Jason Phillips departed a meeting with his companys chief executive officer (CEO)somewhat in shock. Phillips had recently
Question:
Jason Phillips departed a meeting with his company’s chief executive officer (CEO)somewhat in shock. Phillips had recently joined Dragon Soup, a private company thatmanufactured a line of canned soups colored red, green, and even purply-blue based loosely on anidea from a British television cartoon called The Clangers. Phillips had not expected to hear fromhis boss that the company was preparing for another round of fund-raising early the followingyear.
As Dragon Soup’s chief financial officer (CFO), Phillips had been given the task ofmaximizing the value of the firm at the time of the fund-raising. Although he did not want tobreak any laws or violate any accounting standards, Phillips needed to investigate whataccounting choices or changes in the firm’s operations could enhance the company’s financialposition and increase its perceived value to investors.
Background
In their meeting, Rebecca Dunwoody, Dragon Soup’s CEO, had been adamant that investorswere not always careful when analyzing financial statements; she said she thought they generallyjust assumed a multiple of earnings for the valuation. This frustrated her because she saw Dragonas a growth story for which current costs represented investments to build brand loyalty andfuture business. Dunwoody believed this growth was not reflected in most other soup companies’valuation multiples, which typically ran in the region of fifteen times sustainable earnings forlarge public companies (ten times for private ones), in addition to the value of cash andmarketable investments on the balance sheet.
Dunwoody had stressed repeatedly during her discussion with Phillips the importance ofboosting the company’s stock price. This emphasis did not surprise Phillips; Dunwoody hadfounded the company almost ten years before, and with more than 70 percent of the shares, she remained its largest shareholder and had the most to gain from the sale of shares at a high price.
Based on previous discussions, Phillips had assumed Dunwoody wanted to push for a publicoffering of shares, which might provide her a way to sell part of her holdings while retaining aminority interest. In contrast, today’s discussion revealed that Dunwoody might now consider anoutright sale of the company or settle for a private offering to a small group of investors if thecompany could issue a smaller number of shares at the right price, and if she could retaineffective control. Because almost twelve months remained before the planned offering or sale, Phillipswondered whether this was just a way for Dunwoody to test whether he was up to the task ofbeing CFO. After all, his predecessor had left suddenly, and Phillips had been recruitedsurprisingly quickly as a replacement; he doubted that Dunwoody fully appreciated his abilities.
Such thoughts would have to wait, however. Phillips opened the spreadsheet he had beenworking on earlier in the day, which contained Dragon’s base case financial projections as shownin Exhibit 1A, Exhibit 1B, and Exhibit 1C. Dunwoody had been clear—she would implementany action Phillips recommended as long as it boosted the stock price at the time of the fund-raising. The question for Phillips was how aggressive he should be and what the consequentialaccounting disclosures might be. One useful feature of the spreadsheet was that it providedsuggested footnote disclosures depending on the business and accounting choices that were input.
As he considered his options, Phillips reminded himself that the U.S. Securities and Exchange Commission (SEC) recognized that a company’s management had a unique perspective on its business that only it could present. That being the case, the SEC’s specific requirements for the management discussion and analysis (MD&A) section of a company’s statutory filings went beyond those required by auditors. The SEC’s MD&A requirements were intended to satisfy three principal objectives:to provide a narrative explanation of a company’s financial statements that enabled investors to see the company through the eyes of management; to enhance the overall financial disclosure and provide the context within which financial information should be analyzed, and to provide information about the quality—and potential variability—of company earnings and cash flow, so that investors could ascertain the likelihood that past performance might be indicative of future performance.1Given the possibility of a future public offering of shares, Phillips also wanted to be able to provide certification of the financial statements in compliance with the Securities and ExchangeAct of 1934 (the Securities Act), as shown in Exhibit 2. Phillips considered it critical, therefore, that all disclosures complied with the SEC guidelines and the requirements of the Securities Act.
Phillips had several options to consider before his next meeting with Dunwoody.
QUESTION:
In this case, Phillips questioned how far should he push the envelope. Why should he be concerned if all the actions you recommend are legal? Do you think that the associated disclosures satisfy the SEC (also a CICA requirement) requirement for the MD&A that a company provides a narrative explanation of its financial statements that enables investors to see the company through the eyes of management?