For venture firms, hope and anxiety surround legal cannabis market

Since the Nov. 8 elections, when eight states voted to legalize recreational and medical marijuana, adding to the current tally of 27 states and Washington, D.C., investors in the legal cannabis space are feeling alternately excited and nervous.

The latter reaction may seem counterintuitive, but headwinds are disturbing proponents of legalized pot.

For instance, President-elect Donald Trump, who has said he supports medical marijuana and states’ rights to legalize, has nominated the vehemently anti-cannabis U.S. Senator Jeff Sessions (R-Alabama) as attorney general.

Senate confirmation of the appointment of Sessions to the cabinet is no slam dunk as his nomination to a federal judgeship 30 years ago was voted down over charges of racism. Still, it’s a contrary move on Trump’s part, one that clashes with his official campaign stance on cannabis. And it creates a possible setback for the industry, somewhat tamping down the bullish ardor investors felt in the wake of the election.

“It’s been an emotional roller-coaster the past few weeks,” said Ben Larson, co-founder of the cannabis-focused Gateway Incubator, describing the pulse of the community. “We’re still largely positive. The excitement is still there even in the face of what’s going on.”

Larson underscored the latter point by noting that the favorable climate encouraged the firm to launch its second round of funding, targeted at raising $5 million.

Gateway Cannabis
Gateway Incubator co-founders Carter Laren (left) and Ben Larson. Photo courtesy of Gateway.

The year-old Gateway Incubator, based in Oakland, California, snagged $1.7 million in its inaugural round. Jun Hong Heng, managing director of Crescent Cove Capital, was the lead investor. The infusion paid for Gateway’s first session of incubated companies, which saw seven cannabis startups graduate in September. Its current class, comprised of eight, will graduate in March.

For the four-month program, each participating startup receives coaching and mentoring from Gateway, which provides an up-front investment of $30,000 for a 6 percent equity stake.

Troy Dayton, chief executive of San Francisco-based ArcView Group, a marijuana investment and research firm, expresses optimism, the political omens notwithstanding.

Not only does Dayton hail the movement to legalize cannabis as one “whose time has come,” comparing it to another recent cause célèbre — gay marriage — he offers revenue projections that could give hesitant venture capitalists incentive to move forward.

ArcView’s current data, Dayton said, estimates the legal cannabis market’s current annual revenue at $7.9 billion, with that figure reaching $21 billion by 2020.

A week after the election, ArcView held a two-day “Shark-Tank”-like conference in Las Vegas in which a number of legal cannabis startups pitched their wares to prospective VCs.

Dayton says two Colorado startups seemed to excite investors the most as both offer necessary services that fill a market void. They are Flowhub, a Denver inventory-management-systems provider, and BDS Analytics, a supplier of data intelligence for the sector.

Cans of Cannabis energy drink which contains real hemp seed extract are seen at the food exhibition Sial in Villepinte, near Paris, France, October 17, 2016. REUTERS/Charles Platiau - RTX2P7G3
Cans of Cannabis energy drink which contains real hemp seed extract are seen at the food exhibition Sial in Villepinte, near Paris, France, Oct. 17, 2016. Reuters/Charles Platiau

Gateway’s Larson and co-founder Carter Laren gravitate toward quirky concepts, such as an AI-assisted customer-service platform that was in the first session as well as nascent companies in the hardware, consumer-packaged-goods and edible categories.

In the current session, Larson is especially keen on a startup in which one of the founders is from SpaceX. “He’s working on a really cool self-contained operation that one day could help take over Mars,” Larson says.

The startups will be stillborn if they don’t attract capital to nurture them. And since marijuana is federally illegal, prospective backers grapple with this perennial conundrum. Even in states where medical and recreational cannabis is legal, many VCs shy away from committing cash, not wishing to subject themselves to possible regulatory and legal fallout.

But not all VCs are backing off. In October, DCM Ventures participated in a $13 million Series B funding led by Fresh VC for Eaze, a two-year-old San Francisco medical-marijuana-delivery provider dubbed “the Uber for Weed.”

In April 2014, DCM was the lead investor in a $10 million Series A round for Eaze. Other backers included 500 Startups; Slow Ventures; Snoop Dogg’s venture vehicle, Casa Verde Capital; and Tusk Ventures.

“We were looking at the medical-cannabis market,” said Kyle Lui, a principal at DCM, explaining his firm’s investment in Eaze, which was founded by Chief Executive Keith McCarty, a former executive at Yammer.

Eaze Cannabis
Keith McCarty, chief executive of Eaze. Photo courtesy of the company.

“It’s completely underserved from a technology perspective, and it’s one that still has a lot of gray area. We had a belief that the market was going to continue to grow and professionalize.”

DCM initially expressed concern about committing to Eaze, but the doubt evaporated after the firm gained a solid understanding of how the company’s model worked.

DCM has not invested in any legal cannabis startups other than Eaze, but Lui said the firm is on the lookout for other such investments. Right now, it’s eyeing “high-quality teams that have a competitive advantage in the space that they’re tackling.” Categories that intrigue them are consumer technology and enterprise.

Eaze Cannabis
A shopper of cannabis browses the Eaze site. Photo courtesy of Eaze.

Brendan Kennedy, co-founder and chief executive of Privateer Holding, a Seattle legal-cannabis-focused private equity firm, said the firm has made “extremely small” venture investments in very early-stage companies that are working on products or services he deems essential to the industry.

An example is a Canadian packaging company that Kennedy declined to identify “because our competitors use the same company and we don’t want them to buy it.”

Since its inception in 2010, Privateer has racked up $122 million in overall funding. In April 2015, Founders Fund made industry headlines after investing $75 million in Privateer’s Series B funding round. This investment was a milestone as it marked the first time a prominent and well-established venture firm was making a foray into this space.

Founders Fund has not made a follow-up investment, Kennedy said. In November, however, Privateer scored $40 million in the form of a convertible note from undisclosed backers.

Having recently returned from a trip to Europe, Kennedy, a former executive at Silicon Valley Bank, said that California, the first state in the U.S. to legalize medical marijuana (in 1996) and the latest one to legalize recreational use, seemed to be of intense interest for investors.

“People come all over around the world to visit California,” he said. “So people will see recreational cannabis in California and in movies. This will sway opinions in other states and countries.”

With a slew of countries, such as Canada, Germany and Australia, starting to legalize medical and recreational cannabis, Kennedy is especially elated about the industry’s globalization.

“If 2016 was the tipping point year in the U.S., then 2017 is the tipping point globally,” he said.

Action Item: For information about legal issues surrounding medicinal marijuana, go to http://bit.ly/1frNcX8

Downloadable Data in Excel: select-targets-in-the-cannabis-sector

A marijuana leaf at a dispensary in Seattle on Nov. 27, 2012. Photo courtesy of Reuters/Anthony Bolante