U.S. businesses eyeing Canada’s upcoming rec market will find immense opportunities – and many potential pitfalls

by Omar Sacirbey

Forget California and other states that legalized recreational marijuana last year. Instead, look north.

Some U.S. cannabis businesses, entrepreneurs and investors see greener opportunities in Canada, where a massive new marijuana market is poised to materialize. If everything goes according to plan, the country will allow adults to buy recreational marijuana starting in July 2018 – all under the auspices of the federal government.

Legalization will open the floodgates for business and investing opportunities in everything from cultivation and extraction to retailing and testing as well as ancillary products and services. New entrants from the United States will be greeted by a vibrant capital market loaded with cannabis investors willing to open their checkbooks.

“I’m confident Canada is going to be a strong market,” said Paul Pedersen, a cannabis consultant with Vancouver, British Columbia-based Greywood Partners. “Demand is strong, the people want it, and the government is truly behind it.”

Indeed, Canada’s recreational marijuana industry could become a behemoth fairly quickly, reaching retail sales of 6 billion Canadian dollars ($4.45 billion) by 2021, according to financial analysts at Canaccord Genuity, an investment bank and research firm. For perspective, consider that medical and recreational sales in the United States totaled $4 billion-$4.5 billion last year, according to estimates in the Marijuana Business Factbook 2017.

While the opportunities in Canada will be massive, striking green north of the border won’t be easy, and some companies could stumble.

This special Canada package will help U.S. businesses and investors learn about the opportunities and pitfalls of expanding north. In the following pages, we take a look at:

The business sectors ripe for new entrants, plus those areas that may be less promising.

The obstacles you may encounter should you trek north, such as a vibrant black market.

Case studies on two companies with U.S. roots that have made inroads up north.

A who’s who of key decision makers as Canada’s rec program unfolds.

Opportunity Knocks

If you want to break into the Canadian cannabis market, it’s important to understand that each sector has its own unique attractions and challenges. While the exact opportunities will become more clear once the state finalizes regulations on the new industry, some sectors appear more promising for U.S. businesses than others at this time. Here’s a rundown:

Cultivation

At first blush, this sector looks promising for new entrants given the size of the potential market, which could attract more than 10 million Canadian consumers plus millions of tourists, according to various estimates. Huge demand will create large opportunities for companies that want to grow marijuana.

But the industry could become crowded with growers very quickly, and the country’s established medical marijuana companies will have a head start when it comes to tapping the rec market. As of late May, Canada was home to 45 federally licensed medical marijuana growers. The federal government has been licensing at least one or two new ones every month in 2017, and more than 400 others are awaiting approval. So the cultivation side of the industry could become saturated, though there are still immense opportunities for those companies that can get – and stay – on top.

Conclusion: Cultivation is an attractive sector given the huge number of Canadian cannabis consumers, but expectations should be tempered by the knowledge that the number of competitors may increase quickly.

Retail

This sector contains the most question marks and perhaps the fewest opportunities. The Cannabis Act legalizing adult-use marijuana mandates that Canada’s 10 provinces and three territories decide how consumers can buy MJ within their borders. Licensed, private retail stores – like those in U.S. rec states as well as Vancouver – seem like the logical model. But keep in mind this is Canada, which is home to government-regulated liquor stores and highly regulated pharmacies.

In fact, the only province that seems a strong bet to go with dispensaries is British Columbia, home to Vancouver. In Ontario, the country’s most populous province, powerful employee unions are pushing for sales through liquor stores. The unions have the vocal backing of Premier Kathleen Wynne. Other provinces, meanwhile, may not even have a retail distribution system in place by next summer.

Conclusion: Until entrepreneurs know whether individual provinces allow private marijuana retail shops or give the responsibility of sales to another entity like government-run liquor stores, it’s difficult to determine opportunities in this area.

Processing, Extraction, Manufacturing

This could be one of the most promising sectors. It’s perhaps the one with the fewest existing businesses – and therefore represents a major opportunity for new entrants that want to be early movers in processing, extraction and manufacturing.

Health Canada gave permission to some licensed MMJ producers to produce and sell cannabis oil in July 2015 – but the organization kept its prohibition on edibles. A relatively small number of producers make and sell oil products today. In short, oil production is a new craft in Canada requiring people with experience and know-how.

