Investing in the Ancillary Cannabis Sector

October 21. 2019. 8 mins read

We often use the terms “retail” and “institutional” to describe two types of investors. Generally speaking, a retail investor is anyone who invests on their own behalf. In other words, it’s your average Joe with a brokerage account. If said person’s net worth exceeds a certain threshold, they’re considered to be “accredited.” While accredited shouldn’t be confused with sophisticated, anyone who has accumulated meaningful wealth the hard way probably isn’t a fool.

Today, accredited retail investors can invest in startup companies, thanks to secondary exchanges. Retail investors don’t typically have the resources to vet any particular investment so they’re best served “following the money” as they say. In the case of startups, “the money” usually comes from venture capitalists who are very sophisticated investors, but certainly not infallible as we learned from the Theranos debacle.

Whenever we see an investment opportunity like Scuderi Group, or some of the outliers in the fusion space, it’s a huge red flag to see some groundbreaking technology with no institutional investors on board. (This is always explained away by some conspiracy theory, or the “we’re such geniuses nobody understands us” explanation.) We usually assume that if a notable venture capitalist makes an investment in a particular startup, that was preceded by a whole lot more due diligence than we could ever hope to accomplish looking in from the outside. In short, retail investors can learn a lot by paying attention to what VCs do and what they say. That’s why when one cannabis venture capital firm put out a white paper on cannabis, we dug in.

A Cannabis VC Speaks

Denver-based venture capital firm KEY Investment Partners focuses exclusively on providing capital to the cannabis sector. Their team provides institutional-quality investment management services, connecting investors to early-stage cannabis companies backed by exceptional management teams. Just this month, KEY published a white paper on Investing in the Ancillary Cannabis Sector and it’s chock full of insights. We pored through every word of that report and here’s what we learned. Let’s start with this insightful timeline of cannabis legalization.

Source: KEY Investment Partners

KEY begins with some history of legalization, then moves on to talk about medical vs. recreational. They’ve suggested that medical won’t truly reach its potential until marijuana is legal at the Federal level so researchers don’t need to ask permission every time they want to research one of the 113 identified active cannabinoids that might have therapeutic benefits. Consequently, they’re focusing their investment thesis on high growth sub-sectors within adult-use cannabis while waiting for cannabis to become federally legal.

Adults Using Cannabis

If you thought Amsterdam was selling lots of weed to tourists, think again.  In 2018, legal cannabis spending in North America was estimated to be around 95% of total global spending. Of that, 56% was recreational. As a whole, cannabis is expected to experience tremendous growth – 20% CAGR for six years – with $40.6 billion in consumer spending by 2024 according to BDS Analytics, a cannabis market intelligence firm. However, estimating growth by state becomes tricky. As we talked about before, black market cannabis has put a dent in California’s legal use armor. Your neighborhood dealer can undercut Californian dispensaries by nearly 40%.

If you’re wondering when your state might have legal cannabis for sale, BDS projects just over 50% of the U.S. population living in states where cannabis is legal by 2023.

Source: KEY Investment Partners

If you have glaucoma, you’ll be really squared away. BDS thinks there’s a “strong likelihood” that all U.S. states will have legalized medical marijuana by the end of 2024.

The Uniqueness of Cannabis Investing

The elephant in the room is that cannabis is illegal at a Federal level, but that’s just a risk that’s assumed at this point. In their white paper, KEY talks about the more subtle characteristics of investing in the cannabis sector.

The first relates to estimating the market size for cannabis based on a $90 billion black market. KEY doesn’t think this is a one-to-one translation, since many people out there would like to consume cannabis, but won’t buy it on the black market. “Black market demand estimates consider only the amount of flower demand from consumers who are willing to purchase marijuana illegally,” says KEY, and all the other types of cannabis products – vapes, waxes, edibles, etc. – mean that the legal market will be much larger than $90 billion.

The second characteristic is a capital constraint for cannabis startups. KEY’s back-of-the-napkin math estimates that cannabis startups only have access to 15-30% of their capital needs. The problem lies in the regulatory risk. “According to an article in CNN Business earlier this year, only about one in 30 banks or credit unions across the U.S. will accept cannabis businesses as customers” says KEY. Those who do need to file reports with the federal government, and they’ll face heavy fines if they muck something up. Consequently, the cost of capital for cannabis startups is estimated to be between 30-40% higher than normal. Even when cannabis becomes legal at a federal level, investments will still be restricted by “vice clauses” which are rules that restrict some institutional investors from buying stocks in sinful things like alcohol, tobacco, or gambling.

