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Dot-com companies, once the darlings of Wall Street, have been on a long, slippery slope since Jan. 1, facing financial hard times and tough legal and business decisions. For the foreseeable future, more Internet companies’ officers and legal counsel likely will have to choose between bankruptcies, shutdowns, withdrawing their IPOs, fire sales of assets, layoffs, seeking buyers, either another dot-com or an old-economy company. Or they could choose some hard-to-swallow combination of the above. In a report released this month, Tim Miller of Webmergers.com revised his firm’s “Webmergers Watch List” to reflect the tough times. The highlights include the following: � Nearly 30 cash-strapped Internet companies have been sold so far this year, many of them in “fire sales”; � 41 Internet companies have shut down this year; � 83 Internet companies have withdrawn IPO plans since January; � Nearly 15 percent of companies that withdrew IPOs have been acquired to date; � Many companies are refocusing from business-to-consumer to business-to-business business models; � It is not just a business-to-consumer thing — 30 percent of Watch List companies address a business audience, and � California leads the Watch List with 91 companies. Mr. Miller reported that figures indicate that struggling Internet companies mostly are turning to mergers and acquisitions. He said, at least 29 Internet startups have sold all or part of themselves in “fire sales” or IPO alternatives so far this year. Another seven dot-coms are seeking buyers. These findings are derived from the Webmergers.com, a San Francisco-based company and its Watch List, a listing of 238 Internet startups that have taken some action this year to cope with the harsh funding climate. The Watch List shows that from Jan. 1 to Aug. 8, 2000, out of 238 companies surveyed, 98 had layoffs, 83 withdrew or abandoned their IPOs, 36 were acquired or are for sale, 41 were shut down completely, and 17 were refocused. Internet mergers and acquisitions were up 700 percent in the first half of 2000 alone, according to Webmergers.com’s survey of overall mergers and acquisitions involving Web destinations. Buyers spent $230 billion to buy more than 500 Web destinations. First-half spending, fed by the AOL/Time Warner deal, was nearly seven times the amount spent in the first half of 1999. The number of deals in the first half period nearly tripled over the same period last year. INVESTING A swerve in the overall trend is that consumer-content deals have ground to a halt. Business-oriented targets have soared to 20 percent of total spending in the first quarter versus 6 percent for all of 1999. E-commerce targets surged to 75 percent of total spending, compared with 23 percent for all of 1999. Jake Fuller, an analyst with Donaldson Lufkin & Jenrette who follows four public on-line travel companies, Travelocity, Expedia, Hotel Reservations and CheapTickets, agrees with most of Webmergers.com’s data. However, he added that a few public Internet companies in his field are not cash strapped. Most of the travel start-ups have enough cash to last at least 12 months, even 24 months in some cases. But there is a trick: “Of course, some have ‘sponsors’,” Mr. Fuller said. “Microsoft owns 70 percent of Expedia, while Sabre Group is majority owner of Travelocity, which currently has $60 million in cash, enough to last through fourth-quarter 2001.” Mr. Fuller emphasized that lesser-known on-line travel firms have extremely poor cash-flow positions, following closely the data collected by Webmergers.com. “We’ve started to see a lot of M&A and we hear from sources that smaller companies are looking for a cash infusion.” Again, venture capitalists are beginning to say, “No,” and institutional investors are becoming even less friendly, he said. Krista Thomas, director of public relations for [email protected], which has given venture capital to many dot-coms over the past 12 months in return for equity in the startups, says her firm is pulling way back from investing in dot-coms; the rate has gone from one new dot-com per week to one per month. In fact, during May, June and July, [email protected] made no new investments, she said. “It as been similar to the market shift,” Ms. Thomas said, “but not in the way you would think.” Ms. Thomas said that what convinced her company to slow investment “is that now the public is looking for the kind of growth seen by the Amazon.com’s of the world. Investors are looking for clear, steadily-growing revenues that can support real profitability. Many are saying, ‘Just how many Web portals can survive?’” In fact, Mr. Miller and Webmergers.com predict that any prolonged market downturn will usher in a new wave of M&A, causing deals in the U.S. alone to easily surpass the quarter-trillion-dollar mark for 2000. The number of Web M&A deals will, if anything, accelerate in coming months as the market sees a convergence of several factors: a) increased sales of cash-starved