Too High to Survive

When examining the current state of cannabis, we must focus on two distinct groups: consumers and operators. They are the primary drivers of the market's existence, notwithstanding the role the government plays in designing the legalized marketplace. They also bear the brunt of taxation that can discourage or attract consumers to the market, and the highest number of licenses are distributed to this category.

Consumption and approval of cannabis have been steadily on the rise since the adult-recreational use was legalized. The chart to the right is the National Survey on Drug Use and Health (NSDUH) Prevalence of Past-Year Cannabis Consumption, Unadjusted⁵. It indicates that cannabis consumption in California, while lower than in other Pacific coast states, was roughly 11% in 2002-03, and has risen to approximately 25% as of 2021-22. This is a strong indicator that the state's legalized and regulated market is robust, with potential to grow even further, considering the untapped potential still in the unregulated market. ERA Economics, a consulting firm hired by the California Department of Cannabis Control, estimates that the “total value [unlicensed cannabis produced in state] is around $11.9 billion ($2.0 billion within the state and $9.9 billion exported)”⁶. This indicates that the licensed regulated market of $5.43B as of 2023⁷ has at least $2B in additional market capitalization, which is being untaxed and in the unregulated market because consumers have been able to find lower prices and ease of use.

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Interviews and analyses of conversations with experts indicate that California cannabis consumers have easy access to the unregulated market, which is a significant deterrent for investors and is stunting the growth of the market. A simple Google, TikTok, Instagram, or Weedmaps search highlights the locations, dates, and times of events the industry refers to as “Seshes.” These events are held in public places, some near police stations, demonstrating California law enforcement's nonchalant and hands-off approach to the issue. The Department of Cannabis Controls also mentions this as a serious concern for the industry, highlighting that “plant eradications in California are estimated to represent between 6.9 and 16.8 percent of unlicensed production that is cultivated in the state for 2011–2016, and between 7.5 and 18.3 percent for 2019–2024.”⁸ These amounts barely put a dent in the unregulated market which underscores that more law enforcement and a reignitions the “war on drugs” would not solve the provlem of a vibrant underground unregulated cannabis market in California, that is easily 

accessible to most people.

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Operators in the California cannabis industry are struggling to remain afloat, but that was not always the case. Considering that, “2016 was irresistible to cannabis entrepreneurs… capitalists wasted no time investing billions into California’s pot market.”⁹ Cultivation and retail were the early crowned jewels of the early stages of the industry, with companies like MedMen opening “Apple-like” stores with investors promising that they would “virtually print money.”¹⁰ Those days were short-lived, and now many cannabis firms/operators are either struggling to survive, are out of business, or utilizing the unregulated market to make ends meet. In an interview with an expert in the field, they noted that “95% of the income they make comes from 'direct-to-consumer wholesaling,'”¹¹ which is a euphemistic way of saying selling on the unregulated market. 

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From 2020 to 2024, there has been a steady decline in the retail price of the baseline product, dried flower, going from a high of $39 per 1/8th of an ounce to $23 per 1/8th. Typically, we would attribute declining prices to innovations in the market or health competition. These downward price pressures stem from the unregulated market, overproduction, and oversaturation. While we have already discussed the issue of increased enforcement in the unregulated market, poor business practices and rushed venture capitalist investors, mixed with a harsh and complicated regulatory system, also contributed to creating these conditions for California operators. One expert went so far as to say that a significant problem with the industry was too much capital and “not enough adults in the room making decisions,” while also highlighting the oversaturation of licenses due to unlimited access created by the DCC and local governments.¹² 

Additionally, the burden of taxes and regulations on the cannabis industry is overwhelming firms' ability to make any profit, harming the efficiency of the marketplace. A report from the DCC¹³indicates that the state currently has more cancelled or expired licenses than active ones across the supply chain. Industry experts are concerned about the industry's current pricing and taxation trends. Consumers are apprehensive about prices, and the legalized market has higher rates that push people into the unregulated market. With these conditions, the state's goal should be hyper-focused on supporting the capital financing pressures in the industry while reducing taxation and regulatory burdens to allow the industry to grow and sure up the market. 

