The Alternative Realities of Venture-capital-financed Businesses
Accounting scandals undermine trust in the management. Even the vaguest hint of ‘Enronitis’ – the tendency in enterprises to present figures which are better than the reality – prompts frenetic activity among stock exchange regulators, external auditors, and management boards.
Managers who massage the figures too much are presented to the investigating judge – in handcuffs, to get the media interested. External auditors swear they will atone for their past oversight and ramp up their quality assurance procedures. Stock exchange regulators invent new rules to signal to investors that they are doing everything they can to get a grip on creative accounting and auditing.
The impression thus created is that accounting problems are dealt with through monitoring and the punishment of managers, controllers, and external auditors. According to this school of thought, all it takes to win back the trust of investors is to pillory sufficient numbers of managers who have sinned, to introduce numerous new rules for auditing firms, and to create a few more posts at the stock exchange regulator. However, these more or less symbolic attempts at winning back the trust of investors overlook the fact that creative accounting, and its attendant collective outrage, is an almost inevitable side effect of a collapsing capital market. The topic thus usually recedes into the background once share prices begin to rise again.
Creative accounting is the result of a business model in which firms are financed by venture capital and depend on the permanent influx of funds from the capital market. Companies that depend on business angels, venture capital firms, or the stock markets for finance must do whatever they can to avoid sending out any signals that might frighten the capital markets. If the transfers from venture capitalists fail to materialize, if the prospect of bringing in more money by floating the company evaporates, or if its existing shares – the company’s currency for acquisition and refinancing – slump, this can quickly spell the end of any capital-market-driven business.
When investors develop an interest in a new ‘hot’ technology, they expect the companies to grow fast, even if this means a short-term decline in profitability, for it is believed that only those firms that gain a share of the market quickly will prevail. This creates a growth trap for these businesses. In order to justify their large market capitalization, they are forced to expand internationally and to widen their product ranges. Because their survival depends on regular refinancing via the capital markets, these companies, as opposed to businesses primarily driven by product markets, must keep on pursuing a strategy of growth.
A consequence of the growth trap in which such businesses find themselves is the need to constantly inform the capital markets, the media, and the political sphere of increasing numbers of users, rising numbers of employees, and increased turnover, especially in times when the economy is booming. In this way, an enterprise’s legitimacy is preserved. As a result, firms design their strategies in such a way that they will always meet precisely those criteria that are supposed to measure their ‘performance’. There is a temptation to window dress in order to make it to the next round of refinancing.
During a phase of increasing demand for the shares of these fast-growing businesses, investors are not really on the lookout for such window dressing. Even when a company presents an implausibly rosy interpretation of its figures, investors do not bat an eyelid, as there are so many success stories among the other firms. But every boom in the venture capital market eventually peters out – that was the case with minicomputers in the seventies, the PC companies of the eighties, and the internet and telecommunication businesses of the nineties.
Decisive losses on the stock markets for growth companies, and even for blue-chip companies, are often a sign that a cycle of venture-capital-driven growth is coming to an end. During the period of decline, no one is interested in news about increasing user numbers or turnover figures. Instead, the capital markets must be reassured and stabilized through declarations of operational profitability from businesses. And this focus on profit means that close attention comes to be paid to the ways in which businesses have come up with their figures.
The capital markets, usually quite willing to overlook a bit of numerical trickery as long as the boom continues, suddenly begin to fuss over the merest suggestion of creative accounting or any business having to correct its figures. And the media, which up until then had only been interested in success stories, suddenly discover that creative accounting is also news.
Depending on how reliant a business is on the capital markets, the knock-on effects of imaginative accounting may be more or less significant. The drop in share prices that may result is certainly also uncomfortable for primarily sales-driven enterprises, but as a rule it will not threaten their survival. As long as income from the sales of products and services exceeds expenditure, there is no immediate threat to liquidity. But for businesses that are primarily driven by capital markets, the erosion of the investors’ trust often has catastrophic consequences. Capital-market-driven companies include not only small businesses but also fast-growing companies seeking to conquer new markets with the help of venture capital, ‘established companies’ that have taken advantage of booming stock markets in order to pursue expansionary strategies financed by the capital markets. Once the flow of additional finance from the capital markets dries up, the scope for securing liquidity shrinks, and these laboriously erected financial constructions collapse.
Venture-capital-financed companies that were once considered exemplary do not go belly up because, once their accounting tricks come to light, it turns out they had been floundering all along. Rather, they fail because, once their creative accounting is exposed, the capital markets’ trust in them evaporates. Their capital-market-driven business model can therefore no longer work. To put it in more provocative terms: a business practising such financial trickery goes bust not because there is chaos behind the scenes but because the management has not organized the trickery well enough. The management of alternative realities, the real company on the one hand and the way it presents itself on the other, was simply not professional enough.
