The impact of unconventional accounting on startup funding is the focus of a recent Wall Street Journal article, "Tech Startups Woo Investors with Unconventional Finance Metrics—But Do Numbers Add Up?" In the article, the authors compare how the sales figures and projections offered by 50 venture-funded tech IPOs differ from when they were private and the financial results later declared for the same time-period.
Of these firms, 15 reported lesser figures, with "a combined difference" among these companies of "about $760 million, or 25 percent of their original sales or projections."
A Dangerous Trend
The article cites, among other examples, the forecast by Hortonworks, Inc., of Santa Clara, California, of a "strong $100 million run rate" by the end of 2014. After Hortonworks went public, it reported less than half that figure ($46 million) in year-end revenues. The company later contended that the target figure centered on billings, a barometer of earnings not considered among generally accepted accounting principles.
As the WSJ authors note, the use of bookings, annual recurring revenue, and other unconventional accounting numbers is completely legal, because no shares in the company have yet been sold in an IPO.
Some tech company leaders and venture capitalists contend that valuations should be thought of as placeholder numbers, part of a broader equation that includes costs, growth projections, market share, etc. For some VCs, says Tyler Durden of Zero Hedge, "what counts is getting portfolio companies to the liquidity event finish line ... at which point it no longer matters what the long-term outlook is."
According to the WSJ article, critics of this approach point out that "vague, unconventional financial terms are inflating valuations" and contributing to a dangerous trend of using questionable metrics—with little to show for it. Only 17 percent of U.S. tech firms that went public in 2014 showed a profit, the smallest number of profitable companies in a full year since 2000.
Transparency Leads to Trust
Other veteran (and perhaps more level-headed) investors and startup founders assert the ongoing need for transparency with lenders and investors. Jyot Singh of RTS Labs advises tech firms to stick to realistic projections about growth and revenue "because serious investors can tell when something is too good to be true."
Also, says Joshua McClure, founder and CEO of RealMassive, adopting a general practice of accounting transparency can differentiate a startup from its competitors by "employing a model of radical openness with investors and clients." Such transparency, which includes honestly divulging missteps and false starts, contributes to building a stronger relationship with investors over the long-term.
Building trust is a key factor in tech firms' attempts to attract funding. As Lewis Cirne, CEO of the software company New Relic, says, "If you have a culture of hiding, it is perpetuated in the company and has an impact on the business, and leads to erosion of trust."
Without such trust, a new business may enjoy an initial burst of enthusiasm among VCs and others, but gaps between projections and actual revenue will spell trouble for startups seeking to establish a foothold in the marketplace.