One of the largest venture capital deals in Canadian history has been quietly unwound, leaving numerous questions surrounding American Capital Strategies' ( ACAS) $130 million investment in a once-promising start-up Internet company.

In March 2007, American Capital announced it had invested in Geosign Corp., a little known Ontario-based Internet publishing company. The Bethesda, Md., investment firm said the proceeds were to be used by Geosign for working capital and to support the firm's "strategic growth initiatives."

The question now is whether that investment has soured.

In October, American Capital and the entrepreneur behind Geosign split the company in two. The news was first reported in the Canadian newspaper The Record. American Capital never issued a press release relating to the split, but confirmed the move to TheStreet.com.

While the reason for the split-up -- and its ramifications on American Capital -- are unclear, the move raises questions about the value of Geosign and the potential for writedowns on the investment. Any writedown of Geosign would be troublesome for American Capital investors because the company relies on the markup or sale of its investments to cover its dividend.

Google Crackdown

The split-up of Geosign came after layoffs of a big percentage of the company's workforce.

At the time of the investment by American Capital, Geosign said it had 230 employees and annual revenue of more than $100 million.

A few months after the cash infusion, Geosign laid off between 50 and 100 workers, according to the Guelph Mercury newspaper. Various press reports and Internet blogs suggested the layoffs were tied to Google's ( GOOG) crackdown on advertising arbitrage.

This arbitrage process involves buying cheap "ad words" from Google that are tied to common search terms in order to drive visitors to a content-light Web site that includes a lot of additional ads. The Web site owner is betting the visitor directed to his site from the Google ad will click on the additional ads that he sold to other parties for a higher price.

Geosign never said it was involved with Google arbitrage. But a good chunk of Geosign's business model revolved around pay-per-click ads that it sold mostly to attorneys, particularly medical malpractice law firms.

If the original business model relied heavily on Google arbitrage, then one has to wonder about the financial hit to Geosign by the crackdown.

Split Questions

Regardless of whether Geosign turns out to be a success, the split-up poses various questions for American Capital investors. Namely, what exactly did American Capital end up receiving for its $130 million investment in Geosign? And how much money and assets were left in the company when it was divided?

American Capital CEO Malon Wilkus told TheStreet.com that as a result of the split-up, his firm recovered a "substantial" amount of its original investment in the form of cash proceeds. He declined to give the amount.

"We had really two different businesses at the company from the get-go, and it made sense to break it into two pieces and let both groups devote themselves completely to their line of business," Wilkus says.

American Capital's investment was structured as preferred equity and convertible debt and gave the firm a minority interest in Geosign. Part of the funding likely went to Geosign founder Tim Nye through a swap-out of his original equity funding of the company.

Neither company divulged how much of the $130 million was given to Nye personally. It also is not clear why Nye -- the majority investor in Geosign -- would want to split his firm in two and return millions of proceeds to American Capital.

Nye now runs eMedia Interactive, which was part of the split-off from Geosign. An assistant to Tim Nye at eMedia said he is "no longer doing interviews."

In the split-up, most of the Web sites (such as hockey.com) went to eMedia, and the remaining Internet advertising business went to Moxy Media, which American Capital owns.

Wilkus says Moxy Media is profitable but declined to give financial details.

Steve Rossow, vice president of business development with Moxy Media, says the firm is now focusing less on pay-per-click ads and Internet domains and more on a "Web 2.0" advertising strategy that revolves around lead generation.

For example, someone in need of an attorney can submit a request on www.lawfirms.com and receive a telephone call back from a specialist who can cater to the search.

Writedown Worries

American Capital has been a stellar performer over the past decade, as its equity investments reaped a 33% compound annual return over the last 10 years, according to the firm's calculations.

But the stock, at around $31, has fallen 38% from its 52-week high last February. Short-sellers now make up 7.7% of the float, betting that many of American Capital's investments are now set to go sour with a slowing economy and fewer exit opportunities because of problems in the credit markets.

In November, TheStreet.com reported that another firm in which American Capital had invested closed its doors and was on the verge of bankruptcy.

American Capital also recently avoided booking a large loss on its poorly performing investment in U.K. firm European Capital by employing aggressive accounting assumptions.

The worry for American Capital investors is that numerous writedowns may be looming. This issue is important because the firm has been known to book "unrealized gains" in recent quarters by marking up the accounting value of its investments. That results in higher earnings that make it appear as though the company is easily covering its dividend.

In the first nine months of 2007, American Capital paid out $2.72 per share in dividends and reported earnings of $5.50 per share. But the company only reported $2.45 per share of net operating income, or the money earned from ongoing investments.

Net unrealized appreciation -- marking up investments -- boosted earnings per share by about $2.06. Another $1 per share of earnings came from realized gains on investments.

The financials show that American Capital cannot cover its dividend other than by marking up its books or by selling off investments. Wilkus, the company's CEO, points out that the firm has always been consistently able to cover its dividend through ordinary taxable income, which excludes stock-option expenses.

On Monday, American Capital reiterated that it expects a 13% growth in its dividend in 2008 and announced the authorization of an ongoing $500 million share buyback plan.

However, when investments start running into issues -- such as with Geosign -- the dividend coverage issue becomes even more worrisome.

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