Cannabis Musings - June 29, 2023
What's the deal with distribution?
Friends, why is distribution so hard? You may have seen the recent news that Herbl, one of the largest licensed commercial cannabis distributors in California, shut down and filed for receivership. Herbl was a powerhouse in a state where using a third-party distributor, or at least transporter, is a necessity for most due to the large footprint and the plethora of competition. Unless you’re a producer that’s large enough to self-distribute to retailers, or small and local enough to justify self-distribution (although both require vehicles and sales staff), distribution fills a key function within the cannabis supply chain.
Those who’ve been in the industry long enough will know that Herbl is not the first distributor in California to fail (it also had a presence in Nevada, after having acquired Blackbird in 2021). Indeed, the state saw a wave of major distributor failures around 2019, when the state-licensed industry had its first big downturn. I know this because I represented a number of them in navigating their distress (creditor negotiations, fire sales, wind down, etc.).
So, why is cannabis distribution so vulnerable? In short, distributors take on credit risk, and when cash is tight (really, really tight), and vendors don’t pay (on time, or at all), the distributor is left holding the bag (which is empty), and the supplier is left holding another bag (which is also empty). Generally, the distributor is in the middle of the wholesale transaction:
Distributor picks up the products from the Supplier
Sometimes, Distributor also markets the products to Retailer, acting as the Supplier’s salesforce
Retailer buys the products
Distributor delivers the products to Retailer
Retailer pays for the products
Distributor pays Supplier, minus a fee
If you can spot the cash flow risk in this model, you might have a career in finance!
The problem is that, if Retailer isn’t paying Distributor in Step #5, then Distributor is left owing money to Supplier. Distributor ends up acting as a quasi-lender to Retailer – by delivering product without payment, Distributor is effectively lending value to Retailer, to be paid back later (also known as “trade credit”). Herbl reportedly even had a line of credit with East-West Bank to help bridge the payment gap, but that was reportedly cancelled.
This is a very standard model in many other industries, but, in so many ways, cannabis is unique because liquidity is basically unavailable to most industry operators. There are few lenders who are able, let alone willing (it’s hard to lend against cannabis licenses and inventory), to make lines of credit (loans that may be paid down and reborrowed, as opposed to term loans, which are lump sum) available to retailers and producers. These financial instruments exist for the very purpose of smoothing out cash flows.
To make matters worse, and this is just anecdotal based on my own observations, but there’s generally a bit of a culture of not paying bills in this industry. I suspect it comes from the fact that everyone in the industry is used to not doing business the way everyone else does business. One of the more aggressive examples of this is companies accruing (not paying) taxes, because the penalty rate is lower than what a lender would charge a cannabis company. When everything is always on fire, you do what you need to - az me muz, ken men (“if you have to, you can”).
Clearly, however, none of this is sustainable. One California legislator has proposed a bill to statutorily tighten the number of days invoices may remain unpaid, the hammer being the potential loss of cannabis licenses for repeated failures. Producers and distributors are developing their own self-help remedies to tackle the problem. Certainly, as we’ve discussed, the alcohol distributors are champing at the bit to handle this for the industry. All of this should help on the margins, but none of it really fixes the fundamental problem with the financial structure of the cannabis supply chain (and just wait until there’s interstate commerce!).
Maybe the entire model of cannabis distribution needs to be rethought, at least until the business becomes economically feasible. It’s apparent that the distributor-as-creditor isn’t working in this environment. Within turmoil is where opportunity hides.
Be seeing you!
Hauser Advisory provides advice and strategy on business lifecycle events and cannabis industry navigation, tapping into a deep, national network and twenty-five years of dealmaking and capital markets experience.
© 2023 Marc Hauser and Hauser Advisory. None of the foregoing is legal, investment, or any other sort of advice, and it may not be relied upon in any manner, shape, or form.