An important subsection of California operators is social equity, which the state has designated as an area of support essential to California’s market. But what is social equity in cannabis, and how does it impact the health and viability of the cannabis market? Often, people refer to social equity as reparations for Black people or charity for individuals affected by the “war on drugs.” Social equity is a process of the government providing certain business advantages to people impacted by the “drug war” and traditionally marginalized in entrepreneurship. This differs from a rural business program for small-town economic growth or women's business programs to increase female ownership.  

The state adopted a light-touch approach in California, allowing cities and localities to determine whether and how they will implement a social equity program. The requirements generally include a residency within specific historically impacted zip codes, income limits, and/or a conviction for cannabis possession. In comparison, there may be more or fewer requirements based on local laws. However, the ultimate goal is to allow state residents to start a business in an industry where they were previously penalized. Opponents of social equity programs have argued that this is a “form of economic protectionism that limits competition and leaves small local operators vulnerable to predatory out-of-state partners and investors.”¹⁴ While I agree that some predictions of local operators being vulnerable to larger, predatory entities are valid, states often tilt the business landscape or regulatory market in a specific direction for various economic, cultural, or social reasons—for example, through the establishment of monopolies in garbage collection, subsidies on crops, or the creation of opportunity zones. California has created laws and regulations to codify social equity as a goal, alongside the health and viability of the cannabis marketplace. Therefore, as we proceed, it is essential to understand that any corrections or improvements to the industry must include the protection of the cannabis market's social equity sector. 

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For example, the profit margin quickly disappears when the same model is utilized and some core variables are changed. Because it's San Francisco, and your location is in a high-crime and large unhoused community like the Tenderloin neighborhood, and you need armed security, the cost increases to $200k. Your interest rate on a financing loan from a VC firm goes to 27%, and rent goes to $25K a month. Under current market conditions, that would result in a deficit of —$300,000+.

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The core problem with regulated cannabis retail is the inability to earn a reasonable profit. For California, the most optimal outcome of creating a legalized cannabis industry would be its normalization, so that opening and financing a dispensary would be like a bar or restaurant. However, that is not the case because capital is difficult to find, and profit margins are virtually nonexistent. Utilizing the profit maximization model, I created a scenario to project the business environment for cannabis operators. My model makes some basic assumptions about the cost of starting a dispensary in San Francisco, listed below, based on interviews and conversations with over 10 experts in the field. Additional details are noted in (APPENDIX #1).

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The cost of capital is calculated¹⁶ $\frac{P\times \frac{1}{12}}{1-\left(1+ \frac{1}{12} \right)^{-(T-12)}} $. To determine the^‍ variable cost per unit (VC) sold, I use the current wholesale price of ⅛ oz of cannabis flower ($13) and multiply it by the tax rate, utilizing this formula¹⁷ VC = W(1+X) for a VC cost of $17.70 per unit. Total revenue was based on the assumption that this retail local would sell $1M or less of roughly 70K units of product annually at an industry-standard retail markup rate of 2.5 times the wholesale price. To determine this, I used the formula¹⁸ AQ(RP-VC) = TR. Lastly, I calculated the profits/losses by¹⁹ TR-FC = Profit.

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The most important takeaway from this model is that it is an economic loser for any intelligent entrepreneur. No sane person would choose to open a business with a loss of approximately $55K, contend with high taxes, in a federally illegal industry, and have an escalating number of armed robberies and break-ins²⁰. With just one major crisis, like a robbery, debanking because of federal restrictions, unpaid supplier accounts, etc., operators are likely to enter into even more debt with very few financial options to manage it.

Some key factors to note are the higher licensing fees and application costs. State application costs for opening a bar that sells beer and wine in San Francisco would cost $1,500, with annual licensing fees of $1,100. Local licensing in SF is high for selling alcohol, with one-time costs between $150-300k, but this is also a conventional business with more options to finance and manage debt. Also, capital cost rates are exceptionally high in the cannabis industry, unlike the hospitality field, being between 17% and 30%, because of the risk of losing federal banking insurance (FDIC) due to its illegality. For my model, I used the lower end of that scale. Finally, the combined taxation rate that the consumer pays is 36%. That includes a state cannabis excise tax of 15%, state sales tax of 7%, SF cannabis tax of 8%, and a sales tax of 5%. This amount will fluctuate depending on the location of the dispensary. Still, tax rates of 30% and over, generally viewed as deterrents for many consumers, help to prop up the unregulated illicit market that the state desperately wants to terminate. When we return to this model, the profit problem is the primary focus of my policy recommendations.

