Is Idealab! Running Dry?

The incubator's IPO faces woes beyond a dreary market for Net stocks

Just two months ago, it seemed as if William Gross could open a door and money would fly in. In March, the founder of the much-heralded Internet-incubator idealab! announced that he had raised $1 billion in private equity from heavyweights such as Dell Computer, Sumitomo, and BancBoston Capital. That gave Gross's four-year-old company an implied market value of nearly $7.7 billion. In a rare event,

Gross was even able to persuade General Electric Co. Chairman John F. Welch to join the board, luring him with options on 1 million idealab shares. Welch joined a prominent list of idealab investors, including Compaq Computer Corp. Chairman Benjamin M. Rosen and Steven Spielberg.

Now, Gross is pitching his stock again, and this time, it looks like a much harder sell. In late April, Gross announced that he is looking to raise $300 million by selling an unspecified percentage of his Pasadena (Calif.) company in an initial public offering. Just a month later, with tech stocks having fallen out of favor, there are serious questions about whether Gross will be able to complete the offering. Business Week has learned that Gross gave his March investors a guarantee that they will not lose money on their $1 billion investment. If the valuation of the company in the IPO falls below $7.7 billion, then the investors' ownership of idealab increases proportionally.

Deflation. Here's why that's a problem. In March, idealab was valued at roughly 4 times the value of its holdings in the seven publicly traded companies in its portfolio, according to Ethan McAfee, an Internet company analyst at T. Rowe Price Associates, which was one of the investors. Today, the value of those holdings has tumbled to $502 million from $2 billion. If Wall Street were to value idealab at the same multiple of its stock portfolio, the entire company would be worth only $2 billion. Because of their downside protection, the March investors would get almost 50% of idealab, not the 13% originally agreed on.

That's almost certainly a dealbreaker. Gross thought idealab would be valued at more than $10 billion in its IPO, according to McAfee. Now with the company's valuation at about one-fifth that amount, he will probably postpone or cancel the IPO rather than give up a huge chunk of his own equity. A spokesperson for the company says idealab still plans to continue with its offering.

Why is Gross even considering proceeding in such a rough market? Given his fund-raising in March, he doesn't need the cash. He does, however, need to be able to make investments and acquisitions with stock. He has done a small number of acquisitions in the past, but he'll need to do more and larger deals in the future to compete with rivals such as ICG and CMGI. "We are going public to get a currency for expanding our business further," said Gross in an e-mail response to Business Week questions. Gross wouldn't be interviewed by phone because of the quiet period required during an initial public offering.

Gross's timing couldn't be worse. While technology shares in general have collapsed, the slice of the tech world that Gross most often focuses on--e-tailers and other consumer-oriented Web sites--has gotten pummeled. The stocks of the seven publicly traded companies in idealab's portfolio, including eToys Inc. and NetZero Inc., have fallen an average of over 70% from their peaks. That spotty track record is scaring off some investors. "We are not going to participate in the offering," says Lawrence York, manager of the $100 million WWW Internet mutual fund. "Idealab has had some successes, but they still have to prove themselves."

A close examination of idealab's IPO documents shows that there are good reasons to question the company's prospects--even beyond the fall in tech stocks. One major problem may be that Gross's incubator often finances cookie-cutter business plans that are easily replicated. Competitors can quickly set up similar sites, and many idealab companies haven't been able to lead in their markets.

Consider the job-search category. Idealab's ranks only fifth in that market, according to Internet industry data-collector PC Data Online. That's behind jobsonline,, careerbuilder, and And Gross's furniture Web site is barely a player in its market: attracted a mere 93,000 unique visitors last month, compared with more than 1 million for and 390,000 for

Some other idealab companies have had fates worse than obscurity. Gross has abandoned several me-too sites, such as real estate search-site A half-dozen other businesses were quietly shuttered, including Web broadcaster EntertainNet and ideaMarket, an online marketplace for intellectual capital. Idealab contends that even the companies that closed their doors provided value to the incubator's management. "Although the companies failed, we learned a tremendous amount from those experiences that we now use to the benefit of our networks of companies," Gross wrote in his e-mail.

To be sure, Gross has created some leading Internet companies. In the late '90s, he had a string of very successful IPOs, including eToys, Ticketmaster Online-CitySearch, and the search engine, in which idealab has a 44% stake, is one of the top sites for buying cars on the Web. And Inc., 21% owned by idealab, ranks among the most popular pet-supply sites.

But the economics of idealab's businesses may frighten off investors in today's more conservative stock market. The prospectus for idealab's public offering shows that the company reported an operating loss of $252 million on sales of $134 million last year. Even its successful companies are bleeding red ink: lost $72 million last year on sales of $15.2 million. And investors may have trouble getting a clear picture of what the whole enterprise earns: That's because most of idealab's assets are in businesses where they own stakes of less than 50%, and investors won't be able to see complete financial performance data for those companies.

Idealab's investment approach is creating another problem: It has not yet qualified for an exception to a fiendishly complex piece of legislation known as the Investment Company Act of 1940. If idealab cannot convince the Securities & Exchange Commission that it is an operating company and not an investment company, the firm may be limited in its ability to buy and sell portfolio companies and offer stock options to employees.

Potential investors might also want to ask about Gross's compensation package. According to the prospectus, the idealab board granted Gross options on a staggering 150 million shares last year. The options, which vest over four years, are exercisable at a price of just $1.27 per share. If idealab shares trade at just $10 apiece, Gross's stock award last year would be worth more than $1 billion. Gross, already the firm's largest shareholder, will own 41% after the options vest. "I'd want to know why all that is necessary," says Alan Johnson, a compensation expert at Johnson Associates in New York. "It's certainly not a competitive award."

Copycats. Gross has played the maverick before--with stellar results. The 41-year-old serial entrepreneur is credited with popularizing the concept of the Net incubator. His success has inspired dozens of copycats. "They have spread like viruses," says Jon P. Goodman, executive director of the ec2 incubator at the University of Southern California.

And Gross's friends say that selling idealab stock will be just the kind of challenge he relishes. "Bill is an incredibly focused and intense person," says his longtime friend and Ticketmaster Online-CitySearch Chairman Charles Conn III. "I don't think he'll let a choppy market slow his path. He'll power through it." Gross may yet prove all his doubters wrong, but don't bet on it.

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