Growing like weed

It’s official: legalized recreational cannabis is coming to Canada. An already hot market for marijuana companies is set to explode—and a horde of start-ups now face the task of becoming grown-ups in a controversial industry on a short political leash
By Chris Sorensen

Go time: As CEO of Canopy Growth Corp. (TSX:WEED), Canada’s first marijuana producer with a $1-billion valuation, Bruce Linton is happy to pit his instincts against “conventional wisdom”

New York hedge fund managers pride themselves on being able to spot big moneymaking opportunities long before anyone else. But somehow they failed to notice Bruce Linton when he travelled to Manhattan three years ago to drum up interest in Tweed Marijuana, his fledgling medical cannabis business. “The best I could muster was a brief meeting in a hotel lobby bar with a guy who ran his own money,” says Linton, who is now the CEO of parent Canopy Growth Corp., Canada’s first medical marijuana producer with a billion-dollar-plus valuation.

Suffice it to say, Linton no longer needs to sell investors on the potential of a product that, as Ottawa pushes forward with a plan to legalize cannabis for recreational use by July 1, 2018, could soon rival spirits or even wine sales in Canada. These days, the sandy-haired former tech entrepreneur is more likely to be found hosting U.S. fund managers at Canopy’s Smiths Falls, Ont., operation, housed in an old Hershey’s chocolate factory. The visits are supposed to be discreet. But Linton says the parade of chauffeured SUVs rolling past the local Tim Hortons is a dead giveaway. “I’m like, way to blend in guys.”

All those U.S. moneymen are yet another sign of Canopy’s arrival in the corporate leagues. Here’s another: Canopy’s soaring shares, which trade under the ticker WEED, were included in the S&P/TSX Composite Index earlier this year, a first for the pot business. Nor is it just a Canopy story. Beyond Smiths Falls, there are now more than than two dozen cannabis-related firms that trade on Canadian exchanges—many of them among the country’s crop of 40 licensed producers. They include Leamington, Ont.-based Aphria Inc. (TSX:APH), and Vancouver-based Aurora Cannabis Inc. (TSX-V:ACB), which is building the world’s biggest cannabis production facility near Edmonton. Others, like THC Biomed International Inc. (CSE:THC), are focusing on marijuana-related scientific research. Cannabix Technologies Inc. (TSX-V:BLO) is developing a breathalyzer tool for law enforcement. And some companies, like Golden Leaf Holdings Ltd. (CSE:GLH), are making recreational marijuana products, including cannabis oils and edibles, to sell in the handful of U.S. states that have already legalized the drug for recreational use (although pot of all types remains illegal in the U.S. at the federal level).

Supersized: A rendering of the marijuana production facility—the world's largest—that Aurora Cannabis is building near Edmonton (click to enlarge)

For marijuana company managers and directors, meanwhile, the heady times—nearly $700 million was raised in just the past six months, according to one recent analyst report—come with some unique challenges. For one thing, growing weed on a commercial scale isn’t as easy as it looks. Nor is it entirely clear what kind of pressure Canada’s recreational marijuana industry might face from U.S. President Donald Trump’s administration, which has threatened to clamp down on pot-friendly U.S. states. Even the simple act of borrowing money isn’t straightforward—thanks largely to the apparent refusal of Canada’s big banks to participate in the sector.

But by far the biggest risk for Canadian medical marijuana operators is getting ahead of themselves. Canopy, Aurora and dozens of others are rapidly scaling up production, raising capital and inking hundreds of millions of dollars’ worth of deals in preparation for a recreational market that, technically speaking, will remain illegal for at least another year, and may still be in regulatory flux well after prohibition ends. “We’re in a twilight world here,” says Cameron Mingay, a senior partner at Toronto law firm Cassels Brock & Blackwell. “Public company executives and board members need to have proper understanding of the space and treat their product as if it’s a pharma product, which means best practices and procedures to follow the law as it’s currently written.”

Moreover, at a time when Ottawa is stressing restrictions and responsible use—there will prison sentences of up to 14 years for illegal distribution and sale—it’s unclear whether today’s fast-growing crop of marijuana start-ups can demonstrate the responsibility necessary to succeed in a controversial industry that could find itself on a short political leash. Put another way, there’s a lot of talk about erecting giant greenhouses and building great bud brands, but comparatively less discussion about assembling an experienced leadership team and qualified boards of directors, improving financial disclosure or developing best-in-class quality control—oversights that, if left unaddressed, could prove to be a massive corporate buzzkill down the road.

SALES OF MEDICAL marijuana in Canada soared by more than 250% in the year immediately following the 2015 election victory of Prime Minister Justin Trudeau, who had made the full legalization of marijuana a key part of his party’s policy platform. It’s not that more Canadians suddenly became sick, mind you. Rather, doctors became more comfortable with the idea of prescribing cannabis to treat conditions ranging from chronic pain to Parkinson’s Disease. That’s despite a notable lack of clinical studies to demonstrate its effectiveness as a medicine. “Cannabis has taken a very unusual path to the market in that it’s a medicine that’s not gone through Health Canada first,” says Andrea Hill, a lawyer at SkyLaw in Toronto, referring to a series of court decisions that upheld patients’ right to access the drug.

