The Three Core Things Merida Looks For In Our Cannabis Investments
Guest Post by Mitch Baruchowitz, Managing Partner at Merida Capital Partners
Like the internet in 1999, cocktail party chatter is now all about cannabis. I hear people speaking about medical, adult-use, legalization, limited-licensing, descheduling, ballot measures and it reminds me of discussions around bandwidth, pay per click, eyeballs, bounce rate, and uniques. Like early internet investing, cannabis is in hyper-growth, but the challenge in finding the right company to invest in vexes people in much the same way the fragmented electronic landscape did almost two decades ago. Even deciphering which vertical to try and identify a company can be taxing. Add in federal illegality, and you can see why so many investors are in a holding pattern on the industry, even if billions have poured in over the past 3 years.
The public market for cannabis companies is still developing, which leaves the vast majority of investment to the private market. My partners and I formed Merida to take advantage of our sector knowledge and provide a vehicle for rational, institutional quality asset management in the emerging cannabis investment landscape. While there is a panoply of ways to invest in the space, our focus on infrastructure and ancillary companies that do not directly touch the cannabis plant allows us to formulate an investment thesis that has its underpinnings in traditional investment metrics, with a cannabis angle. Due to the incredible entrepreneurial spirit flowing into the industry, there are hundreds of opportunities that cross our desks monthly. Virtually everyone I have spoken to in the past year has received a deck, business plan, forwarded opportunity or other chance to invest in a cannabis company. The core issues we hear most are: How do you evaluate the companies, and what are the non-obvious risks that investors should look for in their own investments?
Merida is a sprout stage investor focused solely on ancillary investments. We look for successful companies in the ancillary space, broadly defined, who are entering the hyper-growth stage of their lifecycle, and we work to supercharge that growth while helping to build necessary corporate infrastructure, rational capital support and governance around bold executives. We have identified three core tenets that we rely on to help us cut through the static to get right to the signal and decide which companies fit our initial review.
We hope these can help individual investors frame their own foray into potential cannabis investments and bring a more efficient capital market into play which benefits the entire cannabis ecosystem. These are not bulletproof dispositive factors, but we have seen over the past 4 years that by applying these initial filters, we can identify companies that are most likely to ultimately grow into successful enterprises with long term value far in excess of their current value. All of the companies currently in the Merida portfolio, which we will discuss briefly throughout, have these three qualities in common. If you seek to invest in earlier stage companies, or cultivation, these three qualities may not be as helpful to your research and diligence.
1-Crossing The Fragmentation Gap
Due to the federal illegality of cannabis, the landscape is more fragmented than any industry we have observed in modern times. There are thousands of companies being launched to serve the needs of operators, governments, regulators and the like annually. Operators in each state have a different environment that does not translate perfectly to any other state regardless of some similarities each state share. In order to reduce risks inherent in an ecosystem that is being built from the ground up across multiple states (and countries) with differing rules and operator profiles simultaneously, it’s essential to find companies that have accumulated a base of business that offers predictability. Without an analog to analyze this unique opportunity, the most important requirement Merida has of any company we are targeting is that they have crossed this “fragmentation gap”, which is the term Merida uses to describe the natural transition between operational launch and stable, sustainable revenue generation and growth. We essentially let the market show us if a business has a rational strategy, and a widely desired product or service. To determine if someone has crossed the gap, we use 30 individual factors to create an “adoption score” which acts like a vote on a company’s relative attempts to cross the “fragmentation gap”.
While you may not have an algorithm handy to score your investment target, we balance the risk of exogenous events in cannabis by pursuing enterprises with big target markets that appear to be hitting them in a manner that lends itself to long term growth befitting a market growing with one of the highest CAGRs in history. Wrap professionalized strategy, governance and capital support around hyper-growth, and great things can occur.
As an example, when we first evaluated data and analytics company New Frontier Data, they were best known for an annual industry report that was incredibly helpful to operators and non-operators alike who were looking for raw data and information to help guide decision-making. They had modest revenue which initially hurt their Adoption Score. However, everywhere we turned, operators and regulators had not just heard of New Frontier, but it seemed like everyone was actively reading the reports, or their newsletter, the CannaBit. At a time when large ancillary companies had 20 clients, or maybe 50, New Frontier was communicating with thousands of people. Vendors who served operators horizontal to New Frontier were in active discussions on sharing their anonymized data with New Frontier in pursuit of strategic goals. And most importantly, they were collecting information that we at Merida were looking for and knew we would need to make smart decisions as we implemented our investment thesis.
