This article is written by Kanishk Gambhir, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.com. Here he discusses “Can a Loss Making Company be an Attractive Target? Why?”.

Introduction

In 2018, Walmart acquired Flipkart for 16 billion dollars even though since Flipkart’s inception in 2007, Flipkart has not earned a profit of even a single penny. In fact, Flipkart losses were approximately Rs. 8,771 crores in FY17. So, the question arises why would such a proficient company like Walmart buy a loss-making unit and this is not an isolated incident, that is, companies merging or acquiring or investing in loss-making entities. In fact, it has been happening for ages and more so in the present era of the startups. Another way to look is the valuations of the companies even after making losses- Paytm valuation is $15 billion but its losses were roughly  471 million dollars. So, the question that arises is how do these loss-making entities have such a huge valuation despite making losses or why would any companies want to acquire them?

The answer for the same is that presently companies have stopped playing the short-sighted game but have learnt to look at the bigger picture and that is why I believe that Yes, Loss-making companies can be an attractive target and the reason for the same are multifold as just looking at the profits of the companies is a very inadequate, orthodox albeit safe way of doing business. So sometimes taking risks in present loss-making entities reap much more financial benefits in future, of course, it doesn’t come without its own risk factor but as Mark Zuckerberg said: “The biggest risk is not taking any risk.” So sometimes taking no risk can very idiotic decision to make. 

So, here are a few reasons why a loss-making company is an attractive target.  

1. Growth – Nowadays in both saturated and unsaturated markets it is more about market grabbing than getting profits. And easiest way to grab the market is by providing ridiculously high discounts in a competitive market (Like Zomato) or saturated market (like Jio).  So, even though initially they suffer high losses, they have grown in revenue and market share which gradually over the years can be easily converted into a profitable venture, once you have developed a loyal customer base.                   

This idea of long term growth plan was further fanned by the entry of new-age Asian investors like Softbank, Tencent etc. So, now it is more about who sells more, whose revenue is higher than profitability. So, companies look at growth in the future, then profit in present.

2. Tax benefits– Sometimes, depending on the laws of the country, countries allow the acquirer to reduce the tax by reduction of profits when a company acquire a loss-making entity by addition of profit of one company to the loss of the another. So, this leads to a deduction of profits which further leads to a reduction in tax payable. This would be a very similar case when Google acquired Motorola back in 2011 and took advantage of Motorola’s 700 million dollars operating loss in the form of tax benefits. 

Generally, such benefits arise due to unused tax losses, unused tax losses, unused debt capacity, surplus funds, and the write-up of depreciable assets.  Tax carry forward helps the acquirer to offset the income it plans to earn which will help in saving taxes. So, sometimes a loss-making entity becomes a very attractive target due to their ability to help in tax gains. 

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3. Future potential – Some companies, especially in the case of unsaturated markets, especially try to look at future potentials of the companies rather than what they are contributing in the present. This would generally be in case of newer ventures like Artificial intelligence, E-Wallets, drones etc. or even industries like e-commerce which is still in the growth stage. So, sometimes you have to bet on how these companies will attract clients in the future to get a first mover’s advantage.

4. Huge valuations of Intellectual Property Rights– This might be one of the few reasons which don’t involve huge risks for the investors as some companies despite being loss-making have some intellectual property rights like patents or copyrights which have huge valuations in the market. So, then it is not rocket science to understand that even though they might be loss-making but investing in them is usually a clever idea as you are not betting on them but you are betting on their Intellectual property rights which would be a good bet in spite of their losses.
    
5. Quality assets underutilisation– Some companies are loss-making not because of their business model or there are providing huge discounts to clients but just because of poor management at the top. Reasons are same can be multifold inefficiency or inapt knowledge in sudden growth of business, continuous departures of the people in top management which leads to underperforming of the assets, so sometimes if an investor/acquirer is able to differentiate between poor management and a bad company, loss-making companies can easily be turned around with proper utilization of assets which makes them an attractive target.
    
