Did SAP pay $3.4 billion for an out of control pup?

Summary:SEC filings show that SuccessFactors had internal control problems. How might this impact SAP results going forward?

Background

When SAP bought SuccessFactors for an eyepopping $3.4 billion, the delight among SAP senior executives was palpable. They might have overpaid for an unprofitable business turning over some $327 million at the time but in their view, SAP was acquiring the kind of go-go leadership that the company believes it needs to become relevant in the cloud part of the enterprise market. To SAP, the huge premium was worth the opportunity to make a knockout offer. It is easy to understand why. 

Salesforce.com was eating its lunch in the CRM space despite being a relative minnow in the market. SAP considered Workday  sufficient of a threat to start thinking serously about how it might counter the potential to disrupt its vitally important and world leading HR business. The on-premise solution wasn't going to cut it. SuccessFactors might only look like a line of business add-on yet SAP was sufficiently impressed with the company's momentum and the charisma surrounding CEO Lars Dalgaard to offer the company the sweetheart deal of a lifetime. 

Then there was the question of how SAP might transition from its on-premise legacy to a market leading cloud player. As a side note, bringing in cloud expertise might also have the added bonus of saving Business ByDesign. Viewed through that lens, SuccessFactors must have appeared to be the right choice. 

Was it sold an out of control pup?

SEC inquiries

SAP knew SuccessFactors was unprofitable but senior management reckoned they had a way to turn it around. In any event, even a business operating at a contracted hypothetical billings run rate of some $550 million to $600 million could be allowed to drop a few profit balls if that helps SAP maintain double digit growth. For a company with aspirations to reach €20 billion in revenue by 2015, a few tens of million here or there is a drop in the ocean. It is less so when SAP is predicting that its cloud revenues will reach €2 billion by 2015. One presumes the internal SAP judgment was that whatever they found could be fixed and SAP investors would not suffer.

What was not immediately apparent at the time but which is revealed in SEC filings is SuccessFactors had internal problems that are not magicked away so easily. 

On December 10th, 2010, SuccessFactors responded to an SEC inquiry about a number of topics. One relates to what SuccessFactors calls 'backlog.' This is a term used to describe an item which the company had been keen to convey as detail related to its business. In layman's terms 'backlog' broadly represents the difference between what SuccessFactors accounts for as revenue, actual invoiced amounts and the total anticipated contracted billings achieved from deals done in the reporting period. From the SEC inquiry:

We note that your Overview section no longer includes a discussion of “backlog,” which you had defined as the portion of future subscription fees under non-cancellable subscription agreements that have not been invoiced and accordingly were not yet reflected in deferred revenue. The inclusion of this information in previous filings provided investors with additional insight to the company’s future revenue streams that could not be obtained from the current financial statements as such information was not included in your deferred revenue balances. These disclosures also explained some of the differences between arrangements with large and small customers as well as the relationship between contract execution, billing and revenue recognition. Please tell us your consideration for including these disclosures in future filings or why you believe such disclosures are no longer useful or relevant to an investor. In this regard, to the extent that your subscription sales to new and existing customers are expected to impact the variability of your revenues and results of operations, both a quantitative and qualitative discussion of such rates would seem useful in evaluating your operating performance. We refer you to Section III.B.1 of SEC Release 34-48960.

The company responded by saying:

The Company chose not to include the backlog reference in the referenced filing, as it did not believe that this was a material metric based on its interactions with investors. However, the Company will include backlog in its upcoming Annual Report on Form 10-K for 2010.

The current climate of creative accounting

Why does this matter? Two reasons. First, in the latest earnings call with Jim Snabe, co-CEO SAP, he said that rather than concentrate on GAAP earnings, Lars Dalgaard CEO SuccessFactors prefers to talk contracted value.

Second, many of the newer companies that are cropping up on NYSE/NASDAQ have been quick to pick up on alternative ways to present financial information that is outside the normal GAAP accounting requirements. They have latitude to do so provided what they say and do fall within SEC rules. Last week, Vinnie Mirchandani opined:

Luca Pacioli, considered the father of double entry bookkeeping with debits and credits, would be fascinated with Facebook’s first ever quarterly earnings report, particularly this footnote with all kinds of interesting metrics and modern day shenanigans.

