Cannabis entrepreneurs have been riding an emotional rollercoaster these past few weeks. Just from Politico, we have seen the following headlines:
- Spicer: Expect to see ‘greater enforcement’ of marijuana law — Feb. 3,
- Sessions pushes tougher line on marijuana — Feb. 27, and
- Sessions reassures senators: No pot crackdown imminent — March 2.
Running a cannabis business under these circumstances can be challenging. Employees get nervous about possible legal repercussions just for doing their jobs. It seems like all anyone wants to talk about is what the federal government is going to do about marijuana.
The uncertainty has started to affect the transactional market as well. Mergers and acquisitions in the cannabis industry are certainly still happening, but we are seeing the rate of deals actually closing slowing down a bit, at least in California, Oregon, and Washington. Would-be buyers of cannabis businesses are having a hard time deciding whether a licensed business that was worth $1.5 million four months ago is still worth the same price.
This type of short-term slowdown is typical of volatile markets, where parties are uncertain of how to price risk into their transactions. Looking back at the great recession, part of the reason economic recovery took so long was because firms were slow to deploy capital. Toxic debt had infected so much of the market that even companies with nothing to do with mortgage investments were affected by the outward ripple. They didn’t know if their investments would be caught up in the same debt spiral that killed so many other businesses. If enough people sit on their hands and wait for someone else to move, markets slow down.
Cannabis markets have always had their share of uncertainty. Legislatures and regulators continue to spend large amounts of time tweaking existing laws and regulations for marijuana businesses. Many of these changes happen at a moment’s notice and can absolutely sink people’s businesses. Sometimes they can save businesses and make them thrive. It’s not that regulatory and legal changes are inherently negative or positive — it’s that they create uncertainty. Local governments do the same thing. Unpredictable weather patterns can doom cannabis crops — more uncertainty.
When uncertainty, like that created by the back and forth Jeff Sessions drama, leads to short-term stagnation in sales markets. The first movers in that sort of market are either the most confident about their analysis of the situation or the most willing to gamble. Players in uncertain markets must price their perception of risk into what they are willing to spend. If I think there is a 90% chance the federal government will leave marijuana businesses alone and a 10% chance they will shut down marijuana businesses everywhere, there’s no way I should pay more than 90% of the value that would be there if the federal risk did not exist.
Where uncertainty and gambling converge is in judging that 90% chance. Do we think the chances that Jeff Sessions goes nuclear on cannabis are 10%? What if someone else thinks the chance is 20% or 30%? If you aren’t certain how to price that risk into your cannabis investments or acquisitions, you’re going to have a hard time participating in the cannabis market right now, and hence short-term stagnation.
At the same time, if you have a high level of confidence in your ability to perceive and price risk into your cannabis transactions, there is money to be made by playing the risk spread. There are sellers right now who think the federal government is going to destroy cannabis businesses everywhere and these sellers are willing to accept lower prices for their assets because they have a higher perception of the risks to that asset. If a buyer feels strongly that the risk is lower than the seller does, there’s room for a transaction.
The next few years are going to be interesting to watch, especially if the Trump administration remains cryptic about its attitude toward cannabis businesses. The risk-tolerant and the risk-intolerant are going to start showing their colors, and we will all learn a lot about the power that early movers in uncertain markets have when it comes to creating price anchors for business valuations and finding the biggest spreads between buyers’ and sellers’ risk perceptions. All of this is worth keeping an eye on, even if you aren’t in the short-term cannabis M&A or investment markets.