Finance is an area of business that is especially poorly understood by startup CEOs who tend to have engineering backgrounds, and underestimate the importance of everything else: account management, marketing and, of course, finance.

Let’s start with how EDA companies report their results. If you listen to conference calls or read press releases you’ll hear two sets of results. These are usually called GAAP (pronounced gap) and non-GAAP. GAAP stands for “generally accepted accounting principles” which actually doesn’t mean generally accepted but means as mandated by FASB (pronounced fazz-bee), the financial accounting standards board. This ought to be a bunch of experienced company financial executives, or perhaps a bunch of experienced investors. But it is actually seven academics on the east coast who’ve never run a company, or even been in one.

Accounting is fundamentally about cash, and if you run a small business then you probably use cash accounting since it is the simplest. But in a larger company it does a poor job of matching income and expense flows together. For that you use accrual accounting. The first change is that revenue and expense recognition are separated from the receipt or expenditure of cash. This matters a lot in a true manufacturing business: you ship a customer a widget and a bill and eventually they pay. Much better to record the money on the same day as the widget went out since it is payment for that widget, and it is just a minor detail that the customer didn’t pay for a few weeks. Similarly, you receive a widget and a bill and you record the expense that day, rather than worrying about whether you pay on 30 or 45 day terms. The second big change is that big-ticket items are not recorded as a single expense but are depreciated, recorded as a series of small expenses, over the life of the item (stepper, computer, fab). Again this does a good job of matching expenditure to use of the money. The stepper last for several years so it makes little sense to record a huge loss one quarter when you buy it, and unrealistically large profits for years while you use it. This is all pretty non-controversial although not so important for software businesses where a lot of money is not tied up in manufacturing plant, inventory, work in process and so on. But GAAP doesn’t stop there.

The trouble is that they have got so messed up with rules for depreciating goodwill, expensing stock options and so forth that they no longer really give a useful view of many companies’ financial situations.

Two examples: a big EDA company buys as startup for $100M and the startup has assets on its balance sheet of just $5M. There are some wrinkles concerned with in-process R&D and capitalized software development, but most of the remaining $95M is called goodwill. It is essentially a plug number representing the difference between the price paid and all the tangible things anyone can find to assign to part of the purchase price. FASB (and so GAAP) used to insist that goodwill be depreciated over a certain period like 20 years, but now insists that each year the company evaluates the goodwill it is carrying on its books to see if it reflects a true assessment of the value of the acquisition and forces adjusting entries if not. That is why, for example, Ebay wrote down billions of dollars due to acquiring Skype when it became clear they paid too much and so had a big paper loss one quarter, that everyone ignored. However, changes like this are somewhat arbitrary and generate fictional gains and losses, not to mention assets on the balance sheet that aren’t really assets (you can’t do anything with them like sell them).

Second example: stock options. When options are granted, which at the time of grant has no effect whatsoever on the companies financial position, FASB (and so GAAP) insist that an expense be recognized. But there is no real expense in terms of money changing hands. So of course this theoretical expense is wrong, and later corrections will be required to bring it in line with what actually happened. If the stock price went down, the options might expire unexercised so it is just as if they were never issued, and the original expense will need to be reversed. If the stock price goes up, they will be exercised and the company will actually gain a certain amount of money from the exercise, and the number of shares outstanding will change. But the notional value will need to be reversed since in the EPS (earnings per share) calculation, option exercise affects the “per share” part and not the “earnings” part, and pretending that it did messes up all the numbers.

Institutional investors ignore all this and focus on non-GAAP numbers, which take all that stuff back out again. In the case of a typical EDA company, non-GAAP numbers remove the depreciation of goodwill from startups acquired years ago, and also take out all the phantom value assigned to stock options. The non-GAAP numbers are much closer to what you need to assess how the business is doing. They are much closer to standard accrual accounting where cash payments are adjusted to do a better job of matching expenses and revenue to time.

For a really good summary of all that is wrong with FASB and GAAP I recommend T.J. Rogers, the CEO of Cypress Semiconductor, who wrote “Making financial statements mysterious”. It’s about 10 pages long. Here’s the opening paragraph:

I first noticed the misleading nature of Generally Accepted Accounting Principles a few years ago when an investor called to complain about the small amount of cash on our balance sheet. Since we had plenty of cash, I decided to quickly quote the correct figures from our latest financial report. But to my surprise, I could not tell how much cash we had either. With its usual—and almost always incorrect—claim of making financial reporting “more transparent,” the Financial Accounting Standards Board had made it difficult for a CEO to read his own financial report.

Of course I’m sure I’ve got some details wrong here. But that’s part of the point, finance is meant to summarize a business for executives and investors who are not deep finance experts.

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