Three main components have exacerbated the decline of the California legalized cannabis market: overcapitalization and commodification, local control, and taxes and regulatory policies. While they were all siloed with very different decision-makers within each, they have collided to create the perfect storm for retailers. Common sense dictates that most people would not start a business that is structurally proven to lose them money. Most people start companies in fields with strong fundamentals where they can predict profits and losses, such as a convenience store, content with steady profits and growth. Or they enter a risky market with gigantic potential, such as cryptocurrencies, gambling on their ability to strike it rich.

However, cannabis retail is currently a losing proposition in California. Using the profit maximization model, I have observed the current economic challenges of the marketplace, outside of the two most significant externalities: federal legal prohibition and a vibrant illicit market. Below, I have illustrated the process model for opening a cannabis retail store in San Francisco. Several important aspects of this process determine much of the initial capital cost to operators: 

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• Operators must secure a retail location before applying for a San Francisco or state license. While this requirement is potentially waived, it is a crucial cost driver because of location restrictions, which create predatory landlords who raise rates for cannabis businesses.  
• Like many localities, San Francisco requires community improvement work to be done at the store's cost and with input from residents and nearby companies. This paternalistic rule is unnecessary in most other industries, adding time and costs to a struggling sector.  
• Lastly, the local process must occur before state licensing can begin. In this process, companies have been approved for local licensing, which have gone on to be stalled or denied at the state level, adding additional bureaucratic steps, time, and resources that firms do not have.  

After adult recreational use was legalized, retail was one of the most sought-after licenses due to the expected exponential growth of the marketplace, with an estimated growth rate of 9.4%. This flood of resources and capital from investors created what was known as the “green rush.” Social equity operators were inundated with offers to partner with, or outright sell their licenses for tens of thousands or even millions of dollars. Reportedly, companies like Eaze would raise over $800M in their Series D round, and PAX was able to raise $420M in their Series A. At Eaze’s peak, they had annual revenues of $200M, while losing $230M annually. The most well-known example is MedMen, called the “Apple store of weed” by many. By going public on the Canadian stock market, they raised over $110M, and were valued at $1.65B in 2018. Today, the company is overrun with lawsuits, has over $137 million in debt, and has only $15 million in cash. At this early stage in California, competition was fierce, and gaining market share was all that most companies wanted. They were willing to lose millions of dollars annually to outlast the next company and be one of the survivors of this initial green rush.

This marked the beginning of the market's overcommodification, leading to valuations that would ultimately crash the California industry. More companies entered the market, leading to overproduction, which caused a price collapse. As opposed to today, where capital investors are scarce, and financial institutions that lend to cannabis companies have interest rates that start at 17%. Leaving the state to be broadly seen as a cannabis money pit, to venture capitalists and hedge funds, who were the original capital funders between 2016 and 2021. Additionally, this makes it difficult or impossible for social equity operators to raise funds to enter the market, a key economic priority for the state. 

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As the chart above highlights, the quarterly price of cannabis product sales, as oversaturation proliferated, prices dropped, creating economic surplus for consumers by taking it from producers. Ultimately, this placed the most pressure on retailers who were already competing with a vibrant and lower-cost, unregulated market, resulting in the most significant decline in the number of cannabis business employees compared to other states between 2023 and 2024. This demonstrates the seriousness of the impact of overcommodification and overvaluation on a market, as capital markets have retreated from California due to billions of dollars in lost investments. Current business financing rates in California for cannabis are between 17% - 30%, even for financially solvent firms, making the cost of capital too high for many. 

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 The process of creating effective industry regulations was hampered by special interest that would cripple the long-term growth of the industry. While the trends are evident that most Californians have no objection to the use and sales of cannabis in their communities, there is still a vocal minority in political leadership that either have moral or other reasons for disliking the new normal of cannabis legalization. Many California medium to smaller cities have had a “history of local bans on all cannabis businesses,” with many stating that crime prevention, restricting access to children, and local aesthetics are the primary reasons. Initially, local control was a way for proponents of Prop 64 to ease concerns by local mayors and city councils on their ability to manage and control cannabis activities in their jurisdictions. However, this has spiraled out to be a cudgel to wield against some legally authorized cannabis business activities in their locations.  The chart below, from a supplemental report from the DCC, illustrates the roadblocks and barriers localities impose on lawful business activities for their purposes, which hinder the state from meeting its revenue and equity goals.

