What is a Vertically-Integrated Cannabis Company?

For the uninitiated, the cannabis industry can seem a daunting sector to understand with conflicting and competing regulations from around the world, making it a very confusing place to operate. Vertical integration is a term used often to describe a number of cannabis-oriented companies, but what does it mean, and how do they work?

Vertical integration is a business strategy term that describes a company which controls every stage of its production path.

By consolidating the multiple steps of cannabis production – manufacturing and distribution – a company can achieve vertical integration. This consolidation can benefit internal cost-saving and efficiency measures, providing businesses with stricter quality control, and increased logistical reliability and control.

However, this consolidation is burdened with an increased level of capital to either combine existing businesses or independently establish a second or third arm of an existing business.

Because of this, many who disagree with vertical integration, believe it prevents smaller players from entering the market. While others claim it increases the level of adherence to cannabis regulations.

Why Are Cannabis Companies Vertically Integrated?

The most direct answer is because the law requires it. However, in some cases, where it is not required (or not prohibited), businesses may choose to engage in this business strategy for the benefits of consolidation such as product quality guarantees or greater operational control.

Another reason is due to federal tax issues preventing cannabis businesses from deducting regular expenses under Section 280E of the Federal Income Tax Code. Consolidated companies are also able to share overhead costs which can assist in alleviating the hindrance of 280E.

Consolidation can also lead to the amalgamation of smaller cannabis players and the formation of synergistically more significant and more meaningful companies, that can compete with more giant corporations.

However, not all US states permit vertical integration, with many, like California, prohibiting the business practice as a result of alcohol pre-prohibition fears.

The History of Vertical Integration

Vertical integration takes its history from the repeal of alcohol prohibition by the 21st Amendment in 1933. This act resulted in lawmakers at the time enacting strict regulations around "tied houses" to minimise problematic, inappropriate or coercive business practices.

Outlined in the landmark 1971 Californian Supreme Court case, tied houses regulations "aimed to prevent two particular dangers: the ability and potentiality of large firms to dominate local markets through vertical and horizontal integration and the excessive sales of alcoholic beverages produced by the overly aggressive marketing techniques of larger alcoholic beverage concerns."

"To avoid these antisocial developments," state legislators eventually brought about the three-tier statutory structure, separating participants in the alcoholic beverage market into three categories – manufacturers (tier 1), importers/ distributors (tier 2) and licensed outlets/ retailers (tier 3) – each with their own regulations and taxation laws.

The fear of monopolisation and decreased competition surrounding the alcohol industry in the 1930s are the same fears that led to banning the practice of vertical integration in some US states today.

As a business strategy that involves control over multiple stages of the production and supply of cannabis, vertical integration presents cannabis businesses with a difficult choice when it comes to their operations.

Just understanding the State by State regulations in the US is tough enough as it is, without having to make decisions regarding structure.

However, vertical integration does give businesses the ability to leverage economies of scale, especially considering the broad and diverse nature of the cannabis industry.

While BDS Analytics, a Boulder, Colorado-based cannabis technology company, reports that only 24% of consumers say it's essential for retailers to grow their own marijuana, the question is whether or not one wants to be the jack of all trades or the master of one.

Craig Goodwin, President and Founder of Hemp-based health foods company Naturally Splendid Enterprises, believes it is a businesses' imperative to "maintain the highest quality control".

"Vertical integration allows for quick reaction to market conditions whether that is developing new products, servicing new clients or expanding distribution channels," said Mr Goodwin.

Another advantage is the assurance of those distribution channels which guarantees there will be a transaction made on the product produced. Some states even support it due to the increased level of oversight and control maintained, while others fear its contributions to monopoly practices and decreased competition.

Unfortunately, the requirement by some states to implement vertical integration dramatically impacts the level of capital required, compared to a more singular focused business model.

US Federal Regulations, Tax and Scheduling

The use and possession of cannabis is illegal under federal law for any purpose, by way of the Controlled Substances Act of 1970.

Under the CSA, cannabis is classified as a Schedule I substance, determined to have a high potential for abuse and no accepted medical use – thereby prohibiting even medical use of the drug.

Those hopeful of the current administration rescheduling the drug under the CSA may not want to hold their breath.

According to a Department of Justice whistleblower, almost a third of all Antitrust probes into company mergers targeted the cannabis industry.