While the Cannabis Act would allow more medically oriented products like oils and topicals, one big question is whether the government will allow edibles, drinks and other more consumer-oriented products. If not, the market opportunities will be greatly reduced and entrepreneurs would need to rethink how much they want to invest in processing talent and equipment. The good news: The country’s cannabis legalization task force recommended edibles.

Conclusion: Canada’s current medical marijuana law already allows for some processed cannabis products, and that could increase under legalized rec. Given the relatively small number of processors, there is a demand for extraction and processing companies, so U.S. companies and investors should consider this sector one of the ripest for expansion.

Ancillary

Canada’s ancillary space will have opportunities across the board as new plant-touching companies sprout up. Consulting services will certainly be in demand, especially those with experience in rec markets such as Colorado and Washington state. And the testing sector could explode, especially following several pesticide-related product recalls earlier this year.

But not all subsectors will be brimming with possibilities, and entrepreneurs will need to be selective about what niches they want to enter. While there will be a need for seed-to-sale software, Toronto-based Ample Organics has already established itself as Canada’s market leader in that niche, with close to half the country’s legal MMJ producers as clients. And Canada has a strong long-standing agricultural base, meaning it has plenty of suppliers serving the farming sector. Ditto for greenhouse companies. In fact, Leamington, Ontario, claims to be the “Greenhouse Capital” of North America.

Conclusion: There will be business opportunities in many ancillary niches, but picking the right ones will require knowing what’s lacking and what’s not.

Obstacles Aplenty

Those wading into Canada’s rec market will confront a host of regulatory hurdles, business obstacles and challenges that come with navigating laws and customs in another country. Here’s a look at two of the larger ones:

Rules and Regulations

U.S. businesses and investors will have to play by Canadian rules surrounding the production, processing and sale of cannabis. Lawmakers writing the rec rules will strive to be thorough, and expansion-minded companies operating in the United States will face different regulatory issues than they do at home.

“They’re politicians and they’re going to move with extreme caution,” said Paul Pedersen, a cannabis consultant with Vancouver-based Greywood Partners, on how Canada’s lawmakers will proceed with the rule-making process.

Moreover, new U.S. entrants will encounter different government regulations and policies across Canada’s 10 provinces and three territories – similar to how each state and even city in the United States handles marijuana differently. One example of how this can create different playing fields: Some provinces, like British Columbia, are likely to pave the way for cannabis-specific retailers. Others, however, might prefer to put sales in the hands of national pharmacy chains.

The exact opportunities and challenges will come into focus in the coming months as lawmakers and regulators finalize a regulatory framework and provinces reveal more about how they will approach recreational marijuana.

Prime Minister Justin Trudeau’s Liberal government is working from recommendations submitted in December by a nine-member legalization and regulation task. The government is expected to adopt most if not all the recommendations, but many of the details remain unclear. For example: What restrictions will be imposed on advertising? Will infused products be allowed? What types of entities – dispensaries, pharmacies or liquor stores – will the provinces allow to sell cannabis?

Canada’s Black Market

On an overcast April afternoon in Toronto, an illegal but highly visible dispensary with a big sign was hopping with customers. The manager of the store – one of several that had expanded from Vancouver, where it began as a “dial-a-dope delivery service” – declined an interview. Small surprise: Toronto’s mayor has vowed to crack down on illegal cannabis businesses. Publicity would invite trouble.

But the stream of customers up and down the staircase to and from a large receiving area displaying products and accessories was testament to the kind of challenge that legal businesses will confront by way of the black market.

The Canadian government, for its part, has made eliminating the black market a central tenet of adult-use legalization. Finance Minister Bill Morneau, who is responsible for the program’s tax policy, has vowed to keep taxes low on legal operators to achieve that goal.

“The key issue is to make sure we eliminate the black market,” Morneau said in April in an interview with Canadian news outlet CBC.

The Canadian government – and legal operators – will have their hands full.

The illicit medical marijuana market, populated by unlicensed growers and dispensaries, outpaces the legal medical market in terms of sales. Despite off-and-on efforts by police in most Canadian municipalities to shutter illegal dispensaries, they continue to operate openly and draw heavy customer traffic.

“On a slow day a dispensary can make what some (licensed producers make) in a month,” Pedersen said.

Will illegal dispensaries disappear when legal retailers appear? Or will the illicit businesses fight back and survive? The latter scenario is the case in Vancouver. The Pacific port city has licensed a limited number of dispensaries. As of May, 10 had full licenses while another three dozen had preliminary licenses – while about 50 black market operators were doing business.

