Cover Story: Regulators Keep Accountants Busy and Keep VCs Guessing –

Competition has not slowed the the giants of the technology age, but a group of accountants in Connecticut threaten to end the party.

Juggernauts like AOL Time Warner Inc. and Cisco Systems Inc. built their empires by acquisition. Cisco has acquired more than 60 companies in the last five years. For the last year, it has been lobbying to save an accounting treatment for acquisitions that is popular among technology companies, but in jeopardy from the Financial Accounting Standards Board (FASB) – which establishes U.S. generally accepted accounting principles (GAAP).

“If America Online could not have used pooling [the accounting treatment in question] to acquire Netscape Communications, the merged company would have been saddled with $688 million in annual goodwill write-offs and turned the next year’s $35 million actual profit into a $653 million paper loss,” read a statement released by Cisco on the issue.

Meeting with opposition from business interests, policy-setters are redefining acquisition guidelines and about a half-dozen other accounting rules affecting venture capital firms and the technology industry, including two issues dear to VCs – options and liquidity discounts. However, opponents concede groups like the FASB are seeking to represent fair value, but VCs wonder why well-established and functional rules have to change.

Warren Packard, managing director at Draper Fisher Jurvetson, says his experience with business issues only gets him so far. “With every change [in accounting standards], we are all a bit in the dark,” he said.

Liquidity Discounts

Tracy Lefteroff, global managing partner and head of the VC practice at PricewaterhouseCoopers, says valuing public securities in venture fund portfolios is a big issue for VCs.

Firms had been discounting the values of their portfolios for liquidity risk, but the American Institute of Certified Public Accountants (AICPA) and the FASB have ordered new firms to carry certain securities at market value and is considering the change for existing firms.

VCs commonly discount the values of their publicly-held stock up to 40% off market prices to allow for liquidity problems associated with lock-up periods and Securities & Exchange Commission Rule 144. Even after the stock is unrestricted, VCs often carry some liquidity or blockage discount to cover possible downward market pressure caused by selling off large blocks.

Michael Maher, chief financial officer of U.S. Venture Partners, says he and most other VCs have followed a consistent internal policy for decades, but those policies differ between firms. Even though firms use different policies, most policies err on the side of conservatism.

Eileen McCarthy, chief financial officer at Alta Communications, says the regulators have targeted discounts because no standard exists, but the discounts are legitimate.

“We want to make sure the numbers we give to our [limited] partners are reasonable,” McCarthy says.

In August 2000, the AICPA and the FASB decided that new VC firms can not discount unrestricted stock. Firms that recorded the discounting policy on financial statements for fiscal years ending in May 2000 or earlier were allowed to continue the practice while the regulatory groups discuss the policy.

So far, some vintage 2000 funds will be the first group to fall under the new regulation, although these funds probably will not actually face the issue until 2002 when their first public companies come off restriction.

The issue was originally raised in May 2000 during the FASB’s review of the AICPA’s Audits for Investment Companies, and the two groups have been debating the issue since. The FASB maintains its position against liquidity discounts, releasing the following statement in a January summary of its discussions on fair value: “Market prices should not be adjusted for blockage factors or control premiums.”

“If the accounting profession thought it was okay for me to take a 25% discount last year, why is it not okay this year,” McCarthy asks. “And, I’m still getting a clean opinion.”

VCs point out that the policy-makers are still allowing liquidity discounts for restricted stock, but they have not established a standard for applying those discounts. VCs claim the discounts are still appropriate for public equity at all stages and say a standard system for applying the discounts might be more helpful.

Some firms begin with a 40% discount they steadily decrease over a set time period, like 36 months. Other firms decrease the discount based on milestones and holding percentages, while some firms carry a stable discount for a set number of months and then remove it completely.

“Our industry has a well-established practice that is broadly followed and understood by investors for applying some discount on illiquid public securities,” says Stephen Holmes, administrative partner at InterWest Partners. He says the error in this debate is that a standard from another industry has been inappropriately applied to VC.

Lefteroff says most LPs will understand the changes in the valuation standards and adjust their expectations accordingly.

Pooling-of-Interests

The FASB says it will issue a final ruling in June on the project on business combinations and in particular on the fate of pooling-of-interests, one of two accounting methods used to blend assets during a merger or acquisition. Leading to the final ruling, the board is releasing rulings on the components of its decision.

