Thriving in Cannabis Chaos: Lessons From Other Industries

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In Nassim Nicholas Taleb’s fantastic book titled Antifragile: Things That Gain from Disorder, he explains the concept of gains made through volatility (negative events). For example, he describes airplane crashes as making the airline industry stronger. Each crash is studied (via its fragility) and lessons are learned and incorporated into the industry as a whole. These lessons have led to dramatic drops in airplane crashes (antifragile) over the past 50 years.

Taleb also addresses the economy head-on by showing that our political leaders consistently make decisions to smooth out every bump in the economic road, creating complacency with risk taking that allows fragility to build up in the system (think the 2008-2009 financial crash). Complacency and 100% stability can be a killer.  

How can we apply this antifragile concept to cannabis given that the cannabis industry is hyper-volatile? The intention is to create a situation where the very nature of the fragility within the cannabis industry can benefit your firm when big, negative events occur. Looking to other industries can give us valuable insights into how companies can benefit from negative events.

Here are some negative events that can affect your cannabis business:

  1. The price of cannabis flower crashes due to overproduction.
  2. The regulatory scheme in a particular state becomes more rigorous and/or expensive.
  3. A product category crisis. (The vape crisis is a good example.) 
  4. An economic crisis that results in the drying up of investment capital.
  5. A key counter-party or relationship goes kaput.  For example, the wholesaler you’ve been relying on is suddenly out of business as a result of financial mismanagement, poor execution or, as recently happened to some farms in Oregon, a fire burning your business to the ground.

These examples are enough to illustrate the potential for negative events and to use in setting up a framework to thrive from the resulting chaos. Some of this may seem counterintuitive, but stick with it and know that this article is meant to jumpstart your thinking as it relates to upping your game in cannabis business risk management.

As French philosophers like to say, knowledge is historically contingent and based on power relations at any specific time. If this is so, then your knowledge of how to be successful in cannabis is also historically contingent and may just be historically out-of-date or just plain historically irrelevant. And needless to say there is always a firm more powerful than yours trying to set the agenda.

Let’s start with the idea of two cannabis companies: Both are two years old, both are growers, but one is 10 times larger than the other. To keep things simple, let’s just say that both have an equal capacity to grow and sell at the same rate in relation to the market. Meaning, if at any time the market is growing at 10%, then each of these firms can grow at 10%. Suddenly, a downward movement in cannabis prices cuts the wholesale price level by 50%. Which grower is at higher risk of going out of business quickly? We would argue it is the larger firm.

As you gird yourself for the inevitable negative events, you should be focusing on which additions to your company can be made that will make the negative event a non-event and help you consolidate market share/power.

 

As an analogy, think of two owners of different apartment buildings. Owner A has an eight-unit building, and owner B has a 100-unit building. If for some reason the market vacancy for apartments jumps to 25%, owner A will have two vacancies. Owner B will have 25 vacancies. Owner A can probably reduce the rent a bit and easily fill two units. For owner B,  reducing the asking rent across the 25 vacant units will have a materially negative impact on the property’s value—probably so much so that the outstanding loan on the property will be more than the building’s value. Also, renting two units versus renting 25 units is a much quicker process. Now substitute building units with crop yields, and the idea comes into focus.

The smaller cannabis grower will more likely be able to ratchet down volume a bit and wait out the storm. A large firm, with higher fixed costs, is probably toast in a matter of a few months because of its lack of agility. When cannabis companies built their grow operations, it really was analogous to a genetic mutation. The bigger firm is a bigger mutation than the smaller firm. A bedrock of biological evolution is that big mutations almost always reduce survival rates.

To build antifragility into the respective growers’ situations, the smaller firm would be wise to add a small dispensary business to its portfolio, even if this means having a smaller grow than desired. In a worst-case scenario, the smaller firm will only need to sell a few pounds of flower a week through its own dispensary, even at a reduced cost, in order to survive an industry-wide glut. For the larger firm to have a similar backstop, it would need to own 10 times the dispensary capacity compared to the smaller firm. This is arguably much harder for the larger grower to execute on and much more costly.

