Valuations play a key role in an array of Cannabis industry business concerns. Nevertheless, there’s a lack of good information for accounting professionals supporting the licensed Cannabis space. When you understand what valuation is—and the different kinds of valuation—you can help clients make choices that align with their needs.
What is Business Valuation?
In a nutshell, business valuation is the process and procedures of determining the value of an owner’s interest in a business. The three most commonly used valuation approaches are the asset approach, the income approach, and the market approach. There is also a “mix of all three” approach that is a mix of the asset, income, and market approaches.
Key Uses of Business Valuations
The key uses of valuations include the following:
- Raising capital for startups
- Obtaining bank loan(s) for existing company
- Supporting mergers and acquisitions (M&A)
- Tax & estate planning
Business Valuations Professionals
Administered by the American Institute of Certified Public Accountants (AICPA), the Accredited in Business Valuation (ABV®) credential is granted to CPAs who pass the organization’s two-part ABV exam and demonstrate skill, experience, and abide by professional accounting standards.
Awarded by the American Society of Appraisers, the Accredited Senior Appraiser (ASA) accreditation requires five years of full-time experience in valuation, successfully completing four courses in business valuation, and passing four respective exams after each business valuation course.
The CFA Institute, an international organization, oversees the Chartered Financial Analyst (CFA) certification. Earning the voluntary credential requires a bachelor’s degree, passing three exams, and three years of relevant industry experience.
The Common Approaches to Business Valuation
Valuation of a business will be performed by a business valuation professional i.e. appraiser who will typically perform the following three traditional approaches and weight according to relevant facts.
The Asset Approach to Valuation
The asset approach to valuation calculates a business’s value based on the value of its assets and liabilities. By determining the difference between the total assets minus the total liabilities, the net asset value (NAV) will be determined. With the emphasis it places solely on assets and liabilities, the asset approach to valuation can be insufficient at times. Companies with assets that have a fair value higher than recorded value (i.e. brand name recognition or a large, loyal fanbase are two such examples).
The Income Approach to Valuation
The income approach to valuation looks at both the business’s current income as well as its future cash flows to determine the value of the company. This approach can work well for businesses with stable revenue and EBITDA growth.
For example, the rental income of a commercial real estate building might be very predictable. Therefore, the income approach would be a good way to predict valuation since rents will not fluctuate wildly from month to month.
In the Cannabis industry, however, estimating future revenue and income is challenging because there are a number of factors that are out of the business’s control, such as IRC 280E, market prices, production issues, state and local laws, ordinances, and regulations, and more.
The Market Approach to Valuation
The market approach to valuation determines value by comparing it to similar businesses that have been recently sold. In the Cannabis space, the market approach can be effective when the business being valued is compared to similar businesses within the same specific market. If, for example, Cannabis dispensaries in Bend, Oregon are selling for 1x revenue for the past two years, that data could be a useful way to determine value.
Two caveats to using the market approach when valuing Cannabis companies are as follows. Firstly, in the Cannabis industry, markets in different locations are vastly different. If location-specific data is not available, looking at other “comparable” markets might not be a reliable indicator of value. Secondly, since most Cannabis companies are private, getting accurate data on the amount other similar companies have sold for can be hard to obtain.
The Mix of All Three Approach to Valuation
The “mix of all three” approach to business valuation is what professionals certified in this area will use. It takes into account all of the three approaches mentioned above to valuation, then adds weight to the approach that makes the most sense for that type of business. Because all three common valuation methods are utilized, this approach can be used to arrive at a comprehensive estimate of a business’s value. In mixing the market approach, income approach, and asset approach to valuation both tangible and intangible assets are taken into account, as well as economic conditions, future cash flows, comparable markets, and more. Due to its all-inclusive structure, this approach is often used in litigation, mergers and acquisitions, estate planning, and in situations that call for a high degree of reliability and accuracy. Make sure you get someone with the credentials and experience to do your valuation!
Challenges in the Valuation of Cannabis Companies
Because of 280E, the relative infancy of the licensed Cannabis industry as a whole, and a lack of accessible market data valuing Cannabis companies can prove challenging. In the event that the federal government decides to remove Cannabis’s designation as a Schedule I substance from section 280E of the Internal Revenue Code, future cash flows and values would be affected by Cannabis becoming legal at the federal level.
Adult-use Cannabis was first legalized in Colorado and Washington in 2012. Since then, twenty other states have followed suit. While that may sound impressive, the relative newness of the industry results in there being a lack of sufficient market data upon which valuations can be made.
Because the industry is young, and future regulation is uncertain, market data reflects the highs and lows commonly experienced in newer economic sectors. Such volatility can make it even harder for valuation experts to get a handle on determining a Cannabis business’s value.
Cannabis Startups & Valuation
Like their technology and cryptocurrency counterparts, Cannabis startups are often looking to raise millions of dollars. Most of them are pre-revenue and have little to no hard assets. Sometimes the only thing they have is the Cannabis license itself. If that’s the case, how can Cannabis startups be valued?
Valuing something with few to no assets and no revenues is typically more art than science. The traditional income approach will not work since during the pre-revenue stage there’s little to no income coming in. And with assets oftentimes being nothing more than a Cannabis license, the asset approach to valuation does not provide much clarity either. The “knowns” that can be valued are the state of licensure, the city or town where the startup is going to operate, the brand’s buzz or popularity (if there is any), and the financial model and pitch deck. Hence, formal valuation in the startup space is rare. In general, it is determined by the market, location-specific market conditions, but most importantly the valuation will first be set via negotiations with arms length investors. If the financial model is realistic and built by a professional, startups will have a much better time “selling” that valuation to an investor. For those raising capital, market conditions also push valuations up and down.
Valuation of Cannabis Startups: Financial Models & Pitch Decks Play a Key Role
For the reasons just explained, a startup’s financial model and pitch deck assist them in their ability to demonstrate value to potential investors. Through having a stellar deck and model they can show investors that they have the right team, plan, and talent it will take for them to meet or surpass their goals and provide a healthy ROI.
The startup’s financial model and pitch deck must agree with one another (many startups fail at this). Rather than aim to “wow” the reader, the information should be accurate and easy to understand. Learn what else investors want to see in Cannabis startups’ models, pitch decks, and entity and funding structures.
Accounting professionals who want to serve Cannabis businesses well need to have a solid understanding of valuation and all it entails so that they can assist their clients in seeking expertise that’s appropriate for their needs. While certainty is not the first thing that comes to mind when thinking about the Cannabis industry, as it grows and time passes there will be greater “knowns” to work with and more precision around the financial metrics. By collectively doing our best today, we’re helping to build an industry that’s sound, fair, and profitable for years to come.
Learn about DOPE CFO’s premier Cannabis/CBD program for seasoned accounting professionals (bookkeepers, tax professionals, Controllers, CFOs, CPAs, etc) who are looking to go fully remote and support today’s fast-growing Cannabis/CBD industry.