Pooling is an accounting treatment where the assets of two merging companies are basically blended together at historical cost and totaled to create the financial statements of the new conglomerate.

Alternatively, purchase accounting requires one company to account for the total cost of the acquisition on its financial statements. The acquired intangible and tangible assets will be added to the acquiring company’s assets, and whatever portion of the transaction cost that is not attributable to an asset will appear on its balance sheet as goodwill.

Companies currently record goodwill as a wasting asset that must be amortized, or annually written down, against the acquirers’ bottom line for as long as 40 years.

Pooling does not require the acquirer to account for goodwill – its main benefit – but board decisions in December and January forecasted the end of pooling as a means of combination.

In the technology and VC arena, the goodwill issue is particularly worrisome. Michael Bernstein, national director of the e*tech practice at Grant Thornton LLP, says goodwill might be 80% of a technology company’s value.

“Current purchase accounting would discourage mergers and acquisitions,” says Paul Brownell, vice president of public policy for the National Venture Capital Association. He says the FASB decided in December to look into the drawbacks of purchase accounting, an initiative NVCA and Cisco support.

“It [disallowing pooling] makes it more difficult for larger [public] companies to acquire smaller companies, because they will take hits on their income statement,” Lefteroff says. It’s particularly tough on profitable companies acquiring unprofitable companies.

In a statement to the Senate Banking Committee in March 2000, Dennis Powell, corporate controller at Cisco, wrote: “For example, since 1993, Cisco has acquired 50 companies amounting to $19 billion. Of these acquisitions, only $900 million, or 5%, is attributed to hard assets – $18 billion or 95% would be left to allocate to intangible assets or goodwill.”

“The valuable asset you are acquiring is smart people – people that can innovate,” notes Kent Jenkins, spokesman for Cisco, which has used both accounting treatments for its mergers.

Heeding protests, the FASB is considering a compromise that does not save pooling, but goodwill may no longer be amortized.

“[Without amortization,] you can write off the acquisition much quicker, and the market can get beyond that [earnings shortfall] faster,” Packard says. Under that scenario, purchase accounting becomes more attractive, but it is still not as favorable as pooling.

Lefteroff says removing purchase accounting’s amortization requirements still keeps an acquisition’s goodwill on the balance sheet as an asset, and the acquiring company may still have to charge it off on the income statement if it becomes impaired, or damaged.

Acquirers may also be required to make large write-offs up front if they pay a premium for the company, but nobody really knows how the debate will end.

“This time of uncertainty is very difficult.” Packard says. “Decisions you make years before the acquisition, before you even think of the acquisition, can affect your ability to be pooled.” Under current standards, a company must conform to rigorous standards to be pooled.

Currently, accountants say a company, like Cisco, might be less attracted to acquisitions that cannot be pooled, and Bernstein points out that at least pooling’s demise will level the playing field for acquisition targets.

Accountants say more companies acquire their targets through purchase accounting, but the largest and most prominent transactions are pooled. Between the two methods, accountants also say they spend more time advising companies on staying poolable down the road.

Mark Spelker, partner at J.H. Cohn LLP, estimates that two-thirds of the mergers he has covered were completed through purchase accounting. He says these decisions do not spell the end of acquisitions, because analysts often discount the effects of goodwill on a company’s financial statements anyway.

Conversely, Brownell suggests the accounting board get rid of goodwill amortization, but keep pooling. Without goodwill amortization, fewer companies would be compelled to use pooling, he says.

Jenkins agrees that the real problem is with purchase accounting – not pooling, and he says purchase reform has become a focus of Cisco’s lobbying efforts.

Either way, accountants are urging their clients to make their transactions before the ruling is finalized, but insiders agree that good deals will continue to happen.

What About Options?

“Accounting rules with respect to options change constantly,” McCarthy says. From 1993 to 1995, a big debate in the U.S. centered on equity-based compensation plans (employee stock options) appearing on the income statement and counting against earnings. Under industry pressure, the FASB settled to leave employee options off the income statements.

However in July 2000, the International Accounting Standards Committee (IASC), an international group with no direct power in the U.S., released the “G4+1 Joint Discussion Paper on Accounting for Share-based Payment” and opened the debate on options again. The paper argued that all equity-based compensation should be reflected as an expense.

