PREMISE: 280E compliance demands, & the focus on minimizing the extraordinarily punitive financial impact have contributed to a priority focus/emphasis for cannabis firms on cost of goods sold (COGS). Which in turn has complicated the process of financial reporting to run the business. Vital to engage financial advisers, cannabis accounting professionals who prioritize the navigation through the turbulent conditions with a keen eye towards the path of performance.
OVERVIEW:
100% of the time, the pitch/ask for 3rd party infusion of capital/financing will get immediately rejected assuming the solicitating business fails to:
- Format financial statements in conformity with GAAP
- Provide financial projections with foundational assumptions grounded in fiscal reality
- Include 60-month forward-looking projections with plenty of support
- Highlight Industry, served market & primary competitor comparative metrics
- Include supplemental, re-stated GAAP income statements to include contribution margin, cost-volume-profit-analysis (CVPA} of profitability, liquidity/efficiency, leverage/solvency & enterprise value drivers/KPIs
Too often, the projected financials and historical results & financial position are not in conformity with GAAP, they’re cash and not accrual basis, the presentation is tax reporting/280E focused, and they don’t reflect cost behavior reality.
280E & Cost of Goods Sold (COGS):
Federal section 280E compliance does not prohibit a participant in the marijuana industry from reducing its gross receipts by its properly calculated cost of goods sold to determine its gross taxable income. The Internal Revenue Service takes the position that section 280E-affected taxpayers must calculate their cost of goods sold pursuant to Internal Revenue Code section 471 and the associated Treasury Regulations.
Generally, this means taxpayers who sell marijuana may reduce their gross receipts by the cost of acquiring or producing marijuana that they sell, and those costs will depend on the nature of the business. Which in essence is consistent with GAAP calculations for cost of goods sold (COGS) for manufacturers, wholesalers & retailers.
Typically, financial statements in conformity with GAAP are required by capital/financing sources, prospective sources, and private equity & venture capital portfolio reporting. Failures to provide financials in conformity with GAAP can create loan covenant defaults, and hurdles in securing 3rd party capital/financing facilities.
Yet, many (most?)cannabis operators are not familiar with GAAP. They tend to produce financial statements on a cash basis instead of accrual basis, or in a hybrid tax/GAAP format that doesn’t facilitate financial analysis.
CVPA & GAAP Compliant Financial Statements:
GAAP compliant financial statements typically omit supporting analysis of profitability, liquidity/efficiency, leverage/solvency & enterprise value KPI reporting metrics/drivers. To run the business and to make forward-looking decisions from projected results, historical GAAP financial statements fail to consider underlying cost behavior in terms of variable, fixed, & mixed costs. And, GAAP only financial packages without CVPA leads to confusion on underlying cost drivers (activities), in particular those that add value in the eyes of the customer (VA) and those that impair/don’t add value (NVA).
Time and again, we’ve experienced this with our CFO clients in industries other than cannabis. Frequently, industrial & retail firms don’t truly understand their costs; what activities drive them, and those that vary or remain fixed as volume changes. We make decisions at the product/product line level, and the customer channel/customer level. This in turn leads to decisions at the profit center level, the cost center level and it demands a clear grasp on capacity, throughput velocity/cycle times, work center productivity and associated performance metrics.
Tax based/formatted financials emphasizing 280E compliance are not GAAP. Non-GAAP financials won’t get you financed. And, GAAP financials without the critical management decision CVPA analysis (restated GAAP) are inadequate for forward-looking projections to support those decisions.
The Guy Favicchio Approach:
Oh man, the power of a great coach and mentor.
Long, long time ago I was a very, very wet behind the ears Cost Accountant. Started my accounting career learning all about GAAP with a Big Eight CPA firm and was well-trained in how to keep a GAAP compliant score.
For 3rd party, external financial reporting that is.
