Industry

Learning from the First Wave Part 1: How Law Shapes the California Cannabis Industry

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As a cannabis attorney, I spend a lot of time thinking about how regulations affect a cannabis company’s bottom line. Since I’ve been in California, the options have been many.

In late 2017, I became Chief Compliance Officer for a startup in Oakland that did delivery, sales, cultivation, and six manufacturing operations. A large part of my job has been preparing my company, along with several cannabis public companies, for the first wave of cannabis licenses in California.

The majority of First Wave’s licensees came from the essentially unregulated medical cannabis market in California and / or the by definition unregulated “traditional” market in California. When California began issuing licenses in January 2018, many First Wavers were unprepared as their business practices evolved in an unregulated market. A big part of my job was helping them adapt to the new demands. As a result, I saw the regulations and the effects of regulations much easier.

Regulation affects virtually every aspect of California’s legal cannabis industry. Anyone who wants to understand the industry should have at least a basic understanding of how the regs work. I’m writing this series to get the big picture.

Some important points:

  • The regulated market needs to be understood in relation to the previous unregulated (medical) market as well as the current traditional market.
  • Regs define the supply chain.
  • Regs are designed to ensure product safety and maximize tax revenue.
  • Many regulations dictate good business practices.
  • Local building, health, and safety code enforcement is typically arduous and costly.

A story of three markets

The California Regulated Cannabis Market can only be understood in terms of the previous medical market and in terms of the traditional market (illegal market) that continues to compete with it.

The prehistoric times

The legal medical cannabis market in California dates back to 1996 when the Compassionate Use Act was passed by ballot. One fact that shaped the medical market was that it was never just medical – while serving gullible patients, it also served as a Trojan horse for adult (recreational) buyers.

Another fact that shaped the medical market was an almost complete lack of regulation. On the seller side you had to be organized as a collective. On the buyer side you had to have a health card. That’s it

Meanwhile, the cannabis supply chain was completely unregulated. This tended to minimize production costs. It also meant that a patient visiting a pharmacy could not verify where and how the products were made.

The regulated times

Approval under the Regulation and Safety of Cannabis for Medicinal Purposes and Adults Act (the “Act”) began on January 1, 2018. It marked the beginning of legal adult cannabis in California. It was also the beginning of the regulated times when the law and 300+ pages of regulations changed the legal cannabis market.

For example:

  • The law defines the cannabis supply chain (as a series of licensees).
  • Throughout the supply chain, cannabis companies’ internal procedures are subject to government scrutiny.
  • Cultivators and manufacturers cannot sell directly to a pharmacy – they have to contact a dealer.
  • All cannabis products must be tested for effectiveness and a long list of contaminants by an approved testing laboratory before they can be sold to consumers.
  • Starting in 2019, all licensees had to participate in the California Cannabis Track and Trace (CCTT) program, which aims to track all cannabis from seed to sale.

Equally important, the law establishes a system of dual licensing – that is, a cannabis company must have a local permit (or other permit) and a state license to operate. In fact, local approval is a requirement for a state license. And your local jurisdiction has its own rules for cannabis, in addition to state rules, including a ban on cannabis activities.

Needless to say, working in the regulated time is much more complicated and expensive than it was before.

Especially when you consider taxes. For example, in the city of Los Angeles, adult cannabis sales are taxed at 10%, which means that every adult purchase in LA receives a 34.5% markup:

  • 15% state cannabis excise tax plus
  • 10% Los Angeles Adult Use Cannabis sales tax plus
  • 5% sales tax.

Note that traders have to collect the excise duty from the retailer, so the 15% surcharge is not necessarily visible to the consumer. Similarly, consumers are generally not aware of a cultivation tax of $ 9.65 per ounce (or about $ 1.21 per eighth) of dried flowers that the trader must collect from the cultivator.

In theory, none of this could be a problem if only licensed retailers were to compete with one another. What brings us to:

The traditional market

The traditional market is the illegal market, that is, the untaxed and unregulated market.

Legalizing adult cannabis was supposed to destroy the traditional market, but it hasn’t. In early 2020, the traditional market was estimated to be 80% of the total cannabis market in California. This is not surprising as the traditional market has the advantage of being untaxed and unregulated.

The traditional market has consistently negative effects on the legal market. For example, the traditional market tends to depress prices in the legal market and pull talent away from the legal market. Some of these effects are discussed in the following articles.

This article is intended as an opinion only and is not intended as legal advice.

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Robert Dunfee