The bottom line, the most important part of any functioning business.
Profit after costs, expenses, and taxes.
The money that the founders and investors in companies get to put back into their pockets
for the risk and effort they put into a business.
Sounds like business 101 right? And it kind of is.
A business that doesn’t turn a profit is like a freezer that kind of make ice, it’s
more or less pointless.
And sure there are things like non-profit charity organizations out there but most businesses
exist to make money!
So why is it that some of the biggest companies in the world are not turning profits? Why
is it that they don’t even plan to?
The rise of so-called zombie companies or companies that have not and have never run
at a profit are raising more and more eyebrows in the investing world.
These businesses are getting too big to ignore as by some estimates over 10% of the s&p500
(an index of the largest companies in America), is now made up of these companies that don’t
serve the one central goal of being in businesses.
What’s more, is that this issue is not just endemic to a particular industry, dozens of
major companies and countless smaller businesses in every sector of the economy from energy,
retail, medical, telecommunications and of course technology are in this profitless boat
together.
So what is going on here?
Why would anybody invest in a business that is unprofitable?
What impacts does this apparent misallocation of resources have on the economy?
And finally,
Will the economic fallout of 2020 show these businesses for what they really are?
Now before we start ripping into these businesses
as blatant ripoffs it's first important to give credit where credit is due. So why are
these businesses looking to speculators like A solid investment
Almost every business in the world starts out as an unprofitable endeavor. Everything
from a corner store to Microsoft had to operate for a period of time where they were developing
a product, building out infrastructure, and growing a customer base.
This is normally expected as part of a regular business life cycle, but the big distinction
is that most businesses will desperately try to get to a point where they break even.
Breaking even simply means that the business is self-sufficient and can cover all of its
own costs and expenses and make exactly zero dollars in profit or loss.
For people starting their own business, this is a really important milestone because it
represents a point where the new business owner does not need to contribute their own
money to keep the lights on.
After the break-even point the next step is of course turning a profit by continuing to
grow revenue and minimizing expenses, and for most businesses out there that can get
to this point, that is where they live happily after.
But of course, some businesses want to continuously grow because their business model suits a
scale slightly more grandiose than a corner store, or a cafe.
To do this these types of businesses will need to attract investors that extend beyond
themselves plus their friends and family.
That’s because unless these hypothetical founders are extraordinary wealthy already,
they will need access to larger pools of cash to develop the infrastructure for yet another
new Uber rival or oil fracking operation
These funding rounds are normally taken out periodically when one of two things happens.
Either the business grows and achieves a new goal like let's say taking 50% of market share
in a new city or the business runs out of cash from the last investment rounds.
Now investors are much more likely to invest in a business that has hit a growth goal than
they are to invest in a company that is running low on cash, so these businesses develop a
growth at all costs mindset.
Now all of this is still actually fine, some businesses naturally take longer to turn a
profit than others and need cash to keep the lights on in the meantime.
Medical research firms for example can takes years to develop a new medicine and get it
through FDA approval, but once they do they are in for the mother of all pay days.
Nobody has any major issues with these types of businesses because they have a plan for
profitability. Sure the drug may not be made, or may not get approved but that just the
equity risk of investing.
What does cause concern is companies that have no plan for profitability. Famous examples
like Uber and we work are not waiting on the rollout of some revolutionary product, and
they have all the market share they could possibly ask for so what gives? How is anybody
supposed to make money off this?
Well this is Uber co-founder Garret Camp’s house which was reportedly purchased for 72.5
million dollars so obviously someone is making money, and they are.
That’s because different rounds of funding tend to attract different types of investors.
Let’s say two engineering friends develop a new system for extracting oil more efficiently.
The first pot of cash a company has to get started with normally comes from these founders.
They will use this money to develop a business plan, a name for the business, some functional
technology demonstrations, and perhaps most importantly a campaign to attract further
investment.
After this comes the Angel Investor. These are investors that are normally ex entrepreneurs
themselves that will seek out good ideas that need an infusion of cash.
This money will be given for a portion of ownership in the company by selling shares
to that angel investor. This cash can then be utilized to do the same thing on a larger
scale. Maybe now an actual product is rolled out and some oil is dug on a test site.
This market test is very unlikely to make that much money but it will show slightly
more conservative investors that this is possible. Which is where the big guns will come out.
At this point the founders can look to raise the next round of funding with other companies
in the industry and Venture Capital firms (which are basically investment vehicles for
rich people).
At this point for the first time ever the founders will get sat down in an office and
be given a choice.
They can sell some of their own equity in the company and that cash will not go towards
business operations but will instead go into their own personal bank accounts.
Normally this is encouraged for 2 reasons. One: it allows these firms to buy into this
company without diluting the ownership as much. And two: it's kind of important for
the founders of a now potentially billion dollar company to look successful.
More investors will need to be attracted in the future and if the founders are still living
at home with their parents it doesn’t send a great sign to the less sophisticated public.
Now this company may repeat this whole process many many times over, and while doing so that
angel investor will probably cash out their shares as well, this is money that they can
use on the next company all over again.
