I Spoke to 25 VC Fund Managers. Here’s What I Learned.
At Poseidon, we track close to fifty funds investing in private cannabis companies. In the current economic climate, only about half are active. Despite lower predictions for 2023 sales, industry fundamentals remain strong. Ten states are eyeing adult-use legalization in the next three years per updates from Vicente Sederberg and the Marijuana Policy Project. These states could unlock nearly 6.8 million new consumers, generate $9.1 billion in new sales, and shift the percentage of representatives in Congress who support legal adult use from 48 percent to 67.5 percent.
Wholesale prices appear to be leveling, and sales trends that flatlined in 2022 are showing signs of life. Yet, custody-constrained public markets and growth-challenged states digesting unexpected revenue gains made during the pandemic are driving negative to neutral investor sentiment despite increasing unit sales and state legalization wins — a rising tide expected to continue over the next three years or more.
The industry is at a point where there are more experienced operators than ever before, and some are looking to emerging regions for new opportunities. For example, southern states like Florida, Georgia, Mississippi, Texas, and Alabama are expanding or implementing new legal programs. Even Tennessee state legislators recently introduced a legalization bill.
All the while, the industry meets the demands of consumers who spent $26 billion in 2022 and prepares for projected revenue growth to $46 billion in 2026, according to BDSA. If history teaches us anything about the legal industry, it’s worth remembering “where there’s a will, there’s a way.” Astute cannabis founders will persevere, and investors with conviction will understand this is a long-term opportunity, not a quick flip. The missing component today is capital, so let’s dig in on what investors are saying.
Ancillary companies on the rise
Few cannabis funds are willing to commit to leading a round of funding, but most are happy to follow. Coming to an agreement on deal terms is difficult, especially since public valuation comparisons are depressed and risk is off. There is a common belief financing in this environment should provide eighteen to twenty-four months of runway. As a result, many investments and rounds have multiple closes as investors ease their way into new deployments with extra caution. Some investors have refocused their efforts toward ancillary products and services, leaving only a few actively looking at licensed operations. Those who invested in the public sector and lost money are licking their wounds, but there is some enticement around the historically low valuations. Raising venture funds is very difficult in this environment. With the Secure and Fair Enforcement Act failing in late 2022 and valuations falling steadily, there is little pressure from limited partners to deploy.
The venture capitalist (VC) community expressed mostly relief in the aftermath of dutchie’s fall from grace. Other private cannabis companies that raised capital at eye-watering valuations in the past two years are likely to see down rounds. Nevertheless, a small handful of ancillary startups are meeting or exceeding forecasts, launching new rounds, and even attracting the interest of mainstream VCs. In fact, there are more conventional VCs in cannabis than ever, and this is a promising sign.
Some VCs who backed growth-stage and later-stage cannabis investments in 2020 and 2021 are not seeing the sales growth or value appreciation they expected and are beginning to accept the fact they may clear only two to four times revenue on these investments. As a result, there is a bifurcation of investor interest developing around early-stage companies with valuations less than $10 million and publicly traded companies trading at one to two times revenue.
Cannabis payment technology is growing in popularity, allowing ancillary companies that facilitate transactions at every step in the supply chain to increase revenues and drive profitability. Although legal cannabis payments are thought by some to be at odds with federal banking regulations, few in the industry operate free and clear of legal norms regardless of the business model. This industry was founded by feral entrepreneurs flouting laws and the status quo. Facilitating payments seems to be the latest frontier for those seeking growth and profitability.
Investors doubling down on due diligence
More VCs are relying on their peers and founder networks to identify companies with solid prospects. Maneuvering around the pandemic forced the entrepreneurial community to rely less on pitch events, conferences, and trade shows, instead solidifying the digital connections that now make up the backbone of fundraising in the industry. We’re seeing more and more VCs team up on deals to mitigate risk and go deeper on due diligence.
The era of “fear of missing out” investing appears to be over. Most angel investors who made early investments are sitting on the sidelines and waiting for returns from their existing portfolio companies. Meanwhile, hedge funds seem to be circling in a holding pattern on new private offerings as they work to resuscitate their larger public holdings.
