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Life at a Photonics Startup: Lessons Learned on Financial Statements – “The Language of Business”

Financial Statements

A regular column by Daniel Renner

In the day-to-day operation of a photonics startup, or any other business for that matter, financial statements are a fundamental tool to understand the health of the company. Engineers do not generally get formal training on this topic and must learn how to read and interpret financial statements on the go. The intent of this article is to help engineers that have become budding businesspeople in this learning process. There are three main financial statements:

  • Balance Sheet
  • Income Statement
  • Cash Flow Statement

Balance Sheets show what a company owns and what it owes at a fixed point in time.

Income Statements show how much money a company made and spent over a period of time.

Cash Flow Statements show the exchange of money between a company and the outside world, also over a period of time.

This is an important first distinction to keep in mind. Balance Sheets are a snapshot of the company value at an instant in time. Income Statements and Cash Flow Statements cover financial transactions over a period of time

This article will discuss Balance Sheets in detail. We will discuss Income Statements and Cash Flow Statements in detail in the next article of this series, to be published in June.

In order to make the discussion more practical, we will follow the story of Nortel Networks from 1997 to 2001 as an example. Nortel Networks Corporation was one of the dominant suppliers of telecommunications equipment in the 20th century with worldwide presence. In the year 2000, as a major participant in the “telecom bubble” burst, Nortel self-destructed, with tens of thousands of people losing their jobs and investors losing billions of dollars. How did this happen? We can gain some insight by evaluating Nortel’s financial statements for that critical period and in the process learning how to read and interpret these financial documents. We will first provide some background, describing the events that unfolded at Nortel at that time and we will then proceed to learn from Nortel’s financial statements. We will discuss their Balance Sheets in this article, followed by Income Statements and Cash Flow Statements in the next article, as previously indicated. This article describes the events that occurred at Nortel based on an extensive report published by The Globe and Mail, a leading Canadian newspaper, in November 2001 and updated in April 2018 [1].

Nortel – The Story

Nortel Networks Corporation was founded in 1895 in Montreal, Quebec, as the Northern Electric and Manufacturing Company. It changed its name to Northern Telecom in 1976 and Nortel Networks in 1995. The company saw several periods of rapid growth, particularly starting in 1977 with the introduction of its Digital Multiplex System (DMS) line of central office telephone switches. The continuous addition of solidly designed optical communications networking products fueled growth in the 80’s and 90’s, to the point where Nortel was one of the top developers, manufacturers and suppliers of telecommunication equipment in the world, particularly optical communications equipment

John Roth was appointed Nortel’s President and CEO in late 1997. When he took the helm, he inherited a company with healthy revenue and earnings growth and solid cash flow. But he and his team saw a way to make it grow faster yet, by buying their way into other areas of the communications networking world and chasing sales from the young, flush companies with “telecom bubble” business plans, based on good intentions but with no connection to reality. This was a common practice for large telecom companies in the heady days of the “telecom bubble” in the late 1990’s and early 2000’s.

Nortel Tele 1
Typical Nortel DMS-100 telephone central office switch installation

The initial apparent effect of Mr. Roth’s strategy was startling success. From 1994 to 1997—when he was named CEO—Nortel’s compound annual revenue growth rate was an enviable 20 percent. From 1998 to 2000, it was an astonishing 25 per cent. For one Nortel salesman, that frenzied period culminated in September of 2000, when he got a call from a washed-up entrepreneur who wanted a slice of the “telecom bubble” and thought he could talk Nortel into financing his plans. “The guy was on welfare,” said the salesman, who unfortunately discovered this only after reviewing a hastily concocted business plan in the hopeful tycoon’s kitchen. Definite signs of a bubble!

The great telecom bubble was inflated by a confluence of events that date back to the mid-eighties and early nineties, when governments started to introduce long-distance competition to the telecom industry. The deregulation process took several years and was largely completed by the mid-nineties, with rules allowing competition in local, long distance, mobile and data services.

The advent of the Internet really got the market drooling. Entrepreneurs already coveting the profits of sleepy phone monopolies now had even better reasons to get into the communications business: the untold revenues a digital society might unlock. They had the plans, and now—thanks to an ample supply of risk-tolerant seed money—they had the means to get started.

An abundance of capital, a lack of skepticism and a sexy story that’s easy to believe, even if the outcome is impossible to predict, make for a dangerous combination.

For a while, though, life was beautiful for everyone involved in the sector. Nortel suddenly had a batch of new customers with lots of money to spend. Traditional customers were also beefing up their capital spending.

But well before the peak, there were skeptics who saw through the rosy optimism and tried—largely in vain—to point out that the appearance of disruptive technology in a deregulated market, such as optical communication networks, always follow the same pattern: Competition spurs capital spending, which creates excess capacity, which guarantees price wars, which kill off the weak and damage the industry, stifling profits and choking off new investment, until a second more seasoned cycle of capital spending takes the new technology to full fruition. Sometimes even further cycles are required to reach industry stability.

