In a tale of two markets, American companies struggle to get financing. For Canadian investors, the risk is of an overheated stock sector.

Rarely a day passes where there isn’t a story about a new cannabis company emerging, a funding round closing or a company going public. But are these markets as welcoming to cannabis as they appear? Do regulators understand how to balance national and local policies to convert illegal markets into legal ones? And do financial markets understand how to appropriately assess risk and value the many companies going public?

For the US, at least, the answer is generally no. The country hasn’t budged on the federal level on either medical or recreational cannabis, unlike Canada, where medical cannabis has been legal since 2001 and the recreational market is set to begin in October 2018. However, there are 30 US states with some form of legal cannabis, and 64 percent of Americans favour legalization, according to an October 2017 Gallup poll. It’s a topic that’s generally drawn more support from Democrats and Independents than Republicans. But more Republicans are getting on board, and this past April, John Boehner, the former Republican Speaker of the House, even joined the board of directors of Acreage Holdings. Seems like plenty of positive sentiment.

So, what limits growth and innovation in the US cannabis market?

Let’s start with the lack of federal-level regulation, which forces companies working directly with cannabis to confine the business to the state it’s in. There are multistate operators, iAnthus and Acreage, for example, but these companies must set up shop in each new state vs. the tried-and-true method of producing at scale in one location and shipping everywhere, as proven effective by other industries. Having said that, it should be noted that ancillary businesses – those dealing with cannabis-related products and services – can operate across state lines since they do not “touch the plant,” but they often run into problems that include limited access to banking services, simply because they serve other businesses that do touch the plant.

The problems stem from the unwillingness of banks to handle cannabis industry money, wherever it comes from, to avoid being charged with money laundering. This has resulted in a US market dominated by cash transactions in a world where cash is beginning to disappear.

Say goodbye to dreams of NYSE or NASDAQ listings, often viewed as the most effective way to raise significant capital for growth or provide liquidity for investors and employees. Unless, of course, it’s a Canadian-based company that does not operate in the US at all, such as Cronos Group and Canopy Growth Corp.

Furthermore, US cannabis businesses face unique challenges when trying to access capital. US-based exchanges cannot list US-based plant-touching cannabis companies. Doing so would violate federal law, even if those companies operate only in states with legal cannabis. Say goodbye to dreams of NYSE or NASDAQ listings, often viewed as the most effective way to raise significant capital for growth or provide liquidity for investors and employees. Unless, of course, it’s a Canadian-based company that does not operate in the US at all, such as Cronos Group and Canopy Growth Corp.

For US cannabis companies, sourcing funding is tricky. Most must go beyond traditional institutional investor-backed capital raises or IPOs and explore lesser-known routes. On the private side, capital has primarily come from high net-worth individuals and family offices, which are family-controlled investment groups. On the public side, US cannabis companies have started to explore alternative public-market paths, like special-purpose acquisition companies known as SPACs. They are shell companies that go public with the intention of merging with or acquiring a company with the proceeds of the SPAC’s IPO. There are also crowdfunded IPOs known as Regulation A+ filings. Debt options in the US are practically nonexistent due to hesitancy by banks to lend to cannabis businesses because of varying state-by-state regulations that conflict with federal law. In other words, the odds of walking into a bank and getting a business loan are slim.

With more defined and perhaps lenient regulations, Canada has become home to many of the world’s largest cannabis companies, and its stock exchanges boast Canadian and American companies that are valued at more than USD $1 billion. In general, companies can access cheaper capital in an easier manner, which allows them to scale and compete on a national and global level. Meanwhile, US banks will barely acknowledge the cannabis market.

The rise of cannabis financing by Canadian financial institutions

The Bank of Montreal recently made headlines for its involvement in Aurora Cannabis’ C$2.9 billion all-stock bid to buy MedReleaf Corp. In addition to advisory services, BMO also provided Aurora with up to C$250 million of debt financing. Moreover, the Canadian Securities Exchange is becoming the go-to place for US cannabis companies to list. This year alone, US companies MedMen, GTI, and Liberty Health Sciences listed on the exchange, with several more announcing their intent to list this year.

But with all this activity, as Canada becomes the first G7 country to fully legalize cannabis, investors face something the US has effectively avoided: the rise of a frothy, potentially overpriced stock sector.

Canadian investors should be cautious about creating a market built entirely on excitement and speculation and not tested performance metrics. Remember the tech boom?

As Canada leads the way, investors shouldn’t lose sight of logical and sound financial judgment. Pulling back on the explosive valuations of public companies might not be a bad thing. Canadians (and Americans) should evaluate the validity and longevity of the plethora of companies now going public and consider their true value. Many US investors are hungry to capitalize on Canadian cannabis plays because US federal law won’t fully allow access to the American cannabis market, so investors are jumping at the chance to buy stocks. But Canadian investors should be cautious about creating a market built entirely on excitement and speculation and not tested performance metrics. Remember the tech boom?

Valuations for companies have soared above C$1 billion in more than one instance, with Canadian operator Canopy Growth Corp. reaching a C$7 billion market cap on less than $100 million of revenue (not including the most recent transaction with Constellation Brands). That lofty valuation doesn’t look justified through a fundamental financial analysis lens. MedMen debuted on the CSE in May and has a market cap just above C$1.5 billion. The company reported a combined total of USD $6 million in sales for all of 2017 and the latter half of 2016, according to regulatory disclosures. During that time, it also reported a net loss of almost USD $31 million.

Don’t get me wrong. These companies (and many others) could prove to be incredible businesses with strong management teams. They might well end up deploying capital wisely and build long-term shareholder value. Conversely, many of the emerging cannabis companies we know haven’t come close to hitting the C$1 billion valuation mark yet. And that’s ok, too.

In my opinion, companies shouldn’t be valued at 100 times revenue until they prove their success consistently over time – and even then, I would be hesitant of 100-times valuations because that’s just a crazy high multiple to this conservative soul.

All this is to say: Watch out for the bubble.

Cannabis public markets are hot, and there is a constant fear of missing out. But investors should not forget to look at each company with a discerning eye when deciding where and how to deploy capital. Cannabis investors should hold a long-term view when evaluating and investing. Easy money has been made in the industry, but going forward, investors should be wary of all the “unicorns” — start-ups valued at more than a billion dollars — hitting the market. They should seek out those companies that are built on good old-fashioned business fundamentals.

Photo: Looking up at the financial district in Toronto. THE CANADIAN PRESS IMAGES/Lars Hagberg

This article is part of The Economics of Canadian Cannabis special feature.


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