Determining a valuation for a cannabis business is more of an art than a science. In any industry, investors and entrepreneurs or buyers and sellers come to the table with different ideas about how much a business is worth. When you combine this nuanced process with the dynamics of the cannabis industry—shifting legal regulations, market uncertainty, and no standardized valuation metrics— how can investors and entrepreneurs or buyers and sellers agree upon a number?

Today, I’ll share my top three tips for determining a valuation of a cannabis business. Of course, there are many unknowns in this market and there is no definitive approach or methodology to determine the “final, official value” of a business. However, I am a strong believer in George Box’s aphorism, “All models are wrong, but some are useful.” We might have to be more creative to evaluate a cannabis business, but it’s possible to apply many of the valuation principles and techniques used in other emerging markets.

Side note: it’s best to hire an independent party to create the valuation—it will carry more weight with investors or buyers. Get in touch for a consultation!

Tip 1: In most cases, use the Income Earnings Method.

There are a few common ways to establish the value of a business. You can use the “asset approach,” which assess the value of the business’s equipment, real estate, and patents, subtracts its liabilities, and essentially determines what it would cost to re-create the business. This traditional accounting approach comes with limitations. The balance sheet doesn’t tell the entire story; a cannabis business could earn millions of dollars in annual revenue with a rented warehouse and one extraction machine. On the other hand, a business could have millions of dollars worth of cannabis cultivation equipment, but if it doesn’t have a license, it can’t produce revenue.

The asset approach also eliminates the dynamic market factors that to come into play in the cannabis market. It’s tricky to nail down a quantitative value of a licensee to cultivate or manufacture cannabis and these are always shifting depending on the state’s regulatory structure. Dispensary licenses are selling for $4.5MM in Los Angeles based on current market demand, but putting that value on a license in Denver wouldn’t make sense at all.

Next, you could try the market approach, where you would look at the sale prices for comparable businesses. There are few publicly traded cannabis companies on the market at this point, so this approach relies primarily on gossip. You might hear that a nearby dispensary sold for $1.5MM but not have the documentation to prove it. The talk of the town can be a good talking point for negotiations, but it’s not sufficient to establish a credible valuation.

And lastly, you have the income or earnings approach, which I’ve found to be the most sensible and reliable way to figure out a value for a cannabis company.

In short, this method draws on the economic principle of expectation to determine the value of a business. We figure out the returns a purchaser or investor can expect to receive from the business in the future and how much they should pay for these returns. Of course, there are no guarantees (especially in the cannabis market), so we have to match these potential earnings against the risk associated with receiving them. To really understand the future earnings of the business, I create future cash flow projections and then discount them using a “discount rate” or “capitalization rate”

Tip 2: Consider Long-Term Market Dynamics, and Don’t Put too much Weight on the Short-Term ones.

The supply and demand dynamics of the cannabis market are constantly shifting. In 2015, Maryland awarded 15 licenses to cultivate medical cannabis in the state. Three years later, the state issued seven more cultivation licenses and is facing outside pressure to issue more. Oligopoly market structures typically don’t last for more than a few years in the cannabis industry, so if you are creating forward-looking projections, it’s crucial to account for additional suppliers that could come online.

On the other hand, there also market dynamics that may affect demand in the short term, but won’t matter for the long-term growth of the company. This could include a spike in sales on 4/20 or a drop in prices in October because of a market surplus from the outdoor harvest. Don’t put too much weight on short-term market dynamics when analyzing a business’s historical financials.

There is no way to predict the future or pinpoint exactly how the cannabis industry will evolve. But it’s important to run a number of different scenarios to account for ways the market could shift and how a business’s revenue may be impacted. The forward-looking financial projections need to account for additional suppliers, lower market capture rates, price degradation, and the potential effects of federal legalization.

Surviving federal legalization is a different topic entirely. But to do a quick smell test, I would look at the company’s profit margins, customer retention rates, patents or trademarks, and their operating and regulatory history. Is the business protecting its brand with a trademark or its processing methodology with a patent? Are they skimming by with their profit margins or could they survive if the market were to be saturated with cheaper products? Does the business have any regulatory violations? Do they have quality financial records? A business with a recognizable brand, a good reputation, quality financial records, and patented technology is much more likely to survive or be acquired by a bigger business upon federal legalization.

Tip 3: Use conservative cash flow projections and a high discount or cap rate.

Cannabis is a high-risk industry and investors and entrepreneurs are going to face a lot of uncertainty. While we can still approach the valuations scientifically, the assumptions built into the model need to be very conservative to reflect the level of the risk. First, I recommend running base case and conservative projection scenarios that account for different business growth scenarios.

Second, I recommend incorporating the risk level into the discount or capitalization rate, which you would use to calculate the Net Present Value of the business from the financial projections. In a Management Issues paper discussing “How much is your private business worth?” law firm Grant Thornton LLP offered this opinion:

“Well established businesses with a history of strong earnings and good market share might often trade with a capitalization rate of, say 12% to 20%. Unproven businesses in a fluctuating and volatile market tend to trade at much higher capitalization rates, say 25% to 50%.”

I tend to classify most operational dispensary and manufacturing business as a “Class 3” risk category, defined as a small to medium-sized business with a possible fast growth situation but limited available capital and a less stable earnings pattern. The recommended discount rate for a Class 3 business is 20% to 35%. I would classify a brand new cannabis business in the Class 4 risk category, with a 35% to 50% discount rate. Again, no discount right is completely accurate, and I would recommend running a sensitivity analysis to determine the Net Present Value of the company with a range of discount rates.

And my last tip: I like to remember the old saying “whoever has the gold makes the rules.” Ultimately, a business is worth whatever a buyer or investor is willing to pay for it. If an investor will pay $10MM for 10% of the company, the business is worth $100MM. If a buyer is willing to pay $2MM, then the business is worth $2MM. Valuations are a useful tool, but ultimately, don’t get tied to any value and come to the table ready to negotiate.