Testimony of Alain J. Hanover,
CEO, InCert Software Corporation,
to the Senate Committee
on Banking, Housing and Urban Development
on behalf of
The Massachusetts Software and Internet Council
on Pooling of Interest Methods of Accounting

10:00 a.m., Thursday, March 2, 2000 - Dirksen 628

Chairman Gramm, members of this committee, thank you for the opportunity to address your Committee. I'm Alain Hanover, President and CEO of Incert Software, a small software company with 40 employees, based in Cambridge, Massachusetts, the heart of the dot.COMmonwealth. I am what is referred to as a serial entrepreneur, and I am here to offer the viewpoint of small and medium-sized companies on retaining pooling of interest accounting.

I'm currently in my third start-up company. I'm an engineer and manager by training, and my opinion of the proposed change in accounting rules is based on experiences from my previous and current start-ups and not any deep knowledge of accounting principles.

In my previous company, Viewlogic Systems, we merged with 7 companies, 3 by pooling and 4 by purchase, in an attempt to grow my company from #10 in the Electronic Design Software (EDA) Industry, to #1. I grew the company from 6 people to 750 people before it was acquired.

I am dead set against the proposed change in accounting rules to eliminate pooling of interest mergers. I think if the FASB goes forward with its plan to eliminate pooling, it will undermine the entrepreneurial climate in which small- and medium-sized high-tech companies create opportunity for their employees, their investors and their communities.

Large companies may be able to adjust to the elimination of pooling, but it will severely impact and handicap smaller companies and prevent us from becoming the large, successful companies that have created and helped to maintain the technological advantage that the U.S. currently enjoys. Simply put, without pooling, small companies won't be able to easily consummate the key deals needed for us to grow.

Let me give you specific examples of why I am here, and why I testified at the FASB hearings in New York instead of staying in Cambridge and working on my business.

In my first start-up company, Xylogics, we were acquired in a purchase transaction for cash. The acquisition was positioned by the buyers as a purchase, and my key technical personnel were totally demotivated because they were not made shareholders in the new company. I struggled to retain key people, who no longer had a stake in the combination. The company eventually declined and sold at a fraction of its previous value. I am sure this downward trend was a result of my key technical group losing their motivation and their focus because the acquirer thought they had bought us. In that pure purchase deal, the new owner had made the mistake of thinking the key asset were the software and computers we designed. While they had bought the desks where people sat, they hadn't bought the people's hearts and minds. And those were the real assets of Xylogics.

In my second company, Viewlogic, I grew it rapidly and when we went public in 1991, it was the 10th ranked company in the electronic design automation software industry. Through internal growth and 7 mergers and acquisitions, Viewlogic grew to be the 4th largest company in the industry.

Of these 7 combinations, 3 were done by Pooling and 4 by Purchase. The mergers and acquisitions ranged from under $1M to $26.5M in value. Purchase accounting was used for the smaller acquisitions, where it was principally a technology and people acquisition with little sales and marketing distribution. Pooling was used for the 3 of the 4 larger ones with $14M to $26.5M in value. These were positioned as a "merger of equals". Management in the combined company was shared because we highly valued and paid a premium for their minds and key technologies, even though they were much smaller than we were. The pooling transactions were, by and large, successes, principally because the people stayed and felt like working together, the product lines expanded and grew our business much faster, and they all became shareholders with a vested interest in the combined enterprise. These mergers would not likely have been done if pooling had not been available to us.

The only large combination we did under purchase accounting, a twenty million dollar acquisition, was a failure because most of the people walked away after getting their cash and went on to other startups. They took advantage of the quick opportunity to cash out.

One option we considered, but did not use, was the purchase in a tax- free transaction for stock, because it had the effect of both a dilution in stock and the write-off of the goodwill of the acquisition, as this had a double hit on my earnings and EPS. The other purchase alternative would be to borrow money, and load up my company with debt, and use cash, but then the employees could cash out.

