A very interesting framing of accounting by John Collison:
Patrick: I’m curious to hear your thoughts on accounting and its need to change.
John: If we imagine we’re the product manager for accounting. Let’s imagine we’re just hired by the agency that manages GAAP — the accounting principles.
Like any good product manager we start with, “Okay, well, what are the jobs to be done here? Who’s our target customer or target persona?” And it’s interesting to think about.
We’re actually trying to do a number of different jobs with accounting:
- We’re trying to figure out how much profit we earn so we know how much tax we have to pay. That’s one job we have.
- We’re also trying to help the business run itself. We’re trying to provide a view of the business to managers so that we can determine whether we need to invest in new machinery to be more efficient or something like that.
- We’re also trying to solve for the needs of creditors, where people want to be able to evaluate the business and understand will it have enough money to pay off its debt.
- We’re also, importantly, trying to solve for the needs of equity holders, where they’re trying to understand what are the long term cash flows for this business going to be.
John Collison talks about the challenges of quantifying OpEx vs CapEx, and intangible capital and R&D vs tangible capital of a software company:
Accounting standards are invented by us humans to give us a view of a business and they’re up to us to choose. They’re generally in kind of long boring committees, but we humans choose how we look at businesses. I have absolutely no patience for the crowd that’s all this winging about non-GAAP metrics. [In fact, the GAAP standards are just] relatively arbitrarily chosen and constantly tweaked set of standards for looking at a business. If they’re constantly tweaked, presumably you would expect that they can be improved upon.
One of the areas in which I think the standard way we look at businesses is just completely wrong, is in reasoning about R&D and intangible capital.
Capital has really moved over the past 100 years away from heavy machines to intellectual capital and intangible capital. Traditionally, if you read a balance sheet and a company has a bunch of stuff, then it has a bunch of assets on its balance sheet. If you’re a cafe, maybe your assets are the coffee machine, maybe a really expensive coffee machine. These days with technology businesses, what are the capital within the business? One of the assets that the business have, it’s probably software that has been developed in house by the business. At Google, for instance, it is the search engine that’s it. Now for 20 years, Google engineers have laboriously worked on to make it good.
Capital used to be about something really tangible, like an espresso machine. Something you can reason about its value really easily. Its value doesn’t change that much over time, and there’s a clear market for it. You could go out and sell this espresso machine for some amount of money. So, one of the accounting principles is that you just carry things at cost, before depreciation. But it’s really hard to reason about the value of intangible capital, like Stripe Radar, how does the value of that system that we built?
The reason this gets interesting is because you and I might very reasonably want to think about: What is the profitability of a business after you strip out all the investment in future growth? Because as you look at the technology sector, one of the things that kind of unifies technology companies is that they don’t tend to produce kind of huge amounts of cash flows until later in their maturity. Companies that are in their growth phase, either pre-public companies or recently public companies tend to be mostly reinvesting in growth.
As we look at how accounting works for this, it’s really basic. All you have is companies that are spending lots of money on operations, engineering salaries, operation salaries, lawyer salaries, kind of the general OpEx, and no real intelligent view on what is the capital that we’re developing. What is the multi-year value that we’re getting from this system that we’re building versus what is the actual ongoing cost of operating the system?
And so that’s something that we spent a lot of time at Stripe getting good internal management views into is as a system-by-system, line-by-line level. How much are we investing in kind of the future potential of this system vs. What is the existing profitability of the system? What is really the core question for a technology business which is: How much are you paying to operate this business, versus how much are you investing in a long lived technology advantage?
Patrick: Everyone will pay a lot of lip service to the concept of free cashflow, but I think for all the reasons you’ve pointed out, it’s a very hard metric to get to. And then there’s also just silly concepts. What is the useful life of a piece of software? Like how do you even reason about something like that? And therefore, think about something like depreciation. A lot of what is registered as operating expenses in a business is kind of like what we used to call capital expenses, because it’s going to be useful for a long time. And I think this is an important, it’s a really important topic for public investors with more of these businesses due to become public.
The most interesting thing about that definition for me was splitting out the two forms of CapEx. CapEx spend that has a multiyear horizon or a multiyear payoff is split out into:
- CapEx into what is just needed to tread water, investment required for the company to keep same competitive position and keep its unit volume
- CapEx required to expand
We haven’t fully chased it through [in Stripe], but I think that’s a really interesting distinction.
Buffett obviously always talks about the example of the textile mill that Berkshire Hathaway got its start with. It was such an incredibly terrible business because you were spending all this CapEx just to tread water, just to stay in place.
I think it’s important for companies to be honest with, I mean, not only external investors, but companies be honest with themselves on this. Is this spend just the cost of doing business, the cost of operating our business, and we are maintaining our competitive position or are we expanding in some way? Are we growing our share of market? Are we expanding to a new country? Are we developing a new product that will monetize separately?