In November 2016, California voters approved Proposition 64, a state ballot initiative legalizing adult use cannabis, by a 57% to 43% margin.

This initiative created several categories of commercial cannabis licenses including cultivation, manufacturing, distribution, retail storefront, non-store front delivery, microbusiness, testing and event licenses. The state also established different license types within each category. For instance, it created different types of cultivation licenses based on the type of production, type of lighting used, and size of the canopy.

The state’s licensing framework allows operators to become “vertically integrated” by holding licenses across the entire cannabis supply chain. However, unlike many states, California does not require operators to be vertically integrated. Asa result, the supply chain in California is highly fragmented, with thousands of cannabis licensees occupying the different parts of the supply chain. It is rare for any operator in California to hold more than 5% market share in any vertical. This stands in stark contrast to many other “limited license” states.

Prop 64 imposed a very high tax burden on legal cannabis operators. First, imposed a cannabis cultivation tax of approximately $150 / lb, which was set to rise with inflation. Second, it imposed a 15% excise taxon the retail sale of cannabis. Third, it subjected cannabis to the state sales tax of approximately 10%. Fourth, it allowed local municipalities to impose a local excise tax on cannabis sales, often ranging from 8%-10%. Fifth, it allows municipalities to impose local cultivation, manufacturing and distribution taxes on legal cannabis as well.

It is worth noting that California’s state tax code does not impose a penalty similar to IRS Code Section 280E, meaning that cannabis businesses in the state can claim ordinary state tax deductions, unlike in some other states. In addition, in June 2022,the California legislature passed a bill suspending the state cannabis cultivation tax as of July 1st, 2022. Thus, the tax burden on legal cannabis businesses in California, while still high, has recently been reduced to some extent.

In addition, Prop64 enshrined the principle of “local control” into the state’s regulatory framework for cannabis. The initiative gave each of California’s 482 cities and 58 counties the ability to ban cannabis businesses from operating within their borders. A rare and limited exception to this principle exists for cannabis delivery businesses, which can deliver cannabis to a physical address in a jurisdiction even if that jurisdiction has not itself licensed any commercial cannabis businesses.

As of July 2022, a retail cannabis business is only open in 135 of the 482 cities in California, despite the fact that voters in 342 of California’s 482 cities voted in favor of Prop 64. Local jurisdictions, exercising the power of “local control” granted to City Councils by Prop 64, have prevented legal businesses from opening across wide swaths of the state. Of the 135 cities that now have dispensaries open, more than 30 cities had their first stores open in 2021 or 2022, illustrating the recent growth in California’s retail cannabis market. An additional 50 cities in California appear likely to license retail cannabis businesses in 2023 or 2024, hinting at future growth in the retail market.

Still, California currently has just over 1,100 licensed dispensaries, a fraction of the 4,000 dispensaries needed to serve its residents, and reach parity with the retail density in other mature cannabis markets, such as Colorado, Oregon and Washington. The high tax burden on legal cannabis businesses along with the lack of retail outlets across the state is contributing to a persistent illicit cannabis market in California. The illicit market in the state is currently estimated to be more than $10 billion.

However, the legal cannabis market in California has grown consistently since adult use sales began. Sales have steadily climbed from $2.5 billion in 2018 to $5.3 billion in 2022. By the end of the decade, California could reach up to $15 billion in legal cannabis sales and be one of the most robust cannabis markets in the world.

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Regulatory and industry insights provided by Ananda Strategy

July 2023 | Gold Flora Coporation completed its acquisition of 19 California dispensaries from various parties

November 2022 | Hightime Holdings announced its acquition of Moxie's California operations

September 2022 | Glass House Brands completed its acquisition of Natural Healing Center for $23MM

May 2022 | Canopy Growth Corporation announced its acquisition of Jetty Extracts for $69MM

April 2022 | 4Front Ventures accounced its acquisition of Island Cannabis Co. and Carousel Bay for $7MM

February 2022 | Gold Flora announced acquisition of Airfield Supply Company

December 2021 | Planet 13 announced acquisition of Next Green Wave Holdings for approximately $91MM

November 2021 | Harborside announced business combination with Urbn Leaf and Loudpack, creating StateHouse Holdings

November 2021 | Flora Growth signed a definitive agreement to acquire Vessel Brand for $30MM

October 2021 | The Parent Company announced acquisition of Coastal Holding Company for $56MM expected to close in 2022

September 2021 | Hound Labs received $20MM from Entourage Effect Capital, Tuatara Capital, among others

July 2021 | Jane Technologies raised $100MM in a Series C round

February 2021 | Indus Holdings announced its acquisition of Lowell Herb Co. from the Hacienda Group for $39MM

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A common way to establish a foothold in the California market is by developing a retail presence. Because of the state’s system of “local control”, there are wide swaths of the state that do not currently have retail dispensaries. Operators that are able to identify limited license jurisdictions that are passing retail cannabis ordinances in these “cannabis deserts” and succeed in the competitive licensing process can establish very healthy retail businesses.

In addition, the California market will likely see an increasing amount of M&A in 2023-2024, as larger out of state operators attempt to establish a retail footprint in the state. The challenging regulatory environment in California means that many of the existing retail licensees are struggling financially, which could increase their willingness to sell to another operator with the scale to establish amore successful operation across the state.

The delivery business in California will also soon become more attractive. In October 2022, California expanded its delivery “case pack value” limit from $5,000 to $10,000. As a result, delivery drivers will be able to carry more cannabis products in their car, have a greater breadth of products that meet consumer needs, cover a larger geographic area, and make more deliveries as a result. Operators that have delivery hubs strategically positioned across the state, particularly in areas that lack a significant retail dispensary presence, will be positioned to expand their business.

California features one of the most competitive environments for cultivation and brands. Due to the lack of retail outlets across the state, these cultivators and brands are competing for limited shelf space. However, as the number of dispensaries in California increases, cultivators that can effectively occupy a niche (e.g .premium flower, low-cost flower) and brands that can establish consumer loyalty will be positioned to succeed. In addition, the most successful cultivators and brands in California will be well-equipped to compete in a national market, once interstate commerce is allowed for cannabis. Still, in the short term these remain very competitive parts of the supply chain to occupy in California.

Regulatory and industry insights provided by Ananda Strategy