For licensed operations and multistate operators (MSOs), debt is a growing concern. As prices compress, the impact of compliance costs and Internal Revenue Code Section 280E have made interest payments more difficult to meet. A chain is only as strong as its weakest link, and any weakness may create systemic problems. Interestingly, a lack of interstate commerce may provide an unexpected firewall from the state where the debt crisis may become most acute: California.
No VCs mentioned New York as an investable opportunity right now. Illegal storefronts, a delayed rollout, and unclear regulations and state funding strategies all are red flags for investors. The VCs interviewed indicated they would wait, watch, and learn with New York, while others revealed a palatable disappointment with the way the state has rolled out the adult-use market.
New mergers are tricky
The industry is in flux, but what’s certain is a downturn follows every economic boom. There has been an increased awareness and sensitivity from VCs and founders on the impacts of additional funding rounds and exit costs (bridge rounds, taxes, legal, bankers, et cetera) that dilute their position and impact their returns. Should founders hold firm on their desire for up-round valuations, the cost is downside protection for investors in the form of liquidation preferences or valuations tied to revenue or profit forecasts.
Flat, down, and more structured investment rounds will become the norm across private companies. Painfully, we likely will see more businesses fail that are unable to raise capital or sell. This culling will thin the herd and hand more power to established incumbents — increasingly MSOs — with a lower cost of capital and a growing footprint of assets and operations. Still, like in any other industry, there is always room for “better.”
When it comes to valuations, flat is the new up. Ancillary companies are raising flat rounds even if they have grown their annual recurring revenue exponentially since their last raise. VCs admit these previous financings were overpriced and are relieved when founders offer flat extensions that bring their portfolio companies closer to public-market multiples. Still, private multiples are two to three times higher than where springbig, Weedmaps, and Leafly currently are trading, which can’t last for long.
Those teams falling short of forecasts are executing layoffs, reducing their workforce, and refocusing remaining staff on surviving to the end of 2024. Paring down product strategy and prioritizing sales may carry these companies through to tomorrow, but execution must be tight.
The companies receiving investment today are managed by polished leadership teams who understand the challenges and complexities of building a business and establishing brands in cannabis. In addition, they likely either are profitable or have found a clear path to profitability. With a short list of VCs investing in new companies, most fund managers are working with their existing portfolios and making tough choices about who to support through an expected downturn. This is not unique to cannabis, but founders who have fallen short of their own forecasts now must contemplate mergers and acquisitions (M&A) much earlier than they imagined.
Still, M&A is tricky. Valuations for unprofitable cannabis companies range between what others are willing to pay and whatever owners can get. Cash deals are very hard to come by, seller’s notes are growing in popularity, and most deals are closing for all stock. This complicates things for investors who originally received preferred shares and now may be forced to accept common stock in acquirers who last raised at inflated valuations in 2020 through 2022.
Despite all this, advocates and legal experts predict ten additional states could legalize adult use in the next three years. However, without movement on the federal level, the calculus for most investors changes. Meanwhile, everyone in the ecosystem continues to work hard to make the numbers work, and this can only be a good thing for the long-term viability of the industry.
This content is not intended to provide any investment, financial, legal, regulatory, accounting, tax, or similar advice, and nothing should be construed as a recommendation by Poseidon Investment Management LLC, its affiliates, or any third party to acquire or dispose of any investment or security or to engage in any investment strategy or transaction. An investment in any strategy involves a high degree of risk, and there is always the possibility of loss, including the loss of principal. This content should not be considered as an offer or solicitation to purchase or sell securities or other services. Any of the securities identified and described herein are for illustrative purposes only. Their selection was based upon non-performance-based, objective criteria. The content presented is believed to be factual and up to date, but Poseidon does not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Past performance is not indicative of future results.
By Patrick Rea
Originally published at https://mgmagazine.com/business/finance-acquisitions/i-spoke-to-25-vc-fund-managers-heres-what-i-learned/?doing_wp_cron=1679939156.8957440853118896484375 on March 17th, 2023.
