The other day, I read a post on Axial about “5 Predictions for Cannabis Investing in 2017“.
One of the predictions was that “Valuation multiples may be on the rise” in the cannabis space. The below chart of price to sales ratios for cannabis companies was included in the post.
At first glance, I thought an average valuation of 16.4X sales was very HIGH. I then realized that these are public (mostly microcap) cannabis company valuations. As many of you know, the majority of these companies have market caps of $10 to $50 million despite little or no sales.
I understand that two things factor into these high valuations; 1. Cannabis is a very high growth and relatively untouched industry and 2. public cannabis companies have inflated valuations because they are the only way for the masses to participate in this blossoming industry.
What I don’t understand is how “investors” plan on making a return on investment at these valuations!
I think very few of these investors will make a return for two reasons:
1. Most Cannabis Companies Will Fail.
Unfortunately, the vast majority of startups and early stage businesses fail. Due to the age of the legal cannabis industry, virtually every cannabis company is early stage. Cannabis companies are even more likely to fail because there are a number of untested unknowns including significant legal gray area.
2. Institutional Investors Can’t Justify These Valuations.
The exit for every investor is either repayment from a company’s cash flow or selling a position to another buyer.
Repayment from cash flow is highly unlikely since you are already buying unprofitable businesses at 16X revenue! Assuming 20% margins at scale, the company’s revenues would need to grow 8,000% to generate enough cash to return your investment.
Your other option is to find someone else to buy your position. Looking at the chart above, valuations are already falling which would make it hard to find a buyer for your position at a higher (profitable) valuation. If the company does grow to the size where institutional investors become interested, institutions will usually not be interested acquiring companies (or taking a position) at 16X sales (primarily for the reasons above).
In short, I think the cannabis industry is a very exciting space but it’s also a very risky space. Becuase of the risk/reward balance, I think the best way to value a small cannabis business is the same way you value any small business. Based on my previous posts on small businesses valuation and general M&A multiples, it’s clear to me that public cannabis company valuations are just too high.
What do you think? Am I missing something? How can a sub $1M revenue cannabis company justify a 16X sales valuation? Let’s discuss in the comments below or email me.
Ben Kotch is a managing director and investment committee member at Acquis Capital, LLC, a private investment firm that specializes in acquisitions. He has extensive experience with both private and public companies. Ben graduated with an economics degree from Bentley University where he concentrated in entrepreneurship and law.
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