Planning for the Coming Consolidation in the Cannabis Industry

By Michael Harlow, CPA, Partner

In today’s Cannabis marketplace, we continue to hear one overarching theme. The industry buzz on everyone’s lips is about “the future consolidation of the industry.

This is driven by several factors: strong customer and revenue growth for retailers, price compression for wholesalers, an expected change in the legal landscape, new interest from private equity funds, new state markets coming on line, recent IPO activity in Canadian markets, plus an overall expectation that there is much more growth ahead. Those in the industry want to position themselves to either be a target for some future roll up or be to prepared to roll up smaller operators into their own structure.

It is nearly impossible to predict what is in store for such a rapidly changing industry, other than the fact that things will look very different five years out. With a U.S. market currently characterized by a high number of single-state operators desiring to exit or expand, high valuations and strong customer growth, consolidation is on track to be one of the largest stories of 2018. It is true that several state regulators are crafting regulations to protect smaller operators, but the sheer size of the new markets coming online will lead to larger operators than we have seen to date. To plan and correctly structure a business in today’s cannabis landscape, you need to keep all these trends in mind.

However, strategies that may minimize current tax liabilities may also limit your ability to participate in some future transactions. This is complicated by a regulatory environment that varies, not just by state, but also by municipality.

We have compiled a few keys to success when structuring your cannabis business:

• Build the right team and recognize what you do not know is as important as what you do know.
  • Having the right attorneys and accountants at the table along with your operational experts will make all the difference. No one individual has all the answers.
• Identify what your growth plans are.
  • Creating a viable private business that will generate positive cash flow for investors probably makes more sense in an appropriate tax partnership structure (depending on the regulatory environment of the state). However, growing a business by reinvesting all cash- flow back into operations and increasing business value for a future sale may be better structured as a taxable C-Corporation rather than a partnership for tax purposes.
  • If you are looking to expand, raise capital or deploy capital, you will need to anticipate how future regulatory changes will impact your business and how future investment will impact your original investors.
  • If you are looking to exit, you need to have a plan for when and how you would like to exit and if you want to exit in whole or in part.

• Segregate business lines.
  • Cultivation, processing and retail operations requires separate licenses in several states and they are distinct business operations. The value of these different businesses varies dramatically based on the specific regulatory and market conditions in each state.
  • There may be parties interested in one portion of your business, but not others and you will be in a better position if they can be legally and operationally separated. The same is true for any non-plant touching operations. Currently, there are many investors who are interested in the overall growth of the market, but are most comfortable investing in non-plant touching businesses.
• Separate real estate and fixed assets from operations.
  • We have seen several operators that have thrown everything and the kitchen sink into one partnership or C-Corporation. Often there were regulatory reasons that required this approach at the time, but that may have changed and several new markets allow more flexibility.
  • Having the real estate and fixed assets in the plant touching business limits your tax depreciation allowed under section 280E of the federal tax code, but also creates future limitations. We have seen several operators face an unexpected C-Corporation level of tax when they sell the real estate under their existing garden or dispensary. Had the real estate been held by a separate tax partnership and then leased to the operating business, the C-Corporation income tax could have been properly avoided.
• Organized 280E compliance and bookkeeping.
  • You may have grown a great brand with first class operations, but if a potential buyer cannot quantify their tax exposure on prior year tax filings or cannot gain any comfort in the state of the financial reporting, your valuation could be negatively affected.
  • Segregating plant touching and non-plant touching business activities can also have a material impact on 280E tax costs.

It is challenging to predict the future, but several issues can be avoided (or at least anticipated) if you spend some time up front brainstorming and planning with your trusted advisors: attorneys, accountants and investors, before you sign any documents. This saves a lot of headaches and meaningful dollars.

This cannabis industry is evolving at a rapid pace. Staying apprised of the changes and how disruption affects your business is paramount to your long-term success.