DISCLOSURE: I own a tiny bit of Upstart. However, I no longer actively invest, so call
it a hobby. I’m using money I can afford to lose. A 100% permanent loss here wouldn’t
affect my retirement or other financial goals one bit. In other words, heads I win,
tails I scrape my elbow, but don’t get killed.
Key points:
** Intangible investments are hidden on financial statements.
** Upstart invests heavily in intangibles.
** Rearranging items on the cash flow statement uncovers intangible investments.
** We create a model that tests assumptions about Upstart’s investments.
** The model clarifies Upstart’s cash flows from intangible investments.
Financial statements use accounting rules that were put in place a long time ago.
Back when these rules were developed, most firms were making money by investing in
physical assets like stores, factories, and machines. Even though these companies paid
up front for these investments, the accounting rules allowed them to spread the expense
over multiple years rather than in the year they paid for them. The reasoning behind
this was to match these expenses with the future revenues they generated.
Nowadays you’re more likely to find a business investing in assets you can’t touch or
feel rather than factories or machines. These “intangible assets” are things like AI,
branding, and employee training. Unfortunately, accounting rules haven’t kept up with
this change in investment focus. Firms that invest in intangibles have to expense that
full investment in the current year, and aren’t allowed to spread it over multiple years
like they can with with tangible investments.
This difference leads to a mismatch. The financial statements for companies that invest
heavily in intangibles fail to distinguish between expenditures that support current
revenues and those aimed at generating future revenues. In short, there’s a gap between
what the financial statements say and what we as investors need to know to understand
the business.
Upstart is certainly a business that invests heavily in intangibles. CEO Dave Girouard
said in the most recent earnings call that the cash Upstart generated in 2021 “allowed
us to significantly invest in our future”, effectively doubling their headcount in
engineering and product development. But where do we see these intangible investments on
Upstart’s financial statements? We don’t! They’re hidden.
Fortunately, a number of practitioners have suggested ways to address this issue. I’ll
be using an approach suggested by Michael Mauboussin. Any shortcomings are mine and not
with his method.
Our focus will be on the cash flow statement. We’re going to move some items around from
one section to another. We’re not getting rid of anything, just rearranging. Our aim is
to gain deeper insight into Upstart’s intangible investments, yet at the same time
preserve Upstart’s bottom line cash total that must tie to the balance sheet.
The cash flow statement assigns all cash flows to one of three buckets – operating,
investing, or financing. Operating cash flow shows cash in and out for activities dealing
with the customer. Investing cash flow shows what the company spent to fund future
growth. Financing cash flow tells you how the company funded the gaps between operating
cash flows and investing cash flows. Upstart’s intangible investments don’t show up on
the cash flow from investing section. We want to fix that – we want those intangible
investments to show up where they belong so they are visible and not hidden.
Recall that accounting rules require Upstart to expense all its intangible investments in
the current year, even though some of those expenditures are investments for future years.
These investments are included in the Sales & Marketing (S&M) and Engineering & Product
Development (E&PD) expenses on the income statement, but are not broken out separately.
The expenses are deducted from revenues to get net income which is carried over to the
cash flow statement. The key to Mauboussin’s technique is to extract the intangible
investments hidden in that net income number in the operating section and move them to
the investing section.
Our first challenge with this approach is to determine what portion of those S&M and
E&PD expenditures were investments in future growth and what portion were necessary just
keep the business running. For discussion purposes, let’s pick 50%. We’ll say that 50%
of S&M and 50% of E&PD are linked to current revenues and are necessary just to maintain
current business and the other 50% are investments in future growth. Applying these
assumptions, we arrive at the following estimate for Upstart’s investment in intangibles
for 2021:
Estimate of Upstart's intangible investments in 2021
Percent
2021 Allocated Intangible
Expenditure to Intangible Investment
----------- ------------- ----------
Sales & Marketing 333,453 .50 166,727
Engineering & Product Development 133,999 .50 67,000
-------
Total 233,726
Our second challenge with this method is to figure out how many years these intangible
investments can generate revenues. We’ll use the number we come up with to spread the
investment expense for those same number of years. Again, just for discussion purposes,
let’s pick 3 years for S&M and 5 years for E&PD. From this we create what’s called
an amortization schedule. Using this schedule, we calculate the amount of investment
amortized expense that accumulated as of 2021 was $108,246M.
We now have all the information we need to make our changes to the cash flow statement:
(1) We add to the reported net income of $135,443 the intangible investment for 2021
of $233,726M minus the accumulated amortization of $108,246M. This gives us adjusted net
income of $260,923.
(2) We add back accumulated amortization of $108,246M because it’s a non-cash charge.
(3) We record the investment in intangibles of $233,726M in the Investing Section.
