Despite legalization issues in some major markets across the globe, cannabis has become legal in other markets. In Canada, widespread legalization has created a massive market opportunity. In the US, legalization in some states has created opportunities for investors. The same can be said of federal legalization for cannabis products with no more than 0.3% THC concentration. Legal inconsistencies and geographic disparities across markets have resulted in a fragmented industry. A few players have risen from the competition to create meaningful names for themselves. But even they face challenges caused by recent industry oversupply and falling product prices.

In an attempt to establish a large, recognizable brand in the industry, the founders of SoKO have come up with an interesting twist. Their goal is to build a CBD/hemp company synonymous with luxury. After creating a lineup of CBD products, the company then began working to tie them into the fashion and arts industries. The end result: a diverse provider of CBD offerings that throws a bi-annual fashion show. This event, named The SoKO Ball, features hemp-derived clothing and similar products.

As of this writing, SoKO boasts 22 SKUs (shelf-keeping units) that it sells throughout the US and parts of Europe. The company’s offerings range from tinctures to topicals. It also includes drops, CBD-infused beverages, pet products, culinary products, and more. One of the company’s latest announced products is its California Sober, CBD-infused sparkling water.

To promote its brand and to create that ‘luxury’ feel, the company has committed to fashion shows and other similar events. The first of these occurred in 2017. Models take the runway to display the latest hemp-based clothing and accessories. The company also uses the event as an opportunity to show off some of its offerings. It does this by giving away gift bags to attendees, providing culinary tastings, and more.

As with any startup, financial results are limited. That said, the latest financial filings provided by the business are through 2019, so they are up to date. Last year, according to the data provided, the company managed to generate sales of $544,360. This was up 5% from the $518,264 seen in 2018. This growth is insignificant compared to the expansion experienced by major Canadian competitors. These include firms like Canopy Growth Corporation, Aurora Cannabis, and Cronos Group. There are, however, some considerations to keep in mind. For starters, in Canada, where the cannabis space is wide open and fast-growing, there’s an industry glut. In other markets, like the US, there is no growth frenzy because of legal differences between states and the federal government. Remaining cognizant of these issues, the growth experienced by SoKO was not all that bad.

This is not to say that there’s nothing questionable or bad about the firm. There are, actually, three issues that investors should be aware of. The first is that there appears to be an accounting irregularity for the firm. In its financial filings, it claims to be creating its financial statements in compliance with GAAP. But when you dig down, the picture looks peculiar. The first tipoff relates to earnings. For 2018, management reported a net loss of $72,107. This is realistic. However, in 2019, this turned to a net profit of $225,577 for a net profit margin of 41.4%. That sounds great but in a highly-competitive industry, even the big players are struggling to generate a profit.

Is it possible management found the secret sauce that allows it to generate strong margins? Sure, but it’s unlikely. A deeper dive into the Q&A session of its fundraising page sheds some light on the firm. In a question pertaining to its profits and valuation, management answered, in part, “In 2018 we reported a loss with no profit because most of our revenue went towards the cost of goods. Thus creating a profit of 225k in 2019 as we no longer had as many costs of goods as the inventory followed through from 2018 to 2019”. This is not how GAAP accounting works.

In GAAP, companies recognize revenue when it’s incurred, as it seems SoKO did. They also recognize COGS, or cost of goods sold, when revenue is recognized. What should have happened can be illustrated. Shown below, in its most simplistic example, is a set of journal entries looking at inventory worth $100,000 and selling that inventory for $150,000. In this hypothetical example, the company received inventory worth $100,000 and paid cash for it in the same amount. These are strictly balance sheet transactions. They have zero impact on the income statement. If a year goes by and the inventory is still on the books and still good, there’s still no impact to the income statement.

The income statement impact occurs once a sale takes place. When a sale occurs for $150,000, the company receives $150,000 in cash and allocates that toward revenue. It then incurs an expense for the inventory in the form of COGS and credits inventory in the same amount, both $100,000. This removes the inventory from its books and allows the company to see the expense move to the income statement. What management describes in its Q&A session is realizing a large inventory purchase in 2018 that created a net loss for that year. What they miss is that GAAP requires that costs be recognized when sales are. This should definitely serve as a note of caution to investors.

A better measure of the bottom line for the company might be its operating cash flow. Assuming nothing else on its books is wrong (usually when one thing is off, there are others), operating cash flow was a net negative $83,164 in 2018. Last year, this turned to a net inflow of $80,575. This is a positive for the company, especially as negative cash flows are typical of small, early-stage companies.

Another concern brings us back to some interesting accounting entries. For starters, the company had a loan, at the end of 2019, in the amount of $21,568, for a car. A Honda CR-V 2WD FX van, to be precise. Companies can have cars, but unless the vehicle’s purpose is to transport company products (in which case a different model of the vehicle might have been a wiser purchase), this seems odd. Companies can even have vehicles for their executives, but for an early-stage company like SoKO, that would seem a questionable (though by no means illegal) use of funds. The last issue is perhaps more significant: distributions. A distribution of $147,344 made out to shareholders in 2019 occurred. The company also saw a negative contribution (whatever that is) bring the net distribution to $168,759. There are many legitimate reasons why this could have happened. Regardless of the reason, though, it’s peculiar for an early-stage firm that’s looking to raise money, to make a large distribution to shareholders.

