How Money-Losing Tech Firms Redefine Profits

Over the past decade, more and more companies are emphasizing measures of profits that exclude various costs and make them look profitable when they’re not. Of 180 publicly traded firms that posted net losses as measured by standard accounting rules last year, 70 also reported profits based on more idiosyncratic definitions of the term, according to an analysis by The Information of securities filings and data from S&P Global Market Intelligence and CalcBench. The analysis included U.S.-based software firms and companies that received significant venture capital backing with at least $150 million in revenue last year.

Companies say the customized profit measures—most commonly a version of earnings before interest, taxes, depreciation and amortization or Ebitda—help them approximate the cash they pull in from operations. While Ebitda has been in use for decades, companies nowadays are using a variation of it that also excludes stock compensation expense and various other costs firms say will only occur once—hence the newer label of “adjusted Ebitda.”

Analysts and bankers have used the adjusted Ebitda measure as a key factor in determining company valuations. Often boards of directors at unprofitable firms set bonus targets for executives based on their ability to hit adjusted Ebitda goals, rather than based on net income or free cash flow.

Loosey-goosey measures of profitability have been popular with tech companies before. During the dot-com craze more than two decades ago, many newly public companies emphasized nonstandard forms of profit, the most aggressive of which excluded regular costs of doing business such as marketing expenses. In a speech in October 2000, after the dot-com investing bubble had burst, the chief accountant of the Securities and Exchange Commission at the time, Lynn Turner, described the questionable profit metrics companies were using in earnings releases as EBS—everything but the bad stuff.

Four of the firms in The Information’s analysis—Robinhood, WeWork, Qualtrics and Rent the Runway—reported differences between their profit margins as measured by accounting rules and adjusted Ebitda margins of more than 75 percentage points the last full fiscal year they reported financials.

Several of those firms’ actual profits took a hit from expenses they say won’t occur again, such as the hundreds of millions of dollars WeWork spent on restructuring its workforce and buildings. It didn’t take those expenses into account in their more customized measures of profit. Robinhood, meanwhile, excluded the more than $90 million it had to pay regulators in fines, as well as a $2 billion charge the firm took after it issued securities to investors to raise emergency funding when it was still privately held. Spokespeople for Rent the Runway, WeWork and Robinhood didn’t have comments.

The use of adjusted Ebitda metrics to show higher margins has “definitely become more prevalent,” said John Yozzo, managing director of FTI Consulting, which undertook a study of the subject, looking at public company accounting over the past four years.

In the past, investors and analysts rarely pushed back on the use of these alternative metrics. A large slice of tech firms that went public over the last few years haven’t yet turned a profit, but relaxed attitudes to profitability allowed them to achieve soaring valuations. Lately, though, investor attitudes have changed, thanks to rising interest rates, which make it more expensive to fund losses. The new focus on real profits is one reason why so many tech firm stocks have fallen so sharply this year. The stock prices of Robinhood, WeWork, Qualtrics and Rent the Runway, for instance, have dropped an average of 63% this year.

Clothing Budget

To fully understand the complexities of Rent the Runway’s profit measures, it’s helpful to consider how the company accounts for the cost of the clothes it buys for its clothing rental service. Rather than deducting that cost from revenue in its profit statement, as would be typical, it sums up what it spends on clothes and adds that to the value of its assets on the balance sheet. The firm does the accounting this way because it considers the clothing it rents out a “long-term productive asset.”

As required by accounting rules, Rent the Runway writes down that asset over time as a depreciation expense, which reduces its net income. But in calculating adjusted Ebitda, the company excludes the depreciation expense—which means the cost of clothing never shows up in that particular profit metric.

Raj Shah, co-founder of tech-focused hedge fund Stoic Point Capital Management, called Rent the Runway’s adjustments “particularly egregious.” He told The Information: “If you’re in the business of acquiring and then renting out inventory, you can’t exclude the cost of holding that inventory from your financials and [ask] to be valued absent that.”

Shah said investors are paying closer attention to how companies’ more-tailored profit figures diverge from their actual free cash, the measure of financial performance that ultimately becomes the most important input in how firms are valued. Free cash flow incorporates both operating cash flow and capital expenditures. Last year, Rent the Runway lost $83 million on a free cash basis, the company’s financial statements show.

Rent the Runway doesn’t hide its net loss as measured by standard accounting methods, to be sure: its press release for the second quarter results acknowledged the $33.9 million in red ink for the period. But in talking with analysts on a conference call, executives focused their discussion of the company’s financial performance on its adjusted Ebitda metric.

