Northern California’s billion-dollar cannabis industry sees big issues to resolve

By revenue to state coffers alone, legal cannabis is a huge industry.

The Business Journal reported last month that since January 2018 when the California legal cannabis permitting program was up and running, the total tax revenue gained by the state to date amounts to $2.8 billion.

But the industry continues to deal with what its backers say are intrusive regulations and high taxes and fees. It’s product is also actively sold on an illegal market and prices for the legal productive have dipped.

The Business Journal asked leaders in the industry to provide a look at where this industry is heading on key issues.

Are we nearing a point as the industry matures in which larger companies will push out smaller ones in the marketplace?

Scot Candell: We are already there. Canopy has a market cap of over $9 billion, Curaleaf $8 billion, Cronos $2.5 billion, and Cresco Labs at over $2 billion. Economies of scale will make it harder for smaller companies to compete. If companies want to survive, they must have brand loyalty which will command higher prices. Then again, those companies with brand loyalty will eventually be bought out as well (remember when Lagunitas was a self-owned microbrew with brand loyalty?)

Joyce Cenali: The cannabis industry reset in 2018 and so many operators had to pause or reset their outlook, and large corporations that had money to burn were able to secure first mover positions.

The major disadvantages in California for small businesses are first, the emergency regulations mysteriously allowed for large uncapped grows while the original law that we the people voted on specified one acre caps for five years and second, there was an unbalanced application of permits by municipalities — the majority electing no cannabis activity while just over 25% allowed for some activity, all with their own unique drafting. The state rescinded a major piece of Prop 64 and yet, no small business specific initiatives have been enacted to make up for the lost impact.

Consumers far and wide look to California as the beacon of the best flower in the world. There is a robust consumer group focused on conscious practices, efficacy and choice — so there will continue to be avenues for small businesses, however without a major focus from the state, small businesses will be somewhat eclipsed by large corporations and California’s claim to legacy craft cannabis will continue to be at risk.

Moses Flickinger: Just like the beer market has seen microbrews become the boom in that industry, our craft farmers and entrepreneurs who have laid the groundwork in organic cannabis for generations will always hold an important cornerstone of the industry.

Even with corporate cannabis threatening the culture and holistic production that has grown literally from grass roots community-based operations, there will always be a demand for high-quality, small batch product that our legacy farms provide.

And what I’ve also learned is that the terpenes and medicinal value of cannabis have a unique way of responding to the quality care and personal touch that occurs in the relationship between farmer, plant and it’ environment, which is generally lacking in large scale agribusiness.

So that kind of product is incomparable to the real connoisseur.

Shannon Hattan: Yes. It has already started happening. There are dozens of brands that were operating successfully in the Prop. 215 era that are no longer in business.

John Houston: The industry has already reached a point where large companies are making it difficult for smaller companies to compete.

However, most large companies are losing money at an unsustainable rate. While this strategy may position them to acquire some assets in the near-term, it will not position them for long-term success. In my view, the best and most efficient small companies remain in a defensible position. Those are the companies you will remember in ten or twenty years from now. And many of them are owned by people who have been in the industry for 10 or 20 years.

Eli Melrod: What’s true is that the current cannabis environment presents significant challenges for operators. The high cost of regulation, high tax burden and current oversupply of cannabis is particularly difficult for smaller operators to navigate. Large, well-capitalized cannabis operators may be better positioned to overcome these challenges.

Julie Mercer-Ingram: What’s driving success right now is less about size than having strong business fundamentals and a healthy EBITDA (earnings before interest, taxes, depreciation and amoritization), two things on which Proof has always been laser focused.

Many large companies are still talking about a “path to profitability,” whereas we’ve worked hard from the beginning to be profitable and have been since our second quarter in business.

Also, it’s more important than ever to be constantly innovating — this year alone Proof has already executed eleven successful product launches. In part because we are smaller, we respond quickly to changes in the law and consumer preferences, which is not always true for some of the larger and less nimble companies.

Illegal growers continue to operate, so what is the path for legal growers to be successful?

