The ongoing struggle for Federal Legalization: An Inside Look
The outlook for federal legalization has dimmed, leaving cannabis businesses and investors in limbo.
Entourage Effect Capital has $200 million invested in cannabis-related businesses and is looking to deploy more. Founded in 2014, the Dallas-based private equity firm’s approach has evolved with the industry, but the larger play remains simple.
“Because of the federal illegality, this is the only industry in our lifetimes where [private capital] has had a head start on institutional capital, and they’re champing at the bit,” said Matt Hawkins, a co-founder and managing partner at the firm.
“Private capital — high-net-worth individuals and family offices — has the sole ability to support this industry. You’re talking about a $30 billion to $40 billion domestic industry that is very much lacking capital. There will be a tremendous upside when institutional capital comes in and valuations skyrocket.”
Getting there is proving to be a bumpy ride in many states, including Florida.
A surprise Oct. 6 announcement by President Joe Biden raised hopes for progress. The president pardoned people with simple federal cannabis possession convictions and ordered an administrative review of cannabis’ status as a banned drug. Cannabis stocks, traded mostly on junior Canadian markets, which had been off 80% since early 2021, got an immediate bump.
But the long-term consequences for businesses remained unclear, and hopes have risen and fallen before.
While more states are embracing medical or recreational use, mature markets are in the doldrums after a pandemic boom. Price deflation is rampant. Small and midsize companies are struggling without standard banking services such as lines of credit and payroll management services. An onerous federal tax code forbids typical write-offs.
“Can you imagine being in an industry where you have zero access to commercial capital and you’re taxed at your gross margin?” asked Jeff Yapp, CEO of Chalice Farms, a vertically integrated company with 16 stores in and around Portland, Oregon. “It’s ridiculous. I don’t know who can run a business within those requirements.”
Chalice is trying to scale up “to allow us to run profitably until there’s a turnaround,” Yapp said, but the capital crunch forced it to terminate deals for additional stores and outdoor grows.
“Our whole drive is to survive, to see if we can get to a better place with the federal situation,” he added. “But the harsh reality is it’s not going to be as soon as we thought.”
'Hockey stick' growth is over
Next month will mark 10 years since Colorado and Washington voters approved ballot initiatives that legalized cannabis for recreational use. Obama administration guidance that gave states a pathway to form markets without interference from the federal government quickly followed, and the cannabis industry was off to the races.
Today, 19 states and the District of Columbia allow legal recreational use. Five more — Arkansas, Maryland, Missouri, South Dakota and North Dakota — have recreational measures on their ballots next month. All but a dozen states allow medical use.
Research firm Cowen estimated U.S. sales at $27 billion in 2021, a couple of ticks above cannabis analytics firm BDSA’s $25 billion figure. The annual Leafly Jobs Report found legal cannabis supported 428,059 full-time equivalent jobs as of January 2022.
New states are pushing sales totals higher, and more are on the way, including New York. The state hopes to begin retail sales by the end of the year, birthing a market that by one estimate could top $1 billion in 2023 and exceed $4 billion in 2027.
But analysts are pulling back on their future targets. Cowen trimmed its 2025 U.S market estimate from $40 billion following the 2020 elections to $28.3 billion more recently. BDSA sliced its 2026 forecast to $42 billion from $47.6 billion.
“The ‘hockey stick’ trend of sales growth seen in the early years of legal cannabis has passed, and economic and regulatory headwinds are exerting pressure on legal cannabis markets,” BDSA CEO Roy Bingham said with the update.
'Congressional dysfunction'
Some of those regulatory headwinds are at the state level. California cannabis sales reached $5.3 billion in 2021, but trailed other mature markets on a per capita basis, thanks to a thriving illicit market. The industry blames layers of taxes and complicated regulations. UC Davis economists Robin Goldstein and Daniel Sumner, who have studied the state’s market for several years, agree.
“Taxes and regulations make legal weed around twice as expensive as illegal weed,” Goldstein said. “That’s extremely difficult to overcome.”
And then there’s the federal situation. Early 2021 hopes that the Democrats might bring major reform slowly faded. Until Biden’s most recent action, the president hadn’t made it a priority, leading Rep. Earl Blumenauer, D-OR, a founder of the Congressional Cannabis Caucus, to say in September “the Biden administration is missing the boat.” Aaron Smith, CEO of the National Cannabis Industry Association, also blamed “general congressional dysfunction.”
There are glimmers of hope for the Secure and Fair Enforcement (SAFE) Banking Act in the lame-duck session to come. It would open up banking services to state-legal cannabis businesses. The bill passed the House seven times, but never made it to the Senate floor, where it would need 60 supporters.
“SAFE Banking alone could pass the Senate,” said Morgan Fox, political director for the reform group NORML. “The issue is finding a sweet spot that brings in enough Democrats who want social justice elements attached to it without alienating Republicans who would prefer a clean bill.”
Many Democrats have called for reform that repairs the damage of a war on drugs that disproportionately targeted people of color. They want to see things like easier expungement of cannabis-related convictions, community reinvestment and support for small, diverse business ownership.
Cowen’s Washington research group put the odds of passage this year at two-thirds under a scenario where Republicans take the House and Democrats retain Senate control in November.
It would move the industry — and its customers — beyond a dangerous reliance on cash, and more.
“It would mean access to commercial banking and insurance [for cannabis businesses], and it would allow for use of credit cards in dispensaries,” Cowen analyst Vivien Azer said. The largest national lenders would likely still shy away from the industry, she added, “but certainly regional and local banking should open up, and in a rising interest rate environment, that should help a little bit with the cost of capital.”
Businesses would still face 280E, a provision in the federal tax code that treats state-legal cannabis operators as drug traffickers, disallowing normal business deductions. That can drive effective tax rates past 70% and lead even companies that lost money to owe taxes.
“That’s probably the biggest impediment the industry faces right now,” the National Cannabis Industry Association’s Smith said. “But I think it’s important to get SAFE passed, because it will help operators in a real way, and it will start building political momentum.”
'It'll be a bumpy ride'
Toward what remains an open question. Industry players widely see a comprehensive reform bill led by Senate Majority Leader Chuck Schumer as too heavy on taxation, with rates rising to 25%. They tend to prefer the States Reform Act from Rep. Nancy Mace, R-SC, which includes a 3% excise.
Goldstein and Sumner, the UC Davis economists, say a lighter hand is the way to go. In a bracing new book, “Can Legal Weed Win?” they warn of the challenge regulated cannabis faces in taking on the illicit trade.
“Federal legalization could put a large percentage of the industry out of business if they add high taxes and a huge amount of regulation,” Goldstein said, drawing a link to what’s happening in California.
Smith agrees, and highlighted interstate commerce as among the trickiest issues the industry will face in a federally legal environment by raising the prospect of cannabis from low-cost production states displacing entrenched producers in high-cost states.
“It’s vital to the industry, but not supported by everyone in the industry, because obviously it could be so disruptive,” he said. “But I think we’ve learned in the states that it’ll be a bumpy ride, no matter what legislation ultimately passes.”
