricate web of tools that must work in tandem, which are not only hard to choose between, but priced according to the use case. Get ready to hear a lot of “Sure it’s expensive, but if you yield XYZ, which this gizmo can achieve, your ROI is realized in 6.5 days of operation!”Don’t get sucked into that trap.
Acquisition of dispensaries and licenses: $200k-$2M per dispensary depending on license fees, build out, and duration of the search.
Staffing and soft costs before reaching break-even: $1-3M. Do you think people are going to wait around for you to succeed for free? Answer: No. Every vertical listed below, including the cost of acquiring the capital, costs money -- not just equity you have to allocate out to give people hope of an upside.
There are dozens more categories which will soak up your cash in an instant, but those are the biggest ones and total a range of $7.2M to $35M just to get started. I have seen examples thrive and die in each of these price ranges and, frankly, you get what you pay for. Understanding how to schedule your fundraising over time and retain investors’ trust, without running out of CAPEX or OPEX or giving up too much of your company is a dance 95% of entrepreneurs are ill prepared for.
Real Estate Holding Company
Anyone who has taken responsibility for the care and maintenance of a home can attest that there is never serenity in real estate acquisition or ownership. The moment you purchase a home, or complete a renovation, it begins to deteriorate and, if you do not remain vigilant and willing to fund the upkeep, your future bills will compound rapidly. This is only magnified in the cannabis industry due to a number of natural forces:
Your selection is very sparse: Still today, in a world with increasing acceptance of cannabis, few landlords are comfortable with the industry and require extra coaxing to allow you to build your dream in their space. If renting, you are likely to gain control over a derelict location that the landlord “allows” you to completely beautify on your dime (always a triple or absolute net lease), while paying 2-4x the average rent in the area.
Cities take their cut: Not only will you be paying to build out the space, but you will be covering taxes and a “Community Host Agreement” whether you are making a profit or not.
The process of finding a domicile is not linear: Rarely are there ads for perfectly zoned and ready, high quality spaces for dispensing or cultivating staring you in the face. More likely, you will try your hand without a broker, lawyer, or lobbyist, and find yourself months behind where you would have been had you ponied up, paid the money, and had professionals team together to find your space.
Trust is hard between strangers. Being approximately four years into the industry in Massachusetts, landlords in legally zoned areas are likely to have received inquiries from many people who are just as well intentioned as you, but also equally frugal or operating with limited cash on hand. This puts real estate owners on the defensive and makes them less likely to establish Letters of Intent, delaying payment on rent, or taking a cut of future sales. Like in so many circumstances, cash is king.
Needless to say, finding, licensing, and defending your position in that physical space takes human capital and capital structures beyond a simple lease negotiation.
Real Estate Development Company
So, you’ve jumped through very expensive hoops to stand in a vacant space -- be it 2,500 feet of retail or 250,000 feet of cultivation. At this point, you could already find yourself holding 30% - 50% less of your company, and having spent millions of dollars of your own and others. Now the work begins. Designers, architects, project managers, general managers, tradespeople, and a growing staff (10 - 25 people) assemble around a conference table looking at you like a Saint Bernese Mountain Dog looks at a T-bone coming off the grill. I recommend calculating the cost of every meeting of minds you assemble in a setting like this. A single hour of bringing everyone together to develop plans and strategies can cost many thousands of dollars.
Best case scenario, over the course of three to four years, you will be leading four or five massive and expensive development projects. If you fail, you’ll have the benefit of not experiencing this brain damage. Multiple dispensaries, multiple phases of your cultivation site, each with their own unique challenges with exploding price tags.
You will be faced daily with the option of saving on CAPEX and increasing your OPEX, or putting the right money in for a sustainable business with low operating margins, so higher profit on the back end – in a perfect world.