Eventually, though these rounds are all shooting for the holy grail of business funding, an
initial public offering where the business will be listed on a public stock exchange
are regular mere mortal investors will have a chance to invest their money into the company.
historically, companies have been profitable when they are listed to the public. In 2019
only one-quarter of American IPO’s were for companies that ever turned a profit.
None the less, IPO’s of non-profitable companies have become more palatable to regular investors
because they have seen the monumental success of companies like amazon which famously did
not turn a profit until late in the last decade.
Outside of being palatable, they are kind of essential.
Public offerings are where these venture capital firms will cash out their shares take their
profits and get ready to do the whole thing all over again with a new company.
But hold up...
Investors getting rich by attracting more investors who only make money by attracting
more investors… you might be thinking hand on, isn’t that a ponzi scheme?
And ehh you know it really does blur the line.
Technically the funds given to these businesses are being used to develop and grow the operations
rather than to exclusively pay out old investors but for many companies, it is starting to
look sketchier and sketchier.
Nikola has famously been in the spotlight recently for attracting huge amounts of investment
money through multiple rounds of funding and a backdoor style IPO using a SPAC. we’ll
do a video on SPAC’s separately because they are a bit wild in their own right.
Despite all of this money being thrown at the business, it has been revealed that they
didn’t even have a working prototype of an electric truck which was their core product,
and instead just rolled an empty model down the hill to fool the general public and potential
investors alike.
What’s more is that it has been reported that the founder of this company Trevor Milton
has had a history of starting unprofitable businesses with no underlying value, selling
it off to investors before moonwalking away with millions of dollars for having actually
made nothing.
Now in fairness, this might very well be a bad egg amongst the bunch, but the reality
still stands that businesses should turn a profit.
The central function of the free market and capitalism is that it can deliver goods and
services to the economy according to what is demanded at an equitable price.
These zombie companies may very well be skewing this system and producing an economy of
Misallocated resources
Uber rides are a cheap and reliable alternative to taxi’s but would you take an Uber if
they were 50% more expensive than they are now?
For some of you out on the town on a Friday night the answer would likely be a resounding
yes.
But a good portion of Uber's customers would likely revert back to regular taxi’s or
use one of the myriad of up and coming competitors.
The reason that this is important is that the operating expenses and all the overhead
of an Uber ride are not paid for by that Uber ride.
What this means is that indirectly investors are paying up to 30% of your Uber ride for
you.
A product that is this heavily compensated probably shouldn’t exists in a regular functioning
market.
Now regular channel viewers will know what happens when external forces try to artificially
push prices down in an otherwise competitive market. You get a deadweight loss.
I won’t go over the exact economic process behind that again but if you are interested
go and watch out video on black market economic to learn more about how deadweight losses
come to be.
But for now just know that they are bad, they represent a burden on society almost as a
punishment for trying to mess with the efficient market. Fortunately for now at least that
burden is being exclusively bared by investors but that doesn’t mean that this isn’t
impacting everybody indirectly.
These investments could just go towards genuine businesses with good products that people
are happy to pay a fair market rate for that covers the actual cost of producing that product
of service.
Channeling money towards profitless endeavors denies these businesses the potential to get
to market and make this happen.
So the question still stands, why wouldn’t investors just go for this kind of option
instead?
Well the unfortunate reality is that growth based businesses are a mare
Stable form of madness
If delta airlines looses 2 billion dollars in a year it makes headlines as a corporate
emergency, if we work looses 2 billion dollars in a year it is considered the cost of doing
business.
Economic downturns, like the dumpster fire that is 2020 are often seen by economists
as a necessary evil to weed out companies with poor fundamentals and leave a leaner
more efficient private sector behind.
But in many ways profitless companies are actually more resilient to these shocks.
For starters their shareholders don’t get as antsy about a quarterly loss because that
is just an expectation but whats more is that these kinds of companies can actually have
their game plan accelerated by a crisis.
So long as funding is still plentiful these businesses don’t have the same risk of going
under. , and in the age of the money printer going brr it most certainly is certainly plentiful.
Whats more is that the goal for a lot of these businesses is to take market share. If they
are competing against other companies that rely on good old fashioned profits they are
going to be able to beat out this competition during a period of reduced customer spending.
Even beyond this a slump in the prices of things like commercial real estate is a great
opportunity for these cash rich companies to buy up some locations as a base of world
domination in the future.
Amazon has famously been buying up abandoned retail parks to use as distribution centre’s.
With the spike in business bankruptcies these opportunities are going to become more plentiful
and a lot cheaper.
All of this means that the stock market rally we have seen since may of 2020 has been primarily
fueled by big tech companies and/or businesses that don’t know what profit is.
Final Thoughts
The idea of investing in something that doesn’t make money seems like a foolish endeavor,
a game of the greater fool.
None the less it is a reality that we are going to have to contend with because it is
here and it has become hugely influential in our finance markets.
What does a world look like where these businesses become the norm? Well hopefully they will
all eventually get to a point where they become profitable and pay lots of dividends to their
longtime investors who bravely battled through the naysayers.
There are a lot of companies with genuine promise. But with anything short of a crystal
ball it is difficult to see this having a happy ending.