Decoding The Loss Making Startup Culture & Why To Invest In Loss Making Startups

By Nandini Marwah
April 28, 2020

 

A start-up is like a baby. You give birth to it; you take care of it and then you watch it go.

“What if equity value has nothing to do with current or future profits and instead is derived from a company’s ability to be disruptive, to provide social change, or to advance new beneficial technologies, even when doing so results in current and future economic loss but a lot of gain in the future?” Hedge fund billionaire David Einhorn, founder of Greenlight Capital

India is struggling to become the third-largest startup ecosystem in the whole world but it is actually going towards unemployment since more and more startups are getting shut down. A report was given by IBM Institute for Business Value and Oxford Economics where they found that 90% of the startups in India fail in the initial 5 years because of lack of innovation or too much innovation. Here are the few issues which lead to startup failure:

  1. Often it is told that if you make a different and out of the box product, your company will touch the sky. So then this saying is followed and a very unique product is trailed. Amidst this whole scenario, one very essential component is lost, the need for the product. Startups come up with such a unique product but forget that those products aren’t needed and aren’t right for the market.
  2. Lack of solving the market problem is another issue. Startups in India have a lot amount of data, technology, great advisors and a good reputation because of thorough marketing. But one issue that prevails is that of market understanding. They do not solve the market issue at large.
  3. India is the second-most populous country in the world and a major economy; however, most startups only cater to a section of the society and not a large chunk of it. The population in the rural areas remain untouched by this. In India, there are less than twenty retailers to serve the market chunk. but there exist way too many online retailers for the customers. likewise, there exist too many startups in a concentrated environment. The increasingly crowded startup ecosystem means there aren’t enough funds to go around for every startup. This is a major challenge that hampers the growth of a startup even when it has all things in its favour.
  4. Another major issue for the fall of startups has been lack of talent/ dedication and shortage of funds. Startups hire the wrong employees and go into the vicious circle of bad human personnel for the whole period. Startups were initially not able to gather a competent workforce due to the limited resources available and the inability to pay high salaries. There was simply the right talent shortage. In the second case, the founders wasted good two years with the wrong staff and paid them from the limited capital they had with negligible returns.

Why Are Startups Bought By Big Giants?

  • The big companies end up buying the startups because of the major reason, cost. Rather than acquiring services from them, they end up purchasing the startup so that in the long run, a very profitable alliance is formed. The entire setup, talent and technologies are purchased. The benefit of two service firms is way more than hiring the service.
  • One of the major reasons of merger and acquisition is that acquiring the startup, the sales of the startup merge with the parent company’s sales. The bigger organization has a win-win situation. The major example here can be of Kiva and Amazon. When the firm, Kiva built robots, Amazon uses that in their warehouses for all the in-house operations.
  • N Ganapathy Subramaniam made a statement that, “We continue to remain open and hungry for acquisitions. We have one of the best track records in terms of acquiring companies and integrating them… the approach is that clearly, we are in the market looking for the right asset which will add a certain amount of intellectual property, market reach or client addition.”
  • Another major reason is the research and development. Research takes up many years. People who start their own ventures have done their share of research. So when a big company acquires a startup, it ends up buying all the things associated with it in a package along with the killer and apt research ideologies.

Why Investors Invest In Loss Making Startups?

  • Going for profitability too early often means limiting growth. An extensive customer base needs to be developed and research needs to be done. Profit in the early stage means something isn’t right.
  • If a venture capitalist firm specializes in technology, they would try to dominate the tech sector by buying as many companies as possible. This way their competitors won’t have much choice but to buy the remaining less appealing firms. This unique strategy can create a favourable jump in their portfolios and often the word investment is deemed to be more attractive than the concept of profit.
  • Investors can still make money from unprofitable companies. VCs frequently sell their stake and often go ahead with the mergers and acquisitions.
  • There is also another very exquisite reason, the brand value. So uber isn’t making profits right now but if a VC invests in uber, he can benefit from it because of the popular name of the brand. The startups market themselves in unique ways and often become more popular than the conventional companies.