6. Asset Stripping –  According to Investopedia, Asset stripping can be understood as a practice where undervalued or loss-making companies are brought with the sole intention of selling the assets to generate the profits. This is usually done in a case where the value of assets separately of the companies is much more than the company as a whole, reasons of which can be poor economic conditions, poor management etc.  This is one of the practices which some people say is in morally grey area but as Jim Slater, one of most infamous British Corporate Raiders, used to say “If a firm has its assets stripped it means they have not been properly used.” and at the end of the day business is about profits, so, sometimes loss-making entities with highly valued assets is a very attractive target.
    
7. Market Goodwill– Some companies have high market goodwill with them despite being loss-making. The best example of this could be Nokia.  So, buying such companies is more about the use of the goodwill then about their assets and liabilities. Generally, the investor backs such companies to cash in on the goodwill of such companies which has been built over the course of multiple years and generally with the right management companies can be turned around. So, high market goodwill can make a loss-making entity attractive.
     
8. High Liquidity– Liquidity, refers to the availability of liquid assets with a business. Some businesses like banks, Investment companies etc. have high liquidity and some times larger companies when they are in a cash crunch and in order to get out of the situations can easily acquire smaller companies which have high liquidity using stocks and shares and benefit from their liquidity to get out of their cash crunch problem. Sometimes this is also done to maintain the liquidity ratio which might have decreased generally in a year in which outflow of cash was very high with minimal/ low inflow. So, that is why even if companies are loss-making on the balance sheet but their high liquidity makes them an attractive target. 

9. Potential Market Valuation –  Lyft Inc., a cab ride-hailing company from the US, recently did its first Initial Public Offering was valued at $24.3 billion. Point of notice should be that this success came even after it’s steep losses. This showcases that even though the companies the unprofitable status of the companies does not affect the stock market and it doesn’t care. It looks beyond the losses and towards future growth. So acquiring such private companies earlier promises a good rate of return on the investments. In fact, according to a new pitchbook report, In US, unprofitable companies had a higher and more profitable debut at the stock market than the profitable ones. What these showcases that profitability as a sole criterion has been long gone and people look at other things like exponential growth rate, gradual turn into profitability. What these promises are huge returns on investments for any investors.

Furthermore, in the case of companies making losses for growth and expansion may seem bad on the balance sheets, but it is doing wonders for the valuations of such companies.  So, a loss-making entity can be very attractive as a target if you won’t make a quick gain out of their good market debut but of course, this gamble won’t be without its own risk. 

10. Eliminating Competition – Sometimes, despite being a loss-making entity company have a huge potential of growth. So to the other profitable companies in the same sectors, these loss-making companies might seem like a very attractive target to remove any future competition in the present itself. They would prefer to splash some money now to lose it later. So, despite being loss-making at present companies might get the attention of the competitors, who would prefer to remove the competition before it becomes a problem. 

Conclusion

The ‘money’ in the world of mergers, acquisitions and investing, it seems doesn’t depend on the present but is more a bet on the future on what the companies would provide in the future. So, the present loss-making has generally stopped worrying any of the bigger investors as there are ready to wait and play the long game and earn big. Further, in businesses the oldest mantra is HIGHER THE RISKS, HIGHER THE RETURNS and investing in loss-making companies might be a risk but may provide exceptional returns. 

References

1. https://www.businesstoday.in/current/corporate/paytm-valuation-rose-25-pc-to-usd-15-billion/story/374415.html (Last accessed on 10-09-2019).
2. https://www.referenceforbusiness.com/encyclopedia/Man-Mix/Mergers-and-Acquisitions.html#ixzz5zFIgTJzc (Last accessed on 10-09-2019).
3. https://www.investopedia.com/terms/a/assetstripping.asp (Last accessed on 10-09-2019)
4. https://www.independent.co.uk/news/obituaries/jim-slater-businessman-who-became-first-famous-then-infamous-for-the-asset-stripping-firm-he-set-up-a6742741.html (Last accessed on 10-09-2019)
5. https://www.vox.com/2019/3/21/18274843/unprofitable-tech-unicorn-ipo-stock-market-profit (Last accessed on 12 -09-2019).

Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skill.