Vertical integration is a hot topic right now in both hemp and cannabis. What are the pro’s and con’s of vertical integration for the hemp industry and how does federal and state law affect what an entrepreneur or business can do? In this article we examine the pros and cons of vertical integration, hoping to help budding businesses evaluate the right move for themselves.
Background: What is Vertical Integration in the Hemp Industry?
When a company controls more than one stage of the supply chain within an industry, it's called vertical integration. There are five phases of the supply chain in hemp: cultivation, processing, packaging, distribution, and retail. A company vertically integrates when it controls two or more of these stages.
The 2018 Farm Bill assured the legality of interstate hemp commerce by explicitly allowing hemp and hemp products to be transported across state lines.This opened the door for national-scale operations to operate in full compliance with federal law. Although on a state by state basis, each state has their own ability to regulate. The cannabis industry is in a more challenging position with some states requiring and some banning vertical integration while interstate commerce remains strictly prohibited.
Who Benefits from Vertical Integration in the Hemp Business?
Highly regulated vertical integration tends to favor bigger businesses, but classic vertical integration resembles farm to table and seed to sale more than Walmart or Google.
In my opinion, less regulation benefits the entrepreneur. The less regulation (not in terms of safety or growing practices, but more in respect to red tape preventing entry) can put the choice of size/scope/size and scope in the hands of the entrepreneurs instead of lobbyists and politicians, which in turn creates a more competitive free-market. States requiring vertical integration for cannabis eliminate an entire arm of the industry. While large scale, cheap production makes sense in the medical space, the recreational market values small batch, locally grown and produced specialty products. Many entrepreneurs don’t want to manage logistics or research and development on a large scale, opting for serving their local communities to the best of their abilities. They may only want to grow cannabis or perfect tinctures.
The prevalence of craft breweries around the nation is a perfect example of America’s appreciation for local businesses. Many people want to pay more for products and services they know profit those geographically close to them. These types of ventures bring something more than jobs to the communities in which they are located. They add culture. Local shops, cafes, restaurants, and bars define a town in a way that factories and corporate office buildings never will.
Furthermore the regulation of vertical integration in the cannabis industry has raised the price of entry to levels that eliminate the small business. States like Nevada, Florida, and California have seen venture capitalists dominant every stage of the chain in the last couple of years. California cannabis businesses have historically been at least partially integrated. Most cultivators would package their harvest, receive lab results and, with those in hand, deliver to retailers.A family with an acre, a garage, and a work van could run a modest but profitable operation; however, recreational cannabis signaled the end of the mom and pop by instituting expensive, limited permit systems. In my experience, multimillion-dollar operations are typically the only ones who can afford the cost of entry to vertical integration across today's budding national market.
Should All Hemp Companies Choose Vertical Integration?
Companies want to vertically integrate for a number of reasons that in sum amount to greater wealth potential, but this arrangement shouldn’t be the goal of every organization.
First and foremost growing brands must develop a sustainable model for their initial offering. Prove the product or service profitable before considering further scalability. As has been the case with many startups in the tech sector over the last two decades, businesses often overlook or underestimate the learning curve of expansion and thriving in a new sector. While many succeed initially because they have a strong offering, their management or structure may be lacking. This gets exposed when production demand increases or they try to diversify.
The best CEOs optimize their internal practices long before scaling. Just because a company makes a great CBD moisturizer doesn’t mean they can successfully cultivate hemp or extract cannabinoids. Is that moisturizer successful because of the packaging or because of the production model, supply margins, and marketing plan? Great packaging isn’t going to translate into farming, but if it's the internals creating the profits, they may be able to implement that into cultivation.
A startup beats the odds when they achieve profitability. Those cards are further stacked against them entering a second market. If in analyzing internal practices it’s determined that its the offering, not the method responsible for the brand’s success, vertical integration isn’t the most productive focus. Taking time to improve production, management, training, and implementation creates a strong base that will scale when the right time does come for expansion. With all that said, let’s take a look at the pros and cons to vertical integration itself.
So, now let’s get to the root of the article!
What are the Pro’s and Con’s of Vertical Integration for Hemp Businesses?
TOP 5 PROS OF VERTICAL INTEGRATION:
1. The company is its own supplier.
There is no concern over a 3rd party changing ownership, failing to maintain equipment properly, or not meeting supply deadlines. If Company M wants their hemp cultivated organically, they don't have to worry about Company J cutting corners with their cultivation practices.
Take Honda the car manufacturer. They have always designed and constructed their engines. Honda makes nearly every part in each of their vehicles, assembled in a Honda plant and then sold at a Honda dealership. They are known for the long lasting reliability of their engines.
When you get inside a Hyundai on the other hand, you are sitting in a hodgepodge of parts from various manufacturers. Their engines come from a venture known as GEMA supplying Hyundai, Chrysler, KIA, and Mitsubishi. All of those makers have a reputation for hit and miss quality, in part because they are using an engine that happens to fit in a vehicle rather than being optimized for that car or truck from the ground up.
Companies benefit from vertical integration when hemp crops or products are in high demand and low supply, market conditions that raise wholesale costs and rates of suppliers. Where other companies lose out on their margin, vertically integrated companies maintain a fixed price on hemp.
2. Economy of Scale
Vertical integration creates “economy of scale,” a situation where the product gets cheaper to make the more volume increases. Shopping at Costco where you get an advantageous price per item by buying in bulk is a simple example of economy of scale. By expanding vertically, the cost to produce a retail product goes down, whether its a CBD company growing their hemp, doing their own packaging or selling from their own storefront.
Vertically integrated retailers can acquire the product at cheaper price points and drive down costs.
