Many venture capitalists are still nervous about investing in marijuana, despite a legal market estimated at $1.44 billion. Worries range from DEA enforcement action to scalability to a general squeamishness about “sin products.” A realistic way to take the risk/reward problem apart may be to look at the industry as a collection of mini-markets, each with unique characteristics. ArcView Market Research tackles the problem in three pieces:
- wholesale growing,
- vertically integrated cultivation and dispensary operations and
- ancillary businesses.
The investor with patience and little tolerance for risk may prefer the ancillary businesses. High rollers may prefer the integrated approach. Farming seems like an obvious winner in a newly legalized industry, but agriculture has always been speculative. There is very little experience with growing marijuana on a commercial scale.
In 2010, RAND Drug Policy Research Center explored the estimated costs and potential return of legalized cannabis production in indoor and outdoor cultivation. The indoor options included:
- private, non-commercial 5’ x 5’ indoor hydroponic grow with lights,
- 1500 square foot residential house with growing lights as a commercial operation and
- greenhouse-based commercial growing.
The estimated cost of production ranged hugely from $225 per pound produced for the 5’ x 5’ grow, to $200-$400 for the residential house and $70 to $215 for the commercial greenhouse. The open field operation used a variety of crops, including cherry tomatoes and industrial hemp as points of comparison, and came up with numbers as low as $1 per pound. However, it is not clear that open field cultivation is a realistic prospect in the near future. Many growers find it easier to regulate potency in an indoor space. Some jurisdictions, like Colorado, require that cannabis be grown in a secure, enclosed space, including indoor and outdoor sites. It could be more challenging for growers to protect open field cultivation.
To the extent that investment decisions are data driven rather than ideologically motivated, the problem with wholesale growing is spotty data. A few things are clear: the potential return grows with scale, outdoor growing is cheaper than indoor growing and costs are expected to drop with legalization. The report speculates that, if marijuana were treated like cherry tomatoes, the cost of complying with regulatory requirements could be negligible. That is a very big “if.”
Vertically Integrated Businesses
Again, the problem is a very small data set. Until October, Colorado requires seed-to-sale integration for at least 70 percent of sales so most marijuana businesses are involved in every stage of the production process. Washington State forbids it, limiting each business to one stage of production. The argument against vertical integration is the very high cost of entry. Mom-and-Pop pot shops cannot afford to play this game. On the other hand, for those who can afford to get in, there are advantages for both branding and quality control. Colorado embraced it in the first several months of recreational legalization for regulatory convenience.
For the investor, there appears to be some safety from the risks of federal enforcement action in a tightly regulated state market. In an interview last year with Business Insider, Kayvan Khalatbari, founder of Denver Relief speculated that legalization in Massachusetts, New York and Illinois would take place in a similarly heavily regulated atmosphere. Requirements for some form of vertical integration could easily be part of that picture. Investors contemplating a vertically integrated business model should also be mindful of the requirements of federal securities laws.
The mind goes immediately to vaporizers or other non-smoking means of ingestion, but the possibilities are nearly endless. Think about insurance, packaging, marketing, quality control labs, delivery services and tour bus operations. The farther removed a business is from the actual sale of marijuana to the customer, the lower the risk of enforcement action. It is an investment truism that low risk is often paired with smaller, slower returns. For the cautious investor or the smaller one, this may be the way to get a toe in the water.
Whether the arc of history bends toward justice is something of an open question. It certainly bends toward commerce. Legalization is generally seen as a given, at least eventually. However, cautious money is still sitting on the sidelines of marijuana investment. One way to take unreasonable fear out of the equation may be to evaluate the risk/reward characteristics of agriculture, vertically integrated businesses and ancillary segments of the market separately.