On my first stop in private industry, I parachuted into a very challenging assignment with a large, multi-national manufacturer of heavy-duty equipment, parts & components, and farm supply for the dairy industry. We made everything from computer-integrated milker units, manure handling equipment, and bulk milk tanks to infused rubber teat dip liners, and various processed chemical products. Almost immediately, I found myself on the road all the time trying to figure out why the physical inventory shrinkage was so large and unexplained. Like a diligent GAAP scorekeeper, I combed through the physical inventory tickets, the perpetual inventory reports, the accounting entries, etc. Nothing was coming up.
One late evening, a long-time and pretty grizzled operations executive/recovering bookkeeper named Guy Favicchio encouraged me to take a break and let him buy my dinner. He noticed all the early mornings, late evenings and weekends, and weeks I was spending away from our newborn son trying to reconcile the huge inventory bust.
At dinner, he shared some of his experience. The rubber extrusion plant was on a union contract that included incentive pay for productivity based on extrusion yields. Guy was also trying to figure out a huge inventory shrink. Like me, he was spending all his time combing through paperwork in the accounting office. He decided to take a stroll across the parking lot to the rubber plant to get a better understanding of what was happening on the shop floor. The production of rubber teat dip liners involved two machine centers; the rubber was first molded into rubber “slugs” which were sausage like materials that then went through an extruder to produce the finished liners.
Turns out the yields through the extruder were not what the standards & engineering specs called for. Which in turn negatively impacted the union incentive.
The shop floor solution??
They made the slugs bigger which in turn increased the raw material cost of the rubber liners. Albeit the % increase was only around 5% or so, they were extruding millions of liners per year.
Guy suggested I join him in the rubber plant early the next morning for a walk-through. 7:00 AM sharp, I showed up at the entrance and there was Guy with an ear-to-ear grin on his face. Indeed, he weighed the slugs and low and behold they were around 5% or so heavier again than the engineering standards. The dudes on the floor solved their problem, but no one responsible for product costing, pricing or accounting knew they had. I did the math and it explained roughly 90% of the shrink.
I learned right then and there that I was destined to become a partner with the operations folks, that I was gonna get and keep my rear out of the office, and I was going to add value to their efforts to continuously improve by providing management insights, reports & information that helped them do their jobs better, and to focus on adding value.
I owe it all to Guy.
Cannabis Management Accounting:
Once again, cash basis 280E emphasized income statements are not GAAP compliant, but they’re also inadequate for running the business and making forward-looking decisions. My read on what I’ve seen with many cannabis accounting/reporting providers, is the over-riding priority is 280E, basic bookkeeping, and financial reporting that fails to prioritize the operating needs, product line management, capacity utilization, productivity/efficiency drivers, and actual cost behavior of the business.
Moreover, the projections I’ve been given almost 100% ignore all of this while making completely unrealistic foundational assumptions not grounded in reality and lacking multi-scenario iterations to help potential financing & investing sources to analyze risk. Overwhelming majority of CPA firms offering cannabis accounting/reporting & “CFO” services have never set foot on a shop floor and have not had to manage cultivation and production activities. They haven’t sat in the decision maker seat, and the focus is on 3rd party external reporting-primarily prioritized on 280E.
To make better forward-looking decisions, cannabis management reporting must include CVPA metrics, and projections must consider capacity, cost behavior, break-even (B.E.) analysis, margin of safety above B.E. sales, degree of operating leverage, combined operating/financial leverage, and contribution and prime margin analysis. CVPA considers critical cost behavior & activity driver elements, but it’s not GAAP. GAAP emphasizes cost of goods sold and selling/general/administrative categorization. CVPA ignores this formatting and focuses on cost behavior and mark-ups to raw materials costs. Highly automated processes tend to have conversion costs that are largely fixed, and cannabis cultivation and MIP processes reflect this. Critical to consider capacity, throughput velocity, work center utilization, and the activities that consume costs-some that add value in the eyes of cannabis customers (VA), and some that do not(NVA).
