The reason the Demand Media IPO has been delayed, Kara Swisher says, is that the regulators are taking a closer look at the company's accounting.
As well they should.
Because it's unusual.
It's also the difference between the company being "profitable" and losing money.
What is this accounting?
The capitalization of editorial costs.
Demand Media doesn't expense the cost of paying its army of freelance writers when it pays them. Instead, it capitalizes the costs and spreads the expenses over five years. This makes Demand Media's bottom line look vastly better than it would look if Demand Media did what just about every other publisher does, which is expense editorial costs when they are incurred.
To take a simple example, let's say a particularly productive Demand Media writer earns $100,000 a year. (Bear with us...) Instead of taking the writer's compensation as a $100,000 expense in the year in which the writer is paid, Demand Media expenses only $20,000. Then it expenses another $20,000 in each year for the next four years. This has a marvelous impact on the bottom line.
If Demand Media earned, say, $25,000 this year on the writer's content this year--and if the company expensed the writer's costs as incurred--its financial statements would look ghastly:
REVENUE: $25,000
COSTS: $100,000
LOSS: - $75,000
So that's why Demand Media spreads the cost over five years:
REVENUE: $25,000
COSTS: $20,000
PROFIT: $5,000
Voila! "Profits."
(Don't you wish YOU could do that? Think about how much different your personal financial situation would be if you could do your household expenses that way.)
Now, Demand Media argues--reasonably--that the writer's content may have value for several years. And, therefore, it continues to argue, it is okay to recognize the cost of producing the content over the years that it has value instead of immediately.
Importantly, this is a theoretically reasonable argument. It attempts to "match" costs with value, which is what many accounting choices do. It's the way companies account for things like buildings and factories, for example. And no one complains about that accounting.
But here are the problems with this accounting choice:
- It's unusual and aggressive. Other publishers don't account for editorial costs this way. (Yes, movie studios do, but Demand Media isn't a movie studio. It's a web-based content company. And we now have 15 years of precedent that web-based content companies expense editorial costs as incurred).
- It makes the company "profitable" when it's actually burning cash, so it is obviously a choice made to spruce up the financial statements.
- It leads to an instant argument/interrogation about how long a writer's content will ACTUALLY be valuable (and Demand Media hasn't even been around for five years, so confidently saying "five years" begs more questions, especially given how dependent the company is on Google for traffic and monetization. What happens if Google changes its algorithm to punish content companies like Demand Media?)
- It is an EASY knock against a company that is controversial anyway
For these reasons, Demand Media should just drop this accounting immediately.
And because none of Demand Media's well-compensated advisors seem to have had the balls to deliver this message, we'll just go ahead and explain why.
One reason Demand Media is accounting for its content costs this way is presumably because Demand Media's IPO advisors--Goldman, Morgan Stanley, etc.--have informed the company that it will get a better price for its stock if it is "profitable." And that may be true. But it's still a shortsighted decision.
If Demand Media presses on with this accounting treatment, here's what's going to happen:
Every shortseller and skeptic about Demand Media is going to hold forth about this issue every time the company comes up. Every time Demand Media speaks at an investment conference or holds any company conference calls, this issue is going to come up. Every time a journalist writes or talks about Demand Media, this issue is going to come up. Every time the SEC looks at Demand Media's financial statements, this issue is going to come up.
It's going to get to the point where every time any investor or pundit thinks about Demand Media, the first thing that he or she will think about is, "Ah, yes, Demand Media, the controversial company with the bogus accounting that makes it look profitable when it actually isn't."
And although the stock may go up for a while, if there's ever ANY problem with the business, the "bogus accounting" story will take over, and shortsellers will move in for the kill.
Demand Media has enough revenue and momentum now that it should be able to go public even while still losing money. If it can't--if its underwriters and management can't convince investors that the model works even using conservative accounting--then it should just postpone the IPO until it can.
This is especially true because using aggressive accounting will hurt the company's stock price. Expensing content costs over five years is not conservative accounting. It's aggressive accounting. And many investors just avoid companies that use aggressive accounting, thus leading to less demand for the stock.
So here's our (free!) advice to Demand Media:
Just drop the aggressive accounting. It may get you public, but you'll never hear the end of it. It's a shortsighted decision. And the issue is not going to go away.