The lack of capital for cannabis startups is actually a blessing in disguise for investors since there is more access to better deals and presumably better terms. Contrast this to popular themes like artificial intelligence which venture capitalists can’t get enough of. KEY talks about startups that aren’t “plant touching businesses.” Also called “ancillary cannabis businesses,” these are startups with business models that mimic other legitimate companies.

Source: KEY Investment Partners

And those legitimate companies may be far more likely to invest in ancillary business models that don’t touch any of those beautiful green leafs.

Big Corporations

In 2018, a $4 billion investment in Canopy Growth by Constellation Brands (STZ) was larger than all previous legal investments in private U.S. cannabis companies combined. Large corporations have been watching the cannabis sector with a great deal of interest, but are unlikely to begin playing until cannabis becomes legal at a federal level. This means cannabis startups can operate without competition from large corporations. When deregulation does happen, we’ll see lots of exits happen. Says KEY:

Early-stage companies in emerging, federally legal industries, such as blockchain technology or AI, will be forced to fight the uphill battle that is the direct competition of large U.S. corporations that are better capitalized and have access to far greater resources.

What mature corporations will do is “acquire cannabis companies operating in a similar sector within cannabis as the regulatory environment continues to ease,” says KEY. It’s another vote of confidence for their bullish thesis on ancillary cannabis startups. What KEY isn’t bullish on are all those cannabis stocks many of our readers – newbie retail investors in particular – can’t seem to get enough of.

Cannabis Stocks

In our series on the largest multi-state cannabis operators, we’ve been looking at topics like the high price of cannabis acquisitions, how to tell if a cannabis stock is good or bad, and the cannabis risk problem. Our past article on how the CSE has become the Cannabis Securities Exchange is also a concern for KEY. We’re growing weary of seeing all the SEDAR filings with “Bob’s Plumbing Equipment Company” now trading as “Mary Jane’s Cannabis Company.” A reverse merger on the CSE is a quick way for many companies to raise capital from investors who don’t have the slightest when it comes to valuations.

We rarely talk about valuations on Nanalyze for two main reasons. First, telling readers that Stock X has a P/E of 36 means eff all to people who make a living doing more interesting things than finance. Second, we write about investing in emerging technologies which means valuations take a back seat to being in on the ground floor of “the next Microsoft.” While that last statement certainly isn’t good advice, we look at investments with a long-term horizon while the notion of valuation encourages investors to try and time the market.

With that said, KEY did a great job demonstrating how overvalued cannabis stocks are today when compared to other vice stocks.

Source: KEY Investment Partners

The calculation is pretty simple. Divide the market cap (shares outstanding X share price) by yearly revenues. We’ve highlighted the calculation for 2018 in the above table since it’s known. The lower the number, the lower the valuation. It’s easy to see just how much growth has been priced into cannabis stocks. And that’s not even at peak mania. Our article titled “Buying Marijuana Stocks in 2018 – Is it Too Late?” looked at how ridiculous valuations became last year.

We’re regularly contacted by readers with the typical “I have X dollars to invest, which cannabis stock should I buy?” question. Our answer is always the same, and it’s similar to what KEY says below:

If we combine the risk associated with investing in a federally illegal and highly regulated emerging industry with the risk associated with investing in a thinly traded, nontransparent and highly volatile exchange, we believe the total risk an investor must assume when underwriting an investment in the CSE is generally not worth the potential return.

The total risk is not worth the potential return. That about sums it up.

The Ancillary Business Thesis

The final section of KEY’s white paper hammers home the ancillary business investment thesis. Unlike all those MSOs, ancillary businesses can conduct business across state lines. They have lower startup costs and they aren’t subjected to certain tax regulations that constrain profits for “leaf touching startups.” And it just so happens that KEY operates in the State of Colorado where 41 of the top 150 ancillary companies operate, more than any other state. That’s the icing on the cake of compelling reasons why limited partners might consider putting some money to work with Key Investment Partners. (We’re simply basing this on the white paper so always do your own due diligence before handing anyone your hard-earned cash.) Here’s a great checklist of what KEY looks for in a cannabis investment:

Source: KEY Investment Partners


We’ve often talked about how we’re not buying into the cannabis investment theme aside from dabbling a bit in Charlotte’s Web because we love their story and management team. If you’re a retail investor looking for exposure to the cannabis sector, you’re best served having someone like KEY on your side. We say that having never even spoken to anyone at that firm, but much of the conclusions reached in this white paper mirror what our MBAs have been reporting.

Cannabis investing risk is particularly high for retail investors who are only now deciding to invest in cannabis because they like to smoke it and it sounds like a great idea. While there are some cannabis ETFs that provide diversified ways to invest, the cannabis theme just has risk written all over it. Check out more risk-averse strategies like dividend growth investing and leave cannabis investing to institutional investors like KEY Investment Partners.


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