Five Questions to Ask About Managed Operations for the Vertically Integrated Cannabis Company

 
Five Questions to Ask About Managed Operations for the Vertically Integrated Cannabis Company
Five Questions to Ask About
    Managed Operations
for the Vertically Integrated
     Cannabis Company
Five Questions to Ask About Managed Operations for the Vertically Integrated Cannabis Company
Five Questions: Managed Cannabis Operations                               Xabis, Inc.

                         Contents:
                         Executive Summary

                         Question 1: Which cannabis-production operations are
                         suitable for outside management?
                         Question 2: Can cannabis-production operations be
                         scaled effectively?
                         Question 3: Are Quality Management Systems (QMS)
                         relevant in the cannabis industry?
                         Question 4: Which manufacturing technologies are best
                         for a given operation?
                         Question 5: How can operational efficiency in cannabis
                         product manufacturing be improved?

                         Conclusions

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Five Questions to Ask About Managed Operations for the Vertically Integrated Cannabis Company
Five Questions: Managed Cannabis Operations                                   Xabis, Inc.

                             Executive Summary:
                             As a vertically integrated (cultivate, extract,
                             manufacture, sell) producer of cannabis products, you
                             are already aware of the industry’s potential for growth
                             in the coming years. Legal marijuana sales in 2017 are
                             expected to total $9.7B and 2021 sales are predicted to
                             reach $24.5B. [1] However, if you are reading this white
                             paper, you may have questions about the future of
Big growth.
                             cannabis-manufacturing operations as the industry
Big opportunity.             grows and matures. While a tremendous amount of
                             capital is flooding into the cannabis market, it is not
Big questions.               clear that all operational investments are equally sound.
                             This white paper intends to present key questions that
                             need be asked by stakeholders about the potential of
                             managed operations – also known as Business Process
                             Outsourcing, or BPO – for cannabis companies in the
                             coming years.
                             BPO consists of the contracting of operations to a third-
                             party service provider. [2] In recent years, BPO has been
                             dominated in the news and in the consumer’s mind by
                             outsourcing of business processes, e.g., IT and customer
                             service. However, outsourcing of manufacturing
                             operations is common [3] and will be the focus of the
                             present discussion related to cannabis cultivation,
                             extraction, production, and retail operations. Although
                             managed operations are common in other industries,
                             the place of BPO in the marijuana industry – due to its
                             rapid growth and immaturity – is still being defined.
                             The central purpose of this white paper is to help define
                             the essential questions that must be asked by vertically
                             integrated cannabis companies about the suitability of
                             managed operations for one or more of their core
                             business functions.

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Five Questions to Ask About Managed Operations for the Vertically Integrated Cannabis Company
Five Questions: Managed Cannabis Operations                                        Xabis, Inc.

                             Question 1: Which cannabis-production operations are
                             suitable for outside management?

                             Background:
                             The cannabis industry in the US is rapidly emerging from the
Managed                      shadows of its hidden, cottage-industry origins. Question 1
                             acknowledges this fact and is composed of 2 practical parts:
operations
                             1) Which practices derived from a previously unregulated,
providers:                      concealed industry are applicable to the legalized,
                                regulated industry that is now developing?
What’s                       2) Can a third-party service provider run things more
behind the                      effectively than companies can achieve in-house? Put
                                another way: What’s behind the curtain of a
curtain?                        management company?
                             We’ll briefly examine the implications of the preceding
                             questions with respect to each of the 4 operational areas
                             outlined previously.
                                     • Cultivation: A practice with which humans have
                                       been involved for millennia. Because sales of flower
                                       (“buds”) are a huge component of overall cannabis-
                                       product sales, artisanal/craft cultivators have a
                                       place alongside large-scale operations. (Think of the
                                       Size matters. The following factors have different
                                       implications depending on scale of operations:
                                               o Genetics and breeding
                                               o Sanitation and safety
                                               o Growth media, fertilizers, pesticides
                                               o Energy efficiency, water use
                                               o Regulatory compliance
                                               o Automation and labor

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Five Questions to Ask About Managed Operations for the Vertically Integrated Cannabis Company
Five Questions: Managed Cannabis Operations                                         Xabis, Inc.