Competent examples which show that losses MIGHT lead to REVENUES

For about 20 years, Amazon was dependent on investors to grow and stay in business.

“One of the main reasons for Amazon’s success was their ability to raise capital and have a story where people believed they would be profitable,” said James Cassel, Founder, and Chairman of investment banking firm Cassel Salpeter & Co. This bond ultimately paid off. In the first quarter of 2019 the e-commerce giant reported about $60 billion in net sales, and it seems like they will maintain these types of massive profits for the foreseeable future because they are one of the biggest companies right now.

Comparing amazon and uber. Amazon took two decades to reach the profitability stage, maybe uber will too. “Until and unless Uber can find ways to overcome the numerous weaknesses in its business model, the company will never be profitable.” Said a great economist.

Each startup has its own strategy to achieve a certain level of dominance in their category, and their own timeline for a path to profitability. The reason why Indian startups end up being acquired is because of the lack of funding and a promise for a better future!

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Community Bank M&A Likely to Take a Twist With Covid-19, Advisors Say

By Surani Fernando
April 17, 2020

 

Takeaways

  • The ongoing economic crisis brought on by the coronavirus pandemic will likely see a shift in factors driving future M&A activity, including exposure to distressed industries and geographies, which may heighten the need for consolidation, advisors
  • Low valuations will dissuade sellers, and cash components of deals will need to be much higher, one advisor
  • Covid-19 may force even larger players to consider M&A options, and there could be more deals involving targets with $2 billion to $5 billion in assets, one advisor

The trend of community bank M&A will likely take a twist in the wake of the coronavirus pandemic as new challenges will reveal additional vulnerable targets, FIG sector advisors said. However, deal activity may not pick up until the end of the year as banks will take time after the financial markets stabilize to assess loan book damage, they added.

Prior to the pandemic, the industry was seeing a wave of consolidation among community banks looking to grow in scale and compete with the larger super-regional players, and the surge in 2019 M&A activity was expected to continue well into 2020, four advisors said.

In 2019, there were about 270 transactions, the highest in the last three years, said Jonathan Roberts, managing director of transaction advisory services at BDO. Macro trends and the need for scale were driving the consolidation especially in some of the larger states like Florida, Illinois and Texas, said Roberts. According to the Federal Deposit Insurance Corp. (FDIC), there are more than 5,000 community banks in the United States, which represent 92% of insured institutions.

Significant merger of equal deals in 2019 include First Horizon National’s combination with Iberiabank for $3.9 billion, and Texas Capital Bancshares’ merger with Independent Bank Group in a $3 billion deal.

The ongoing economic crisis brought on by the pandemic will likely see a shift in factors driving future M&A activity, including exposure to distressed industries and geographies, which may heighten the need for consolidation, advisors said. The pandemic is also expected to affect deals that are yet to close, as evidenced by Flushing Financial’s $111 million acquisition of Empire Capital, which was announced in October and has been delayed due to financial and stock market volatility.

M&A Dynamics to Change

Potential buyers need to focus on their own businesses now, and it will take time to build an offensive strategy, said James Cassel, chairman and co-founder of boutique bank Cassel Salpeter and Weber.

The more likely buyers for the smaller regional banks with $1 billion to $3 billion in assets are perhaps the institutions with $10 billion to $30 billion in assets, said Timothy Johnson, partner at KPMG’s transaction services, adding that mergers of equals between two banks each with $3 billion in assets are also a possibility.

When M&A activity in the space regains momentum, community banks in a position to use cash for deals are the likely consolidators, as depressed stock prices will deter sellers from agreeing to typical stock deals, Cassel and Johnson said. Low valuations will dissuade sellers, and cash components of deals will need to be much higher, agreed Osnat Naporano, managing director at independent investment bank Brean Capital.

