Critical Errors at Critical Path

The e-mail handler focused on building the stock price, not the business. Now, Chairman David Hayden is mounting a start-over effort

If Richard A. Juarez could live last Jan. 12 over again, he wouldn't have knocked off work early and gone jogging along the bayfront green in San Francisco's Marina District. On the path, Juarez, then a senior research analyst at investment banker Robertson Stephens, heard someone call his name. Running in the opposite direction was Douglas Hickey, CEO of Critical Path Inc. (CPTH ), a promising young company that managed e-mail for corporations that Juarez covered for the investment bank.

As the two exchanged greetings, Juarez seized the opportunity to pump Hickey for information. An earnings announcement was just six days away, and Juarez wanted to know if Critical Path would keep its yearlong promise of emerging as one of the few profitable Internet companies. Juarez asked: "How's business? Are you sleeping well these days?" Hickey declined to comment for this story, but according to Juarez, Hickey replied: "I'm sleeping very well." Juarez interpreted his response as confirmation that Critical Path would show a profit. He did some research, calling Critical Path customers and employees. With signs looking positive, Juarez issued a report reiterating his "strong buy" rating and urging clients to buy Critical Path stock.

It was a grave error. On Jan. 18, Critical Path reported a loss of $11.5 million, on revenues of $52 million--nowhere near the forecast of $700,000 in profits and $55 million in sales that the company had been giving Wall Street. Within 24 hours, 10 analysts, including Juarez, downgraded Critical Path's stock, which tumbled 64%--from $25.13 the day before the announcement to $9 the day after. But the real bombshell came on Feb. 2, when the company disclosed that its fourth-quarter earnings report may have contained accounting irregularities. In a matter of days, 88% of Critical Path's market cap and $1.7 billion in shareholder value had vaporized.

Since then, things have only gotten worse. In its first quarter ended Mar. 31, Critical Path said revenues declined to $27.2 million, and its net loss, excluding special charges, was $42 million. On top of that, the company is facing an investigation by the Securities & Exchange Commission and more than two dozen shareholder lawsuits, claiming that the company artificially inflated its stock with unrealistic revenue and profit projections. The stock now trades below $1 per share.

What happened? This highflier had seemed so promising. In March, 1999, when Critical Path had an initial public offering on Wall Street, the stock immediately soared from $24 to $65. Last year, it emerged as the leader in the market for handling e-mail for corporations, a $570 million market that is expected to grow to $780 million by 2002, according to market researcher IDC. Critical Path's reported sales were growing 35% a quarter, and its high-profile management team had beefed up its product line with 10 acquisitions over two years.

Critical Path's was an archetypal dot-com disaster. Its leaders made a critical error: Like many other dot-com execs during those manic go-go years, they became slaves to Wall Street instead of focusing on building a long-term business. According to interviews with current and former Critical Path executives, Hickey and his team had decided last year to sell the company. For them, that meant that maintaining a high stock price trumped all other business fundamentals. Once they set on that course, move after move propelled them down a disastrous road.

What had started as a dream of building the Internet future ended up a cynical exercise in seeking quick profits. According to current and former employees, sales and executive meetings turned into unbearable pressure cookers, as staff members were told to meet their numbers at all costs so that the company could impress analysts and prospective acquirers. Most of Critical Path's acquisitions were carried out to harvest the revenues and customers of the acquired companies, instead of adding compelling technologies that improved Critical Path's core business. That left the company's culture in tatters as it tried to glue together 1,000 employees from 10 different companies. "It was just total chaos," recalls Jerry Seikel, a former Critical Path account executive.

Dark odyssey. Making matters worse, BusinessWeek has learned, were possible violations of accounting rules by Critical Path executives who were trying to prop up revenues. According to several current and former executives, the company backdated sales contracts, pushing deals back by several days to count in an earlier quarter. It also relied on so-called side-letter deals, which made it appear as if Critical Path's services were being ordered up by clients when instead they knew this would allow customers to renege on purchase agreements without penalty. "The line between right and wrong wasn't just blurred. It was wiped out," says a former sales manager.