When I saw the Facebook analyst presentation I was horrified. The meat of the presnetation barely bore any relationship to a financial statement that I recognise and senior Facebook leadership steered clear of any meaningful discussion about the numbers. It was almost as though they were an incidental discussion topic. They are of course free to do that and it has become common practice to steer analysts towards non-GAAP measures - i.e. those the company wants you to believe but which are a larded version of what the SEC demands for filing purposes. Why does this matter re: SuccessFactors?

Analysts dont like numbers they dont understand. The stock price gets punished. Facebook's stock price is but one example. In other words, creative accounting and non-standard methods of communicating results to the market comes at a price. Get it wrong and the price takes a beating. 

Understanding SuccessFactors revenue recognition issues

SuccessFactors wanted the market to understand the importance of its contracted revenue and potential future billings. Analysts have claimed it is hard to gain insight into SaaS and cloud company revenue forecasts because the subscription model is so very different from the 'throw the CD over the wall and get paid' model. In essence, SuccessFactors wanted the market to believe in its analysis as it went through the 'fake it to make it' period post IPO. 

It can get difficult and cumbersome to find good predictive measures when contracts run multi-year and may have get out clauses. Don't believe all this non-cancellable contract stuff. Contracts get negotiated to exit as well as onboarding. It gets even more complicated when companies are making many acquisitions as was the case for SucessFactors in both 2010 and 2011. In response, many vendors, SuccessFactors included, use some variation of a broad billings measure as a way to steer analysts, hopefully in the right direction while at the same time find a formula that allows them to stay GAAP compliant. It's not a bad measure provided the parameters, assumptions and guidelines underpinning the methodology are well understood. I don't believe that was the case here as evidenced from the SEC inquiry. 

If analysts were gaining insight into predictions based upon this measure why was it suddenly dropped? SuccessFactors does not provide a good reason but then agrees to re-instate - at least for FY2010. Its 10-K for that period duly provides guidance. So at this point you might argue it is in compliance. Hold on a moment. 

Switching auditors

2010 was the year that SuccessFactors switched auditors from Ernst & Young to KPMG. Both gave it a clean bill of health.  That was also a year when SuccessFactors changed its method of accounting for income, in part because of a change of rules but also in part because its business had become more complex. I asked Francine McKenna for her interpretation of the accounts and inquiry because in places I was struggling to work through the financial double speak. As far as I was concerned, the explanations given to desctibe how SuccessFactors was measuring GAAP revenue were borderline nonsensical, even taking into account the complexities of acquisition and acquired business models. She said in email:

The issue about allocation of selling price in multiple deliverable arrangement is one of the most often discussed for software vendors, especially business software vendors that bundle software in a deal all at once with multiple modules, maintenance, consulting, etc.  It's what vendor after vendor has been caught on and it's a perennial topic for software vendors to be questioned on if they are not good at describing a very tight, very constant method for deciding how they would price each component alone of it was not bundled before recognizing the revenue when they close the deal.

[My emphasis added]

Some may argue that the SEC rules are overly complex or capable of interpretation. I come from an old school accounting background that says you can always identify components inside a bundled deal. If you want to.

OK - so we're not seeing any smoking gun but we are seeing potential difficulties. As we will see, aspects of these changes, or rather the controls around them, came back to haunt SuccessFactors in 2011.

Regardless, a change of auditor in these circumstances is at best 'unusual.' Along with some colleagues, I regard a change of auditor in these circumstances as something of a red flag. It can - and I stress can - mean a fundamental disagreement between auditors and internal staff. It can also mean the company is looking to overcome an accounting issue and what better way than to bring in a firm that has little or no background on the business? However, in recent years, auditors have gotten such a bad reputation for being asleep at the wheel that few people ever really question what's going on. It is not uncommon for analysts to simply skip the audit report. 

As an example, Groupon has had its own issues around the creative use of financial metrics designed to make the company look good where in practice they backfired...until their results were re-written. Francine McKenna follows these topics assiduously. At the time of the Groupon issue she said:

...the premier source of daily deal dish got knocked down a few more pegs after announcing a revision to 4th quarter earnings and the announcement by management that there was a material weakness in internal controls over financial reporting that was causing their disclosure controls to be ineffective.

She then goes on to demonstrate how Ernst & Young developed disclosure methods that can best be described as 'interesting.'

Ernst & Young published a model “ reliability disavowal” disclosure in its implementation guidance in 1995 to help clients mitigate the impact of the required disclosures under SFAS 123, a standard adopted by most firms in fiscal 1996. The firm also “encouraged companies to adopt the supplemental disclosure if they believed it would be useful to investors and creditors.”