Viewlogic had a pristine balance sheet: No long-term debt, no major intangible assets and always positive earnings and an EPS that grew and was measurable, with few, if any write-offs.

One major benefit of the pooling for small companies is that employee-shareholders can read the financial statements and see that the combination is desirable and accretive to them; thus they remain shareholders. Another reason is that our company was not followed by a lot of analysts. My family, friends and lots of small shareholders owned our public shares. Wading through complicated financial statements with lots of write-offs and negative earnings, was difficult for them, and, of course, there were few if any analysts' reports. They read the newspapers that quoted the final earnings, PE's and EPS, without all the footnotes and explanations. To them a loss was a loss. I think this is the most important economic impact of this rule. For large companies, their financials are just the starting point of the information investors, and the larger market use. With small companies, financials are the beginning and the end. Confusion as to the impact of amortization of goodwill and other intangibles will be just enough to discourage small investors from what might be a great opportunity for them and a needed source of capital for the company.

With Viewlogic, I wanted to stay away from creative accounting rules. For my small (less than 500) shareholder base, pooling is the best and easiest way to account for mergers. Shareholders right away see the effect both historically and in future projections of merging the 2 entities without the confusion of huge write-offs. After a merger, our stock price and PE immediately the new value of the combined companies.

After a torrid 5 years of increasing sales and shareholder value through internal growth and acquired technology and companies, when we reached the #4 position, Viewlogic merged with the #3 player, Synopsys, to form the #2 player in our industry in a pooling transaction. Our market cap grew from $150M to $550M with all this growth and our employee numbers went from 250 to 750.

Today this combination is rapidly moving to becoming the number one company in its market. This has created a lot of value for shareholders by eliminating redundancies and taking advantage of economies of scale. Pooling made all employees and shareholders feel proud to be part of the new company, and converted their loyalty from one entity to the other very smoothly. Today Synopsys has a market cap of about $3B, and Viewlogic's acquisitions are a substantial part of that.

I've now started a new company, Incert Software, and plan to follow the same strategy of growing it quickly, taking it public, and then using our publicly-held stock to merge and acquire other companies and technology to create more shareholder value. The elimination of pooling will severely hamper my strategy, and I am concerned for the thousands of similarly-positioned smaller companies.

Some have taken the position that the FASB should retain pooling, but only in certain circumstances such as a "merger of equals". Let me emphasize that this is no solution for entrepreneurs working to combine small companies with smaller companies or with larger ones. Our best and largest acquisition was one-twentieth our size, but it grew most rapidly to eventually account for half of our business.

Why is this important to you and me? The EDA industry is the oil that lubricates the design and implementation of all industrial, consumer, defense and semiconductor electronics, a Trillion dollar industry that is inside nearly everything we touch. In the 80's, key companies such as Daisy, Mentor Graphics, and Valid, grew rapidly and pioneered this. In the 90's, companies like Cadence, Synopsys, Viewlogic and Avanti all grew through mergers and acquisitions to gain market share and dominate the industry worldwide. Our customers include IBM, AT&T, Intel, Motorola, Ford, British Aerospace, Siemens, Ericson, Nokia, Toshiba, Hitachi, Sony, Mitsubishi, our NSA, DOD agencies, and hundreds of others, representing every major industrial country. As a result of our rapid growth by mergers and acquisition, mostly through pooling of interests, the U.S. EDA Software industry dominates over 90% of the worldwide software market for designing electronics. The EDA industry is strategic and critical to the U.S. to maintain its worldwide technological and military lead.

Pooling ought to be retained, so that small companies like mine can continue to expand and benefit from this key accounting rule that benefits small companies and small shareholders. I believe FASB is not just setting new accounting rules in this case, but it is also setting economic policy. The elimination of pooling will prevent well-intentioned smaller entrepreneurs from building their companies quickly with substantial mergers and acquisitions into the powerhouses of tomorrow that will sustain our country's advantage.

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