How Silicon Valley VC is disrupting legal marijuana

Microsoft and Peter Thiel are getting into the legal marijuana business. What does that mean for VC in Silicon Valley?

The New York Times reported what was either the most or the least shocking piece of investment news in 2016: Microsoft is investing in “marijuana tech”. It’s shocking if you couldn’t imagine a mega-corporation like Microsoft getting involved with weed. It’s not shocking at all if you’ve been following the marijuana legalization movement. 

With eight more states set to vote on marijuana legalization in November, smart money is investing in the growth potential of cannabis as the market moves out of the black and into the mainstream.

But we all know it’s never that simple. Despite legalization efforts, and sales that tripled in 2015 to $1.2 billion nationwide, marijuana remains an illegal Schedule I drug. This means that at any time, and in spite of state law, federal agencies can completely shut down marijuana businesses, wiping out investments and sending profits up in smoke.

Unless marijuana is legalized federally, anyone who grows or deals with the plant is subject to felonies that range from drug trafficking to acquisition of a controlled substance by fraud.

And yet, cannabis is attracting an increasing number of investors willing to bet on an exceptionally resilient market. Marijuana-specific VC already awaits those ready to navigate the reams of red tape, ready to make early investors out of all interested parties who have been watching the sea change.

“Smart investors in the space know that de-scheduling won’t materially change the industry. States will continue to have their home-grown version of the industry outside of federal law,” says Steve Albarran of Palo Alto-based marijuana tech startup, Confident Cannabis. The Signal covered the legal cannabis space previously with Confident Cannabis, but our exploration of data science and marijuana was just the tip of the proverbial iceberg.

“Schedule I, Schedule II—it doesn’t matter,” Steve continues. “People are breaking federal law right now regardless of which way you slice it. Traditional VC is betting on a bigger future.”

A legal cannabis industry could exist, and has existed, without Microsoft and even without traditional VC. While the trajectory of the emerging legal market is still unknown, a new crop of Silicon Valley investors—galvanized by mainstream investments like Microsoft’s—could be the ones to break through the haze and turn stigma and profiteering into transparency and profit.  

VC = Vice Capital?

The legal cannabis industry is accompanied by formidable regulatory and financial entanglement. On the surface, however, marijuana looks like a simple legalize-and-sell problem. But only those individuals with the financial and political clout to lobby and outlast governmental agencies will be able to shape this industry as it comes out of the shadows. And they’re arriving in droves, ready to spend.

This is why marijuana VC funds emerged, to bring together third parties, leverage their industry knowledge, and take the risks few were willing to take to help cannabusiness entrepreneurs. And they have their roots in Silicon Valley.

Firms like Oakland’s ArcView Group, San Francisco-based Poseidon Asset Management, Peter Thiel-backed Privateer Holdings, and Canopy are at the fore of investments in the industry. Separate from more traditional venture capital funds, ArcView alone has helped nearly 130 companies raise more than $80 million from its high net worth Investor Member network since ArcView’s founding in 2010.

But by Silicon Valley standards, these funds are chump change, and can barely keep up with the demand of a $7 billion market (projected to grow to $25 billion in under four years). Privateer raised a $75 million Series B at the end of 2015, which was the record for the industry until Tuatara Capital closed a $93 million private equity fund in early August 2016; its initial target was $80 million.

The cannabis VC ecosystem has evolved so rapidly that players like ArcView seem like the elder statesmen of weed investing. One thing they all have in common: none of them existed six years ago.

The legal cannabis landscape in 2010 was a much bleaker place. It was the peak of Mexican drug cartel violence, with over 11,000 homicides that year alone. Just 13 states had legalized medical marijuana (with three more by year’s end). The nation’s most trusted physician, Dr. Sanjay Gupta, had just written a later-recanted screed against legalization for TIME, “Why I Would Vote No on Pot.” And regular DEA raids on medical marijuana outfits were simply the cost of doing business.

While perceptions continue to change and minds continue to open, a century of cannabis prohibition make mainstream approval an uphill slog. Hence the rise of venture capital, by the industry, for the industry.

“Firms like ArcView, Privateer, and all these other seed funds are doing specific cannabis investing… they’re 100 percent necessary,” says Jack Scatizzi, managing director of Canopy San Diego, a member of the larger Canopy cannabusiness accelerator ecosystem.

