Despite the proliferation of medical and recreational cannabis use throughout the country, the U.S. government classifies marijuana as a Schedule I drug. Without a nationwide regulatory framework for marijuana, medical and recreational states are left to pass legislation to control the cannabis market from seed-to-sale. Local governments have even taken initiative by enacting their own cannabis regulations to limit or ban cannabis cultivation and retail locations.
In the beginning, many states favored a rigorous medical cannabis program by limiting licenses or requiring that retail locations grow most of their own product. These strict rules were arguably designed to stomp out black market weed and make it easier for states to track product from harvest to dispensary shelf. For many investors, vertical integration in the cannabis industry allows for massive scale but can risk creating cannabis monopolies.
What is Vertical and Horizontal Integration?
When an entrepreneur wants to grow their cannabis company, they can either choose to develop their own business or acquire or merge with a company that does the same thing to create a more vigorous company. Horizontal integration can grow a cannabis company by adding another flourishing business without the prohibitive cost of starting a business from the beginning. Large-scale acquisitions and mergers can reduce operational costs over time.
With vertical integration, a company controls more than one aspect of their supply chain. For example, a vertically-integrated business could own everything from a cultivation facility to a retail location where they can sell their products. States have experimented with regulatory models that require, permit, or prohibit vertical integration. While prohibition is meant to reduce use and discourage negative business practices, states are warming up to vertical integration.
In terms of horizontal integration, cannabis companies can focus on growth by acquiring or being acquired. As companies begin to expand, larger companies can end up buying their competitor to increase revenue and become market leaders. Vertical integration and horizontal integration can limit the number of people that can enter the cannabis market. When farmers attempt to compete by getting retailer licenses, they may lack expertise in that area and fail. Consolidation, however, can incentivize businesses to create high-quality products since they have to control from seed-to-sale.
What are the Advantages of Vertical Integration?
Vertical integration in the cannabis industry enabled states to control the number of cannabis companies in operation. This defacto limit on licenses meant states could effectively manage the supply from seed-to-sale. Since companies could cultivate and sell their own product, there was no need for paying wholesale prices for their products. Instead, vertically-integrated retailers could sell their own products for less and reap more profit margins.
By controlling the cultivation of raw cannabis and where it's sold, companies with vertical integration can set their own prices for the raw material and manufacturing costs. If cannabis companies cultivate too much product, they can sell it elsewhere for wholesale prices. Vertically-integrated companies can mine their retail data to ensure they focus on the products the customer enjoy most. While companies can grow exponentially by owning their entire supply chain, vertical integration for a company comes at a high cost.
What are the Disadvantages of Vertical Integration?
In states that require or permit vertical integration for cannabis companies, the startup costs are astronomical. In terms of a cultivation facility, cannabis business owners must heavily invest in equipment and a location that meets or exceeds regulatory standards. Farmers are hesitant to invest in post-production and retail for fear they'll be run out of business by larger vertically-inclined businesses. For vertically-integrated companies, the drawback is that they are required to meet their production needs or else their entire business suffers.
A vertically-integrated business requires that owner to handle multiple moving parts. A need arises to hire experts in cultivation, retail, product development, and more in all aspects of the business. If one area of the vertically-integrated business fails, it affects the entire operation. Vertical integration can leave independent cannabis cultivators struggling to find a place to sell their product. Without a retailer license, the fate of cannabis farmers is left to retailers who may favor their own product.
How Does Each State Handle Vertical Integration in Cannabis?
Many states have enacted a variety of rules and regulations regarding licensing with mixed results. Since the cannabis industry is relatively new, the effects of different regulations aren't very clear and won't be for a while. States like California, Illinois, and Washington have adopted restrictive rules on vertical integration. Other states like Maine, New Jersey, New Mexico, and New Hampshire require vertical integration for many reasons. Every type of regulatory framework comes with pitfalls, but forces states to find solutions to the problems it faces.
When Colorado began to create regulations for the cannabis industry, legislators favored a vertical integration framework. Colorado required that medical dispensaries grow 70 percent of the product they sold. Many states followed suit by integrating a similar mandatory model for vertical integration. Colorado's regulatory model put many operators out of business due to the high upfront costs and restrictive requirements. Some states have learned from Colorado's experience and opted to allow vertical integration, instead of making it mandatory.
Colorado has since loosened the requirements in its state. As of July 1, 2018, the 70/30 rule in Colorado was phased out. After July 1, 2019, vertical integration will no longer be required for medical cannabis in Colorado. This new framework will enable farmers to focus on growing the best cannabis possible without taking on processing and retailing operations.
Washington regulates cannabis like most states regulate the alcohol industry by the Washington State Liquor Control Board. Its prohibitions on how many licenses a business can hold are seen as restrictive for some. For example, cultivators are not allowed to own cannabis dispensaries. Similarly, dispensaries can't hold a cultivation license. By separating the supply chain, the producer, distributor, and retailer can focus on their respective goods and services. In theory, this type of regulation can prevent consolidation and overconsumption of cannabis.
California limits vertical integration by restricting licensees from holding more than two license types. Some combinations of licenses are not allowed. For example, this regulation ensures cultivators licensees do not have undue influence or financial interest in retail operations. Undue influence can be hard to detect since the law is so vague. New regulations in 2017 clarify these confusions to define best business practices. By January 1, 2026, vertical integration will be prohibited.
In Nevada, medical cannabis businesses can hold three licenses to become vertically integrated. Businesses can own a cultivation, production, and retail license. For example, a cultivator can choose to get a production license to infuse cannabis products and sell them to retailers for wholesale prices.
As the cannabis industry continues to experience mergers, acquisitions, and new businesses sprouting up, regulatory frameworks must learn from others and adapt as needed. Every approach has its benefits and drawbacks, but regulatory models should benefit standalone farmers and vertically-integrated businesses. For now, states have adopted a unique blend of regulations and rules to reduce exploitative business practices and efficiently control the market. The effects of each system won't be evident for a while, but hopefully, lead to a better overall product and customer experience.