Oct 23, 2023
Investing in Controlled Environment Agriculture with Confidence
Written by: Djavid Amidi-Abraham
September 13, 2023
Controlled environment agriculture (CEA) is a rapidly growing segment of the farming industry. Demand for localized food systems and the products coming from them is rising, and companies are responding to it. Vertical farms and greenhouses are seeing much more capital investment than they had in the past, and CEA businesses are improving their unit economics through new technologies which attract investment, as well.
Many investments come from venture capitalists who want to treat vertical farming like a tech investment. However, a vertical farming company is a farming company after all, and those misaligned expectations have resulted in high-profile closures causing investors to pull back. Not unrelated to the previous challenge, a lot of people who are involved in this industry are coming from other industries that don't understand agriculture as fully and holistically as traditional farmers do.
After completing multiple due diligence projects, which is essentially an auditing service for CEA operations, we've learned that many people make the same mistakes. In this article, I am sharing the six separate categories of assessment we use so that you can begin investing in CEA with confidence.
1. Cultivation Technology
Cultivation technology lies at the center of many strategies and modern CEAs. When reviewing a CEA operation, we ask the questions: “What is the cultivation system being used? Is it providing a significant competitive advantage to their operation? Is it worth building or is it worth looking at off-the-shelf options?”
Many companies we've looked at are proposing novel cultivation technologies and what we often see is that the performance is not much better, or sometimes even worse, than systems off the shelf. Companies developing these novel cultivation systems are typically motivated by lowering their CapEx. I hear this time and time again: “We looked at systems available on the market, but they're very expensive and we think we can do it cheaper.” That can sometimes be true, but oftentimes, the R&D is very expensive, and the timelines for developing these technologies are often longer than expected. Plus, many companies would choose their technology differently if they did it all again.
If a company chooses the novel development route, a key question to answer is whether or not the cultivation system is ready to be deployed at a commercial scale. Oftentimes, companies seeking investment in technology that is at a pretty early stage are unclear how their systems can be integrated with existing automation and mechanization systems. I frequently hear from companies that they have a very competent engineering team, and they are confident they'll be able to figure it out. However, that type of wand-waving does not work. Development timelines get extended because challenges arise with integrating existing systems with custom ones.
Regardless if it’s an off-the-shelf system or a novel cultivation system, it’s important to know the market history and how reliable the quality and yield claims are. We've been presented with snapshots of data that are taken during a couple of favorable months of the year and aren’t truly reflective of a year-round operation.
2. Commercial Strategy
Commercial strategy is focused on a good fit between the product being grown and the proposed offtake strategy. It answers the questions: “Is the company growing the right products for the right markets? Are they distributing into the right market segments?”
I've seen several instances where a company will be growing a product for a very small distribution channel. They don’t understand the total market saturation potential of the product, or they operate with the idea of “if we grow it, it'll be sold,” particularly if it's a higher-quality product. Microgreens are a great example of this as microgreens are a relatively niche product, and there isn't a whole lot of demand for them.
It's challenging to distribute a niche product that doesn't have a strong market demand. Yet, building out market segments is never a good formula for rapid distribution rates. Niche products need to be paired with niche market offtake opportunities. Matching those distribution channels with the correct distribution costs is very important as well. For example, the packaging used to sell leafy greens at a farmers market will not cost the same as the packaging you’d need to distribute through Whole Foods.
In order to properly prepare an offtake strategy for the crops you’ve selected to grow, you need to work backward. Let the market opportunity determine what crops to grow and how to distribute. If you do it the other way around, you'll find yourself in a situation where you have a farm built in a place that doesn't really want what you're growing.
3. Economic Feasibility
Economic feasibility is at the core of any business. It indicates how that business is going to make its money and, ultimately, meet the investors’ goals. During this portion of our audit, we develop parallel economic models to the operation in question in order to better compare where they are currently to their theoretical maximums in terms of yield rates and other performance metrics.
Oftentimes, as we begin looking into the economic feasibility of a CEA company, we see very dreamy scenarios with rapid market saturation and newer products treated similarly to a static established product type. People are expecting their herb sales to increase as fast as their leafy greens. That's simply not a reality. The different product categories have different levels of demand. What we like to see is sensible market product matches.
