Case 4 Pot of Gold?

The US
Legal Marijuana
Industry

During the early months of 2015, the US venture capital industry was waking up
to the opportunities offered by the legalization of marijuana in several US states.
Several specialist investment firms had been established to invest in marijuana-
related businesses. An early leader was Seattle-based Privateer Holdings, which
sought “to cement a leading position within the legal cannabis industry by con-
solidating market share through strategic investments”—these included Marley
Natural, established in collaboration with Bob Marley’s daughter. Another pioneer
was Emerald Ocean Capital, founded by Justin Hartfield, which sought to “own and
operate the ‘Starbucks’ and ‘Bacardi’ of the marijuana industry.” Mainstream interest
in the industry was triggered by the news in January that Founders Fund, led by
PayPal co-founder Peter Theil, and a major investor in Airbnb, Lyft, and Spotify, was
investing in Privateer Holdings. The Cannabis Capital Summit held in Denver during
June 2015 organized by the Rockies Venture Capital Club provided a further boost
to the marijuana industry by linking the growing number of potential investors with
the many entrepreneurs seeking to exploit the business opportunities that legaliza-
tion had made available.
However, amidst the “new gold rush” hype that surrounded the rapid growth
of the legal marijuana industry—especially in Colorado—were perplexing ques-
tions over the industry’s potential to generate attractive profits. Would the industry
offer the sustained high profitability associated with the two other heavily regulated
industries supplying recreational drugs—alcohol and tobacco—or would the indus-
try be associated with the squeezed margins and low returns typical of the agricul-
tural sector?

Legalization

Legalization of the sale of marijuana by the states of Colorado and Washington

in 2014 was a milestone in the transition of America’s marijuana business from a
clandestine activity—where growers, dealers, and consumers risked fines and jail
sentences—to a legitimate economic activity, which many believed would increas-
ingly resemble tobacco and alcoholic beverages. By the beginning of 2015, Colorado,
Washington, Oregon, and Alaska allowed the sale of marijuana for recreational use,
12 other states and the District of Colombia permitted its sale for medical use, and

This case was prepared by Robert M. Grant. ©2015 Robert M. Grant.

 CASE 4 POT OF GOLD? THE US LEGAL MARIJUANA INDUSTRY 467

six states (Massachusetts, Maine, Rhode Island, California, Nevada, and Hawaii) were
expected to legalize recreational use by 2018.
Yet, amidst continuing concerns over the physical and psychological ill effects of
marijuana consumption, the impetus to change federal law was weak. Continuing
illegality of the production, sale, and possession of marijuana under federal law
was a major handicap for the industry, even if the federal government did not seek
to counter or overturn legalization by individual states. In particular, firms engaged
in producing and selling marijuana had very little access to the US financial sys-
tem. Banks were fearful that involvement with the industry might contravene drug-
racketeering or money-laundering rules. In the US as a whole, law enforcement
against consumers and suppliers of marijuana continued to be active. In 2013, there
were 693,481 arrests throughout the US on marijuana-related charges—88% of them
for possession.

The Market for Marijuana

The US market for marijuana may be segmented between legal and illegal sectors
and between medical and recreational use. Table 1 provides some data.
There were various estimates as to the extent of marijuana consumption in the
US. A US government survey found that:
Marijuana was the most commonly used illicit drug in 2013. There were 19.8 million
past month users in 2013 (7.5 percent of those aged 12 or older), which was similar
to the number and rate in 2012 (18.9 million or 7.3 percent). The 2013 rate was
higher than the rates in 2002 to 2011 (ranging from 5.8 to 7.0 percent). Marijuana
was used by 80.6 percent of current illicit drug users in 2013.1
One suggested that 7.5% of adult Americans were regular users. A 2013 study by
Pew Research found that 12% of adult respondents had used marijuana in the previ-
ous 12 months: 30% of which were for medical reasons, 47% “just for fun,” and the
remainder for both reasons.

TABLE 1 The US marijuana market

Market feature Data

Numbers of users, 2014 Total users 19.5m (of which, legal users 1.5m)
Marijuana sales, 2014 Legal: $2.7bn (of which 82% medical, 18%
recreational)
Illegal: between $18bn and $30bn
Top six states for legal marijuana sales, 2014 California $1.32bn; Colorado $0.81bn; Washington
$0.22bn; Arizona $0.16bn; Michigan $0.11bn;
Oregon $0.05bn
Rate of annual growth of US legal 2012—18%; 2013—35%; 2014—74%; 2015E—31%;
marijuana sales 2016E—23%
Estimate of US annual sales of marijuana Between $20bn and $46bn
with full legalization
Sources: Houston Chronicle, ArcView Market Research, Medical Marijuana Business Daily.
468 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS

The Colorado Legal Marijuana Industry

Because Colorado was the first state to legalize recreational marijuana, it was seen as
a bellwether for how the legal marijuana industry might develop elsewhere—even
though the structure and conduct of the industry would depend greatly upon how
each state framed its regulations.
From January 2014, Colorado residents were allowed to possess up to one ounce
of marijuana, and could make purchases not exceeding one ounce per transaction.
Initially, recreational marijuana licenses were only available to existing medical mari-
juana dispensaries and retail dispensaries had to produce at least 70% of the mari-
juana they sold. From July 2014, newcomers could apply for a license and separate
cultivation and retailing licenses were issued—thus allowing the development of a
wholesale market.
All marijuana facilities had to have elaborate security equipment installed, includ-
ing surveillance camera and RFID tagging and tracking of every plant.
Costs included a $5000 application fee plus a licensing fee of $4000–$15000.
Separate, lower-cost, licenses were issued for companies producing food and drink
products with marijuana as an ingredient.
By the end of 2014, Colorado had approved 833 recreational licenses (322 of
which were for retail stores) and 1416 medical licenses (505 of which were for retail
dispensaries). There were many times more applications than this. Cannabis sales
during 2014 comprised 109,578 lb to the medical market and 38,660 lb to the rec-
reational market.
The companies engaged in cultivation and retailing varied greatly in size from
tiny owner-proprietorships growing a few hundred plants to industrial-scale opera-
tions. In 2014, Garden of the Gods produced about 280 lb a month from dozens
of 1,000-square-foot growing and flowering rooms. Medicine Man, “the Costco of
weed,” generated revenues in the region of $11 million during 2014.2
Around the core cultivation and retail distribution businesses, a variety of other
businesses had emerged providing services to the industry and complementary
products:

● MJ Freeway offered “seed-to-sale” tracking software that met states’ regulatory

requirements and assisted operations management.
● Advanced Cannabis Solutions leased real estate to large commercial growers.
● Waste Farmers supplied soils for cannabis growing.
● ArcView Group was the industry’s premier hub for investment, data, and
progress, including market research and a network of venture capitalists and
entrepreneurs to facilitate investment in marijuana-related businesses.
● Denver-based Dixie Elixirs & Edibles offered a range of THC-infused choco-
lates and drinks—one of 92 businesses with licenses for producing edible
marijuana products at the end of 2014.

The Economics of the Marijuana Business

Growing marijuana, whether for the medical or the recreational market, required,
first, a license, then investment in a growing facility. Most of these were indoor,
 CASE 4 POT OF GOLD? THE US LEGAL MARIJUANA INDUSTRY 469

climate-controlled buildings with artificial light, but could also be secure greenhouses.
The growing process involved the following stages:

1 Establishing stage: cloning new plants from existing female plants and allowing
the new plants 7–12 days to become established.
2 “Veg” (or growing) stage: two months under constant light.
3 Flowering stage: about two months of a cycle of 12 hours of light followed by
12 hours of darkness.
4 Processing stage: hanging the plants upside down then harvesting their buds
and leaves.
5 Curing stage: drying the buds and leaves.

Most published sources suggested that marijuana was a highly profitable crop.
For example, Motley Fool estimated that a 10,000-square-foot growing facility
with five annual growing cycles could produce 1250 lb a year with a wholesale
value of $2.75 million. With production costs of $1.25 million (i.e., $1000/lb), this
implied a profit margin of 55%.3 Estimates of production costs were highly vari-
able: one study estimated a range of $70–$400/lb4 another study put them as high
as $1606/lb.5
Legalization had impacted production costs. Technological advances and greater
operational efficiencies had reduced production costs to around $802/lb, according
to one estimate. It was predicted that costs could fall further: to $602/lb for indoor
and $400/lb for greenhouse-grown marijuana. However, the costs of the required
initial investment were rising. In addition to the long and arduous process of obtain-
ing a license and fees that could be as high as $20,000, capital costs were typically
between $100 and $150 per square foot, implying an investment of $600,000 to
$900,000 for a modest-sized facility of 60,000 square feet. For some of Colorado’s
largest facilities, initial capital costs amounted to around $15 million. Real estate
prices for facilities suitable for marijuana cultivation had risen sharply during 2014.
Figure 1 shows the layout of a typical growing facility.

FIGURE 1 Layout of a typical marijuana indoor cultivation facility

Veg State Veg State

Flowering State
Veg State

Processing Facility
Flowing State

Office Cloning & Curing

Source: J. Maxfield, “More Legalized Drug Dealing: An Inside Look at Colorado’s Massive Marijuana Industry,”
Motley Fool (January 5, 2014).
470 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS

Most estimates of the profit margins on marijuana growing failed to take account
of risks: diseases and other sources of crop failure were common; in a cash-based
business, crime was an ever-present risk; finally, there was the risk of closure or loss
of license from failure to comply with state or local regulations. As a result, most
Colorado marijuana businesses reported modest margins: La Conte’s Clone Bar &
Dispensary estimated its margin to be just 6% on revenues of $4.2 million.
Future profit margins depended upon the trends in costs and prices. On the cost
side, electricity prices, tax rates, and wage rates were the key variables—workers
in licensed facilities required occupational licenses, and hourly rates tended to be
significantly above those in similar horticultural and retail sectors. As for prices, most
predictions were for a downward trend. Colorado Pot Guide’s Denver price survey
found an average retail price of recreational marijuana of $327 in mid-November
2014 and commented: “The amount of marijuana grown in Colorado is expected to
increase 200–300% over the next year, as more ‘grow only’ operations get up and
running. This is going to result in an oversupply, which can only mean lower prices
for consumers.”6 In mid-March 2015, the Price of Weed reported retail marijuana
prices in Colorado as $242.20 per ounce for high-quality and $197.07 for medium-
quality marijuana.7

