Washington Is Killing Silicon Valley
sec.online.wsj.com/article/SB1229904720289252...Posted Dec 22, 2008, 3:00 PM UTC
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sec.online.wsj.com
What's wrong with mark to market accounting? Its using inflated figures in 'market to model' that's led to some of the biggest fraud in history.
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The problem is that the way it's implemented creates just as much work for small companies as it does for large companies, so small companies are at a big disadvantage. It's hugely expensive and time consuming to meet sarbox compliance, and a lot of it is just a big make-work song and dance.
Enron happened, they freaked out, and went way overboard punishing everybody. VCs don't want to start small public companies and be hobbled with the cost. So they start small private ones, and try to sell them to larger companies. Now, try to imagine what that does to the competitive landscape and how it changes the incentives for start-up employees. It's not cool.
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So the solution would be different standards of compliance for different size companies?
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I can't truthfully say I know the proper solution, but that would seem to be a reasonable start. Small companies can't cause as much market damage as bigger companies, so it would seem lower standards are appropriate.
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So it sounds like asking whether mark-to-market accounting is "wrong" isn't as relevant as asking if we should require all companies to follow the practice.
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Accounting majors want to make sure they have jobs
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There's nothing wrong with 'mark to market' accounting. Accounting is merely an abstraction - adjusting accounting rules does not change the fact if there are underlying structural problems in a company's balance sheet. If a company has assets that are worthless on their balance sheet, then this should be represented somehow -- mark to market is as good a method as any. Otherwise, the companies are literally inventing -- and often misrepresenting -- the worth of their assets.
These companies acquired the assets knowing that the mark to market rule was in effect when they acquired them, and that this would affect their capitalization requirements.
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mark to market accounting definitely has its flaws, as demonstrated in the most recent financial crisis. during irrational times (such as these) securities may take on valuations that are not indicative of the underlying quality of the assets - it's merely priced on fear. by forcing companies to apply irrational valuations across their entire portfolio discounts the real value of those assets drastically - and as shown - it can lead to an unnecessary amount of bleeding.
you can argue until you're blue in the face that a AAA prime FRM's irrational market value is its real value, but you're simply wrong. the valuations that are being applied to loans in the market are not indicative of the underlying credit qualities.
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forcing companies to apply irrational valuations across their entire portfolio discounts
why does this appear to be more true during a 'bust' than during a 'boom' ?
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Could you explain this? I don't know what you're talking about, but it seems important.
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Basically a bunch of crooks in Texas wrecked it for everyone else.
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Enron resulted in Sarbox which applies to public companies only. Which is bad enough. Though the specific rules don't apply to privately held start-ups, the effect is to eliminate IPOs as an exit strategy.
Exit strategies are the only "event" when the founders can get their pay-off for starting the company. Up to that point they are locked in because the majority of their value in the company is locked into preferred shares. And often founders take less salary than they could get competitively with bigger companies or even no salary.
Pretty there is only M&A these days, which is a very different animal in terms of how you set up the cost structure of the company and how you plan product strategy. It's not for the long-term and if you try to structure for the long term (because you know that's only way to compete or that's only only way the market will have it) then you have to take the higher risk of getting a bigger buy-out and extend yourself more thinly to justify the bigger buy-out.
Most people just throw in the towel with some of those odds or stick with the "safe" Fortune 500. Tens years ago, however, the handwriting was on the wall that the Fortune 500 would not be a safe bet any longer. Finally (sadly) we are seeing why.
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In about 2000, FASB changed the way you have to account for uncertain assets, especially "goodwill", IP like patents and trademarks, contracts, and general intangibles. Essentially intangibles has to be explicitly valuated in some way.
FASB, btw, is another one of those professional but private NGOs that enacts rules as law like the AMA, ABA and The Fed.
Previously you could lump intangibles into a category called "goodwill" on the balance sheet when you bought another company based on the differences between tangible assets and the selling price. At a top level you still do that but now the specific intangibles have to be broken up in the books. There's list (which is explicitly claimed not be be complete) in FASB 141 p20. Link below.
The kickers are things like patents - the value of a patent? How about Dc-to-daylight?! But then it's also unpatented technology and trade secrets as well.
Since nothing has value with any certainty until it is transacted directly or indirectly, I really don't know what to make of this in any intellectually honest way.