Visually, CVPA at a high level considers:
- Profit centers
- Cost centers
- Work center throughput velocity & yields
- Product line profitability
- Customer channel profitability
- VA & NVA costs
- Capacity
Case Study of What Not to Do:
What follows is a real-life, sanitized projected financial summary for a vertically integrated license holder needing help in placing $ 5-$ 10 million to finish off the construction and start-up of a new cannabis venture:
When it comes to the search for 3rd party capital, so often the cannabis prospect is attempting this effort for the first time & has no first-hand experience soliciting financing sources and investors; especially those PE, VC, family office, & commercial finance lenders who are in the business. The perspectives, needs, concerns, risk tolerance, industry experience & deal size criteria are either not known or not specifically considered. Without question, they need GAAP compliant financial statements but they need a lot more to analyze the funding opportunity.
To the extent you’re soliciting investors, they’re concerned with return of capital with a start-up venture in a development stage industry, and they’re contemplating exit alternatives even before they cut their check.
Irrational exuberance is the norm with those soliciting capital, and experienced/sophisticated sources know this and as a result, they’re exceptionally disciplined. Throughout the process from initial ask, through due diligence, negotiation and before they fund, they’re looking for reasons to say, “no”. And, assuming they’re experienced in the cannabis space, they also know that pretty much 100% of the time the enterprise value estimation & resultant ask are nowhere close to actual cannabis operating performance in this space. As a result and when considering the substantial dynamic uncertainty and risk, this remains a pretty frozen market with traditional sources.
Lotta, lotta problems with this projected “income statement”:
- It’s not GAAP, it’s “cash basis” and it emphasizes 280 elements/tax formatting
- Cultivation, manufacturing & retail operations are very different and have activities, cost drivers and operating variables that drive financial results. This summary fails to show profit contributions from the individual operating entities.
- It lacks consolidating, consolidated transparency
- Under GAAP, revenue less COGS is gross profit and income taxes are deducted at the very end of the statement after computing pre-tax operating income. We need to see operating profit, then non-operating expenses (e.g., interest expense).
- No projected balance sheets were provided and a company growing at this rate would likely consume lots of working capital to fund increases in accounts receivable and inventory. Moreover, the omission of projected current assets/liabilities, and long-term assets and liabilities makes it impossible to assess profitability, liquidity and efficiency, leverage/solvency and enterprise value.
- No CVPA analysis was included.
- Underlying performance assumptions for a pre-revenue start-up in a highly dynamic development industry and new state market were wildly optimistic and very atypical of what most firms have experienced in this space.
Summary/Conclusions/Recommendations:
Tax compliance reporting, external financial statement reporting, and management reporting for decision-making are very different animals, they serve different purposes, and the needs of their audience have to be prioritized. Make it tough to make an investment or lending decision, and you can pretty much assure yourself of hearing “no”. If you provide financial statements on a cash basis formatted for tax/280 compliance, they won’t be in conformity with GAAP and it will make industry and competitive analysis extremely difficult to complete.
If you opt to engage the services of a CPA firm to help you co-pilot the financial aspects of your cannabis venture, be careful not to select those who’s careers have been spent only doing taxes, performing audits, or punching journal entries to the general ledger. You’re not looking for a score. You need the stories behind the numbers, and you need the financial and operating insights from one who hasn’t spent decades on the shop floor. Do your homework, and hopefully this conversation helps you know what questions to ask of your accounting & financial service provider candidates. Make sure you engage a trusted financial advisor/point man who’s never above you, never below you and always beside you.
Value$Canna CFO LLC is a specialty cannabis CFO services/consulting firm that delivers accounting and financial reporting, risk management advisory, CFO contributions & cannabis value driver/KPI dashboards to cannabis business owners and their team members. Tony Wayne is an active member/committee contributor to numerous cannabis professional & trade associations, and he holds various cannabis & professional certifications including CPA, CVA, CFF, CIRA, CCCE & CSC. Tony is also President of IronHorse LLC. IronHorse LLC is a specialty consulting firm that specializes in distressed enterprise consulting, CRO engagements, receiverships & complex commercial litigation support. https://www.valuecannacfo.com/
