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Cannabis Startups Navigate Regulations, Lack Of Capital To Plant Industry Seeds

Illustration of cannabis in a jar and payment via smartphone.

Startups in the background of America’s cannabis industry are developing the infrastructure and support system for the budding industry, and experts say federal legalization can open the floodgates for more activity and venture capital investment in the sector.

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“Cannabis dispensaries were labeled ‘essential’ and stayed open during the pandemic in California,” said Sam Dibble, partner at the law firm Baker Botts’ San Francisco office. “It makes a statement that, at the government level, these businesses are being taken seriously, as well as the role they play in society and highlighting opportunity for growth.”

The industry itself is still in startup mode as it waits for states to legalize weed either medically and/or for adult recreational use. In March, New York became one of the latest states to legalize cannabis, following 35 others that have also legalized the substance in one of those two ways.

All told, investors have injected $5.3 billion in known venture capital into 544 cannabis-related companies globally since 2014, according to Crunchbase data. Funding seems to have peaked in 2019, when nearly $1.9 billion was handed out to 178 companies. In 2020, investment dollars were down nearly 68 percent from the year prior.

One reason for the decline in available capital was companies putting out unrealistic projections they were not able to meet, according to Jim Cacioppo, founder, chairman and CEO at Jushi Holdings. Now, the market is separating out the winners and losers, and capital is coming from hedge funds and family offices versus just from venture capital, he added.

Crunchbase data shows 2021 investment in the space is rebounding a bit after last year’s lull. Some $357 million has gone into 29 companies so far, led by a $200 million Series C round last month for Dutchie, which outfits dispensaries with the technology and tools needed to provide safe and easy access to cannabis.

Seeking out public markets

Companies building infrastructure for the fledgling industry have found success supporting cannabis businesses with their sales, retail, cultivation, e-commerce and delivery operations, according to Cacioppo. Along with growing its own product, his Florida-based company develops and operates facilities for cannabis retail and brands.

“We find that 70 to 80 percent of customers would prefer to go online, look at what is available, preorder and come in and pick it up,” he said. “Our system is designed to do that.”

Jushi is what’s known as a multi-state operator (MSO), which is a U.S. company involved in the legal production and distribution of cannabis in states where the substance is approved. MSOs typically aim for vertical integration into the industry, but raising capital to do all of that was a struggle, Cacioppo said.

Some MSOs tried to raise money via the public markets decades ago, but ran out of money when the markets closed to them, he added. Within the past five years, MSOs were able to successfully list on the public markets, and some venture-backed operators even enjoy billion-dollar-plus valuations, including Curaleaf and Green Thumb Industries, according to Motley Fool.

Cacioppo believes that what’s changed is that those stocks have done well over the past 10 months, and the companies are attracting investors due to positive performance metrics.

Parallel, Ascend Wellness Holdings and Gage Cannabis are three recent examples of cannabis companies tapping the public markets for capital.

In February, Parallel announced plans to go public via a merger with special purpose acquisition company Ceres Acquisition Corp. in a deal that values Atlanta-based Parallel at $1.88 billion.

Company chairman and CEO William “Beau” Wrigley Jr. said in a written statement that the move would enable the company to “accelerate existing investments to transform not only our company but also the cannabis industry … As a public company, we will have access to capital to grow our national footprint through new licenses and M&A, improve our cultivation and production capacity, expand our established retail footprint, develop and launch rare cannabinoids products with therapeutic benefits, and conduct important clinical research in partnership with the University of Pittsburgh Medical Center.”

Then in March, Boston-based Ascend filed for an initial public offering of up to $125 million, according to its U.S. Securities and Exchange Commission filing, while Gage Cannabis applied for a direct listing in Canada and began trading this month.

Calling all investors

Banks are generally prohibited from dealing with cannabis businesses because the substance is still illegal on the federal level. Some venture capital firms are also not yet willing to take the risk of working with cannabis-focused businesses, so capital is coming from other sources so those businesses can keep evolving rapidly, Dibble said.

Those investors who put money into the cannabis sector often back what Dibble called the “ancillary businesses” — companies that support the growth, processing and sale of cannabis, such as compliance, crop monitoring, point-of-sale, payment processing and order tracking. These are the areas where innovative technologies have emerged, such as blockchain-enabled nanodots that can track plantings, Dibble added.

