Insider’s Guide to Cannabis Investing: How to Tell When NOT to Invest in A Cannabis Startup

Can you guess what I’ve never heard another early stage investor say while deploying capital?

“I can’t find enough companies to pitch me. My inbox really could use a few more pitch decks.”

If you are investing, this probably elicits a chuckle. When you put your name out as one who can write checks, those looking will inevitably follow. Separating the wheat from the chaff is no small task.

The truth about investing in companies is it is a trail paved with rejection. And yet, we investors do eventually say yes.

That is why last year was a record year for cannabis fundraising, with more than $13.6 billion raised globally. That’s four times the amount raised in 2017.

However, to put this in perspective, cannabis fundraising remains dwarfed by the $293 billion raised in the global venture industry. For every company funded, thousands are not. In fact, most venture capitalist funds invest in fewer than 5% of the companies we see.

Companies should have to pry open our fingers with ideas and facts so compelling and teams so strong that we can’t help but open our pocketbooks.

What does that mean for you as an investor, especially one in cannabis? It means you need to get supremely comfortable with saying no.

While investing in cannabis has more similarities than differences to other industries, such as CPG, biotech, agtech and retail, there are some very unique aspects of this industry—and three particular tells that immediately elicit a “no” from me:

The Walking Unbanked

A startup doesn’t have a valid and functioning bank account? You might want to rethink that investment. The days of this industry as a cash-only business are behind us. According to FinCEN, there are 375 banks and 111 credit unions worldwide that offer services to cannabis businesses. In fact, banks even reach out to investors to pitch their services to our portfolio companies. And that number is growing.

One of the quickest ways to screen a less-than-savvy founder is for them to demonstrate they don’t have the ability to manage their finances, the prowess to convince any bank to take them on, and the system setup to ensure their business has its lifeblood: cash flow.

While payment processing may still be an issue, having a bank is a nonnegotiable. Billion-dollar cash businesses do not function. If they don’t have an account, I typically send them an article on how to get one.

Low Gross Margins

Before I take a meeting, I always ask a few questions:

  • What are your financials? Here, I am looking for annual and monthly recurring revenue for as far back as they have them, runway left/cash on hand, and cost of goods sold or unit economics on their products.
  • What is your current funding structure and what does your cap table look like?
  • What are you raising? At what valuation? And how did you get to that amount?

The first question is one of the most overlooked in this space. Much of the industry looks at grow capacity as the gauge for value, but as quality, production output and premiumization happens, capacity is no longer the only factor.

Companies that explain away low margins will struggle to get funding as investors know that margin compression is not an if but a when.

Is a company’s gross margin less than 50% in its projections? If so, you are in trouble. Low margins in this business will kill you. As will margins that do not fully include all aspects of this labor-intensive, capital-intensive business where unique regulations and taxation can have you selling millions and making pennies.

For instance, assume in your investor pitch that those on the other side of the table are going to question you on the tax assumptions you have, which can range from as low as 10% to as much as 37% for growers.

The unicorns in the space are largely vertically integrated companies, due to the ability to cut out costs throughout their supply chain and thus increase their margins and capacity as well as the belief they will control this space. The largest Canadian cannabis companies average a gross profit margin around 50% – and you can be sure since their founding those numbers have compressed.

If They Build It, They Won’t Come

About 20% of the decks I see are automatically discarded because there is no clear path to profitability, which means no breakdown of cost of customer acquisition (CAC), lifetime value (LTV), conversion rate, etc.

Investors have a responsibility to our limited partners to provide a return on investment. Thus, we need to see how founders are going to get their idea into users’ hands and how much it will cost to do it.

This needs to be broken down into excruciating detail. While their potential revenue numbers may be sky high, the devil is in the details of achieving those numbers. For instance, there are widely varying predictions on the median spend of a customer, anywhere from $33 to $250—depending on the reports you cite—which is a critical consideration for cannabis dispensaries.

If we assume that each customer will spend $33 per visit and that your gross margin is 50%, you better spend less than $16.50 per customer. Here’s one of my favorite lessons learned from one of my founders, who sold two very successful consumer packaged goods companies: “If a founder won’t get their hands dirty old-school selling, they won’t win in CPG.” That’s why I will go in depth with founders on how they sell. I’ll ask them:

  • If I were a customer, how would you pitch this to me?
  • What was the biggest account/sale/sales day you’ve had, and how did that happen?
  • When was the last time you tried to sell this idea and failed? What happened?
  • What are your sales and distribution strategies?

Often, decks are heavy on ideas and hockey-stick-like returns, and founders forget that once you build your game-changing business, users can buy it only if they know about it. It is the founder’s job to go spread the gospel, and I love nothing more than seeing those who do it just like breathing.

Remember, each year more than 627,000 new businesses open, according to Small Business Administration estimates. Industry consensus is that a few thousand get funded each year.

We have to use our “nos” to find the few “yeses” in the 627,000 haystack.

Codie Sanchez is a cannabis investor and partner at Cresco Capital Partners, a cannabis-focused private equity fund.