With all the investment streaming into cannabis, investors that are considering the sector might be suffering from a severe case of FOMO – the fear of missing out. With one eye on private markets, where prudent investments can return many times what public markets can, investors nonetheless are watching the performance of stocks and wondering: Should I just jump in here now?
Recently, Bank of America Merrill Lynch initiated coverage on several marijuana stocks. Having seasoned financial analysts evaluating listed stocks will be a huge help to investors.
Similarly, investors looking to purchase businesses in the cannabis industry have been very active, with acquisitions up significantly in 2018. While some acquirers also exhibit FOMO, the more experienced investors will not rush. When we counsel them, we talk about having confidence in investment fundamentals: Companies in the cannabis and hemp sectors should be acquired or invested in based on multiples of EBITDA within the bounds of multiples paid for other companies that have nothing to do with cannabis and hemp. Of course there will be a slight premium for strong growth, but that premium may very well be zeroed out when discounting for risk.
The reason we counsel adherence to traditional metrics is that cannabis and hemp companies have to be run based on the old, somewhat boring metrics that drive the success of, say, clothing companies, door distributors or cabinet installers:
- Solid gross profit margins (with control of price discounting for high-volume customers).
- Strong EBITDA margins.
- OPEX control.
- Regulated inventory.
- Avoidance of customer concentration.
- Manageable debt.
Once you lose sight of these traditional metrics and buy into a fantasy that marijuana and hemp companies are somehow immune to the rules of running a business simply because they can grow faster than most companies, you’re at risk of paying a multiple of EBITDA that is outside the norm. The risk profile of the deal rises, and you are dependent on extraordinary growth – and everything else going perfectly – for you to achieve the high rate of return expected by your fund or family.
Rapid growth can solve a lot of problems, but it cannot overwhelm nor compensate for a company that is poorly run.
What Stage of Maturity Are We In?
As for timing the market, we believe that private placement activity in cannabis and hemp is just starting to spark to life. Although it’s all changing rapidly, up until now it’s been held back:
The federal government still has not opened up banking for cannabis revenues. The feds opened banking for hemp with the 2018 Farm Bill, but some firms are still leery of dealing with hemp companies. The Secure and Fair Enforcement (SAFE) Banking Act of 2019, which would allow access to banks, is still not law. It has merely been introduced.
Ownership of cannabis companies is still regulated in some places. For instance, in Colorado, which has a rapidly maturing landscape despite ownership constrictions, the Legislature passed HB19-1090 Publicly Licensed Marijuana Companies, which will broadly open up ownership of cannabis companies to ownership by nonindividuals. But at press time, it was still awaiting the governor’s signature.
We hear from investment funds every single day that have cash they want to put to work. But when we mention that we have cannabis companies on the market or about to go to market, the majority of funds back away, saying they are disallowed from that type of investment by their guidelines or by personal aversion to getting into these sectors. This, too, is rapidly changing in favor of cannabis.
Once the federal banking issues are worked out, and any company can buy any cannabis company anywhere, and funds see a pathway to place money in a fully legal environment, then M&A activity will start to reach stride.
A Seller’s Point of View
Now, let’s switch to the sellers’ point of view to see if we can determine their motivation for selling their companies today. Are they at risk of rushing to market?
As much as business owners understand that the worst time to sell a business is during a bad economy, those same owners generally don’t hold the reciprocal perception that a strong economy is a great time to sell a business. They think the party will go on forever.
When recessionary pressures come into play or – much more likely – the multiples paid for cannabis and hemp companies start to behave like mainstream companies, as they should, that’s when we – as “sell-side” representatives – tend to get calls from business owners who say: “I probably should have called last year, but I’d like to test the markets now.”
What motivates a sale of a successful and growing business? While a business may not be exactly at its peak today, some business owners have simply had enough. They may be exhausted from years in startup mode. Or the value of the company exceeds what they need, even if it can grow a great deal more. Or they want to feel secure by paying off the debt they incurred to launch. Or they are buying out family/early investors who want liquidity.
That said, no matter when an owner sells, there will always be a niggling fear that you left a little money on the table. But what’s that old business cliché? You’ve made a smart move if you sold just before the peak.
Do the Math
Let’s do a little math to discover the mentality of today’s sellers, assuming that they are watching the multiples paid for marijuana and hemp companies as closely as you are.
For ease of math, let’s say that a company is booking $1 million EBITDA. If the multiple drops from 7X to 5X, its value drops to $5 million from $7 million.
If an owner sells at 5X, they would need to increase their EBITDA by 40% just to get back to a dollar valuation equal to the 7X multiple they might have obtained in a market driven by investors who have FOMO. Increasing EBITDA by 40% in any market would be an extraordinary accomplishment, even in the rapidly growing marijuana and hemp sectors. That’s serious motivation for owners to sell in a good market with high multiples rather than risk an unknown future, while perhaps leaving some money on the table.
Given how long it takes to complete a deal – the journey from the informational memorandum draft to the definitive purchase agreement/deal closing can take up to a year – should an owner sell today, near the peak or risk waiting?
A middle path they might take is to start preparing now by obtaining a valuation of your business from an outside M&A advisory firm/investment banker (our valuations run around $5,000 for nonclients) and perhaps even test the market to see whether offers might be forthcoming. You can always say “no” – or, if surprised by a strong offer, agree to a sale.
From the investors’ point of view, the more deals that are out there, the more data points they have to determine if the multiples they are paying are prudent … or if they’re chasing after a value that might or might not be achieved in the future.
John D. Wagner and Dr. Carl Craig are managing directors of Colorado-headquartered 1stWest Mergers & Acquisitions, which offers a specialty practice in the marijuana and hemp sectors. 1stWest M&A has transacted more than $1 billion in deal values.