Putting it all together, here’s how the cash flow statement looks before and after our
changes:
Cash Flow Statement
As Reported by Upstart As adjusted by me
2021 2021
-------- --------
OPERATING SECTION
Net Income 135,443 Net Income 135,443
Intangible Investment 233,726
Accumulated Amortization -108,246
-------
Adjusted Net Income 260,923 (1)
Accumulated Amortization 108,246 (2)
All other operating 32,910 All other operating 32,190
------- -------
Cash from Operations 168,353 Cash from Operations 402,079 <= Increase of 139%
INVESTING SECTION
Intangible Investment -233,726 (3)
Other Investing -143,877
--------
Cash used in investing -143,877 Cash used in investing -377,603 <= Increase of 162%
FINANCING SECTION
Cash provided by financing 855,432 Cash provided by financing 855,432 <= Unchanged
Net change in cash 879,908 Net change in cash 879,908
Beginning Cash 311,333 Beginning Cash 311,333
Ending Cash 1,191,241 Ending Cash 1,191,241 <= Same as on Balance Sheet
You may be asking: what’s so special about the inputs you’ve chosen – 50% and 3 years
and 5 years? You could have chosen any numbers!
True, but our goal isn’t to precisely pin down the intangible investment number. Our aim
is broader. First, we want to make sure that intangible investments are visible. And
second, we want a model where we can vary our inputs to see what effect they have on cash
flows. The inputs we pick are based on assumptions about the business. The model helps us
test those assumptions to see how they affect cash in and out.
Think of it this way. The cash flow statement for 2021, using required accounting rules
as reported by Upstart, would have 0% and 0 years as inputs to the model. The reported
numbers are telling us that Upstart’s S&M and E&PD amounts include zero investment in
future growth! That’s not an accurate portrayal of Upstart’s business.
In our example above, where we assume 50% of S&M and E&PD expense was actually
investment in future growth, we see that cash from operations increases 2.4 times and
cash used by investing increases 2.6 times. If we run a few different scenarios with
different inputs, we’ll develop a much better understanding of the effect of Upstart’s
investments on their cash flows.
This model substantially improves the description of Upstart’s business. It’s important
to note that the bottom line cash number has not changed. The payoff of the model is a
more informed interpretation of Upstart’s cash inflows and outflows.
Best to you,
Ears
Note: Below are the Upstart reports used in the discussion above. You should be able to
cut and paste these into worksheets to make your own Excel model.
TABLE 1 - Income Statement as reported by Upstart
TABLE 2 - Amortization Schedule using 50% and 3 years and 5 years
TABLE 3 - Cash Flow Statements as reported by Upstart
TABLE 4 - Cash Flow Statements as adjusted
TABLE 1 - Income Statement as reported by Upstart
2017 2018 2019 2020 2021
------- ------- ------- ------- -------
Revenue from fees, net 51,161 88,482 159,847 228,600 801,275
Interest income and fair value adjustments, net 6,128 10,831 4,342 4,816 47,314
Total revenue 57,289 99,313 164,189 233,416 848,589
Sales and marketing 33,838 63,633 93,175 99,659 333,453
Customer operations 10,232 15,416 24,947 37,581 117,579
Engineering and product development 5,324 8,415 18,777 38,802 133,999
General, administrative, and other 15,431 19,820 31,865 45,609 122,677
Total operating expenses 64,825 107,284 168,764 221,651 707,708
Income (loss) from operations -7,536 -7,971 -4,575 11,765 140,881
Other income (expense) 330 487 1,036 5,549 -5,174
Expense on warrants and convertible notes, net -1,649 -3,734 -1,407 -11,364 -1,976
Provision (benefit) for income taxes 6 0 74 371 -1,712
Net income (loss) attributable to non-controlling -1,144 1,101 -4,554 -404 0
Net income (loss) -7,717 -12,319 -466 5,983 135,443
Net income (loss) per share diluted -0.56 -0.87 -0.03 0.34 1.43
Weighted-average number of shares outstanding dilu 13,874 14,128 14,336 17,514 94,773
TABLE 2 - Amortization Schedule using 50% and 3 years and 5 years
Cap Rate Years
Sales and marketing (S&M) 0.50 3
Engineering and product development (E&PD) 0.50 5
2017 2018 2019 2020 2021
------- ------- ------- ------- -------
