Inside Idealab: A Confusing Fiscal Formula
Thumb through the financial statements for Idealab and you’ll be left with the impression that the company is a cross between an auto dealership and a mutual fund that is hemorrhaging hundreds of millions of dollars.
In fact, under Chief Executive Bill Gross, Idealab has created more than 30 Internet companies that sell everything from cars to cosmetics to cookware. And despite the fact that none of Idealab’s companies is profitable, in its most recent fiscal year, which ended Jan. 31, the Pasadena business incubator made a whopping profit of $118.5 million.
Welcome to the accounting wonders of being both a creator and a holder of “dot-com” companies.
With interests ranging from free Internet service provider NetZero Inc., to online retailer EToys Inc., to online bill payment firm PayMyBills.com, Idealab doesn’t fit neatly into any well-defined corporate mold. Its financial inner workings, detailed recently in documents filed with the Securities and Exchange Commission for its initial public offering, are about as murky as a speech by Alan Greenspan.
Because of accounting rules, Idealab can’t simply add up the revenues and profits of all its offspring companies and list them on its own balance sheet. Instead, Idealab divides its companies into three categories, which then contribute in different ways to Idealab’s overall results.
To make matters more confusing, one of Idealab’s primary sources of revenue comes from collecting management fees for its venture capital funds. Likewise, Idealab’s gains from selling shares in its public spinoffs can count toward its overall profit but not its revenue.
Idealab isn’t the only company forced to
describe its “new-economy” business using “old-economy” accounting rules. Publicly traded Net incubators like CMGI Inc., in Andover, Mass., and Internet Capital Group Inc. of Wayne, Pa., face the same predicament.
But analysts complain that these incubators’ financial statements do a poor job of describing their true financial health.
“When you look at the income statements of these companies, they don’t really reflect much of the underlying partner companies,” said John Ederer, a senior research analyst for E-Offering in San Francisco. “When you look at their income statement, the revenue line means absolutely nothing.”
Consider that Idealab’s 198 employees are just a fraction of the total work force among its portfolio of 30 companies. Altogether, those companies boast revenues in excess of $1 billion. Yet Idealab’s own revenue in its most recent fiscal year was only $18.6 million, and that was up dramatically from $459,000 in revenue in 1999 and $154,000 in 1998.
This imbalance occurs because Idealab owns pieces of many companies, and arcane accounting rules slot those investments in three categories, based on the size of Idealab’s stake. Of those categories, only “consolidated” firms--those Idealab owns at least 50% of--contribute directly to its revenue. Idealab currently has eight “consolidated” firms.
Of those, the biggest revenue contributor is online auto seller CarsDirect.com Inc., which generated $15.2 million in revenue in fiscal 2000 and is 66% owned by Idealab. CarsDirect.com takes orders on its Web site, then acquires the appropriate cars from dealers. Once a car is in hand, the company resells it to its Web customer.
Some analysts believe CarsDirect.com is actually an auto broker and should only count as revenue the difference between what it collects from customers and what it pays to dealers for the vehicles.
But Idealab argues that CarsDirect.com is entitled to count a car’s entire purchase price as revenue because it bears some risk in buying cars from dealers. A CarsDirect.com customer can back out of a sale before his car is delivered, but CarsDirect.com can’t return undeliverable cars to dealers. Canceled sales could leave the company stuck with vehicles worth tens of thousands of dollars.
Other Net retailers use a similar practice. Priceline.com Inc. records as revenue the total amount of money its customers spend buying travel services on its site, even though it only keeps about 12 cents of each dollar after paying others to procure airline tickets, hotel rooms and rental cars.
Still, some critics charge that the real goal of CarsDirect.com and Idealab is to maximize their revenue numbers. Revenues are doubly important, because in the absence of profits for money-losing Internet firms, many analysts use revenue numbers to calculate appropriate stock prices, said Patricia Hughes, head of the accounting department at UCLA’s Anderson School of Business.
The big sources of Idealab’s profit last year were stock sales, especially from trimming its stake in EToys, the Santa Monica online toy retailer it started three years ago. On Dec. 31, Idealab sold 3.8 million EToys shares for a gain of $193 million. Idealab also bagged a $9-million gain by selling its remaining stake in Shopping.com, a Corona del Mar e-commerce firm that Gross chaired for about a year.
Idealab also realized a large noncash gain by selling Free-PC.com to low-cost PC maker EMachines Inc. Idealab had invested $7 million in Free-PC.com, which gave away 30,000 desktop computers to people who were willing to share personal information and let the company track their Web-surfing habits. In November, Idealab sold the firm to EMachines for $97 million in stock and warrants.
Outside investors also helped pad Idealab’s balance sheet. Idealab pulled in $870 million last year by selling preferred shares to investors such as Dell Computer Corp. and Hikari Tsushin, a Japanese telecommunications firm. And Idealab hopes to raise up to $300 million more in its IPO. Idealab also picked up $1.5 million by collecting rental and service fees from the companies housed in its incubator facilities.
Yet hardly any of Idealab’s gains count as revenue. Instead, the bulk of its moneymaking activities are listed as “other income.”
Accountants say a strict interpretation of accounting rules by Idealab may force it to list many of its income-generating transactions as “other income” instead of as revenue. But they also say Idealab probably has the leeway to list some of the money it made by selling stock in its companies as normal revenue from operations.
Indeed, companies generally prefer to have predictable revenue streams so that Wall Street can gauge their performance. But because of its reliance on start-up firms, Idealab is subject to “big fluctuations,” said Andy Mintzer, a Santa Monica certified public accountant. So by recording stock gains as “other income,” instead of revenue, Idealab avoids some of this volatility on its revenue line.