Jack continues: “The only way that you’re going be able to grow legal cannabis companies to a point where they become attractive to institutional investors is through the funding provided by the ArcView members. Or through some of these more progressive, smaller funds that are doing cannabis-only investing.”

Fully legal marijuana feels inevitable. It is the driving force behind big companies and high net worth individuals dipping their toes in the investment waters. The least risky way to do so is via private equity investments in cannabis tech (that is, software that facilitates compliance, chemical analysis, sales, or other everyday regulatory requirements) that’s one or two steps removed from “touching the plant” as the industry parlance says.

That’s the “safest” investment one can make in legal cannabis right now, and it’s one that even big corporations like Microsoft are already behind.

Big business, little risk

While announcements like Microsoft investing in marijuana tech make headlines, Jack Scatizzi is quick to point out the difference between what Microsoft has done and the reality of the cannabis investing landscape.

“Microsoft didn’t really make an investment,” he says. “They partnered with Kind [a cannabis-specific fintech and software company] and they’re going to help Kind develop their ‘seed-to-sale’ software.” This “seed-to-sale” software is a common requirement for businesses in marijuana-legal states. It allows local law enforcement to keep tabs on where all the legal marijuana is going.

“Microsoft’s involvement [in legal cannabis] has been very explosive, but they’re only interested in it as a software play for state regulatory reasons,” says Jack. In other words, Microsoft didn’t make the statement it appeared to on the surface.

There’s no multi-million-dollar Bill Gates marijuana play… yet.

Steve Albarran agrees, but his is a more traditional Silicon Valley perspective. His company, Confident Cannabis, is a lean tech startup that has positioned itself as a B2B cannabis marketplace—without funding from marijuana VC.

“Most of the time the cannabis industry investors are not tech investors,” Steve says. “They’re looking at grow rooms or dispensaries or edibles companies that don’t have the ability to get really, really big, really fast. But they do generate profits and revenues.

“If you’re a dispensary or a cultivator or an accessory manufacturer, and you need to raise money, then ArcView is probably a good place to go,” Steve continues. “ArcView investors get the market, and get the needs of your particular product. The terms are probably fair and structured adequately for the kind of business that you’re raising for, like the bulk of the cannabis industry.”

Not all cannabis VCs invest in marijuana operations, however. Currently, there are two types of investors in legal cannabis: those that are interested in the risks with investing in operations that are “touching the plant”—cultivators, distributors, dispensaries, and products or brands—and those that invest strictly in marijuana tech. For example, Canopy accelerators only invest in technology-based companies while ArcView caters to both types of investors.

But when you’re building infrastructure for an emerging multi-billion-dollar market, funding from more institutional sources, or at least mainstream sources, will become become more common out of necessity.

Microsoft is only the latest example of this. Silicon Valley stalwart and early-stage startup accelerator Y Combinator, for one, has funded not just Confident Cannabis, but also Meadow, an Uber-like delivery service for medical cannabis patients.   

Already, the two worlds of cannabis VC and mainstream VC are starting to meld.

Gateway, a newcomer in the cannabis startup incubator world, has created partnerships for cohorts that include AWS or Azure services on top of industry education and legal advice.  

For an industry as cloaked in stigma as legal cannabis (even private investors are seldom willing to go public with their support of the nascent industry), Microsoft’s tacit support could be the break that institutional investors need to come out of the shadows.

“As the industry opens up, and cannabis tech companies can access more traditional kinds of financing—like angel financing—like any other type of company, they won’t have to go to ArcView and Canopy,” Steve says. “They’ll go through Y Combinator and 500 Startups and Techstars, and raise from Sequoia.”

Silicon Valley shows no sign of slowing down its investments in the space, and the competition for marijuana startups between marijuana VCs and institutional VCs is only beginning.

But not everyone is happy about the coming ganja gentrification.

Plant before profits?

Good intentions and bad business mix often in the legal cannabis space. For many activists, the hope was, and remains, for a marijuana utopia, where the plant would be cultivated and shared among all. But legal marijuana has simply become too big to ignore, and its myriad uncharted territories are begging for tech-based solutions.