Executives said last month that in the “medium term” it would start producing adjusted Ebitda profits even when it includes the depreciation expense associated with its clothes. (On that basis, the company lost $11.7 million during the second quarter, its financial statements show.) Once it turned profitable on that measure, it would become cash flow positive, the company’s chief financial officer, Scarlett O’Sullivan, told analysts.

O’Sullivan added: “Adjusted Ebitda was a very important first milestone for us to show our ability to generate cash from operations to cover our [operating expenses].”

Virtual Reality

Ken Stillwell, chief operating officer and chief financial officer of Pegasystems, a publicly traded software company, said unprofitable tech companies often highlight adjusted income metrics as a way of suggesting they will start generating free cash in the near future. But, he added, the tech industry “got separated from that reality over time.”

“I worry that we as an industry, in tech specifically, have lost track of the cash generation piece and have focused so much on manufactured profitability metrics,” he said.

The most common expense tech companies exclude from their bottom line is stock-based compensation. This is also a convenient exclusion for tech executives getting increasingly big stock paydays after their companies go public.

Stock trading app Robinhood reported a profit of $34 million last year in its first year as a public firm on an adjusted Ebitda basis. That was a drastically different picture from the $3.7 billion it lost under standard accounting methods. The biggest expense Robinhood excluded from the adjusted Ebitda line was $1.6 billion it recognized in stock-based compensation, $500 million of which was “executive compensation arrangements,” the firm’s filing shows.

Qualtrics, a software firm, also excluded more than $1 billion in share-based pay expenses last year. Its CEO, Zig Serafin, had one of the biggest compensation packages of any executive in 2021, the year it went public.

Under accounting rules, that kind of payment is an expense in firms’ earnings statements, but because it doesn’t involve paying out cash, it doesn’t directly affect cash flows. There is a cost to shareholders, however: Issuing stock to employees dilutes other stockholders’ ownership, meaning they own less of the firm.

The stock compensation expense can look particularly high in the year a company goes public because hundreds or thousands of employees’ restricted stock units vest.

In June, Morgan Stanley software analysts said in a research note that clients had been asking how to take stock compensation into consideration when determining companies’ valuations, particularly if they issue new grants to employees to make up for falling share prices. The analysts said their research suggested taking stock-based compensation into account should depress the enterprise values of fast-growing software firms 7% to 10%.

Executives and board members at some high-growth tech firms have sometimes dismissed the significance of stock-based expenses. Keith Rabois, co-founder of tech-infused home-buying firm Opendoor and a board member at financial tech company Affirm, said stock-based compensation expenses were “a red herring in evaluating a business,” he told The Information in an email. “The way to evaluate a business is at the marginal economic level, which is how many contribution dollars you generate.”

Not all of Opendoor’s peers have the same view. Glenn Kelman, CEO of brokerage Redfin, another tech-focused real estate firm, told The Information that the firm’s executives believed “all expenses matter, including stock-based compensation and capitalization expenses.” He added: “We cannot ask investors to give us cash for our stock, then turn around and say that it shouldn’t count as an expense when we give that stock to ourselves.”

Redfin was one of the few large money-losing tech firms that doesn’t emphasize an adjusted earnings metric with investors.

Some firms have noted that investors are souring on nonstandard accounting metrics. Uber, for instance, used to be the poster child for extensive adjustments to its losses. The company took “the idea of adjusted earnings on a wild ride” last year with 13 adjustments for expenses, according to an accounting blog published by financial software firm Calcbench.

Those adjustments allowed the company to hit its profit target for the year, contributing to a $2.4 million bonus in 2021 for CEO Dara Khosrowshahi, according to a securities filing.

But in May this year, Khosrowshahi emailed employees that he had spent time with the firm’s investors to understand the “seismic shift” in the market and that “the goalposts have changed.” Rather than focusing on adjusted Ebitda, “now it’s about free cash flow,” he wrote. “We can (and should) get there fast.”

Len Sherman, a former senior partner at consulting firm Accenture who now teaches growth strategy at Columbia Business School, said the boards of directors at unprofitable companies like Uber incentivized executives to focus on less rigorous profit measures through their bonus plans. An Uber spokesperson didn’t return requests for comment.

“It’s an important symptom, and one of many symptoms, that’s led to the massive correction we’re now going through,” Sherman said. “Everyone has been in cahoots supporting this.”