Understand the risks associated with cannabis investments to safeguard your interests as much as possible.
- Do your due diligence to understand the risks of a certain opportunity – as well as the potential returns.
- Consider how the competition in the market will change over time.
- Likewise, know which type of shares you are buying and what impact dilution has on them.
Speak to one of our experts if you need help evaluating a cannabis investment.
The cannabis industry is ripe for investors, with more and more cannabis companies joining the Canadian Securities Exchange (CSE). California’s cannabis market alone is estimated to reach $5.1 billion in market value. The cannabis industry remains a largely untapped market that has potential for exponential growth and high revenue.
That said, it is difficult for many investors to evaluate their investment options.
To give you some estimate of the market trends, here are some key stats:
- In the fourth quarter of 2018, $7.9 billion of capital was raised by cannabis companies globally.
- The market is extremely volatile, with high highs and low lows. For example, Green Organic Dutchman (TSX:TGOD), fell nearly 70% from peak to trough.
- Nevertheless, major corporations continue to take big positions in cannabis companies: alcoholic beverage conglomerate Constellation Brands invested $4 billion in Canopy Growth (CGC – Free Report), upping its stake in the cannabis company to 38%.
Right now, there is much speculation and little hard data on past trends and company track records. How can you tell if an investment opportunity in the cannabis market is a good option?
This guide can help you understand the risks associated with investments in emerging sectors, like the cannabis market, and help you to safeguard your interests as much as possible.
With laws and businesses continuing to evolve and mature, here’s what you need to know about cannabis investing in the current market environment.
ROI in the Cannabis Industry
As a basic investment principle, generally the higher the potential return of investment, the higher the risk.
However, there is never any guarantee that a higher return will always happen when the risks involved are greater.
The best way to assess the viability of an investment is by performing due diligence into understanding the investment, its offerings, and the company behind the offering.
Some key elements to conduct due diligence on are:
- Problem they are solving: Is there really a need for this business and is it addressing a ‘real’ customer pain in their market?
- The team behind the company: One thing you’ll hear a lot in investing…..”Bet on the jockey, not the horse”. So how good are your jockeys in this new business venture? What’s their experience? Do they have a multidisciplinary team? What’s their interpersonal-rapport like?
- Competitive advantage: What defensible ‘thing’ does this team or company do or have that’s better than the competition?
- Traction: Does this company have customers and/or sales? How long have they been operating?
- Cap Table: If this company is private, who else is on the capital table and how is it split? Owning a business is like getting married, so the cap table are your partners for the long haul until you get enough liquidity to exit.
Cannabis Business Investment Risks
There are several risks associated with cannabis business investments that any prospective investor should take into consideration when evaluating investment opportunities.
No Guarantee on Positive Return on Investment
Many cannabis companies stake their success on future profit and sales. This means that often times, investments are hinged upon the attractiveness of a future business’ profitability. There is never a guarantee that a company will successfully generate profits or increase their stock’s value.
Make sure that you thoroughly understand their business model and how it can be affected by the many external factors including regulation in a good way and unfavorable way.
As the industry evolves and markets mature, new companies will enter into the market and compete with existing businesses. Increased competition could mean existing companies having to adjust their existing business model and product prices, which would directly affect the value of an investment.
Continue to reflect on what your potential investment’s ‘secret sauce’ is…do they have a competitive advantage the keeps their position secure?
Note: Points of difference like price are never a long-term competitive advantage. Look for proprietary processes, intellectual property, and technology.
In the US, some states have legalized the use and sale of medicinal and recreational cannabis. However, cannabis remains an illegal substance under federal law, which means the federal government could decide to seize a cannabis business’ assets at any time. Once a business’ assets are seized, all investments are lost.
Keep a close eye on the investment’s legal strategy and their future plans to understand how they will adapt to new legislation. In cannabis, companies that focus on compliance will likely be the long-term winners.
Pricing, Taxation, and the Black Market
If legal cannabis is priced and taxed higher, then cannabis on the black market- which it almost always is, then cannabis companies may lose their ability to perform as well as they had projected and will lose profits to the black market.
Take time to review the investment’s business and entity structure to understand how the financials flow and what potential tax issues could be.
Inflated Share Prices
Cannabis business investments are highly speculative since the cost of an investment is based on the expectation of its future success rather than its current performance. Some companies who announce their intention to go public drive their share prices up before their businesses are even profitable. If this happens, their stock prices will never increase in value.
Look at the historical prices if they are available. You can usually find these in funding term sheets, quarterly reports, or other financial documents.
Companies may issue additional stocks in order to raise capital to invest in building out or expansion. When more stocks are issued, the value of the stocks decrease.
When making an investment, know which type of shares you are buying and what impact dilution has on them.
Taking these risks into consideration, there are still some very valuable investment opportunities in the industry. Generally, a solid speculative investment demonstrates a 30% or more return on investment (ROI).
Other Investment Considerations
Some things a smart investor will looks at are a company’s financial statements and business plan. These tools should show how much the company needs to build out, expand, or go public, how the funds will be used, its timeline to execute its plans, as well as its projected revenue. These are all the factors that could determine the viability of an investment.
Make sure you fully understand the company’s use of funds so that you can make an educated judgement on whether or not the company has proper plans to execute their vision or not.
If you feel that investing directly into a cannabis company is too high a risk for you, consider investing in a company in a related sector to start.
Some other sectors related to cannabis that are seeing growth and activity are:
- Agricultural Technology
- Organic Farming
- Industrial Hemp
- Cultivation and Retail
- Ancillary products and services
- Consulting Services
- Holding Companies
- Cannabis Products and Extracts
- Branding and Marketing
There will never be a return without a risk. Managing what type of risk you can manage taking could be the difference between making your money make money—or not.
If you have more questions about investing in the cannabis industry, click the button below to talk to our team. We’ve helped dozens of cannabis companies grow successfully and can help give you guidance on what to look for in an investment opportunity.