The Hempire Strikes Back: The financial ups and downs of setting up in the marijuana business

    By Dan Tynan | Small Business

    He told me his name was John.

    "Last name?" I asked. "Just John," he said. "And the name of his store, the one that just opened?"

    He demurred.

    “I don't want to invite undue scrutiny,” he said. “There is so much uncertainty in this space right now.”

    “Most new businesses welcome media coverage,” I persisted. “Don't you want customers to be able to find you?”

    “They will,” he said. And then he went quiet.

    John is in the medical marijuana business. In early August he opened his first cannabis dispensary somewhere in Los Angeles (he declined to get more specific). Despite the fact that medical marijuana has been approved for sale in California and 17 other states – two of which, Washington and Colorado, have also legalized adult use starting next year – it remains a shadowy industry whose members tend to avoid the spotlight.

    That's because, in the eyes of the federal government, marijuana remains a Schedule 1 drug, subject to the same legal enforcement as heroin, ecstasy, and crystal meth. Even in states where medical marijuana is legal, dispensaries have found themselves raided by local or federal authorities, their inventories confiscated, their proprietors arrested. Most banks are unwilling to do business with them, and they must navigate a tax code that is both schizophrenic and unforgiving.

    Yet at the same time, the cannabis industry is booming. Support for legalization is at an all-time high (no pun intended). Another handful of states are expected to legalize medical use over the next four years, creating an industry projected to be worth $6 billion by 2018, according to Medical Marijuana Business Daily (MMBD). Venture capitalists are itching to dive in. One ambitious entrepreneur, former Microsoft executive Jamen Shively, has already announced plans to launch the “Starbucks of pot,” with franchises across multiple states.

    In many ways legal marijuana stores are like any small retail business. Owners need to find a location, build out the facility, obtain inventory, hire and train employees, and attract clientele. They need to meet payroll and pay taxes, purchase insurance and protect against theft.

    In other ways, though, marijuana dispensaries are utterly unique. Imagine opening a Starbucks in a country where drinking coffee was considered a crime, and crossing a state line carrying a cappuccino could land you in prison.

    No free launch

    Fortunately, not all marijuana dispensary owners are as tight lipped as John.

    Ken Sobel opened The Green Halo in Tucson last January. It's one of 48 medical marijuana dispensaries currently licensed to operate in the state of Arizona. A practicing attorney, Sobel got into the cannabis business after his mother-in-law and later his father died from cancer.

    “When my mother in law became ill, medical marijuana was the only thing that relieved her pain and gave her an appetite,” he says. “The same with my father. I went into this business so that people who were sick wouldn't be forced to meet someone in a back alley to get the medicine they need.”

    Before launching The Green Halo, Sobel co-founded the Arizona Dispensaries Association. He also serves as a consultant for other cannabis dispensaries in his state. Being an attorney helps him navigate the morass of regulations engulfing legal dispensaries, which vary wildly from one state to the next,. In Arizona, for example, dispensaries must be not-for-profit entities but can buy supplies from any licensed grower. In neighboring Colorado, the opposite is true – dispensaries can pocket a profit but must grow at least 70 percent of the cannabis they sell, significantly increasing barriers to entry.

    Intense regulation is just one way that opening a Starbucks of pot is different than opening just a Starbucks. But most of the big differences revolve around money.

    The money trap

    If you're seeking to build your own hempire, you'd better have deep pockets.

    Constructing a 5000-square-foot indoor cultivation facility costs around $350,000, says Sobel. That doesn't include the cost of employees, supplies, or electricity. He says a 2400-square foot retail operation can cost up to $250,000 to build and lease – and potentially much more if you're buying the property. (Landlords invariably charge a premium for dispensaries who choose to rent.) Other dispensary owners contacted for this story estimated start-up costs ranging from $150,000 to over $1 million, depending on the size of the operation.

    Don't even think about applying for a loan. According to MMBD, more than 80 percent of all dispensaries are self financed, while the rest receive funding from friends, angel investors, and VCs. And don't count on help from your friendly neighborhood banker. Thanks to federal rules regarding money laundering – and, yes, drug trafficking – many banks refuse to do business with dispensaries. Legal cannabis facilities are often unable to open checking accounts, let alone find a bank to handle credit card transactions. Most operate as a cash-only business, as The Green Halo does.

    Having large amounts of cash and stash also demands more attention to security than in your average coffee shop. The Green Halo has at least one unarmed security guard on duty at all times, says Sobel. (Others, like John's unnamed Los Angeles facility, feature armed guards.)

    “We are literally as secure as a small bank,” says Sobel. “But we are mostly interested in ensuring the safety of our patients and employees, not the money or the medicine.”

    But the worst part may be the tax hit dispensaries must absorb. Thanks to an obscure part of the federal tax code known as Section 280e, costs associated with the sale of Schedule 1 drugs are not tax deductible. But dispensaries can still deduct the cost of goods sold. That means the cost of the marijuana itself can be deducted; the cost of the employee who dispenses it cannot.

    As a result, dispensaries often end up paying two to four times the effective tax rate of comparably sized small businesses, says Betty Aldworth, deputy director of the National Cannabis Industry Association, a trade group that's attempting to reform tax laws for dispensaries.

    Big green machine

    With all the barriers to entry, why does anyone bother? Most dispensaries were started by activists seeking to reform attitudes and laws surrounding marijuana. But the vast potential for profit is changing the nature of the game.

    Operating at scale, a medical marijuana dispensary can be a cash cow. A pound of cannabis that costs $500 to $1000 to grow can fetch $6000 to $8,000 at retail, depending on quality of the herb and location of the store. While 15 percent of dispensaries take in less than $100,000 a year, according to the Marijuana Business Factbook, more than one in four have annual revenues in excess of $1 million – with Harborside Health Center in Oakland, California, topping the list at $22 million.

    Sobel says money is not the point. But even in states like Arizona where dispensaries operate as nonprofits, some are biding their time in hopes the law will change, says Khurshid Khoja, an attorney with Greenbridge Corporate Counsel in San Francisco who represents dispensaries like Harborside.

    “Medical cannabis laws are not set in stone,” he says. “I expect that the days of cannabis prohibition are numbered. And as the regulatory landscape evolves to allow for broader use, the people running dispensaries as nonprofits may be able to convert into for-profit entities.”

    MMBD estimates that if marijuana were legalized across the US, annual revenues would exceed $45 billion – or more than four times the size of the coffee and tea industry.

    Still, the legal cannabis business is not for everyone, admits Adam Bierman, president of The MedMen, a consulting and marketing group that has advised dozens of dispensary start-ups over the last three years.

    “The first thing I tell people who want to get into this business is, you're about to break federal law,” he says. “If that bothers you, go do something else. There are really few people who possess the ambition, entrepreneurial drive, and tolerance for risk to be in this business. You've got to want to be in it.”

    With such intense regulatory oversight, Sobel feels the weight of constant scrutiny.

    “It's like living in a fishbowl,” he says. “On the other hand, I get to help people get the positive energy and care they need. This isn't a get rich quick scheme – or even a get rich slow one. My goal is to build a stable business for our patients. And in one or two years I think I'll be there.”

    All graphs republished with the permission of the Marijuana Business Factbook.
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