Picking Over the Carrion: Leave It to the (Big) Birds

Buying into battered startups can be awfully tempting. Don't go there.

By Tom Taulli, August 2000 Issue

When good stocks go bad, the bargain shopper in each of us takes notice. Expensive at $135 looks pretty cheap at $35 (and even cheaper at $3.50), especially when there's a specter of a chance that a bigger, better-capitalized company could invest in it or swallow it. Either way this would lift the stock price. That's the whole idea behind vulture investing: Swoop down and pick up clipped highfliers for a song.

With the recent Nasdaq plunge, there's lots of prey out there. Stocks of many formerly soaring Net companies are now going for cheap. Drkoop.com hit a high of $45.75 and is now going for $2 or so; eToys rose to $86 and is currently at around $6.50; CDnow was at $23.25 and then collapsed to the low single digits. Yet brave investors are willing to buy those stocks as rumors fly about corporate white knights coming to the rescue.

This is exactly what happened with CDnow. After a recent announcement of a potential merger or investor by June 30, its shares were driven up 110 percent to nearly $5 in a matter of days.

Finding the bargains in the carnage can be dangerous -- you can get burned easily. (In CDnow's case, when it subsequently announced that a white knight wouldn't arrive on schedule -- and might likely offer less than market price -- shares plummeted.) It's safer to invest in companies that have made a sideline business as professional acquirers (see "Personal Shoppers," page 158 in the August issue of eCompany Now for a list). These are the ones with the clout to get the best deals. More important, they can make the deals work for them. Good vultures are easy to spot: They've already made some nice purchases and have a lot of cash on hand, typically from secondary offerings (before the market correction, of course); many have actually turned profits.

Companies in trouble are rarely in a position of negotiating strength. One such desperate seller was Peapod. Nearly out of cash in April, it sold a stake to Royal Ahold, the Dutch global grocery store operator, for $73 million. This included convertible preferred shares representing 51 percent of the company's outstanding common stock, plus warrants to take as much as 75 percent of the voting shares. In case of liquidation, Royal Ahold gets paid first -- not such a smashing situation for Peapod's loyal stock investors.

Troubled dotcoms commonly get screwed through multiyear, multimillion-dollar deals with portals to carry their content. The investing public often thinks these deals are cash infusions, but they're quite the opposite. If the startup can't pay, the portal has the option of taking an equity stake. That's exactly what happened with Drkoop. In late April, when the company announced it was quickly running out of cash, AOL (which hopes to merge with Time Warner, parent of eCompany Now) converted its portal deal into an equity stake. In reaction to the news, Drkoop shares rose 53 percent to $3.59 in one day; investors incorrectly thought the company was getting some money. When investors came to their senses, shares fell below their pre-announcement levels.

A similar situation existed with car e-tailer Autoweb.com. With its stock plummeting from a high of $33.50 to the single digits, and with its coffers getting thin, the company announced in April that Lycos would be taking a 10 percent stake. Again, this was not fabulous news for the downed dotcom and its investors. Though many details aren't publicly available, the terms call for Autoweb to make "multimillion-dollar payments" to Lycos over four years in exchange for a chance to develop a channel on the portal. And if the payments don't materialize, Lycos could very well grab some more equity in the company. But investors know what's up: After the announcement, Autoweb's stock went downhill. (In a bit of irony, Spanish Internet service provider Terra Networks snatched up Lycos in May because it saw promise for that portal internationally. However, in a merger of equals or near-equals, the terms tend to be more gentlemanly. Lycos's beaten-down shares are now going for a nice premium.)

Still feel you can pick fallen angels? A safer option might be convertible securities -- the hybrid of bonds and stock. Like bonds, convertible securities offer interest payments and better liquidation rights than stocks. Plus, there's the possibility of converting your holdings into actual shares of the company -- ideally done at a price higher than the share price at issue. Many convertible securities are at junk levels, meaning they offer a high return in exchange for high risk.

Convertibles caveat: Since many Net stocks have collapsed, it may be a long time -- if ever -- before you'd want to convert your shares into stock. So if it's the equity play and not the yield you're after, look for newly issued convertibles for which the conversion level is much lower. But should the company go bust with no real assets to pay off debts, it doesn't really matter how "safe" the investment is.

That's why you should look for beaten startups with hard assets -- such as plants, equipment, and inventory -- that can be liquidated readily. It's simpler for them to be restructured and eventually generate positive cash flows. They are not easy to find, however, since the value of most Net companies often lies in intangibles such as customer loyalty and intellectual property.

Bigger, stronger, and richer vulture companies have the advantage of solid strategy and infrastructure in place to make their acquisitions work for them. Anyone, it seems, can grab eyeballs -- just ask the folks at CDnow -- but the trick is to turn them into profits. A big company like AOL has the expertise that might make that happen.

In many cases, we're talking about huge companies where a few $10 million stakes in beaten startups here and there aren't bet-the-farm situations. So leave the vulture investing to the professionals. There are people out there who know more than you do.

Tom Taulli is Internet.com's Internet stock analyst and the author of Investing in IPOs. As an attorney he's had a lot of experience with vultures. Sharks too.