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.
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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.