                                     • Extraction: People have been extracting
                                       cannabinoids into butter and baking pot brownies
                                       for decades – and there is certainly a place for that.
                                       But if a company is intent on commercial-scale
                                       operations, the old methods may fall short.
                                       Following are several factors related to extraction
                                       that a cannabis company should consider in
                                       formulating its approach to those operations:
                                                o Solvent extraction: CO2 vs BHO vs Freon
                                                   vs ethanol (and many more)
                                                o Mechanical extraction
                                                o Extraction equipment
                                                o Purification and isolation equipment
                                                o Analytical instrumentation/QC
                                                o Safety, sanitation, and security
                                                o Automation and remote monitoring
                                                o IT, data management, inventory control
                                                o Regulatory compliance
                                                o Facility design (directly impacted by the
                                                   preceding choices)
                                                o Technically skilled staff
                                     • Manufacturing: This is the part where the infused
                                       butter is baked into the brownies. And many of the
                                       considerations related to extraction apply here,
                                       too. That said, there are additional considerations
                                       because state regulations usually tightly control
                                       cannabinoid content, packaging, and distribution of
                                       finished products.
                                                o Manufacturing equipment
                                                o Analytical instrumentation/QC
                                                o Safety, sanitation, security equipment
                                                o Automation and remote monitoring
                                                o Data management and inventory control
                                                o Regulatory compliance
                                                o Facility design (directly impacted by the
                                                   preceding choices)
                                                o Skilled and unskilled labor

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Five Questions to Ask About Managed Operations for the Vertically Integrated Cannabis Company
Five Questions: Managed Cannabis Operations                                        Xabis, Inc.

                                      • Wholesale and retail sales: Once your
                                        manufacturing pipeline is ready, the rest of the
                                        world needs to know about your products and then
                                        buy them. This is the operational area that is the
                                        most like existing businesses, with a few additional
                                        considerations:
                                                o Security and regulatory compliance
                                                o Data management and inventory control
                                                o Facility design (directly impacted by the
                                                   preceding choices)
                              For the sake of practicality, the four operational areas listed
                              above are considered somewhat separately. However, as the
                              industry matures and additional efficiencies (and
                              corresponding competitive advantages) are sought,
                              additional factors that link all operations become relevant.
                              These factors encompass activities that affect the entire
                              company and include:
                                  •   Quality Management Systems
                                  •   ISO certification
                                  •   GMP/GLP compliance
                                  •   ERP/MRP
                              The lists above are not exhaustive but do cover the major
Can you meet                  operational requirements. As suggested previously, some of
                              the historical cottage-industry techniques can be effectively
the new                       utilized within the new regulatory regimes while others are
challenges on                 simply irrelevant. As an example, breeding a strain for
                              desirable aroma can be achieved without any special
your own?                     technology. On the other hand, developing a strain having a
                              very specific CBD:THC ratio requires analytical
                              instrumentation, technical staff, and a rigorous QA program.
                              Given the immaturity of the industry – particularly with
                              respect to large-scale processes and regulations – the
                              interested reader is encouraged to consider how effectively
                              their company can meet these new (and evolving)
                              challenges.

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Five Questions to Ask About Managed Operations for the Vertically Integrated Cannabis Company
Five Questions: Managed Cannabis Operations                                       Xabis, Inc.

                             Question #2: Can cannabis-production operations be
                             scaled up effectively?

