Aw SNAP something went wrong: valuation

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 InsiderSEC 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:

  1. 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?
  2. 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?
  3. 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)

Data, the politics of risk, and botox

If you work in or experience bystander exposure to, an organizational or corporate zero-error environment you may quickly pull the dots together. Data, spanning from KLIs* over KPIs* and KCIs* to KRIs* and beyond, i.e. the whole spectrum of performance metrics may be fear-inducing per se: whenever the thresholds, balanced scorecard objectives, or plain old deadlines are at risk of not being met.
*KI=key indicator, C, L, M, P, R=control, lead, management, performance, risk

When the engines which are supposed to be crunching figures and producing the desired metrics and reports, fail to deliver on time, then, well then, breaking into a sweat and feeling the heat is probably the most natural response a human being may be experiencing in such a situation.  Not surprisingly, the quest for means to cover up such visible signs of weakness (functional would be calm caring, expected may be dysfunctional detached cool) has resulted in a significant increase of requests for Botox (a form of paralysis-inducing toxic botulinum).

While diversity policies and strategies have been implemented and celebrated widely, homogeneity at recruitment stage is surreptitiously reproducing monocultures which offer little if any space for thinking outside-the-box.  In light of popular quick fixes in challenging times, most prevalently applied are drastic downsizing, restructuring, and right-shoring (a euphemism that hints at prior attempts of off- and on-shoring) which are all adding to the malaise. All of which have resulted in the opposite of genuine zero-error cultures. Rather, these factors in combination may explain why major errors such as a neglected server at JP Morgan’s could happen. We see such failures and negligence (including pervasive data massaging) frequently, although differences in forms, shape, and dimension can be observed, entailing various degrees of active or passive neglect and manipulation.

Restructuring workloads and task areas often result in fewer individuals doing more work. Permanent staff may have been laid off in favor of newly hired contractors and temps. Overall, the [permanent] headcount appears reduced and shareholders are pleased. In times of downsizing and cost cutting, coupled with key decision-makers being keen on maintaining their budget rather than investing in smarter technology and revising processes and procedures with a view to efficiency, remaining staff often are crippled by fear of what will happen next. Add the typical lack of clear communication, direction and reliable visionary stances from the top that marks these situations, the sheer overload induced by the additional work becomes even more of a botox-requiring sweat factor. Who will be axed next? Which department evaporates entirely in the next round?

In industries where particular aspects of corporate sub-culture add a layer of misuse of power onto those who are charged with tasks beyond their meaningful boundaries and structure of responsibilities (see discussion of the 100 hours workweek), the error rate is further multiplied.  Stakeholders and shareholders should feel alarmed as such incidents reveal only the tip of the iceberg of operational risks.

Responsible and dedicated management (not to be confused with micro-management that creates more of the above-mentioned issues) and meaningful staff development go hand in hand with sustainable risk management. It cannot be “happily de-coupled”, rather it needs to remain consciously intertwined and run within a wider framework of ethical values and legal requirements.  For instance, operating with rest times and sensible breaks keeps the human error rate down and contributes to maintaining high levels of morale, creative problem-solving and energy levels.  This will also facilitate retention and maintenance of trust in order to ensure the organization finds its position at the front of the competing pack when it comes to lasting long-term success.

In an interconnected and highly interdependent global economy, such contradictions and irrational sub-cultural aspects can have vast and potentially hugely damaging ripple effects: risk of human error, on the one hand, severe retention issues on the other.  Where zero-error policies are still in place and staff fear showing weakness or admitting to gaps (take the “fat finger” trade at Deutsche Bank for instance) they cause havoc with sensible risk mitigation strategies as the instant knee jerk response of firing will shift blame to those who were at the receiving end of failing policies rather than focusing on those who devised them in the first place.

Smart risk governance will embrace and harness the power of information, the knowledge of potential weaknesses and incidents that need to be addressed.  The aim has to be prevention and mitigation policies, methodologies and mechanisms that need to be devised in order to avoid losses and costs related to reputational risks entailing them. Providing a safe environment (World Bank case) in which to disclose potential or occurring risk events without fear of censorship and scapegoating gagging those who are mindful of their work and environment is key to sustainable leadership and a leading position of the organization – it requires much higher priority in strategic considerations than currently recognized.

Acknowledging the possibility of human error in a heavily competitive, excessive hours-environment would be the intelligent thing to do.  After all, it’s a strength to know your weaknesses (see this SWOT discussion)– and not push them under the rug.  It is a strength to acknowledge the flows and dynamics of power but your policies, processes, and framework need to be more than reflections of realpolitik.  Intelligently avoiding being in the eye of the storm of the next big conduct and reputational risk case can be achieved by methodological triangulation.  That would entail incorporating realistic ethics and enhancing the governance framework by insights and data gained from disciplines outside the narrow confines of your subject matter experts’ realm.  In the course of this, you might actually discover some entirely new strengths.

Forensic Accounting and Fraud Examination: Case Study – Online Pharmacy