MARYLAND MATTERS: Recreational cannabis sales show no signs of slowing down in Maryland. They reached $92 million in August, up from the previous month, and state officials believe they will continue to increase in excess of a billion dollars by 2025.
This trajectory shows cannabis has tremendous potential to help drive the state’s economy through job creation and by injecting revenue into neighborhoods. Also, as we’ve seen in other states, the tax revenue from cannabis can be immensely beneficial for community investment, education programs, and social services. For example, Illinois legalized cannabis less than three years ago and has already brought in more than $450 million in tax revenue.
With the stakes so high, the industry should do everything possible to avoid any unforced errors that would slow down this emerging and dynamic market. A great place to start is getting business valuations accurate. It’s critical for any industry and even more so for a rather nascent one like cannabis. It’s important not just for the companies themselves but for the entire marketplace ecosystem for business planning and financial management.
Nevertheless, there’s a lack of good information readily available for investors and other stakeholders in cannabis. This knowledge is vital especially for a new recreational state like Maryland, because once a valuation is understood it can help retailers, cultivators, distributors, manufacturers, and other businesses make choices that align with their needs.
The three most commonly used valuation approaches are the asset approach, the income approach, and the market approach.
The asset approach to valuation
The asset approach to valuation calculates a business’ value based on the value of its assets and liabilities. By determining the difference between the total assets minus the total liabilities, the net asset value will be determined. With the emphasis it places solely on assets and liabilities, the asset approach to valuation can be insufficient at times for companies with assets that have a fair value higher than recorded value (i.e. brand name recognition or a large, loyal fanbase are two such examples).
The income approach to valuation
The income approach to valuation looks at both the business’s current income as well as its future cash flows to determine the value of the company. This approach can work well for businesses with stable revenue and growth.
For example, the rental income of a commercial real estate building might be very predictable. Therefore, the income approach would be a good way to predict valuation since rents will not fluctuate wildly from month to month.
In the cannabis industry, however, especially for licensees in Maryland just hitting the ground, estimating future revenue and income is challenging because there are a number of factors that are out of the business’s control, such as market prices, production issues, state and local laws, ordinances, and regulations, and more.
The market approach to valuation
The market approach to valuation determines value by comparing it to similar businesses that have been recently sold within the same specific market. If, for example, cannabis dispensaries in Silver Spring are selling for a certain figure, that data could be a useful way to determine value across the state.
Two caveats to using the market approach when valuing cannabis companies are as follows. First, in the cannabis industry, markets in different locations are vastly different. If location-specific data is not available, looking at other “comparable” markets might not be a reliable indicator of value. Second, since most cannabis companies are private, getting accurate data on the amount other similar companies have sold for can be hard to obtain.
Cannabis startups and valuation
Like their technology and cryptocurrency counterparts, cannabis startups are often looking to raise millions of dollars. Most of them are pre-revenue and have little to no hard assets. Sometimes the only thing they have is the cannabis license itself. If that’s the case, how can cannabis startups be valued?
Valuing something with few to no assets and no revenues is typically more art than science. The traditional income approach will not work since during the pre-revenue stage there’s little to no income coming in. And with assets oftentimes being nothing more than a cannabis license, the asset approach to valuation does not provide much clarity either. The “knowns” that can be valued are the state of licensure, the city or town where the startup is going to operate, the brand’s buzz or popularity (if there is any), and the financial model and pitch deck.
As a result, formal valuation in the startup space is rare. In general, though, it is determined by the market and location-specific market conditions, but most importantly the valuation will first be set via negotiations with arms-length investors. If the financial model is realistic and built by a professional, startups will have a much better time “selling” that valuation to an investor. Note, for any formal valuation you should use a CPA that has formal training and certification in this service.
It’s in the interest of everyone in Maryland to see cannabis’ promise fulfilled. Those who want to get involved in the businesses need an accurate valuation for financial planning, investor attraction, compliance, taxes, and strategic decision making. Understanding this key factor will help plant the seed for growth and stability into the future.
The writer is CEO of Dope CFO Certified Advisors, an accounting firm serving businesses in the cannabis and CBD/hemp industry.
