“Big Trouble in Little Canna” – How Small Businesses Struggle To Compete Within the CA Legal Market

Written by BlackbirdGo August 27, 2018
The Industry

Disclaimer: Keep out of reach of children. For use only by adults 21 years of age and older.

Since 57% of Californians voted to legalize recreational cannabis in 2016, the already-thriving industry has seen a huge surge in activity. Dispensaries are performing well, the state has benefited from a boon in canna-tourism, and all cannabis products legally sold in California are now required to undergo testing and regulation. Overall, legalization seems to be going well in the Golden State. In the first quarter of 2018, state cannabis taxes brought in $33.6 million - but that seemingly-impressive tax revenue is, nonetheless, far short of the projected haul.

State officials predicted that the legal cannabis market would net upwards of $185 million in taxes over the first six months of 2018 alone, yet first quarter tax revenue came in at just under one-third of what was anticipated. Though second quarter numbers have not yet been released, it’s likely that statewide tax revenue has still not caught up with the numbers that economists predicted just last year.

These statistics suggest that the state is having a difficult time competing with the black market, which affects both new and established businesses that have struggled to enter the legal mainstream. This problem is being fueled by several factors: local municipalities placing restrictions or outright bans on cannabis production and sales, a high demand for blackmarket cannabis due to high taxes on legal products, and the high cost of entry into the cannabis industry.

Pushing Out Small Businesses

Depending on where in the state a business hopes to operate, the required permits and licensing fees could be a huge barrier to entry, especially to small business owners. In some cities, opening a dispensary can cost upwards of $500,000. The process is much more complex than some may realize - in addition to renting or purchasing a storefront, any dispensary operating in California must also pay an application fee to the state as well as the city in which they intend to operate. Dispensaries only pay a $1,000 annual license application fee, but businesses may also be charged up to $72,000 in additional fees, depending on how much cannabis they sell. Distribution licenses can cost upwards of $125,000 in some municipalities. Businesses that wish to operate as both medical and recreational dispensaries must acquire two separate licenses: an M license for medical cannabis operations and an A license for recreational sales. On top of that, a dispensary owner will need equipment and employees to run the store, arrangements with licensed growers, adequate security on premises, and a varying number of legal as well as financial advisors. Cannabis business owners also need to hold a $5,000 surety bond payable to the state, which would be used to cover the cost of destroying that business’s cannabis and cannabis products in the event that they’re found to be in violation of the licensing terms set forth by the state and local municipality.

Because starting a cannabis operation requires so much overhead and the diligence needed to secure the proper paperwork, some businesses have started selling pre-made medical dispensaries with all the necessary permits and licensing already secured. These so-called “turn-key” dispensaries can range in cost from $100,000 to several million dollars.

Dispensaries aren’t the only players in the cannabis industry being hit hard by the state’s regulations. Testing labs can expect to pay anywhere from $20,000 to $90,000 if they want to operate within the legal market. Companies that produce cannabis-infused edibles will have to pay up to $75,000 in processing and license fees. Growers will need to pay an annual licensing fee based on crop yields that could cost up to $78,000, depending on the size of their production facilities. Anyone growing cannabis in the legal market will also need to ensure that their grow sites comply with state and local regulations, which could mean an investment of several hundred thousand dollars to get the property compliant with any and all codes in place. And any cannabis brand hoping to stay competitive in this market will have to pay additional costs for research and development, marketing, design work, and lab testing on each batch of flower, concentrates, edibles, or topicals that they produce.

The Birth of Big Canna

High costs make it increasingly difficult for small business owners to compete, even for businesses that have been established for years. Countless farmers who have been growing cannabis for decades on the black market are finding themselves unable to secure the necessary permits and paperwork that the state now requires. Part of that problem is what many growers see as a flaw in the legislation itself.

Proposition 64, which legalized adult recreational use of cannabis, was put on the ballot with a provision that was ostensibly meant to help small farmers gain some footing before corporate interests could move in. The state wasn’t supposed to issue licenses for any grow operations larger than one acre until 2023, approving only small cultivation licenses for the first five years of the legal market.

But after California voters approved Prop. 64, the state’s Department of Food and Agriculture seemingly shifted course by allowing growers to compile an unlimited quantity of small grow licenses. NBC News found that one business in Santa Barbara secured 200 licenses covering 46 acres of land. Another report from the Sacramento Business Journal found that in February 2018, just two months into the legal market, 10 businesses had already gained control over a combined 30% of the grow licenses issued by the state. Some organizations are fighting to protect small growers. But many in the industry fear that the cannabis world is being primed for a major takeover by big corporate interests, in the same way that the agricultural industry came to be run by monoliths like Monsanto.

Seeking Funding From Unexpected Places

To make matters even more complicated, most banks will not work with cannabis companies because cannabis is still a Schedule 1 drug at the federal level. Some banks will allow cannabis businesses to make deposits and withdrawals, but securing a bank loan to open a dispensary or grow operation can be difficult for aspiring small business owners. That’s where the real money in cannabis comes in.

Since most small cannabis operations struggle to get a loan through mainstream banks, they often end up turning to outside investors for funding. Private equity firms, venture capital firms, and individual wealthy investors will finance a burgeoning cannabis business, but this route often requires a greater return on the loan than a bank would charge.

If aspiring dispensary owners or growers don’t want to take on a huge amount of debt, they may need to sell off part of the company to an outside investor, which means they could lose some control over their own business. Yet even this option isn’t a guarantee for funding; some investment firms require that a cannabis business be in operation for at least six months and pull in steady revenue before being considered for a private loan. One private firm requires that any cannabis business seeking funding must make at least $10,000 in gross monthly transactions. The odds of successfully competing against a corporate-backed enterprise seem daunting to many growers, manufacturers, and dispensary owners, meaning a small business owner looking to enter the legal market for the first time may already be out of luck.

Enabling The Black Market

The majority of cannabis grown in the state continues to find its way to the black market, either in California or (more lucratively) in other states. Some growers who used to operate on the black market have tried to apply for legal permits. But out of the estimated 68,000 cannabis grow operations across the state, the California Department of Food and Agriculture reports that only 8% have applied for permits, and only 5% have had their permits approved.

Nearly 60% of the state’s growers will not be able to secure permits due to a lack of funding, business savviness, or up-to-code facilities, and many of those growers will most likely leave the industry or find work with someone else’s operation.

A whopping 30% of current cannabis growers across California - roughly 20,000 farms - plan to continue operating within the black market, according to the California Growers Association.

Part of the problem is that there’s still a steady demand for black market cannabis from consumers in California. Dispensary owners across the state have noted that the increased cost of legal cannabis sales due to high state and local taxes (up to 45% combined sales tax in some cities) has caused a dip in business. Some consumers may simply be smoking less cannabis to save money, but many of them are buying from black market growers and dealers instead of going through legal, regulated dispensaries. Unless the state takes active steps to adjust taxes and incentivize permitting for businesses (or at least ease the process), it’s likely that the black market will continue to be a part of the cannabis conversation for the foreseeable future.