Why failing startups that do stupid things get bought for millions

Year zero. Your hip new startup—it’s like Uber, but for trees—just got off the ground, and lost a million dollars. On the plus side, it had no taxes. Year one: it took off, and made three million bucks. Your company is allowed to carry over the losses from the prior year, so that the reported taxable profits in the second year are only two million. This story of a company that loses in its first years and then starts gaining is a common one, but any year that a company records a loss means that next year’s taxes will be a little lighter.

Bolstered by your success, wealthy investor Eva Peronosi gives you $3 million to develop your new startup. It’s like pets.com, but with more square dancers. Year zero: lose a million dollars. Fine, but year one: lose another million. Year two: lose another million dollars, and go out of business. You call a friend at Multinational Business Ventures, and ask MBV to buy your company, which is like pets.com but with more square dancers.  Naturally, MBV offers to pay a million dollars for your startup.

After MBV buys your company, your $3m loss carries over to the now-parent company, and they can use it to lower their business expenses. If their balance sheet showed $30 million in profits after the purchase, then your $3m loss turns that into $27 million in taxable income. With a corporate tax rate of 35%, a $3m reduction in MBV’s taxable income equals a $1.05m reduction in taxes. Taking into account the million it just paid, and MBV saved $50,000 by purchasing a worthless asset.

To whom the million dollars MBV paid depends on contracts, existing debts, and other such details we could only guess at. But Eva got where she was by making sure that payments like these go back to her. With a corporate tax rate of about a third, Eva can always gets back a third of her losses by selling the company and its carried-over losses. The papers said Eva bet $3m on your project, but if the existence of a $3m loss is itself worth $1m, then she really only put $2 million on the line (which is still more than I’d put on a gamble…).  And as per the title of this post, when you read about a company that got pounded in the market getting bought anyway, this carryover of losses has to be at least part of the buyout story.

Is there a conservation of tax liability, like the conservation of energy, so that when one body subsumes another, it absorbs all its liabilities? Is a corporation a “going concern” that has an annual tax check-in, or can we treat it as a new corporation every year?  That MBV bought a worthless company for big bucks is certainly odd, a distortion of market behavior caused by the tax system, but it is the product of not-insensible answers to these questions about the meaning of a corporation.

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