Critical Path officials concede there were accounting irregularities but contend they were spearheaded by a few individuals who are no longer with the company. Since uncovering the problems, the board has pushed out CEO Hickey, President David Thatcher, and Sales Vice-President William Rinehart. Hickey, Thatcher, and Rinehart declined comment about why they left the company. The company also has revised its third- and fourth-quarter sales downward by a total of $19.3 million--nearly one-fifth of the sales it had originally claimed. "The financial events that impacted the company earlier in the year are behind us and were clearly isolated incidents," says founder and Chairman David C. Hayden, who stepped in as interim CEO in February and says he was not aware of the problems when they occurred. "We have put the necessary controls in place both in terms of systems and personnel to ensure that those events will not be repeated in the future."

Now, Critical Path is fighting for its life. Hayden has streamlined the company's offerings from 40 products and services to a dozen. He has cut the workforce 40%, to 650 employees. And he is attempting to preserve its $171 million in cash. But even Hayden knows a comeback will be difficult. "The start-over effort will be more challenging than the startup phase," he says.

Here is the inside story of how Critical Path went so wrong. BusinessWeek interviewed 25 past and present Critical Path employees and executives to weave together its dark odyssey. What emerges is a cautionary tale about a company that put too high a value on catering to Wall Street and prettying itself up for a sale, rather than focusing on its business.

California Dreamin'. Critical Path was steeped in idealism at its birth. In 1997, Hayden and a group of programmers set out to build a world-transforming business, creating an e-mail service that they hoped would be used by thousands of corporations and millions of employees. Their goal: to turn e-mail into a simple utility, much like water or electricity. Critical Path would run all the software and deliver e-mail accounts to corporations, which would pay them for the service on a monthly basis. The corporations would be relieved of the burden of buying and managing the technology. "We wanted to be nothing less than the central switchboard of the grand thought matrix," recalls Steve Simitzis, a former Critical Path engineer and the company's fifth employee.

The vision appealed to customers and investors alike. Hayden, who co-founded Magellan, one of the Net's first search engines, began lining up Critical Path's first customers that October. By mid-1998, the company had pocketed $17 million in backing from venture-capital firms, including Benchmark Capital and Mohr, Davidow Ventures. Critical Path also snared funding from Internet heavyweights E*Trade Group Inc. and Network Solutions Inc., both of which would become cornerstone customers. In just 15 months, a small band of geeks had built what was suddenly one of the Internet's most promising companies.

Seasoned managers would be required to take Critical Path to its next level--and also to take the company public. In October, 1998, the board hired gritty, hard-driving Douglas Hickey as CEO. On paper, it was an ideal fit. Just nine months earlier, Hickey had orchestrated the $185 million sale of his former company, Web-hosting outfit GlobalCenter Inc., to telecom provider Frontier Communications. Known for table-pounding pep talks, Hickey brought over key sales execs from GlobalCenter and quickly infused the techie outfit with a sense of business urgency.

Hickey's background, however, could have raised some eyebrows. In his previous job at GlobalCenter, he had succeeded as a short-term specialist--rapidly expanding the company's business before selling it 19 months later. He pushed his sales team to reach roughly $25 million in 1997 sales. He then raised the goal to $60 million for 1998, the forecast upon which GlobalCenter would eventually be sold. In fact, according to former GlobalCenter executives, sales ultimately totaled just $48 million in 1998. His critics say that his lofty projections helped GlobalCenter fetch more money in the sale. And if a buyer had not surfaced in time, the company's prospects might have been damaged. Global Crossing, which now owns Frontier, declined to comment.