That is, Ernst & Young encouraged and aided its clients in telling investors, “We have to tell you this but we don’t trust the calculations so look over here instead.”

At this point many readers will be glazing over. Push on, this is important stuff. 

Misstatements in SuccessFactors accounts

The SAP acquisition was not completed as quickly as everyone would have liked. The net result and almost unseen by everyone was the fact SuccessFactors was obliged to file a 10-K for the year to 31st December 2011. By this stage, things had become more interesting. The 10-K report says:

Our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of our fiscal year, December 31, 2011. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures as of December 31, 2011 were not effective because of the material weaknesses described in Management's Report on Internal Control Over Financial Reporting below.

[My emphasis added.] What was the problem?

The Company's control related to the review and approval of the accounting for significant and unusual transactions did not operate as designed. As a result, the Company did not identify on a timely basis a liability of $2.9 million related to professional services received from an investment banker that should have been accrued for at year-end. This material weakness resulted in a material misstatement of accrued liabilities and general and administrative expense that was corrected prior to the issuance of the Company's consolidated financial statements.

The Company did not have appropriately designed controls in place to evaluate the application of certain accounting policies related to professional service revenues. This material weakness resulted in the Company not appropriately evaluating the impact to their consolidated financial statements of the method used in transitioning certain contracts from completed contract method of accounting to the proportional performance method of accounting. As a result of this material weakness, there is a reasonable possibility that a material misstatement of the Company's annual or interim consolidated financial statements would not be prevented or detected on a timely basis.

[My emphasis added]

The liability in the second paragraph is not defined but could easily relate to commissions. In addition, the backlog numbers which were reported in 2010 had, once again, disappeared. SAP closed the SuccessFactors acquisition on 16th February, 2012. KPMG issued an adverse audit report dated 16th March, 2012. 

That means SAP would likely only have known about the adverse report and management admission AFTER the acquisition was concluded. I suspect that with all the excitement around the deal, some aspects of due diligence were either sidelined or at the very least, rushed through. That's not uncommon. Neither is it uncommon as Ms McKenna implies, for companies to misunderstand how SaaS/cloud revenues (and by implication, expenses) need recognising. Even a company as seasoned as SAP can trip up on this. 

There is another explanation. SAP could have become aware of the problem as part of due diligence and insisted on the note in the accounts and inevitable qualification as part of its negotiation with SuccessFactors. That would mean when it reports to the SEC, SAP can demonstrate that it is cleaning up SuccessFactors books. 

SuccessFactors' frenetic pace

Is there anything else? It is difficult for example to tell whether the change in accounting treatment for revenue impacted the bonus allocations to sales staff. However, the 2010 inquiry did ask a pertinent question about "additional analysis of the effect of individual performance on cash bonuses and stock option and equity awards." Now and again I hear of complaints in that direction but nothing that has so far been proven as fact. What's most likely is that SuccessFactors attempted to keep sales people onside even as it was going through a period of rapid change. If correct then that would have impacted operating income. Again however that is difficult to discern because SuccessFactors acquisition strategy introduced all sorts of new factors that inevitably make like for like comparisons difficult for outside observers. 

A few comments about the company from the Glassdoor provide some insights into the frenetic pace at which SuccessFactors was operating. One reviewer says:

Pros – Culture of execution. We believe we can do anything. It's not perfect but everyone believes in what we do and the value our solutions provide.

Cons – Lots of change. Comes with the territory in the software world. If you're not changing and evolving, you become stagnant. We are definitely not stagnant.

Advice to Senior Management – Take it easy on all the change at once. Talk to the people that have been around from the beginning to make sure you don't lose the culture which is our DNA.

The 'lots of change' theme rings true with many of the reviewers, some more scathing than others. In that type of environment, anything can go wrong and often does. It is in the nature of speed and growth where all sorts of gotchas creep up on management, often without their knowing about it until it is too late. Some of these can be fatal. More often than not it is a combination of poor management and slack controls that catch up with a company which is ultimately put on an even keel but with major internal disruption. 

Again, why does this matter? During 2010 and 2011, SuccessFactors was something of a revolving door. According to one reviewer, turnover among sales staff was 50% in a six month period during 2010. Bad luck or something else? A tech vendor CMO once told me that his problem with sales people was the 70% of D grade students they had to nurse along. It's a common theme I have seen repeated elsewhere. In some companies it is practice to cull the bottom 10% each quarter. But when sales staff are turning over that quickly, something has to be awry. 

