Million dollar business, million dollar business!
We hear about it all the time. But what’s so special about owning a million dollar cannabis business?
Well, businesses — either cannabis businesses or mainstream enterprises — are often valued on a “multiple” of earnings. So, getting to $1 million in profits means you’re not only getting a higher multiple, but you’re also applying that multiple to a higher base number. Essentially, you’re getting to be a really valuable company.
Now, before we get started, let’s pause for a moment to make sure we’re on the same page. Earnings before interest, taxes, depreciation and amortization (“EBITDA”) is a mainstream financial concept. And when we talk about a $1 million profit cannabis business, we’re talking about one with $1 million or more in EBITDA.
And, that’s because EBITDA it’s a measure of past profitability and an indication of future profitability. In fact, it’s the measure. And, it’s been used to invest in businesses and to buy-and-sell companies for more than 40 years. It’s that tried-and-true “acid test” to determine what companies are worth and it’s increasingly being applied to cannabis business too.
Thinking this isn’t important to you because you operate in a highly-regulated industry that really only cares about cash? Well, that makes sense if your goal is to continue to run your business and never consider exiting. If so, I get it.
But, if you’re thinking about exiting in the future or getting more investor dollars into your business, read on.
Let’s talk finances
From state licensing requirements to IRC section 280E, your cannabis business is a complicated business to run. For this article, we’re going to focus on the business and financial end of the cannabis industry (we’re accountants after all!). Let’s leave the other stuff to cannabis consultants and industry veterans.
As you’re likely aware, 280E prevents you from taking most “below the line” deductions when determining your company’s federal tax liability. And, 280E can’t be beat. Full stop.
Now, you can do things legally to ensure your tax bill is as small as possible. But, you’re still going to pay substantial taxes until Congress takes action.
So, how useful is EBITDA as a financial measure when you’re already paying a huge tax bill each year?
Well, EBITDA is a financial measure, while 280E and Section 471 are tax concepts. A lot of folks think their tax books and their financial books are the same, but they’re not. They’re actually very different for purposes of creating a valuable business and for investors.
Getting your books and records in order and getting your cost accounting correct to support paying only the taxes you legally owe and having an audit-ready level of comfort is very critical for the survival of your business. No question about it.
But, if you want to make your cannabis business more valuable, you’ve also got to look at it from a financial perspective. That’s where EBITDA comes in.
So, why all the fuss about $1 million?
Quite simply, the million-dollar mark is a tipping point at which the number of buyers interested in acquiring your business goes up dramatically. And, the more interested buyers you have, the better multiple of earnings you will command.
For example, according to the research at The Value Builder System, a company with $200,000 in EBITDA might be lucky to fetch three times EBITDA (a 3X multiple), or $600,000. A company with a million dollars in EBITDA would likely command at least five times that figure, or $5 million. So while the company with $1 million in EBITDA is five times bigger than the $200,000 company, because of its higher multiple it’s almost 10 times more valuable!
There are a number of reasons that companies with a higher EBITDA get higher multiples, including:
Frictional costs are the total direct and indirect costs associated with the execution of a financial transaction. The friction cost comprehensively takes into consideration all of the costs associated with a transaction. Calculating the friction cost provides an investor with a full range of expected costs they can expect to incur.
It costs about the same in legal and banking fees to buy a company for $600,000 as it does to buy a company for $5 million. In large deals, these “frictional costs” become a rounding error, but they amount to a punitive tax on smaller deals.
But, here’s the reality for you. The greater the frictional costs, the less someone is willing to pay for your company or to invest in your company. Why? They have to consider these costs in what they pay and whether it’s worth it to them.
The 5-20 rule
There’s a rule in mainstream mergers and acquisitions that is just as true in the cannabis industry. And, it comes from M&A firms who have discovered that in many deals, the acquiring company is between 5 and 20 times the size of the target company.
I’ve seen this 5-20 rule at play in many situations. And, more often than not, your natural acquirer will indeed be between 5 and 20 times the size of your business.
Why? If an acquiring business is less than 5 times your size, it’s a “bet-the-company” decision for the acquirer. If the acquisition fails, it will likely kill the acquiring company. So, lot’s of risk right?
Likewise, if the acquirer is more than 20 times the size of your business, the acquirer will not enjoy a meaningful lift to its revenue by buying you. Most big, mature companies aspire for 10 to 20 percent top-line revenue growth at a minimum. If they can get 5 percent of organic growth, they will try to acquire another 5 percent through acquisition, which means they need to look for a company with enough girth to move the needle. You want that to be you.
Private equity and venture capital
Private equity groups (“PEGs”) and venture capital firms make up a large chunk of the acquirers in the mid-market. And, the interest of venture capital and private equity on the cannabis industry is growing and will continue to grow. It’s the reality of the industry. As we inch towards federal legalization, we also more toward mainstream acceptance, which brings with it investable capital from more mainstream sources.
And, in 28 years of working in accounting and finance, I know for certain that the value of your company will move up considerably if you’re able to get a few private equity groups interested in buying your business. But most PEGs are looking for companies with at least $1 million in EBITDA (remember, we’re talking finance in this article, not federal taxes).
Yes, the $1 million cut-off is somewhat arbitrary, but it’s also very common. Similar to homebuyers who narrow their house search to houses that fit within a price range, or colleges that look for a minimum SAT score, if you don’t fit the minimum criteria you may not be considered.
If you’re wondering when is the right time to sell your cannabis business, you may want to wait until your company is generating $1 million in earnings before interest, taxes, depreciation, and amortization (EBITDA).
So, what’s next?
If you’re close to $1 million in EBITDA and getting antsy to sell, you may want to hold off until your profits eclipse the million-dollar threshold. The universe of buyers—and the multiple those buyers are willing to offer—jumps nicely once you reach seven figures.
Now, there are things to do now to help you get there. Continue to assess vendor relationships to make sure you’re maximizing profitability on a vertical-by-vertical basis. That can help get you over the hump. Oh, and did we mention getting those cost accounting records sorted out? Because if you’re thinking of exiting, it’s worth it.
There’s trillions of dollars of capital in private equity and family offices. And, many of them focused solely or primarily on the cannabis space. They’re looking for good cannabis companies for investments or growth capital. We read it everyday in the pages of industry publications like Cannabis Business Times or Ganjapreneur.
So, if you’re thinking of exiting your cannabis business someday, there are real opportunities out there for you, and the way to maximize those opportunities is to get laser focused on that $1 million EBITDA mark.
Want to learn more? Speak with us about how we can help you with increasing EBITDA while staying compliant with the myriad rules and regulations, including helping you grow the value of your business.