Licensed recreational cannabis cultivators, meanwhile, will confront a legion of MMJ home growers. Pedersen said at least some of that crop already is going to the black market.

As of May, more than 4,000 individuals were registered with Health Canada to produce cannabis for their own medical purposes.

According to Pedersen, some home growers are allowed to cultivate as many as 200-300 plants. Moreover, those larger home growers sometimes band together and between them form enterprises with several hundred plants. In 2014, by way of comparison, Health Canada reported that there were some 2.97 million plants being grown in homes legally. If you figure that one plant at a minimum yields at least half a pound, that total would have amounted to almost 1.49 million pounds.

The country’s licensed producers, by contrast, either grew or had in inventory a combined 70,468 pounds of plants in the final nine months of 2016.

“Cannabis entrepreneurs are a resourceful bunch,” Pedersen said of the home growers.

It means their U.S. counterparts hoping to capitalize on Canada’s new recreational program will have to be resourceful themselves.

Expanding Into Canada: A Tale of Two Companies

A look at how Cronos Group and The Green Solution tapped Canada’s MMJ market

The Cronos Group, a cannabis-focused holding company formed by U.S. and Canadian business partners, and The Green Solution, an infused products producer and retailer in Colorado, both saw opportunity in Canada. But their paths to America’s northern neighbor and its looming recreational market are decidedly different, with one taking the acquisition route and the other entering via a partnership. There are lessons to be learned in both approaches.

Case Study #1 : The Acquisition Route

The Cronos Group forged its own path. The holding company, headquartered in Toronto, came about after a group of U.S. business partners initially invested in an MMJ company north of the border. They later relaunched it as Cronos Group. Their experience demonstrates that investing can involve far more than simply wagering money on a business. It can mean taking over a business and overhauling its strategy and structure.

Cronos Group CEO Michael Gorenstein started investigating how to enter the cannabis space a few years ago when he worked in New York City, first as a corporate lawyer with Sullivan & Cromwell and then a hedge fund manager with New York-based AlphaBet Management, which later became Saiers Capital. He and his AlphaBet partners were drawn to Canada in part because MMJ was legal nationally.

In 2016, the AlphaBet partners targeted a canna-centric investment vehicle, PharmaCan (not to be confused with the U.S. PharmaCann), which at the time owned stakes in five licensed producers: In The Zone, at 100%; Peace Naturals, 27%; Whistler Medical Marijuana Corp., 21%; ABcann, 6%; and Hydropothecary, nearly 2%.

“It was mismanaged and, because of that, very undervalued. And it was public,” Gorenstein said of PharmaCan.

In Gorenstein’s view, PharmaCan was undervalued because management did not spend its capital wisely. And, he reasoned, the company’s real value lay in the licenses and real estate it held. Peace Naturals, for example, had a lot of land and a generous license – in terms of canopy space – to work with.

Gorenstein liked the potential to scale Peace Naturals, which occupied a mostly flat, 95-acre property in Stayner, Ontario, about two hours north of Toronto.

“When I saw the Peace Naturals property for the first time (in 2016), that was the moment when my thinking changed. I had been to a lot of grow facilities, but this presented a whole new opportunity with what we could do with this place,” Gorenstein said.

The lesson: When evaluating acquisition targets in Canada, scrutinize what licenses the companies hold and what the licenses allow and will permit later.

“We looked at PharmaCan and the assets and it just made a lot of sense to us. We wanted to have these large scalable licenses that we could build on and supply not just Canada but the world. We wanted to create these global platforms.”

Gorenstein and three of his AlphaBet partners each bought $2 million shares of PharmaCan. Gorenstein also took a board seat to ensure the money and company were managed properly.

But he and his colleagues didn’t like how PharmaCan was being run. They went from wanting to be investors to wanting to be owners and operators.

“Our thought was we would build our own team, create a platform that we wanted, and run things that we as investors would want things to be run,” Gorenstein said.

Convincing the Investors

The next step was convincing a conglomerate of hedge funds and private equity and real estate firms to help bankroll the takeover of PharmaCan.

Gorenstein and his colleague pitched the potential positives, such as:

Canada had many MMJ patients but few suppliers, meaning there were opportunities for new and/or larger growers.

Unlike the United States, Canada had a legal national market.