Candell: Illegal growers are often legal growers that can’t make ends meet due to low prices and high taxes, so a portion of their crop finds its way onto the black market. Brand loyalty is the only thing to keep prices high in the legal market. Vertical integration also helps the bottom line for legal cultivators if they can pull it off.

Flickinger: The path for successful licensed farmers is paved by supportive local and state ordinances. It does not help our small business owners or their communities when regulations create difficult demands in licensing, permitting, taxing, etc.

Illegal farmers are not going to disappear, as there is always going to be an “black” market or underground market for anything. Small licensed cannabis farms could use the support, resources and benefits that are granted other mainstream businesses.

Hattan: We have to see some drastic changes made at the state and local level. The cost of compliance is too high for “legal” businesses to compete with the traditional market.

California, and Sonoma County, had an opportunity to allow people with existing thriving businesses to transition into the regulated market, and they completely blew it. Overly burdensome regulations, high startup costs, and delays in processing applications has forced many legacy operators who tried to enter the “legal” market out of business, or back to the unregulated market.

Houston: Most unlicensed cannabis flower is shipped out-of-state. A change in regulations that would allow interstate commerce would be very helpful for the licensed industry. The path to success for licensed growers in this environment is to grow high-quality cannabis efficiently.

It’s important for growers to set themselves apart in some way, either through branding, genetics, or some unique product or process.

At Prime Cuts Nursery, we’re intensely focused on helping small to medium-sized farms and cultivation facilities find success by offering unique, high-value genetics.

Melrod: High quality products and consumer education is critical for legal growers to achieve success. Not only do legal growers need to produce unique, top quality flower, it’s critical that they develop strong relationships with distributors and dispensaries that truly value their product and are committed to educating consumers about what makes their products so special. Legal growers must avoid joining the race to the bottom which is accelerated by oversupply and major price compression.

Mercer-Ingram: Licensed cannabis operators need the state and local authorities to lower taxes and license fees. The cost of cannabis will always be lower in the untaxed traditional market; however, at this point the regulated industry cannot compete.

Cannabis taxes in California and Sonoma County are so high it is putting companies out of business. Proof pays an effective tax rate of about 80% after local, state, and federal taxes. If the taxes were less burdensome, Proof would be able to scale faster, hire more local talent, and deliver lower costs to consumers.

No other industry is taxed so heavily, and when you add in the state license and local permit fees, the California cannabis market does not make sense, which is why you’re seeing investors flee to other states. California cannabis companies are, at this point, functionally nonprofits for the benefit of the state and local governments.

How should government step in, if at all to help address the issue?

Candell: The government needs to lower cannabis taxes, which is the single greatest cause of the thriving black market in California. The government does not understand that raising taxes creates a black market which costs millions of dollars to try to combat. Minimizing cannabis taxes (and legal federalization) will eliminate the black market.

Cenali: The cannabis industry is quite simply more scrutinized than any other industry in California including oil and gas, power, plutonium, and prison systems.

The oversight applied causes massive waiting periods and costly delays for small business owners. In addition, there are many inequities in police responses to business break-ins and losses, despite the industry's excessive tax exposure. The role of the DCC and local bodies should be to work patiently and in good spirit with those that are permitted or those seeking to be permitted. In utilization of our tax dollars, higher budgets should be earmarked towards enforcement against illicit actors, and enforcement should be unilaterally targeted to unlicensed parties and where misused — local bodies should cover the costs of their enforcement errors, through some transparent grading system. Police and law enforcement should also be measured and graded by the DCC in terms of their response time to targeted industry crime.

Flickinger: The federal block to nationwide legalization creates difficulty in accessing funds through banking, loans, and other resources like affordable insurance. We need this nationwide example to encourage all other local authorities who are just waiting for the OK to make forward movements.

Hattan: At the state level, we need the following:

1. Eliminate state level cultivation tax.
2. Declare cannabis as agriculture and get rid of the CEQA requirements for anyone who is planting in the ground.
3. Reduce state excise tax significantly.
4. Provide subsidies and small business incentives to operators from California who were here before the MSOs came in.

