HP/Autonomy – how could so many smart guys get it so wrong?

HP has written off nearly 90% of the ~US$10bn it paid for Autonomy less than a year ago, alleging fraud and accounting irregularities. While we can’t comment on whether or not there was fraud or deliberate misrepresentation, some of the allegations relate to mistakes acquirers commonly make. Here’s our advice for acquirers on how to get it right, and for vendors on what to be ready for.

There seem to be two issues at work:

  • Revenue recognition: whether Autonomy overstated its performance; and
  • Alleged fraud: whether they did so deliberately in order to mislead, and how acquirers can protect themselves.

Revenue recognition:

For a SaaS business or an IT services company, revenue recognition is absolutely key – how do you allocate the value of a contract over the life of that contract? This issue not new – it was at the root of Enron’s troubles.

It gets genuinely complicated when hardware and software sales are bundled together, along with consultant time, maintenance, service and upgrades over multi-year contracts. Although this should be an objective area, and accounting standards try to make it so, there is inevitably a degree of subjectivity and approaches vary significantly from company to company. Smaller companies are least likely to account for these revenues correctly, and purchasers need to apply more scrutiny to these smaller deals.

The only way to address this is a detailed, accounting-led exercise to understand the way the revenue is built up and what’s been included, and then to re-state this in line with your own accounting policies. You should make this as detailed as you can; for example, HP has alleged that Autonomy inappropriately recognised ‘sales’ to its VARs (essentially, its distributors) – a detailed review of debtors and customers should have identified this.

In Autonomy’s case, people seem to have been querying their ‘unique’ approach to this issue for some time.

For a seller, making sure your revenue recognition policy is consistent and approved by your auditors is key to presenting it effectively and to heading off problems before they arise.

Fraud:

We can’t comment on whether Autonomy’s statements were fraudulent or not, but there are general ways in which acquirers can protect themselves from misleading or fraudulent statements by sellers. Ensuring the right level of warranty and indemnity protection is the most obvious for purchasers of private companies (this wouldn’t have helped HP as Autonomy was a public company).

Making a claim under a warranty means going after a seller who’s already received the money – and who may have spent it – so it can be difficult and time consuming. Another option is a retention, where the acquirer holds back some value for a period of time. Sellers are often reluctant to accept these, and they are much more common in deals with US acquirers.

Finally, warranty insurance may help give acquirers additional protection or reassurance, as the insurer stands behind the claim so the sellers don’t have to. There will be a question as to who arranges the insurance and who pays the premium.

We’ll post further analysis as the story evolves and more details come to light.


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