United States: The More Things Change In Marijuana Investment Law, The More Things Stay The Same

Voters in eight states legalized marijuana on November 8: recreational marijuana in California, Maine, Massachusetts and Nevada and medical marijuana in Arkansas, Florida, Montana and North Dakota. More than one-fifth of all Americans now live in states with legal recreational marijuana markets, a number that nearly quadrupled in size overnight. Investors hoping to capitalize on new opportunities nonetheless face continued risks. This article summarizes the current state of the market and highlights certain of the ongoing obstacles to investing in marijuana companies.

Marijuana Investment Activity Update

The total marijuana market (recreational and medical) is on pace to reach $7 billion in sales this year, and some analysts predict it could exceed $20 billion by 2020. Revenues will of course depend on how quickly new licenses are issued. States with new regimes do not have to recreate the wheel, in terms of tax rates, licensing procedures, safety requirements, etc., as early-adopter states (Colorado, Washington) have created the road map, and the new state propositions included detailed provisions for the regulation of marijuana. These states can therefore jump out of the gate with a running start once licenses are issued in 2017 or early 2018. Meanwhile, attitudes toward marijuana will also affect sales, and recent polling by Gallup shows 60% of Americans support legalizing marijuana, historically high levels. Finally, competition from the underground market, mostly on price, continues to be an issue, but the price of legal marijuana is falling as the number of retail dispensaries rises and the cost of production falls.

Yet despite the momentum, marijuana companies still lack adequate access to capital and financial services. This is because marijuana's federal illegality creates money-laundering issues and poses reputational and other risks for many traditional institutional investors. Although the big banks have not ventured into the market, there has been restrained interest, particularly in the medical marijuana field, that may develop once federal obstacles are removed. In the meantime, to fill the void, several specialized funds have completed or are currently seeking, in the wake of the state election results, to complete financing rounds, including Tuatara Capital, which successfully closed a $93 million raise, and Privateer Holdings, which used proceeds from a March 2015 $75 million raise to invest in Leafly (a review aggregator for marijuana strains), Marley Natural (a brand licensed from Bob Marley's family) and Tilray (a Canadian medical marijuana company) and has recently raised another $40 million.

This activity is part of a larger landscape of investment that one company (Viridian Capital Advisors) estimated to total more than 250 capital raises worth over $800 million in 2016. Equity raises substantially outnumbered debt raises, perhaps in part because marijuana businesses are generally prohibited by Section 280E of the Internal Revenue Code from taking business tax deductions, so interest payments on debt do not offset income (see below discussion), and perhaps because investors want to be positioned to capitalize on their investment in marijuana.

Some investors are interested in the market but have focused on products and services ancillary to the marijuana industry because such investments have less regulatory uncertainty and business risk. Microsoft made headlines for announcing it was partnering with Kind Financial to provide software that will help marijuana-related businesses comply with "seed to sale" tracking laws and regulations. Marijuana agricultural equipment has seen much activity, headlined by Scotts Miracle-Gro's 2015 $135 million acquisition of two hydroponics equipment manufacturers. Although many pharmaceutical companies have opposed liberalization policies, others have invested millions researching drugs containing synthetic cannabinoids, such as GW Pharmaceuticals' Sativex. And in October, a marijuana-focused real estate investment trust filed disclosures with the Securities and Exchange Commission as part of a $175 million public offering, describing plans to acquire marijuana-growing facilities and engage in leaseback deals with marijuana companies, thereby freeing capital for marijuana companies to focus on growing and retail operations.

Investors are also watching Canadian and Mexican policies with interest because of the potential for sales and because prohibition policies will become increasingly difficult to enforce as American neighbors liberalize their policies. In Canada, medical marijuana has been legal since 2001 and recreational marijuana is expected to be legalized by the spring of 2017. In Mexico, the Supreme Court in 2015 found the world's first constitutional right for marijuana use, which, together with President Enrique Peña Nieto's proposal to legalize marijuana, has bolstered legalization momentum in the country.

Marijuana Regulatory Update

The marijuana industry's growth has been, and continues to be, held back by federal policy, including marijuana's classification as a Schedule 1 drug, which means marijuana businesses:

  • May generally not take business tax deductions because of Section 280E of the Internal Revenue Code (which prohibits deductions for businesses trafficking in controlled substances) – although Section 280E does not prohibit a deduction for cost of goods sold, it precludes all other traditional business expense deductions.
  • Struggle to access banking services; those who do often pay steep fees to offset banks' regulatory and compliance burdens.
  • Have little recourse if federal enforcement policy changes.

In response to a 2015 letter by eight U.S. senators calling for the DEA to review marijuana's classification, the DEA in the summer of 2016 ultimately declined to reclassify marijuana, relying on analysis by the Department of Health and Human Services that there is no currently accepted medical use of marijuana. Despite this decision, now that more than half the states have legalized medical marijuana and scientific research will be easier going forward (the University of Mississippi no longer has a monopoly on producing marijuana to be used for clinical trials seeking federal approvals), marijuana may yet be reclassified in the future. Reclassification will also depend on President-elect Trump's political appointments and policies – he has recently expressed support for states' rights on medical marijuana, but he has also referred to Colorado's regime as a "real problem" – so time will tell how the new government will enforce marijuana laws.

Looking Forward

We will continue to monitor this exciting and rapidly evolving market.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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