Warnings that the cannabis industry is a bubble that is going to burst at any moment have been rampant for a few years now. News of high valuations, million and billion dollar investments and cannabis companies going public in the U.S. and Canada have stoked both excitement for potential riches and fears that it could all come crashing down. Commentators can’t help but compare the cannabis industry today to the tech industry boom we experienced in the 1990s and early 2000s, which eventually led to the “dot-com” bubble bursting.
The 1990s was a period of increased optimism and rapid economic growth. The internet was emerging as an exciting new industry with potential for exponential growth. Many internet-based companies, known as “dot-coms,” were launched and investors showered these companies with venture capital, betting that their investments would quickly yield significant returns. However, the very high valuations being given these companies were not supported by the business and financial reality. Many companies were not profitable and had no solid plans for revenue generation. Investing was speculative rather than grounded in sound investment principles. Companies burned through capital without observing business fundamentals. Many of these companies crashed when the bubble burst and investors lost billions.
The cannabis industry is now experiencing the same kind of exuberance in an environment of economic optimism and growth. Like the tech industry in the 1990s, the cannabis industry is relatively new (although the illicit trade has been operating for decades and continues to do so) that is sparking a lot of excitement. With the legalization of recreational cannabis spreading across the United States and federal legalization in Canada, many new companies in the legalized market have been launched. In addition to cannabis products containing THC, hemp-based products and products containing CBD derived from hemp are trending, and many new and established companies are jumping on the opportunity, even with a regulatory environment that is still murky. However, not all of these companies will be successful. Some founders are launching licensed operations after years of operating in the black or gray markets, but may not have the business background needed to run a legitimate company. Despite this, investors are still making big investments in these companies.
Anticipating widespread legalization, investors are jumping on the opportunities for fear of missing out or getting left behind. Investments by large food and beverage companies, such as Constellation Brands’ investment in Canopy Growth, as well as big pharma and an increasing number of venture capital investors, have given some legitimacy to the industry. As with the dot-coms of the 1990s, however, many of these companies are overvalued and lack the earnings that would support the high valuations. Because the legal cannabis industry is still so new and transparency regarding the illicit businesses was so limited, it is difficult to get an accurate valuation of these companies. We are already seeing large drops in share prices for public cannabis companies such as Aurora, Canopy Growth and Tilray, as earnings reports have been less spectacular than anticipated.
Cannabis is still a heavily regulated market. The requirements for obtaining a license to operate are sometimes onerous and extensive and there are high startup costs before a company can commence operations. Heavy regulation and taxation cut deeply into profits, and the still-illegal status of cannabis at the federal level makes the industry unpredictable. While federal legalization is expected at some point, the slow pace of legislation means that it probably won’t happen any time soon. The industry could suffer significant setbacks if governmental authorities decide to crack down on the industry. While growth is projected, it is not guaranteed. Overvaluations of cannabis companies and increased media attention have generated high expectations from shareholders and cannabis companies may not be able to rise to these lofty projections.
Two decades after the dot-com bubble, the internet has become a mainstay of our everyday lives. The industry has matured and we are in the midst of another tech boom, with lessons learned from the past being applied today to help prevent another bubble from bursting. The companies that survived the dot-com bubble the first time around, such as Amazon and eBay, have grown larger and more dominant. Likewise, the cannabis industry is likely here to stay. Markets will open up as legalization becomes more widespread and recreational use becomes more normalized, even if it will take a while to get there and the road is bumpy along the way. As the cannabis industry matures, there will be some companies that will emerge as dominant forces. However, before the winners emerge, many companies may become victims of the bubble bursting.
If the cannabis industry is indeed a bubble, what can companies do to weather a downturn and be one of the companies to survive?
Operators can increase the likelihood of success from the very beginning by how they set up their companies. They should carefully select members of their team that can help guide the business not only through the specific issues that face cannabis companies (i.e. navigating regulations, licensing issues, taxation), but also with making sure that the company is focusing on the business fundamentals, focusing on long-term growth and on building a better product. The team should also be focused on following sound accounting principles and keeping on top of regulatory developments to make sure they remain in compliance.
Companies can also increase their likelihood of success by diversifying their business, developing multiple paths for growth, investing in innovation and developing new product lines. Vertically-integrated companies that cultivate, manufacture, distribute and sell the products and are developing a strong brand identity may be more likely to succeed. The focus should be on increasing revenues while minimizing costs and improving the bottom line. Companies should develop solid business plans with reasonable goals for short- and long-term success.
Companies should also think carefully about how much investment to accept and from whom. While it may be possible to find an investor that is willing to invest significant amounts of cash, does your business plan really call for that much capital? Can you execute with less? By taking in more investors and more capital, founders could lose control over how they run the business. They invite additional pressures to perform and to do so quickly in order to provide a return to their investors.
The companies that will emerge from a potential cannabis bubble bursting are the ones that have an understanding of the industry, a solid plan for growth in multiple areas and a willingness to stay in it for the long-term, as the industry matures and consolidates and the legal landscape evolves.