3. Consolidating Management and Eliminating Bloat
Most managers want to bring more operations in-house as a matter of risk management. Vertically integrated companies can streamline production, packaging, and distribution, often by consolidating upper-level oversight. Manufacturing and packaging can be integrated as one. Flow, including shipping, can be managed from a central point.
Fully integrated business models create synergies, so the different aspects of the supply chain complement each other. Without an in-house grow a company could struggle with supply. Without extraction, brands leave themselves out of a high margin market. Without product, there is no way to capitalize on new consumer offerings. Lacking retail means that a good CBD product could potentially find itself with no shelf space.
4. Tax benefits.
A benefit for production facilities is that there are tax deductions available to them that aren’t available to retailers [under IRS tax code 280E]. A company that's vertically integrated is writing off costs and paying zero markups every step of the way. Rather than pay a processor a fee that pays both their overhead and their income, vertically integrated companies only spend money on direct business costs which are significant tax write-offs. Ultimately, it can transfer those savings to the consumer as lower prices or to the investors as profits. This tax leverage is an important differentiator compared to smaller companies who struggle to pay the high tax rates within a limited scope of business.
5. Market Flexibility and Data
Seed to sale companies get the most accurate market data as they know what the customer is experiencing and purchasing during their time in store or online--especially if they retail other brands as well. Vertically integrated sellers will know which products may be outselling their own and why. They can control the experience and the products available to their end customer, steering them if necessary. These companies don’t have to negotiate wholesale prices with retail either. They know precisely their margin and translate the savings directly to the public customer. They can stay on top of consumer preferences and emerging product markets more easily than a manufacturer trying to procure analytics.
CONS:
1. Cost
The most significant disadvantage of vertical integration is the expense. It used to be the opposite. Without burdensome regulation and licensing fees, small-time farmers could grow some hemp, process it, and then offer it for sale. Now the entry costs discourage small-time operations who often need to pool resources with other farmers to get off the ground. It takes even deeper pockets to get permitted for multiple parts of the supply chain.
2. Loss of Flexibility
Companies must invest a great deal of capital to set up or buy factories, farmland, distribution systems and storefront real estate. With each piece of the chain connecting like a puzzle piece, a vertically integrated company can't change parts of its chain as quickly as a smaller company can switch vendors when industry changes occur.
Companies that white label instead can more easily adjust to market changes. Vertically integrated companies can't change products as quickly as those who use third parties. They have a production line which they need to work within, or they need to overhaul their process.
For example, many companies use CO2 extraction to derive their CBD from hemp. If a more popular technology came out, they would have to buy new equipment necessary for that process and revamp their whole supply chain. A company that isn’t vertically integrated on either side of that chain could hire a third party for extraction and continue with their production schedule.
3. Specialization
For many brands their claim to fame is quality. They do one thing, and they do it well. Vertical integration can potentially reduce expertise by making their brand scope too wide. Scaling is one of the hardest things to do with business. Not every brand is meant to become the next Walmart. For many great companies, their brand differentiator is in one specific offering. They are often better off refining their process than trying to reinvent the wheel elsewhere since they have already done what most brands are ultimately trying to accomplish in being unique.
Jason Boyer of cultivator Wild West Growers in Eugene, Oregon has said about vertical integration, “What we view as our specialty, which is growing cannabis and processing it into edibles and extracts, allows us to create the highest quality we can, work on the efficiencies of our business model, and try to create a sustainable model.”
There is value in knowing what is one's lane and keeping the focus there. If expertise is a company differentiating factor, they shouldn't abandon that in their quest for growth.
Divided Company Culture
It's also not likely that any company will have a culture that supports both retail stores and factories. A successful retailer attracts marketing and sales standouts. A factory is more conducive to engineering and logistics talent.
This was the case with Theranos the blood analysis company. Their research and development side of the business knew it had a lousy product and needed help, but the marketing side ignored this and pushed their marketing plan ahead. Theranos found themselves marketing a product that wasn't developed. Executives allowed them to attempt executing on these plans and it destroyed a multibillion-dollar company.
The clash of cultures can lead to misunderstandings, conflict and lost productivity. A non-integrated company can even use cultural diversity in the workplace to compete against the vertically integrated one.
In Summary
Vertical integration isn’t easy, it isn’t cheap, it may reduce flexibility, and it may introduce risks that more than replacing those it manages. With that said, taking steps in that direction can ultimately improve efficiency, quality control, and bottom line. For those that can scale wisely, vertical integration means the sky is the limit.
References
7 Point Law. "Vertical Integration: What Is It, and Why It Matters to Cannabis." 7 Point Law. October 16, 2018. https://7pointlaw.com/vertical-integration-what-is-it-and-why-it-matters-to-cannabis/.
Kane, Jenny. "Nevada Marijuana Growers Fear Going out of Business." Reno Gazette Journal. January 17, 2018. https://www.rgj.com/story/news/marijuana/2018/01/16/nevada-marijuana-growers-fear-going-out-business/1037931001/.
Lovett, Ian. "In California, Marijuana Is Smelling More Like Big Business." The New York Times. April 11, 2016. https://www.nytimes.com/2016/04/12/us/in-california-marijuana-is-smelling-more-like-big-business.html?utm_medium=email&sslid=Mza0sDAwsTQzNLIEAA&sseid=MzYxMDc3tTS2AAA&jobid=0fa66ba0-adea-4291-87b6-90d025ab5d31.
Somerset, Sara Brittany. "Florida Governor Wants To Modify Its Marijuana Market." Forbes. January 25, 2019. https://www.forbes.com/sites/sarabrittanysomerset/2019/01/25/florida-cannabis-market-is-getting-rid-of-vertical-integration/#3e56c178cd3c.