By Melissa Diaz, CFO, Rebel Rock
The rapid growth and ever-evolving nature of the cannabis industry has resulted in wild and hyperinflated business valuations, making it extremely difficult for companies to zero in on a fair valuation as they seek to acquire or be acquired in the up-and-coming field.
What can cannabis companies do to counter overinflated valuations as they pursue an exit or acquisition strategy? The best approach is to better understand what investors are looking for when they evaluate a company for a potential merger and acquisition deal.
Many Ways to Determine Value
Pinpointing the value of a business is not an exact science. Investors rely on a variety of methods and evaluation techniques to help them land on a fair valuation. Let’s break down some of the most common methods.
- Discounted Cash Flow: A Discounted Cash Flow (DCF) analysis attempts to determine a company’s value today based on projections of how much money it will generate in the future.
- Market Transaction: This method estimates a company’s value by comparing the business to similar companies in the marketplace. This approach works really well with publicly traded companies.
- Adjusted Net Asset Method: A company’s value is determined by analyzing the net value of its assets minus any liabilities.
- Revenue Multiplier/EBITDA: A company’s value is determined by dividing its revenue multiplier ratio by its earnings before interest, taxes, depreciation, and amortization (EBITDA).
Unique Cannabis Challenges
Because of the unique nature of the cannabis field, each of the above-mentioned valuation methods come with their own challenges when applied in the industry.
- Discounted Cash Flow: Because cannabis businesses’ operating costs are so high and their margins are so slim, a DCF analysis will likely produce a more modest valuation than some of the eye-popping ones seen throughout the industry in recent years. But that doesn’t mean it’s unfair or wrong. DCF analyses take into account the current realities of U.S. tax code and the impact it has on costs and earnings.
- Market Transaction: A market method should not be used by cannabis companies in pinning down a valuation because cannabis companies that have gone public – most notably in Canada – have not been able to sustain their sky-high IPO values, which raises concerns that they were overvalued. Also, public cannabis companies north of the border have seen their values plummet in recent months because big promises of heady market growth don’t seem to be coming to fruition.
- Adjusted Net Asset Method: While this method can be beneficial for certain cannabis businesses with a lot of assets (cultivators, for instance) one potential downside is it assumes the value of the company is simply the value of its assets and does not take into account any potential for future earnings.
- Revenue Multiplier/EBITDA: This is currently the most widely used valuation method in the cannabis industry and is likely going to be used in tandem with another valuation method. That’s because EBITDA eliminates the impact of tax restrictions under IRS tax code 280E. It allows investors to look at a company’s hypothetical profitability for when those tax issues are eventually resolved. Most professionals in the cannabis industry agree those tax and legal issues will be eliminated in the next five to eight years. The risk or challenge with this method, then, lies in if that timeline ends up being longer than expected.
Other Valuation Considerations
Evaluating a company’s valuation is a multifaceted approach. Investors often rely on a hybrid approach, using more than one of the standard valuation methods. But they also take into consideration other metrics that have little to do with the bottom line. Some of those include:
- Management Team: Who’s on your board? Who are your top executives? Investors take a look at management before any other metric. Because of the industry’s legal haziness, investors want to see legitimate industry expertise on boards and management teams.
- Brand Loyalty: Brand loyalty is big in cannabis. If buyers find a strain they really enjoy, they are more likely to try other strains from the same brand when the preferred product is out of stock. Investors will look at how companies measure brand penetration as part of their due diligence.
- State of Financials: How quickly are you able to produce them? Is your accounting managed through a cloud-based system? Are your company’s financials messy? Unbalanced? Clear and organized financials are important, as is responding to investor requests in a timely manner. Otherwise, an investor will get the impression that you are disorganized and don’t truly understand your business – which can have a huge impact on any potential valuation.
Be Your Own Advocate
Whether a cannabis business operator is pursuing an acquisition or an exit, it’s important to understand the standard approaches investors take when evaluating such opportunities. Also, don’t be afraid to suggest a particular valuation method or approach to potential investors. Ultimately, nobody knows your business better than you – it’s vital to be your own best advocate.
Advocating for your business and having a better understanding of the valuation process will go a long way toward landing on a fair valuation for your business.
Melissa Diaz is a co-founder and CFO of Arizona-based Rebel Rock (https://rebelrock.co), which provides cannabis businesses across North America with specialty accounting solutions, income tax services (U.S. only), CFO and controller services, and business system implementation. She guides companies of all sizes through GAAP compliance, financial modeling, financial reporting and general financial accounting inquiries and functions.