                             Background:
  A thousand                 As we suggested earlier, the challenges involved in baking a
  toy trains are             sheet of brownies is different from those encountered while
                             baking 1000 sheets of brownies. The basic problem with
  no substitute              multiplying existing equipment, labor, and processes is that
  for a                      all the small-scale inefficiencies and waste are also
                             multiplied. You gain no operational efficiency. Additionally,
  locomotive.                new problems arise. For example, how do you
                             simultaneously withdraw and cool 1000 sheets of brownies
                             so that none of them burns?
                             While “getting big” is the goal of many businesses, including
                             cannabis companies, additional resources cannot be easily
                             brought online to accommodate many physical processes.
                             With hosted data storage, for example, a provider such as
                             Microsoft, Amazon, or RackSpace will gladly let you double
                             your storage with the click of button.
                             With chemical and manufacturing processes, however, no
                             such option exists. Moreover, increasing production by
                             simply multiplying existing equipment and processes is very
                             risky.
                             The considerations for different operations are not
                             consistent, either. State regulations (and biology) can limit
                             the productive size of a cannabis plant, which means that
                             scaling-up processes basically consist of multiplying the
                             number of plants under cultivation. The amount of light,
                             nutrients, and water also scale proportionally. There are, of
                             course, opportunities to increase automation, improve the
                             building configuration, and so on. But cannabis plants will
                             never reach the size of the potato pictured on the train car.
                             Wholesale and retail sales models, although subject to
                             additional regulatory scrutiny and constraints on location,

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Five Questions to Ask About Managed Operations for the Vertically Integrated Cannabis Company
Five Questions: Managed Cannabis Operations                                                          Xabis, Inc.

                             are well established; scaling considerations will therefore not
                             be discussed here.
                             The operations that are constrained by the ability to
                             effectively scale up are extraction and manufacturing.
                             Running multiple smaller extractors can be useful up to a
                             point, for example. After that, it may be useful to consider
                             larger extraction systems. But even that is not a given,
                             because pressure vessel costs increased non-linearly with
                             capacity and the consistent availability of uniform, high-
                             quality cannabis feedstocks can be a serious concern when
                             trying to fill an industrial-scale extractor. (If you don’t fill it,
                             you may be seriously undermining the efficiency gained by
                             purchasing a larger extractor.)
                             The bottom line about increasing production of extraction
                             and manufacturing operations is this: Scaling up physical
                             processes is first and foremost an engineering issue. Of
                             course, costs are a critical factor in making decisions about
                             scaling up, but business units are poorly suited to providing
                             the technical requirements and engineering constraints
                             necessary to make the business decision. The issue requires
                             input from scientists and engineers.

                             https://www.chemicalprocessing.com/cartoon-caption/cartoon-caption-1/

                             “We’re still working out the bugs in our scale-up process.”

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Five Questions: Managed Cannabis Operations                                        Xabis, Inc.

                             Question #3: Are Quality Management Systems (QMS)
                             relevant in the cannabis industry?

                             Background:
                             Throughout the cannabis industry, superlatives like “top
  Best-in-                   quality,” premium product,” and “artisanal hand-crafted” are
                             thrown about like cheap confetti. But the basic reality is this:
  class, huh?                Many of the “experts” in the industry has never been
                             subjected to tough scrutiny about the purported quality of
                             their products. It’s easy to make claims about quality but
  Show us                    much more difficult to prove them.
  your data.                 Referring again to the cottage-industry origins of cannabis
                             operations, it is easy to see how we got here. Prior to
                             legalization, knowledge was distributed largely by word-of-
                             mouth, and claims of quality, potency, and value were
                             essentially impossible to dispute. There was no regulation,
                             and scientific verification was basically irrelevant. Fast-
                             forward to today: Despite testing requirements imposed by
                             states, there is still tremendous wiggle room regarding
                             claims of quality. For example, many states will tolerate a
                             measured potency that is within ± 15% of the potency stated
                             on the package. And only a limited set of residual solvents
                             and pesticides are included in required testing protocols.
                             The take-home message: Minimum regulatory requirements
                             are not even close to the best that a company can achieve.
                             And aside from what is permissible, competition among
                             cannabis companies is heating up. As consumers become
                             more sophisticated, they will become more demanding
                             about the quality of the products they buy.
                             A company can ensure the quality of its manufactured
                             products using different approaches. However, it is safe to
                             say that systematic implementation of a rigorous Quality
                             Management System (QMS) is a requirement, not an
                             option, for cannabis companies seeking to be as competitive
                             as possible now and ready for FDA approval in the future.

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Five Questions: Managed Cannabis Operations                                       Xabis, Inc.