Overall, Idealab posted an operating loss of more than $241 million for fiscal 2000. Stock option grants to Idealab employees and its majority-owned companies accounted for more than 40% of its operating expenses. Gross, 41, who earns an annual salary of $250,000, holds more than 390 million Idealab shares and stock options and owns 42% of the incubator.
“The core operations of Idealab are not profitable,” Hughes said. “They’re not covering any of their costs. It looks like it’s going to be a long time before they’re profitable.”
Idealab declined to comment because it is in a pre-IPO quiet period.
But people familiar with the incubator’s thinking said Idealab expects Wall Street to judge it on the basis of its combined worth of various stakes in its spinoffs.
Meanwhile, Idealab’s windfall from selling some of its EToys shares demonstrates that it can turn a profit even if its companies are losing money. But that can’t last indefinitely. “In the short term, all you have to have is a belief in profitability,” Mintzer said. “But ultimately, the underlying companies are going to have to make money.”
On its income statement, Idealab can count all the revenues from its majority-owned, “consolidated” companies as its own revenue.
But to account for the portion of those “consolidated” companies that it doesn’t own, Idealab subtracts the portion of revenues and expenses that it isn’t responsible for, to match its ownership stake. Since Idealab’s companies are now losing money, it gets to offload part of those losses to its investors and records that in an item called “minority interest.” In fiscal 2000, Idealab’s “minority interest” was $95.5 million.
Then there are the companies in which Idealab owns a 20% to 50% stake; in these cases it follows the “equity” rules of accounting. To determine how much each of these 11 companies are worth to Idealab, it records what it paid for its stakes in them. Then every quarter, Idealab calculates the value of each of its companies and computes the value of its own stakes in each of them. The difference between the investment amount and the current value then shows up on Idealab’s balance sheet as an asset.
Last year, the value of Idealab’s investments in its “equity” companies was $488 million, up from $1 million the previous year.
If Idealab owns less than 20% of a company, the money Idealab spent for its stake is considered a capital investment, just as if it bought a piece of machinery. The total dollar amount appears on Idealab’s balance sheet as an asset but is not listed on the income statement. In fiscal 2000, Idealab’s investments in these so-called cost companies were worth $126 million, up from $1.2 million the previous year.
Most companies that own chunks in other firms typically hold them until they are ready to sell the entire stake, Mintzer said. But Idealab tends to sell off stakes bit by bit, as the firms mature and take on financing from outside investors.
And since Idealab’s companies typically are losing money on operations, each reduction in its holdings also trims the share of losses that Idealab is responsible for shouldering. So Idealab’s gains from these transitions further obscure the underlying strength--or weakness--of Idealab’s finances.
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Idealab’s Finances
Idealab’s recent SEC filing for an initial public offering gives an insight into the incubator’s complex finances. Very little of its income is derived from traditional activities such as selling goods and services. It made far more money in its last fiscal year from selling 3.8 million shares of EToys for $193 million.
Primary sources of income in fiscal: 2000*
Consolidated revenue from companies in which Idealab owns majority stakes: $18.6 million
Gains on the sale of stock in Idealab companies: $202 million
Stock gains from sale of Free-PC.com to EMachines: $90 million
Management fees Idealab charges its venture capital funds: $2.5 million
Income from issuing Idealab stock to private investors: $870 million
Income from rental and service fees:: $1.5 million
* Fiscal 2000 ended Jan. 31
Source: Idealab and SEC filings
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Idealab’s Portfolio
Idealab’s ownership stakes of its companies fall into three standard accounting categories. A look at the companies, and the Idealab’s stake in them.
Consolidated: 50%-plus ownership
Idealab counts these firm’s revenues and operating expenses on its income statement, but subtracts the portion attributable to other investors.
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Company Business Idealab’s ownership CarsDirect.com Online car sales 66% DotTV Sells Internet names and 50 addresses ending in ‘.tv’ EntryPoint Personalized Web content 55 and online payment FreeMusic.com Site for 88 musicians, music enthusiasts HomePage.com Offers Web home pages 56 Jackpot.com Ad-supported online slot machine 81 MyHome.com Online sales 70 of furniture and fixtures Z.com Original entertainment programming 51 for the Web
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20%-50% ownership
Each company’s value is calculated by gauging the worth of Idealab’s stake, minus the dollar amount Idealab invested to acquire its stake.
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Company Business Idealab’s ownership EVoice Internet-based telecom services 31% FirsttLook.com Preview 44 marketing for music and videos GoTo.com Pay-for-placement Web search engine 27 IExchange Site for investors to trade opinions 44 Intranets.com Ad-supported corporate 33 intranet networks OpenSales E-commerce software 46 PayMyBills.com Online bill-payment service 50 PetsMart.com Online pet supplies retailer 21 Sameday.com Same-day 46 delivery of online purchases Swap.com Online 44 merchandise trading site for kids Utility.com Online electricity sales 34
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Less than 20% ownership:
Idealab records the cost of acquiring its stakes in these companies as capital investments during the quarter when they occur. They remain on Idealab’s balance sheet as assets until Idealab decides to sell.
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Company Business Centra Software Web collaboration software Cooking.com Online retailer of cookware and specialty foods EMachines Low-cost PC maker EToys.com Online toy retailer Eve.com Online cosmetics retailer Jobs.com Recruiting and employment Web suite NetZero Provider of free Internet service PeopleLink Software for building Web-based communities Ticketmaster Online Online- city guides and ticket sales CitySearch Tickets.com Online ticket sales WeddingChannel.com Online bridal resources
Company Idealab’s ownership Centra Software less than 1% Cooking.com 6 EMachines 10 EToys.com 12 Eve.com 17 Jobs.com 2 NetZero 5 PeopleLink 11 Ticketmaster 1 Online- CitySearch Tickets.com 5 WeddingChannel.com 7
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Source: Idealab SEC filings