In a start-up where the company's product itself is highly variable in value due to simply uncertainty. Unless you have been bootstrapping for a while even the sale pro forma figures are guesswork and it's easy to be too high or too low.
Trying to value a patent in that kind of situation is a derivative of derivative of a derivative; simply insane guessing of value with no certainty whatsoever. The justification is that some information is better than none but that's not correct because it automatically "frames" the expectations (see cognitive limits) either too pessimistically or too optimistically.
Oh yeah, the last part. The preferred universal methodology for valuation of intangibles is the Black-Scholes options/derivatives pricing model. This was preferred over NPV, IIR or other methods.
Statement 141 & 142
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Since nothing has value with any certainty until it is transacted directly or indirectly, I really don't know what to make of this in any intellectually honest way.
The name of FAS 141 is Business Combinations. It's how you account for the company that you just bought in a transaction. Emphasis: you just paid for the company, therefore the price is based on the transacted price.
The preferred universal methodology for valuation of intangibles is the Black-Scholes options/derivatives pricing model. This was preferred over NPV, IIR or other methods.
I am very interested to hear you explain how that could possibly be done. If you actually read the pronouncements, the preferred method is discounted cash flows (i.e. NPV).
Btw, the pronouncement that governs derivatives is FAS 133, not 141 or 142 as you suggested.
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The impact on start-ups, as I mentioned, is that start-ups must have this information in order to be acquired or go public.
It's like capital gains basis values - if you are going to be taxed on it later you have start worrying about the asset value before you necessarily need to worry about it operationally. You do not pay taxes on your investments either when you buy them or while you hold them but you'd better have the basis before you transact them. So it is with a privately held, start-up and these valuations.
Also (not mentioned) most start-ups buy up other companies to acquire critical technologies so business combinations hit them then.
Also it's common to structure start-ups in ways that help organize spin-outs or M&As of portions of their businesses without affecting the ability of the remaining portions to continue doing business. For example, holding companies for shared IP among separately operated subsidiary entities. Again - a business combination.
All of these involve business combinations as defined in 141 & 142.
Actually if you read the 141 & 142, the committee responses to inputs for cash flow analysis and objections to the rule changes repeatedly describe how cash flow methods are too arbitrary because there is no standard time line or interest rate, hence the need for a single uniform method.
My point about it is that it really can not be done with any less guess work or arbitrariness than NPV in the first place, and Black-Scholes is far more opaque than cash analysis which is at least somewhat intuitive while Black-Scholes is a black box. Black box formulas are always abused by commission or by omission. It's human nature.
These is why I and most people I know don't like the rules. They seem to help but ultimately they only obfuscate and create a false sense of security while simultaneously creating unnecessary, unproductive work that small start-ups can ill afford.
FAS 133 is specific to derivatives and securities markets accounting. There is a section in 142 about these as well, but the point of the original article wasn't derivatives per se but how rules to reign in accounting abuses such as those committed by Enron have only made the US far less competitive by making it disadvantageous to form new high tech start-ups.
The key reason is what I was referring to 141 & 142 is because it is specifically changes in how valuation must be done, which was specifically triggered by things that happened at Enron, that has worked against US high tech start-ups as the article claims.
Sarbox was also triggered by Enron, and also works against high tech start-ups because it virtually eliminates (US market) IPOs as an exit strategy. All start-ups need an exit strategy to be viable. Otherwise you are taking reduced salary and benefits with no hope for a payoff.
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Er...
President Ronald Regan's tax cuts
Isn't misspelling Reagan's name on the WSJ editorial page illegal or something?
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According to the National Venture Capital Association, in all of 2008 there have been just six companies that have gone public. Compare that with 269 IPOs in 1999, 272 in 1996, and 365 in 1986.
Two of those numbers are immediately preceding a market crash. GREAT WORK, WSJ.
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Oh, the old Rupert Murdoch... He KNOWS what's killing innovation (*)...
(*) Hint: it's the liberals! Insisting on proper disclosure is something Hitler would do!