Short interest

During 2010 and 2011, SuccessFactors was consistently among those stocks where there was considerable short interest. In other words, some people thought the share prices was due for a tumble. The main reasons are attributed to continuing operating losses at the GAAP level, compensated for by stock based compensation that serves to boost cash holdings  in the absence of paying cash bonuses. This article at Seeking Alpha sets out the reasons why this happens and SuccessFactors part in the tale. This extract from 2011, shortly after the SAP acquisition announcement provides an indication of the activity around SuccessFactors both immediately before and after the announcement. 

My sources tell me that while institutional investors were trying to shore up the stock price, individuals inside the company were aware that all was not as well as it could be and were trying to get out of their holdings. The extent to which this is true will never be known and as it turns out SAP rode in to save the day. Even so, it is yet another indicator that SuccessFactors was experiencing problems. 

Fast forward: Q2 2012

In my preliminary analysis of SAP's Q2 2012 results , I had trouble figuring out how the cloud related figures work. My initial conclusion was that they were going backwards rather than forwards, a point I made to co-CEO Jim Snabe. I suggested this was possibly as a result of an accounting difference that had yet to wash through. He said "You are right" adding that SAP knows it has to do a better job of providing transparency into cloud earnings.

While re-assuring to hear, that left me none the wiser. Analysts at Morgan Stanley took a stab at it and reckon they are looking at north of 50% growth based upon the assumptions they were making at the time. Having reviewed those assumptions on their face, I would tend to agree there was at least significant growth but as I have said on many occasions I am not a fan of non-GAAP measures as a starting point. They are riddled with problem that can make meaningful comparisons and analysis very difficult. That's not to say my inital analysis was without flaw. However, in light of the reported material weakness, it is now even more difficult to be certain what we should be looking at. 

After publishing several articles on this topic I received a stream of emails from sources 'close to events' who encouraged me to look further. That proved more troublesome than should be the case. It was once I found the old 10-Ks plus related inquiries that things got interesting. 

In light of the SEC filings and inquiries, fresh questions emerge:

  • Was SAP aware of the initial SEC inquiry and did it ask enough detailed questions to satisfy itself that it understood the basis upon which SuccessFactors was accounting for revenue?
  • Was SAP aware of the material weakness that KPMG must have discovered? KPMG are also SAP's auditors of record.
  • What measures did SAP take to ensure that the price it was paying fairly reflected the impact of any possible mis-statements and material weakness?
  • How will SAP explain SuccessFactors revenue in a way that provides sufficient transparency into its financial statements?
  • To what extent has the move to Business ByDesign improved financial control over the company?
  • What is the impact arising out of the control weakness on recorded expenses and thereby profitability both as recorded and predicted?

I put those questions to SAP along with some context and Ms McKenna's note. SAP declined to comment. 

Concluding thoughts

Truly successful acquisitions are few and far between. Acquisition of a cloud player when you don't have experience of a cloud pure play carries many risks, regardless of the willingness of the acquiree to become part of the enlarged family. 

I find it hard to believe that at least some if not all the questions I am now raising have not come up in discussion between SAP and SuccessFactors' management. What is less clear is how SAP will manage SuccessFactors so that it can continue to grow apace but without running aground on measures that while designed to paint a specific growth picture will be difficult to mesh with SAP's current reporting methodology. 

It would not surprise me if there were a slew of problems, some minor, some major in the assembly of SuccessFactors accounts. Francine McKenna has already demonstrated that in fast moving situations, it is all too easy for growth companies to slip up. I saw something similar the other week in a pending acquisition case upon which I was consulted. A material contract was not what it seemed. The shape of the deal seriously threatened to torpedo acquisition ambitions. 

SAP managed to close off the SuccessFactors Q2 2012 books using Business ByDesign but that's not the same thing as arriving at a conclusion about how revenue, expenses and ultimately profit is earned or compared with past periods. Similarly, this opens up important questions about whether SAP paid the right price for a company that had problems sufficiently serious to merit audit attention at a time when it was repeating the original offer price following regulatory hold ups in concluding the deal.

As the old saying goes: marry in haste and repent at leisure. 

Topics: SAP, Enterprise Software

About

Dennis Howlett has been providing comment and analysis on enterprise software since 1991 in a variety of European trade and professional journals including CFO Magazine, The Economist and Information Week. Today, apart from being a full time blogger on innovation for professional services organisations, he is a founding member of Enterpri... Full Bio

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