May 27, 2020

Investing in Cannabis: Industry Update

The cannabis industry has been prone to some volatile stretches, and Q1 2020 was no different. Even before the onset of COVID-19, the industry was experiencing much slower growth than in 2018 and the beginning of 2019. There were several factors at play, including:

Slower than anticipated expansion: The continued loosening of regulation provided optimism for the industry throughout 2018 and 2019, with more municipalities expected to address legalization in the near future. However, Canadian sales (while still strong) struggled to meet high expectations, as expanded retail infrastructure in critical markets was still needed. In the United States, antitrust reviews and key state legislation failures slowed down the anticipated growth of the industry.
CBD Issues: Cannabinoids have been a growing and lucrative market over the past few years. The market is anticipating explosive growth in the near future (from $5B in 2018 to $20B by 2024);¹ however, it is still a highly competitive industry with high costs for production and sales. In addition, it’s an ever-evolving market with the 2018 U.S. Farm Bill drastically reshaping the industry as a whole. While the bill has loosened restrictions and removed CBD as a Schedule 1 illegal substance, it has led to increased focus from the FDA regarding illegal marketing and uses.

These issues, among others, have combined to restrict access to capital for cannabis companies. Companies switched from private funding to public funding in early 2020. Public companies represented 90.5% of all capital raises in March 2020, up from 40.4% for Q4 2019 and 67.6% for Q1 2019. In addition, the reverse merger/takeover market has become non-existent (there was one in Q4 2019 and none in Q1 2020). The number of capital raises also decreased more than 45% during the same timeframe, with the average tranche size decreasing by over 25%. Of those capital raises, there was decreased interest in several sectors such as cultivation/retail and infused products. Even the form of financing has changed. For private capital raises, including investment Funds, debt has not been used nearly as frequently as previous periods (private financing has primarily been through equity). The anticipated instability in the market will continue to hamper capital raises as a whole.

Effect of COVID-19

The cannabis industry has been particularly hard hit by the effects of COVID-19. On the production side, the virus has had a thorough effect. While the consumption of cannabis products is illegal in China, the country has played a large part in the industry. Much of the vape equipment, LED lighting, packaging and laboratory equipment is produced in China. With the country in lockdown during Q1 2020, this caused a chain reaction of issues in North America regarding consumption and production. In addition, China was one of the world’s leaders in hemp production. With the restrictions in place, that production has reduced dramatically.

From a financial perspective, the instability in the markets mentioned above is expected to continue through the rest of this year. Funding will be difficult to obtain for all types of cannabis companies. This concern will be exacerbated by increased restrictions over consumption and production. While most of the eleven U.S. states where marijuana is legal for medicinal and recreational use have deemed these business to be essential, others such as Massachusetts, Vermont, and Maine have listed recreational use as non-essential (medical was classified as essential). In addition, some states (Pennsylvania, Arkansas, Utah, Missouri, and North Dakota, West Virginia) have deemed medicinal marijuana to be non-essential. These restrictions have caused numerous pains for companies. Cannabis industry groups have increased pressure on the state governments to minimize the financial effect on companies and reopen the industry.

Similarly, there is fear that states which had been working on legalization will now focus on other matters in the immediate and long-term. Many state courts have been closed or reduced since the start of the coronavirus outbreak. This has dampened expectations for increased statewide legalization in the near future.

In addition to the restrictions put in place by the state governments, there has been increased concern regarding the consumption of cannabis during the pandemic. For individuals infected with COVID-19, there has been evidence of damaging effects on the respiratory system. There are concerns that the ingestion of cannabis products could heighten the effects of the virus and/or limit the body’s ability to recover. While there is much still unknown about the virus, health agencies are asking for increased caution when consuming products. All of these factors have caused a marked decrease in the retail sector that could have long-lasting effects for the industry.

COVID-Related Regulations

State governments in the U.S. have tried to pass several measures to contain the spread of COVID-19. As mentioned above, some states have limited recreational and medicinal sales of cannabis. Guidance for reopening the industry has been done a case-by-case basis and is ever-evolving. Massachusetts, for example, will allow dispensaries to open May 25 under specific guidelines including remote fulfillment and curbside pickup only. Similar measures are anticipated for other states as restrictions loosen and the effects of the virus are contained.

Other measures enacted for the economy as a whole have significant implications for the cannabis industry. There were three main measures passed as part of the federal stimulus in the U.S.:

H.R. 6074: Coronavirus Preparedness and Response Supplemental Appropriations Act, 2020 (P.L. 116-123) (CPRSA)
- Includes provisions relating to the Economic Injury Disaster Loan Program (EIDLP). The EIDLP provides working capital loans of up to $2 million to eligible small businesses through the Small Business Administration (SBA).
- This bill formally declared the pandemic as a qualifying disaster for which EIDLP loans may be granted. The SBA can now provide loans up to $20M to support administration in the wake of the emergency.
H.R. 6201: Families First Coronavirus Response Act (P.L. 116-127) (Families First Act)
- Employers with under 500 employees will receive tax credits to offset the cost of providing two weeks of paid sick leave to employees unable to work due for the following reasons:
  - Quarantine or isolation,
  - Coronavirus symptoms,
  - Needing to care for someone in quarantine or isolation, or
  - Needing to care for children in schools that have closed.
- Employers with under 50 employees are exempt from certain paid sick leave and expanded FMLA requirements (e.g., those relating to school/place of care/childcare closures or unavailability) only if providing those employees with such leave would jeopardize the viability of the business as a going concern.
H.R. 748: Coronavirus Aid, Relief, and Economic Security Act (CARES Act)
- $2 trillion stimulus package including $350 billion to support small businesses.
- Includes the Paycheck Protection Program.
- Expands the EIDLP.
- Establishes an emergency grant program with $10 billion for small businesses, nonprofits, and agricultural cooperatives.
- Provides $9.5 billion to the Department of Agriculture for financial support to farmers and ranchers, $14 billion to the Commodity Credit Corporation for support programs to assist agricultural producers, $20.5 million to the USDA Rural Development Business and Industry Loan Guarantee Program, and temporary extensions on repayment of commodity marketing assistance loans.

While these measures were designed to help many farmers, most cannabis-related companies are ineligible to receive SBA loans and other federal assistance. The reasoning for this is that the cultivation and sale of marijuana is still illegal under federal law. One distinction is that hemp-related businesses under the 2018 Farm Bill do have access to SBA financial assistance. For marijuana-related businesses, both direct (i.e., a business that grows, produces, processes, distributes, or sells marijuana or marijuana products, edibles, or derivatives even if it applies to recreational and medical use in states where it is legal) and indirect (i.e., a business that derived any of its gross revenue in the prior year or a start-up that projects to derive any of its gross revenue for the next year from sales to direct marijuana businesses) are still deemed to be ineligible to receive SBA loans.

The inability to obtain this funding at such a critical time has provided a serious challenge for cannabis companies in the U.S. In Canada, there are many fewer issues for the industry, as all cannabis companies are deemed to be essential. The Canadian government created a wage subsidy that provides three-month emergency funding during the pandemic. The subsidy will cover 75% of an employee’s wages up to $847 Canadian dollars per week from March 15 to June 6, 2020. The ability or inability to receive funding based on where the company is domiciled could have significant implications on the company’s value and operations moving forward.

Effect on Financial Reporting

The pandemic has also led to changes in taxes and financial reporting.

Significant tax law changes include:

Net operating losses (NOLs) for the years 2018, 2019 and 2020 can be carried back five years. Previously these losses could only be carried forward. There may be a rate play as the top corporate tax rate for years prior to 2018 was 35% (it is currently 21%). Note: NOL carrybacks cannot be used to offset the TCJA (Tax Cuts and Jobs Act of 2017) Transition Tax related to foreign earnings.
NOL carrybacks and carryforwards originating in the years 2018, 2019 and 2020 can offset 100% of the taxable income in the carryback or carryforward period. Previously, these NOLs could only offset 80% of taxable income.
The alternative minimum tax (AMT) credit is fully refundable with the 2019 return. Previously, the unused AMT credit was refundable over a period of four years ending in 2021. There is an election to file an amended 2018 return and obtain a refund of 100% of the alternative minimum tax credit.
For 2019 and 2020, the limitation on interest expense has been increased from 30% to 50% of “adjusted taxable income.” There is a special rule for partnerships that maintains the 30% limitation for 2019 but allows a catch up adjustment in 2020 for the additional interest deduction that would have been allowed in 2019 under the 50% limitation.
Qualified improvement property (QIP) (which in general terms is leasehold improvements or improvements to the interior of a building owned by the taxpayer) placed in service after December 31, 2017, can be depreciated over 15 years or immediately deducted as bonus depreciation. Previously, these assets were depreciable over 39 years due to a technical error in the TCJA.
Businesses may be eligible for tax credits for retaining employees (as noted above) and paying employees for sick time and family leave.
Payment of the employee portion of FICA tax for the remainder of 2019 may be deferred and will be payable in 50% installments on 12/31/21 December 31, 2021, and December 31, 2022.

These items will most likely have minimal to no effect on investment Funds themselves, but the underlying investments could be effected leading to valuation changes. As for the financial statements of the investment Funds, there are more specific disclosure implications.

Fund-specific financial statement disclosures include:

Subsequent event disclosures should be updated to reflect the pandemic and the fund’s continued monitoring of the situation. This disclosure should be tailored specifically to the operations of the fund and whether or not there was any specific impact that could be determined. Most funds we have seen so far have stated that the impact on their financial performance cannot be reasonably estimated at this time.
Risks and uncertainties were already a robust section of the funds’ financial statements and should be further expanded to include the pandemic. Among the items discussed is the inability for certain cannabis companies to obtain additional assistance from the U.S. stimulus package. There should also be discussion about the liquidity of investments held and whether the pandemic will cause issues in a changing marketplace. For funds with significant debt holdings, there will be additional risks to consider when it comes to repayment, and those should be addressed in the financial statement disclosures.
Valuation process and related disclosures may require broad revision in 2020 based on the impacts of COVID-19 (financial statements for years ending December 31, 2019, will need less revision as COVID-19 was not declared a pandemic until March 2020). For privately held investments or valuations determined by management, the estimates involved in the valuation process will require significant review and skepticism. For companies using forward-looking cash statements or market comparables, the effect of COVID-19 could be significant and should be evaluated for each of these investments.