Life in the fast lane. Just five months into his tenure at Critical Path, in March, 1999, Hickey got his chance to shine. His knack for winning over Wall Street analysts and investors would propel Critical Path's blockbuster IPO, when the stock price more than doubled on the first day of trading. Overnight, the company that had racked up just $900,000 in sales the previous year was valued at a staggering $2.5 billion. The staff was awestruck. "Nobody worked for a week and a half," recalls former Critical Path systems administrator Peter Radavich. "Everyone was just hitting reload on the stock ticker all day."

The jolt of publicity created by the IPO helped the company grow faster. Within months, it had struck deals with British Telecom and Sprint to provide e-mail services for their customers. Critical Path began using its stock for acquisitions, ponying up $20 million in June, 1999, for e-mail provider Fabrik Connect and its 500 customers. Revenues jumped from $70,000 in 1998's first quarter to $1 million in 1999's first quarter. It was a glorious period for Hickey and his team, who had delivered exactly what the board and investors had hoped for.

Beneath the surface, though, tensions were brewing. Hayden and Hickey butted heads about the chairman's role in company affairs. Even though Hayden still occupied a corner office and wanted more of a say in the business, he wasn't included in Hickey's inner circle, according to former executives. Meanwhile, Hickey was jealous of Hayden's position in the spotlight. For instance, Hickey was furious when tech industry magazine Red Herring stuck Hayden's picture on its cover following the IPO, say current and former executives. "There just wasn't enough room for both of their egos," says a former vice-president.

Hayden was the odd man out. Elbowed out of day-to-day duties by Hickey, who had the board behind him, Hayden was a rare sight around Critical Path's offices by late 1999. Over time, his relationship with the new management team disintegrated to the point where he and Thatcher were no longer on speaking terms, even though Thatcher had attended Hayden's wedding just two years earlier, says Hayden. Thatcher declined to comment for this story.

The company's engineers were chafing, too. As Critical Path snatched up three companies in its first five months as a public corporation, the startup's technology vision became clouded. Hickey and his team sought to buy complementary companies to harvest their existing revenues and customers. But engineering execs felt Critical Path should develop its own products to insure the technology would work together seamlessly. Hickey's strategy of buying rather than building would win out, speeding the departure of co-founder and Chief Technology Officer Wayne Correia in late 1999. Hickey's team "disregarded the key elements of our original vision," says Hayden, who says he opposed some of the acquisitions but was overruled by the board.

Internal war. With his hand firmly on the wheel, Hickey started looking for a quick payoff. Publicly, he set the goal of bringing to profitability by the fourth quarter of 2000 a company that had lost $117 million in 1999. Privately, he began looking for a potential buyer, say former execs and company insiders. Among the numerous companies Hickey approached: Internet software makers Verisign and Inktomi. Inktomi declined comment, and Verisign did not return phone calls. Hickey's initial asking price, say the execs: $100 per share--some $5 billion. It was a hefty premium for a company that was trading at about $70 a share, but in those days of unbridled optimism, a soon-to-be profitable Internet company could command it. "I had no idea he was trying to sell the company," says Hayden. The other board members would not comment.

To achieve his ambitious goals, Hickey began beefing up his executive ranks. Then-Chief Financial Officer Thatcher was promoted to president, while Mark Rubash, who had audited Critical Path's books as the leader of PricewaterhouseCoopers' Silicon Valley Software Industry practice, stepped in as CFO. Although Thatcher and Rubash had worked together on Critical Path's books in the past, their relationship would come to epitomize the company's rocky year.

The first signs of strain came on the personal front. On a cross-country business flight, Thatcher trounced Rubash in a poker game--and claimed the CFO Owed him $3,500. Rubash refused to pay, saying they had agreed on a far lower limit before they started the game. Thatcher would frequently goad Rubash about the poker debt up until the CFO's departure in November. On another occasion, at a New York hotel bar after a day of business meetings, Thatcher dashed his mixed drink in Rubash's face, enraging the CFO, say former execs. "I think it was his idea of a joke," says a former executive. "Thatcher's got a weird sense of humor like that."