Geographies will play a big role in where community bank M&A might occur, said Naporano. Florida has historically seen a high number of community bank mergers, while Arkansas, Louisiana and Oklahoma have also been active states, said Johnson. Traditionally banks within the same geography merge to build a larger community presence, but this could be an opportunity for regional banks to expand into another geography, said Cassel.

But for the time being, pre-Covid-19 negotiations have been halted as the industry waits for the financial markets to settle, advisors said. Only then will it be possible to evaluate the extent of the damage caused by the global shutdown, particularly to small businesses, the advisors added.

Once the economy is in a less volatile state, it could take up to three months to fully assess credit losses and the credit quality of the loan books, said Roberts. If that initial stability comes sometime in the summer, it may mean no deal flow until the fourth quarter at the earliest, Roberts said, with the other advisors agreeing on the timeline.

In 2019, a larger majority of community bank M&A involved targets with less than $1 billion in assets that were struggling to compete, said Johnson. The trends of the past year spoke to long-term community bank consolidation, and at the start of this year, given margin pressures and the lack of economies of scale, there was anticipation for mergers among smaller banks going as low as $250 million in assets, said Roberts. But Covid-19 may force even larger players to consider M&A options, and there could be more deals involving targets with $2 billion to $5 billion in assets.

Covid-19 Direct Impacts

Covid-19 will amplify the yearn for digital enablement as citizens get used to accessing their online account for banking needs, and given that expansion requires capital investment, M&A among smaller banks may be the only way to achieve that, Johnson said.

The next few months will be telling, and the major difference between now and the global financial crisis is capital, Cassel said. Regulators did a good job of making sure banks had adequate capital to withstand stress in their loan portfolios, said Johnson. Even so, being liquid will be much more important, said Naporano, adding that better deposit franchises will be more attractive.

The U.S. Federal CARES Act has resulted in a surge in applications for the Paycheck Protection Program (PPP), and smaller banks may struggle to service this demand, Johnson said. Consolidation may be one avenue to maintain customer service standards, which is  the main draw for community banks, he added.

A big concern is around commercial real estate, and the exposure that banks have in their unique geographies, Naporano and Cassel said. Johnson agreed, saying over the next three months, institutions over indexed to commercial real estate may need help sooner than later, and if they have a decent franchise that is distressed, it may push them closer to a transaction.

It will be unique to the institution, but banks with a fair amount of business in the hospitality and leisure space, will be exposed to higher risk. Community bank books reflect the health of the economies in their geographies. Florida and Southern California, for instance, have local communities that are dependent on tourism, while community banks in Texas could be suffering due to links to the energy industry, said Roberts.

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What Is Cash Basis Accounting?

By Mark Henricks
April 08, 2020

Learning about cash basis accounting, one of the most common business accounting methods around, can help your company’s cash flow.

The two most common methods of business accounting are cash basis accounting and accrual accounting.

While each has different characteristics and advantages, the basic difference between them comes down to timing.

Cash Basis Accounting: Examples

“Cash basis accounting captures transactions when there is cash involved,” explains Lisa Koonce, an accounting professor at the University of Texas at Austin. “For example, when buying office supplies, the company typically pays cash for them. Under cash basis accounting, the company then has a business expense and a reduction in their cash balance.”

For an example of how cash basis accounting would work with revenues, consider a small business that sells to other businesses. Its customers pay its invoices in 30 days. The business would record revenues from sales when the payment actually arrives, 30 days or so after the invoice is sent.

With expenses such as payroll, a similar small business would record the expense of paying workers on payday. In other words, cash basis accounting calls for recording payments to workers when paychecks are actually distributed, rather than when the workers earned the pay.

Cash basis accounting adequately reflects many small firms’ financial situations, says James Cassel, chairman and co-founder of Miami investment banking firm Cassel Salpeter. Restaurants, for instance, are often well-suited to cash accounting because there’s little difference in the timing of when they receive money and pay bills.

“With most restaurants if they’re paying bills on time, everything is within 30 days. They’re getting paid when the customer comes in with cash or a credit card, then receiving the credit card payments in a couple of days,” Cassel says. “It doesn’t make a lot of difference in how they manage the business whether they use cash or accrual.”

