Students recently emailed me about a new opportunity, a company called CannaSense. According to these students (though not evident from the company website) CannaSense is considering a multilevel marketing (MLM) distribution business model. Before we indulge, let's examine that model in this context.
Inhaling dried herbs goes way back and continues to be popular. Having served in the military in the early '70s, I can say that some parties at the time gave credence to the popular song Momma Told Me Not To Come (dig the green pants). There are apparently numerous medical reasons for using marijuana and many product variations. If an opportunity to invest in a marijuana MLM presents itself, what will it mean to investors and for companies such as GW Pharmaceuticals (NASDAQ:GWPH), Insys Therapeutics (NASDAQ:INSY), and numerous smaller companies with marijuana and/or its derivatives in their product portfolio?
Marijuana use still requires a medical reason as producers and distributors seek to address the market. For example, in step 1 of becoming a member CannaSense recommends: "Register with CannaSense and we will guide you to receiving a doctor's recommendation for medicinal cannabis." Forgetting for a minute medical ethics and that we are talking about your sons and daughters, let's consider the appropriateness of the MLM model.
MLM companies often claim to offer three benefits-two involving the potential to gain income. The non-income benefit comes as distributors buy product at a "discount" for their own consumption. One can imagine that buying marijuana at a discount could have a certain appeal. I have noted here and here, however, that sales to MLM distributors, not retail customers outside the distribution network, generate above average margins. Given frequent use - to keep that medical condition at bay - can a marijuana MLM sell to distributors at an above average margin?
Presuming CannaSense's offer to "guide you to receiving a doctor's recommendation for medicinal cannabis," to be an important part of becoming a buyer, how then will members develop sales? Will all buyers need to become members? Suppose, hypothetically, I want to buy some high quality weed. Do I pay more if I buy it in order to gain the opportunity to earn rewards from getting others to join to buy weed in order to gain the opportunity to earn rewards? If we are going down this road then my students and I need to have a serious conversation about pyramid schemes.
Some marijuana distributors prefer a buying club approach. There is little publicly available evidence to support the argument that an MLM is a buying club, certainly not in the tradition of retail buying clubs such as Costco, a business model that measures success by actually retaining customers. Instead, MLM companies report not tracking sales beyond the distribution network. Will marijuana companies take pains to refine product variations for different market segments simply to sell to distributors attracted by the business opportunity?
The two income generating benefits of the MLM model include: 1) margin (or mark-up) from selling product to non-distributor customers at a price above distributor costs and 2) earning rewards, bonuses, incentives, etc. from the parent firm based on purchases made by a distributor and his/her downline. [Note: Some MLMs may offer the opportunity to make margin on sales from one distributor to another.] Let's first consider earnings from building a downline.
For example, Herbalife (NYSE: HLF) reported that in the US in 2014 approximately 2 in 1,000 members (called "distributors" prior to 2013) earned more than $50K and 1 in 1,000 earned more than $100K (estimates rounded down from 2.4 and 1.3, respectively). The two previous year's earnings were amazingly consistent -- 2.4 ($50K+) and 1.3 ($100K+) per 1,000 members in 2012, and 2.5 and 1.3 in 2013. These numbers COULD indicate a consistent probability of success year after year.
Appearances, however, are not always as they seem. Would-be members/distributors should consider the issue of persistence. That is, how many of those distributors who earned more than $50K in 2013 did the same in 2014? If distributors at the top of the earnings chart persist, year-after-year, then the probability of success in a given year for others declines by multiples. For example, if 90% of 2013 distributors who earned more than $50K continue to do the same in 2014 then Herbalife will have minted only 180 new distributors earning above $50K in 2014. The odds of achieving that level of earnings for all US members then goes to 3.25 in 10,000. To fairly represent the actual probability of success and avoid misleading prospective distributors, I recommend the Federal Trade Commission require MLM companies to report the persistence of top earners.
Growing a network of distributors selling marijuana to retail customers makes sense when the product is illegal and users prefer to buy from a small number of trusted sources. Selling legal medical marijuana differs both in terms of the need to document the medical eligibility of buyers and the potentially unlimited number of sellers advertising their wares. Imagine tens of thousands of marijuana distributors vying for your hard earned medical marijuana dollars. Given the all-against-all MLM competitive structure, will distributors be able to sustain margins? It would be helpful if we could find evidence among current MLM companies that such profits can be earned. Thus far, however, such evidence is lacking.
When I talk with students I will advise them to consider what they do not know, namely: 1) the persistence of top earners and 2) the possibility that the business model could actually operate as a pyramid scheme. I will recommend that they ask these questions and do the math before they have partaken of their product.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have received no compensation from any parties associated with the Herbalife controversy and have no known financial position associated with any firm mentioned.