Cannabis Startups Face Unique Challenges

The fast developing U.S. marijuana industry provides unique opportunities for entrepreneurs launching cannabis startups and investors seeking to cash in. My experience building software for legal marijuana businesses provided some insight into what makes this burgeoning industry different.

Oftentimes, people compare cannabis to the development of the modern alcoholic beverage industry that occurred as a result of the end of Prohibition in the 1930s. Dan Weil and David Lenok wrote that Prohibition’s conclusion, “led to a $200 billion business in the U.S….The fact that pot could be on a similar trajectory makes investors take notice and look for ways to get in early.”

While the outcome might seem clear, those looking to launch, or invest in, cannabis startups face a range of unique set of challenges. 

Cannabis Startups Have Limited Access to Banking

Cannabis is still largely a cash business.

Cannabis is classified as a Schedule 1 controlled substance, making it illegal to grow, possess, sell, distribute, or consume under federal law. That prevents FDIC-insured banks and other large financial institutions, including large pension funds and insurance companies, from providing investment capital or even a payments infrastructure behind the budding industry.

In other words, cannabis startups often find it very difficult to maintain a checkings account, to obtain merchant processing, and to receive loans of any type.

But.. cash is king, right?

It can be but something as mundane as paying taxes highlights the challenge faced by cannabis startups.

Last year the IRS collected $4.7 billion in taxes from legal cannabis businesses on nearly $13 billion in revenue. In order to make a cash payment to the IRS, the cannabis startup has to set up an appointment with their local IRS office. They then go to the office with bags of cash with the hope that they don’t get robbed. The cannabis startup waits at the office while the IRS counts the whole payment. Two IRS employees must be present in the counting room at all times. (Civilized)

The time and hassle mixed with serious security issue of handling so much creates a lot of logistical headaches.

It’s also much more expensive for cannabis startups to maintain an account at one of the very few banks and credit unions in the country that take marijuana businesses as customers than it is for everyone else.

“If you open a checking account in this industry, it’s going to cost you $3,000-$5,000 a month,” says Jim Marty in a recent article published by Quartz. “And all you get is a checking account; no lines of credit, no merchant services, no mortgages. It’s really not full banking services, so some people choose to stay on a cash basis.”

Few Options to Raise Capital

Another nuance of the industry is the small pool of investors cannabis startups can tap. This is something to consider when a company or project requires multiple rounds of financing in order to become profitable.

High-net-worth individuals have become a go-to source of investment dollars. Generally, the size of investment is too small for institutional investors. A larger concern is that investors are required to have a willingness to operate in a moral and legal gray area.

Fortunately, there are cannabis-focused venture capital and private equity funds. In comparison to other industries, VC- and PE- funds are difficult to come by. They are limited in number and are small in size.

Getting to an exit to obtain liquidity can be pretty complex. Major U.S. stock exchanges will not list cannabis companies. Filing over-the-counter is the most direct way of selling shares to the public.

But, wait, what about all the potstocks that’s been all the buzz?

Reverse mergers have been a backdoor for cannabis companies to pursue financing. Reverse mergers are when a private company buys a shell company that’s already publicly-traded. It’s a strategy that several of the largest U.S. cannabis startups have done to go public quickly. These mergers, oftentimes referred to as reverse takeovers, have been occuring on the cannabis-friendly Canadian Stock Exchange (CSE).

Going public on the CSE, despite its complexity, means these companies can roll up competitors using their stock as the cannabis industry enters a wave of consolidation.

Federal Tax Rates Can Be as High as 70%

Section 280E of the Internal Revenue Code prohibits businesses engaged in the trafficking of Schedule I or Schedule II controlled substances in contravention of state or federal law from deducting normal business expenses, such as payroll and rent, from gross income.

So a cannabis startup that isn’t using creative accounting can pay effective tax rates as high as 70% compared to the current 21% tax rate for corporations. The National Cannabis Industry Association published an informative video describing the effects of Section 280E.

The good news is that creative accounting exists and it falls into what’s commonly called a two-business strategy. The two-business strategy has been upheld in federal court with the most notable case being CHAMP v. Commissioner:

In CHAMP, two cannabis-related businesses operated in close coordination — one with the federally illegal activities and one with the legal activities. In some cases, the IRS has even upheld arrangements where employees worked for minimum wage for the company that was barred from deducting wages under Section 280E but also received a higher wage from the company able to deduct wages.

In Canna Care v. Commissioner, the Tax Court made three key findings, upholding previous cases as well as the application of Section 280E to cannabis companies:

    • Cannabis is still a controlled substance under federal law.
    • Despite California laws, federal law still holds that cannabis companies are still engaging in trafficking for the purposes of Section 280E.
    • A taxpayer engaged in the trade or business of selling cannabis falls under Section 280E and cannot claim business deductions other than the cost of goods sold.

In establishing these facts and confirming that the taxpayer failed to properly follow the two-business strategy, the cannabis startup was not entitled to the deductions. But had they followed the two-business strategy, the court stated the business holding the legal activities would have been entitled to its full deductions.

Compliance Culture is Critical for Success

When states legalize marijuana, it’s never a free-for-all and it doesn’t mean that any cannabis startup can start growing and open up shop.

Public safety is at the forefront of policy. Just as they’ve done with alcohol and other regulated products, the government passes laws, sets up new regulatory systems, and enacts policies to guide and monitor the new industry. The consequences of non-compliance can range from fines to imprisonment. This ensures that the newly-legalized industry is safe and accountable.

The biggest compliance challenges for cannabis startups pertain primarily to the need of satisfying new state and municipal compliance laws. Across the country, the common hurdles that have emerged include seed-to-sale tracking and advertising.

Regulators need to monitor marijuana products through every step in the supply chain. Whether it is sold to consumers in its flower form, as an oil, in an edible product, or any of the other ways that cannabis can be consumed, each product must have a clear and traceable trail indicating where it was planted, harvested, processed, and ultimately sold. All of this requires almost real-time updates and syncing large sets of data and documentation — making it quite onerous for any cannabis startup to meet regulatory standards.

Advertising and marketing is also a problem. Most social media sites, online ad networks, broadcasters, and print publications enforce partial or outright bans on cannabis content. Neither Google nor Facebook, the two most important ad companies of our generation, accept marijuana advertising and both have been known to delete accounts of cannabis startups that violate its policies.

This means cannabis startups are focusing their advertising locally—primarily turning to magazines, newspapers, podcasts and billboards to promote their businesses. The cost per impressions are typically higher in these avenues. Marketing campaigns and their effectiveness can be difficult to track.

The state of California and some city governments have moved to further limit the cannabis industry’s marketing opportunities. A new law in L.A., for instance, requires cannabis ads to be at least 700 feet away from schools, day care centers, public parks or public libraries. Meeting these types of nuanced requirements forces cannabis startups to be very detailed in their diligence and impeccable in their marketing.

Unique Challenges Make For Unique Investment Opportunities

While the nascent U.S. cannabis industry looks promising, launching and investing in cannabis startups is not without its unique set of challenges. Legalization has brought with it a variety of complications and risks that many in the industry––have found burdensome or, in some cases, insurmountable.

Ironically, the federal illegality of marijuana actually benefits current and prospective marijuana startups. The current regulatory environment discourages big business from entering the industry — including pharmaceutical companies, retail chains, and beverage companies to name a few.

This may be why it’s the best time for investors to get in too.

Jon Trauben, a partner at the New York City-based Altitude Investment Management, which manages $25 million, said in a recent interview that the firm is taking advantage of that short “window of opportunity” to invest in marijuana before prohibition recedes and the big institutional players jump into the sector.

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