                             Question #4: Which manufacturing technologies are
Will you fully               best for a given operation?
depreciate
                             Background:
your capital
                             This question is closely related to Question 2, above, in that
equipment                    the intended scale of an operation will dictate the nature of
before                       the equipment and processes necessary to efficiently achieve
                             the desired production capacity. (It is not that hard to
cannabis                     inefficiently produce cannabis products at large scale if
regulations                  profitability is not a concern!)
change?                      To reiterate a previous point: Design (and scale-up) of
                             manufacturing processes should be left to engineers. Experts
                             in related areas such as commercial food production can
                             provide valuable manufacturing insights, but constraints
                             imposed by use of a drug – also known as an Active
                             Pharmaceutical Ingredient (API) – mean that process and
                             product tolerances must be very tight.
                             And as was implied previously in this paper, everyone has an
                             eye on federal regulatory approval of cannabis. What this
                             looks like precisely is anyone’s guess, but a move toward
                             tighter regulatory scrutiny and pharmaceutical-type
                             manufacturing requirements such as GxP-certified
                             operations is likely. As such, keeping an eye on cost-
                             effectiveness now with a keen awareness of a system’s
                             potential for GMP compliance – as applied to both food and
                             drug manufacture – is probably a smart move if the
                             differential costs are not too great.
                             Consider cannabis-extraction technologies as an example.
                             The two biggest contenders for solvent extraction, butane
                             and CO2, may have different potential futures. Each
                             technology has pros and cons. Butane extractors are less
                             expensive and require less technical know-how than CO2
                             extractors. They also tend to yield a more terpene-rich
                             product from a single run. On the other hand, CO2 extractors
                             don’t require an explosion-proof room (Class 1 Division 1),
                             are tunable for selective extraction of terpenes and

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Five Questions: Managed Cannabis Operations                                        Xabis, Inc.

                             cannabinoids, and use a solvent that is economically
                             available in ultra-high-purity grades. (High-purity butane isn’t
                             cheap and is still highly flammable.)
                             The preceding characteristics of extraction systems should
                             also be considered with respect to the implications of each
                             for future operations in a different regulatory regime and/or
                             competitive landscape. Additional manufacturing equipment
                             relevant to cannabis extraction and product creation is listed
                             below. As with extraction, careful thought should be given
                             both to current performance of a given piece of equipment
                             as well as to its expected suitability under tighter
                             regulations.
                                 •   Bulk food mixers/homogenizers
                                 •   Bulk liquid dispensers
                                 •   Bulk powder/granule dispensers
                                 •   Tablet presses
                                 •   Packaging equipment
                                 •   Labeling equipment
                                 •   Coolers and refrigerators
                                 •   Rotary evaporators
                                 •   Distillation equipment
                                 •   Automatic dishwashers
                                 •   Laboratory hoods
                                 •   Many other pieces of equipment

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Five Questions: Managed Cannabis Operations                                       Xabis, Inc.

                             Question #5: How can operational efficiency in
                             cannabis product manufacturing be improved?

                             Background:
                             People. Processes. Products. Profit. These four “Ps” are key
  Aesthetics or              elements (but not the only ones) in the operation of a
                             successful cannabis business. Previously in this paper, we
  maximum
                             discussed the critical considerations related to scaling up
  value? What                extraction and manufacturing components of a vertically
                             integrated cannabis company. As we pointed out,
  is your                    engineering-based modifications to physical, as opposed to
  priority for               business, processes are essential to improving operational
                             efficiency.
  your product
                             What wasn’t discussed, however, were the efficiency
  set?                       improvements related not just to the equipment itself, but
                             also to the ways in which the equipment is operated and the
                             types of products being manufactured.
                             As the reader is already aware, people (employees) can
                             represent a huge variable in the context of a manufacturing
                             process. Additionally, the product and packaging designs and
                             specifications can lead to an easy-to-manufacture widget or
                             an intricate, labor-intensive piece of confectionary art.
                             (Compare a jar of unrefined oil to a piece of infused
                             confectionary art.)

                             There are two components embedded in the efficiency
                             question. (Neither is necessarily more important than the
                             other.)