Experts bemoaned what they have observed as cities and counties believing that they can use cannabis as a “piggy bank”. This idea echoed through all qualitative interviews of industry experts in and outside of the state. This indicates the disconnect between the government regulators and the industry itself. The California League of Cities has long advocated for local control, lobbying effectively on local taxation rights, community benefits requirements, and local licensing requirements. As my profit model demonstrated, local governments have increased the cost to consumers by adding cannabis taxes and general sales taxes, making the regulated market economically unattractive to consumers who can easily find unregulated operators selling the same products at half the price with no taxes. At the same time, business owners have argued that these rules are killing their businesses and reducing local tax revenues, hindering governments from maximizing potential benefits from cannabis sales. The underlying issue is that a nascent cannabis industry in the original days of adult-recreation legalization was tied down before it could take flight.  

The California DCC continually highlights that cultivation and production of cannabis are up, while simultaneously stating that, “despite annual increases in cultivation volumes and consumption, retail sales of licensed cannabis have been decreasing since 2022”. They argue that this is because reduced retail prices are lowering the value of current sales, while the number of units sold is steady. Both are still poor outcomes for the state, with over $2B in unregulated sales annually. Experts and analysts alike agree that overtaxation is a primary driver in the unregulated market that is keeping an estimated 60% of the California cannabis market in the unregulated sector, with a compounded tax rate (depending on jurisdiction) as high as 40% on regulated cannabis. Local control of cannabis has exacerbated this issue, allowing cities to place taxes on cannabis to fill budgetary shortcomings. Limitations on local control, such as caps on cannabis tax maximums, removing local licensing requirements, and reducing annual fee amounts, would go a long way to addressing the overtaxation problems in the system. 

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Additionally, as the state reports, excise taxes and fees for cannabis are roughly 77.5% of the wholesale value. Excise taxes and fees for alcohol are about 8.4% of the wholesale value, and excise taxes and fees for tobacco are 29.5% of the wholesale value.” The concern here is that cannabis is statutorily mandated to use tax revenues to support anti-drug programs, and the California Highway Patrol, along with other programs. This leaves no additional funding to support the growth and stability of the cannabis industry through tax abatements, loan programs, and capital expenditures incentives to promote hiring and business-to-business (B2B) purchases. Furthermore, the DCC itself is funded through application and regulatory annual fees, which have placed them in a budgetary deficit of $23M for 2024. This model of department funding only incentivizes the department to raise fees as its workload grows, making it harder for firms to obtain licenses due to the higher cost, which creates a steady decline in application/licensing, thereby increasing the department's deficit even more. 

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Overtaxation and high fees also do not deter the growth of the unregulated market.  The Tax Foundation has observed that tax rates exceeding 30% did not prevent the unregulated market in Colorado or Oregon, and California’s rate is 40%. Underlying this entire process is IRS Code 280E, which prohibits cannabis companies from utilizing the federal tax code to offset expenses and costs. For example, most companies can claim a tax deduction for employee costs, purchasing equipment, and virtually any other legitimate business expense. This is the most pressing issue that can only be addressed by the U.S Congress. To make an industry work, the government should focus on reducing the barriers to entry and the barriers to remaining open, like high taxation.   

An important subsection of California operators is social equity, which the state has designated as an area of support essential to California’s market. But what is social equity in cannabis, and how does it impact the health and viability of the cannabis market? Often, people refer to social equity as reparations for Black people or charity for individuals affected by the “war on drugs.” Social equity is a process of the government providing certain business advantages to people impacted by the “drug war” and traditionally marginalized in entrepreneurship. This differs from a rural business program for small-town economic growth or women's business programs to increase female ownership.  