Capitalized S&M 16,919 31,817 46,588 49,830 166,727
Capitalized E&PD 2,662 4,208 9,389 19,401 67,000
Total Capitalized 19,581 36,024 55,976 69,231 233,726
Amortized S&M 5,640 5,640 5,640 0 0
0 10,606 10,606 10,606 0
0 0 15,529 15,529 15,529
0 0 0 16,610 16,610
0 0 0 0 55,576
0 0 0 0 0
Total Amortized S&M 5,640 16,245 31,774 42,745 87,715
Amortized E&PD 532 532 532 532 532
0 842 842 842 842
0 0 1,878 1,878 1,878
0 0 0 3,880 3,880
0 0 0 0 13,400
0 0 0 0 0
Total Amortized E&PD 532 1,374 3,252 7,132 20,532
Total Amortization 6,172 17,619 35,026 49,876 108,246
TABLE 3 - Cash Flow Statements as reported by Upstart
2017 2018 2019 2020 2021
------- ------- ------- ------- -------
Net income -8,861 -11,218 -5,020 5,579 135,443
Change in fair value of financial instruments -5,201 42,282 34,716 29,049 -228
Stock-based compensation 1,290 2,045 3,806 11,513 73,186
Gain on loan servicing arrangements 1,515 2,169 856 -1,530 -6,916
Depreciation and amortization 93 314 774 2,278 7,541
Incentive share expense 0 0 0 787 0
Noncash interest expense 42 19 74 73 1,983
Gain on repurchased and retired stock warrants 0 0 -3,657 0 0
Accrued Interest on convertible notes 416 794 0 0 0
Purchase of loans for immediate resale -580,438 -1,115,049 -1,779,180 -2,540,948 -8,713,476
Proceeds from immediate resale of loans 580,438 1,115,049 1,779,180 2,540,948 8,713,476
Purchase of loans held-for-sale 0 0 0 -116,127 -219,128
Principal payments received for loans held-for-sale 0 0 0 18,218 8,659
Net proceeds from sale of loans held-for-sale 0 0 0 47,604 112,569
Other assets -4,147 -3,001 -11,957 -13,186 -62,042
Operating lease liability and right-of-use asset 0 0 871 251 3,126
Accounts payable 946 1,118 3,613 7,033 -7,513
Payable to investors 23,525 14,100 -14,875 19,446 62,097
Accrued expenses and other liabilities 739 1,716 22,381 4,709 59,576
Net cash (used in) provided by operating activities 10,357 50,338 31,582 15,697 168,353
Principal payments received for loans held 49,556 199,325 158,921 24,018 0
Net proceeds from sale of loans held-for-investment 45,084 45,698 100,678 97,340 51,403
Principal payments received for loans held-for-investment 26,660 38,678 48,124 15,758 24,532
Principal payments received for notes receivable 0 1,229 8,760 14,665 11,458
Purchase of loans held-for-investment -102,541 -169,442 -265,286 -9,655 -159,398
Purchase of non-marketable equity securities 0 0 0 0 -40,000
Purchase of notes receivable and residual certificates 0 0 -485 -4 0
Purchase of property and equipment 0 -148 -4,004 -1,355 -8,427
Capitalized software costs -773 -896 -1,275 -4,250 -6,688
Acquisition, net of cash acquired 0 0 0 -16,757
Purchase of loans held by consolidated securitizations -411,407 -251,681 0 0 0
Net cash (used in) provided by investing activities -393,421 -137,237 45,433 136,517 -143,877
Proceeds from initial public offering 0 0 0 159,488 0
Proceeds from secondary offering 0 0 0 0 263,931
Proceeds from borrowings 118,780 144,048 153,491 92,057 718,422
Payment of debt issuance costs 0 0 0 -15,727
Purchase of capped calls 0 0 0 -58,523
Taxes paid share settlement of equity awards 0 0 0 -236
Payments made on securitization notes and certificates -49,262 -226,775 -176,742 -26,126 0
Repayments of borrowings -111,139 -92,954 -109,939 -148,113 -71,316
Repayments of notes payable -13,634 -21,468 -22,637 0 0
Distributions made to noncontrolling interests -2,238 -11,238 -4,960 -622 0
Repurchase of convertible preferred stock warrants 0 -1,426 0 0
Repurchase of convertible preferred stock 0 -661 0 0
Proceeds from issuance of notes payable 31,399 42,537 39,863 0 0
Proceeds from issuance of convertible preferred stock 1,112 49,925 1,912 0 0
Proceeds from convertible preferred stock warrants 0 1,631 6 0
Proceeds from employee stock purchase plan 0 0 0 4,145
Proceeds from exercise of stock options 142 323 278 2,362 14,736
Proceeds from the issue of securitization notes 400,866 242,454 0 0 0
Proceeds from the sale of non controlling interests 16,689 8,914 0 0 0
Proceeds from the issue of convertible notes 20,000 0 0 0 0
Net cash (used in) provided by financing activities 412,715 135,766 -119,190 79,052 855,432
Net increase in cash and restricted cash 29,651 48,867 -42,175 231,266 879,908
Cash and restricted cash at beginning of period 43,724 73,375 122,242 80,067 311,333
