8 Ways Cannabis Startups Differ from Traditional Startups (and the Vital Skills Accountants Need to Help Them Flourish)

Cannabis startups are much more complicated than traditional startups. They face a set of unique challenges that require accountants to be clear on state licensing rules and federal regulations regarding controlled substances, making Cannabis companies 10x more likely to fail than non-Cannabis.

We’re not talking about not being successful in business -- we mean getting audited and paying massive fines, criminal charges against CEOs for illegal market activity, loss of licensure, and running out of money due to poor financial planning and insights.

We promise there’s a way to help things run smoothly and set your clients up for long-term success. It just requires understanding the day-to-day challenges a Cannabis startup faces and dedicating yourself to learning the skills necessary to help your clients navigate those issues.

Major Challenges for Cannabis Startups

Lack of Banking Solutions - Cannabis companies are in a sticky situation when it comes to banking because they trade in a federally illegal substance. Even with an increasing number of states legalizing the plant, banks are still hesitant to work with Cannabis clients due to legal and regulatory risks.

Banks that do help Cannabis companies make them jump through compliance hoops that traditional businesses don’t have to deal with. These challenges include charging higher fees for serving the industry due to complex operations, required monthly or quarterly mini-audits, and training their staff to monitor, report on, and handle these special accounts.

What You Can Do: The best thing you can do to help your clients find and obtain access to banking is by ensuring that they aren’t dealing in illegal market activity.

To prevent this, all cash needs to be accounted for, all forms need to be in place, and state taxes must be paid accurately and on time. Accurate record keeping and paper trails will help you and your clients maintain good banking relationships.

Cash Handling/Control Issues - Another ripple effect issue from Cannabis’s federally illegal status and lack of banking options is that companies have to operate solely in cash. Fraud, skimming, and theft are much more likely to occur as tracking cash can be a challenge without the right processes in place. A legally licensed Cannabis company is responsible for reporting every dollar and piece of inventory that goes in and out of a company.

If cash reconciliations show that your client is reporting less cash than what the state or IRS thinks they should have based on inventory that has been sold, the IRS and state agencies see that as a red flag, which may inevitably trigger an audit. They suspect illegal market activity or that someone is skimming or trying to avoiding paying taxes on revenue. As a result, CEOs could end up losing their licenses or facing criminal and/or civil charges.

Another big challenge for Cannabis startups and companies is Form 8300, an IRS tax form that was created after 9/11 to prevent fraud and money laundering. Applying to all cash-based businesses, Form 8300 is required when any company receives or conducts a series of transactions totaling $10,000 or more in cash. The tricky part is understanding the requirements for each 8300 filing and being aware of the potential errors that could lead to damaging fines and audits.

What You Can Do: To prevent cash handling complications, you need tight internal controls and accounting processes that monitor where cash is kept, transactions are processed, and inventory is held. Regimented cash counts should be in place, including supervisor double-counts. We always like to say that those who handle the money should not count the money. This rule will greatly limit skimming and theft issues among employees.

You’ll also want to ensure that your client has on-site safes that aren't accessible to any employees who take cash for transactions. Also, make sure you understand how to properly file Form 8300 to keep your client’s cash flow transparent and compliant.

Difficulty Accessing Capital - It’s been said that a successful Cannabis company is a well-capitalized company. Although most Cannabis businesses will gross more than $1M in the first year, it can be ridiculously hard for them to remain profitable, especially with the heavy tax burden brought on by 280E.

To be well-capitalized they either need to rely on substantial reserves of money in the bank, have access to money via loans, or bring on investors. Startups may not have the money necessary in reserves to keep them above water for the few years of business, so having a plan in place to raise capital is crucial.

For most startups who can’t just bootstrap it, having connections to various types of investors is ideal. Frequently, Cannabis startups turn to private investors or individual angel investors to help float cash in the form of a convertible note or in exchange for equity.

The problem is that while Cannabis is a hot industry and many investors are interested in  the space, there’s a ton of risk exposure. Private, unsavvy investors may not understand the ramifications of poor accounting when they jump on a deal, only to regret it after the startup struggles for several years (or worse, goes under or loses its license because they didn’t have leadership in place to help them comply with licensing rules, regulations, and understand 280E).

Institutional investors or networks, on the other hand, are much more in the know about the possible pitfalls that accompany Cannabis companies. If your client decides to approach more seasoned investors, you should know that they’re probably going to do a good amount of due diligence, and are more than likely fully aware of their liability as a result of recent court proceedings where owners were held liable for negligence. They’ve read or at least have been warned about the cautionary tales of Harborside, AlterMeds, and Sweet Leaf, all of which are cautionary tales for why trying to “beat” 280E will never work, and for thinking you can set up multiple entities in a way to circumvent the strict tax laws.

What You Can Do: As with many issues in helping Cannabis startups succeed, successful capital raising comes down to rock-solid accounting as the foundation. This means that as an accountant it’s up to you to ensure that your startup clients have all their internal controls, accounting policies and procedures, seed-to-sale tracking, Perpetual Data Room, and accurate reports (among many other essential components) in place long before you help them attract investors.

Buggy Software Solutions - Software solutions (or a lack thereof) are a major block for both Cannabis startups and accountants. Due to that pesky federally illegal status, many software vendors won’t touch Cannabis, and those that do have developed buggy software that struggles to integrate with a client’s existing accounting software.