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Five Questions: Managed Cannabis Operations                                       Xabis, Inc.

                             One question: What product set does the company intend to
  Automation                 offer consumers? This is analogous to the Apple-vs.-Android
                             or WalMart-vs.-Whole Foods question: Are your customers
  and remote
                             looking for a gourmet chocolate truffle infused with 5 mg of
  monitoring for             THC distillate or a 20-mg sour gummy worm?
  the cannabis               The other question: Are your procedures fully documented
  manufacturing              so they can be reviewed and evaluated to help identify
                             inefficiencies and subsequently improve your processes?
  company: Is it             Accurate, version-controlled, and complete Standard
  even an                    Operating Procedures (SOPs) need to be in place for every
  option?                    activity that materially affects the quality of a process or
                             product.
                             SOPs, as key components of a comprehensive Quality
                             System, are critical pieces from both a quality perspective as
                             well as from an operational efficiency point of view. This is
                             where the efficiency of People and Processes can be
                             evaluated and improved once a given product set is chosen.
                              While throwing more low-cost labor at production can get
                             more widgets out the door, the risks increase rapidly with
                             the complexity of production. In other words, folding boxes
                             does not require the same skillset as adjusting extraction
                             conditions to get a more favorable cannabinoid profile to
                             include in a tablet intended to promote sleep.
                             While automation can be a big part of the answer, computer
                             control and monitoring of processes and equipment can be a
                             challenge for the small-to-medium manufacturer in any
                             industry. And for cannabis, economical automation and
                             monitoring may be even harder to achieve than it is for the
                             small-scale baker or parts manufacturer – the industry is
                             simply not mature and neither is all the equipment.
                             In any case, having evaluated efficiency from the
                             perspectives of People, Processes, and Products, a company
                             can then assess corresponding improvements in Profitability.
                             Because profit a big part of what everyone is after, isn’t it?

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Five Questions: Managed Cannabis Operations                                       Xabis, Inc.

                             How to find the answers you need
                             This paper poses a set of tough questions, all of which are
                             asking whether the reader’s company has the critical pieces
                             in place to take operations (and profits) to the next level.
                             Following are suggestions for finding answers.

                             Suggestion #1: Assess your company’s ability to
                             undertake complex processing operations
                             It is not difficult to find cannabis product companies that
                             bought an extractor, put together a few recipes, and then
                             struggled to achieve their business objectives when the
                             manufacturing component of the operation didn’t fire on all
                             cylinders. (There are many other pitfalls; manufacturing is
                             but one of them.)
                             As we suggested early in this white paper, there are several
                             potential impediments that can make it difficult to increase
                             the production of an operation while simultaneously
                             benefitting from economy of scale. (Recall that simply
                             multiplying the number of physical processes often
                             multiplies the inefficiencies and may actually increase them.)
                             Ask yourself the following questions as you consider
                             implementing larger and/or more complex manufacturing
                             steps:
                                 • Do you understand, from a technical perspective, how
                                   to fit the different operations together (cultivation,
                                   extraction, manufacturing, sales)?
                                 • Do you have the resources (capital, people,
                                   documentation) to properly scale up your processes?
                                 • Where can you turn for answers to questions that are
                                   specific to cannabis extraction and manufacturing?
                             If you cannot readily answer these questions, it may be
                             difficult for your company to take advantage of the

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Five Questions: Managed Cannabis Operations                                         Xabis, Inc.

                             opportunities that this emerging industry can offer. Or you
                             may spend more and take longer to reach your goals than
                             necessary. The bottom line is that if you have a grand vision
                             for your vertically integrated cannabis business but don’t
                             have the technical expertise to get there, you might consider
                             Managed Operations as an option.