The FASB’s response said the IASC standard was philosophically the correct way to account for options, but the board did not require U.S. firms to comply. The statement detailed the option reporting guidelines for companies that chose not to include them as expenses.

“It’s [the FASB response] like saying, would you like me to take your money or leave it in your pocket,” Spelker says. He was not aware of any companies who voluntarily had opted to record options as expenses as the FASB and the IASC suggested.

The FASB already requires companies to record options on the financial statements in some cases, such as options given to non-employees and repriced options.

With so many options packages out of the money in the current market environment, repricing has become an issue. Companies offer option plans as an employee incentive, but some options may be so far out of the money that the company’s stock would have to double several times before the market price even matched the exercise price.

According to FASB guidelines, companies with under-water options have three alternatives. They can arbitrarily change the option’s strike price (repricing); they can issue new options on top of the old options (in effect doubling the amount of stock an executive could potentially own); or they can cancel the current options and issue new ones six months later.

(The SEC is also investigating cases where companies have allowed employees to cancel the exercises of their options when those decisions have been unprofitable.)

It used to be the norm, but today repricing options can end a company’s favorable fixed-plan treatment under FASB APB Opinion No. 25. Translation: the company would have to use variable-plan accounting; or the difference in the exercise price and fluctuations in the market price pass through to the income statement and affect earnings.

Reportedly, the only company that choose to reprice their options and take the earnings hit is Amazon.com Inc., whose accounting practices have come under fire for reporting earnings projections that blatantly do not conform to GAAP.

When a company issues new options without canceling the old ones, investors can face undue dilution (another disclosure issue the SEC is considering), and the company is basically betting against the original options ever coming back in the money. “That’s quite a gamble over a 10-year period of time,” Lefteroff says.

Alternatively, canceling them for six months leaves the employees unable to participate in any stock appreciation during that time.

Going forward, rather than front-loading options, Bernstein suggests granting options more frequently at lesser amounts. Many companies want to incent their employees with equity, but find current market conditions and accounting standards to be unforgiving.

Other Issues

According to Bernstein, the number one cause for earnings restatement is error in revenue recognition. Implemented in 2000, SEC Staff Accounting Bulletin 101 attempted to clarify the issue, but the issue continues to make companies nervous. Technology start-ups in particular have non-traditional purchase agreements and service arrangements that make recording sales difficult.

The SEC also expressed concern over increases in a company’s valuation before an initial public offering. The SEC asked companies to justify any valuation increases, but valuing a private company is the heart of the problem.

Accountants advise keeping reconciliations for each transaction and justification for each change in value, but companies unwittingly get in trouble for giving discounted equity to their strategic partners.

Regulators are not always the source of changes. At a January Deloitte & Touche tax seminar, Neal Lipschitz, partner at the firm, suggested that the C-corp., the favored legal structure among VCs for portfolio companies, may not always be the most effective structure. In some cases, he recommended considering the LLC structure for its potential flexible exit strategy as well as passing losses to certain investors in the initial stages of operations.

Taking a step back, Ed Goodman, partner at Milestone Venture Partners, says his main accounting worries do not have anything to do with acquisitions or repricing stock options. He just wants the early-stage companies that make up his portfolio to make payroll and get a product to the market.

FASB

The FASB, the AICPA and the SEC set and influence U.S. accounting standards. “The majority of the time I think the FASB is conceptually heading down the right track,” Spelker says.

VCs and accountants agreed that FASB decisions were often theoretically solid but not always practical in real applications. On issues that affect investors, the SEC encourages the FASB to act, especially when the SEC feels that there have been abuses.

“Some companies are quite aggressive, and sometimes they get too aggressive,” Lefteroff says.

The U.S. has also begun to receive considerable pressure from abroad, mainly from the IASC, to conform to an international standard. The IASC has been around since 1973, but Brownell said it has been largely ineffective, until recently when the FASB and its international counterparts revived the organization. As businesses continue to trade on multinational exchanges and merge across borders, the push for an international standard will increase.

“My guess is 25 years from now there will be one standard across all the major nations,” Spelker says. Some countries set their own standards (like the U.S.), some follow IASC suggestions and some base their standards on tax codes.

He notes that the U.S. with its large capital markets will not likely be compelled to accept another body’s accounting standards, but thinks the different standards will become more similar until the distinctions are less defined.