The two began to clash on the professional front as well, say their former colleagues. Thatcher would occasionally remind Rubash that he wasn't an outside auditor anymore--chiding him for being too strict about following accounting rules. Another area of disagreement came on cost-cutting measures. Rubash argued that the company's acquisition binge, which had added nine companies by June, 2000, had created far too many overlaps in departments such as human resources and accounting. When Critical Path cut 100 jobs, or 13% of its workforce, in July, 2000, Rubash said it wasn't enough. He argued they would have to keep cutting costs to show a profit in the fourth quarter. Thatcher and Hickey vetoed further job cuts, because they thought multiple layoff announcements could cause concerns on Wall Street. Hayden wasn't included in the discussions, he says.

Rubash's nine-month tenure ended last November, when he resigned. Attributing his departure to a family illness, Rubash pocketed a $250,000 bonus and left, to be replaced in late December by Lawrence P. Reinhold, another PricewaterhouseCoopers veteran. When Rubash's bonus check came in, Thatcher couldn't resist one last dig, say former executives. He dialed up the former CFO's voice mail, told him his check had arrived, and asked him if he wanted him to deduct the $3,500 poker debt, plus interest, before sending it along.

By last fall, the helium had started leaking out of Hickey's balloon. The collapse of dot-com funding and the financial problems of telecom companies struck hard at two of Critical Path's biggest customer groups. To counterbalance growing expenses, Hickey was pushing his internal sales target up by $2 million or $3 million--to $60 million. And Hickey continued to promise profitability by the fourth quarter.

Some company execs were concerned. In an early October executive staff meeting, Sales VP Rinehart told Hickey the projections were too high, that $47 million was more realistic, according to two executives at the meeting. Hickey didn't budge, telling Rinehart he didn't want to hear the goal couldn't be met. "Not many people wanted to stand up and tell [Hickey] they couldn't do it," says one former executive who attended. "He was like the emperor without any clothes."

No suitor. It became a race against a Dec. 31 deadline. With a surly Rinehart barking into the phone, sales reps felt the heat all quarter long. "That was their strategy. Hickey and Rinehart used to always say: `Pressure makes diamonds,"' according to one former sales manager.

It was looking less and less as if Critical Path would find a suitor to save it from its impending Judgment Day. Hickey had received lukewarm interest from companies such as Verisign, but nobody would even come near his asking price. With the gloomy economy tightening the purse strings at most tech companies, Critical Path's chances of selling would only get slimmer. "I was always thinking: `If we can just keep the wheels on this thing for one more month, or one more quarter. Just until we can get it sold,"' recalls a former Critical Path executive.

By early December, achieving the sales and profit goals was looking impossible, say former executives. Revenues from some acquisitions were coming in well under expectations. For instance, collaboration-software maker docSpace, acquired in March, 2000, for $258 million in stock, had projected $3 million in 2000 sales when it was purchased. In reality, it would deliver revenues of just $300,000, according to a former executive.

Fearing the company would fall short of their fourth-quarter projections, Thatcher urged Rinehart to get some side-letter deals so that sales figures could be inflated in the fourth quarter, according to two former executives. Side letters are additional pieces of a sales contract that are generally frowned upon--but are sometimes acceptable if disclosed to auditors. For instance, a side letter may give a customer a certain window of time to back out on a deal. The procedure is O.K. as long as the auditors are informed, though most conservative accounting methods would not count it as revenue. Problem is, Critical Path didn't share its side deals with its auditors, according to former executives. Side deals that aren't disclosed are "an accounting violation," says Mary Barth, professor of accounting at Stanford Business School. "It calls into question the validity of the deals." The SEC would not comment on its investigation.

Critical Path's salespeople landed these deals by tapping into their friends in the computer industry. A staffer would call a friend and ask him or her to sign a deal, with the promise they would rip it up after the quarter was over. "They were getting very desperate," says a Silicon Valley Internet exec who received one such pitch last December.

