I came across this FT.com article today about SEC investigating into Kraft Heinz regarding its accounting practices amid an impairment charge.
To startup founders this might sound like foreign languages. It all comes from the traditional concept that the book value of “assets” drive company value, e.g. factories generate revenues. When a corporate acquires another company (let’s say 100% with cash to make it simpler), on the balance sheet the entirety of the acquisition value comes off the “cash & cash equivalents” and moves into “long-term assets”, where it might be broken down into different kinds of “operating assets” and “good will”, the later being a mere residual term of acquiring value minus the fair value of the acquired.
Accounting rules state that you have to examine if the value acquired is still there every accounting period. Let’s say if Kraft Heinz bought a cookie brand and the sales dropped a lot thereafter, then there’s reasonable cause to write off some or all value of the acquired brand. This leads to a one-time (or multiple-time) non-cash charge on the bottom line of the income statements.
Keep in mind that accounting is a very backward oriented (trying to reconcile the past) while finance is always forward looking (trying to predict the future). For traditional businesses like that of Kraft Heinz, more likely than not the market already reacted to falling sales of a declining brand. The impairment charge, if for this exact reason, is irrelevant to the Wall Street.
In other words, in the most efficient financial market, book value (total accounting value of the assets on the balance sheet) does not matter. The market only cares about the free cash flows that could be generated from the operating assets in the future. Whatever numbers that are accounted on the books, such as how much the office building is still worth, does not matter.
For tech firms it’s even less relevant. Most tech firms get acquired not for the physical, accountable operating assets but more for its product lines, expertises, IP portfolios or even just talent in the house. Unless a fraud is detected afterward, usually nobody tracks the fair value of an acquired tech firm and try to keep the book updated.
For startups acquisition it’s even more extreme. Most startups are acquired at extremely high multiples simply due to the nature of their low revenues. Think about Nest (Google) and Oculus VR (Facebook). As long as the acquisitions continue to bring strategic values to the acquirers, it’s hard to see the rationale to proactively “write off” any value.
This is why you see startups get acquired by large tech firms but then their services get shut down a couple of years later, but there isn’t even any mentioning of write-off, let alone impact on the income statement, or even the market caps. Because the financial market has already factored in all effects on free cash flows.
Still, looking back to the old world of the likes of Kraft Heinz and these occasional news helps recalibrate the general ideas about businesses and values. Worth the time.