As Smaller Marijuana Businesses Get Squeezed, State Revenue Takes a Hit

This article was originally published by Stateline, an initiative of The Pew Charitable Trusts, and was written by Scott Rodd.

SACRAMENTO, Calif. — Tyler Kearns, owner of the cannabis cultivation company Seven Leaves, stood in one of his half-dozen temperature-controlled grow rooms on a recent day, surveying a crop derived from the same mother plant.

“We have really tried to educate the general public through talks, tours, communication and presentations,” Kearns said, “to bring a better understanding of the legal California cannabis industry.”

But winning public favor is only half the battle for operations such as Seven Leaves. The other challenge is trying to survive as a small business in the state’s increasingly crowded cannabis industry. At about 10,000 square feet of indoor marijuana canopy, Seven Leaves is small for a California cultivator—the kind of business the new law was supposed to help.

The ballot measure legalizing recreational marijuana in California, which voters approved in 2016, promised that the recreational marijuana industry would “be built around small and medium-sized businesses.” Lawmakers placed size limits on cannabis cultivators and prohibited monopolies in the recreational market.

The goal was to protect nascent businesses from being crushed by big farms or well-financed conglomerates. The protections also were supposed to give existing pot businesses—especially those in the black market—a chance to transition to the legal, taxable recreational marijuana industry.

But many small businesses have struggled to gain a foothold in California’s cannabis industry. A loophole in the licensing scheme has allowed larger cultivators to stack dozens of licenses and expand virtually unfettered. Meanwhile, the costs and regulatory requirements of entering the legal cannabis industry have persuaded many smaller cultivators to stay in the shadows, causing state tax revenue to take a hit.

Their reluctance to enter the legal, taxable marijuana market is one reason why California’s pot revenue is coming up tens of millions of dollars short of projections.

“We need to do everything in our power to assist and incentivize business to move from the black and gray market to the regulated market,” said state Assemblyman Rob Bonta, an Oakland Democrat. “And we need to do it this year—because people make their decisions early.”

Cautionary Tales

The experiences of Colorado and Washington, the first to legalize recreational cannabis, serve as cautionary tales about the way the promise of a small-business-friendly marijuana industry can leave those small businesses hanging out to dry.

As in California, legislators in Washington viewed cannabis as an industry that could support small farmers. When crafting the state’s recreational cannabis legislation, they created three tiers of licenses to support small, medium and large growers. The thinking was that the market would support farms of different sizes.

But retail and wholesale pot prices in Washington have plummeted since 2014, squeezing smaller operations.

In 2014, the average price of marijuana exceeded $35 a gram retail and reached nearly $10 a gram wholesale, considerably higher than black market prices.

By late 2017, the average price fell to about $7.50 a gram retail and $2.50 a gram wholesale, according to FiveThirtyEight.

“There are a lot of businesses struggling with this price pressure,” said Steven Davenport, a researcher at the RAND Corporation who formerly worked as a Washington state regulatory consultant. “People refused to believe that it could happen before it happened.”

Colorado has witnessed a similar plunge in cannabis prices. The wholesale price of marijuana dropped from $2,000 a pound in January 2015 to $1,300 a pound in late 2017, according to The Economist.

Lower prices, while welcomed by consumers, come at the expense of small growers’ profits. Washington state observers point to the consolidation in the recreational cannabis cultivation market as a cause of declining prices. Through most of 2017, 10 farms harvested 17 percent of Washington state’s dry weight cannabis yield.

Large-scale growers are better positioned to weather a big drop in wholesale prices. While their profit margins are smaller, large growers have the scale to sell more product and still turn a profit. For small cultivators, the diminishing margins can be debilitating.

“We’re not there yet, but there’s a very real possibility that a few larger farmers could dominate the cultivation market in Washington,” Davenport said.

Small-License Loophole

As in Washington, officials in California created different license classifications depending on the size and type of cultivation: small, medium and large, and indoor, outdoor and so-called mixed-light cultivation.

