Funding Start-Up With Stock, Internet Capital Raises Eyebrows

The raging bull market has made the stock swap the merger vehicle of choice, providing buyers with cheap, easily obtainable currency. Now an Internet venture capitalist has taken the next step by using its stock in a financing package for a start-up. But some observers wonder whether soaring stock prices haven't lulled takers into overlooking the risks.

Internet Capital Group (ICGE Quote), one of last year's great Nasdaq success stories with a gain of more than 1,000% following its Aug. 5 IPO, last month issued stock to a private metals supply site MetalSite.net. Internet Capital declines to provide details of the $180 million deal, but venture capitalists and market players wonder why a company with $1.5 billion in cash and other assets on hand would fund a start-up partly with stock.

The action in Internet Capital's stock Friday and Monday highlights the potential risk, primarily that stock issued now could drop in value. Internet Capital dropped 7% Monday and is now off more than 40% from its early January high of 200. Even so, the stock has a P/E well above 1,000 and the company at current levels sports a market cap of $31 billion, more than that of aluminum giant Alcoa (AA Quote).

Remember Gravity

The use of stock in these deals is, if not unique, at least unusual. CMGI (CMGI Quote) blazed the Internet venture-capital trail in 1998, becoming a market phenomenon. Internet Capital smartly marketed itself as a CMGI clone in the B2B field last August when it went public. But CMGI says it has yet to use stock to fund any of the ventures it launched, including the GeoCities unit of Yahoo! (YHOO Quote) and Lycos (LCOS Quote).

"We are truly open to creative deal structures, but it doesn't make a lot of sense for us to give stock to a start-up, or for a start-up to take stock," says Brad Garlinghouse, general partner with CMGI's @Ventures.

Internet Capital's largest success story thus far is VerticalNet (VERT Quote), a B2B darling that went public last February and turned out to be one of the best IPOs of 1999. VerticalNet now sports a market cap of nearly $8.4 billion. Yet even VerticalNet CFO Gene Godick says that taking stock isn't the typical way his firm would want to raise money. "Internet Capital, if it were to give us stock for a larger stake, we would have to have them register that stock with the Securities and Exchange Commission before we could ever sell it," Godick notes. Internet Capital has been building up its stake in VerticalNet since 1996 and now owns 35% of the company.

Adding to recipients' unease is that Internet Capital shares may continue to feel significant selling pressure in coming months, as more than 185 million locked-up Internet Capital shares are scheduled to become unlocked through June, according to Securities and Exchange Commission documents. The company has 261 million shares outstanding.

"What happens when Internet Capital's stock goes down?" asks Jerry Murdock, a partner at Insight Capital Partners, a private venture capital firm based in New York. "These companies are really making a big bet."

Nothing Succeeds Like Success

MetalSite, for its part, doesn't have a problem with taking Internet Capital's stock. "We are absolutely thrilled because Internet Capital brings us operational expertise and a lot of value for our business," says Maggie Bray, MetalSite's communications manager, who declined to disclose the breakdown of the stock/cash payment.

"We will use everything we have -- stock, cash, everything -- in funding new companies," says Internet Capital spokeswoman Michelle Strykowski, though she declined to comment on whether Internet Capital would continue to use stock in start-up deals. The use of stock begs the question whether the company, which is acquiring minority stakes in companies at a rate of two a month, might be burning through cash. Internet Capital declined to comment on its cash burn rate.

Internet Capital has a number of promising private and public outfits on its roster, including Breakaway Solutions (BWAY Quote), which has doubled since its October IPO and now showcases a $1.5 billion market cap, as well as eChemicals and Computerjobs.com. Onvia.com, Emerge Interactive and Universal Access are in registration.

And as last year's stock chart shows, there's always the prospect the stock will not only rise but skyrocket. But for the companies desperate to get a piece of that Internet Capital B2B magic, fortunes could turn if they have to rely on their angels' stock price when things aren't looking so heavenly.