With a glimmer of light at the end of the tunnel for a move from a Schedule 1 drug to a Schedule 3 drug the cannabis industry has begun to contemplate how the removal of 280e would impact licensed operators. Most of the focus has been on the top publicly-held 12 MSOs and how this benefits their businesses, with many analysts demonstrating free cash flow savings measured in the hundreds of millions of dollars. But what does rescheduling mean for thousands of smaller operators from an operational and capital markets perspective?
There are a few obvious benefits, but there are also several less obvious benefits that may prove as meaningful as the removal of an onerous tax burden. Let’s explore.
Free cash flow impact
Of course it all starts with the bottom line impact for plant touching operators. A cannabis retailer generating $10m in revenue that is not vertically integrated could see a free cash flow benefit exceeding 10% (or $1 million} through the elimination of 280e. Similarly, a cultivator or brand generating about the same amount of revenue could easily see upwards of $600-$750k in free cash flow benefit. It goes without saying that a $1 million added to the bottom line will be a tremendous benefit to cash strapped operators under the current tax scheme. But there are a number of benefits that aren’t as obvious and which we consider here in no particular order.
Valuation Increase
As most cannabis operators that have been looking to raise capital are aware, valuations are in the tank. However, industry valuations of many MSOs doubled on the news of the Department of Health and Human Services recommendation (since pared back). A select few were fortunate to have raised capital or exited during the heyday of 2021, when transactions were closing based on revenue multiples in the 3-4x revenue range. While those days are gone, the fact remains that the multiples paid for traditional CPG brands can still provide a handsome return for shareholders. In 2022, CPG multiples in cannabis businesses (beverages, food, tobacco) were in the 12x-20x EBITDA range. With the profitability boost from the elimination of 280e, operators should see valuations increase to levels that are comparable to mainstream CPG industry averages.
Equity Capital
Investor ROI evaluation has been challenging under 280e, forcing many funds that had interest in cannabis to remain on the sidelines. With the elimination of 280e, access to capital will accelerate, creating equity financing options to fund growth. While the MSOs will likely benefit first, a slew of new investors entering an industry that has taken its first significant step towards legalization will also create funding options for smaller operators. With more seats at the table, operators should be able to provide a more compelling ROI analysis to investors and, with more options available, negotiate better terms.
Debt refinancing
For all but a few operators the only option to fund growth is to work with lenders at onerous rates often north of 20% interest. With the elimination of 280e, we will see a flock of new players entering the industry who are willing to provide financing in the more traditional 10% range. A company with a 3-year, $2 million loan would save $350,000 over the term of the loan if rates were reduced from 20% to 10%.
Corporate Hygiene
Many strategies have been deployed over time to deal with the realities of 280e. One of the more common strategies has been to set up multiple operational entities that provide services to other entities. Removing 280e will also remove the need to create complicated corporate structures that are costly to set up and govern. Traditional Hold-Co structures with a more streamlined subsidiary Op-Co structure will make due diligence easier and reduce costs associated with more complex structures. A simplified corporate structure should reduce legal costs and management bandwidth required to manage complex structures, resulting in a simplified Capitalization table that can easily be vetted by investors.
Transaction closing
One quirk of the cannabis industry is that if a cannabis operator wants to acquire another licensed operator, they must acquire the equity of that operator so that the license can be transferred. The challenge with transactions structured as stock deals is that the buyer must assume the liabilities of the seller (both known and unknown). Since many operators have liabilities (IRS debt or lender/shareholder debt being the most common), buyers have been walking away from deals because they a) don’t have the cash to pay off those liabilities and/or b) are not equipped to absorb those liabilities, even with seller notes and more aggressive Representations and Warranties provisions (not to mention paying legal/tax/broker obligations at closing). Cash is critical to closing transactions in today’s cannabis market, in large part due to overregulation in general and 280e specifically, there isn’t any. As more cash enters the ecosystem there should be a greater appetite for buyers to close deals that include seller liabilities.
Taken together, all of these benefits will reduce friction in the market and create a more efficient industry from the capital markets perspective. This will benefit the large scale players initially but will eventually float all boats. It may take a little time to work itself through the system, but rescheduling may finally remove a different “stigma” – that of cannabis being the most financially challenging industry to succeed at in North America.