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The most important government actions to foster business creation were the 1978 Steiger Amendment, which cut taxes on capital gains to 28% from 49%, and President Ronald Regan's tax cuts, which reduced them still further to 20%. These tax cuts unleashed the PC and consumer electronics booms of the 1980s, just as the Taxpayer Relief Act of 1997 restored the 20% rate and did the same for the Internet economy in the late 1990s.
Proof or STFU. Bonus points, the late 1990s saw an Internet bubble. I'm not sure why we are supposed to clamor about it.
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That's hilarious. It wasn't exponential advances in semiconductor technology which created the PC market, it was an 8% tax cut. Thanks WSJ.
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It's almost like Rupert Murdoch never even bought it...
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Correlation /= Causation. Timing has a lot to do with it, but yes, they provide no proof.
I'll go one step farther. Put the short-term Capital Gains back up a bit, lower the long-term. Get Wall Street out of this stupid quarter-to-quarter mentality that has ruined investing and our economy. Hell, make quarterly reports illegal. We're going to keep getting our clocks cleaned if no one will operate with the long term in mind.
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What possible coherent argument could there be against options expensing? Not knowing exactly what something is worth is not an excuse to pretend it's worth nothing...
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It's not that you shouldn't. It's that the same rules apply to all other intangibles of which start-ups have a disproportionate share - things like all your IP, all you business relationships, databases, trade secrets, joint ventures, etc.
If you look at FASB 142, the same section that covers all options and securities/options trading also covers all intangibles. Just reading through it it's clear that the rules for securities trading is way too light and the intangibles is way too heavy.
And I should add that options that are traded are very different in scope of downside from pre-IPO issued employee stock options.
Edit: and they weren't ignored before - they would be accounted for in an IPO (the first time the "real" value of a company is determined transactionally) as goodwill. The whole point of the IPO is that no one really knows the value of the company before that other than strongly-held, biased opinions.
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Aww, the poor executive managers & lawyers & bankers are taking their ball and going home.
Accountability is hard! Let's go shopping!
Google buyouts aren't the only alternative to IPO. The other is creating a profitable company and reinvesting the profits. If all this accountability means you can't figure out how to find enough shills for your IPO, I don't care.
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The other is creating a profitable company and reinvesting the profits.
Thanks to the economic brilliance of Bush and Co., we've eliminated "double taxation" and now companies no longer have any incentive to reinvest their profits into growing their enterprise.
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Joseph Stieglitz says in one of his book that not accounting stock options (one of the thing this article thinks is wrong) was a major problem in the 2001 bubble, (taking the example of Yahoo that was hugely over-valued at the time).
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This article lost me at 'FASB's "mark-to-market" accounting rules helped drive AIG and Bear Stearns into bankruptcy, even though they were cash-positive.'
That statement is just wrong on so many levels that my mind boggles.
edit: Thankfully, there is sanity elsewhere: http://www.guardian.co.uk/commentisfree/2008/dec/22/congress-us-economy-gary-younge
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There are plenty of companies that become successful without VC. In fact, I tend to agree with Joel Spolsky that VC's are inherently evil, because they're more focused on short-term capital gains than long-term healthy companies.
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When it comes to VCs I'd say they are inherently not looking out for the interests of either the entrepreneur, the product or the technology. Entrepreneurs inherently have their own "blind spots" that are often as bad as VCs. The biggest one is the squick about sales and marketing.
The start-up situation is also very different with software because there are almost zero capital costs (a few computers, maybe an office, bootstrap the operating expenses).
But software has problems.
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Most "mainstream" software markets (read: Web 2.0, most internet or DB products) are way too oversaturated competitively
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Software is less defensible competitively in a Porter sense than tangible products
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The price valuation is more difficult and generally lower than tangible products
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The price valuations by the market decline faster than tangible products
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Most of the really big problems the US has can not be met by intangibles like software or services (e.g. energy, economic growth)
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High value, high margin market opportunities have better survival and profitability chances for a start-up but require direct sales for tangible or intangible products, which cost plenty
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Using only Internet channels allows only lower value, lower margin market opportunities to be met (i.e. money is left on the table) and set-up a product price and cost structure to guarantee no long-term growth is possible.
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Locking into a low-margin price/cost structure will affect the company valuation (by NPV of future possible sales cash flows to the buyer) that will likely be too low to support any exit strategy other than bankruptcy.
