It’s an especially challenging time for cannabis businesses. Although
legal cannabis markets exist at some level in the majority of states in
the country today, they fight to survive amidst a web of restrictive and
confusing regulations that make it difficult for businesses to operate
in the black.
Cannabis entrepreneurs and investors need to understand the unique legal
aspects and learn how to navigate the wobbly industry in order to avoid
ruinous financial outcomes. Factors that negatively affect profitability
in the cannabis industry include federal prohibition, state regulatory
structures, taxes and lack of access to financial services. Tightening
your knowledge gaps and knowing where to get support when you need it
makes all the difference when forging a successful path through an industry
in distress.
Federal Cannabis Policies: What’s New
Operating a business based on a plant that is illegal at the federal level
is not easy. While there is momentum building behind efforts to reform
federal cannabis laws, outright legalization is most likely still years away.
Among notable signs of progress in 2022: Senate Majority Leader Chuck Schumer
(D-NY) announced that a bipartisan effort is underway on a bill to allow
financial institutions to engage with and lend money to cannabis companies,
and President Joe Biden recently signed a watershed
cannabis research bill that will ease access to cannabis for study and enable research into potential
cannabis-derived medications. Attorney General Merrick Garland, who leads
the Department of Justice, was also directed to reassess how cannabis
is scheduled. It currently sits in
Schedule I on the Drug Enforcement Administration’s tiered system of controlled
substances, and rescheduling (or full descheduling) could have a profound
impact on the ways cannabis products are regulated.
Inflation Impacts on the Cannabis Consumer
Inflation is also plaguing the industry as consumers drop cannabis from
their shopping lists or reduce their purchase amounts. Just like any other
commodity, cannabis is subject to price fluctuations. The rise in prices
for essential goods mean consumers have less disposable income and cannabis
sales have understandably plummeted. Meanwhile, cannabis companies are
dealing with the increased operating costs associated with residual post-pandemic
supply-chain issues and the impact of Russia’s invasion of Ukraine
on global fuel prices.
Punitive Taxation and Overregulation
The financial challenge of running a cannabis business under the weight
of federal prohibition is also debilitating.
Internal Revenue Code Section 280E defines all “plant-touching” cannabis businesses—regardless
of state legality—as criminal enterprises “trafficking in
a controlled substance” under federal law. Currently, cannabis businesses
cannot deduct “ordinary and necessary” business expenses after
reducing gross receipts by the cost of goods sold (COGS). The result is
a huge federal income tax liability that, unlike other businesses, is
calculated based on gross rather than net income.
Tax burdens for cannabis companies can be
as much as five times as large as non-cannabis businesses. And while the cannabis business is effectively
taxed at a much higher rate, it will take longer for that business to
recoup its startup expenses and turn a profit. Standard operating decisions
like choice of entity, ownership structure and accounting practices are
also complicated and have far higher degrees of risk.
Excessive and ambiguous state regulations also abound across the cannabis
industry. Say you’re a successful edibles maker in Colorado and want to
expand into Oklahoma. What else do you need to know to properly navigate the state’s
regulatory compliance standards and the local laws, how they are enforced
and how the officials of the state regulatory boards interpret the law?
Rules regarding labeling and packaging can change often and without warning.
Even the regs for cannabis product testing are all over the place; cannabis
testing labs can face heavy scrutiny in some states but virtually no oversight
in others, which can lead to
opportunities for fraud.
One example of an expensive regulatory demand is in security compliance.
Most legal-use states have strict security and monitoring regulations.
The need for 24/7 surveillance, access control, burglary alarm sensors
and dozens of surveillance cameras to monitor a cultivation facility comes
at a hefty cost. This is just one instance in which a cannabis business
might fall out of compliance and get hit with a large fine that makes
continued operations impossible or lose their cannabis license outright.
All of this
overregulation and heavy taxing stymies industry advancement and profits.
Price Compression, Consolidation and New Markets
Consolidation and
price compression are two dominant factors affecting the cannabis sector. The
drop in the wholesale price of flower and trim for concentrate manufacturing in many markets is favoring
multistate operators (MSOs) and larger-scale business entities. Small
operators are struggling and traditional mom-and-pops are in danger of being
sucked up by bigger brands that can handle the downturn in industry fortunes. This scenario, coupled
with new markets (and plenty of new production) in states like New York,
New Jersey and New Mexico is contributing to the uncertainty in the industry.
