Learning from the First Wave Part 2: California’s Cannabis Supply Chain and Vertical Integration, with a Grain of Salt
Part 1 of this series dealt with the question of how the regulated cannabis market can only be understood in relation to the previous medical market as well as the current “traditional” market. Part two of the series describes how regulation defines vertical integration in California cannabis and, conversely, how vertical integration can solve some of the problems that regulation creates. But first:
A grain of salt
Take the conventional wisdom about integrating vertically with a grain of salt. The expected benefit may not materialize under the current circumstances:
- Overall, the business environment is very challenging due to extensive regulation, over-taxation, insufficient retail capacity and competition from the “traditional” market. As a result, integrating upstream or downstream businesses can mean capturing losses, not profits.
- The three main types of cannabis activities encompass three main industrial sectors: raw materials (i.e. cultivation), manufacturing and service (distribution, testing and retailing). As a result, a vertically integrated company must perform very different types of activities that require very different types of core competencies, equipment, and facilities.
- Developing core competencies is particularly challenging as each of the major cannabis sectors is still evolving.
- Realizing the advantages of vertical integration requires an additional core competence in cross-sector operation.
Regulations define the supply chain
California regulations define the cannabis supply chain by defining both the individual links (licensees) and the relationships between those links. An understanding of vertical integration must therefore be based on an understanding of the underlying regulatory definitions.
The regulatory definition of each link is extensive. For example, each licensee is tied to a specific facility and must have their own procedures for production, inventory control, security, and so on. If the links are strung together, this definition preserves operational redundancies and hinders operational integration.
Overall, the relationships between the links are primarily defined in terms of maintaining the chain of cannabis custody. In addition, regulations define very specific (and very consistent) associations between certain licenses, as explained below.
A taxonomy of links
There are currently 26 types of cannabis licenses in California, 25 of which can be vertically integrated:
- Cultivation – 14 licenses, of which 4 sizes each for indoor (up to 22,000 sf), mixed light (up to 22,000 sf) and outdoor (up to 1 ha) as well as kindergarten and processing (drying, trimming and packaging / labeling)). Note that cultivation licenses are the only licenses that limit the scope of activities.
- Manufacturing – 5 licenses including volatile extraction, non-volatile extraction, everything except extraction (i.e. infusion) and packaging / labeling.
- Testing (Type 8) for testing cannabis according to state standards prior to sale. A trial license holder cannot have any other type of license.
- distribution (Type 11) acts as a gateway between cultivation and production on the one hand and retail trade on the other. The dealer’s gateway status is an artifact of regulation – cannabis must be officially tested before it is sold to a consumer, and only a dealer can order the official test. All products must be in a quarantine area of the retailer until they pass the test. Products that fail the test must be destroyed if they cannot be fixed.
- transport (Type 13), used to move cannabis between licensees (with one narrow exception). This license does not allow official testing.
- Storefront retail (Type 9) which is the best and the hardest license to obtain.
- Delivery retail (Type 10) for delivery services that are subject to the uncertainties of software platforms and the intransigence of local authorities.
- Microbusiness (Type 12) that enables licensee to conduct cultivation (up to 10,000 square feet), nonvolatile manufacturing, distribution, and retailing.
- Event manager
Self-Distribution – A Case of Useful Integration
You can see from the previous section that moving a free and mandatory dealer to the middle of the supply chain creates problems for cultivators and manufacturers. Experienced operators solve this problem by purchasing a distribution license. This enables the cultivator or manufacturer to:
- Select the time and place for the cannabis products to be tested.
- Avoid paying other people to store cannabis products as they wait for test results or purchase.
- Reduce transportation costs (especially if the dealer is close to the other establishments).
- Sell direct to retailers.
The bottom line is that vertical integration in California cannabis is useful as a means to an end rather than an end in itself. Therefore, cannabis operators should carefully consider how vertical integration benefits their core business before taking on the risks and costs associated with an additional license.
This article is intended as an opinion only and is not intended as legal advice.