By the beginning of 2000, the doubts were confirmed. Big money investors realized that the demand assumptions in “telecom bubble” business plans were far too optimistic. They reacted by cutting off the funding, the fuel driving Nortel’s phenomenal growth. In spite of that, Nortel would maintain its aggressive forecasts for almost a year.

Although most investors were oblivious to the drying capital pools, some of the equipment makers were not. Other telecommunication equipment manufacturers acknowledged the industry’s downturn months before Nortel. In October, the company warned that its revenues would fall far short of forecasts for the year but denied that it was because of softening demand, insisting that it was a problem with supply. Nortel finally admitted the drastic downturn in the telecom sector in February 2001.

Nortel’s acquisition strategy severely taxed the company’s capital stock. The company spent 972 million shares on acquisitions and assumed stock option plans amounting to a potential 161 million shares between early 1998 and early 2001. Together, these extra shares added more than 50 percent to Nortel’s diluted stock outstanding. However, most of the firms acquired in this process had no sales. While the value of the stock issued was $32.1 billion, the total tangible net worth of the companies acquired was only $1.1 billion

By aggressively writing off most of these investments in mid-2001, Nortel acknowledged that it had overpaid for them. It wasn’t the only technology company to make such admissions, but its write-offs were among the biggest. In hindsight, of course, it’s easy to criticize. But even at the time, there were doubts. One of the owners of an early Nortel acquisition says that the purchase of his company was “dubious. There was a lot of hype back then.”

Besides perhaps breaching unwritten protocol, there is nothing technically wrong with a CEO enthusing over his company’s stock. Nor is there anything technically wrong with using reams of shares to buy dozens of companies with no revenue, besides the excellent odds that it will prove a colossal waste of shareholders’ money

The fallout from this story is by now well known. Investors lost billions and Nortel—the crown jewel of Canada’s technology industry—eventually disappeared from the map.

After struggling for a few years, on January 14, 2009, Nortel filed for protection from creditors, in the United States under Chapter 11 of the United States Bankruptcy Code, in Canada under the Companies’ Creditors Arrangement Act, and in the United Kingdom under the Insolvency Act 1986. Nortel shares were delisted from the Toronto Stock Exchange on June 26, 2009 at a price of $0.185 per share, down from its high of $124.50 in 2000 when it comprised a third of the Toronto composite index. Nortel subsequently sold its remaining assets and wound up business.

Balance Sheets

Let us have a close look at the Nortel Balance Sheets over those crucial years, from 1997 to 2001. The tables below show data for the five Balance Sheets corresponding to that period: a snapshot of the company as of December 31st of each one of those years. Typically, when you look at a Balance Sheet it will only show one year, the year being discussed, and the previous year for comparison purposes. This information comes from Nortel Networks Annual Reports [2–4]

NORTEL NETWORKS CORPORATION
Consolidated Balance Sheets
As of December 31st of each year
(millions of U.S. dollars)

ASSETS19971998199920002001
Current assets
Cash and cash equivalents
Accounts receivable
Inventories
Other current assets
1,371
4,880
1,765
531
2,281
5,462
1,687
887
2,153
5,808
2,663
1,508
1,644
8,198
4,336
2,352
3,513
2,923
1,579
3,747
Total current assets8,54710,31712,13216,53011,762
Long-term receivables3345731,3561,5281,031
Investments2855211,072892253
Plant and equipment2,0402,2632,3333,4192,571
Intangible assets and Goodwill8535,6206,29518,9663,095
Other assets4954388198452,425
Total assets$12,554$19,732$24,007$42,180$21,137
LIABILITIES AND
SHAREHOLDERS’ EQUITY
19971998199920002001
Current liabilities4,8835,8937,1019,0589,457
Long-term liabilities2,1292,1853,8344,0136,219
Total liabilities7,0128,07810,93513,07115,676
Minority interest in subsidiary
companies
13289657804637
Shareholders’ equity5,41011,56513,07229,1094,824
Total liabilities and
shareholders’ equity
$12,554$19,732$24,007$42,180$21,137

The Balance Sheet, as you can notice, is divided in two sections:

  • Assets
  • Liabilities and Shareholders’ Equity

Assets are things that a company owns that have value. This typically means that they can either be sold or used by the company to make products or provide services that can be sold. Assets are generally listed based on how quickly they will be converted into cash. Current assets are things a company expects to convert to cash within one year. Current Assets include:

  • Inventories. Most companies expect to sell their inventory for wash within one year
  • Cash in the bank and cash to be received within a year (Accounts receivable)

Noncurrent assets are things a company does not expect to convert to cash within one year or that would take longer than one year to sell. Noncurrent assets include:

  • Cash to be received at a future time longer than a year (Long-term receivables)
  • Investments that the company makes.
  • Fixed assets. Fixed assets are those assets used to operate the business but that are not available for sale, such as facilities and equipment.
  • It also includes things that can’t be touched but nevertheless exist and have value, such as trademarks and patents. These are intangible assets.
  • Goodwill is a particular type of intangible asset. Goodwill represents the premium for the market value of a company over the value supported by identifiable assets of that company. Goodwill is a parameter which is very difficult to quantify and opens a wide door to playing games with the balance sheet, as we will see later for the case of Nortel.

