With the mainstreaming of cannabis and hemp, private equity groups, family offices, private investors and publicly held companies have all taken note of this high-growth industry. But, as with any nascent sector, there is a glaring question: How should cannabis and hemp companies be valued for strategic investment or acquisition?
As untraditional as cannabis and, to a lesser degree, hemp companies are, they have been valued, to date, by mainstream investors using traditional metrics.
Performance indicators such as EBITDA, OPEX and COGs are all used, just as they are in other industries. A business operator, such as a clothing company, who monitors traditional “pulse-of-the-business” features such as customer concentration and maintaining gross profit margins would be right at home running a cannabis business – albeit after mastering the cumbersome regulatory and tax environment.
Another traditional feature of valuing cannabis and hemp companies is that they are often acquired, or invested in, on the tried-and-true multiple of EBITDA basis (calculated as total enterprise value divided by EBITDA).
As much as investors want a simple answer to methods of valuation, the response in this industry sector is nuanced.
In fact, the value depends on the type of business being acquired, or invested in, as well as the operative time frame investors chose when examining financial statements and determining the EBITDA on which the value is based.
For instance, given the high-growth phases that cannabis and hemp are in, a software company serving the cannabis and hemp sectors could reasonably be valued using future revenues for consideration, especially if the company has booked recurring subscription income and has a stable, well-developed product with solid branding. That is a common exception recognized more broadly in the M&A world; software companies have often been able to achieve premium valuations on predicted revenues.
On the other hand, an HVAC or lighting company that serves undercover grow operations would probably have its value based on historical financial performance, either three years back or trailing 12 months (TTM), with a slight premium paid for the high-growth nature of the sectors. A well-run laboratory focused on regulatory compliance for cannabis and hemp probably doesn’t have to reach too far into its financial performance folder to show rapid recent growth and great prospects, given the predictability of demand for required product testing. There, too, expect to pay a premium for such performance and strong prospects.
Another variable that comes into play with valuation for acquisition and investment is the prospect of an earnout, which puts lots of faith in historical numbers yet serves as a risk-allocation vehicle that rewards actual future performance, where part of the purchase price of a company is deferred and not paid in cash at closing.
A look at the multiples paid today
What are the multiples being paid for cannabis and hemp companies? There are databases that publish stats from recent deals, often using the NAICS codes to group deals by category. (We use GF Data Resources.) Because there is no dedicated code for cannabis or hemp companies yet, investors have to triangulate.
Two codes we at 1stWest Mergers & Acquisitions are watching (until NAICS issues a dedicated code) are 325411 (medicinal and botanical manufacturing) and 424210 (drugs and druggists’ sundries merchant wholesalers).
Keep in mind these data points are for triangulation and not an apples-to-apples comparison for cannabis and hemp. The multiple of EBITDA range for recent deals was 5.5X to 6.2X EBITDA for the 325411 code, with the higher revenue companies achieving the premium.
For the 424210 code, the multiple ranged from 7.0X to 7.9X EBITDA.
For ease of math, we can make the general assumption that a $1 million adjusted EBITDA company in these two categories would be worth between $5.5 million and $7.9 million, based on a total of 23 recent deals.
It never ceases to amaze us how many companies, no matter what the sector, sell within the 5X to 8X range. We see that multiple often, from manufacturing and logistics, to companies of almost any type. That consistency indicates that the consensus multiple paid for successful companies, in and out of cannabis and hemp, is around 5X to 8X earnings. We have seen extraordinary multiples (10X, 12X earnings) paid for some companies, but they are typically high-tech or software companies with strong growth trajectories or, perhaps, a collection of valuable patents. The rationale for these higher multiples is that the acquirer is looking a year or two out and reasoning that, once that time period has elapsed, it will have paid 5X to 8X based on those future achievements.
Paying high multiples today for future performance always involves risk.
In a recent public transaction, special-purpose acquisition firm MTech paid around 6X revenues to acquire cannabis tech company MJ Freeway, a premium price indeed. But if you are reading these multiples and wondering why public companies are getting such sky-high values on dangerously high P&E ratios, note that public markets are a breed of their own, and we are commenting just on the world of private equity and strategic acquisition. In fact, each time we approached a potential buyer of a cannabis or hemp business, we immediately ask if the sellers are expecting fantasy multiples because of the cannabis or hemp affiliation. Economic buyers and investors typically do not take on the level of risk that the stock market embraces.
The counsel we can offer at this time for investors itching to be part of the gold rush:
- Don’t use nontraditional metrics for valuing companies.
- Be prudent when determining the total available future market share and what percent your prospect is truly likely to grab as it moves into this increasingly crowded space. ?
Dr. Carl Craig and John D. Wagner are managing directors of Colorado-headquartered 1stWest Mergers & Acquisitions, which offers a specialty practice in the cannabis and hemp sectors. 1stWest has transacted more than $1 billion in deal values.
