Comparing Marijuana Licensing Models

One of the key provisions states enact when they pass marijuana legislation is their model for how the state will dole out marijuana business licenses. We have worked on license applications in many states, including Washington, Nevada, Florida Illinois, Minnesota, New York,  Every state has presented unique challenges, but how they run the licensing process can be split into a few key decision points. This post will look at three of these decision points and run through some of their pros and cons.

Recreational MarijuanaState Residency — Washington and Colorado led the charge for requiring business owners and operators to reside in the state where they are operating the marijuana business. Most of the other states have not had a residency requirement, though many of them did include state residency as a positive factor in their application scoring systems where there was a competitive process in place. At first glance, it is easy to see the draw of state residency. The state wants to see its own residents rewarded for the legal risk that the state is taking. The federal response was also unclear early on, as the federal enforcement memoranda all warned against leakage from marijuana-legal states to states where it was still illegal. Would the federal government treat cannabis money moving between states as “leakage” or as an independent reason to prosecute, even where the product itself all stayed in-state? Nobody really knew, and the U.S. Attorneys were coy about it.

The big drawback to residency requirements is that they severely limit access to capital. Financing is harder to come by if the pool of available financiers is severely limited. Even when a company can find it, the cost of the capital is higher because the competition for providing that capital is small. This is one of the reasons why the cannabis debt market in Washington is still so expensive. Servicing this debt has proved and will continue to prove to be a big burden for a large number of marijuana businesses in places like Washington, and it will lead to marijuana business’s cutting expensive regulatory corners to scrape by or failing outright. It looks like the financing market is stabilizing somewhat, as more conservative financiers are seeing that the early adopters have not run into any trouble, but allowing interstate financing would still be a good thing for the cannabis industry.

Vertical Integration — Bans on vertical integration — that is having a single company or set of owners operate the production, wholesaling, and retail operations of a cannabis business — stem from a prohibition mindset. Early post-prohibition states had the idea that separating alcohol manufacturers, distributors, and retailers would put a damper on corporate encouragement of heavy drinking. The model has had limited success in that arena.

For marijuana businesses, vertical integration can present a good way to mitigate the damages of the federal tax system. Marijuana businesses cannot deduct regular business expenses, but they are allowed to deduct their cost of goods sold. So, a vertically integrated business has fewer regular expenses because it can combine advertising and accounting and other business items into one pot. Its cost of goods sold will end up being a higher percentage of the year-end expense tally, and it will be in a better position for deductions.

On the other hand, market economics have generally proved that businesses that go horizontal by having third parties do more of their work often see cost savings, especially in highly competitive markets. It is hard to be good at a lot of things all at once. What will be interesting to examine after we have more market data is whether being vertically integrated in a state that allows it leads to better business outcomes than those businesses that chose to concentrate on just the production or retail end.

Liquidity Requirements — Setting up a marijuana business in highly regulated markets is really expensive. Fire suppression, security operations, database software that connects with the state, and other similar expenses add up. States understand that, and many of them have requirements that applicants show a certain amount of cash on hand prior to startup. The number is often in the $250k – $500k range for each license applied for. This serves as a streamlining factor in the process, so that only those that can afford the high cost of compliance are going through the license application process at all. By showing significant cash in the bank and legitimate sourcing of it, the state licensing agency has one fewer headache.

That requirement, however, can serve as a real barrier to entry to those that would still be legitimate players in the market. Many applicants for cannabis licenses have their investment wealth tied up in assets that either are not liquid or would be penalized upon liquidation. They want to have some assurances that their application will go through and that their license will be approved before they convert those assets into cash. When a state mandates seeing cash in the bank at the outset, many applicants have to decide between declining to move forward with the application process or taking a gamble by liquidating their assets, and potentially getting nothing for those liquidation costs if their application is not selected. Also, financiers are often not as attuned to the licensing process until after it has begun. Requirements in cash up front limit the pool of available capital, and it keeps some money on the sidelines that could have been provided at cheaper rates and to a more competitive pool.

Licensing so far has created winners and losers in every state, and it will continue to do so. As more and more states come online, the licensing paradigm has begun to harden, coalescing around substantially similar application requirements and review protocols in each state. Legislators and initiative drafters need to understand all of the pros, cons, and unintended consequences of the decisions they make as they draft and revise implementing legislation for marijuana legalization.