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Loss-making start-ups’ IPO subscriptions show investors valuing potential over performance

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A recent research paper by Daniel Su of the University of Minnesota has examined the phenomenon of negative earnings firms in the US financial markets.

By Siddharth Pai

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In the weekend just past, I watched a clip of Infosys Ltd. founder NR Narayana Murthy in conversation with Shereen Bhan, a TV journalist. The discussion was about the strong pipeline of Indian start-ups who are readying themselves for an initial public offering or IPO, and Murthy was asked what his advice would be to the founders of these start-ups.

Murthy maintained that the day he and his founding team took ‘one paisa’ from an outsider, the ball game changed. He felt that he had to act as a trustee of other people’s money. Murthy spoke of taking Rs 60 lakh from families and friends during the early days of Infosys.

He said that when he went to well-to-do friends, they asked a myriad of questions—including questions about the firm’s business model, demanded guarantees for a return on their money, and were savvy about the investment.

The questions changed when Murthy went to his sisters, friends, family, and others who were less educated and informed about the financial markets. This set of “lower middle class” friends and relatives of Murthy asked questions like “are you certain that you will use this money carefully?” and “are you sure that you will not spend this money recklessly?”. His response to them was that he would treat it “more carefully” than his own money.

Murthy further said that when his firm was about to go public, he cautioned his team that they needed to always remember their promise to these lower middle-class people. According to him, his team had done an excellent job of forecasting their revenues. His memory, he said, was that they also had beat their own excellent projections by a factor of two or more. He claimed that he could not sleep easy until three years after the event, when in his estimation, Infosys’s performance as a stock had become well-established. According to Murthy, having an IPO is not “fun”. It is not just to start calling oneself a “billionaire”. He says that these statuses are only illusory, and what goes up, can come down. He channeled Mahatma Gandhi and said that founders should think of the “poorest retail investor” before they decide on an IPO.

I agree with the overall thrust and high-minded intent of Narayana Murthy’s comments here, but the truth is that the world has long been investing in tech start-ups (and then their IPOs) even though these firms have negative earnings.

Despite our pride in India’s success as an IT-services destination, the IT-services world is an old-economy world. It relies on the numbers of people it has billing time to clients at specified rates. Their fundamentals are simple—for a given financial quarter, the only questions one must ask is for what percentage of that time (or actual hours) was the workforce billable, at what rate, and how much did it cost to keep the workforce paid for that quarter. These three numbers are the sum and substance of any IT services firm’s performance.

Any attempts to move to a ‘non-linear’ model by delinking the number of directly billable employees from actual revenue are only snips around the fringes of such enterprises. Infosys and its ilk are decidedly old school, and do not lead today’s tech-driven market.

A recent research paper by Daniel Su of the University of Minnesota has examined the phenomenon of negative earnings firms in the US financial markets.

We are only now beginning to see this phenomenon play out in India, but it has been part and parcel of the American market (which is significantly more tech-heavy) for decades now.

Su documented the prevalence of public companies with negative net earnings since the 1970s. The fraction of firms with negative net income has increased sharply from 18% in 1970 to 54% in 2019. By the end of 2020, this rose, with US public firms with negative net earnings at a record, accounting for 62% of public firms. Su says such an increase is mainly driven by the increasing popularity to the investing public at large of sizeable firms that are not profitable.

Based on the existing literature on customer capital, Su conjectures that the increasing returns-to-scale in the new economy is the main driver behind it. Su provides three pieces of supporting evidence. First, earning losses mostly come from the growing customer capital expenses instead of production-related costs, capital investments, or R&D expenditures. Second, cross-sectionally, firms with higher markup tend to have lower net incomes, at least according to his research. Third, industries with low marginal production costs, on average, have higher percentages of unprofitable companies.

According to Bloomberg, the trend is unsurprisingly strongest among newly minted companies, with 77% of IPOs not making money when they came to market in 2019. The reason for the rise of money-losing public firms is being driven not just by tolerance among investors, but an overt preference for a certain kind of loss-making firm: one built on intangible assets, according to Su.

Businesses are being encouraged to sell stock years before they are profitable because of a belief that some formula or idea will attract a network of users that will one day prove exceedingly valuable.

And this bet isn’t being made solely in IT. It’s also being made in areas such as electric cars. Around 63% of publicly listed manufacturers in the US didn’t turn a profit in 2020, compared with 19% in 1970.

The overwhelming numbers evidenced in Su’s study suggest that today’s investors either have new risk preferences than the “poorest investor” or are much better informed. Loss making start-ups going public is here to stay.

By invitation; The author is co-founder, Siana Capital; has also written “Techproof Me: The Art of Mastering Ever-Changing Technology

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