Counting Their Chickens

Equity-based transactions may save cash, but you don't always get what you bargain for.

Last summer, when Irvine, California, semiconductor maker Broadcom Corp. was negotiating to buy Altima Communications Inc., its biggest concern was the company’s relationships with its customers. As with any small company in the hypercompetitive technology sector, winning and keeping customers is everything. In an effort to strengthen its relationships, Broadcom urged Altima executives to strike product purchase agreements that gave customers like 3Com and Pace Micro Technology performance-based warrants in the company. The more products the customers bought from Altima, the more warrants they were eligible to receive.

Broadcom itself pursued a similar strategy prior to going public in 1998, and it encouraged four other private companies it acquired last year to offer such incentives to their customers. When the acquisitions were completed, the warrants were converted into Broadcom warrants. In addition, their cost, considered part of the price paid for the companies, was rolled into goodwill and amortized over a five-year period. “We and the acquisition candidates viewed these transactions as a way to promote and solidify relationships with key customers,” explained CEO Henry T. Nicholas III in a March 6 press release.

But when the Wall Street Journal and the Securities and Exchange Commission regulators got wind of the transactions, the deals were suddenly viewed in a more sinister light. Existing accounting guidance directs that any performance-based grants of shares or warrants to customers be charged against the revenue they relate to–like a cash rebate–thereby reducing the amount of revenue recognized. Because Broadcom simply dumped the cost of the warrants into goodwill instead of matching it against the revenue earned from the contracts, accounting watchdog groups like the Center for Financial Research and Analysis say the company is inflating its revenues. Ashok Kumar, a technology analyst with US Bancorp Piper Jaffray, suggests that the accounting method may have overstated Broadcom’s sales growth rate by as much as 50 percent.

Nonsense, say Broadcom executives. Only about $20 million in sales related to the agreements has been recognized by the company, and the initial accounting treatment–which the company announced it would change on March 21– was cleared with the company’s auditors, Ernst & Young. “I don’t think there’s anything to be concerned about,” said Broadcom CFO Bill Ruehle to a Wall Street Journal reporter. “Last time I checked, aggressive marketing practices were OK.”

But aggressive accounting–even the whiff of it–is another matter altogether. In a market sensitized by scores of share-price meltdowns resulting from aggressive accounting practices, Broadcom’s unusual treatment of the transactions was bound to generate bad press and SEC inquiries, not to mention the shareholder lawsuits that have lately been filed against the company.

Broadcom’s use of warrants in performance-based contracts, however, is by no means unusual. For years, New Economy companies have been testing the tolerance of generally accepted accounting principles (GAAP) in matters of income statement presentation, revenue recognition, and the capitalization of expenses. And while companies in other industries (notably the oil and gas exploration industry) have entered equity-based transactions to share risk and build relationships with customers, technology companies have taken the practice to new, ever more complicated lengths.

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