The easing of the application process in some states has contributed to
the rush of products hitting the shelves, but there are some positives
that have emerged as new markets come online. Applications in early medical-use
states such as Illinois, Maryland and Massachusetts were comprehensive
in their demands for detailed operating plans, including facility construction
and security. There was a heavy amount of paperwork required, and state
regulators were involved to offer guidance on how to operate a cannabis business.
Now, in states like New Mexico—where the adult-use market launched
in April 2022—the application process has evolved to a simple online
application with no cap on licenses distributed. This is the result of
a decrease in regulatory fear on the part of state legislators. Having
seen how overregulation has been so detrimental in other states, New Mexico
has opted for a streamlined approach. For comparison, Ohio had 10 medical
cannabis licenses for the entire state when its program began.
The social equity component of New Mexico’s application process requires
the most attention and focus on compliance. Otherwise, the application
process is simple and regulators tend to not get involved unless there
are compliance issues.
More and more states are moving toward something akin to liquor licensing
because they now know that a crisis will not occur if the application
process is eased to allow greater access and a democratization of the
process. Lawyers are most often called upon to assist with drafting the
social equity plan. A lawyer should know exactly what the regulators want
and how the client must present the plan to set up a framework for success.
There remain downsides to the easing application process, though, as a
lack of cannabis operations and industry knowledge by both lawmakers and
entrepreneurs leads to problems. The naivete on both sides of the aisle
persists as the business owners assume they will make easy money and the
state expects its coffers to rapidly fill with tax revenue from the new market.
Sadly, the lack of qualified or experienced executives like CFOs and CROs,
coupled with a dearth of financial cannabis experts, opens the door to
business failure. Legislators with little industry knowledge draft the
regulations and the lack of banking options due to federal prohibition
makes real estate negotiations and transactions difficult. Cannabis is
a commodity with varying returns, and business owners must know how to
best handle oversupply issues in uncapped markets.
Cannabis Business Bottom Lines
While IRS Section 280E takes a massive toll on cannabis business profitability
from a revenue perspective, the lack of access to capital and “normal”
banking and lending services also makes life difficult for cannabis businesses
in distress. There are few options for distressed companies because there
is no federal bankruptcy protection for restructuring. Receivership is
one option, but that comes with great costs and more often than not results
in a distribution of assets to creditors as opposed to successful restructuring
and business turnaround.
The scenario is not ideal at the moment, but there are several steps that
owners can take to avoid becoming a victim of the struggling industry.
They need to know exactly what they are getting into.
Cannabis business entrepreneurs should understand the real cost of production—inclusive
of federal tax restrictions and regulatory compliance costs—so products
are priced accordingly, and see the bigger picture of the industry as
related to agriculture, manufacturing and retail sectors. There are unique
regulatory and market pressures that are constantly applied to all three sectors.
Due diligence is key. Both financial and personal/partnership research
should be conducted to fully understand and plan for how relationships
must function for success. Transparency between owners and staff, and
the ability and eagerness to address any problems early and do things
right up front will be critical to realizing the
long-term savings of avoiding litigation, shareholder disputes, regulatory
fines, and ultimately, potential disciplinary action.
How a Cannabis Lawyer Can Help
A legal team that knows the cannabis industry—both locally and across other state markets—can be the difference
between whether a business succeeds or fails. Experienced cannabis lawyers
should not look at regulatory relationships as adversarial. Rather, they
will have strong relationships with regulators and policymakers to know
what is happening at the compliance level and how they can best use that
information to benefit their clients.
As the industry develops, expert cannabis merger and acquisition assistance
is also becoming more essential. Your lawyer should be able to provide
a proper letter of intent and term sheet, along with a thorough structure
of transaction, and details of all of the tax aspects of the merger.
The cannabis industry is unlike any other. A lawyer who is immersed in
the cannabis business environment can provide a holistic picture of regulatory
and market environments, and will provide immeasurable value in the distressed
cannabis industry.
Learn more about Cantafio & Song’s
cannabis legal services for businesses.