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Cannabis Industry Outlook and Trends – What Lies Ahead for 2020

The Cannabis industry continues to attract growers, retailers and other entrepreneurs in large numbers. While sales have increased substantially over the last several years, it is becoming apparent that a focus on fundamentals is becoming more important to stay solvent or become an attractive acquisition target. We recently participated in a webinar where a group of industry specialists discussed current market activity, M&A trends, valuation, capital availability, and regulatory environment in cannabis. Here are some of the highlights:

  • Cannabis companies with steady corporate governance, internal controls, processes, compliance, and strong focus on bottom line will be more attractive targets.
  • Cannabis global market development is the next chapter for the industry. Legalization is growing outside of the United States and countries that are first to the global marketplace can create sustainable advantages.
  • De-scheduling from Schedule I of the Controlled Substances Act will push multiples downwards. Multiples have already compressed substantially with revenue multiples averaging 6.3 times – 6.4 times for deals $1MM and up.
  • CBD is being added to products across the retail spectrum from food to make-up, but with little legal oversight or requirements. While the industry has seen more investor and commercial lawsuits to date, consumer class action lawsuits could become more prevalent since CBD products can easily be mislabeled or ineffective. 
  • Best practices command quarterly or some other frequency valuations to support ROI analysis.
  • Acquisitions are getting done via the Canadian stock exchange market. While some companies have been successful in that strategy, in the long-term that strategy is going to be viable for only a minority of companies.

If you’re a partner who participates in the cannabis industry and would like to learn more about The Cannabis Best Practices Group, contact Victoria Hall at hall@quistvaluation.com.

The market recognizes that companies with high ratings for environmental, social and governance (ESG) factors are lower risk than other companies and the market rewards them accordingly. In the hierarchy of factors that count with investors and markets in general, governance is ranked highest and then environment, followed closely by social factors.  A recent scandal involving Volkswagen cheating U.S. diesel emissions tests sent company shares plunging and exposed Volkswagen to potentially up to $18 billion in federal fines. As a result, the trust of Volkswagen’s customers and the public has been undermined and the company will now face intense legal scrutiny. Despite numerous instances of proven corporate disregard, there has been a notable rise over recent years in attention to the management of ESG issues. However, a common challenge for many companies is whether managing ESG issues really help create value and how to quantify the value of ESG initiatives?

“Companies that are considered leaders in ESG policies are also leading the pack in stock performance by an average of 25%.” —Goldman Sachs[1]

The responsible investment strategy that many companies embrace today is based on the view that the effective management of environmental, social and governance issues is not only the right thing to do, but is also critical to value creation. Responsible investors believe that companies which are successful in avoiding ESG risks while capturing ESG opportunities will outperform over the longer term. When it comes to environmental issues, for example, environmental challenges can present opportunities for value creation (i.e. generation of incremental revenue from new technologies, products and markets such as sustainable products and services). Investors also share the view that ESG issues have the potential to materially impact the valuation of investments over the longer term. According to a survey of the private equity industry conducted by PricewaterhouseCoopers[2], environmental and social issues are considered to some extent during investment appraisals. The survey results further reveal that while there has been progress in developing and implementing responsible investment strategies over recent years, there has been lack of a policy on ESG issues and systems in place to measure value created from ESG initiatives (particularly for initiatives addressing environmental and social issues).

So, what motivates companies to pursue a responsible investment strategy? Some of the most common drivers include risk management, interest from investors, opportunities for cost savings and operational efficiencies, direction from upper management and regulation. Reputation and competitive differentiation also drive a responsible investment strategy, but the importance of these drivers will dissipate eventually given that the need for managing ESG issues has been arising.

Considering the importance of ESG factors, why is it many companies still lack a policy on ESG issues and don’t have systems in place to measure the impact of ESG initiatives on their business? The reason can be lack of internal capacity and expertise. Hiring an in-house team with specialized knowledge can be cost prohibitive, especially for smaller companies, and not sustainable given fluctuations in business and economic cycles. Many investors continue to view ESG only as a means of de-risking their investments and sideline environmental and social points as niche issues rather than being integrated into core business strategy. Measuring ESG performance and assigning financial value to ESG factors remains a challenge, especially considering the availability of ESG relevant financial data. Other reasons include limited ESG reporting requirements in the private sector.

When it comes to measuring value from ESG activities, it can be difficult to quantify how much value is tied to ESG factors. While it is difficult to quantify the extent to which strong ESG management contributes to a good valuation, companies recognize that a sound approach to ESG issues can enhance both earnings and multiples and can improve salability of the company or the asset. The challenge has been identifying ESG metrics and developing an effective measurement framework for ESG activities. Some companies have begun to attach a financial value to ESG initiatives by tracking their direct benefits. These include cost savings achieved from eco-efficiency initiatives or revenue growth achieved from more sustainable products.  However, fewer companies have been able to quantify the indirect value achieved from ESG activities (i.e. customer loyalty, brand value or protection against reputation risk). There are a number of challenges in valuing the indirect benefits of ESG initiatives, since there is no market price for the intangible assets and the fact that their value to one company may be completely different to another. Despite difficulty in measuring indirect value achieved from ESG activities, some companies adopted strategies of using non-financial and qualitative indicators to measure ESG factors. Such approaches allow companies to track progress on ESG issues year over year. One of the approaches is to score company performance on key ESG issues (i.e. environment, workplace, and community), against pre-defined ‘maturity levels’.