The questionable accounting didn't stop there. Days after the quarter's official Dec. 31 close, the company's books remained open, say several former execs--meaning contracts could, and did, still come in for the fourth quarter. Revenue-recognition experts say companies such as Critical Path that rely primarily on written contracts should not leave a quarter open-ended. Critical Path's new CFO Reinhold, who had taken over the books days earlier, declined to comment.

Critical Path also backdated several deals in early January to count in its fourth quarter, say former execs and company insiders--so the deal could be counted in an earlier accounting period. That's against SEC rules. At Critical Path, "there was nobody standing up and saying it's [wrong] to backdate contracts," recalls a former sales manager. "Just about everyone at the company knew it was going on." Hayden and the board of directors were not aware of what was happening, however, say several former executives.

One such deal was pulled from the books before it could be counted. In early January, a handful of Critical Path execs, including Vice-President for Business Development Mari Tangredi, flew out to Comverse Technology Inc., a customer in New York. Comverse signed a deal for some additional software licenses, then agreed to date it before Jan. 1, according to the former executives. Reinhold pulled that deal from the fourth-quarter books before reporting earnings. While such a move could have been an accounting violation on the part of Critical Path, according to legal experts, Comverse faced no legal repercussions because it had no insight into how Critical Path would eventually report the sale. Tangredi, Reinhold, and Comverse declined to comment about the deal.

Road to a meltdown. Critical Path made a last sales blitz. One target was computer maker Sun Microsystems Inc. Critical Path was attempting to construct a deal in which it would sell about $7 million of software to a distributor, which would then sell it to Sun, say former execs. Problem is, only about $1 million of that software would be immediately sold to Sun by the distributor. Critical Path's auditors put a halt to the arrangement. They felt that counting the entire $7 million in the fourth quarter was overly aggressive accounting. End result: Instead of missing its fourth-quarter projections by a few million dollars, Critical Path would miss by more than $11 million.

News of accounting problems wouldn't surface for 11 days. CFO Reinhold launched a two-day investigation, culminating in a Feb. 1 board meeting. Hunkered down in the San Francisco offices of Critical Path law firm Wilson Sonsini Goodrich & Rosati, the board sat stunned as Reinhold laid out his findings. "I was pissed," says Hayden. "I still felt that this was my baby." By midnight, the board called Rinehart and Thatcher, telling them they were being suspended. Within days, Hickey, Thatcher, and Rinehart would all be asked to resign, and Critical Path got word of the SEC investigation.

Operating under the taint of scandal is no easy chore. Hayden has shifted the company's focus drastically from Wall Street back to the customer, spending the bulk of his time with existing clients. He has helped put in place new accounting processes, such as requiring the CFO's signature on every deal, to avoid future trouble. All of this encourages some customers. "He has done some of the seriously tough things. It's great to see," says Terry McFadden, associate director of Procter & Gamble Co., which is a big Critical Path customer.

Will it be enough to shake the company free of its dark past? Probably not. Potential customers may be hesitant to hand over something as crucial as e-mail to a company that may not be in business a year from now. "It's like a throwing a weak person out in the summer heat. It's hard to survive," says analyst George Chandler of Frost Securities Inc. Critical Path also has to dodge some legal bullets. It has a $30 million insurance policy against the shareholder suits, say former execs and insiders, that it can only hope covers the damages if it loses. Any SEC action, if taken, could also lead to fines.

The company's stock is a pariah on Wall Street. Only five analysts now cover it, down from 17 at the start of the year. And the price has been below $2 since April, raising the possibility that it could be delisted by Nasdaq. That's just more bad news for burned shareholders such as Geraldine Carly, 57, a Springville (Utah) homemaker, who says she and her husband lost their nest egg of $20,000 by investing in Critical Path shares. Months later, husband Dan succumbed to cancer. Now, Geraldine, a lifelong homemaker, is struggling to find a job and pay her mortgage. "I just don't think they realized that they were playing with other people's money," she says. That could be the epitaph not just for Critical Path's saga, but for many participants in the dot-com era.

By Ben Elgin

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