Meet the Marijuana Industry's Secret Weapon

By Markets Fool.com


Image source: Flickr user Cannabis Culture.

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What happens when an unstoppable force meets an immovable object? One only has to look at the rift between the marijuana industry (aka, the unstoppable force) and the federal government (the immovable object) to get a good feel.

The unstoppable force and the immovable object
Two decades ago the idea of legalizing marijuana in any way was considered highly taboo. Then, in 1996, California became the first state to pass a law legalizing the use of marijuana for medicinal purposes. Some 20 years later we now have 23 states that have legal medical marijuana laws on their books, with four states (along with Washington, D.C.) allowing for the sale of recreational marijuana as well.

With a few rare exceptions, such as Ohio this past November and Florida in November 2014, marijuana has been breezing to steady victories when put on the ballot and voted on by state residents. This isn't all too surprising considering that national polls peg respondents to be slightly in favor of legalizing the drug. Gallup's October 2015 poll showed that 58% of respondents wanted to see marijuana legalized.

Image source; Flickr user Cannabis Culture.

Legal marijuana is also translating into substantial tax revenue for states like Colorado and Washington, the first two states to legalize recreational use of the drug. In 2015, Colorado netted close to $1 billion in combined medical and recreational sales, and it generated around $135 million in tax and license revenue. At least $35 million has been earmarked for the state's education department, with additional funds also expected to be doled out to law enforcement and drug abuse programs.

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In short, marijuana looks unstoppable.

Then we have the immovable object: Congress and the president. President Obama has suggested that marijuana isn't on his agenda during his final year in the Oval Office, and Congressional lawmakers haven't demonstrated any urgency in addressing a possible rescheduling of marijuana. Part of this has to do with lawmakers viewing other issues as more pressing -- economic growth, jobs, national security, and so on. However, lawmakers also don't want to make a hasty decision on marijuana without having a complete safety profile on the drug. It takes time for long-term use studies to emerge, and until those studies are available, Congress appears content sitting on its hands.

Marijuana businesses face inherent disadvantages
The issue with federal government inaction is that it puts marijuana-based businesses at an inherent disadvantage to normal businesses.

Image source: Drug Enforcement Agency.

First, despite marijuana being illegal at the federal level, marijuana-based business still need to pay federal income taxes. The kicker is that because they're selling a federally illegal substance, they can't take normalized business deductions, such as rent, on their taxes. Being forced to pay tax on their gross profits rather than net profits means marijuana business are brutally overtaxed relative to other businesses.

The other major issue here is that marijuana businesses have minimal or no access to basic banking services such as checking accounts or lines of credit. In some states, laws have been established to allow banks to interact with marijuana businesses, but the work-arounds are quite extensive. Most banks have chosen to simply avoid the industry rather than risk potential prosecution from the federal government. This leaves the marijuana industry dealing with an expansion problem since it has minimal access to loans, and a security problem since it deals mostly with cash.

However, a solution, or should I say a secret weapon, could be on the way to partially rescue the marijuana industry.

Meet marijuana's secret weapon
Venture capitalists could wind up leveling the playing field for marijuana retailers, growers, and processors by providing the access to capital that's mostly lacking.

Think about this for a moment: ArcView Market Research, after announcing that legal marijuana sales grew by 17% to $5.4 billion in 2015, is estimating that legal marijuana sales could grow by an average of 30% per year between 2016 and 2020. By 2020, this would peg legal marijuana as a $22 billion industry. That type of growth is bound to attract money, and while it's been a dismal performance for money-losing publicly-traded marijuana stocks, it's a potentially intriguing opportunity for venture capitalists.


Image source: Flickr user Sebastiaan ter Burg.

According to AngelList, a website that allows people to land jobs at start-ups, invest in start-ups, or raise money for their start-up business, marijuana is a hot investment. As of Feb. 21, 2016, its website listed 449 companies, 1,625 investors, and nearly 5,800 followers interested in various marijuana start-up businesses. Of those companies listed, each had an average valuation of $3.5 million.

We certainly don't have far to look to see just how quickly the VC influence is spreading. Privateer Holdings, arguably the largest and most influential marijuana-based privately held VC, raised $75 million last year and has a variety of holdings it believes can reshape and take advantage of growth in the marijuana industry. It owns Marley Natural (and yes, the brand does have a licensing deal in place to use Bob Marley's name and likeness to sell medical marijuana), Tilray, a pharmaceutical-grade distributor of cannabis in Canada, and Leafly, an enormous resource of cannabis knowledge.

But what makes Privateer so unique is that it's garnered an investment from Peter Thiel's Founders Fund. Thiel, if the name rings a bell, is one of PayPal'sco-founders and its former CEO. He may also be, next to Calvin Broadus (aka, Snoop Dogg), the most influential investor in the marijuana industry to date.

The other component that makes the VC-funding route so exciting is that they're bringing more to the table than just capital. VCs have innovative ideas that could take legal marijuana beyond the bounds of just growers, processors, and retailers.


Image source: Flickr user Mark.

For example, Eaze, a California-based medical marijuana delivery service, has developed an app that allows medical users to order marijuana with the click of a button. The company, which has received a healthy $12.5 million in funding and now services nearly 100 cities in California, suggests on its website that deliveries occur about 15 minutes after an order is placed. Convenience is key in any retail environment, and Eaze is hoping to capitalize on this trend.

Transcend Lighting, which may I add is targeting more than just the marijuana industry, is another start-up that offers a new type of LED light that can reduce energy consumption by up to 70%, essentially paying for itself in a matter of a year due to cost savings. Lighting and energy costs are a major drain on marijuana growers, so Transcend and its VC investors are hoping its new LED option will catch on with growers.

Still a risky proposition
Comparatively speaking, VCs appear to offer more variety to prospective investors wanting to get in on the marijuana boom relative to the small handful of publicly traded marijuana stocks (most of which are losing money). Still, going either route offers major risks.

As stated above, government inaction makes the long-term survival of the industry somewhat cloudy. As long as tax disadvantages exist at the federal level, growth in the marijuana industry will likely be constrained.

Additionally, investors have to understand that businesses (including VCs) fail all the time. According to Harvard Business School senior lecturer Shikhar Ghosh in 2012, about three-quarters of all venture capital firms fail to return investors' capital. This means investors in VC firms need to accept the possibility that they may lose all of the money they invest into marijuana-based ventures.

Personally, I'd suggest keeping to the sidelines until we see changes enacted on Capitol Hill. If marijuana is rescheduled, then it's quite possible marijuana becomes a viable investment opportunity -- but not before.

The article Meet the Marijuana Industry's Secret Weapon originally appeared on Fool.com.

Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool owns shares of and recommends PayPal Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.