Houston: The government is doing the best job they can in my view. This is the aftermath of unreasonable investor optimism around the time MAUCRSA passed in 2018.

Banks continue to generally hold off handling cannabis business. If Congress continues to fail to act, what are the long-term ramifications of this for the industry?

There are banking options for cannabis companies through local credit unions. The cost of compliance for these banks is high and the expense is passed through to cannabis companies. In addition, cannabis companies do not have access to business loans and other financing options available to businesses in other industries. The security required in order to deal in cash safely is expensive.

These are problems the industry has had for many years. An improvement in this area would be tremendously helpful.

Melrod: Government can help alleviate the current challenges by reducing regulatory burdens and costs, lowering taxes and increasing the number of retail outlets in California.

A large percentage of local municipalities don’t allow retail cannabis, and this is an existential crisis for the industry. There simply aren’t enough retail outlets to satisfy the ever-growing demand for cannabis products produced in the state.

Mercer-Ingram: Lower taxes and reduce license and permit fees.

Banks continue to generally hold off handling cannabis business. If Congress continues to fail to act, what are the long-term ramifications of this for the industry?

Candell: Certain banks are choosing not to do business with the cannabis industry. I believe we should work with those banks that support the cannabis industry (East West, for example), and continue to be loyal to those banks once cannabis becomes federally legal and the big banks are fighting for a piece of this multi-billion-dollar industry.

Cenali: The long-term risk in restricting banking access is institutionalizing bias and access. Banks that are taking risks in the space are benefiting from much higher fees but also have to absorb more scrutiny and apply rigorous compliance practices on their plant-touching clients.

Those same practices are often intrinsically already applied by the states track and trace system, Metrc, and it seems that legal states could be more helpful in affording banks an easier solution to track those legal operators.

Regarding the federal initiative, if Congress fails to act, the biggest banks in the United States will continue to look the other way as their biggest clients make private investments, but then turn away transparent operators, furthering the divide between Main Street and Wall Street.

Flickinger: There are cannabis banks that do exist and do support the entrepreneurship of cannabis. DAMA being one, and Safe Harbor being another just off the top. I am getting emails from different payment processing companies that also help streamline financial operations.

So it seems there are ways through, beyond whatever Congress may or may not do. The downside is of course, that cannabis banking is usually very costly, and makes it difficult for small businesses to participate. With today’s cannabis market taking a dip in wholesale prices, we do need solutions that are more affordable, and I think we may begin to see other folks step in with non-traditional ideas that could be useful.

Hattan: Banking needs to be addressed immediately at the federal level. This is another reason that the regulated market cannot complete with the unregulated market. The costs associated moving cash around the state from retailers to distributors and from distributors to farmers and manufacturers go beyond just the physical costs of moving money.

The result is that cash is slow moving through the supply chain, and when there aren’t options for traditional loans, this has a real impact on businesses. Additionally, you are paying employees to drive around to pay bills in cash and record-keeping is significantly more complex.

The other major reason Congress needs to act is because cannabis businesses now employee hundreds of thousands of people. Getting loans for homes, cars, etc. is more challenging and people are still losing personal bank accounts for being associated with legal cannabis companies.

When Congress finally does act, it will also have to address 280E, a section of the IRS tax code, that prevents cannabis companies from writing off normal business expenses and only being able to deduct COGS. This tax code results in cannabis companies essentially paying income taxes on their gross sales.

Melrod: Banking is very expensive and burdensome for cannabis companies, and because of this, many small operators are forced to operate all cash businesses. This is unsafe and risky. If Congress doesn’t make changes, banking will continue to be extremely cumbersome and cost-prohibitive for many.

Mercer-Ingram: Cannabis banking has become much more accessible in the past several years. While Proof is glad to have a cannabis-compliant bank account, the fees are very high, we are unable to access traditional business lending, which has the effect of inhibiting growth.

