Valuing Net Operating Losses

by JT McGee

Let’s talk about net operating losses. I haven’t been able to find much information on NOLs in the past, so hopefully we can shine some light on the value of NOLs to investors. Expanding the internet one page at a time…

Net operating losses are one of my favorite things to see in an annual report for a company. A net operating loss is a forward tax benefit from historic operating losses.

Suppose that I start a business and lose $1 million every year for the first 5 years. I have net operating losses of $5 million.

Now suppose that in year 6 I reverse the course of the business and generate profits of $5 million. That $5 million in profits is tax free, since it will only get me back to zero. Assuming a combined federal and state tax rate of 35%, I’m looking at $5 million in net profits vs. a post-tax $3.25 million.

The Value of NOLs

Net operating losses are very, very valuable, especially when a company only recently turned profitable. However, not all NOLs are valuable.

First, understand that NOLs have to be used up within 10 years. So a corporation can usually carry forward net operating losses younger than one decade. Some NOLs go unused because they expire before a company can earn enough to reduce the entirety of its net operating losses.

Secondly, understand that recent tax law makes NOLs less valuable to an acquirer. In the event of a change of ownership, the § 382 limitation in IRS tax law significantly devalues net operating losses for the acquiring firm. A change of ownership is quite complicated, and a firm does not have to be bought out to trigger this event. However, most companies will not allow share transfers in magnitudes great enough to trigger a change of ownership as defined by the IRS. Basically, investors and board members aren’t dumb enough to do something that would trigger the loss of benefit from net operating losses unless someone wants to buy the whole company.

In a buyout, one of the most practical ways to trigger a § 382 limitation, net operating losses become complicated.

Valuing NOLs

The § 382 limitation came into being to prevent acquisitions for tax savings. For example, if my business were to lose $5 million in 5 years, it would arguably have zero value. It’s a money loser.

However, because another company could purchase my business and use its NOLs to reduce the acquirer’s net income going forward, my business would have a value of $5 million x .35 (the corporate tax rate). Basically, another business could pay me $1 million for my unprofitable business, shut down operations, and turn a profit on the transaction since my NOLs would have a value of $1.75 million.

Pay me $1 million for my company with $5 million in net operating losses or pay the IRS $1.75 million for $5 million in future profits. Which is better?

Clearly, paying me $1 million for my loser of a business beats paying the IRS $1.75 million.

So the IRS thought this was nuts, and it kind of is. The IRS has relatively new rules for NOLs and how they can be used after a change in ownership.

Change of Ownership

In a change of ownership, net operating losses can be used at a rate equal to the lessor of a) the company’s equity value x the long term tax exempt bond rate or b) the aggregate total of net operating losses x the long term tax exempt bond rate.

So let’s use an example. A company has a market value of $20 million and net operating losses of $40 million.

Naturally, the market value is smaller than the total NOLs, so we have to use this figure. Now we grab the long term tax exempt bond rate from the IRS and find it is 3.26%. For each year going forward, because we triggered the § 382 limitation, we can use only $20 million x 3.26%, or $652,000 in net operating losses.

Hmm, suddenly the $40 million in NOLs don’t seem all that valuable if we can only use $652,000 in each future calendar year.

Keep in mind that before the change in ownership, we could use any amount of NOLs that we wanted to in any given year. So if we earned $5 million the next year, we could use $5 million in net operating losses to offset our tax burden. However, after the change in ownership, only $652,000 in net operating losses are available each year. This obviously creates a problem if the business improves substantially in the years following acquisition.

New Ways to Look at NOLs

Thanks to the way tax law works, we can use NOLs to give us an inside advantage. Net operating losses and their expiration dates can be used to determine:

  1. The most likely date for a buyout. There is tax incentive to wait for a firm to use its NOLs up by itself before acquiring it. This is even more important if the company is literally hoarding cash on the balance sheet rather than returning it to shareholders. It indicates either stupid management, or that some large owner or institutional investor is thinking about pushing a sale in the future. You have to use your own judgment here.
  2. A better value for a firm, since net operating losses affect positively future free cash flows to the firm. This should be fairly obvious, so if it isn’t, please don’t venture into individual securities. You shouldn’t buy any piece of a company if you can’t understand accounting. It’s really that simple. But people do it all the time, so you wouldn’t be the first.

Focus on point number 1. Finding a buyout date. One of the reasons I was so confident that a buyout was nearing for my beloved Adams Golf was that it had exhausted most of its net operating losses. It was go time for an acquirer to pick it up. Buying it out had only a minute effect on future income taxation after several million dollars in NOLs were consumed.

Just before acquisition, it received a rather substantial payout of $5 million from an insurance lawsuit. The company sold for less than $100 million – $5 million is a substantial amount of money. So too was the benefit from the NOLs when Adams got that $5 million check. We’re talking $3.25 million post-tax vs. $5 million. It’s better to wait to acquire a firm after it gets a substantial tax-free payday like that than to buy it before…this gets into a discussion about market efficiency and the relative value of cash on a balance sheet in a buyout, so we won’t go there. (I hit on this in posts about CROIC and strategic alternatives and buyouts.) Anyway, when a company gets a single buyout offer, markets are not efficient. Auctions do not create substantial value for the seller unless two parties are willing to duke it out. Essentially, assuming Adidas was the only company interested in Adams, waiting for it to use millions in net operating losses before making a bid made perfect sense.

The first quarter is obviously great for golf companies, anyway, so it makes even more sense to buy out a firm after all those earnings come into the picture. The deal closed after the first quarter…I wonder why. 😉

NOLs. That’s why.

So, that’s the deal with net operating losses. Learn to love them. Net operating losses are awesome things, they really are.

{ 2 comments… read them below or add one }

PK June 12, 2012 at 10:55

NOL > LOL > SOL in the hierarchy of OLs, right?

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JT McGee June 12, 2012 at 10:58

Without question. NOLs are best of the bunch.

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