 

At Quist, we work with companies across the full lifecycle of their businesses from start-up stage through growth to eventual exit. Our Management Insights™ tool is designed to engage company leadership teams, board members and investors in a more robust value creation and risk management process. Quist Management Insights™ tool poses questions for management teams to assess direct and indirect valuation drivers to help companies determine where they can improve and create financial value.

[1] Goldman Sachs – Goldman Sachs Global Investment Research, “Overview: Introducing GS SUSTAIN,” July 2, 2007.

[2] Responsible investment: creating value from environmental, social and governance issues. PricewaterhouseCoopers International Limited. March 2012.

No one will argue that a transaction in a company’s own stock is the best indication of value – provided, of course, that the transaction occurred among willing and able buyers and sellers, neither acting under compulsion and both having reasonable knowledge of relevant facts. In fact, it is typical for the valuation community to look at prior sales of company securities as an indication of value. These third party sales are often in the form of new capital raises.

Entrepreneurs often raise capital in multiple rounds of financing, and valuations tend to rise over subsequent rounds as a company progresses through stages of enterprise development (i.e. proof-of-concept, product development, customer orders, revenue, operating profitability, and positive cash flows). Each round of financing is priced independently and typically involves new investors. The price in each round is ideally set by the cash flow expectations of the company and return objectives of the investor. As long as the company is growing and achieving milestones, it is reasonable to expect that the stock price in the new round would be higher than in prior rounds. The value of the company can simply be determined by looking at a post-money value calculation ($ Amount of Capital Raised / % of Ownership Acquired = Post Money Value).

However, when valuing companies with “complex” capital structures (meaning companies with different classes of stock and multiple rounds of financing), looking at a straight post money calculation as an indication of value for the company does not take into account the rights and preferences that may have been negotiated on the preferred shares issued. If you were to apply a traditional post money calculation to determine the value of the company then the protective provisions and other economic rights of preferred shares would be assumed to have no value. As such, the valuation and the audit community have relied on the utilization of a Backsolve Option Pricing Model method (“Basksolve OPM”). The Backsolve OPM has evolved into a standardized and broadly accepted method to determining the equity value of companies with complex capital structures.

The Backsolve OPM method takes into account the rights and preferences of each class of stock, market interest rates, industry sector volatility data, and the appropriate time period to a liquidity event to calculate an implied indication of total equity value for the company. Under the Backsolve OPM, the appropriate market value of equity for the company is solved for where value allocated to the most recent capital raise equals the amount investors paid to purchase the shares.

The rights and preferences negotiated on preferred capital raises impact the implied equity value of the company. Often times, the more onerous the rights and preferences, the lower the implied equity value. When investors negotiate liquidation preferences that are senior to prior rounds or are one time, two times, three times, etc. the original issue price, those benefit the investor. It results in a lower implied equity value for the company, and it assumes that those rights and preferences had to be given in order to secure financing. In most cases when those more onerous preferences are negotiated, it is for good reason because the company may be struggling to hit operational milestones. Where the Backsolve OPM method can “break down”, however, is in late stage companies.

Late stage financing rounds are typical small (compared to the total amount of capital raised) and are meant to bridge the company to a desired liquidity event. In our experience in valuing portfolio companies for venture capital firms, we have seen where the application of the Backsolve OPM method results in an indication of value that is unsupported by the fundamentals of a late stage company. Ultimately, the venture capital investor is faced with a write down in its holdings because the senior rights and preferences of the “bridge” round crams down the value of the prior rounds of funding.

An example can help illustrate the impact of a senior financing round on a company’s valuation. A late-stage technology company closed a Series D preferred round of financing at two times the price of the prior round, reasonably indicating an increase in value. Management indicated that the company had been performing well and had been achieving operational milestones. The price of the new round and management outlook suggested that the company’s value should rise. Utilizing the Backsolve OPM method and the recent Series D preferred financing, however, would have resulted in the investor taking a write down in its holding value (which included prior series of preferred shares) because of the seniority of the Series D shares and their higher liquidation preference compared to the prior rounds of financing. In this example, the Backsolve OPM method understated the equity value of the company.

While the Backsolve OPM method is simple and remains the most preferred valuation method by the valuation and audit community, it doesn’t always reflect the fundamentals of the company and should be carefully considered. The stage of a business greatly influences the merit of any valuation approach whether that is a Backsolve OPM method or other more traditional approaches to value such as the market approach and the income approach. However, when raising capital, management would be well advised to better understand the impact of certain rights and preferences on the implied value of their company. Management’s ability to understand the nuances of their capitalization structure is just as important as understanding how revenue and profitability drive financial value.