Other key questions we ask when measuring a company’s economic feasibility are: What are the near and long-term plans for labor reduction? How many farms has the company built?
CEA is expensive, and the costs of production are much higher than field-grown. So, when it comes to lowering your unit economics, labor reduction is the number one thing to consider. You want to make sure your labor numbers are dropping and that you have a plan for that for the future. You also need to track your unit cost of production. I see a lot of inaccuracy in how this is done, and that is problematic because it leads to unknown costs in the future which can end up compromising the whole operation.
4. Management Team
Assessing the staff and management team helps us determine if the company is well-equipped to execute its stated objectives. Everyone from the cultivation team to the marketing team, to the sales team, to the management team is very important. We see a lot of CEA operations pulling in people from other industries, and while that can be beneficial in some ways, there are some inherent realities to agriculture that aren’t always translated well by individuals not experienced with agricultural systems.
While there aren't many established CEA businesses, traditional farms are great labor pools to draw from. We also see growers with experience in greenhouses adapt well to vertical farming. By and large, we recommend hiring a grower with experience in growing that particular crop and producing it on a commercial scale. We see much better results when the grower has familiarity with the specific crop than familiarity with the technology. Technologies can be learned, but learning how a crop grows and how to grow it for commercial sale requires a lot of experience and deep understanding.
When it comes to the marketing and sales team, we look to see if the individuals have a food industry background, specifically in selling similar products. We call them “products,” because in CEA they are unique, premium products that are different from a standard head of lettuce grown in the field. We are also seeing a lot of CEA farms put their products into salad kits. Regardless of the product’s presentation, there is a lot of competition on the shelves, particularly with cheaper field-grown products. So, you have to differentiate them from the others. You do that through branding, attraction marketing, and the language on your packaging. You need team members who understand how to do that and how to market it and sell it that way.
5. Competitive Advantage
Competitive advantage shows us how the operation compares against traditional sources of competition, i.e., field-grown products. The core costs of production for field-grown product is very cheap and something that's very difficult to compete with in a lot of areas. Additionally, we're seeing competition between greenhouses and vertical farms in some markets which is causing some reticence to invest in certain markets because of these pre-existing businesses. In addition to field-grown product, this is another source of competition that we assess.
Determining a company’s competitive advantage is about determining its differentiators. These elements will not only differentiate you from other field-grown products but also from other CEA companies. The main differentiators we typically see are “pesticide-free,” “locally grown,” “uses less water,” and “uses less fertilizer.”
Competitive advantage also extends beyond yield rates. Companies need to produce better quality with better consistency, harvest after harvest, especially at volume. Additionally, scalability potential is important to consider. Once again, novel technologies are probably not going to scale as quickly as incumbent technologies. When you have bespoke systems with custom engineering and immature supply chains, that essentially leads to delays which has a negative impact on competitive advantage in terms of scalability.
Not all folks are interested in the sustainability aspects of these operations, but we are seeing the topic of sustainability becoming more and more important, particularly from the consumer end. We also keep an eye out for greenwashing claims. For example, a lot of CEA companies use reduction statistics like “95% less water use”, “90% less fertilizer,” etc. However, many companies conveniently leave out the carbon footprint conversation.
CEA systems have a much larger carbon footprint than field-grown products, even when considering the carbon footprint of transport. For example, if you ship a pound of lettuce from California to New York, it's about 1/3 of a pound of CO2 per pound of product that's moved, but to grow a pound of lettuce in New York, it's about 6 pounds of CO2 if you're relying on a grid power source.
For the most part, I think sustainability claims are a bit cherry-picked in this industry. But we are seeing solid steps made by CEA operations to decarbonize their footprint by buying from wind power sources, co-locating with solar farms, integrating microgrids, and other steps to decarbonize.
Invest with Confidence
There is a lot of excitement around the controlled environment agriculture space. Even with the recent high-profile vertical farm closures, Agritecture believes in the long-term success of this approach to growing. However, to get there, investors must know how to evaluate opportunities, and that’s why I am providing our 6 categories of assessment.
This really is just the beginning of a transition for the way certain crops are grown, particularly leafy greens. Success in this space will hopefully lead to a more sustainable future for agriculture, as we see these businesses become more efficient and respond better to market needs.