An Israeli company recently sued an US company from which it had acquired an entire division. The reason: one month after the transaction was completed, it transpired that one of the division’s ten largest customers had not paid its bills in a long time. In fact, it would have been more accurate to call it a debtor than a customer. The Israeli managers approached the recalcitrant customer, but it refused to pay, unless the debt was spread over a longer than usual period of time, an arrangement to which it would have been difficult to agree. After that, contact was lost. The US company was punished after the fact, by the Israelis’ demand that tens of millions of dollars represented by the vanished customer should be deducted from the company valuation. This story is just one example of a phenomenon the proportions of which are becoming clearer in the wake of the high-tech crisis: that of fictitious numbers.
In recent weeks, and in view of a forecast recession this year, many investors in Israel have been working with their start-up entrepreneurs and high-tech companies on one of two objectives: building efficient, lean budgets for 2023, or preparing the companies for sale. In doing so, investors are uncovering accounting errors that reveal how the valuation bubble was created: inflated revenue calculations, faulty tax planning, poor intellectual property strategy, or repeated instances of accidental or deliberate juggling with the accounts. And it’s not only the companies that have been caught out.
Over the last two years, high-tech founders and financial managers had gotten used to a relaxed approach by investors, who simply wanted to purchase a stake in a growing technology company. Veteran investor Bill Gurley has called the phenomenon "proxy due diligence," whereby investors pass on doing their own due diligence and rely instead on the other investors. Today, with interest rates rising and the high-tech bubble bursting, the mistakes at these companies are coming to the surface.
The most common mistake: Revenue run rate
The most common misrepresentation relates to how annual revenue is calculated. One leading Israeli venture capital investor told "Globes", "The revenue run rate for startups is like dough: you can knead it any way you like, but once it goes in the oven - you can’t know what will come out."
The revenue figure commonly accepted by investors and entrepreneurs of private companies and start-ups is annual recurring revenue (ARR). Each month, the calculation predicts, on the basis of the current rate of revenue, what revenue will look like at the end of the year. The trouble is that many entrepreneurs tend to embellish reality, or simply make mistakes in the way the data is presented.
A common tendency is to present one-time service contracts as annual contracts that automatically renew. In other cases, monthly contracts are presented as annual subscriptions. Although the agreements generate income per month, the amounts are included in the calculations as though they will bring in revenue every month for a year. Elsewhere, multi-year agreements are also presented as recurring annually, even though they have a clear end date. Another form of accounting gamesmanship is the presentation of only the strongest months in the case of contracts based on use, or overly optimistic interpretation of agreements.
In all such cases, it is a matter of misleading presentation of data, as these figures cannot be treated something that will necessarily repeat itself the following year. The problem is that ARR is a popular yardstick among investors and entrepreneurs, but it is subject to interpretation, and there is no single standard agreed upon by all. "Although ARR is a popular metric for the industry, it is not a generally accepted accounting principle, and in fact it is not regulated," Amir Shani, a principal at KPMG Israel, explained to "Globes". "Revenue is the most important figure in audits, but it does not enable entrepreneurs or investors to present a company’s momentum in the way that ARR does."
"It is important that the company's commercial agreements should reflect the SaaS (software as a service) business model, certainly when the company is valued on the basis of p/e ratios of software companies," says Adv. Yair Geva, a partner and Tech Division Head at law firm Herzog, Fox & Neeman. "Entrepreneurs and investors should prioritize annual contracts that renew automatically every year, unless the client notifies otherwise. It’s important to understand how the income from each client increases over time, and to make sure these are not per-project agreements that require customization. In this context, it’s important to note that, when measuring growth, we also look at the churn rate of existing customers and whether net revenue from existing customers at any given moment has increased relative to the total revenue from the same customers in previous years. This is one of the important metrics for testing the health of a business model."
SPAC companies become "a magnet for fraud"
Privately-held companies are not the only ones engaging in accounting machinations. The special purpose acquisition company (SPAC) trend, which has gained momentum in recent years, has become fertile ground for this phenomenon. Through SPAC mergers, relatively young companies could become listed on the stock market by merging with "blank check" companies, waiving some of the reporting rules required of public companies and without sufficient analyst coverage.
Law firm Pomerantz, which specializes in lawsuits against public companies, calls SPACs "a magnet for fraud". "There is a clear relationship between the low standards expected from these sorts of transactions and the results we’re seeing," managing partner Adv. Jeremy Lieberman told "Globes". "Entrepreneurs inflate their revenue or their backlog of orders, and tell fibs about their technological achievements. The tales they told were in line with hot trends like electric vehicles and clean technologies, and looked to investors like the next Elon Musk."
One such company was Nikola, the US-based electric truck company bearing the first name of Serbian-American inventor Nikola Tesla. Nikola went public through a SPAC merger in March 2020, after raising $2 billion from General Motors in exchange for 11% of its shares - which are now worthless. The revolutionary battery presented to investors probably never existed; the same goes for the revolutionary hydrogen propulsion technology. Another electric truck company, Lordstown Motors, became the subject of an investigation by the US Department of Justice after its $675 million SPAC merger, and it was was proved that some data it had presented was misleading, including a figure of over 100,000 orders.
Published by Globes, Israel business news - en.globes.co.il - on January 17, 2023.
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