Why, you ask, must you stay so deeply ingrained in this aspect of the business? Two reasons: One, when tens of millions of dollars are spent, there are myriad ways for you to be overcharged; Two, if you fail to properly compensate, incent, and retain your construction crews (i.e., have them put hard cash into the project early on, for example), the likelihood of them walking off the site never to return is high. This happens frequently and sets companies back months, if not years. Building these companies and facilities is an ultra-high-stress experience with competing timelines. Management wants everything done yesterday, of utmost integrity, and yet inexpensively. The construction crew and engineers have their own lives, timelines and greater knowledge of what is real. They also have the benefit of working during a wildly lucrative time in the U.S. economy’s cycle so will gladly take the money you’ve paid already and leave you in a lurch to go do something where the management is not ruining their Sundays with demands.
Finally, you’ll want your grower to be hired and to sign off on everything or you will never be able to hold them accountable for anything if it is not their own, approved system.
Genetics and Pharmacological Company
Like me, most readers of this article have probably planted some hydrangeas on the back porch for their wife, or helped their husband with a small vegetable garden in the yard. Whether those hydrangeas whither, or the tomatoes actually bear fruit will likely not alter the course of your life. Alternatively, if those tomatoes weigh 50% less at their pinnacle than your neighbors, you’ll still be proud of the bruschetta you present at the next cocktail party.
What if your future did depend on the weight of those tomatoes - and their flavor profile was the key to success, failure, or absolute future of your enterprise? This is the case within your vertically integrated cultivation and dispensary network and 95% of operators entering the space do not do so with their eyes open to this fact. Before you even begin large-scale cultivation, you darn-well better start with thousands of babies you can be sure of. Seeds or clones -- each has its challenges. Be prepared for a very costly learning curve wherein you discover the depths of differences amongst strains, ultimately discover the strain names, indica versus sativa, and all else you thought you knew about the genetics of your plants is wrong and you need to start from the beginning again.
The right genetics can be the difference between half-a-pound of hermaphroditic flower per light (HPS or LED) and three pounds of high quality dry bud per light. In Massachusetts’ early days, that is the economic difference of $3,000 yield compared to $18,000 per light per turn. Did you choose quickly flowering strains? Strains that can be densely populated? Strains that have high trichome output on their sugar leaves -- or even on their fan leaves? Or did you purchase seeds that created slow flowering, high-stretch, low-yield plants who will take your turns per year from 6.5 times down to 3 times?
This does not even begin to explore how the terpene profiles and cannabinoid potency balance each other in the ultimate effect by your end consumer -- nor where you are intending to place this throughput (flower, oils, MIPs). But, it all begins with the genetics for your strategy.
You thought you were growing a simple plant.
Now the fun starts. On the average cultivation floor, staff number approximate .75 full time employees (FTEs) per thousand square feet of grow. Also, the average ratio of your space will look like the following: 60% of your floor is dedicated to growing, of which 70% will be actual canopy. That does not leave very much for flower unless you are at full scale. What does this look like in practice? If you have a 100,000-square-foot building, 60,000 will be grow, 40,000 will be offices, dry, cure, production, manufacturing, packaging, and inventory space. Of the 60,000 square feet, approximately 42,000 will be actual canopy.
This means you would have about 32 growers on your floor (forgetting for now about the other lines of business) making sure your plants are happy and healthy. Keep in mind, the average grow in Colorado is about 18,000 feet. Why does this matter? Because the level of expertise in indoor farming at scale is in its absolute infancy, therefore making hiring for this role a nightmare. Head growers can demand up to $400,000 and a handsome portion of the company. Whether you give it to them and trust them to execute is a challenge all in itself. Keep in mind that you will be navigating years of product development with these folks and the overlap between cultivation and construction is as critical as any other intersection of your main pain-points in starting this series of companies. They will devastate your future if parties are in opposition, or may unlock multi-generational wealth for you if properly aligned and compatible.
Books can be written about the upstart to the cultivation portion of your enterprise. I will leave you here with some questions:
How do you incentivize a grower without breaking the bank?
How do you hold your grower accountable when working with difficult to source and track genetics that no one is quite certain of how they will work?