Cash and restricted cash at end of period 73,375 122,242 80,067 311,333 1,191,241
TABLE 4 - Cash Flow Statements as adjusted
2017 2018 2019 2020 2021
------- ------- ------- ------- -------
Net income -8,861 -11,218 -5,020 5,579 135,443
Intangible Investment 19,581 36,024 55,976 69,231 233,726
Amortization of Intangible Investment -6,172 -17,619 -35,026 -49,876 -108,246
Adjusted Net Income 4,548 7,187 15,930 24,933 260,923
Amortization of Intangible Investment 6,172 17,619 35,026 49,876 108,246
Change in fair value of financial instruments -5,201 42,282 34,716 29,049 -228
Stock-based compensation 1,290 2,045 3,806 11,513 73,186
Gain on loan servicing arrangements 1,515 2,169 856 -1,530 -6,916
Depreciation and amortization 93 314 774 2,278 7,541
Incentive share expense 0 0 0 787 0
Noncash interest expense 42 19 74 73 1,983
Gain on repurchased and retired stock warrants 0 0 -3,657 0 0
Accrued Interest on convertible notes 416 794 0 0 0
Purchase of loans for immediate resale -580,438 -1,115,049 -1,779,180 -2,540,948 -8,713,476
Proceeds from immediate resale of loans 580,438 1,115,049 1,779,180 2,540,948 8,713,476
Purchase of loans held-for-sale 0 0 0 -116,127 -219,128
Principal payments received for loans held-for-sale 0 0 0 18,218 8,659
Net proceeds from sale of loans held-for-sale 0 0 0 47,604 112,569
Other assets -4,147 -3,001 -11,957 -13,186 -62,042
Operating lease liability and right-of-use asset 0 0 871 251 3,126
Accounts payable 946 1,118 3,613 7,033 -7,513
Payable to investors 23,525 14,100 -14,875 19,446 62,097
Accrued expenses and other liabilities 739 1,716 22,381 4,709 59,576
Net cash (used in) provided by operating activities 29,938 86,362 87,558 84,927 402,079
Principal payments received for loans held 49,556 199,325 158,921 24,018 0
Net proceeds from sale of loans held-for-investment 45,084 45,698 100,678 97,340 51,403
Principal payments received for loans held-for-investment 26,660 38,678 48,124 15,758 24,532
Principal payments received for notes receivable 0 1,229 8,760 14,665 11,458
Purchase of loans held-for-investment -102,541 -169,442 -265,286 -9,655 -159,398
Purchase of non-marketable equity securities 0 0 0 0 -40,000
Purchase of notes receivable and residual certificates 0 0 -485 -4 0
Purchase of property and equipment 0 -148 -4,004 -1,355 -8,427
Capitalized software costs -773 -896 -1,275 -4,250 -6,688
Acquisition, net of cash acquired 0 0 0 -16,757
Purchase of loans held by consolidated securitizations -411,407 -251,681 0 0 0
Intangible Investment -19,581 -36,024 -55,976 -69,231 -233,726
Net cash (used in) provided by investing activities -413,002 -173,261 -10,543 67,287 -377,603
Proceeds from initial public offering 0 0 0 159,488 0
Proceeds from secondary offering 0 0 0 0 263,931
Proceeds from borrowings 118,780 144,048 153,491 92,057 718,422
Payment of debt issuance costs 0 0 0 0 -15,727
Purchase of capped calls 0 0 0 0 -58,523
Taxes paid share settlement of equity awards 0 0 0 0 -236
Payments made on securitization notes and certificates -49,262 -226,775 -176,742 -26,126 0
Repayments of borrowings -111,139 -92,954 -109,939 -148,113 -71,316
Repayments of notes payable -13,634 -21,468 -22,637 0 0
Distributions made to noncontrolling interests -2,238 -11,238 -4,960 -622 0
Repurchase of convertible preferred stock warrants 0 0 -1,426 0 0
Repurchase of convertible preferred stock 0 0 -661 0 0
Proceeds from issuance of notes payable 31,399 42,537 39,863 0 0
Proceeds from issuance of convertible preferred stock 1,112 49,925 1,912 0 0
Proceeds from convertible preferred stock warrants 0 0 1,631 6 0
Proceeds from employee stock purchase plan 0 0 0 0 4,145
Proceeds from exercise of stock options 142 323 278 2,362 14,736
Proceeds from the issue of securitization notes 400,866 242,454 0 0 0
Proceeds from the sale of non controlling interests 16,689 8,914 0 0 0
Proceeds from the issue of convertible notes 20,000 0 0 0 0
Net cash (used in) provided by financing activities 412,715 135,766 -119,190 79,052 855,432
Net increase in cash and restricted cash 29,651 48,867 -42,175 231,266 879,908
Cash and restricted cash at beginning of period 73,375 122,242 80,067 311,333
Cash and restricted cash at end of period 73,375 122,242 80,067 311,333 1,191,241