Competition
Competition among the 800+ outlets supplying marijuana to the retail market in
Colorado was limited by two factors: first, the market was segmented between medi-
cal and recreational markets—the medical market was open only to Colorado citi-
zens with the necessary medical approval; second, suppliers were differentiated by
geographical location and their offerings. In terms of offerings, marijuana comprised
two species: Cannabis indica and Cannabis sativa, each with distinctive character-
istics and each comprising many different strains. Leafly.com (“The World’s Cannabis
Information Resource”) listed and reviewed some 800 strains. Individual dispensa-
ries used quality and customer service to build loyalty. Although individual firms
established and promoted their own brands of marijuana, the potential for brand
differentiation was limited by the inability to register trademarks for marijuana-based
products with the US Patent Office.
Competition extended beyond the boundaries of the legal market for marijuana.
Users, both medical and recreational, had the option of growing their own (in
Colorado adults could cultivate up to six plants) or could buy illegal marijuana.
Illegal marijuana was produced domestically and imported from Mexico, Canada,
and other countries. Mexico was the principal foreign source: outdoor production
and low-cost labor gave producers a huge cost advantage that was only partly offset
by the costs of clandestine, high-risk transportation and distribution. Nevertheless,
the supply chains and distribution networks for illegal marijuana were well estab-
lished and the lack of sales tax and regulatory compliance more than compensated
for their inefficiencies. According to data from Price of Weed, marijuana prices in
states where marijuana laws were lightly enforced (e.g., California and Florida) were
similar to those in Colorado and Washington. However, in states where marijuana
laws were heavily enforce (e.g., Texas and Georgia), prices were about 40% higher.
Marijuana also competes with a host of other recreational drugs. These include
cocaine, amphetamine, methamphetamine, ecstasy, and a number of other organic
and synthetic drugs.
 CASE 4 POT OF GOLD? THE US LEGAL MARIJUANA INDUSTRY 471

The Future

The primary determinant of the development of the US marijuana industry in the

coming years would be government policy. While in 2015 the forces for legalization
had the upper hand at the state level, the widely predicted expansion of legal
marijuana to new states would depend greatly upon the success of legalization
in Colorado and Washington—in particular the impact of legalization on overall
consumption, the incidence of health and social problems, and the economic impact—
especially in terms of tax revenues. However, as far as the industry’s development
was concerned, what happened at the federal level was critical. So long as marijuana
remained classified as an illegal drug, the industry would be excluded from the
banking system and intellectual property protection, and business enterprises would
find it difficult to expand across state boundaries. Certainly it would be impossible
for established corporations selling intoxicating and addictive products—tobacco
and alcoholic beverages—to enter the industry. However, the tobacco and alcoholic
beverages industries did offer some pointers to how the marijuana industry might
evolve over the longer term. In the case of tobacco it was interesting that, despite
falling consumption, tight regulation, and heavy taxation, tobacco remained one of
the most profitable industries in the US, with the major cigarette suppliers (Altria,
Reynolds American, BAT, and Lorillard) earning an average return on equity of 64%
during 2012–2014. However, there were major differences in structure between the
tobacco and marijuana industries: while the former was highly concentrated with
strongly entrenched brands, the latter was fragmented and brands had yet to emerge.

Notes
1. Substance Abuse and Mental Health Services
Administration, Results from the 2013 National Survey
on Drug Use and Health: Summary of National Findings,
(Rockville, MD: SAMHSA, 2014).
2. “Family Bonds Holding Marijuana Business Together
Showing Strains,” Denver Post (April 13, 2014).
3. “More Legalized Drug Dealing: An Inside Look at
Colorado’s Massive Marijuana Industry,” Motley Fool
( January 5, 2014), http://www.fool.com/investing/gen-
eral/2014/01/05/legalized-drug-dealing-an-inside-look-at-
colorados.aspx, accessed July 20, 2015.
4. J. P. Caulkins, “Estimated Cost of Production for
Legalized Cannabis,” RAND Corporation ( July 2010),
http://www.rand.org/pubs/working_papers/WR764.html,
accessed July 20, 2015.
5. PBS Frontline, “Marijuana Economics 101,” http://www.
pbs.org/wgbh/pages/frontline/the-pot-republic/mari-
juana-economics/, accessed July 20, 2015.
6. “Marijuana prices in Denver and Colorado: Fall 2014
Update,” Colorado Pot Guide (November 20, 2014),
www.coloradopotguide.com/colorado-marijuana-
blog/2014/november/20/marijuana-prices-in-denver-and-
colorado-fall-2014-update/, accessed July 20, 2015.
7. “Price of Weed: A Global Price Index for Marijuana,”
http://www.priceofweed.com/prices/United-States/
Colorado.html, accessed July 20, 2015.