WASHINGTON, D.C. – Venture capitalists likely do not spend much time contemplating the accounting practices of public companies, but a Securities and Exchange Commission (SEC) initiative to curtail suspect accounting by such companies could affect the acquisition market for VCs’ portfolio companies.
Since mid-1998, SEC Chairman Arthur Levitt has been increasingly vocal in criticizing corporations that use questionable accounting methods to meet earnings predictions, a practice Mr. Levitt calls “earnings management.” The distorted numbers are deceptive to investors, the SEC says.
One of the practices the SEC is focusing increased attention on is the use of in-process research and development (IPR&D) write-offs. An acquiring company must account for the difference between the actual assets of a purchased company and the higher purchase price. Often companies chalk some portion of the difference up to the value of the purchased company’s ongoing research and development. If the buyer does not take the so-called IPR&D write-off, the difference generally must be counted as “goodwill.” That, however, means the acquirer must capitalize on the goodwill over several years, which can drag down earnings over that period.
In recent years, IPR&D write-offs have skyrocketed, drawing SEC scrutiny – and the regulatory agency does not like all of what it sees. If a company’s IPR&D write-offs are flawed and cause a material error in a company’s earnings statement, the SEC could force the company to restate its earnings, which could result in a fallout among analysts and in the public markets.
The regulatory agency rejects IPR&D write-offs for improvements to existing products, for example. The SEC also is concerned about the reliability of some aggressive methods used to determine the value of IPR&D write-offs.
Despite the SEC’s initiative, Tracy Lefteroff, a partner in charge of PricewaterhouseCoopers L.L.P.’s global life-sciences industry services group, does not see the M&A market drying up. “Companies still are going to buy companies,” he said. “It’s a question of what price they’re willing to pay.”
In a September 1998 letter to the American Institute of Certified Public Accountants, SEC Chief Accountant Lynn Turner noted that although acquisitions were common prior to 1990, large IPR&D write-offs were not. The agency, however, recently has seen IPR&D charges used to write off larger portions of a company’s purchase price as more and more companies use the practice without being penalized.
Ken Marceron, the SEC’s associate chief accountant, said the IPR&D write-offs have increased to 70% to 80% of a purchase price from about 10% seven years ago, a startling jump that attracted the SEC’s attention.
Buyers Seek Guidance
Fred Ruegsegger, senior vice president and chief financial officer at Axys Pharmaceuticals Inc., is well aware of the SEC’s concerns. What he is hoping for is clearer guidance from the agency. A few “bright white lines on the pavement would be a beautiful thing,” he said.
Mr. Ruegsegger’s company has made two acquisitions in about the last three years in a private, venture-backed company for $22 million in 1995 and in a larger public company. In both cases, Axys wrote off 95% of the purchase price as in-process research and development.
Like Mr. Lefteroff, Mr. Ruegsegger does not see acquisitions ceasing because they are strategically important to the buyers, but he does see acquisition prices falling. After all, the lower the price, the less it can hurt earnings, he reasons. While Axys is a public company, it is not yet profitable and, therefore, not as sensitive about dampening earnings as profitable companies, he said.
Cisco Systems Inc. understands that pressure. As a large public company with a healthy appetite for acquisitions, Cisco looks for deals but at the same time does not want earnings to suffer, especially for several years after a transaction, explained Ammar Hanafi, director of M&A for Cisco’s business development group.
Cisco bought nine companies last year, eight of which were private and had backing from angel investors, VCs or both. In eight of the purchases, Cisco took an IPR&D write-off. Buying companies is too important a “strategic weapon” for the networking equipment maker to quit, but the management – and venture backers – of young technology companies might have to adjust pricing expectations, Mr. Hanafi said. “It’s going to be a painful process, I think.”