no harm | financial express

by Siddhartha Pai

Last weekend, I saw a clip of Infosys Limited, Founder NR Narayana Murthy in conversation with Sherin Bhan, a TV journalist. The discussion was about the strong pipeline of Indian start-ups preparing 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 said the day he and his founding team took “one paisa” from an outsider, the game of ball changed. He felt that he would have to act as a trustee of other people’s money. Murthy had talked about taking Rs 60 lakh from family and friends in the early days of Infosys.

They said that when they went to affluent friends, they asked myriad questions—including questions about the firm’s business model, demanding a guaranteed return on their money, and were knowledgeable about investing.

Questions changed when Murthy went to his sisters, friends, family and others who were less educated and had knowledge of financial markets. This group of “lower middle class” friends and relatives of Murthy asked the question, “Are you sure you will use this money carefully?” and “Are you sure you won’t spend this money carelessly?”. 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 revenue. His memory, he said, was that he beat his own excellent estimates by a factor of two or more. He claimed that he did not rest until three years after the event, when his estimation of Infosys’ performance as a stock was well established. According to Murthy, having an IPO is not “fun”. It’s not just to start calling yourself a “billionaire.” He says that these conditions are only illusions, and that what goes up can come down. He channeled Mahatma Gandhi and said that the founders should think of the “poorest retail investor” before deciding on an IPO.

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

Despite our pride in India’s success as an IT-services destination, the world of IT-services is an old-economy world. It depends on the number of people who have billing time for customers at specified rates. Their basic principles are simple – for a given fiscal quarter, the only questions to ask are what percentage of the time (or actual hours) the workforce was billable, at what rate, and how much was spent to pay the workforce. . that quarter. These three numbers are the sum and sum of the performance of any IT services firm.

Any attempt to move to a ‘non-linear’ model by separating the number of directly billable employees from actual revenue is only a small part of what such enterprises do. Infosys and its ilk are decidedly old school, and don’t 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 US financial markets.

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

Su documented the prevalence of public companies with negative net income since the 1970s. The fraction of firms with negative net income has risen sharply from 18% in 1970 to 54% in 2019. As of the end of 2020, it accounted for 62% of public firms, with negative net income for US public firms on record. , Su says such growth is primarily driven by the growing popularity of the public investing in large companies that are not profitable.

Based on the existing literature on client capital, Su estimates that increasing returns-to-scale in the new economy is the main driver behind this. Su provides three pieces of supporting evidence. First, the loss of earnings mostly comes from increased customer capital expenditures rather than production-related costs, capital investments, or R&D expenses. Second, cross-sectionally, firms with higher markups tend to have lower net income, at least according to their research. Third, industries with low marginal cost of production, on average, have a higher percentage of unprofitable companies.

According to Bloomberg, the trend is surprisingly strongest among newly minted companies, when 77 percent of IPOs that hit the market in 2019 didn’t make money. The reason public firms lose money is not simply tolerance among investors. , but a clear preference for a certain type of loss-making firm: built on intangible assets, according to Su.

Businesses are being encouraged to sell stock before it becomes profitable because of the belief that some formula or idea will attract a network of users who will one day prove to be highly valuable.

And this bet isn’t just being placed in IT. It is also being built in areas such as electric cars. About 63% of publicly listed manufacturers in the US did not make a profit in 2020, compared to 19% in 1970.

The overwhelming numbers evidenced in Su’s study suggest that today’s investors have new risk preferences or are better informed than “the poorest investors.” Loss-making startups are going public.

by invitation; The author is co-founder, Sienna Capital; also wrote “Takeproof Me: The Art of Mastering Ever-Changing Technology”

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