Now Spotify Is Daring To Disrupt The Investment Banking Industry

When a privately owned company decides to list its shares on a public exchange. it is expected to follow the rules.

What rules? Well, for starters, the company is expected to hire an investment bank to guide it through the legal process. The bank also organizes promotional presentations for company representatives to “pitch” to potential investors. And perhaps most importantly, the bank underwrites the transaction by placing a value on the stock and then guaranteeing that the firm will receive that value during the sale.

The underwriting guarantee can be a risky proposition for banks. But by charging lucrative fees, the financial institutions can afford the risk of a massive financial obligation if the investors pay far less than expected.

Spotify, the streaming music provider that has disrupted the entertainment industry, is about to disrupt the investment banking industry by refusing to follow these rules. What does it intend to do? And why is it so daring?

The firm is not hiring an investment bank to provide any IPO services. Instead, by using an obscure “direct listing” process that has never been attempted by an organization of its size, Spotify simply intends to notify the New York Stock Exchange that it wishes to begin trading its shares.

No bank will organize any promotional presentations. None will provide any legal guidance, and none will be paid any fees. Perhaps most notably, none will provide Spotify with an underwriting guarantee.

For Spotify, this “direct listing” gambit is a reflection of its daring management style. Namely, it seeks to disrupt entire industries by eliminating the middlemen and by contracting with stakeholders directly.

In the music industry, for instance, the firm has dared to contract with the public while eliminating CD, DVD, and vinyl retailers. And now, on Wall Street, it is daring to attempt to reach investors while eliminating investment banks.

If Spotify succeeds, two different industry sectors will be disrupted by its daring strategy. Considering the buoyancy of today’s financial markets, it may prove foolish to bet against them.

The Inevitable “Sameness” of Wall Street

Last week, in his final appearance on the television show The Colbert Report, Stephen Colbert reflected on the “sameness” of the political environment throughout the nine year term of his series. “I did more than change the world. I ‘samed’ the world,” he said. “The country isn’t so different than it was in 2005, he reminded us—we’re publicly debating torture, a Bush is running for president, and we’re sending troops into Iraq.”

Mr. Colbert could have easily extended his soliloquy to issues involving Wall Street. Two weeks ago, the government regulator FINRA fined ten banks for engaging in an illegal practice that was first exposed to the public in 1999.

What did the banks do? They utilized their (ostensibly) impartial research analysts to praise Toys ‘R’ Us in the hopes of winning an IPO stock trading contract from the retail giant. The analysts, of course, are responsible for evaluating firms in an objective manner and issuing buy, hold, or sell recommendations to the public.

Back in 1999, a Citigroup analyst named Jack Grubman was caught manipulating his recommendation of AT&T stock so that his firm could win a similar trading contract. In that particular case, though, Grubman did more than earn new business for his employer; his willingness to compromise his impartiality led to a prestigious pre-school’s “quid pro quo” decision to admit his child to its program.

Citigroup’s public embarrassment over the Grubman episode, along with regulatory reforms that were promulgated in the wake of the episode, were supposed to deter research analysts from compromising their ethical standards in the future. But today, fifteen years after the Citigroup fiasco, FINRA’s punishment of ten banks (including, ironically, Citigroup itself) illustrates that the same illegal practice plagues the industry.

Thus, as Mr. Colbert might say, the financial industry is still “saming” the world with its ethically questionable activities. Fifteen years of boom, bust, recovery, and regulation haven’t compelled the institutions to change their practices at all.

Creative Accounting: Groupon’s ACSOI Profits

Where did the phrase “creative accounting” originate?

It’s a tongue-in-cheek expression that refers to accountants who find “creative” ways to manipulate the books and make companies appear to be healthy when they are actually near ruin. The phrase was originally used in the Mel Brooks film The Producers when accountant Leo Bloom explained to Broadway impresario Max Bialystock that he could optimize his profits by intentionally producing a “flop” of a show. He could then close the show, pay the outstanding bills, and keep the significant remaining balance of his shareholders’ investment proceeds.