From managing seed-to-sale tracking to weekly and monthly reporting to reconciling POS systems for dispensaries, integrative software solutions are essential for proper Cannabis accounting. Otherwise, reports, tax prep, day-to-day accounting, perpetual data rooms, and  payroll are much harder to do with any accuracy and efficiency.

What You Can Do: Fortunately, there are many workarounds and hacks for Cannabis software solutions. Even though the few software programs designed for Cannabis are fairly new or hard to come by, you can tweak non-Canna solutions and/or learn to manage the bugs in the niche-specific products.

Traditional and non-Cannabis options that many DOPE CFO students have found luck with include good old Excel and DropBox for creating month-end reports, consolidating data, developing balance sheets, and managing chart of accounts (COAs). Other programs like Xero and Quickbooks Desktop (QBDT) are ideal for daily bookkeeping.

For a full list of recommendations and software hacks from eleven VIP DOPE CFO accounting members we polled, check out this software blog.

Deductions - Under the iron fist of IRC 280E, Cannabis companies cannot take deductions like non-Cannabis companies can. Most traditional companies deduct businesses such as rent, vehicle expenses, mortgage interest, and marketing. Because Cannabis companies are associated with the “trafficking” of a Schedule 1 substance, the only way for your clients to lower taxable income without being subject to thousands of dollars in fines or maybe even losing their license is by allocating costs to inventory and Cost of Goods Sold (COGS) in compliance with IRC 471 (the tax code that breaks down how Cannabis companies can allocate inventory costs to COGS).

What You Can Do: Keep your clients out of hot water and help them legally reduce tax liabilities that are allowable by understanding 471 and the prerequisites for inventory accounting. By learning the grow cycles and the intricate operations for each vertical type, you’ll be able to identify and allocate each inventoriable cost and component that goes into fulfilling your client’s products; allowing you to save them money and keep them compliant come tax season.

GAAP Requirements - GAAP (or generally accepted accounting principles) are official rules or standards that allow lenders, investors, and other relevant external parties to compare and analyze a company’s financial statements. Publicly traded companies and as well as many private companies must comply with GAAP, which means that these companies have more demanding and/or complex accounting requirements, such as accrual accounting, cost accounting, revenue recognition, and more.

Although GAAP isn’t required for many small businesses, Cannabis companies must comply with GAAP for inventory accounting if they want to properly utilize IRC 471-11 to legally reduce tax liability.

What You Can Do: To follow GAAP standards for your clients and properly lower taxable income (and add even more costs into inventory), you’ll want to have a deep understanding of cost accounting. This skill will help you correctly value inventory costs pursuant to IRC 471 without raising red flags with the IRS. You’ll also want to have a strong cleanup process in place to make sure that the client doesn’t miss out on deductions from prior months or years. Your GAAP and cost accounting toolkit will require access to vertical-specific Charts of Accounts and cost accounting workpapers to determine which reporting periods correlate with which costs and how much can be allocated.

Prone to Audits - It can practically go without saying that Cannabis companies are extra prone to audits. Yes, all companies in all industries can be susceptible to audits if their financial and tax discrepancies are not accounted for. However, Cannabis companies are under a much closer microscope due to its potential for illegal market activity.

What You Can Do: You and your client may be trying to do everything by the book, but anything from inventory mishaps, cash discrepancies, missing tax deadlines or excessive theft/loss can trigger an audit. You’ll want to make sure you have studied up on recent Cannabis court case decisions to ensure that your client is as prepared as possible for this inevitable event.

To hear a first-hand account from one of DOPE CFO’s students, listen to this podcast on guiding a client through their first audit.

State-Mandated Seed to Sale Tracking- One of the biggest headaches for Cannabis companies and accountants alike is seed to sale tracking. Every state mandates its own seed to sale system for tracking the production and distribution of Cannabis plants. If license holders don’t accurately track their inventory, they risk losing their license or at least paying crippling fees.

The challenges with seed to sale systems are directly linked to the software required by each state to track the plants and finished goods, to the point of where they are sold.

What You Can Do: Each state has a software that it prefers, so the best thing you can do is to investigate your state’s requirements and start learning the ins and outs of that software. Companies like Metrc (a popular seed to sale tracking software) have information online about their systems that you can reference.

Next, you’ll need to ensure that you are up to snuff with regards to operations and accounting for the vertical(s) that you're serving. Onboarding and cleanup can be a daunting task, depending on how much time has passed since they have had an experienced accounting professional review their financials and records for accuracy. Cleanup is inevitable, but can go more smoothly with the right tools and your own processes in place, such as obtaining the right onboarding (PBC) documents, having vertical- specific Chart of Accounts, a Cannabis grow template to help with inventory counts, cost accounting templates to expedite and standardize your processes for allocating costs to inventory, and a month-end system for accurate reporting and maintaining a permanent audit trail. Learn more about the skills and tools needed to manage seed to sale systems in this webinar replay.

Helping Cannabis startups flourish (and not fall on their faces within the first year) is complex, but highly rewarding, work. Once you have the tools, skills, and knowledge in place to confidently guide them towards success, you can become a trusted advisor for many startups to come.

Want more information and education on assisting startups? Apply to our program today and get started serving thousands of startups in this booming niche.