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Autonomy, Revenue Recognition and the Duping of HP

HP’s acquisition of Autonomy, and subsequent write down of $8.8B amid allegations of fraud by the Autonomy management team, is going to show up as a business school study one of these days, and so it should.

The practice of revenue recognition in software, and how you can be misled by it, is simply not well understood by enough senior management and board members. And as companies shift their software products from license to subscription revenue it becomes imperative that board members do understand it or they can be easily misled.

In the Autonomy case, it appears they did two things that, while not illegal (I think HP will have a hard time proving fraud) are questionable…unethical…short term thinking… pick your poison.

The first is recognizing revenue up front. I interviewed a VP sales candidate from Autonomy a couple of years ago. He was proud of how they were growing their revenue so fast — and I was horrified. They were signing long deals – 6+ years long – and structuring them so they could take the license revenue up front.

As he proudly described to me, he had recently won a very large contract with a global bank to use Autonomy to analyze internal data following the 2008 recession. Sign a 9 year deal, structure it so you take the license revenue up front and maintenance over time (here’s a primer on revenue recognition if it will help), report the revenue on your call as a great deal and never tell anyone that it’s 9 year’s worth, because you are not required to tell them. Pay the sales team commission, the stock goes up, everyone’s happy. Except the analysts who smell a rat but can’t prove it — they will be cautious on your stock.

Software revenue recognition rules are sufficiently complex now that this is not hard to do, it’s all in how you write the contract terms. And because it’s not illegal the auditors, like Deloitte, will not technically cry foul. As Dennis Nally of PwC told the FT last year:

“There
are professional standards out there [and] an audit is not designed
under those standards to detect fraud,” he says, pointing out that
detecting fraudulent behaviour rests on other indications including a
company’s governance, management tone and control systems.”

I agree, it’s all about management tone.

The practice of overly aggressively recognizing revenue up front is not new. Cadence did it for years to inflate their value, and nearly pulled it off.  Before Cadence crashed in October 2008, they were in negotiations with KKR for KKR to take the company private. My network told me (so it’s hearsay) that the deal broke apart on $1 per share. KKR offered $24, Cadence management and board held out for $25. But it was not long afterwards that the board figured out just how much Cadence had been advancing revenue and fired the entire management team.

It takes character and spine to convert your business from up front license revenue to ratable revenue. If you start the business as a SaaS business (like salesforce.com, or FirstRain) your revenue starts out low, but it grows exponentially and you never have to make the switch. But to switch from license to subscription means at some point you have to slow down your growth rate. Both Oracle and SAP are dealing with this right now, and the Autonomy management team must have decided it was easier (and more personally lucrative) to sell to a mug than deal with it themselves.

The second practice reported by AllThingsD is channel stuffing. Again, not fraud but really short term because it creates a future problem every time.

Channel stuffing is selling product on to distributors before they have found a buyer. So this means you sell to your distributor (who is never going to use your product themselves), they pay you, you take revenue and it sits on their shelf until they can find a buyer. This is unforgivable in software.

This practice developed in hardware years ago because the distributor wanted to have the product ready for delivery so they’d buy it from the supplier, but these days, with modern reporting systems, there is no need because your product can sit on your distributor’s shelf while you still own it, and in software there is no reason at all to do it…. unless you are trying to inflate your revenue in the near term and you are willing to bet your revenue will grow fast enough to cover the stuffing.

In the end this is about business judgement and advice. As Reuters headlined a story this morning: In HP-Autonomy debacle, many advisers but little good advice.

Autonomy had the best advisers in the business. They don’t come any better than Frank Quattrone, George Boutros and the Qatalyst crew. I have worked with them on both sides of deals, on my side selling and against me when I was buying, and they know how to develop the case to extract maximum value for the asset they are selling.

Time will tell now whether this colossal acquisition write down was the result of fraud — and so reputations will be destroyed on both sides — or whether it was an overly aggressive tone at Autonomy that inflated the value. But the resulting destruction of value and reputation is the same in both cases.

Equality

The dark side of Silicon Valley

Silicon Valley is on a roll right now. The relatively low levels of capital needed to start a software company has meant that start up incubators and small software companies wanting to be the “next big thing” are popping up all over. Bars are crowded, San Francisco is hip and traffic is worse than L.A. All signs of a booming economy and tech infrastructure that has spawned new wealth-generators like Facebook, Zynga, Instagram and now Yammer.

And yet, this is just the face we like to present to the world. Underneath, as in any competitive society, there is a dark side.

