The McQuillan Group News

Published on: Fri 4th Sep, 2020 By:

A few of our clients have been approached and asked to invest in the cannabis industry. We expect more contacts to occur.  While we are not offering investment advice, we want you to be aware of a few important issues related to a prospectus or financial forecast as part of the marketing effort of the investment that you will probably receive. We want you to be aware of the following so your due diligence can be as comprehensive as possible.

1. When examining the financial forecast within the prospectus, pay specific attention to the tax calculations.  Internal Revenue Code 280E penalizes “traffickers of controlled substances by denying them deductions from gross income.  Since cannabis is a Schedule 1 drug, this makes the calculation and assignment of costs important. Attention must be paid to the cost of goods sold categories of the profit and loss statement.  Federal Taxes are applied to the gross income of the business less cost of goods sold (very well defined by IRS), not the net income.  State taxes are applied to the net income.  There are two tax calculations and if the taxes are not applied correctly the net after tax cash flow could be overstated leading to a higher enterprise valuation. Takeaway: ask to see the tax calculation applied in the forecast and verify its accuracy and do not accept an enterprise value without double checking the tax calculations
2. Canada has been early to the table regarding cannabis.  If the prospectus uses Canadian companies in the valuation be aware that Canadian companies use the International Financial Reporting Standard (IFRS) while the U.S. uses Generally Accepted Accounting Principles.  There are differences. Primarily the IFRS requires the fair value of assets to be represented on the balance sheet.  Plants in the ground are valued at a fair value while they are still growing. Given the fluctuating nature of cannabis prices, this could lead to an overstatement of asset value and could lead to future write downs if prices fall.  This makes many ask whether IFRS accounting rules make Canadian cannabis companies look better than they really are.  So, if Canadian cannabis companies are referenced in any prospectus supporting an investment in a U.S. company, be aware that the utility of that information may be very low given the difference in financial reporting rules.
3. Valuations often use multipliers.  When multipliers are used, the approached is called the market approach.  The concept uses multiples from transactions of similar companies to determine the price of the target company. The method relies on using multiples from “similar” companies.  The term “similar” is open for interpretation. Size, industry, public or private, capital structure as well as product mix all need to be similar. If the market approach was referenced and used in a prospectus, we encourage you to examine the sample of similar companies used. Similar companies should be limited to other “plant touching” agricultural businesses. Using for example data from an alcoholic beverage company would not, in our opinion be a similar company.  Also, only utilize after tax multiples given the split nature of the tax calculation which we discussed earlier.  We encourage the use of the income approach over the market approach especially for private companies.  The income approach relies on after tax cash flows as the primary benefit stream.  We also encourage the use of multiple discounted cash flow calculation models where the revenue line fluctuates given a range of cannabis pricing that may occur.  The assumptions behind any financial projection you received should be investigated.  Weigh the various scenario outcomes based on the probability of their occurrence from your perspective and then determine the most probable scenario and corresponding value.
 Be prudent in your due diligence, it is a relatively new industry and there are a lot of questions related to regulatory, political, and practical business issues that still need to be worked out.  Risk exists and when risk exists, discount rates are higher, and values are lower.  Make sure the discount rate applied in the projection within the valuation’s discounted cash flow calculations reflect a reasonable level of risk and that the discount rate fits into your individual risk tolerance for an investment of this type.  

References:William Fowler (2019). A candid discussion on the cannabis industry.  The Value Examiner, September – October 2019, National Association of Certified Valuators and Analysts.

Peter Lohrey (2019).  Academic research briefs: An overview of the literature on the cannabis industry. The Value Examiner, September – October 2019, National Association of Certified Valuators and Analysts referencing Kilpatrick, S. & Owaram, K. (2018). Marijuana sector’s accounting quirks generating “audit Hallucinations”, The Globe and Mail. The Canadian Press and Bloomberg News.