Funding Freeze: What’s Next for Cannabis Startups?

While many might see a hot market, a closer look reveals a chilling reality: a mix of economic uncertainties and market dynamics are causing some investors to pull back.

Regulatory Uncertainty and Federal Prohibition

The cannabis industry is not an easy place to make a profit. The continued federal prohibition of the plant means the industry is subject to IRS Tax Code section 280E, removing the ability to take most normal business deductions. This disproportionate tax severely impacts the profitability of operators in this space and eats up cash flow, neither of which sounds good to investors. The patchwork of state regulations that exists in the absence of federal legalization makes it complicated to operate within multiple states, a huge operational hurdle to scaling.

If that weren’t enough, the industry also faces massive banking barriers for both plant-touching and ancillary businesses. While there are more banking options than a decade ago, the lack of progress on the SAFE Banking Act means this isn’t likely to change anytime soon.

Market Maturation and Oversaturation

While a new cannabis market is thought to be a wealth of profit potential, as the market ages, operators face a new problem: oversupply. Too many licenses in a given sector of the supply chain, too much product on the market, and too many people trying to undercut the competition mean the more a market matures, the more competitive and less profitable it becomes. Since most consumers see cannabis products, particularly flower, as generally interchangeable, there is also a problem with commoditization and increasing prices.

Oversupply in a market can also lead to high burn rates, as enthusiastic investors jump in with both feet and no clear plan, leading to unsustainable business burn rates. Watching the same pattern play out across legal states time and time again has eroded investor confidence in long-term returns and dried up cannabis funding.

Past Disappointments & Investor Burnout

If an investor is curious about funding cannabis startups, one of the first places they’ll look is at the stock market. Historically, publicly traded cannabis companies have underperformed, missed revenue targets, and generally been bad investments. This lack of performance does nothing to assuage investor fears about the unprofitability of the cannabis industry. If an IPO doesn’t make a cannabis company profitable, investors are unlikely to be interested.

Additionally, M&A activity in cannabis has been on the decline, which is an exit strategy that many venture capitalists are interested in. In short, past performances have shown that there’s not a lot of money to be made in cannabis—and investors are all about that return.

Broader Economic Headwinds

The cannabis industry doesn’t exist in a silo, and when economic confidence is shaken in other areas, it trickles into this cannabis funding too. Rising interest rates and inflation make capital more expensive and reduce investor appetite for “high-risk” ventures across all industries. Given the very real fears about a potential recession, many investors are pulling back in their portfolios, leaning into steady investments and away from nascent, turbulent, or federally illegal industries.

Just because traditional investment options aren’t playing out for cannabis startups does not mean there aren’t other options to seek funding through. As with most things in cannabis, it simply requires perseverance and creativity.

Non-Dilutive Cannabis Funding Options

With traditional equity funding often leading to dilution, cannabis companies are increasingly seeking alternative, non-dilutive options to finance their growth and maintain control of their businesses.

State & Local Grants (Social Equity Focus)

Some states, like New York and Colorado, offer special funding specifically for social equity applications and/ or businesses operating in “disproportionately impacted areas,” like the Colorado Cannabis Business Grant.

To access this line of funding, consider a business partnership with someone from the legacy market or placing your operations in a neighborhood that was impacted by the war on drugs. Applications for this line of funding will still need a strong business plan that demonstrates market need and community benefit.

Strategic Partnerships & Joint Ventures

Perhaps you don’t need to build an entirely new business from the ground up; perhaps the best route lies in collaborating with established businesses in the cannabis industry. Where can you fill a need for a dispensary that grows its own flower? What’s an outstanding tech need that manufacturers could use help with? If you can provide a unique and beneficial resource to an existing business, they may be willing to support you with capital, resources, real estate, or market access.

These types of partnerships only thrive when the benefit to both sides is clear, communication is open, and values are aligned. Partnerships like this take time and professionalism to establish, but offer a unique route of entry into the cannabis market.

Non-Traditional Lenders & Debt Financing

In the absence of traditional banking options, niche solutions arise—like the emergence of private lenders specializing in lending to cannabis and hemp companies. Smaller credit unions like FundCanna and local banks may also be an area of alternative financing. While a business owner must carefully consider the potential interest rates and collateral requirements, working with cannabis-specific lenders or a credit union may open an alternative route to financing equipment, business loans, lines of credit, or merchant cash advances, all of which can be a major breakthrough for a small cannabis business.

Community-Based & Grassroots Funding

Crowdsourcing startup cash is an option that’s become increasingly popular in recent years, and may work well for community-based cannabis businesses. Crowdfunding platforms like Wefunder offer the opportunity for a community to invest in businesses they believe in, and take the financial power out of the hands of banks that refuse to play ball.

And then there’s the classic funding source: friends and family. Entrepreneurs have been getting seed money from loved ones since time immemorial, and in the absence of traditional startup funding, offering a friends and family round of crowdsourcing can bring in a much-needed cash influx.

Ancillary Business Focus

Plant-touching businesses have the most challenges with finances, federal restrictions, and 280E. Ancillary cannabis businesses, like software development, packaging, security, and consulting, often do not face the same challenges and have a much easier time finding banking. Ancillary businesses are often not subject to 280E, which is a huge boost to potential profitability.

If you are set on attracting investor interest, there are a few best practices to follow.

Insurance as a De-Risking Tool

Insurance may not be the glamorous side of a cannabis business, but it is a vital piece of de-risking. A comprehensive umbrella of insurance provides a financial safety net that mitigates potential financial shocks from unforeseen events like fire, theft, and crop loss. Most investors won’t even consider a business that does not have the proper insurance to protect business assets, and oftentimes, non-traditional lenders require specific insurance policies as a prerequisite for funding. Having robust insurance in place now signals a level of business maturity.