Although some VC investors are sitting on the sidelines due to the risk involved in putting capital into something not yet federally legal, others have more desire to get involved in funding weed, said James Pelligrini, managing partner at Goat Rodeo Capital, a venture capital fund focused on early-stage alcohol beverage companies.

“Most invest in cannabis and not much else,” he told Crunchbase News. “Our funds operate in a similar space and include cannabis. Our background in beverage and alcohol, as well as understanding how brands can grow in regulated environments, gives us interest in the space because of the nascent characteristic of it today.”

Meanwhile, Pelligrini believes no other industry has such growth potential right now, but being a fragmented industry due to the heavy regulations is causing some sectors to lag in availability, such as cannabis beverages. There is a growing demand, but a limited number of existing production and distribution facilities will get involved, he said.

“A large network of backers dealing with non-alcoholic drinks were prohibited from working in cannabis, but we are starting to see a couple of players emerge to create what looks like long-term companies in this space.”

Inside the industry

Cy Scott, co-founder and CEO at Seattle-based Headset, operated in the cannabis space for more than 10 years. He previously co-founded Leafly, a website to rate and review cannabis and dispensaries, which was acquired by Privateer Holdings in 2011. At that time, no adult-use markets existed, and venture capitalists didn’t see it as an addressable sector, he told Crunchbase News.

After leaving Leafly in 2015, Scott started Headset, which provides a business intelligence platform for the cannabis industry. To date, the company has raised $19.2 million in venture capital funding, according to Crunchbase data.

“Dispensaries can have a product catalogue with hundreds of thousands of SKUs, so we help them level the playing field by giving them the tools to understand the inventory carry and turn, as well as customer demographics,” Scott said. “When there is federal legalization, there would be retailer-specific tools that they can use, but it is currently a challenge with the fragmentation and state-by-state models.”

On the grower side, Agrify is a Massachusetts-based developer of indoor grow tools for cannabis and hemp. Now a public company, it raised $79.5 million in venture capital since being founded in 2016, according to Crunchbase data.

Michelle Sitton, Agrify’s senior vice president of marketing, told Crunchbase News that cultivators must deliver high-quality products across markets and do it at the lowest possible costs. By integrating data into decision-making, cultivators can tweak their environment to produce a consistent product, she said.

Early innovators in the industry were small growers, extractors and retailers. Many of these ancillary businesses are still in the startup phase, she said, but as the industry grows, she predicts bigger players will enter the scene.

“Startups built the infrastructure and now ancillaries are building it,” she added. “While vertical farming is big, we are not seeing others yet combine expertise with software that gives you millions of data points to tell you how one strain of genetics performs on certain days. The ability to go fast and innovate, with AI playing a big part, is what is going to drive this segment of the business.”

Compliance software and database services company Fyllo is growing quickly, co-founder and CEO Chad Bronstein told Crunchbase News. The company raised $60 million in under two years, most recently a $30 million Series B round earlier this month.

Regulations differ state-to-state, so business owners leverage Fyllo’s software to understand and comply with those rules. That includes advertising for marijuana products, which was not possible two years ago due to the many regulations, Bronstein said.

“This is a sophisticated arena, and cutting corners will cost a lot of money,” he added.

Bronstein expects the cannabis industry to attract more investment. About 60 percent of investors into Fyllo’s recent round were new non-cannabis investors, he added.

“That is a signal to us that it is opening up,” Bronstein added. “Limited partners are taking this seriously and don’t want to miss more opportunities.”

Cannabis industry of the future

The future of the cannabis industry will depend on federal legalization, experts say.

Jushi’s Cacioppo believes regulators need to pass laws that make sense and that companies can execute on. At the same time, states need to create successful medical marijuana programs from the beginning, which can include patients registering with a state’s department of health or setting up a prescription program. Some already do well, such as Illinois and Pennsylvania, he said.

Consolidation is likely as multi-state operators roll up mom and pop shops, and as restrictions ease up on who can apply and get operating licenses, according to Headset’s Scott.

And, as startups continue to build cannabis’ infrastructure, it will evolve and mature, Goat Rodeo’s Pelligrini said.

“What we enjoy about the process, and this new market being created, is getting to watch something that we spent so long as a community talking about — and what it would look like — coming to fruition,” he added. “We are a place to watch smart companies lay down the groundwork for what this will look like going forward.”

Illustration: Dom Guzman

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