Another big issue is that investors struggle to move money into cannabis due to Federal illegality and banking issues. Retailers and most supply chain operators struggle with cash logistics, which adds hugely to the cost of doing business, not to mention the security risks introduced to the public.

Federal cannabis legalization is a commonsense move, and the voters know it; national polls reflect strong and diverse support. We just need to see action from our elected officials.

States, at least 36, have so far have legalized cannabis in some forms. Yet cannabis continues to be illegal on federal books. What's the future of interstate commerce of cannabis products if this continues as is?

If Congress fails to pass cannabis reform, state cooperation will likely be the only option. Advocates and legislators in several states have been working on ways to allow cannabis to travel between legalized states.

However, this type of legislation would likely be vulnerable to legal challenges. Eventually, there will be a change in interstate commerce, whether federal or between states. To be competitive, California needs to lower taxes and ease regulations. Otherwise, California will continue to lose out to more lucrative states like Illinois, Massachusetts, Colorado, or basically every other state.

States, at least 36, have so far have legalized cannabis in some forms. Yet cannabis continues to be illegal on federal books. What's the future of interstate commerce of cannabis products if this continues as is?

Candell: Cannabis will become legal federally – it is inevitable. At that point, all cannabis for the entire country will be grown in California and exported to the rest of the country. Small growers have to hold on until that happens.

Cenali: The cannabis industry should not be borne by lobbyism and major corporations, it should be borne by small community businesses and should seek to build generational wealth for those that have been affected by the war on drugs.

In 2020, all five ballot measures posed were overwhelmingly approved by the public, and since that time, New York state has made legislative move to recreationally legalize, becoming the 2nd largest state in the nation to do so (alongside California, with Florida being medical).

The people did not vote to exercise their dollars for some major corporations with Canadian exchange backed budgets, they did so because the war on drugs is a farce and they want to see shifts towards better wellness solutions in their communities.

The federal government is always a slow mover behind our nation's private market innovation, and cannabis is no different.

The current silhouette state solution breeds inefficiencies and environmentally vacant prospects, encouraging massive infrastructure builds in cold and humid geographies and makes for a difficult path for small businesses in low population states.

This causes a grip by bigger corporations and a massive federal lobby focus. If the federal ear does not shift its reception, then it will be their failure in supporting small businesses which are of course the backbone of local economies.

Flickinger: It’s important for America to open up to what’s going on in the rest of the world. Other countries are already in international cannabis trade. Looking at South Africa where AFRICALI already has a branch of our business started in cultivation, they have begun import and export, as well as Canada and some European nations are already dealing internationally.

So the fact the U.S. is still fighting to get unified on legalization in all 50 states is a bit behind the times and seems to halt our overall progress as an international player. In the states, if we continue to prohibit interstate commerce I think we will see continued growth in illegal sales across state lines, as well as unnecessary roadblocks to a fully thriving regulated industry.

Hattan: California is known for growing some of the best cannabis in the world and it has been an export crop for the state for decades. A 50-year failed drug war has proven that law enforcement cannot stop it. “Legal” businesses will never be able to compete with unregulated cannabis until we allow states like California and Oregon to legally export the product that is already crossing state lines.

Houston: Economic incentives drive interstate commerce. It’s less expensive to cultivate cannabis outdoors in a state with a good climate like California than it is in most other markets. Therefore, some growers will continue to export products with or without a system for licensing and taxation.

Federal legalization and licensed interstate commerce would generate revenue for both federal and state governments. It would also reduce the health risks for consumers associated with pesticides and other chemicals sometimes found in cannabis products grown in an unregulated market.

Melrod: With so much speculation, it’s much too soon to make predictions about the true future of interstate commerce.

Efforts have been discussed to bring more diversity into leadership of cannabis businesses. How successful have these been so far, and what's needed to have been be more successful?

Candell: Not very successful. I believe white men make up about 70% of the leadership in the largest cannabis companies, and only 22% are women. This is an issue that needs to be addressed in society in general, not just the cannabis industry. Unfortunately, I am not aware of a simple fix for this systemic problem.