Canada had plenty of vacant land to build out grow operations.

“The biggest question was: ‘Are you willing to move from the West Village in Manhattan to Stayner?’” Gorenstein noted, referring to the rural Ontario town where Peace Naturals is located. “The fact that I was willing to leave my partnership in a successful fund and leave my life in the West Village and move to Stayner and start a turnaround spread a lot of confidence.”

Aside from Peace Naturals and In the Zone, Gorentein also likes Whistler Medical Marijuana, which he describes as an “artisanal craft” grower in British Columbia that carries the cache of the “BC Bud” appellation.

Gorenstein and his partners haven’t decided what to do with Hydropothecary and ABcann. They aren’t central to Gorenstein’s strategy and he wouldn’t hesitate to sell them and use the money to “keep building up our core assets.”

Focusing on Core Assets

Gorenstein and his team plan to build their remaining core assets to serve both the medical and recreational markets.

In The Zone will be Cronos’ “mainstream” recreational brand while Whistler will be the company’s premium brand. Peace Naturals, meanwhile, will be the chief MMJ supplier and serve the export market.

Cronos’ first objective is to expand its Peace Naturals grow site footprint out to nearly 350,000 square feet from the current 38,000 square feet.

Cronos also will expand In The Zone’s site in British Columbia and make it a hub for a “social entrepreneurship” project, Indiginous Roots, a venture led by well-known Indigenous Peoples leader Phil Fontaine.

Gorenstein said Cronos plans to build a 30,000-square-foot Indigenous Roots grow facility at In The Zone. Fontaine’s First Nation group will provide capital and operational funding, while Cronos will provide the intellectual property and know-how.

“It’ll be used as a training ground so we can open up new grow and distribution hubs in different indigenous communities,” Gorenstein said.

Case Study #2: The Partnership Route

The Green Solution (TGS) in Colorado opted to pursue the partnership route. It plans initially to sell its infused medical products – and later its rec products – north of the border via an exclusive partnership with OrganiGram. The Canadian MMJ cultivator has made TGS its exclusive product licensor and commercial scale extraction facility consultant.

TGS, for its part, has given OrganiGram its infused products intellectual property and know-how – the company makes some 250 drinks, edibles, tinctures, balms, pre-loaded vape cartridges and other products – along with the right to reproduce the products in Canada.

The partnership dates to last year when TGS co-founder Nick Speidell met then OrganiGram CEO Dennis Arsenault at a cannabis business conference in Canada. The two huddled about the country’s new law that allowed licensed growers to start producing oils.

Canada had just allowed licensed producers to start producing oils. And OrganiGram was looking for an American partner to help launch its oils operation. TSG, meanwhile, wanted to expand outside of Colorado and had Canada on its list if possibilities.

“Nick knew we had the bandwidth and the support structure set up to support OrganiGram,” said Trent Woloveck, TGS’ vice president of national operations.

Woloveck said Canada’s biggest attraction was having the freedom to manufacture products without fretting the federal government might crack down. Another draw was the ability to bank and conduct business without the barriers companies face in the United States.

The lesson: If partnering with a Canadian company, bring something to the table to offer in exchange for the benefits that a partnership can provide.

Confronting the Unknowns

TGS’ venture, however, underlines the potential pitfalls companies face when entering an emerging rec market like Canada’s. It’s unclear what adult-use products Canada will allow, for example. And it remains to be seen how the government will regulate adult-use cannabis advertising and marketing.

Under the existing medical program, licensed producers can sell flower as well as oils, lozenges, creams and other topicals. But edibles are out. Does that concern Woloveck that the country might not allow adult-use drinks and edibles?

“We’re fully committed to be ready to sell whatever products we’re allowed to sell when the time comes,” Woloveck said. “We also believe that as more products are approved to come online, OrganiGram will know how to adjust our production capabilities in a way that’s quick and cost effective.”

If current restrictions on the country’s medical cannabis industry, as well as its tobacco and alcohol industries are any measure, it will be hard for cannabis companies to advertise. For example, Canadian regulators are very concerned about advertising to children.

What does that mean for TGS? The company hopes to sell products under its Nectar Bee brand, but Woloveck’s “best guess” is that it will be “Nectar Bee manufactured by OrganiGram.”

“As it stands, we believe we’ll be able to use our brand,” he added. “But we’ll of course defer to the regulators.”