Accrual Basis Accounting: Examples

“In contrast, accrual basis accounting captures transactions when an economic event occurs, which may or may not involve cash,” Koonce elaborates. “So, for example, when a company uses electricity, they would under accrual accounting recognize electricity expense at that time. They would do so even if the payment for that month’s electricity bill occurs later on, like the next month once the bill arrives.”

Payroll provides another important example of how accrual basis accounting treats expenses. A business using accrual basis accounting would record the costs of paying its workers as they do the work, rather than when the paychecks are distributed.

Revenue works similarly. A business using accrual basis accounting records income when the company has earned the revenue. So a consultant would record revenue as billable hours are completed. A building contractor would record revenue when a remodeling job is finished. A manufacturer would record revenue when product has shipped.

In these cases, actual payment may not arrive for weeks or even months, but the revenue is recorded when it is earned.

Which to Use? Cash vs. Accrual Basis Accounting

Since cash basis accounting is focused on cash transactions, it highlights other differences between the two accounting methods. For instance, cash accounting doesn’t recognize accounts payable or accounts receivable, which are important parts of accrual accounting.

The cash accounting method is more popular among smaller businesses. Sole proprietors, especially those who don’t have inventory, are particularly likely to use cash basis accounting rather than accrual accounting.

“Cash basis accounting is much simpler than accrual basis accounting, so for small businesses it is a more cost effective way in which to keep track of transactions affecting the company,” Koonce says.

Although it’s simpler, cash basis accounting does have some limitations.

“The biggest disadvantage of cash basis accounting is that it doesn’t capture economic transactions in the right time period,” Koonce notes. (For instance, a business incurs expense for electricity when the business uses the electricity, not when it pays the bill the following month.)

Looking at cash flow seems more straightforward and less complicated for a business that uses cash basis accounting, Cassel notes.

“If you have more money in the bank at the end of the month than in the beginning of the month, and you have paid all your bills, it’s a good month,” he observes.

But accrual basis accounting can give a more accurate financial picture of business’ financial status, especially if there’s a time gap between having to make and receive payments. Accrual accounting is often more useful for long- term planning, Cassel says. This is part of the reason why larger companies are more likely to use accrual accounting.

Another key reason for using accrual accounting is when it is required by a third party. If a business is looking for a bank loan or preparing for sale, the lender or buyer might require accrual based accounting, Cassel says. In addition, public companies always use accrual based accounting.

Lenders, investors and private equity buyers often want a business to have audited books, he explains. And an audit performed under Generally Accepted Accounting Principles (GAAP) requires accrual accounting.

The Internal Revenue Service also has rules about using cash basis accounting. The IRS will accept either approach, including a hybrid of the two, with some exceptions. One is if a company that is not an S corporation has more than $25 million in annual sales. In that case, the IRS requires accrual accounting.

If accrual accounting is not required by some third party, companies are free to use either method. Some use a combination of the two, employing accrual method for sales and purchases of inventory and cash for other income and expenses. Companies may also use one method for managing the business and the other when it comes to filing taxes, Koonce says.

Companies can switch from cash basis accounting to accrual accounting for tax purposes by filing Form 3115 with the IRS. Switching often occurs as a company gets larger and long-range cash flow planning and dealing with investors and lenders becomes important, Cassel says.

But switching accounting methods isn’t common, and it usually means going from cash to accrual.

“From the IRS standpoint you can pick a method, but once you pick it you have to stick with it. You really can’t go back and forth,” Cassel says. “And generally, you see people change from cash to accrual. It’s rare you see someone go from accrual to cash.”

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Are we headed for a depression? Economists weigh in

April 4, 2020
By Erik Sherman

Another day, another surprise for the economic forecasters: a record 6.6 million people filed for unemployment last week. Oxford Economics in an email called it an “incomprehensible jump” that may be “the new normal.” Joe Brusuelas, chief economist for middle market audit and advisory firm RSM, wrote that such “tectonic shifts” imply a “real-time unemployment rate of 10.1% at a minimum.”

