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California cannabis operators cheered when Gov. Gavin Newsom pledged to overhaul the state’s tax structure to shore up the troubled industry.
While the proposal is short on details, reducing state tax burdens could be an immediate boost to a company’s bottom line.
But even with a reduction of state tax burdens, cannabis companies still will need to contend with the impact Section 280E of the federal tax code has on their operations.
Even if you’ve been in the industry for a few years, the details behind 280E can be confusing. The IRS allows for the deduction of direct costs of goods sold (COGS).
And what qualifies as COGS is a pretty limited list:
- Purchase cost of the cannabis itself.
- Transportation costs related to the product.
- Electricity costs for your storage areas.
That’s pretty much it.
Besides creating confusion, 280E can extend a business’ valuation.
Because marijuana is such a new industry, many operators and observers look to a company’s EBITDA – earnings before interest, taxes, depreciation and amortization – to help determine the earnings potential of a cannabis company.
But taxes play a bigger role in the profitability of a cannabis company than they do for most other industries because of 280E.
And unless there are serious signals from the federal government (spoiler alert: there aren’t any yet) that change is on the way, your current net income might offset the potential when you’re looking for investors.
After all, investors invest because they’re looking for a return.
So what can you do?
- Make sure you claim your allowed deductions. Work with a professional who has experience with cannabis companies to keep yourself on the right side of the rules.
- Ensure that you have the documentation to back up your deductions.
- Be realistic in your valuation expectations. As MJBiz co-founder Cassandra Farrington noted in a recent episode of Seed to CEO, yes, your potential earnings is a factor, but until you get there, they remain only a possibility. Investors will look to both your EBITDA and your net profit when considering the terms of their investment.
Bottom line: Positive EBITDA is great to have, but don’t lose sight of where your operations are today.
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Deal of the Week / In partnership with Viridian Capital Advisors
Where is U.S. cannabis debt is heading?
Decibel Cannabis Co. (TSXV: DB; OTCQB: DBCCF), a $50 million market cap cultivation and retail company based in Calgary, Alberta, announced an amended and restated commitment for a credit facility of 54 million Canadian dollars, increasing its debt availability by CA$20 million.
Why is this interesting? In short, terms of this deal are far better than top U.S. multistate operators have received.
- Term debt has a fixed rate of 4.75% in an increasing rate environment.
- Deal amortizes over 12 years.
- Covenants seem reasonable and achievable, including a debt-equity ratio of less than 1 and debt service coverage of less than 1.4X. Current debt-equity ratio is greater than 1.25.
- ConnectFirst Credit Union in Calgary is the lender on the facility.
Existing term debt will increase from CA$28.5 million to CA$40.5 million with a five-year initial term. A CA$6 million overdraft facility, secured against government receivables, also will be added.
Decibel will gain access to a CA$7.5 million accordion line of credit once the company achieves a last-12-month (LTM) debt-to-EBITDA ratio of less than 4X.
Decibel is a strong credit as far as small Canadian cultivators go. The Viridian Capital Credit Tracker ranks it as the fifth-best credit among the 23 Canadian cultivation and retail companies tracked with market caps between $10 million and $100 million.
However, its credit statistics are not nearly as strong as large U.S. MSOs.
The fact that Decibel can borrow at these terms marks this transaction as a road map to where U.S. cannabis debt financing is headed post-legalization/ banking reform.
Here’s what that could look like:
- Pricing will improve by more than 200 basis points.
- Debt ratios will head upward as Section 280E tax relief frees up cash flow.
- A public debt market will develop for larger companies, modeled after the U.S. high-yield market.
- Competitive bank and nonbank financing options will develop for smaller competitors.
- Second- and third-tier MSOs will borrow without equity kickers.
In other words, U.S. cannabis companies might be able to start borrowing on terms more like other mainstream companies can get.