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Yet, as impressive as those figures are, they pale in comparison to what’s expected once any Canadian adult can legally consume pot. A recent study by Deloitte (see chart) projected the industry could be worth as much as $5 billion to start, based on a survey that found 22% of adults already consume marijuana on occasion (not including medical users). That figure could climb as high as $8.7 billion if the additional 17% of Canadians who told Deloitte they might try legal forms of recreational marijuana actually go ahead and buy some. Add in ancillary businesses such as security and transportation and Deloitte estimates the economic activity generated by the industry could approach $23 billion in Canada alone.

With so much pent up demand, the country’s licensed producers and their investors are understandably eager to cash-in on a once-in-a-lifetime opportunity. Take Aurora, for example. The grower, which already operates a 55,000 sq. ft. plant in Cremona, near Calgary, is building an 800,000-sq.-ft. facility—about the size of 16 football fields—that could eventually produce 100,000 kilograms of cannabis a year. Executive vice-president Cam Battley says the facility’s address near Edmonton International Airport makes it possible to offer same- and next-day delivery to patients and other customers who order via the company’s smartphone app: “Our intention is to provide the same level and quality of service as retail giants like Amazon.com.” (Linton, incidentally, also invokes the online retail giant when discussing Canopy’s own growth strategy).

But running a pot company circa 2017 comes with far more twists and turns than launching an e-commerce platform. When the Liberals unveiled their plan in April, they deliberately painted with a large brush: users will need to be 18 or older, producers will not be allowed to target young people and adults would be allowed to possess up to 30 grams in public. But many questions remain. Where will it be sold? In what type of packaging? Can you buy it alongside alcohol? All will have profound implications for the industry’s evolution, as well as the success of individual companies.

There are other less obvious challenges, too. Canada’s Big Six banks have so far taken pass on the industry—apparently because of reputational concerns—leaving smaller institutions to raise the necessary money for expansion. Of course, that hasn’t presented much of a problem to date given investors’ appetite for a chunk of one of the few growth industries outside of Silicon Valley. Jason Zandberg, an analyst at PI Financial, says the $685 million raised in recent months is more than would have been raised in any other niche market through similar-sized dealers. “Clearly, the money is flowing in,” he says. “Whether it’s led by RBC or PI Financial, there’s capital that’s looking for a home in this space.”

But what happens if the enthusiasm dries up? At present, there are almost zero opportunities for marijuana companies to raise money through debt financing. “The lenders in this space tend to be your traditional chartered banks,” according to Zandberg, “but they have chosen to sit on the sidelines for now.”

The situation is a clear source of aggravation for people like Linton. “I have to issue equity or other expensive instruments to run a normal course business with tangible assets of $100 million,” he says. “So when people say, ‘The banks can do what they want,’ I say they’re being unfair to anyone who has a medical right to have [marijuana].”

A spokesperson for the Canadian Bankers Association declined to comment on business decisions by individual banks, saying only that “banks must conduct their typical due diligence to assess a number of factors.”

The headaches don’t end at the CFO’s desk. America’s patchwork of marijuana laws—prohibited at the federal level, approved for medical use in some states and both medical and recreational use in others—creates a legal minefield for marijuana companies on both sides of the border. Consider the following bizarre scenario: once legalization is in place in Canada, a B.C. resident who travels across the Peace Arch border to Washington state, where pot has been legal for several years, could be fined or even jailed if he or she is caught with a few legally purchased grams thanks to the current zero-tolerance policy of U.S. border agents. “You’ve got even more of a grey area than here,” says Matt Maurer, who heads up the cannabis law practice at Toronto law firm Minden Gross. The upside? It’s great time to be a lawyer who specializes in the sector. “There’s a lot of work to be done and there’s going to be a ton more going forward,” Maurer says.

U.S. marijuana firms don’t have it much easier when looking north into Canada. Cassels Brock’s Mingay says many U.S. companies are eager to raise money on Canadian exchanges because of the challenges of doing so in a country where marijuana remains illegal at the federal level. But he says TMX Group, owner of the Toronto Stock Exchange and TSX Venture Exchange, has so far been reluctant to list U.S. recreational marijuana businesses—apparently for fear of doing business with firms who are engaged in activities that are still technically illegal in Canada. It’s a policy that sounds reasonable enough on its face, but doesn’t stand-up to close scrutiny given the way some Canadian TSX-listed companies are preparing for prohibition’s end. Says Mingay: “My U.S. clients will say, ‘Excuse me, I’m confused about which doctor is saying Snoop Dogg [Canopy signed a high-profile partnership deal with the U.S. rapper and pot aficionado last year] is an appropriate brand for medical marijuana.’”

