Valuation Challenges for Cannabis Investments in 2020
By Marni Pankin, CPA, Partner, Alternative Investment Group
Valuation of private and less liquid investments has continually been a challenge for portfolio managers and investors in the nascent cannabis industry. The 2020 year-end reporting period will be no exception with a trifecta of issues to consider. The economic and social impact of the COVID-19 pandemic on growers, distributors and retailers; the increased market volatility and fluctuations in capital markets; and speculation in the regulatory environment coupled with anticipated legislation due to upcoming changes in administration have created a conundrum for portfolio managers, investors and valuation specialists. Re-evaluation of valuation approaches and techniques certainly warrant consideration during these uncertain times.
Valuation Approaches: What Makes Sense for Cannabis Investments?
Investment funds following generally accepted accounting principles are required to value their portfolio investments at fair value, which is the estimated price at which an asset could be bought or sold in a current transaction between willing parties. It’s best practice to consider multiple valuation approaches, and weigh the results of the most meaningful and relevant approaches to value a private or illiquid investment. However, given the issues that face this industry and the current environment, certain valuation methods may not be appropriate for private and thinly traded cannabis investments.
Limitations of the Market Approach
A market approach has limitations for cannabis, as the guideline public companies may not be comparable in size, product mix (including “plant” vs. “non-plant touching”), and jurisdiction, and public transaction data is limited. This is especially true this year, when transactions are down significantly. According to Viridian Capital Advisors Deal tracker, year-to-date public and private capital raises are down to 224 ($2.97 billion) as of September 18, 2020, as compared to 469 ($10.5 billion) at the same time in 20191. Further, using prior year transactions and trailing multiples of public companies may not be a good indicator by which to value the subject company, as prior period exponential growth and speculation can likely skew current year valuations. On the flip side, forward-looking multiples may also pose challenges if public companies have withdrawn earnings guidance. Also, most of the tier 2 and many of the tier 1 cannabis companies have had negative EBITDA, so enterprise values need to be computed using revenue multiples, which are less comparable.
When using a market model, it is highly recommended to perform a calibration analysis such that on the date of an initial transaction, the fair value resulting from that valuation technique is equal to the initial transaction price (assuming the transaction price is at fair value). These assumptions are then updated and rolled-forward for subsequent measurement dates.
For venture capital and pre-revenue companies, a recent round of financing is often used to estimate current value. The latest round, however, can become outdated and stale very quickly in this fluid environment. The cannabis industry has witnessed many strategic transactions over the past few years, whether to gain entry into a specific market or to acquire a competitor; accordingly, these transactions may not be at arms-length and indicative of fair value. Further, if the fund did not participate in the latest round, there are likely differing preferences when it comes to priority of dividends, convertibility features, or warrant exercise dates and rates. In this case, it is recommended to utilize an option pricing model that considers the different attributes and preferences unique to each class of stock.
Flexibility and Reliability of Income Approach
An income approach such as a discount cash flow (DCF) model which focuses on company fundamentals could provide a more accurate and flexible valuation, but projections of start-up companies with shorter operating histories on which to judge future performance are inherently subject to uncertainty and inaccuracies. It’s important to understand the assumptions behind the projections when evaluating the reliability of these valuation inputs. Give consideration to qualitative factors that support projected revenues, expenses, and cash flows such as 1) processes and controls to maintain compliance with state and local regulations; 2) supply and access to licenses for each state; 3) lease terms and enforceability of contracts; and 4) skills and experience of the operations and management teams.
For more mature businesses, historical results may no longer be a good starting point of future projections if the business has been severely affected by COVID-19. Management needs to consider the impact of the pandemic on the supply chain, sales, production (considering the effect of social distancing at facilities), and consumer behavior, and adjust the forecasted sales growth accordingly. Evaluating the current cash run rate is critical, considering the lack of access to capital from strict banking laws and tightened capital markets. Consideration should be given to size, concentration, and credit quality of the company’s customers, suppliers, and lenders and its ability to raise additional capital. Companies that can negotiate with creditors and restructure debt or pay interest in kind will minimize cash burn and preserve working capital. Projections should be updated for cost reduction measures and changes to capital in-flows.
This uncertainty in projecting cash flows, along with the subjectivity of discount rates inherent in cannabis valuations, may warrant the need to consider various probabilities pertaining to future events and scenarios. This is especially important when dealing with convertible instruments with an increasing risk of default and dilutive financing. The various scenario outcomes would be weighted based on the probability of their occurrence. A Monte Carlo simulation where the current value of an investment is expressed as the sum of probable future cash flows across various scenarios and time frames, discounted for risk and time, is an industry-accepted modeling tool for this purpose.
Asset Approach gaining Relevance in Post-Pandemic Environment
Given the increased uncertainty of continuing as a going concern, the asset (or cost) approach for valuing portfolio investments may gain more relevance this reporting period. This approach is generally used for asset-intensive situations in which a business is worth more under a liquidation model. In this method, one considers the value of the tangible assets held by the company and evaluates whether the book value provided by management is indicative of fair value. For instance, is the carrying value of equipment based on historical or replacement cost? Has obsolescence of inventory been accounted for adequately?
The current economic, social, and political environment has many cannabis portfolio managers and valuation specialists scratching their heads: How long can the portfolio company survive with negative cash flow? Will the company be able to raise capital or draw on credit lines to fund operations? Will election results loosen regulation and how does that impact growth rates? Has the pandemic decreased marketability, warranting larger corresponding discounts? Do public company market multiples need an additional adjustment for the potential incremental incomparability between the public and private markets? With stock prices rapidly rebounding, but revenue and earnings down, multiples could be significantly higher. Private equity cannabis firms will have a difficult choice to make in how they utilize these inputs and which valuation techniques are most appropriate to fairly value their investments this upcoming reporting season.
- Viridian Capital Advisors