Owners of private companies may not have to pay attention to earnings season, but there's at least one big lesson they can learn from some of the billionaire-run public companies: how to lose money the right way.
A common quarterly complaint from shareholders of public companies is how richly valued success stories like Netflix, Amazon, Salesforce and Tesla can fail to turn a profit. But often, especially in the early days of new companies, losing money is part of the plan.
Some of these companies have the ability to go back to the capital markets for more cash, as Elon Musk has done multiple times. Many of these tech companies also have long-term, institutional shareholders who buy into the CEOs' grand plan and are willing to ride out the ups and downs in quarterly financials.
Amazon, now a mature technology giant but long known for not worrying about short-term financials, last week announced a 77 percent decline in second-quarter profit as it invests heavily in video content and global expansion. There are some advantages the big guys get that don't apply equally to all business ventures, especially outside the tech sector. Few banks are going to give a small business the amount of running room stock investors have given Amazon and Tesla. And private business owners are more likely to be forced into a sale of their own equity than find a way to hold on when times get tough.
But there are good reasons for a healthy business to lose money. It falls under the general theme, especially early on, of investing for the long run. The recent CNBC/SurveyMonkey Small Business Survey found that when asked to cite critical issues, business owners, especially younger ones, put customer demand ahead of any costs. And the youngest subset of owners — those under age 35 — are the most confident about current business conditions. Both private and public sources of capital understand that losing money is a known path to success and will work with promising companies that aren't quite at profitability.
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This lesson applies mostly to technology and new media companies, notably Facebook and Google (now Alphabet). It's the now familiar management idea known as "first-mover advantage," which dates from the dot-com gold rush of the late 1990s, and it still works sometimes.
Facebook took over social networking for many reasons, but one of them was that it hit the market early and raised enough capital to hit the opportunity hard, investing in new products and the technology to make its system serve millions of people. Done one way, this approach can lead to consistent and widening profitability as the need for fresh investment either wanes, or shrinks in significance, because the business gets so much larger. That's the Facebook/Google model.
Amazon did it another way: Any time it threatened to make much money, CEO and founder Jeff Bezos would cut prices or enter new businesses, pushing for even more growth over approaching near-term profit, just as he vowed in his first letter to Amazon shareholders back in 1997.
Netflix takes grief from skeptics who point to the company's giant losses in free cash flow as a result of its spending — for example, the $6 billion this year slated for new original content. It becomes quickly forgotten that the company reported a $245 million profit in the first half of this year. "We are in no rush to push margins up too quickly, as we want to ensure we are investing aggressively enough to continue to lead internet TV around the world," the company states to investors on its own website.
But how can it both spend a ton and be profitable? Simple.
On its cash-flow statement, Netflix reports spending all of the money this year, which is true. But the spending shows up on the income statement more gradually as the company writes off the value of the programming over its useful life. Writing off its current-year investment gradually is how the company makes a profit while still bleeding cash. Some investors will be skeptical, but markets mediate conflicts between those who believe the original content will create long-term customer relationships and those who don't.
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The idea is that cash-flow losses are seen as investments in the future profitability and cash flow of the business — in Netflix's case, grabbing so many new subscribers that it pays back money the company borrows to pay for programming. To make it work, Netflix, like any business large or small, has to be able to forecast some point when the investment slows down.
The question to ask yourself: Is this spending really an investment in long-term customer relationships or just plugging gaps in a business that's not fundamentally working?
Many businesses that don't make a profit under formal accounting rules are actually perfectly sound cash generators. Their losses reflect gradual depreciation of money spent long ago, which is proving the value of a company's investments over time.
Many manufacturing companies fit this description, at least early in their lifetimes, and it's true of even many big, established real estate development companies. It's routine for office buildings, hotels and warehouses to be built with borrowed money, and annual write-downs of projects can continue while they generate cash. But in the long run, loans to build the facilities are paid off and the depreciation is complete, and positive cash flow gives way to profits. In the meantime, the cash flow from the building, or from products made there, is more than enough to repay the loans if done right.
This is one issue at Tesla, where reported losses last year were inflated by more than $1 billion in depreciation, much of it from the Gigafactory where the company makes batteries, which didn't open until the second half of the year.
Remember: Most businesses are valued based on cash flow, not accounting profits. That's especially true for closely held companies.
The previous accounting examples may give business owners pause — and they should. But there are a few straightforward business factors to consider that don't require mastery or arcane accounting principles. Both public and private companies often find that they can run at a loss, as long as they either generate cash or have a plausible plan for it. The key is to know where the money to cover the losses will come from and to understand the conditions, either formal or informal, that financiers are demanding in order to keep the credit or equity investment flowing.
Stock markets have tolerated start-up losses throughout the internet era, now 20 years old. Even companies that have had plenty of time to get profitable, like Amazon and Salesforce.com, have been allowed to lose money under accounting rules for a decade or more without seeing investors bail out.
That's also been true for companies going through leveraged buyouts, which often lose money while paying down the debt taken on for the deal. They have to rely on banks, which have turned that kind of lending into a big business.
This certainly applies to public companies who would like their stock price to climb, but it's even more crucial for private-company managers who rely on credibility in relationships with lenders and trading partners.
One crucial reason Netflix has always been a Wall Street favorite even as it loses money is that CEO Reed Hastings has a reputation as a straight shooter. Right now analysts are taking Hastings at his word that growth will overcome losses in Netflix's international business, because its progress so closely resembles what happened in the United States — just as Netflix has gradually rolled out globally, so it once rolled out city by city in the U.S. New cities (and now countries) take a predictable amount of time to produce profits.
On the other hand, one reason Tesla stock has been a short seller's favorite is founder and CEO Elon Musk's propensity to talk loosely, especially when making promises about when products might hit the market or how quickly production of new models can scale. Musk has prevailed because he has tended to get the big things right: The Model S has been every bit the sensation he predicted, and the much-delayed Model 3 sedan shipping this month has put up big numbers for pre-orders, which Musk now has to convert into closed sales.
The bottom line won't ever change: Profits ultimately matter. But the indispensable elements of managing start-up losses on the way to profits include having a credible plan, being able to communicate the plan (and any changes to it) effectively, being able to keep your promises and understanding the nuances of accounting (or hiring someone who is a whiz to handle that).
— By Tim Mullaney, special to CNBC