Marijuana VC may have had the first mover advantage, but Silicon Valley is poised to disrupt the original disruptors.

At the outset of the legalization movement, the looming existential threat was always the bogeyman of Big Marijuana. But it’s not Big Marijuana that’s so scary to investors these days; it’s Bad Marijuana.

Unwitting consumers are bearing the brunt of an era of unprecedented and dangerous experimentation and cavalier attitudes towards federal law. (Companies like Confident Cannabis are seeking to change this by making their lab data accessible and transparent.) It’s why institutional investors—like banks or pension funds—have held out for so long.

But the reticence from institutional investors feels less like a step back and more like a bandage stanching new blood. “I think you have just as many people coming in early as you have that are sitting back,” Jack Scalizzi says.

“Personally, we haven’t found anyone that’s said, ‘I’m not interested until after the November election,’ or anything like that,” Jack says. People are ready to invest now. Legalization or no, there’s no getting the toothpaste back into the tube.

“The demand exists, the production exists,” says Steve Albarran. “I can’t think of any other industry that’s new, but that is essentially cannibalizing a mature black market. This is simply a regulatory shift from black to white market, which means there’s already demand there. This isn’t some software that may or may not meet investor expectations. This is an established market screaming for optimization.”

The future is green

Microsoft is far from the first, nor will it be the last, mega corporation to get in on the venture capital world. American institutions like General Electric have venture funds to help locate and partner with cutting edge entrepreneurs. Massive CPG companies like General Mills and Kellogg’s look at VC as an opportunity to stay on top of trends and pivot more quickly into emerging markets. All leverage their expertise, their connections, and their deep pockets in exchange for innovation, risk-taking, and a chance at a piece of the “Next Big Thing.”

Microsoft isn’t investing in legal cannabis technology for moral reasons, but because it’s a multi-billion-dollar “Next Big Thing.” Their interest is not just a signal to investors, but also that big tech players want to hoist up nascent industries like cannabis. And it appears that the ripple effect of their interest in legal marijuana may already be showing.

“The terms that we got from outside the cannabis industry were tremendously better,” says Steve Albarran. “However, betting on the big institutional capital players to take an interest in your marijuana app is going to be a bigger crapshoot than the patchwork progress of state-level marijuana legalization, and just as nonlinear.” 

So, if you’re looking for the multi-million dollar round, you might be looking for a while.

“We’re probably three to four years away from true institutional funding,” Jack admits.

“I would define institutional funding as large either private equity funds, hedge funds, venture capital funds, or other large funds—where the fund is writing $50 million to $100 million checks per company. Those are the kind of funds that are currently backing Uber and similar companies,” says Jack. “Those funds are not involved in cannabis. I’ve talked to a couple of them, most of them are excited about what the market holds; however, they can’t get involved for a couple of reasons.

“The first is there aren’t many cannabis companies that can take a $50 million investment from a big institutional presence,” Jack continues. “The second reason is that their LPs aren’t okay with them investing in cannabis right now. You’re going to need probably two to four more years worth of legislative movement in the right direction.”

Until the needle starts moving more in favor of federal legalization, mainstream investment funds have to keep their distance.

Fortunately, the industry is so young that it doesn’t require much capital to get the wheels moving. You may not even need to rely on marijuana VC; Silicon Valley is ready, interested, and funding.

“Nobody’s really raising in the tens of millions for one startup,” says Steve Albarran. “The industry is really small and young. Plenty of growers and dispensaries have raised that much and more. But these aren’t the kinds of deals VCs would ever do. There are no marijuana tech companies that are actually trying to raise that level of money.”

Tech is playing a big role in the emerging cannabis market, but it’s running very lean. Still, raises in the low millions in seed funding outside of marijuana VC are not uncommon. If current trends are any indication, it won’t be long before even more traditional Silicon Valley money enters the fray.

Cannabis is a commodity people have long wanted to capitalize on legitimately. As bigger players take legal marijuana seriously for the first time in history, there are considerable startup costs associated with taking an industry from black market to grey market to mainstream market.

Luckily for Silicon Valley, this presents endless opportunities for investment and product development. It’s a gold rush in every sense of the term—or a “green rush” if you follow the cannabis industry—where investors stand to benefit, in spite of the risks. The disruption is only beginning.