From a presentation to the Benzinga Capital Conference

Assessing the true value of a cannabis company can be a complex task due to the unique dynamics of the industry and the evolving regulatory landscape. However, there are several financial metrics and valuation methods that can be applied to gain insight into the value of the company. Here are some key considerations:

Revenue and Growth: Look for consistent and sustainable revenue streams, as well as a strong growth trajectory. This can be challenging due to regulatory constraints and market volatility, so it’s important to assess the company’s ability to generate revenue within these limitations.

EBITDA and Profitability: Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is often used as a measure of a company’s operating profitability. In light of cannabis companies’ unique tax and accounting challenges, EBITDA can provide a clearer picture of their financial performance. Assess the company’s ability to generate positive EBITDA and ultimately achieve profitability.

Cash Flow: Analyzing a cannabis company’s cash flow is crucial for understanding its liquidity and ability to fund operations and growth. Positive cash flow indicates the company has enough cash to cover expenses and invest in expansion. Negative cash flow may suggest a need for additional financing, which can impact valuation.

Comparable Company Analysis: Compare the target company to similar publicly traded cannabis companies or companies in related industries. Key valuation multiples such as price-to-earnings (P/E), price-to-sales (P/S), or enterprise value-to-EBITDA (EV/EBITDA) can be used to assess relative value. Carefully select comparable companies to ensure they have similar business models, growth prospects, and market positions.

Discounted Cash Flow (DCF) Analysis: DCF analysis is a valuation method that estimates the present value of a company’s future cash flows. It involves projecting future cash flows, applying a discount rate to account for the time value of money and risk, then summing the present value of these cash flows. DCF analysis requires making assumptions about future revenue growth, profitability, and risk factors, making it more challenging in the cannabis industry due to the uncertainties unique to the industry.

Market and Industry Analysis: Analyzing the overall market and industry trends can provide insights into a cannabis company’s potential. Factors such as market size, growth rates, competitive landscape, and regulatory environment can impact the valuation. Assess the company’s market share, growth potential, and competitive advantages within the industry.

Management Team and Operational Efficiency: Evaluate the management team’s experience and track record in the cannabis industry. Strong leadership, effective operational strategies, and efficient cost management can contribute to a company’s value.

The cannabis industry is still evolving, and valuing cannabis companies can be challenging due to the regulatory complexities, legal restrictions, and market volatility. Therefore, a comprehensive assessment should consider both financial metrics and qualitative factors to form a well-rounded valuation. Additionally, consulting with industry experts or financial professionals experienced in the cannabis sector can provide valuable insights.

For more information on HBK Cannabis Solutions Group, contact us at hbkcannabis@hbkcpa.com, or visit our website at www.hbkcpa.com/cannabis.

Companies operating in the cannabis industry, especially cannabis cultivators, are no strangers to IRS Code Section 280E and its provision that businesses legally cultivating or distributing marijuana products can only deduct costs-of-goods-sold when calculating federally (and some state) taxable income. General and administrative expenses such as salaries, rent, and advertising aren’t deductible.

So, if costs-of-goods-sold is the only category of expense eligible to be deducted, how can businesses ensure they are maximizing their deductions? By accurately recording inventory from seed to sale.

All states that have authorized the production and sale of marijuana, whether for medical or adult use, require the use of seed-to-sale tracking software. The software is mandated by the states to ensure compliance with cannabis laws. While seed-to-sale software enables cannabis businesses to update inventory as it moves from stage to stage and maintains a log of all employees who have handled the inventory at each stage, the software has presented cultivators with challenges, including:

• Accurately recording harvested plants moved to the drying rooms
• Appropriately updating the weight of work-in-process inventory after it has been removed from the drying room and before it has been packaged as a finished good
• Appropriately tracking inventory physically still in work-in-process inventory but moved to “finished goods” in the seed-to sale software prior to packaging
• Producing historical reports

Such challenges can lead to the improper recording of inventory and non-compliance with relevant state regulations. The following procedures can be used to mitigate those risks:

• Save reports from the seed-to-sale system daily.
• Perform cycle counts of all inventories:
  • Once a week for all raw materials
  • Once a week for work in process inventory
  • Three times a week for finished goods
• Keep a physical inventory sheet in each room to be signed by employees as they make updates and a digital copy outside the seed-to-sale software with the same information.
• Reconcile reports from the internal spreadsheets with reports produced by the seed-to-sale system after each internal cycle count is performed.
• In the rooms containing work-in-process inventory, physically separate and label the inventory being regarded as finished goods in the seed-to-sale system.