Cenali: Many cities and states have put forward favorable social equity focused programs, but in the end, many of those programs do not contemplate traditional outside funding needs and leave operators struggling to build their businesses without major corporate backers.

The state has issued certain grants, but most folks don’t have awareness of how to secure funds. Additionally, many municipalities posture towards equity programs and then award based on highly complex and complicated structures. There should be a higher threshold for awarding within communities as a reflection of those communities.

Most MSOs and ancillary providers have a focus on social equity programs and ensuring some portion of their staff reflects a broad demographic. However, those same companies need to apply a concerted effort to hire diversity at executive levels and outside capital needs to deploy to diverse business owners.

Flickinger: We need more efforts to bring diversity into cannabis leadership because the consumer is diverse. What we can do is to have equity that actually works for all.

Because when we went looking for equity resources here in Sonoma County, as a minority-owned business, they told us to go to Oakland. It made us feel like black people are not included in this movement and really shined a light on how we need better policy making to create accessibility for businesses and diverse leaders to succeed.

Hattan: There has been a lot of discussion at the state and local level about “equity” programs, but thus far implementation has been a failure.

You also see a lot of companies talking about diversity and equity, but their actions don’t match their words.

The fastest and easiest way to see more diversity in the leadership teams is for end consumers to use the power of their cannabis dollars. Consumers need to know which companies are partnering with legacy cannabis operators and are hiring women and people of color for leadership roles.

If you see a brand that has a largely homogenous leadership team and no past cannabis experience, maybe you don’t buy their products. If we start using our consumer dollars to support businesses we believe in, we will either see companies pivot towards diversity to retain market share or they will exit the space because it is not profitable for them.

Houston: Some effort has been made to bring diversity into the industry. Social equity programs have been successful in some cases. People who were affected negatively by the “War on Cannabis” are clearly disproportionately non-white Americans, and many of them also identify with other marginalized groups.

Many of those people have been and continue to be negatively affected by institutional racism and other forms of institutional bias.

The “War on Cannabis” cost people their lives and well-being and left people with severe post-traumatic stress in addition to its economic impact. People continue to serve prison sentences for non-violent cannabis convictions. I’d like to see all those people released and all money and property that was ever confiscated by law enforcement returned to its rightful owners.

In addition, reasonable damages should be paid to each of those people. This would be a far more comprehensive solution in my view and would give people a choice in how to invest reparations.

I believe it would increase diversity in the industry by giving resources and advantages to groups of people who are interested in cannabis in proportion to the resources that were taken away from people in those groups. And it would give those who were affected but are not interested in the industry a chance to invest in whatever they choose.

Melrod: Results to date have been mixed. Many social equity programs are well intentioned but struggle when it comes to implementation. It’s important to evaluate these programs, clearly identify what works and what doesn’t and optimize existing and future programs for greater success and impact going forward.

Mercer-Ingram: True diversity starts at the top. More companies need to be owned and operated by a more diverse group of people, but the barriers to enter the cannabis industry are extremely high.

At this point, hundreds of thousands of dollars are needed to start a licensed cannabis company in California. While the state cannabis taxes are funding some equity grants statewide, including Sonoma County, the regulations and local rules can effectively eliminate opportunities for equity applicants. Those rules need to be changed to promote diversity in cannabis.

On an industry level, companies benefit if more diverse voices are present. Proof’s leadership team is 80% women. We pride ourselves on being inclusive and encourage other businesses to do the same.

And if those were successful, what would change?

Candell: If the cannabis industry and the country were able to increase diversity in leadership, the world would be a better place.

Cenali: The general public will inevitably apply conscious decisions with their dollars. Monolithic leadership causes monolithic product outcomes, and the market will ask for variety. Diverse communities consume cannabis and it’s quite simply better business to reflect that diversity in product realization and therefore on shelves.

Melrod: Greater diversity in cannabis will bring with it numerous benefits including increased creativity, higher productivity, broader perspectives and improved impact just to name a few.

Mercer-Ingram: Whether it be products or accessibility, consumers will benefit from diversity in cannabis.