In Techland, Startups Are Hot, But Who’s Minding the Numbers?

If the numbers coming out of tech startups are any indication, it may be time to party like it’s 1999.

The Wall Street Journal reported Wednesday (June 10) that a plethora of young technology companies have liberally used nontraditional metrics to help put a shine on financial results and — arguably more important to capital raising — potential results.

The use of those metrics — from billings to bookings, to name a few cited by WSJ, though not necessarily revenues — comes in conjunction with company presentations to venture capital and private equity firms that have millions, tens of millions, and in some lucky cases, hundreds of millions of dollars to invest in promising startups. It’s a trend that might smack a bit of the Internet days of yore when dot-coms touted unconventional metrics — “eyeballs,” of course, and clicks and even sacks of dog food (we hardly knew ye, pets.com) — and other metrics that might materialize to drive real results higher but often didn’t.

Back to the fevered competition for venture backing.

The one thing investors with deep pockets like to see most when they are choosing who gets seed capital or new funding rounds is growth. Because, as everyone knows, growth means several things lie on the horizon. If a company’s top line surges, then eventually profits materialize, all else being equal. And if profits show up, then investors can see outsized returns on capital.

The other wrinkle is that growth can entice public equity investors, the funds and retail players who commonly scramble in the wake of a hot IPO to snap up shares, bidding them up as they soar hugely in the first day of trading and beyond. That’s also a boon to pre-IPO investors, who usually get handsome equity stakes (alongside management, of course) in return for their help in getting an entrepreneur’s dream off the ground.

WSJ found that in the battle for investment dollars, startup projections may not always be startup reality just a few months out — and may instead be something closer to what would-be backers want to hear. WSJ also found that, upon analyzing 50 tech companies including the biggest IPOs in the past two years and their projections made when they were both private and public entities, 15 companies, or 30 percent, in fact reported revenue declines once documentation crossed the Rubicon from pitchbook to SEC documentation.

And overall, the revenue declines were pretty heady, down 25 percent on average.

Uh-oh.

Of the 15 firms with receding top lines, six firms reported declines due to more conservative accounting measures that hold sway once the companies were public.

Now granted, 30 percent of the firms analyzed by WSJ does not make a majority, nor does it mean that the accounting system is failing investors.

But taking that metric in tandem with the fact that 15 percent of all tech companies that went public thus far in 2015 are showing black ink on the bottom line (as University of Florida professor Jay Ritter noted to WSJ), and the question remains whether the rush to raise money is getting a bit crowded, and whether the exits may be even more crowded when investors rush to abandon previously sexy IPOs that just seem to keep hemorrhaging dollars (not to mention stock prices).

The issue goes beyond stock options and whether tech companies should be allowed to report adjusted earnings per share (now many firms use their discretion here, and many firms do indeed expense option as a cost of doing business). The issue may revolve around why pre-IPO companies are allowed to skirt conventional accounting — wherein, for example, revenue recognition requires persuasive evidence that an agreement exists, that goods and services have or will change hands, and payment is a matter of when, not if.

The host of revenue permutations mentioned in the WSJ report, ranging from “gross” revenues to “managed” revenues, show that even financial metrics can be massaged. Uber, for example, would likely have to tweak its use of bookings as a public company, reporting the roughly 20 percent of every dollar it collects after paying to run its business, making it to the top line instead of how much it charges its passengers to hop a ride.

Perhaps curiously, WSJ did not spend much time on cash flow, which may be because of the relative youth of these companies, and perhaps operating cash had yet to be realized. But in the end, cash on the books trumps GAAP accounting any day of the week.

Clearly, the SEC is waking up to the discrepancies between Silicon Valley pitches and eventual metrics that get disclosed in quarterly and annual filings. As WSJ reported, the SEC has stepped up its policy of asking tech, media and telecom companies just how they account for sales, and the tally as of 2014 stood at 88 percent of firms in those industries, up from 79 percent a year prior. And that far outpaces the 46 percent ratio of SEC scrutiny seen across all other industries. But in the end, it’s not too far-fetched to believe another tech downdraft forces regulatory hands to institute standard metrics across all investment offerings, not just IPOs.