There is so much uncertainty in the world right now that economic forecasters are downgrading their predictions almost as fast as they can make them. Within a few weeks, Goldman Sachs downgraded its second quarter GDP estimates from –2% to –24% to –32%.

Fortune discussed the issue with 10 economists and financial market experts. Most at this point consider a recession essentially a given. And a depression? That’s where opinions start to diverge wildly.

After all, out of the 22 recessions since 1900, according to the National Bureau of Economic Research, only one was dire enough to warrant such a title: the Great Depression. There had been four in the preceding 19th century.

Right now there appear to be two camps. Those in the first say economic fundamentals have been essentially sound and that a depression is almost unthinkable. The other group says that a depression is very much a possibility.

What is a depression?

Unlike a recession—two consecutive quarters of negative GDP growth—there is no compact universal definition of a depression.

Absent an official definition, economists have a variety of working ones. According to some, “in a depression, you have to have a decline in GDP of two or more years,” said Shahid Hamid, professor of finance and chair of the finance department at Florida International University. “Another is if the GDP decline is greater than 10% [for two years]. A third is if unemployment is more than 10%,” again for two years.

Then there are economists who take a more relative approach. “Some people say it has to be a year [of severe economic contraction],” said Derek Horstmeyer, an associate professor of finance at the George Mason University School of Business. “Some people push it further.”

There is even a question as to whether it must be obvious to everyone at the same time. “It is possible for one sector of a society to be trapped in an economic trough—a depression—while another sector is feeding from the trough and living the high life,” said Michael Merrill, an economist, professor of professional practice, and director of the Labor Education Action Research Network in the Rutgers School of Management and Labor Relations. “Traditional Middle America has known exactly such a situation since the mid-1970s, and African-Americans have known it for even longer. The effects are evident in every health, economic, and social welfare statistic one might want to consult.”

Or, as goes the old saying that James Cassel, co-founder, and chairman of investment banking firm Cassel Salpeter & Co., mentioned: “When your friend’s out of a job, it’s a recession. When you’re out of a job, it’s a depression.”

As with recessions, depressions are typically diagnosed in retrospect, after the data is in. But that typically comes after events have happened and not as they are occurring, unlike in many other aspects of American life.

“We actually have data for minute-by-minute listeners to major radio shows,” said Usha Haley, W. Frank Barton distinguished chair in international business, professor of management, and director of the Center for International Business Advancement of Wichita State University. “We know who’s going to buy products and what’s going to happen. Here, for the first time, we don’t have [the economic data we need to forecast].” The changes are so swift and large that forecasters can’t build projections from patterns in the recent past.

“This [pandemic] scenario is very new, and economists don’t have a good model to predict how the recovery would be,” Hamid said.

There is also an inherent issue in how economists measure GDP. They usually look at change between quarters and then project that out into an annual growth rate. When a forecast projects that GDP will be –32% in the second quarter, it’s really saying that if the change between the first and second quarter kept up all year, it would be like losing 32% of GDP over that year.

That can get confusing for a lay audience when trying to understand the state of things. “The way the quarter-over-quarter math works, if it goes down a lot in quarter one and it stays at that low level of activity in quarter two, [the rate is] zero,” said Steven Blitz, chief U.S. economist of TS Lombard. Suddenly the rate economists and the media mention is 0%, which sounds far better than –32%, but it means things are still as bad.

Between all these factors, trying to pinpoint whether we’re heading for a depression is extremely difficult.

The optimists

The optimists, if you can call them that, cite a basically strong economy, the noneconomic nature of the pandemic, and the presumption of pent-up demand once things are back to normal as evidence that as quickly as we fell into this hole, we can pull out of it.

Florida International University’s Hamid is among those who think a depression is “very, very unlikely” given the economy’s performance coming into the crisis. Haley at Wichita State University agreed. “We’re in the center of it all,” she said. “We’re on the battlefield. Once that is over, we will recoup.”