As we drilled through our filtering system, New Frontier’s adoption became apparent even if revenue had not yet followed, like many SaaS companies. We used traditional SaaS metrics to look at New Frontier’s business and realized that even though they were focused on cannabis, their trajectory was very common for SaaS and data-focused companies. A year after our investment, New Frontier’s data is ubiquitous. Equio, their platform for delivering operator tools, analytics and data, was recently launched and now has thousands of users. They have been featured on the cover of the Washington Post, and their data was cited in the preamble to a congressional bill that seeks to change the taxation of cannabis. If you open a newspaper article on cannabis, you have an 80% chance of reading data New Frontier has collected and distilled.
Rule #1: Focus on adoption and make sure your investments have crossed the “fragmentation gap”
2-Management With Relevant Experience
After you have found a company that looks to be adopted, we recommend focusing on management. The angle we believe gives us the greatest insight into potential success of a management team is the relevance of their background to the goals of their company. Merida loves the entrepreneurial spirit that is currently being unlocked in the cannabis industry. Its the most incredible thing we see daily. To be a good steward of capital requires us to look a bit deeper than passion and opportunity into probabilities of sustained growth. We love intelligent management (who doesn’t?). We love sophisticated and polished executives (everyone does). The problem we are trying to address in our assessment of management teams has more to do with our investment backgrounds than cannabis, per se.
Our team has made hundreds of investments collectively over our careers, possibly thousands. The earlier the company, the bigger the risk and the more difficult it is to make accurate prediction of results. We have often made investments that had a big name involved or an executive with success from another field. Many people like us have invested in an executive leading a new company after a big exit. Our opinion is the results do not often follow.
To do that, we target companies whose executives have encountered the specific species, and kingdom and phylum for that matter, of challenges they are likely to see in their current company. Every growing company faces challenges that must be met intelligently. Cannabis offers unique challenges that other industries don’t have. It requires a pioneering spirit and force of will to push through these unique issues. We admire all of the companies that have shown that will and intelligence, and the number is large, and getting larger every day. However, it is our belief that regardless of how smart or polished an executive team is, people who have lived through identical challenges in other arenas will be able to meet those, and the challenges of cannabis, more efficiently, with less disruption to their business. They will better understand the long term consequences of actions taken and will better project their results and give you, the investor, better predictability, which gives you greater ability to assess their performance. That is a virtuous circle we aim for.
When we performed diligence on GrowGeneration (OTCQB: GRWG), we saw a retail-focused business that needed to transition enterprise level sales if it were to really scale. GrowGeneration’s management team has a background in retail sales and distribution and in one case, one executive had extensive experience with getting consumer beverages on the shelves of over 20,000 stores. Their understanding of the dynamic at the store level gave us confidence that they could implement their business model at a larger level and replicate their early revenue success. Two years later and they have grown from $4MM in annual revenues to a projected $15MM for 2017 since Merida’s investment. They were able to project their full year revenues in March and announced the number to the public market in April. Very few public cannabis companies project full year numbers because of the volatility of the business but GrowGen does. It’s not coincidence. It’s planning and predictability that management has when they understand their business thoroughly. They just announced a $4MM quarter, and we could not be more pleased with how they handle the daily challenges of their business.
Rule #2: Find management teams who have direct experience with the types of challenges they will face in their cannabis enterprise.
3-Fundamental Growth That Tracks with Consumption
All businesses have risk and inherent challenges. Cannabis enterprises, t-shirt brands, financial firms, law practices… each has a unique set of risks and challenges. Not surprisingly, the federal illegality of cannabis adds a further layer of complexity and unique challenges. While you cannot mitigate every risk, and we have already addressed how we analyze how a company can weather such challenges, Merida focuses on large, demographically valid opportunities so that the risks we take are justified by the inherent size of the opportunity. By “demographically valid”, we mean specifically opportunities in large addressable markets that grow simply by virtue of more demographic use, whether it’s medical, adult-use, research, etc. We then look at the regulatory frameworks around such demographic growth and zero in the intersection of what regulations require and how increased use will drive the further reliance on such tools. We are not arrogant in believing any investor can perfectly predict which companies will win the competitive battles, and so we focus on areas that give us better probabilities of success even if we pick the second, or third largest provider in a vertical.