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Most entrepreneurs underestimate the necessity of an exit strategy option
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Silicon Valley is just Collateral Damage in the current collapse of Capitalism. Sucks, but that's the story.
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Silicon Valley is GROUND ZERO of the collapse of the American economy. It happened in April of 2000 and that's why we've been living in a totalitarian police state since.
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Actually it's the Washington-Wall Street Consensus, that has developed since the 70s when Nixon moved us off the gold standard to a fiat currency, and later administrations and Congress opted for a strong dollar, globalized & outsourced economy. Some of that was to strengthen the West against Communism, but now it is working against us. Paper wealth creation centered around Wall St. and financial services will never sustainably replace the real wealth creation of manufacturing, tech, and similar industries, and we're living through the demonstration of that now.
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Exactly my point. Silicon Valley would be creating new industries right now if folks here in California weren't being treated the same way as Texas criminals.
Look at Tesla Motors. They should be able to go public and raise capital to finance their manufacturing operations, but they can't because the geniuses on Wall Street and in Washington are more interested in liquidating Mervyn's.
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Gotcha, misunderstood. Wall Street has deep-captured Washington, and is using that influence to screw the entire country. I hope California's rising influence in Congress and with Obama, along with Obama's clear techno-savy approach and relationship with Google, Lawrence Lessig, and other tech heavyweights, will change that equation somewhat. What do you think?
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Actually, Silicon Valley and Agriculture are just about the only thing America has going for it. This is not a Totalitarian Police State. Business elites like their freedoms as well.
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VC funding is still off from its highs by a factor of 2-3x.
I find it hilarious that these guys want a kidney, your first-born child, and the entrepreneur to assume all R&D risk and show a profit but anyone who makeum signs on paper to show him friend of white man could get a million dollars to buy Barbie's dream home.
Business elites haven't deserved their freedoms since 1999.
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Like I said, Collateral Damage. The internet bubble has justifiably cut investment in Silicon Valley since 2000; what fool would throw money into a hole again? I'm not saying that worthwhile investment has not suffered, just that this is the understandable reaction to a bubble. The good suffers along with the bad.
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Only thing I disagree with here is the last part about Obama being remembered as a Hoover rather than an FDR. Both sucked, especially FDR. Through trial and error, FDR managed to turn what would have been a sharp, one to two year recession, into the Great Depression.
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Wow. That is a monumentally stupid comment.
US GDP started dropping in late 1929, Roosevelt took office in January 1933.
The depression had already lasted a full three years when FDR took office. It was already two years old when the presidential campaign started up.
So how to explain ablawren's drivel?
Perhaps he thinks the depression started in 1932? Perhaps he thinks FDR took office in 1930? Perhaps he thinks FDR had a time machine, and went back in time to prolong the depression to win the 1932 election?
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Rather than attack me personally, why not address the argument that the New Deal actually prolonged the Great Depression? There are some very bright economists who criticize the New Deal on both the Right and the Left. Milton Friedman commended FDR for some of the emergency relief measures and even the WPA work program, but criticized him for the bigger things like the NRA, the Agricultural Adjustment Administration - both of which were declared unconstitutional later - and Social Security. These things, he said, inhibited a speedy recovery during the 1930s. Frederick Hayek was also very critical of these policies, among many others. I just read a book called FDR's Folly that gets into a lot of the bad effects of his policies during the 30s -- which I suppose is why I made my comment in the first place. About the timing thing, yes I was off but I stand by my main argument.
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So how to explain ablawren's drivel?
Perhaps this will suffice: http://www.amazon.com/Forgotten-Man-History-Great-Depression/dp/0066211700
It goes into a similar argument, along with the argument that FDR deliberately avoided working with Hoover before his inauguration in order to make the crisis worse. (So he'd look better, have more of an argument for his reforms, etc.)
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Presumably he is rather inaccurately regurgitating something he got somewhere.
Even if I were to take Amity Shlaes as an authority on depression economics and assume that FDR were sabotaging everything from the start of the presidential campaign in early 1932 the depression would already have been two years old at that time hitting the top end of ablawren's estimate for how long the depression would have been without FDR's "trial and error". His bottom end estimate would still require a year of time travel.
That's how you know you are reading some high grade 100% pure bullshit. It isn't just wrong it is wrong on many levels.
