Wednesday, November 21, 2012

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.

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