The state’s Department of Food and Agriculture set the size limitations for each license type. A small license allows for cultivation on less than 10,000 square feet indoors and a quarter-acre outdoors. A medium license allows for cultivation on less than 22,000 square feet indoors and 1 acre outdoors.

Large licenses allow for cultivation on more than 22,000 square feet indoors and 1 acre outdoors. Lawmakers in California prohibited large licenses from being issued until 2023, and regulators imposed a limit of one medium-sized license for each grower.

The state did not impose a similar limit for small licenses. This loophole has allowed larger cultivators to proliferate — especially in areas of the state where the land, and local ordinances, are good for growing cannabis outdoors.

To date, California has issued over 2,700 small licenses to hundreds of companies. Many growers hold several small licenses.

Five farms have accumulated 579 small licenses, more than a fifth of awarded licenses.

A Santa Barbara County cultivator, Organic Green Farms, has accumulated 200 small licenses. The company did not respond to a request for comment.

Forty-two percent of statewide small licenses, nearly 1,200 licenses, have been issued to growers in Santa Barbara County alone.

The proliferation of cannabis cultivation in Santa Barbara has been driven by several factors. Unlike many other cities and counties in California, Santa Barbara until recently did not license and tax cannabis businesses.

County voters this month approved a ballot measure that included a 4 percent tax on cultivators and a 6 percent tax on retailers.

The county is home to large stretches of farmland, but crops traditionally grown in the area, such as strawberries and cut flowers, have been less profitable because of a saturated market and competition from South America.

“Farmers are subject to many outside forces including consumer demand, foreign competition and regulations,” said Mollie Culver, a consultant with the Cannabis Business Council of Santa Barbara County. “The ability to switch crops and to integrate new crops is essential for long-term sustainability.”

Some smaller cultivators have cried foul over ballooning cannabis farms, many of which dot the state’s central and northern coast. In January, the California Growers Association, which represents cannabis cultivators and has helped shape legislation, sued the California Department of Food and Agriculture, which oversees statewide licensing for cultivators.

“Authorizing large cultivation operations prior to 2023 will have a devastating effect on small and medium cannabis businesses, local economies throughout the state, and the environment,” the Growers Association said in the lawsuit.

Gray Markets

Cultivation is not the only area of California’s cannabis industry where the state is struggling to combat the black market and the semilegal gray market. Regulators in March warned 900 retailers to stop operating without a license. Permits can be prohibitive, more than $70,000 for some stores, and there are several layers of taxes on pot.

Retailers must pay a 15 percent state excise tax on cannabis sales, as well as local tax — on top of the minimum 7.25 percent state sales tax. For small retailers, those costs can be prohibitive for getting off the ground — or remaining in the regulated market.

A primary facilitator of the retail and delivery gray market, at least to state and local enforcement agencies, is a company called Weedmaps, which offers online reviews and product listings by area businesses. Weedmaps has allowed unlicensed cannabis businesses to advertise on its site.

The state Bureau of Cannabis Control, along with the city of Sacramento, sent cease-and-desist letters this year ordering the company to remove listings of unlicensed cannabis businesses. Earlier this year, Weedmaps listed about 200 cannabis delivery businesses in the Sacramento area. Fewer than 10 were registered with the state.

Weedmaps says that excessive permitting fees, high taxes and local restrictions on cannabis are creating unfair barriers to entry to the legal market for owners of small cannabis businesses.

“Weedmaps is operating in good faith, and we want to do what’s right to ensure that the will of California voters is realized,” said Weedmaps spokesman Carl Fillichio in an emailed statement. “We also want to help make sure that people have access to cannabis, good sustainable jobs are created, and communities gain much-needed revenue.”

California Gov. Jerry Brown, a Democrat, and state lawmakers appear to be at an impasse over how to fund enforcement of the illicit cannabis market — but Oakland’s Bonta thinks that enforcement is essential for preserving the regulated market.

“It can’t just be a business decision to stay out of the black market. There needs to be some enforcement,” Bonta said. “It’s not fair to those businesses that are following the rules. We can’t let them undercut the businesses that are in the regulated market and following the rules.”