The takeaway is that in order to build antifragility into your company, you need to include antifragility in your plan when developing your business in a vertical manner; the ratio of the parts to each other should be consistently grown in tandem. A grow should have a certain level of dispensary capacity. As the grow gets bigger, the dispensary capacity should grow in tandem. Let’s call this the vertical integration ratio model, VIRM. Not to do this causes enterprises to be too weighted toward one vertical and face extinction risk in response to a negative event.

Now, let’s say the regulatory scheme becomes much more restrictive.

This was the case in June 2018 when the state of Oregon put a de facto cap on licenses by stopping the acceptance of new license applications in June of that year. Oregon had been an unlicensed cap state; if you qualified, you got a license. Then it became a capped state with a huge pipeline of applications. What to do?

Well, if you are nimble in your thinking, you see this as a huge opportunity. Even though the licenses have been capped, plenty of firms were looking forward to becoming vertically integrated. Such firms are now left with only two choices: merge or buy a firm in another vertical. Sticking to VIRM, you need to look around for an appropriate partner to buy or merge with that pushes your plan of vertical integration one step further. The target company, being in the same boat as you, will see the wisdom of such a merger. Before there was the United States, there were 13 colonies. Same concept.

The vaping crisis caught everybody in the industry flatfooted. Anecdotally, however, if you were a grower whose business was almost entirely or entirely focused on flower production, you tended to perform well in late 2019, early 2020, because consumers and patients on a broad level temporarily shifted to flower. If you were an extraction company, you could attempt to sell your oil and distillate to other derivative product makers—gummies, brownies, chocolate, all of which are substitute products. In High Desert Flower’s case, the team bought a distillation machine from a California extraction company that was hit so hard they changed their business model. 

The overall point is that as you gird yourself for the inevitable negative events, you should be focusing on which additions to your company can be made that will make the negative event a non-event and help you consolidate market share/power.

The Bigger ‘Black Swan’

An economic crisis, whether specific to your industry or macro in nature, is a much harder “black swan” (another Taleb meme) event to deal with. The old saying that “If your neighbor is out of a job it is a recession, and if you are out of a job it is a depression” is apropos to cannabis.

The goal is never to have your cannabis business in a depression. Obviously, the first goal in an economic crisis is survival, but assuming you have designed your firm for such an event, then your radar should be on the lookout for depression-level asset opportunities in your vertical or a vertical you recently moved into or are planning to annex (see VIRM above). Equipment, machinery, real estate, and other tangible goods always come on the market when the kief hits the fan. Be on the lookout for people and licenses in the unwind process.

This is very analogous to how the mortgage banking industry operates. Mortgage banks are those private firms that constantly advertise for your mortgage business (think Quicken Loans). When the industry hits a slump, existing firms absorb other firms and increase their economies of scale. Adding capacity with the concurrent decrease in back office expense throws dollars to the bottom line.

The most interesting cataclysmic event in the aforementioned list is when a key counterparty goes kaput. We have faced this multiple times but have not been able to take advantage of it, as of yet, for our firm’s growth. The most successful version we’ve seen of this is when a friend of ours, who owns a fairly large mortgage company, was tied into a technology platform when the software company’s CEO called him and said he had a week to find another vendor because the software company was going out of business and the software was going to shut down. My friend offered him $25,000 for the software source code as long as the lead engineer also became an employee of his mortgage firm. The CEO took the deal.  Masterstroke of brilliance.

We believe there are instances where this strategy can work in cannabis. If you do pull off this strategy we’d love to hear from you.

The big overall lesson here is not to be stuck in a linear thought process that blinds you to unorthodox growth opportunities in the midst of calamity. Look at streaming services (Netflix, Amazon), food delivery services (Uber, DoorDash), and video conferencing (Zoom) for inspiration. Granted, some were lucky, but others were heading in the right direction and the COVID-19 crisis compressed time for them. 

Loren Picard is CEO of Oregon-based High Desert Flower Inc. Alex Lee is vice president of High Desert Flower Inc. and co-founder of Oregon-based Engineered Extracts, LLC. You can reach Loren at loren@highdesertflower.com or Alex at alex.lee@engineeredextracts.com.

 

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