dot-coms; b) continued strategic position-taking in the business-to-business market; c) defensive consolidation in business-to-consumer sectors; and d) entry of new buyers into the marketplace. M&A has been one of the most popular exits for former IPO hopefuls. However, mergers are only one of several alternatives for Internet companies concerned about cash burn rates. By far the most common coping mechanism remains cost cutting, Mr. Miller said. Nearly half of the companies on the Watch List have laid off employees and dozens of others have cut back on a variety of other expenses, with marketing spending appearing to be the first to be trimmed. Other companies have shifted from cash-hungry, business-to-consumer activities in favor of less cash-intensive business-to-business models. One popular refocusing tactic is to begin selling existing business-to-consumer infrastructure to other companies that want to reach consumers, a model otherwise known as the “business-to-business-to-consumer” model, said Mr. Miller. LATEST UPSWING Although the current dot-com shakeout is largely viewed as a business-to-consumer phenomenon, the Watch List contains 65 Internet companies (30 percent of the total) that primarily serve a business audience. Acquirers in the quarter ending June 30 abruptly shunned consumer markets and embraced business-to-business e-commerce. Spending on business-related sites surged to $14.5 billion, or 28 percent of the total compared with $2.6 billion or 6 percent of the total for all of 1999. Meanwhile, spending on consumer sites plummeted to 7 percent of dollars in the first quarter versus 40 percent for 1999. General-interest properties account for most of the remainder (these and all following statistics omit AOL/Time Warner numbers, which are so large as to obscure meaningful trends). The shift to business-to-business fed an explosion in e-commerce deals, which rose from 23 percent of total spending for all of 1999 to 72 percent of total spending in the first quarter. Nearly $12 billion of that amount went into classic business-to-business exchanges or supply chain automation companies while nearly $21 billion went to e-commerce services ranging from online investing to Web site domain registrations. Because the dot-com shake-up has happened primarily since late last year, the debate rages on about the best course of action, and the alternative courses of action. As Miller said, most dot-coms first lay off workers to cut costs. Then many change strategy, focusing on sales to businesses instead of consumers. Some, who only a few months ago were called “trailblazers,” now are taking the plunge into Chapter 11 bankruptcy to protect employees and assets, and even their board of directors. Lawrence P. Gottesman, who heads Brown Raysman Millstein Felder & Steiner LLP’s bankruptcy practice, said, “The main issue still is whether new economy companies should seek bankruptcy protection. For a subsidiary, the questions become if it should most likely use bankruptcy vehicle to effect a sale, a sale before bankruptcy. Because they don’t have hard assets, how are they going to finance operations from the beginning of bankruptcy to the end.” Mr. Gottesman said that out-of-court restructuring still is the preferred course of action because of the expense of bankruptcy. “It’s not clear how a bankruptcy action would affect such a company. Everything is on a case by case basis.” “Because of the uncertainty as to how a dot-com bankruptcy will play out, absent compelling benefits to be derived from filing for bankruptcy protection, no company will voluntarily choose to be the trailblazer,” Gottesman said in May. However, since then, he has seen many firms choose bankruptcy, grimacing as they do. “A Chapter 11 bankruptcy case, with its provision for creditors’ committees and the requirement of bankruptcy court approval for various actions, can rapidly result in significant administrative expenses,” Mr. Gottesman said. “The uncertainty resulting from the bankruptcy filing, coupled with the fact that the stock options that are the most significant component of employee compensation may now be worthless, will make the retention of critical and highly mobile employees such as software developers extremely difficult.” Mr. Gottesman pointed to recent case law as adding to bankruptcy-filing woes: “Because of decisions such as Perlman v. Catapult Entertainment Inc. ( In re Catapult Entertainment, Inc.), which appears to preclude assumption in bankruptcy of intellectual property licenses over the licensor’s objection, there exists considerable uncertainty as to the ability of a company that is dependent upon its intellectual property licenses to survive in bankruptcy without the consent of its licensors.” “Under federal common law, the patent licensor would be excused from accepting performance from a third party,” Gottesman said. “The court therefore concluded that the debtor in possession could not assume the license.” Nevertheless Mr. Gottesman says there are reasons to seek bankruptcy protection: � Automatic Stay. Commencement of a case under the Bankruptcy Code results in an automatic stay preventing parties from sending termination notices or seizing assets without permission of the court. Bankruptcy may enable the dot-com company to preserve valuable assets and contracts. As is the case with traditional retailers, an “e-tailer” may find that its vendors are more willing to provide goods on trade credit after a Chapter 11 petition is filed than before. This is because the claims of creditors who provide goods and services on credit after the case is commenced are entitled to administrative priority over pre-petition, unsecured claims. � Ability to Obtain Debt Financing. Even if the financially distressed company has valuable assets, possible lenders may be reluctant to lend against such assets if there is any uncertainty regarding the perfection of their liens against such assets. For example, it is unclear whether a security interest in an unregistered copyright can be perfected. Similar uncertainty exists regarding perfection of security interests in domain names. Currently, it is unlikely that traditional asset-based lenders will want to lend to financially distressed dot-com companies. Likely lenders are parties who already have a stake in the company, such as venture capitalists and debt holders. An order approving debtor in possession financing can go a considerable distance in eliminating such uncertainties. Under �364(c)(2) of the Bankruptcy Code, the bankruptcy court, provided certain conditions are met, may authorize the debtor in possession or trustee to incur post-petition credit secured by a senior lien against the property of the estate. Such orders typically provide that the post-petition lender is deemed perfected without the need to file financing statements or take other action to perfect its security interest. A lender who advances funds post-petition can have a high degree of assurance that it will have a first priority lien against the debtor’s assets, whereas a pre-petition lender will face considerable uncertainty. In addition, even if perfected, there is a real issue as to whether such security interest in Web pages and software will continue post-petition. For Web pages and, to a lesser extent, software, which are revised frequently, the real value lies in their current versions. The question arises whether such modifications make these items new property that has been acquired by the debtor post-petition and, if so, whether the new property fits within any of the exceptions enumerated in �552(b). The answer is probably not, Gottesman said. � Treatment of Customer Information as an Asset. Frequently, the most valuable asset held by a dot-com company is information regarding its customers, such as their buying history and product preferences. Although most Web sites post privacy policies, their legal status is unclear. Are these policies binding contracts? Most dot-com’s reserve the right to modify their policies at any time. In spite of the ability of the dot-com company to modify its privacy policy, the unsettled issues may make it difficult for such information to be sold outside of bankruptcy. The comparative certainty of a Bankruptcy Court order may enhance the debtor’s ability to realize value from these assets. Section 363(f)(2) permits such sale if the holder of the interest in such property consents. Section 363(f)(4) permits a sale if the interest in the property is subject to bona fide dispute. Given the unsettled and undeveloped state of the law in this area, it seems likely that the debtor in possession could establish that the privacy right of any objecting consumers is subject to a bona fide dispute. MORE CHAPTER 11 ISSUES Continuing with Mr. Gottesman’s reasons for Chapter 11 filing: � Fiduciary Obligation of Directors. The board of directors of an insolvent company owes a fiduciary duty to its creditors. Approval by an insolvent company’s board of directors of a liquidation or sale at fire-sale prices potentially exposes the board to personal liability for failure to maximize value in breach of its fiduciary duty. A bankruptcy liquidation or sale, by contrast, will have imprimatur of the Bankruptcy Court, and as such should go a considerable distance in insulating the board of directors from liability arising from such transaction. � Debt Restructuring. As noted at the beginning of this article, the more-established dot-com companies may have significant debt obligations. For these companies, Chapter 11 has the same utility that it has for old-economy, bricks-and-mortar companies: the ability to restructure debt under a plan of reorganization and, if necessary, to bind dissenting creditors to such plan. Given all of the uncertainties inherent in a dot-com Chapter 11 case, however, there is a particularly strong incentive for the parties to reach a consensual restructuring that is then implemented pursuant to a “prepackaged plan.” Related Chart: Dot-Coms in Distress

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