by Boris Feldman
The Industry Standard (March 2000)
If absolute power corrupts absolutely, what does absolute wealth do? The wealth at stake in the Internet revolution will tempt some citizens of "The New Dotconomy" to cheat. As dot-coms go public, their executives often feel pressured to maintain their astronomical stock prices. Most will resist the temptation to inflate results. Some will not.
The management at Internet companies tends to be less seasoned than at other public companies. Historically, senior executives at public high-tech companies brought years of experience (and ethical grounding) from respected industry leaders, such as Hewlett-Packard (HWP) or IBM (IBM) . At many Internet companies, the management team lacks such experience. Their youth, combined with meteoric and fluctuating net worths, can lead to unchecked temptations.
In place of the accounting fraud that has occurred at some high-tech companies, Internet companies will confront a different danger, which I call "metrics fraud." Generally Accepted Accounting Principles are of limited relevance to the market valuation of many Net companies. At least so far, most Internet companies have not been valued on traditional income-statement measures. Rather, in search of the next Yahoo (YHOO) or Amazon.com (AMZN) , the stock market is groping for the right yardstick by which to evaluate the dot-com's success. For some, the metric is "hits-per-month"; for others, "connected desktops." Some tout the "stickiness" of their Web site. Others emphasize the number of return visits or unique visitors.
Many of these metrics are sound ways of valuing the company. But these metrics are rarely governed by GAAP. Thus, no established rules are keeping score on them. Different companies may sling the same metric while measuring it in radically different ways.
Unlike items on an income statement or balance sheet – such as revenue or accounts receivable – metrics are subject to few safeguards against error. Internet companies rarely have internal controls governing the collection or calculation of the metrics. In a traditional company, it is difficult for an employee to falsify sales; elaborate controls have been established over the years to provide reasonable assurance that a revenue entry in the general ledger reflects a product that has actually shipped and for which a customer has been invoiced. In contrast, many Internet companies take an employees' report of a particular metric as true, without any formal verification system.
Compounding the risk, a company's outside accountants almost never audit these metrics. Auditors focus their energy on financial statement items that are governed by GAAP – not on metrics that appear in a press release and not an income statement. As a result, if an employee exaggerates a metric, he is less likely to be caught in the audit process.
Thus, the temptation to fudge the metrics will be as strong to some as the pressure to ship after the quarter has been to executives at companies where earnings have been restated – but the ability to do so undetected is greater for non-GAAP metrics. What can an officer or director at an Internet company do about this? Drill down into the company's metrics. Ask management: What are your key metrics? Does the market agree with you that those are the most important ones? How do you measure them? Does anyone verify them? Does anyone audit them?
Above all, the company should fashion internal controls to ensure that no one manipulates the key metrics. Financial executives in the Internet industry need to create controls that parallel those in place for GAAP issues. Dot-coms should expand their engagement of outside auditors to cover key non-financial-statement metrics, along with traditional GAAP items. Moreover, audit committees of the board of directors need to expand their charters to include Internet metrics in the items scrutinized by the audit committee. Implementing these safeguards may ensure that the time you spend with lawyers involves raising capital, not attending depositions.
Boris Feldman is a partner at Wilson, Sonsini, Goodrich & Rosati in Palo Alto, Calif. This article represents his views, not anyone else's.