For example, lab testing is going to be in high demand over the next decade as virtually every state adopts quality control standards around cannabis production and sales. As more people consume cannabis, more testing will be required. As regulations drive more types of testing (microbiological, toxins, contaminants, potency), diversified, scientific lab testing companies will thrive. Enter Steep Hill Labs. Merida’s investment in Steep Hill is driven by the fact that the demand for lab testing is going to explode, especially in California, and operators will not tolerate bottlenecks on testing results, thereby requiring lab testing companies efficiency, technical excellence, and professional management to handle such volume. Steep Hill has a broad set of related technical excellence on genetics and characteristic identification but their core business is going to grow by multiples in the coming years. That is the type of market we target for our investments.
A second example is LED lighting. More energy efficient, with granular controls, LED lighting has been something of a black swan for the cannabis industry over the past few years. After years of being a cautionary tale of chasing unicorns, LED solutions are becoming entrenched as larger growers search for ways to bring their costs down and lower their carbon footprint. When we invested in Lumigrow, we were skeptical about the fragmentation of the lighting space but ultimately we were swayed by the evidence that LED lighting will make large operators more efficient, with greater control over their crops, which will drive massive adoption as cannabis agriculture moves towards a commodity model and cost controls abound. The fact that fruits and vegetable growers have already moved towards LED as a normalized solution was a further determinant that the addressable market for LED lighting is bigger and the tipping point of usage approaching much faster than originally anticipated.
Lastly, returning to GrowGen again, the opportunities in the hydroponic retail sector are significant. Cultivation equipment and the equipment supporting smaller scale growing is a $5B market and growing, and the retail side remains one of the most fragmented sectors of cannabis. GrowGen has found compelling acquisition opportunities in each target market and a pipeline of intriguing prospects as commercial growers require larger, better funded suppliers, who can provide volume discounts. The size of the hydroponic retail market is hard to predict but the size of the addressable market is massive and will grow naturally as more cannabis is consumed, which Merida (and everyone else) not-so-boldly predicts will occur in 2018, 2019 and beyond.
Rule #3: Look for companies that serve large addressable markets that naturally increase as cannabis use increases.
Following these core three rules is no guarantee of success. Merida has found that our strategic influence and involvement in our portfolio after investing is just as important as the criteria we use for assessing where we deploy capital. As an individual investor, we hope that following this brief guide will allow you to narrow opportunities you see and could lead you to “weed” out potentially high risk investments for those that have a higher probability of success.
About the author:
Mitch Baruchowitz , Managing Partner at Merida Capital Partners, has seven years of experience in the legal cannabis industry and is considered a national expert in the diverse licensing regimes governing each state. His cannabis career began when he was asked by several Colorado-based legal cultivators to structure state compliant capital transactions and assist them in analyzing the legal cannabis market in order to develop an optimal business strategy for their operations. After several years of work with Colorado companies, he cofounded Theraplant, LLC with Ethan Ruby, where he architected the highest scoring application in Connecticut’s highly selective licensing process. In 2014, while overseeing Theraplant’s strategic direction, he cofounded LeafLine Labs, LLC, which was one of only two Minnesota companies to win a license to cultivate and dispense cannabis in extracted form.
Overall, Mr. Baruchowitz has approximately 20 years of experience in the legal and finance fields. He is the former Associate General Counsel and Chief Compliance Officer of publicly traded MarketAxess. He was also the General Counsel of investment banking boutique Pali Capital, which had revenues of $200 million nearly 200 employees when Mr. Baruchowitz was appointed in late 2009 by the Board to lead the restructuring and wind down of the company. Since 2010, he has led numerous public and private offerings, assisted in the formation and funding of several credit funds and a $60 million REIT while the Head of Investment Banking of ACGM, Inc. and at Cavu Securities.
Mr. Baruchowitz is a graduate of Brandeis University and Boston University School of Law. He currently sits on the Board of New Frontier Data. He is a member of the New York and Massachusetts Bars and holds FINRA 7, 24, 63 and 79 licenses.
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