Pros and cons of vertical integration
States continue to create medical marijuana programs that trend towards tighter regulation, many of them requiring that licensees by vertically integrated. This license structure provides a medical marijuana business with complete control over the production, processing, and retail distribution of medicine. Licensees cultivate marijuana on an industrial scale, produce infused products and edibles, transport products between their production facility and retail dispensary (if they are not co-located in the same facility), and sell the products to consumers or patients in their retail storefront or via delivery.
4Front believes an optimum model would provide dispensary operators with the option to produce their own medicine, though vertical integration should not be mandatory.
Dispensary operators should have the opportunity to produce medicine because they best understand the needs of their patients. And since the cost of production is typically lower than wholesale prices, retailers can provide medicine to patients at lower retail prices through vertical integration.
In addition, retailers need access to products and strains that may be beneficial to their patients, but which they may not have the capacity or expertise to produce themselves. We believe state programs should additionally license separate cultivators and producers, ensuring competition on the wholesale market and leading to more cost savings for patients.
State Approaches
Vertical integration is not possible under all state regulatory environments. Every state has different regulatory structures, some of which allow or mandate vertical integration, others prohibit it, and some provide a range of options for going to market. Here are a few examples of different regulatory models and how they handle vertical integration.
Massachusetts — Permit holders are essentially required to vertically integrate their entire businesses. The Commonwealth only issues vertically integrated licenses, disallowing third-party cultivators or manufacturers of infused products. A dispensary license in Massachusetts allows an operator to cultivate marijuana and create infused products. The Commonwealth does allow for very limited wholesale opportunities between license holders, but only in the cases of crop failures, medicine shortages, or demonstrated patient need. And even then 70% of a dispensary’s inventory in a given year must be produced by that operator. Other states with mandated vertical integration include Maine, New Jersey, New Hampshire, and New Mexico.
Washington — For its adult-use program, the State of Washington issues three separate licenses: dispensary, producer (infused products), and cultivator. Businesses that hold a dispensary license are not allowed to hold a cultivation and/or production license, and vice versa. Under this model there is complete separation between production and retailers. This is closer to an alcohol distribution model than most other states, with the exception that the state does not license third-party wholesale distributors. No other states currently mandate separation between production and distribution.
Arizona — In Arizona’s medical marijuana program, the state’s Department of Health Services only issues dispensary licenses. Unlike Massachusetts, dispensary permit holders are not required to produce their own medicine, but are allowed to should they choose to do so. Dispensary license holders are allowed to produce as much or as little medicine as they choose, and can purchase the rest of their inventory on the wholesale market from other permit holders. They are also allowed to produce excess medicine and wholesale it to other license holders around the state. This creates a robust wholesale market where operators can produce much of their inventory, but supplement it with additional products from other producers. It also allows dispensaries in sparsely populated rural areas to boost their income by wholesaling to dispensaries in densely populated urban areas that would have trouble producing enough medicine and a diversified product line sufficient to meet patient demand on their own. Arizona is currently the only state with this model.
Nevada — In Nevada’s nascent medical marijuana market, the state issues licenses for cultivation, production, and retail distribution. Unlike in Washington state, businesses are allowed to own all three licenses, so vertical integration is possible. But it also opens the door for businesses to obtain licenses to cultivate and produce infused products strictly for the wholesale market. This model provides retailers with the optimum amount of choices, since they can produce what they have the capacity for and supplement the rest of their inventory on the wholesale market, assuming they are able to secure a cultivation and production license as well. We believe the Nevada model of limited retail licenses and unlimited cultivation and production licenses is the preferred model and one that other states should look to emulate in the future. The programs in Colorado and Illinois also feature elements of this model, granting separate licenses for some of the cultivation, production, and retail distribution functions, while placing caps on the numbers of some licenses that can be granted.
Benefits
4Front recommends that potential operators take advantage of the ability to vertically integrate if it is allowed by their states.
Vertical integration ensures that operators can offer their products at lower prices to patients or consumers and can maximize profit margins, since retailers do not have to pay wholesale prices for their inventories. In some cases, excess product can be sold wholesale for further profits, albeit at lower margins. Additionally, vertical integration allows retailers to maintain greater control over their inventory, providing them the ability to focus on producing strains and products that best meet the needs of their patient or customer base. If an operator has the capability and capacity to vertically integrate, it offers the best combination of inventory control and profit margin, making it a very attractive option.
Drawbacks
There are downsides to vertical integration, however. First, it is very expensive to get a vertically integrated business up and running. Build-out costs for a cultivation center can be levels of magnitude higher than a retail dispensary, as renovation, lighting, power, water, HVAC, equipment, and nutrient costs can easily run into the millions of dollars for a larger facility. Setting up a commercial kitchen and infused-products laboratory are also significant upfront expenses. While a business may be able to get a retail dispensary up and running for $500,000 to $1 million or less in markets like Colorado, it often costs between $3 million and $10 million to set up a fully vertically integrated facility.
Running a vertically integrated operation requires a lot more expertise than just running a dispensary, cultivation center, or infused-products facility on its own. An operator must hire or partner with cultivators, retail experts, chemists, and professional chefs/confectioners in order to effectively run all facets of the business. Controlling all aspects of supply and distribution chains introduces risk of a failure in one area impacting other aspects of the business. If there is a crop failure in the cultivation center, for example, it will negatively impact the business’ ability to offer a diverse product line at the retail level, or worse, create product shortages that could alienate a customer base. Very few retailers outside of marijuana are responsible for producing their own products, and generally have a number of wholesalers that supply their retail product lines. If one is unable to meet a wholesale order, a retailer has other options and other goods they can sell. But if a vertically integrated dispensary is unable to meet their production needs, it can have a devastating impact on their retail business and their patients.
Alcohol Industry Comparison
In the alcohol industry, there is mandated delineation between producers, distributors, and retailers. Under federal law, and in the majority of states, it is illegal to hold a license to both produce and retail alcohol, with limited exceptions for producers that sell bottles on premises, and factory stores for larger breweries and distilleries. In fact, alcohol manufacturers are not allowed to sell their products directly to retailers. They are required to sell to third party distributors who then wholesale products to retailers. This system made sense for most businesses, since manufacturers like wineries, breweries, and distilleries did not have access to the nearly infinite number of retailers that exist in the market. Selling to a distributor with these connections allowed manufacturers to get their products in as many stores, bars, and restaurants as possible.
However, this is also largely a vestige of a long-gone era, as the internet has made it much easier for manufacturers and retailers to find one another, giving them the ability to cut out the middleman and improve margins for both parties (manufacturers can sell at a higher cost than they would to distributors, which is still a lower cost for the retailers to pay than they would buying from the distributor). Since this three-tiered system has been in place for so long, it has allowed the distributors to grow large and powerful enough that they lobby intensely to keep the mandated three-tiered system in place, despite there being little practical reason for it to remain. This is something that the marijuana industry should try to avoid if possible. Third-party distributors can play a role in the marijuana market, but it should not be a requirement.
In today’s marijuana market, where each state develops its own set of rules and regulations, the industry has the opportunity to test out a variety of models, from mandated vertical integration to delineated three-tiered systems, to hybrid models of the two. In these early years, it appears that the best system for both businesses and consumers is a model that allows, but does not require, vertical integration. In the years ahead, we will have the ability to observe and analyze each of these options and make a much more informed decision about the best way to regulate marijuana businesses.
