A very interesting framing of accounting by John Collison:
Patrick O’Shaughnessy: I’m curious to hear your thoughts on accounting and its need to change.
John Collison: 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.
Here is what John Collison recommends for anyone looking to study the history of successful B2B companies in tech:
Question: If someone wanted to understand kind of how we got to where we are today in 2020, what technology companies would you encourage them to study and why?
John Collison: Stripe sells to businesses, and so I am probably indexed more on boring B2B behind the scenes, content then maybe someone who is starting a consumer company. I think the history of Salesforce is quite interesting to look at, similarly the history of Oracle is interesting to look at.
There’s a good book on Oracle called Softwar: An Intimate Portrait of Larry Ellison and Oracle.
I would say there’s obviously tons of content on Google, Facebook, all the super prominent mainstream companies. I think the interesting things to think about are, one, there’s a lot of content out there that’s essentially propaganda by these companies or “the blessed accounts”. And so it’s not like there aren’t interesting facts there, but they’re probably not as interesting as the thing is the company really wished you didn’t read because they go a little bit off script as the official accounts. And those can be a little bit harder to find.
John Collison talks about the challenges of quantifying OpEx vs CapEx, and intangible capital and R&D vs tangible capital of a software company:
John Collison: 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 O’Shaughnessy: 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.
John Collison: [I like] the concept Warren Buffett introduced in his 1986 letter of “owner earnings”.
Check out the following two links about Buffett’s owner earnings:
Back to John:
John Collison: The most interesting thing about [Buffet’s] 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?
John Collison talks about why the Dot-Com Bubble is a misnomer:
People don’t really remember this, but by market cap, the 2000 bubble was really a Telco bubble and not an internet bubble — in that the run-up of the WorldCom stock’s and companies like that, it was much larger in terms of total size than all the internet companies [at the time].
There’s some good reading to be done on what happened with that. It really drove a lot, you basically had all this investments and optimism around the growth of the internet.
I think it was WorldCom kept going around with this talking point of the internet is doubling every 4 months and it felt like it was going to the moon and bandwidth and things like this. That ended up with this incredible oversupply of internet capacity, fiber especially, that then made things really cheap for when everything washed out in 2001, 2002. And as a result, it was a platform on which everything else could build [upon] during that period following.
John Collison on how history rhymes:
I was pretty interested in the cable companies that emerged in the late 1980s, early 1990s. This is like a particularly American phenomenon. It was a new technology platform, new technology paradigm, laying coax cable to all these towns across America. And you had way more television bandwidth, number of channels possible, than previously was the case. When you read it, it actually rhymes a lot with some of the technology shifts that we see.
Firstly, [there is] John Malone, who’s one of the most successful serial acquirers of all time with Liberty Media, where they basically continue to roll up small cable companies and build a very large company out of acquiring kind of small little local cable companies.
The second thing that was of course, interesting is it was one of the original kind of new technology company from out of town versus local municipalities. And it was funny as I was reading Cable Cowboy: John Malone and the Rise of the Modern Cable Business, they describe how one of the cable companies, I can’t remember who, getting into spat with a local Colorado town and changing the programming to just be “Call your mayor and tell him you want cable in your town.” And you know, exactly like the tactics Uber might’ve used, during that period when they were getting into fights with local cities.
Again, there’s a lot of history repeating itself.