In an email to Fortune, Kundan Kishor, a professor of economics at the University of Wisconsin–Milwaukee, saw a depression as only a “one out of 100 chance.” He sees two potential likely scenarios. One is a large drop in the economy and rapid recovery in the third and fourth quarters. The other is a “double-dip recession” if the pandemic reemerges in the fall.

If an economic fall happens and continues for months, the situation becomes more grave, thinks Sevin Yeltekin, a professor of economics at Carnegie Mellon University’s Tepper School of Business. “But if we can restart, even a staggering restart, we’re not really destroying capital,” she said. “We’re not destroying labor. The ramping up should happen quite quickly,” putting danger at a distance.

“When you recognize that the contraction of economic activity was imposed [as a response to the pandemic] and therefore can be lifted, that makes this very different from your plain-vanilla ordinary recession in which policy missteps turned into a depression,” explained TS Lombard’s Blitz.

The pessimists

And then there is the other view. “Most economic models now point to a 25% to 30% unemployment rate in Q2,” said George Mason’s Horstmeyer, who focuses more on the degree of contraction and not the length. “The numbers we’re seeing trickling in are very bad. This projection is worse than anything we saw in the Great Depression. So we can certainly call this a depression even if it only lasts for a quarter or two.”

Alessandro Rebucci, an associate professor of finance at the Johns Hopkins Carey Business School, also stressed the depth of the collapse that his research shows using current indirect measures of activity, like energy use and traffic patterns. “This [recession] poses formidable challenges and could be more prolonged and more severe, possibly worse than the Great Recession of 2008 to ’09, which lasted six quarters and saw the unemployment rate reaching 10% of the labor force,” he said. “Current estimates put it at two to four times as severe, making it more profound than the Great Depression.”

Rebucci also points to cascading effects that will stretch through the economy. “People will start to lose jobs, which means they will lose houses,” he said. “We’re used to thinking of recession driven by shocks that are short-lived. This is not only a shock that will last a while but will have long-term effects. What is shocking is that institutions continue to forecast moderate output declines, which has to do with the fact that they don’t want to sound the alarm.”

“The odds of a depression are quite high,” says Merrill of Rutgers—in fact he thinks we might already be in one. While the stimulus packages will “slow the decline somewhat,” changing the direction of the economy means addressing the pandemic and bringing it under control, and then restoring confidence afterward. “As long as people remain afraid of getting deathly ill and maybe dying every time they go to a mall, grocery store, or barber shop, the economy will not recover,” he said.

Avoiding the danger

For the U.S. to avoid a depression, says Blitz, three things must occur.

  • First, the Federal Reserve must do everything in its power to ensure that “credit contagion doesn’t cascade through the system.” The Fed has taken many extraordinary steps not seen since the 2008 collapse, which hopefully will keep the global financial systems If there are additional liquidity problems, however, the Fed may have reached the end of its options.
  • Second, the federal government needs a large enough fiscal response of the right type. The $2 trillion aid package is enormous, but Blitz thinks it may not offer the best approach. “The problem with giving people money to spend [is that] you have to be balancing that against the fact that you have social distancing rules preventing people from spending money,” Blitz said. “I’d rather them front-load a trillion dollars of spending by all the various nondefense government “
  • The biggest question is Blitz’s third point—that the shutdown of activity needs to end quickly. “You need to stop the imposition of social distancing sooner [rather] than later, and government has to realize that the lifting of this can’t be a six- to 12-month process,” he “Then they have to encourage people to go out and live their lives. Once government takes this power to shut things down, they’re very reluctant to give it up.”

Although Donald Trump has said that he’d like to end isolation by the end of April at the earliest, the mathematical models the administration is using suggest that social distancing may have to continue through at least May. And that aggravates the problem.

Because while scientists are working to make strides on treatments and vaccines for coronavirus, economists are still searching for their magic bullet: a way to bring an economy out of a depression.

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