It is important to remember that while seed-to-sale software helps track inventory, the software is still subject to human error.

The importance of properly recording cannabis inventory should not be underestimated. It is the key to understanding operations and consumer patterns, and correct financial reporting, as well as compliance with regulations.

For additional inquiries or cannabis consultations please contact HBK Cannabis Solutions at 856-486-2299.

Register for the next cannabis webinar on April 8, 2022 here.

Consider the legal landscape for cannabis businesses:

• Cannabis remains a Controlled Substances Act Schedule I substance.
• Cannabis businesses operating in states where they have been legalized are denied federal tax deductions for ordinary and necessary business expenses under Internal Revenue Code 280E.
• The Agriculture Improvement Act of 2018 legalized the business activity of growing, selling, possessing, and transporting hemp-derived and cannabidiol (CBD) products.

Now consider a potentially favorable scenario for hemp and CBD businesses: a tax credit for companies engaging in qualified research and development activities (the “R&D Credit”). It is important to note that due to the federally illegality of THC, businesses involved in the production or sale of THC are not eligible for this credit.

Section 1.174-2 of the U.S. Treasury Regulations state that, “whether expenditures qualify as research or experimental expenditures depends on the nature of the activity to which the expenditures relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents.” Under the regulation, qualified activities include developing a new or improved product, developing new technology, creating a new production process, or improving current processes.

Notably, the efforts do not need to be successful to qualify for the R&D Credit. Nor does the product or process need to be unique to the industry. It only needs to be new or improved for the business conducting the research and development.

Qualifying Expenditures

Qualified R&D expenditures can include operating expenses such as wages, materials, and payments to third-party contractors if the activity that gives rise to the expenditure is a qualified research activity. Examples of qualifying activities include:

• Cultivating new varieties and/or characteristics
• Developing new growing methods and procedures
• Devising new or improved ways to process and harvest plants
• Experimenting to grow healthier, stronger, and better quality plants
• Developing and testing new filtration or irrigation systems
• Testing new farming methods to increase crop yield
• Investigating new ways to use industrial hemp fibers
• Developing new products
• Formulating new topical creams and other absorption methods
• Testing new CBD oil products and extraction techniques
• Exploring alternative uses for hemp
• Designing and incorporating new or improved processing equipment or systems
• Developing custom enterprise resource planning (ERP) or inventory and production management software
• Designing and integrating new or improved processing equipment, systems, and software, including custom enterprise resource planning (ERP) and inventory and production management software

Examples of qualifying costs include, but are not limited to, those incurred in performing the qualifying activities, such as:

• Compensation paid to employees or contractors involved in the process or activity, whether directly or in a supervisory or management capacity
• Raw materials and supplies consumed during cultivation
• Solvents, testing materials, and materials employed during processing
• Supply costs

Using the R&D Credit

Note a nonrefundable credit can only be used to reduce a taxpayer’s liability to zero. However:

• Any credit not used in a current year can be carried back one year or carried forward for up to 20 years. Amended tax returns can be prepared and filed for years where qualifying activities can be documented.
• Startup companies without an income tax liability may be able to take the R&D Credit against up to $250,000 in employer payroll taxes during the first five years of operations.
• Most states conform to the rules for taking the federal credit. Some states conform, but they have their own rules that must be followed.

As with most deductions and credits taken by taxpayers, documentation and substantiation is imperative. Contact HBK for information and assistance.