Snap Inc.’s IPO has turned from hyped to sour in less than a week – NYSE: SNAP. I had already flagged some concerns with the company’s valuation and potential issues as to underlying metrics which were, according to the lawsuit linked in my previous post, alleged to be fraudulently inflated.
There has been much debate across various media channels as to the underlying metrics which informed the calculation of the valuation. However, goodwill remained unmentioned. While notoriously hard to value, it deserves more public debate. In particular so, as in the case of Snap Inc.’s going public the goodwill valuation shows a significant increase from 2015 (USD 133.9 mn) to 2016 (USD 395.1 mn), see p 35 in SEC Statement under The Securities Act 1933 where Snap Inc. states:
If our goodwill or intangible assets become impaired, we may be required to record a significant charge to earnings, which could seriously harm our business.
Under U.S. generally accepted accounting principles, or GAAP, we review our intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Goodwill is required to be tested for impairment at least annually. As of December 31, 2016, we had recorded a total of $395.1 million of goodwill and intangible assets, net related to our acquisitions. An adverse change in market conditions, particularly if such change has the effect of changing one of our critical assumptions or estimates, could result in a change to the estimation of fair value that could result in an impairment charge to our goodwill or intangible assets. Any such material charges may seriously harm our business. [emphasis added]
The quick return down to earth may not come as a surprise to those who refrained from investing and held a critical view on the corporate governance issues and Snap Inc.’s business model. But those among the public investors who hoped for sustainable profit may have had a rude awakening.
Some argue that a segment of the investors confused popularity with profitability. Looking beyond the hype and one’s personal preferences should be part of due diligence every potential investor invests in – as a tool of damage control and sound risk management practice, before the actual investment. Conducting this due diligence with respect to goodwill valuations and the choice of metrics underpinning the overall valuation is a challenge, though.
It helps, especially when it comes to tech stock or unicorns to keep a set of questions in mind, coupled with a few considerations that should guide the investor’s evaluation. Goodwill valuation, its challenges and the particular risks embedded in the metric that is prone to bias and often deemed an art rather than fact-based science, is equally important and difficult to assess in terms of accuracy.
For the purpose of understanding a whole range of motives, pressure and influencing circumstances that may inflate a valuation underpinning the going-public of a tech company, the following questions and aspects should be kept in mind:
- Generally speaking, the industry’s standard needs to be taken into account – keeping in mind the dot-com bubble during the late 1990s and the related history of very short track records coupled with thin profits.
- A key concern is and remains the fact that underwriters, such as large investment banks, charge considerable fees. Up to 6-10% of the capital raised in the IPO are due and represent a considerable lucrative incentive, making this a non-deferred reward system prone to fraud.
How do underwriters make their money? A bank or group of banks put up the money to fund the IPO and ‘buys’ the shares of the company before they are actually listed on a stock exchange. The banks make their profit on the difference in price between what they paid before the IPO and when the shares are officially offered to the public. Competition among investment banks for handling an IPO can be fierce, depending on the company that’s going public and the money the bank thinks it will make on the deal. (CNBC explains:IPO)
- CEOs and CFOs are disproportionately frequently involved in financial statement fraud (underpinning the valuation), this is largely enabled due to their position of power, status and related access to systems and coupled with particular pressures and expectations that these roles entail.
- The pressure and common reasons senior management cite when caught overstating their financial statements include (a) compliance with loan covenants, (b) meeting and exceeding earnings or growth expectations of stock market analysts, (c) showing a pattern of growth to support a planned securities offering or sale of the business, (d) meet personal or corporate performance criteria – to name only the most prevalent ones in this context (see Forensic Accounting and Fraud Examination, 2010, Wiley, by John Wells, Mary-Jo Kranacher, and Richard Riley).
- Taking the figures at face value is not advisable, frequently footnotes and disclosure notes might indicate deviations from generally accepted accounting principles (GAAP). Despite standards, guidelines, and rules, it is vital to keep in mind the subjective nature of book- and record-keeping. Differences in judgment can result in significantly differing valuations. To illustrate:
.5 Fair value measurements for which observable market prices are not available are inherently imprecise. That is because, among other things, those fair value measurements may be based on assumptions about future conditions, transactions, or events whose outcome is uncertain and will therefore be subject to change over time. The auditor’s consideration of such assumptions is based on information available to the auditor at the time of the audit. The auditor is not responsible for predicting future conditions, transactions, or events that, had they been known at the time of the audit, may have had a significant effect on management’s actions or management’s assumptions underlying the fair value measurements and disclosures.
source: AICPA (American Institute of Certified Public Accountants) Standard Audit Test AU00328 and VS Section 100: Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset
The issue with valuing young companies is not a new one. In recent times we witnessed the case of Theranos (Fortune, 2016, Wired, 2016, Gawker) which turned from a USD 9 billion valuation into a serious fraud disaster. Then there is The Honest Company which has been under persistent criticism for product fraud but more importantly in this context is its seemingly inflated and unjustified valuation, given these issues. Of course, there is also the valuation controversy around Uber, to name only a few examples.
Some argue that the current tech valuations are entirely made-up (see Zero Hedge, 2015). We know for certain that the dot com bubble was a culprit in this regard (Business Insider, SEC action against Henry McKelvey Blodget, Merrill Lynch, internet sector stock fraud). As mentioned above, the not so distant past might be an indicator as to where valuation practices remain problematic and require further regulation or more meaningful methodologies.
The key nagging questions that remain:
- If investors who provide large amounts of funds aren’t doing their proper due diligence, does this mean the data they rely on is insufficient and not sufficiently transparent?
- If availability, accessibility, and transparency of data are not the issue or main driver of lack of rigorous due diligence, what irrational drivers make such investors ignore all (or any) red flags?
- Is it the simple but persistent Gecko’s “greed is good” which appears to work again and again, even if in the very short-term only?
Further reading on valuation, in particular also goodwill valuation, in the context of IPOs:
- SEC Comments and Trends: An analysis of current reporting issues (2012) Ernst & Young (167 pages, pdf)
- Valuing Young, Start-up, and Growth Companies: Estimation Issues and Valuation Challenges (2009) by Aswath Damodaran Stern School of Business, NYU (67 pages, pdf)