As investment tide ebbs, the lies are revealed
An Israeli firm recently sued a 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 10 largest customers had not paid its bills in a long time. It would have been more accurate to call it a debtor than a customer.
The Israeli managers approached the recalcitrant customer, but the customer 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 hi-tech crisis: 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 hi-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.
Over the last two years, hi-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 hi-tech bubble bursting, the mistakes at these companies are coming to the surface.
The most common misrepresentation relates to how annual revenue is calculated. One leading Israeli venture capital investor told Globes, “The revenue run rate for start-ups 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 startups is annual recurring revenue. Each month, the calculation predicts, on the basis of the 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 tendency is to present one-time service contracts as annual contracts that automatically renew. Also, monthly contracts are presented as annual subscriptions. Although the agreements generate income per month, the amounts are calculated as though they bring in revenue every month for a year.
Elsewhere, multi-year deals are also presented as recurring annually, even though they have a clear end date. Another form of 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 like 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.
Amir Shani, a principal at KPMG Israel, explained, “Although ARR is a popular metric for the industry, it is not a generally accepted accounting principle, and in fact it is not regulated. 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.”
Yair Geva, a partner at law firm Herzog, Fox & Neeman, said, “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.
(Globes/TNS)