The testimony, which was released by John Elias, a career department employee, accused Attorney General Bill Barr of improperly investigating cannabis suppliers due to his personal feelings about the industry.

"Personal dislike of the [cannabis] industry is not a proper basis upon which to ground an antitrust investigation," said Mr Elias.

While this indicates a probable Federal concern with the cannabis industry, it may lead to better regulations within the sector.

Finally, nothing herein precludes investigation or prosecution, even in the absence of any one of the [cannabis regulations] listed above, in particular circumstances where investigation and prosecution otherwise serves an important federal interest.David W. Ogden, Deputy Attorney General

State By State, USA Regulations

Cannabis legalisation is a growing movement in the US, with 35 states implementing medical cannabis programs for patients, and 11 states allowing the use of recreational cannabis, despite the federal restrictions.

While all US States must adhere to federal law, States that have legalised the use of cannabis are allowed to do so as a result of the relaxed approach taken by the former Obama administration.

These can be traced back two memos written by attorneys at the United States Department of Justice during the Obama administration.

The first, written by Deputy Attorney General David Ogden in 2009, provided guidelines on medicinal cannabis operations for legal States and focused on "the disruption of illegal drug manufacturing and trafficking networks".

The other, known as the Cole memo was written by Deputy Attorney General James Cole in 2013, lists eight issues that could bring the wrath of federal prosecution.

According to the Cole memo, States with robust regulatory systems in place were, "less likely to threaten the federal priorities".

However, this does not constitute guaranteed federal protection, with David Ogden reiterating that his "memorandum is intended solely as a guide to the exercise of investigative and prosecutorial discretion."

Despite these warnings States continue to operate in contradiction of the CSA – a gentleman's agreement – even with the Trump administration announcing back in 2017 that the Department of Justice will pursue states that have approved recreational cannabis.

USA State Vertical Integration Laws
Source: Marijuana Business Daily

Colorado, for example, one of the first states outside of California to approve cannabis sales, requires businesses to adhere to a 70/30 production rule.

Cannabis retailers must grow at least 70% of the product that they sell in-store, which forces all retailers looking operating in Colorado to establish a cultivation arm of their business.

States such as Oregon and Nevada allow more economic freedoms as they do not require vertical integration by law.

These states allow licensed producers to sell their products, or wholesale it to other retailers.

California, Washington, and Illinois, on the other hand, either limit or outright prohibit vertical integration by law.

These states enforce various degrees of separation between the cannabis procurement process, with regulations mirroring traditional alcohol distribution models.

Some say it limits the cannabis industry to the rich, while others say it increases controls and efficiencies. Whatever the consensus is, vertical integration is a part of this industry.

Over at Cannabis Business Times, individual stakeholders in crucial aspects of the cannabis sector shared their insights on vertical integration and how it has affected the industry.

According to Ben Kovler, founder, chairman and CEO of Green Thumb Industries (GTI), a critical element of vertical integration is whether or not the market allows for wholesale business.

"Massachusetts, for example, is forced vertical integration. There's no wholesale market in Massachusetts right now, but that's coming," said Mr Kovler.

The advantage of this forced consolidation is access to consumers, "that's given [GTI] some insights into tastes and preferences of the patients and consumers."

"That can drive innovation."

Former State Senator Roger Katz and Chairman of Maine's Committee on Marijuana Legalization Implementation doesn't necessarily see anything wrong with being involved in all three aspects of cannabis, however, "[the committee] didn't see any good reason to require it either."

"[Vertical integration] would seem to favour larger businesses and larger investments, and that hasn't been our guiding goal. We want to make it available to the little guy as well as the corporations."Former US State Senator Roger Katz

As one of the top-grossing retailers in Washington, Ramsey Hamide, owner of Main Street Marijuana doesn't believe in mandated vertical integration, instead, putting his faith behind the Oregon strategy – "let the market decide what fails or survives".

Brian Vicente, one of the primary authors of Colorado's Amendment 64, which led to the 2012 legalisation of adult-use recreational cannabis, claims a big reason for the tighter regulations was for security.

"In 2010, we were essentially working from scratch to create the regulatory structure," recalled Mr Vicente, who felt there was a need for "tight controls at the beginning."

"But as these programs expand and the regulators become more sophisticated in tracking the parties involved, I think that need for required vertical integration is certainly going away."

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Elliot Nash
Elliot Nash

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