Key Insurance Coverages to Highlight for Investors

While the exact umbrella of insurance coverage your business needs is unique, there are a handful of policies that are important for most cannabis businesses to hold.

1. Commercial Property Insurance: 

Property insurance protects your business’s physical assets like your building, equipment, and inventory, from unforeseen perils, including fire, theft, and vandalism. This policy is vital for proper protection, but also must be customized to provide the level you need; an accurate business valuation is important.

2. Commercial Crime Insurance: 

Crucial for cash-heavy cannabis businesses, this policy protects you from theft from any source: employee dishonesty, transport theft, robbery, forgery, and even computer fraud. Crime insurance provides a valuable safety net for your cannabis company against damages from crime.

3. General Liability & Product Liability: 

These are two separate, but equally important policies. General liability protects your business against third-party bodily claims of injury or property damage (sometimes called “slip and fall” insurance). Product liability provides a safety net against claims of defective products or adverse side effects, which is vital for investor confidence in your company.

4. Crop Insurance: 

This policy is essential for cultivators to protect their bottom lines. It provides coverage against financial losses resulting from crop loss due to peril. These policies are specifically written to cover the entire lifespan of a plant, from seed to finished stock, which offers stability to the supply chain.

5. Cyber Liability Insurance:

In today’s digital world, a cyber safety net is a necessity. Cyber liability protects your business from lawsuits relating to “electronic activities” and can be customized to add recovery benefits and reimbursement as well.

6. Directors & Officers (D&O) Insurance: 

For larger cannabis companies, D&O insurance is crucial to attracting investor attention, offering vital protection for the company’s executives and their personal assets.

Strategic Insurance Placement

Getting the right umbrella of cannabis coverage is vital to your business’s long-term success—and the partner you work with matters. The cannabis industry can be challenging to understand, which makes it all the more important that you work with an insurance broker who has cannabis-specific expertise, so you can feel confident in your risk management and coverage.

General insurance policies are often insufficient in the cannabis industry; customization and accurate company valuation are key to getting complete protection—and the interest of investors.

In a climate of economic uncertainty, cannabis businesses must shift their focus to demonstrating stability and mitigating risk in order to attract and secure crucial investment.

Financial Prudence & Operational Efficiency

Are you as lean as you could be? Operational efficiency during tough times means running a lean, mean fighting machine—or at least an organization that has an unwavering eye on optimizing supply chains and cost-cutting. This requires constant management in the form of record-keeping and financial reporting, both of which can help your business develop accurate forecasting.

Financial prudence takes on a new importance in the cannabis industry, where there is a surplus of companies avoiding their outstanding invoices. Companies must strategize for cash flow, managing receivables and payables as if their business depends on it—because it does. In today’s digital world, there are many options for instant digital payments to avoid those dreaded “Net 30” terms—consider one.

Robust Compliance & Governance

Compliance is the backbone of long-term success in cannabis; a noncompliant operator is not one who will hold onto their license for long. Putting compliance at the forefront of your business and risk management plans ensures that your business stays within the lines. This can take many forms, but may include robust inventory management and compliance systems. Many states require Seed-to-Sale tracking, but going above and beyond what is required is a great way to reduce certain risks, like diversion.

A culture of compliance comes from the top down, where employees are empowered to speak up if something isn’t right. Regular audits of your functions, such as security and finances, are a good way to identify potential vulnerabilities or areas of risk and show commitment to insurance providers and cannabis regulators. A culture of compliance also comes from a work environment where things are done by the book and to the letter, a mandate that is made much easier with comprehensive standard operating procedures across all departments.

Enhanced Security Measures (Physical & Digital)

Cannabis businesses face an increased risk of theft and burglary, and an occurrence of one or the other can rock a business out of stability into dangerous waters. Investing in robust security measures is important for long-term success, and often mandated in certain insurance policies. Advanced surveillance systems, tight access control, and secure cash handling protocols are best practices, but are also often mandated requirements for risk management.

Theft can also occur digitally, and cannabis companies must go the extra mile to protect their digital assets well, using multi-factor authentication, data encryption, and regular employee training on cyber threats and best practices.

Building a Strong Team & Advisory Board

A successful team has the right people in the right positions. But getting the right people in those positions and retaining them is a success strategy unto itself. Companies offering minimum wage salaries for “experienced” positions, or asking C-suite employees to work without benefits, will never attract top talent—in cannabis or any other industry.

In cannabis, however, building the right team may not require hiring a staff of full-time employees. Success may come from building external partnerships with legal, accounting, and risk management professionals, or by engaging fractional positions for CMO, CFO, and other similar roles. Flexibility and creativity are encouraged to attract the right people—but cutting corners is not.

The current funding freeze within the cannabis industry is a necessary but unpleasant market correction. As the cannabis industry continues to mature during its second decade, cannabis startups must too, showing greater strategic foresight with market resilience.

It won’t be an easy path forward—but blazing a new path never is. It required creative thinking, alternative funding, and rigorous risk management to build a company that stands the test of time in an industry still finding its feet. The founders who will make it are the ones who fearlessly tackle the intimidating and less attractive side of doing business, taking every chance to turn a challenge into an opportunity.

Protecting your cannabis company can seem confusing; however, we’re a full-service insurance brokerage working with carriers worldwide to offer you the best coverage possible. We’re here to help! Please reach out to us today by email [email protected] or calling 646-854-1093 for a customized letter or learning more about your cannabis insurance options.