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WITH THE ROAD TO legalization poorly marked and strewn with hazards, it’s little surprise that some Bay Street lawyers are warning Canada’s marijuana start-ups to slow down and keep both hands firmly on the wheel. Emily Larose, a litigation partner and Mingay’s colleague at Cassels Brock, says too many operators are myopically focused on obtaining a licence—Health Canada says that it’s received 1,561 applications as of last August, 400 of which are in progress—or rapidly expanding once they have one. She would like to see more attention paid to the responsibilities that come with manufacturing and selling a novel consumer product like cannabis. “Companies—including public companies—need to consider if they have the right leadership in place, policies, advisers and other considerations to manage those risks and compliance with regulations,” she says. Among the areas where skills and experience are needed, according to Larose: management of health information; quality control systems, marketing claims related to products, and regulatory compliance.

There have already been some embarrassing lapses. Two years ago, the Ontario Securities Commission conducted a review of 62 issuers who claimed to be entering the marijuana market. It found nearly half of them offered insufficient information about their plans, raising “serious investor protection concerns.” While the situation has since improved, some argue investors would still benefit from more and better disclosure. “There’s nothing nefarious going on,” says PI Financial’s Zandberg. “But it’s a new industry and the IFRS accounting for this sector tends to be more confusing than enlightening. For example, a better indication of the cost-per-gram to produce is needed. Everyone calculates it in their own way so it’s not apples to apples. When it comes to production statistics, some disclose it, some don’t.”

Quality control has been another problem. In late 2016, the entire industry was rocked by a scandal after it was revealed that two producers, New Brunswick’s OrganiGram and Mettrum Health, were voluntarily recalling large amounts of marijuana because it contained banned chemicals. It was later learned that one of the substances in question was the fungicide myclobutanil, which is used to control diseases like powdery mildew (Zandberg says the biggest challenge producers face when growing commercial quantities of weed indoors is high humidity levels). Though myclobutanil is deemed safe for use on food like grapes, it is prohibited on medical marijuana or tobacco. Why? It can emit poisonous hydrogen cyanide when lit on fire.

Phatty pharma: Quality control is critical for all pot producers; lapses have put a spotlight on process improvements and transparent testing

The recalls, and the inevitable class action suits that followed, are a particular headache for Linton since Canopy acquired Mettrum late last year for $430 million. Linton says he was aware of the problem when Canopy made the deal, save for rumours that Mettrum employees stashed myclobutanil in the ceiling during Health Canada inspections, and promises it won’t happen again. “These guys were not following the rules,” Linton says, noting Mettrum’s senior management, including former CEO Michael Haines, is no longer with the company. OrganiGram, meantime, has also responded to its recall crisis with a management shuffle, while other producers not involved in the recalls have voluntarily vowed to beef up testing of their products. Aurora has even promised to share the results of its tests with the public, via its smartphone app. “This was a situation that called for someone to take the lead and set the standard for the industry,” says Aurora’s Battley. “Our hope is that we will elevate the standard for the entire sector.”

As for the broader question of corporate leadership and governance, the industry’s existing players argue, not surprisingly, that they’ve taken the necessary steps to build professional, well-managed companies. “The entire sector is in the process of going from start-up to grown-up,” says Battley. “To that end, we did a number of things, including enhancing our corporate governance. In 2016, we added two independent directors who, like me, come from biopharmaceutical backgrounds.” Indeed, several marijuana companies boast directors with either Big Pharma or medical experience. Others have lawyers and former government officials on their boards. Aphria even made waves last fall by tapping Dragon’s Den star Arlene Dickinson to sit on its board.

Larose, however, remains unconvinced. While she notes most of the industry’s bigger operators are professionally run, it’s also true that young companies lack the bench-depth of more mature ones. So what makes the cannabis business unique? It’s essentially a giant experiment taking place while the whole world watches. There may only be one chance to get it right. Hence, Larose recommends “setting up your business and processes in a way that’s perhaps overly cautious.”

Back in Smiths Falls, Linton is making no apologies for moving quickly. He foresees a golden opportunity to establish Canopy at the forefront of a new global industry and protect that lead over the long term by filing patents for cannabis-related health research and consumer products. Recalling his previous life as a tech entrepreneur, he dismisses the idea that his rapidly growing company is suddenly in need of an army of MBA-toting managers or blue-chip board members. “You get to a point where people say, ‘You guys are doing really well as a bunch of aggressive, smart entrepreneurs, so now you should go hire a bunch of older folks from Nortel.’ Well, that worked really badly,” he says. “So maybe you don’t want to listen to the conventional wisdom, but instead think about what the hell you’re doing, how you do more of that—and better.”

You can hardly blame Linton for being skeptical. Just 36 months ago nobody wanted to talk pot. Now that he’s built the biggest company in a sector set to boom, seemingly everyone has an opinion about the best way to do business.

Photography (slider and article) by Jessica Deeks

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