Depression:

Ben Horowitz captured the psychological pain of the struggle of being a company founder and leader in his blog post The Struggle last week. He captures perfectly the isolation, the pain, the cold sweat of building a company which, in 99.99% of cases, does not goes smoothly. Being on the emotional roller coaster of building a new company can lead to depression. It can be hard to setp up every day and face your demons and the risk of failure while all around you seem to be succeeding (because no one talks about the failures). We saw this tragically recently in the case of the suicide of Diaspora founder Ilya Zhitomirskiy.

I try to remember that it’s “not checkers; this is mutherfuckin’ chess” (to quote Ben) and manage my stress with swimming. But even for me, who’s lived the entrepreneur’s life for 15 years, there are days…

Discrimination:

It’s illegal to discriminate on age – employees over 40 are a protected class. But the new generation of companies doesn’t seem to know or care. The median age of Google is 31, the median age of Facebook is 26. They are hiring a generation of new employees who know Java but not C++, who can sell ads over the phone, and who cost a great deal less than experienced employees. Contrast that with computer and communications companies like HP and JDSU who need experienced hardware engineers and have median ages of 44 and 47. At FirstRain, we need both experienced and less-experienced employees to build our solution so we have a healthy mix, but even so I am the oldest employee. Yikes.

It’s illegal to discriminate on race too – and yet, as Vivek Wadhwa discovered when he reported the dearth of black and latino employees in Silicon Valley, it’s a contentious issue and he found himself being dismissed by Techcrunch’s Michael Arrington for highlighting the issue. As Vivek says “an elite group of power brokers, exemplified by Arrington, is totally ignorant of the hurdles faced by minority groups”. But like the shortage of women, this issue starts in middle school and perpetuates into college with the shortage of graduating engineers. We are so short of good engineers in the Valley now that I don’t see race or gender discrimination at the engineer level — I see a dire shortage of qualified candidates.

Feeding the cash monster:

Companies take cash. They consume cash. Salaries, rent, insurance, computers, bandwidth, data center fees… it’s never ending. And once you raise money you are a slave to the cash monster because you have investors who want growth. They want success. And that takes more cash. I watch some of the new young companies raise (too much?) cash, and then spend it on flash offices and parties (see below) and fear for them. Do they know what a down round feels like?

In the social media world, like the dot.com era, the focus is on users and eyeballs, not on profitability, which will work for the very few who ramp fast, get bought and exit. But it takes cash to do that. Consider Yammer which raised $140M to build a Facebook-like service for the enterprise and has purchased by Microsoft for $1.2B. But that’s the exception. Most new companies cannot get access to that level of capital and they underestimate the cost of user-acquisition. Unless you are in the in-crowd with a runaway success you’ll be feeding the cash monster with VC rounds and sleepless nights until you get profitable.

Excess:

But on the flip side of the cash monster… The dot.com boom brought with it a period of excess that hyped, and ultimately hurt the Valley. Companies celebrated raising money and launching products with wild parties – never mind that they had no idea how to make money. Then for a while the Valley sobered up. Companies got back to work, profitability became fashionable, companies talked about helping non-profits and excess was considered bad taste. Especially as the great recession hit and companies worked hard to preserve their cash.

But now, even though the rest of the world is still struggling, the Euro-zone is in crisis and 8.1% of the US workforce is without work, the excess is back in Silicon Valley. Once again companies are celebrating launches, and recruiting and, as Business Insider reports, there sure are a lot of parties going on.  Are we tone deaf to what’s happening to the rest of the world? Is this, again, the result of too much money flowing in?

As Rob Cox wrote in Newsweek, in his analysis of Silicon Valley’s undeserved moral exceptionalism – we are not as altruistic as we’d like the world to believe. He makes the case that “though Silicon Valley’s newest billionaires may anoint themselves the
saints of American capitalism, they’re beginning to resemble something
else entirely: robber barons.”
  For example, the flagrant disregard for privacy prevalent in the new, free apps is stunning. When I gave my TEDx talk at Gunn High School a few weeks ago I surprised many of the students as I explained how they are now the product – their every move and action is being recorded and sold in a way most of them simply do not understand.

But, in the end, these facets of Silicon Valley are capitalism at work. A lot of people work very hard, a few get very rich. Many make healthy salaries working on fun products and in exciting companies. Most will not get rich, but most will have a fun experience. But as the leaders in Silicon Valley, we need to pay attention to the dark side and not perpetuate it. We need to be aware of the stress the long hours and intense deadlines can create. We need to be circumspect about our good fortune. We need to hire the best and the brightest, no matter their age, gender or race.

And on the good days, like today, bring in ice cream for everyone!