Although Brooks was primarily a comedian and not a financier, he had actually devised a strategy that has subsequently been applied in the real world. Some small-market professional sports teams, for instance, have been accused by their wealthier and more successful rivals of pocketing their share of league-wide revenues and then optimizing profits by refusing to sign talented (and costly) players.

Earlier this month, in another display of creative accounting, the internet coupon distributor Groupon astonished the financial markets while filing a plan to “go public” soon. Their filing plan itself didn’t generate any astonishment; rather, it was the valuation that advisors placed on the firm, and the manner in which they quantified that valuation.

Profits vs. Losses

Financial analysts have traditionally multiplied a firm’s accounting profits by a risk-adjusted multiple to estimate its value. A low-risk, low-growth firm with $1 million in profits, for instance, might be assigned a multiple of 2.0 and valued at $2 million. A high-risk, high growth firm with the same $1 million in profits, however, might be assigned a multiple of 10.0 and valued at $10 million.

The higher valuation of the second firm is attributable to its greater growth potential, a condition that inevitably attracts Wall Street investors. Those same investors, though, would take note that the second firm’s price-to-earnings ratio is 10:1 instead of 2:1; they would thus be forewarned that an investment in the second firm might carry a higher risk of failure.

What if a firm “goes public” while it is earning no profits at all? What if it is actually losing money and yet needs to value itself? Traditionally, investors would expect such a firm to develop detailed strategic plans to turn its losses into profits in the relatively near future, and thus would utilize that future profit forecast as a basis for valuing the firm.

Groupon, though, is using a novel approach to support its valuation methodology. Although it is currently incurring losses in a traditional accounting sense, it has creatively invented a new accounting term called ACSOI to restate those losses as profits.

Introducing … Adjusted CSOI!

Groupon acknowledges that it is losing money when profits and losses are measured in accordance with Generally Accepted Accounting Principles (GAAP). The firm claims, however, that its profits and losses are more meaningfully measured by a metric they call Adjusted Consolidated Segment Operating Income (ACSOI).

How does this number differ from profits and losses that are measured in accordance with GAAP? ACSOI apparently includes all of the revenues, but only some of the expenses, that are recognized by GAAP. By excluding certain significant expenses, Groupon manages to convert its losses into profits.

The expenses that are excluded from ACSOI encompass some of the most common expense items found in GAAP reports. Marketing expenses, for instance, are ignored by the ACSOI formula. So are acquisition-related expenses, stock compensation costs, and interest and taxation expenses. Groupon claims that these expenses are all unrelated to its current business of serving its core customers, but prospective investors may wish to think twice before embracing this creative accounting metric.

More Aggressive Than EBITDA

In all fairness, Groupon is certainly not the only firm that utilizes a profit measurement that is different than the traditional GAAP metric. Many analysts, for instance, utilize a measurement known as EBITDA, which refers to Earnings Before Interest, Taxation, Depreciation and Amortization Expenses. As is the case with ACSOI, EBITDA includes all revenues recognized by GAAP but excludes certain expenses, ensuring that it will usually produce a larger profit number than GAAP.

ACSOI is particularly aggressive, though, because it excludes marketing expenses. Groupon claims that its marketing activities are targeted primarily at attracting new clients and are not designed to retain current clients, and thus should be excluded from any profit measurement that is focused on current operating activity. Nevertheless, analysts have noted that Groupon’s “customer acquisition” marketing expenses are extremely high; such costs are completely ignored when excluded from metrics like ACSOI.

Ultimately, each investor must decide for himself whether Groupon actually deserves the mammoth $30 billion valuation estimate that has been calculated by analysts on the basis of its ACSOI metric. Whether you agree or disagree with that particular valuation number, you would be hard-pressed not to admire the creativity of the ACSOI metric, as well as (as Max Bialystock might say) Groupon’s sheer chutzpah in promoting it.