One final issue relates to management’s business strategy. There are other cannabis names that have several different product lines. However, they are largely big players. Due to a wave of legalization through Canada, these companies have seen extraordinary growth. They have also struck major investments from other firms that have been instrumental in achieving that growth. Canopy Growth Corporation, for instance, raised $2 billion in funding from Constellation Brands. Cronos Group raised $1.8 billion. Aurora Cannabis has not struck any major deals, but it has made many smaller ones over the past two or three years. These investments have allowed these firms to expand quickly and in a diverse fashion, even as they have struggled to generate a profit.

For smaller firms, the better route seems to be to focus on one thing and grow from there. Including all the variants shown on its website, SoKO has at least 22 SKUs. If all of these were in one category, like beverages, it might be fine. But ranging from pet products to beverages to tinctures and more is odd. Tackling one market first, performing well in that space, getting costs down, and then moving on to another product line makes more sense. If management can do multiple things at once, then more power to them. But for the rest of us mortals, that looks like a tough road to travel.

The CBD and broader cannabis space is attractive from a long-term perspective. According to Canopy Growth Corporation, the global opportunity for cannabis is around $250 billion. By global, the company is mostly referring to North America, Europe, and some other select markets. Given SoKO’s emphasis on the US though, it makes sense to focus more on the CBD space. CBD-infused products are legal nationwide so long as they meet the THC requirements. This space is considerably smaller than the global cannabis market, but it’s attractive nonetheless.

According to BDS Analytics and Arcview Market, it’s believed that by 2024 the CBD space in the US will be worth around $20 billion. This implies an annual growth rate of 49% from the $1.9 billion opportunity estimated in 2018. If THC products are combined with the CBD space, the opportunity is slated to be worth more than double that at $45 billion. Cowen & Co places the market at around $15 billion in size by 2025, with a similar annualized growth rate underpinning its assumptions.

While the upside for this space is appealing, it’s important to keep in mind that there could be issues along the way. In Canada, for instance, players are dealing with significant overcapacity that has led to a supply glut in the market. Prices have plummeted as a result and some firms have even been forced to take write-downs on inventory. It is uncertain to what extent regional problems could affect other areas like the US, but it’s not outside of the realm of possibility. Canopy Growth Corporation, for instance, does have a presence in the US. It is in the process right now of investing $500 million into the US hemp industry. Between $100 million and $150 million of that will be allocated to production in New York. The company also launched, in December of last year, its First & Free product line. This line consists of softgels, oil drops, creams, and more, and it caters specifically to the US CBD market.

At this time, the transaction being sought after by SoKO is relatively straightforward. The business is issuing common shares at $0.24 apiece in an effort to raise between $9,999.84, and almost $1.07 million. The minimum investment per participant has been set at $360, and as of the time of this writing the company has $14,277 committed to its cause. The transaction assigns a pre-money valuation on the business of $11 million. If this transaction were done even a year ago, and if the firm were located in Canada instead of the US, this valuation would have been deemed appropriate by the market. As a US firm, with a supply glut up north, the deal does look rich compared to SoKO’s revenue and cash flows.

At the core of SoKO is founder and CEO Dave Soko. Dave Soko fashions himself as a ‘visionary with ingenious creative passions’. He has no other work history besides his time running SoKO that we could identify. He does hold a Bachelor’s degree in Business/Managerial Economics from Alfred State College that he received in 2001. He also has served as a volunteer athletics and self-defense instructor for women in San Diego since 2001. Helping Soko to run the company are two individuals: Jon Melicharek and Dave Hebron. Melicharek is the business’s VP of US Operations, and Hebron is its Director of US Operations. Melicharek claims to have more than 7 years of experience in the cannabis/hemp industry but does not provide details. Hebron has more specific examples of relevant experience. At present, he is the owner of BLNCD Lifestyle, a cannabis education resources provider. Before that, he worked as a Trade Development Manager for nine months for a firm called Ghost Tequila. Prior to his time there, he served in various roles at Beatbox Beverages for two-and-a-half years.

After careful consideration, SoKO has been rated a “Deal To Watch”. But just barely.  On the good side, the company has managed to show year-over-year growth through 2019. This was on both the top and bottom lines. It also operates in an attractive and fast-growing market that offers tremendous upside potential. This alone could help to create a great deal of value for the business and its shareholders down the road. On the other hand, there are a lot of red flags.

While the underlying premise of mixing fashion with CBD and hemp to create a luxury brand is interesting, the company has issues. Its accounting is questionable at a minimum. Though the firm has big goals, its decision to dive into several different products instead of focusing on just one or two of the most attractive categories is worrisome from a strategic perspective. This is especially true when you consider the current state of the market. Experience/work history from two of its top three executives is also lite. Though none of these issues are necessarily problematic from a legal perspective, they do warrant concern. This is especially when taken all together. The company’s valuation also appears to be quite rich.

All of these risks combined add up to create a rather uncertain picture for the future. This is not necessarily a sign of bad things to come. In fact, if the business does achieve its objectives, it could become a niche player in the space. That is why the company, in our eyes, does have potential, but investors should be aware of the risks involved.