Liabilities are amounts of money that a company owes to others. Liabilities are generally listed based on their due dates. Liabilities are said to be either current or long-term. Current liabilities are obligations a company expects to pay off within the year. Long-term liabilities are obligations due more than one year away.

This can include all kinds of obligations, like money borrowed from a bank to launch a new product, rent for use of a building, money owed to suppliers for materials, payroll a company owes to its employees, environmental cleanup costs, or taxes owed to the government. Liabilities also include obligations to provide goods or services to customers in the future. So, typically they are also shown in the balance sheet as current liabilities and long-term liabilities.

Minority interest in subsidiary companies corresponds to the equity that minority shareholders hold in a company’s subsidiaries. Until 2007, minority interest information was listed under the liabilities section, as shown in these Nortel Balance Sheets. Starting in 2008, the Financial Accounting Standards Board (FASB) introduced a significant change and companies were required to list their minority interest information under the Shareholder’s Equity section. Accounting is a dynamic art!

Shareholders’ Equity is sometimes called capital or net worth. It is the money that would be left if a company sold all of its assets and paid off all of its liabilities. This leftover money belongs to the shareholders, or the owners, of the company.

The following formula summarizes what a balance sheet shows:

ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY

A company’s assets have to equal or “balance” the sum of its liabilities and shareholders’ equity

A company’s balance sheet is set up like the basic accounting equation shown above. On the top of the balance sheet, companies list their assets. On the bottom, they list their liabilities and shareholders’ equity.

Comments on the Nortel Balance Sheets:

  • A striking observation is how quickly Intangible Assets and Goodwill built up from 1997 to 2000. This line item went from $853 million in 1997 to $18,966 million in the year 2000! An increase of $18,113 million. Then, it deflated to $3,095 million in 2001. The increase from 1997 to 2000 was driven by over-valuing the “telecom bubble” acquisitions. The dramatic decrease in 2001 was caused by the realization that these companies were not really that valuable. The Goodwill line decreased further in 2002 and later years. The lesson here is to always be very critical of the values appearing under Intangible Assets and Goodwill!
  • Current Assets grew from $8,547 million in 1997 to $16,530 million in the year 2000. This increase of $7,983 million was mostly driven by an increase in Inventories and Accounts receivable. In the year 2000, Nortel was making a lot of equipment that did not sell, given that demand had come down (high Inventories). Or, if the equipment did sell, it was not being paid since the customers were having financial difficulty (high Accounts receivable).
  • Shareholder’s equity grew from $12,554 million in 1997 to $42,180 in the year 2000. An extraordinary increase of $29,626 million! Most of this increase was due to the increase in Intangible Assets and Goodwill plus the increase in current assets, which we have already discussed. So, this increase in Shareholder’s equity was based on over-valuing acquisitions and fabricating equipment for which there was no demand. The Balance Sheet numbers clearly show this issue! Shareholder’s equity was reduced by $21,043 million from 2000 to 2001, as appropriate corrections were made.

Balance sheets contain a wealth of information! I hope that this article has stimulated you to learn more about this topic, which is absolutely necessary to managing a successful photonics startup. If you have any questions or comments please contact me at IPSNEWSLETTER@IEEE.ORG

About the Column

This is a regular column that explores business aspects of technology-oriented companies and in particular, the demanding business aspects of photonics startups. The column touches on topics such as financing, business plan, product development methodology, program management, hiring and retention, sales methodology and risk management. That is to say, we include all the pains and successes of living the photonics startup life.

This column is written sometimes by me (Daniel Renner) and sometimes by invited participants, so that we can share multiple points of view coming from the full spectrum of individuals that have something to say on this topic. At the same time, this is a conversation with you, the reader. We welcome questions, other opinions and suggestions for specific topics to be addressed in the future.

The expectation is that this column will turn into a useful source of business-related information for those who intend to start, join, improve the operation, fund, acquire or sell a photonic startup. A fascinating area that I have been one of those lucky to enjoy as a way of living for a long time.

References

[1] Taylor, Fabrice; “The story behind Nortel’s fall”; published by The Globe and Mail on November 17, 2001; Updated April 12, 2018.
[2] Nortel Networks; Annual Report 1998.
[3] Nortel Networks; Annual Report 2000; Unleashing the potential of the high-performance Internet.
[4] Nortel Networks; Annual Report 2002.

A Bit About Me

Daniel Renner Headshot 2 1

I (Daniel Renner) grew up in the wilderness of Chilean Patagonia, which is one of the sources of my quest for adventure and for exploring new areas. In my early twenties I went to the University of Cambridge in England to do a Ph.D. in Opto-Electronics, a new area at the time. Now, decades later, I have lived through the whole range of experiences that relate to the development, manufacturing and commercialization of complex photonic devices and systems used in communication, sensor and industrial applications. My experience spans both technical and commercialization aspects of photonic products. This experience has included both large and small companies, which gives me a reasonable vantage point to comment on the ups and downs of life in a photonics startup.

I am currently Chief Business Development Officer at Freedom Photonics in Santa Barbara, CA, and I look forward to the regular conversation to be carried out through this column!