The state adopted a light-touch approach in California, allowing cities and localities to determine whether and how they will implement a social equity program. The requirements generally include a residency within specific historically impacted zip codes, income limits, and/or a conviction for cannabis possession. In comparison, there may be more or fewer requirements based on local laws. However, the ultimate goal is to allow state residents to start a business in an industry where they were previously penalized. Opponents of social equity programs have argued that this is a “form of economic protectionism that limits competition and leaves small local operators vulnerable to predatory out-of-state partners and investors.”¹⁴ While I agree that some predictions of local operators being vulnerable to larger, predatory entities are valid, states often tilt the business landscape or regulatory market in a specific direction for various economic, cultural, or social reasons—for example, through the establishment of monopolies in garbage collection, subsidies on crops, or the creation of opportunity zones. California has created laws and regulations to codify social equity as a goal, alongside the health and viability of the cannabis marketplace. Therefore, as we proceed, it is essential to understand that any corrections or improvements to the industry must include the protection of the cannabis market's social equity sector. 

Before we review possible remedies for the problems highlighted in the System of Failure section, we should first define a healthy marketplace. Part of having a viable industry is managing fixed and variable costs. Retailers' variable and fixed costs, such as the rate of utilities, raw materials, and products, can be outside their control. However, there are some steps the state government can take to reduce these costs for retail shops.

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Policies to Support Retail Dispensaries with Fixed and Variable Costs

• Develop a low-interest loan program for cannabis operators
• Bring cannabis licensing fees and applications more in line with Alcohol 
• Prohibit localities from requiring any additional licensing, outside of general business licensing practices for the city
• Cap or prohibit the amount cities can charge in a cannabis tax between 0% and 0.025%
• Reduce the state excise tax to between 0% and 5%
• Remove or reissue the CCTT program to reduce support businesses frustrated with the program, entice operators to staff, and reduce errors that contribute to the unregulated illicit market

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The California cannabis market faces several challenges, one of which is being undercut by the unregulated marketplace. As we move towards policy recommendations, the impact of taxes and regulations on the ability of retailers to maximize their profits in the industry is a better criterion for measuring the health and stability of the cannabis industry in California. The current equilibrium price per ounce of legal cannabis is $258.88 (P1), while the current unregulated price is $175.00 (P2). Due to taxes and regulations, the cost of transitioning from unregulated to legal markets has increased by 32%. Any intervention should reduce this gap, allowing retailers to make operating in the legalized market more profitable than in the unregulated one.

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Any effective policy criteria should understand the values embedded in the development of the current system and how it needs to be supplanted with a new system. The criteria selected that provide the framework for my policy recommendations include: 

• Equity & effectiveness: Increases the number of successful social equity businesses as a state goal.
  
  • California’s stated goal is to support and increase the viability of equity operators, so all policy recommendations must not negatively impact this segment of the cannabis economy.  
• Harm reduction: Reduce unintended consequences to currently operating businesses.
  
  • Because the industry is already suffering from harmful policies, it is important that we reverse these effects at best and do not increase their influence at worst. 
• Generate Economic Activity: Lowers the cost of market entry barriers.
  
  • As the evidence demonstrates, sales are flat, if not down, in California, and the wholesale price is currently not optimal for retailers. Recommended policies should increase sales and activities that increase retailers' bottom lines.
• Feasibility: Political and bureaucratic implementation.
  
  • What is politically possible is generally a subjective term. Because of this, I will push the boundaries of what is usually considered possible, assuming that a motivated executive branch will move bills in the legislature and confront some special interest.  

The health of the cannabis retailer is paramount to the longevity and viability of the California cannabis industry. Policy recommendations that are siloed and implemented individually often do not address all of the core concerns of the specific problem. The recommendations I am presenting are best done in conjunction with each other, and the level of alterations to existing policies will determine the overall effect on the marketplace.

To illustrate this, I will present three scenarios utilizing my profit maximization model to provide the state with the current case, base case, and best case possibilities. The chart below will highlight the exogenous parameters(red) outside the state's control that influence the market. I will note the implementable policy variables (blue), where variations in these categories can dramatically change market dynamics. Also, after Appendix 1, I have included a bar chart demonstrating each policy scenario's economic impact on an operator's financial decision to open a retail dispensary by highlighting their estimated profits and losses. Optimally, the state would implement scenario #3. However, scenario #2 is a more realistic and effective policy framework for improving cannabis in the state.