How do you maximize your square footage used, while optimizing workflow efficiency?
What happens when your plants hermaphrodite?
What happens when your mother stock dies from a room becoming too hot or too cold?
Who is responsible for low yields if environments are insufficiently controlled?
How do you minimize the number of full time employees to increase margin at the bottom line without encountering risk factors due to less man hours per plant?
The plant wants to grow once per year. How do you go from once, to thrice, to seven turns per year?
What has been your head grower’s experience at scale with any horticultural product?
Business #6: Processing, Branding, Manufacturing and Distribution Company
So, here’s a laugh. You’re a few years into the dream and process of growing cannabis, and now people don’t want cannabis?! They want breath-spray, foot cream for plantar fasciitis, a discrete study aid, a Viagra alternative, and a way to fix their mother-in-law’s lyme disease because they heard this stuff works! All of these products have been created to various levels of sophistication. They each took years of research and development and have layers of complexity including micro-emulsions and encapsulations to divert compounds from one part of your body to another, increase bioavailability, decrease onset time, and beyond. In short, this is not your grandfather’s joint. (But - your grandfather’s joint, too, now has a brand and beautiful packaging and supposed consistency that you now get to compete with!)
This company you must start takes time, finesse, connectivity, and a combination of the patience of a Buddhist monk and the discernment of a CIA spy to get to the bottom of a business deal with the scientists who have conjured these formulations and their financial backers. You can opt out of playing this game, and just sell pot, but you’ll fail slowly. Flower sales generate approximately 50% of gross sales in the United States and that number is falling precipitously.
So, I ask you: From where are you going to source the beer-tasting elixir that crushes the alcohol industry that took five years to develop; the sleep aid that binds to CB1 receptors and creates a non-addicting, non-hangover sleep for thousands; the inhaler that has pharma-grade air in it that would be prohibitively expensive had the producer of this product not had a connection to the lead purchaser of this air for all of the inhalers for the country of Germany….?
Or, are you going to create an R&D company on top of these seven to create better solutions - then brand it, then design packaging, then manufacture, then package by hand (or spend $250k for an automated solution), and then distribute it?
Retail Operations Company
Remember when you said you wanted to start “The Starbucks of Cannabis”? Now’s your chance. You have more money at stake than you can possibly repay in your lifetime, you have some product, and you’ve built things, grown things, and packaged things. Uncle Sam has been critiquing you the whole way – treating you like a criminal for wanting to responsibly sell something that has never killed a human yet has helped millions. You’ve proven to Uncle Sam that you intend not to be a criminal and you’ve put your money and years of your time where your mouth is. Most entrepreneurs who have stepped up to the plate do not make it this far.
In Massachusetts, for example, of the 400 or so medical licenses that were initiated, about 25 (established by 15 companies) were granted the right to sell cannabis in the first four-and-a-half years of the industry. The sacrificed man-hours represented in that 93.75% failure-to-launch rate is hard to digest.
Welcome to the big game. You now get to create all kinds of systems and feedback loops to determine: What are you going to prioritize selling? Where are you going to wholesale from? How do you determine what is “High Quality”? How do you segment your shelf-space for wholesale product versus your own? How do you get people to drive past other dispensaries to get to yours? How do you teach someone about the medicinal properties of this product without stepping too far and illegally giving medical advice? How do you hire the best people when you’ve just spent tens of millions to get started and now you’re only generating $100,000 each month?
And, let’s go back to the beginning: How do you tie this all together to save on your tax bill thanks to 280E? Isn’t that why you wanted to be vertically integrated in the first place?
Frankly, this is just the tip of the iceberg. Each of these seven businesses are so riddled with challenges that the re-creation of the wheel, because of our regulatory frameworks, is often a requirement. Anyone going into a vertically integrated strategy in cannabis must do so with open eyes and a regenerative wallet. Deciding to do so in order to avoid 280E is a terrible business plan. There are much easier ways to make money inside and outside the cannabis industry.