Source: Open Clipart
Over the past decade and a half the tech industry has quietly added over $60 billion onto its collective balance sheet. Where did that money come from? And where did it all go? The money is hiding in plain sight, on a balance sheet line called “goodwill.” Goodwill is created when a company pays a premium for another company. It’s a way to lump all the “good” items together that make an acquisition worth more than its bricks and mortar. Suppose a hardware store pays $5 million for a neighboring store—they want to create economies of scale. But the other store only has property and equipment and inventory worth $2 million. The remaining $3 million would go onto the purchaser’s balance sheet as goodwill.
Well, in Silicon Valley there’s a lot of acquiring going on right now. In fact, that’s the dominant business model: conceive of a bright idea—like ride-sharing or house-sharing or some e-commerce niche; raise funds, higher some people, ramp up production; then look for a tech giant like Google or Facebook or Amazon or Apple to buy you out. There isn’t much tangible value to a tech startup—just computers and desks. Most of the buyout price goes into goodwill.
Goodwill in S&P Tech sector. Source: Bloomberg
Only, what the giants are doing isn’t buying companies. They’re buying engineers. They purchase firms like Two Big Ears or Offerpop or Fly Labs or Bandpage—startups you’ve probably never heard of—for $10 million or $50 million. The terms aren’t disclosed. Facebook doesn’t care about the software, they just throw that away. What they just did is hire some proven engineers, signed them to a contract, and paid them a signing bonus.
Now, there’s nothing wrong with signing bonuses. Firms use them all the time to attract scarce talent. But normally these expenses are, well, expensed. They’re part of the income statement, they count against revenues, they’re the caught in the net of net income. But not when they’re part of a buyout premium.
In these cases the premium becomes an intangible asset on the acquirer’s balance sheet and it never has to amortize. As long as the acquired asset has potential value, it can be carried on its new home forever.
Why would tech giants with hundreds of billions in market cap seek to hide a few hundred million dollars of expenses on their balance sheets? Why not? If the accounting rules let a stack of hundreds fly around on the street, why not stoop and pick them up?
But what accounting gives, accounting can take away. Bookkeeping gimmicks won’t disguise whether economic value is created or not. The proof of the pudding is in the eating. And if their hired guns can’t deliver higher revenues and earnings, that goodwill will become “bad will” pretty quickly.
Right now the four tech giants mentioned above (Google, Facebook, Amazon, and Apple) have almost $50 billion in goodwill on their combined balance sheets—about half of last year’s collective net income. Right now the markets are showering them with praise, inflating their multiples as they squeeze revenue and earnings growth out of our slow-growth economy.
Photo: Davide25. Source: Pixabay
But these high-flyers had better keep soaring. Because if the air starts to come out of all those inflated assets (and engineers), it won’t be pretty.
Douglas R. Tengdin, CFA
Chief Investment Officer