                             Suggestion #2: Conduct additional in-house
                             research. (Hint: It doesn’t have to be in the lab.)
                             As a vertically integrated cannabis company, you may have
                             in-house R&D resources or you might work with outside
                             vendors or contractors. If you have the means to investigate
                             the potential of new products or scaled-up processes, have
                             relevant staff put together a brief research proposal. If the
                             work can be completed economically and on a reasonable
                             time, it can provide valuable insights into the viability of the
                             project for commercial adoption.
                             But always remember: Scaling up from a test tube (or a
                             formerly illegal operation) to a high-volume production line
                             without proper engineering is a recipe for losing money. If a
                             new product or process looks promising on the lab bench,
                             make sure you know how to benefit from economies of
                             scale.
                             The shortcut to discovery is to piggyback on the work of
                             others. But there is a problem when it comes to this
                             industry: Whereas academic researchers and commercial
                             vendors publish papers and technical documents,
                             information about cannabis extraction and manufacturing
                             can be harder to obtain. Competitors are not keen to reveal
                             trade secrets and equipment vendors – often with little
                             experience or competition – have a vested interest in
                             steering you toward their offerings.
                             One of the most important things to keep in mind when
                             reviewing available literature, which can include material

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Five Questions: Managed Cannabis Operations                                      Xabis, Inc.

                             available on various websites, is that reliable information
The industry is              will be clear, quantitative, and backed by actual data. (This
                             can include both financial and/or physical/chemical
in the midst of              measurement data.) Additionally, all the important variables,
an arms race.                including performance baselines, operating conditions, and
                             assumptions, should be explicitly declared.
(Even if you
                             When it comes to cannabis equipment vendors, wading
didn’t know it.)             through the marketing and jargon requires a degree of
                             skepticism and often requires direct engagement with sales
                             and technical staff. The key takeaway for vendor-specific
                             documents is this: If the vendor can’t answer your technical
                             questions, keep looking.
                             The same thing is true for Managed Operations service
                             providers: If the claims are vague and the provider cannot
                             provide real-world performance data (financial and
                             operational), then you should steer clear.

                             Conclusions
                             Recognizing that competition in the cannabis business is
                             presently something of an arms race due to the number of
                             players rushing into the space, it is essential that cannabis
                             companies ask questions that will help set them apart
                             competitively. More so than in almost any other industry,
                             wild claims abound and are hard to evaluate due to the lack
                             of historical reference information. It is incumbent on the
                             business owner to ask hard questions and do what it takes to
                             answer them.
                             In this white paper, we have tried to identify critical
                             questions and challenges facing the vertically integrated
                             cannabis venture as the industry matures and competitive
                             pressures increase.
                             The underlying premise – that managed operations might be
                             an option – is dependent on the technical abilities and
                             industry-specific knowledge of your company’s employees,
                             the desired timeframe for implementation, and the

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Five Questions: Managed Cannabis Operations                                                   Xabis, Inc.

                             availability of capital to fund an in-house scale-up project. If
                             these pieces are in place, your company is likely well-
                             positioned to be an industry leader. If not, there are options
                             for utilizing others’ expertise – and potentially their
                             equipment – on a contractual basis. After working through
                             the questions posed above, you will hopefully have a much
                             clearer idea of what makes sense for your company.

                             About Xabis
                             We published this white paper to help vertically integrated
                             cannabis companies evaluate the suitability of managed
                             operations for their businesses.
                             Specifically, we are promoting the view that a company’s in-
                             house technical capabilities vis-à-vis advanced cannabis
                             extraction and manufacturing operations should be a
                             primary determinant of whether they consider Business
                             Process Outsourcing as part of their overall business plan.
                             To find out more about posing the right questions for your
                             cannabis company – and carefully formulating answers that
                             acknowledge the risks and benefits of incorporating
                             managed operations – please contact us at 303.217.2097 or
                             garret.nicodemus@xabisinc.com.
                             Xabis Inc
                             12015 E 46th Ave
                             Suite 550
                             Denver, CO 80239
                             www.xabisinc.com

                             References:
                             [1] http://www.businessinsider.com/legal-weed-market-to-hit-10-billion-in-
                             sales-report-says-2017-12

                             [2] https://en.wikipedia.org/wiki/Business_process_outsourcing

                             [3] https://www.forbes.com/sites/greatspeculations/2015/06/22/getting-a-
                             piece-of-business-process-outsourcing/#12f28af82a64

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