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I'm not saying he's right, just trying to clarify why he might be saying what he is.
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Evidence? Or did it not come with the talking points they read you on the radio?
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Common sense, actually. The allocation of capital through political means is far more inefficient than allocation of capital through private means (e.g. bridge to nowhere).
Savings and underconsumption is source of capital for growing an economy.
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Ah, yes. If it's "common sense", no proof is required. That's a sound foundation for decision making.
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Wealth is created with capital. Capital is created with savings and underconsumption.
FDR spent at a time when the nation should have been saving, and therefore committed more of America's future resources to programs that did not add value.
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Rather than attacking me personally, why not address the argument that the New Deal actually prolonged the Great Depression? There are some very bright economists who criticize the New Deal on both the Right and the Left. Milton Friedman commended FDR for some of the emergency relief measures and even the WPA work program, but criticized him for the bigger things like the NRA, the Agricultural Adjustment Administration - both of which were declared unconstitutional later - and Social Security. These things, he said, inhibited a speedy recovery during the 1930s. Frederick Hayek was also very critical of these policies, among many others. I just read a book called FDR's Folly that gets into a lot of the bad effects of his policies during the 30s -- which I suppose is why I made my comment in the first place. What's with the talking points attack?
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Right wing talk show hosts never need evidence! How dare you! You must be Anti-America! Blah, blah, blah...
/sarcastic
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Its about time Washington put Silicon Valley out of its misery.
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This article lost me when it started talking about eliminating options expensing.
FACT: Options are not difficult to value. Just use black scholes. For public companies there might even be an options market so it's even easier. The idea that a company can give away something of value and not count that on their books as an expense is ludicrous.
That said, the general point about small public companies being over-regulated is true. Also, double taxation is a huge problem in the U.S. Although in my opinion the way to fix that isn't to lower capital gains tax, it's to just eliminate corporate income tax and then tax capital gains as regular income. (BTW the reason capital gains is taxed differently in the US is to help compensate for corporate income taxes the company is paying before it pays you dividends. In most other countries they just explicitly allow you to deduct the taxes paid by the companies you own from your income taxes that you pay on capital gains and dividends. So it's intended to soften the blow of the double taxation but it's unfair because not all companies pay the same tax and really there shouldn't be double taxation in the first place.)
I gave up planning my lengthy rebuttal to Mr. Malone when it was revealed that his hardest proof (it's scientific 'cos it's got nummers, innit?) was comparing the number of IPOs in 2008 with those in 1999, 1996, and 1986. If you can't spot the cherry picking in there, maybe you shouldn't be starting a company.
Here's an article with a good chart on the number of IPOs since 1991, and it clearly shows both that they spiked after SOX was passed, and that they never achieved pre-dotcom bubble running averages after that bubble burst. That might have been a bit much for Mr. Malone to digest, though, and it doesn't prove his point that evil, mean, nasty, inhuman regulation destroys good, happy, capitalism.
You apparently think that Black-Scholes is some absolutely, divinely revealed formula. It's not.
BS has very serious problems when applied to sub-market, non-equilibrium cases like start-ups and their employee stock option values.
The options being discussed here apply to public companies, so the stock price is known. The volatility can be reasonably estimated from peers if there is no explicit options market for the company in question.
The only possible complication I can think of is if there is a non-definite expiration date. I think (not 100% sure) that some companies let you exercise as long as you work for the company. This might require a more sophisticated model, but even so black scholes can provide you with a reasonable upper and lower bound.
The idea that companies should be given carte blanche to pay employees as much as they want through options without putting a single cent on their expenses simply because they're hard to value is insane.
In point of fact, the options being discussed are PRE-IPO start-ups so the value of the stock is 0 unless the employees work hard to ensure that it is not.
Therefore, companies should be allowed to dole out as much equity as they want to their employees in order to motivate them to create value. IF the options end up being worth anything, it is down to the hard work of the employees who created that value, while drawing a salary below market rates.
I'm not sure what you're referring to. This is the paragraph from the article I'm talking about:
The FASB is only for public companies as far as I know. Private companies can do whatever they want wrt options.
Double taxation is a choice companies make when they are started. It's part of paying for the benefits of corporate status in the US. You know, that whole limited liability thing, rights of personhood, etc?
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