An SEC Probe of Groupon Could Help Tame the Tech Bubble

Last Updated Jul 28, 2011 1:46 PM EDT

Looks like Groupon might have to explain more about its accounting to the SEC. Apparently the way it defines gross profits and a way of looking at performance that it calls adjusted consolidated segment operating income, or adjusted CSOI, aren't getting a warm and friendly embrace from regulators.

Nor should they. Some in the tech industry argue that there is no bubble. But they are insiders who invest early and cash out at an IPO or acquisition. When valuations race ahead of what companies' s performances can justify, you've got the makings of a bubble. Warping or even inventing accounting terminology to dazzle the reader and perpetuate an inflated view of operations throws gasoline on the fire. If the SEC can halt or at least slow the practice, it's good for not only investors but the industry.

The captain readies his personal life raft
Metaphorically speaking, Groupon has the whiff of aging fish. In January, the company raised nearly $950 million in additional venture backing "to fuel global expansion, invest in technology, and provide liquidity for employees and early investors." But the emphasis was on the latter, as Peter Kafka wrote at All Things Digital
Out of the actual $946 million obtained, $810 million went to CEO Andrew Mason and backers like Eric Lefkofsky. There should be no surprise -- in April 2010, the company took in $130 million and paid out $120 million to insiders. Click the link to Kafka's piece for some of the salient details.

When founders and early investors push so hard to cash out in advance of an IPO, you have to wonder whether they know something that potential investors ought to know. At the very least, it suggests a lack of confidence in the business.

Running hard to stay in place
The world of commerce has developed standard accounting practices -- generally accepted accounting principles, or GAAP, in the U.S., for example -- so people can speak a common fiscal language. When a company plays with the definitions, it's not for fun. It's because the financial black and white picture isn't flattering. And Groupon has been a veritable cruise ship recreation director in this regard.

The adjusted CSOI figure leaves out some enormous expenses, like online marketing to acquire new customers, acquisition-related costs, and stock-based compensation. This can make quite a difference. In 2010, Groupon's GAAP operating loss was $420,344,000. After the adjustments, adjusted CSOI was a positive $60,553,000. That's a swing of nearly $481 million.

Groupon argues that the figure is important because it "excludes certain non-cash expenses and discretionary online marketing expenses that are incurred primarily to acquire new subscribers." However, Groupon resembles a Ponzi scheme, as my BNET colleague Jim Edwards has pointed out:

Groupon takes in a positive amount of cash because it collects payments from its consumers immediately and doesn't give the spas, cafes and yoga studios who made the offers their share of that money until a later date. Groupon gets to keep the "float," in other words. As Groupon is growing quickly, this float allows the company to stay in the black even while it services its consumers and merchants at a net loss.
What keeps the company going is the constant growth of new merchants and new customers, which seems like a pyramid scheme. Once that stops, unless it can get all of its expenses under hand, Groupon might find itself grinding to a halt.

It depends on the meaning of the word "profit"
The other item grabbing the SEC's attention is the term gross profit. It's not that the term gross profit is unheard of. Yahoo (YHOO) uses it to indicate revenue less the cost of acquiring that revenue from third parties. But for Yahoo, payments to third parties (traffic acquisition costs) are only part of revenue cost. The company recognizes other components, like stock-based compensation.

Groupon, on the other hand, says that cost of revenue "primarily consists of the amounts paid to and accrued for our merchants associated with the sale of Groupons [deals]." There may be other significant costs that don't get represented, making the basic business look stronger than it is.

Supposedly, Groupon is ready to drop the accounting twists if the SEC insists. Here's hoping it does. The tech sector took years to rebuilt after the previous bubble. Now that real IPOs are again possible, it's in the industry's interest to keep investor confidence by having accounting descriptions that are on the up and up.

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Image: Flickr user pheezy, CC 2.0
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    Erik Sherman is a widely published writer and editor who also does select ghosting and corporate work. The views expressed in this column belong to Sherman and do not represent the views of CBS Interactive. Follow him on Twitter at @ErikSherman or on Facebook.