Net Operating Loss Carryforwards

A startup that burns $200m before turning profitable hasn't just lost money — under most tax codes it has also earned the right to shield up to $200m of future taxable income from tax, once it starts making it. That right is a net operating loss (NOL) carryforward, and it sits on the balance sheet as a deferred tax asset (DTA): future tax savings, valued today.

How the asset is sized and impaired

The DTA from an NOL is roughly the loss balance multiplied by the applicable tax rate: a $200m NOL at a 21% federal rate is worth up to $42m of future cash tax savings. Under current US rules, NOLs generated after 2017 carry forward indefinitely but can offset only 80% of taxable income in a given year, stretching out the payback period. If a company's own auditors doubt it will generate enough future profit to use the NOL, accounting rules require a valuation allowance that writes the DTA down — sometimes to zero — even though the tax loss itself hasn't gone away; it's just judged unlikely to ever get used.

A second constraint bites in M&A: tax law (Section 382 in the US) sharply limits how much of a target's NOL an acquirer can use each year after an ownership change of more than 50%, specifically to stop companies from being bought purely to harvest their tax losses.

Worked example

A company has $200m of accumulated NOLs and a 21% tax rate, giving a gross DTA of $42m. Its auditors judge that recent losses and going-concern uncertainty make it unlikely the company will earn enough taxable income to use the full amount, so they book a valuation allowance of $30m against it, leaving a net DTA of $12m on the balance sheet. The next year, the company is acquired in a transaction that triggers a greater-than-50% ownership change; Section 382 caps the NOL the acquirer can use each year to roughly the target's pre-deal equity value times a long-term tax-exempt rate — often far below the pace needed to use $200m quickly, so the practical value of the loss to the buyer is much less than $42m even before considering the valuation allowance.

What this means in practice

Analysts modeling a turnaround or an LBO target with a large NOL should check three things: whether a valuation allowance already signals management's own doubt about usability, whether the company remains a takeover or restructuring candidate (which triggers Section 382), and whether projected taxable income is large enough, given the 80% annual cap, to use the loss before any expiration windows on older, pre-2018 losses.