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The bricks-and-clicks joint venture is rapidly emerging as a leading business model for Internet startups. The Old Economy company — the bricks — contributes products or services, while the New Economy company — the clicks — supplies Internet technology and know-how. Both parties usually provide an initial round of equity, and look to venture capital and eventually the public markets for additional funding as the business progresses from startup to active, growing business. Given the simplicity of the business concept, it is surprising how difficult the structuring can be. The problem is not the typical economic and governance issues facing virtually all startups. Questions of board composition, antidilution protections, and control of the timing of an initial public offering and the like usually get resolved with little angst; well-understood market norms largely determine them. The difficulty in creating the bricks-and-clicks joint venture lies instead in the vastly different cultural and economic heritage of the two partners. The clicks company comes from an environment created by a raging bull market for all things technological, most recently the Internet. Its fundamental value creation paradigm is getting the business up and running in order to be the first mover — and ultimately the dominant player — in its chosen field. Until recently, success in this effort was instantly rewarded by ever-increasing equity market valuations that depended on promises of rapid revenue growth; positive cash flow and accounting profits were typically deferred for several years — or even indefinitely. The bricks company, on the other hand, has a stock valuation premised on current delivery of positive cash flow and earnings. Unlike its freewheeling counterpart in the Internet world, the bricks company must respond to investors’ demands and continue to produce earnings and cash-flow growth on a current basis. Given these different heritages, it’s no surprise that clashes occur over joint venture partners’ earnings per share and earnings growth. These issues constitute the lifeblood of the bricks company but are of little immediate concern to a revenue-growth-driven clicks culture. Disputes typically occur over accounting treatment, tax planning, and executive compensation. Accounting treatment of the venture at the parent level is at the top of the list of disputes. Conventional accounting treatment of a 20 percent or greater investment in another company is the equity method (the parent entity records its share of the venture’s profit or loss on its books). For the bricks company, this means that unless it keeps its stake in the joint venture below 20 percent, it must absorb the losses of the business — a cruel fate considering that a one- or two-cent drop in earnings per share or a small dip in earnings growth can significantly erode its stock price. Accordingly, the Holy Grail for the bricks partner is avoidance of equity accounting, even for investments in excess of 20 percent of the capital of the joint venture. Some accountants believe that this is achievable, albeit with difficulty and at the cost of great structural complexity. The clicks company regards structural complexity as an enemy of speed and success. After all, the new complicated structure has to be explained and understood. What if the venture capitalists don’t like it or don’t get it? What if the IPO underwriters don’t like it? What if the public investors don’t like it? A parallel conflict often surrounds tax planning. If the venture is structured as a conventional corporation, its losses — which will be meaningful for at least the first several years — will not be deductible by the parents for tax purposes (unless one of them owns more than 80 percent of the venture). The bricks company is thus faced with a double whammy. Not only must it record the venture’s accounting losses on its own books and risk a drop in its stock price, but it also loses the opportunity to shelter its hard-earned income because it can’t take a tax deduction for the venture’s losses. There is, however, a solution to this tax problem: Use a two-tier structure for the venture, with a partnership on the lower tier and a conventional corporation on the top tier. But once again, the structural complexity of the solution goes against the clicks culture. It means the venture won’t mirror every other Internet startup — a difference that the clicks company will not see as a virtue. Until profits are routine and tax savings have a meaningful current value, sophisticated tax planning won’t be on the clicks’ radar screen. The third problem area is stock-option pricing. While the norm is articulated in both cultures as fair market value, the interpretation can be vastly different. It is common for clicks companies to grant management options at 20 percent of the economic value charged to virtually contemporaneous venture capital investments. The justification is that the VC investors have additional rights, such as antidilution protection or board representation not accorded the management’s stock. The Securities and Exchange Commission, however, requires companies to reexamine “cheap stock” option grants for at least a year prior to an initial public offering. When the pricing differential for options cannot be justified, the SEC requires that the spread between the option-exercise price and the redetermined fair market value be amortized over the life of the option, creating a built-in charge against earnings. While this earnings penalty may be palatable to a clicks company whose equity value is not earnings-related, it is anathema to the bricks partner that finds the earnings charge flowing onto its books as a result of equity accounting. The irony is that a rapidly disappearing New Economy paradigm is driving the bricks-versus-clicks structuring debate. Increasingly, the equity markets are pressuring Internet companies to produce positive cash flow and earnings. Sooner or later, clicks companies must adjust their thinking and join their bricks partners in crafting joint venture structures that reduce taxes and maximize earnings. Charles Nathan is a partner with New York’s Fried, Frank, Harris, Shriver & Jacobson. This article originally appeared in The Daily Deal.

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