By Ed Zwirn

(published Aug.19, 2016 in CFO.com

The legal cannabis sector is experiencing geometric revenue growth, but finance execs face formidable challenges managing the money.

If one looks at the top line, the legal marijuana business may very well be the stuff that entrepreneurial dreams are made of. As of this writing, some 25 states in the U.S. have passed laws that allow for some degree of medical or recreational use of the cannabis plant.

This trend toward growing acceptance of what had been until recently a surreptitious national pastime has resulted in a heady flow of revenues. This tally reached a whopping $4.8 billion in 2015 and, “based upon the trajectory of legalization and implementation of new markets,“ should reach $25 billion by 2020, according to Matt Karnes of GreenWave Advisors, a New York-based consultancy. This number could reach $35 billion in the hypothetical first year of complete legalization, he adds.

But legalizing cannabis sativa is not the same as making it a solid business proposition. Despite impressive cash flows, the newly emerging companies face considerable challenges when it comes to translating top-line revenue into bottom-line results.

For one thing, purveyors of marijuana face daunting federal (marijuana is still classified as a Schedule I drug, along with heroin) and state regulations that make it difficult to obtain access to banking, financing, and leasing services that most businesses would take for granted when formulating business plans. That results in their having to deal with many or most customers on a cash-only basis and necessitating their use of armored cars and other security as they guard both their cash and their cash crop.

Facing the Tax Bite

In addition, cannabis companies face a federal tax bite that would daunt even the most nimble startups. In an apparent reaction to a tax court ruling that allowed a drug dealer to deduct business expenses after he had been audited by the Internal Revenue Service and taxed on its ill-gotten gains, Congress in 1982 enacted IRS code 280E, which prohibits deductions for anyone with income derived from the sale of Schedule I and II drugs.

“We’re involved in a very fast-moving business,“ says Michael James, CFO of Terra Tech, a publicly held Newport Beach, Calif.-based agricultural company founded in 2010 which divides its operations between production and sale of marijuana out West and a more traditional herb business operating out of Belvedere, N.J. The company, which trades over the counter, booked nearly $10 million of revenues last year, which translated down to about a $9.3 million loss.

James says that although his company has been able to obtain satisfactory banking arrangements, many of the dispensaries and other retail customers it serves are operating on a cash-only basis because despite legalization banks are still reluctant to provide services to marijuana companies less they run afoul of federal Racketeer Influenced Corrupt Organization (RICO) statutes. “We do have locations where we have to have safes,“ he admits.

“If you are not allowed to deduct the wages you pay, it makes it harder to do business,“ he says of the federal tax situation.

According to Chuck Smith, who serves as CFO and COO of Dixie Brands, a private Colorado-based company which sells a line of candy bars and other goodies infused with THC, the active ingredient which produces the “high“ in marijuana, Uncle Sam is taking an effective 60% to 70% at tax time. “We can’t deduct for ‘budtender’ wages or anything other than cost of goods sold,“ he says, adding, “everybody in our industry gets audited.”

In addition, “banking for the industry is still very difficult,“ he says. “We’ve had to grow every penny from organic growth.”

“Our retail customers all pay in a combination of cash and checks, because they don’t have bank accounts, so from them we take cash,” says Smith. As a result, “we spend a lot of money on security.”

The industry also faces major compliance costs as the rules of the marijuana game evolve. Colorado, which legalized recreational marijuana use in 2014, has promulgated regulations three times since then which have required Dixie Brands to change packaging and labeling requirements. This and other examples of continuous regulatory change have driven compliance costs to “well north of $400,000 to $500,000.”

Banking on Change

“Some of the biggest businesses in Colorado are operating at breakeven,“ says James Marty, a Denver-based certified public accountant who counts more than 100 marijuana license holders in Colorado and elsewhere among his clients. He notes that many of them are treating the federal tax bite as a “one-time“ cost, in effect banking on a change to the rules. “The industry can’t survive 280E, but Congress is unlikely to repeal it, especially in an election year,” he says.

“Most of my clients are on Quickbooks, and with this they have to manage constant inventories of both cash and cannabis, plastic bags that can’t be reopened, and the services of armored car companies,“ he says.

Henry Levy, who runs an Oakland, Calif.-based tax consultancy specializing in the legal cannabis business, advises clients trying to cope in a growing industry hampered by regulatory and tax hurdles to invest in systems and procedures that enable them to track inventory costs (enabling them to maximize the cost-of-goods sold deduction). “You need to get somebody who knows what he’s doing on inventory costs,“ he stresses.

For his part, Dixie Brands’ Smith is bullish on the marijuana sector in general and his company’s place in it in particular. For one thing, there is the trend toward legalization, at least on a state-by-state basis, and he says his company should receive a healthy boost as soon as this year, especially if ballot initiatives aimed at legalizing “recreational“ adult use pass muster in California and Nevada.

This ongoing political evolution has made Smith and other cannabis CFOs particularly aware of the impact of the changes upon which they base their business plans.

“The inevitable is that there’s always going to be changes,“ Smith says. “The rules are constantly being rewritten and we are the ones writing them. The question we face is that when all this normalizes, how are we positioned for that?”

Ed Zwirn is a freelance writer based in Bethel, N.Y.

Image: Thinkstock