The Dot-Domino Effect

Behind every dot-com failure lies a host of unhappy creditors. Here's how the happy few have managed to mitigate the risk.

Covad Communications Group Inc. has just experienced the dot-domino effect. In December, this Santa Clara, California-based high-speed Internet and network access provider announced that it would show a $180 million to $190 million fourth-quarter loss, up from a predicted $140 million to $150 million loss. It attributes the unexpected difference to the fact that 14 of its service resellers can’t pay their bills. The troubled resellers account for 27 percent of Covad’s 270,000 customers, according to company reports. Since November, the company has laid off 800 employees, and its stock plunged from a 52-week high of 66 to 1.25 in mid-December. (Covad executives declined to be interviewed for this story.)

Covad is only one of hundreds of companies that leaped to service the new market created by the Internet boom. With all the speed and enthusiasm of the dot-coms themselves, these suppliers rushed to grab market share. But without a tried-and-true way to evaluate the creditworthiness of this fledgling industry, many extended credit on little more than faith in the sector’s ability to succeed. Today, they’re paying the price. Companies as diverse as Internet consulting firm MarchFirst, AnswerThink Consulting Group, online ad seller Engage, electronic commerce software company Ariba, and Internet service providers PSINet and NorthPoint Communications are among the many that have recently announced dramatic increases in uncollectible dot-com debt.

“It’s a new phenomenon,” says Paul Mignini, president of the Columbia, Maryland-based National Association of Credit Management and the Credit Research Foundation, “but it’s definitely a big issue with our members. The dot-coms are crashing even faster than they were rising. Now the horse has left the barn, and it all comes down to a collections matter.”

When big suppliers like Lucent and Nortel lose tens of millions of dollars in bad debt write-offs, they can usually weather the storm, because their losses are a small percentage of their total revenues. But when start-ups or companies that rely heavily on dot-coms as a revenue base start writing off tens of millions of dollars in accounts receivable, bankruptcy can result.

San Francisco­based NorthPoint Communications Inc. recently filed for Chapter 11 protection after Verizon Communications Inc. backed out of a deal to buy a controlling stake. This event occurred when NorthPoint dramatically increased bad debt write-offs and the business foundered.

In its 10-Q filing in November, MarchFirst indicated that it is reserving $59.8 million of its accounts receivable for bad debt, much of which came with its March 2000 merger with USWeb/CKS. If the company continues to have trouble collecting accounts receivable, “our liquidity, financial condition, and operating results will be materially adversely affected,” the filing states.

Credit-ratings agencies can’t help but say, I told you so. “When the Internet bubble was still a bubble,” says Bob Konefal, managing director of Moody’s Investors Service, “we were already pretty focused on the percent of revenue companies got from dot-coms. We knew that a lot of these ventures were high risk by nature. We recognized that revenue from this sector wasn’t certain revenue, and we were haircutting some of the growth expectations in cases where it colored our rating view of a company.”

SLEEPING WITH THE DOT-COMS

That’s not good news to companies like DoubleClick Inc., a New York­ based online advertising firm. Until spring 2000, its media division received 60 percent of its revenue from pure-play dot-com clients, according to Glenn Robertson, who is the vice president of finance, global media, at DoubleClick.

“For the first three years of DoubleClick,” he says, “the venture capital money was flowing. If customers didn’t pay, we thought, ‘Who cares?’ There was someone else right behind them.” Even then, DoubleClick saw about 6 percent of its revenues go up in bad-debt smoke. But the March 2000 tech-stock crash was a wake-up call to tighten credit policies, or face even higher bad-debt write-offs.

The company has always employed a due-diligence process for new customers, which includes analyzing credit reports and financials for revenue and profit trajectories. “But since there’s not a lot of profitability out there in the dot-coms, we also look at cash-burn rate,” says Robertson. DoubleClick examines news reports, and it considers the timing and source of venture capital funds. “Even if they don’t look financially viable, that’s not necessarily a deal breaker,” he notes. “We determine whether they have a good business model with large market and growth opportunities.”

Based on these findings, a customer is classified as an “A” through a “D” credit risk, says Robertson. “A” companies are blue chips to which DoubleClick is willing to extend credit. Those companies generally pay on their own terms, although DoubleClick’s standard terms are within 30 days. “B” companies also get credit, but are considered a higher credit risk. “We have the ‘B’ class so a company can either be upgraded to ‘A’ or downgraded to ‘C,’ which triggers a dramatic change in treatment,” says Robertson.

That change, implemented in March 2000, requires “C” companies to prepay a portion of their orders. If they can’t prepay the predetermined amount, DoubleClick won’t take the business. “D” companies get even harsher treatment–they prepay 100 percent, or no ad. The change in policy did not go over well with DoubleClick’s sales force, and caused a hit to revenues.

“The first thing that happens when you tighten your belt is the ad revenues start to go away,” says Robertson. “Our salespeople were saying, ‘This stinks. Why are you doing this right as things are slowing down?’ But it’s because of our credit tightening that our bad debt isn’t worsening. It’s stayed the same, which for us is a huge win.”

Clearly, DoubleClick and the entire advertising industry face a far larger threat from the overall decline in online advertising sales than they do from uncollectible accounts receivable. In fact, DoubleClick and its rivals, Engage and 24/7, all recently announced layoffs that they attribute to the general industry slowdown. But today, DoubleClick’s media division obtains only 50 percent of its revenues from pure-play dot-com businesses, and Robertson is more confident in the revenues that he is booking.

LINE IN THE SAND

The trick, say executives, is to identify a new set of standards by which to judge dot-coms, since the traditional measures used to evaluate credit risks, like existing credit history and positive cash flow, don’t apply. Then, you must stick to them.

Ingram Micro Inc. (IM), a wholesale distributor of computer technology and services, sells more than $1 billion of its roughly $30 billion in annual revenues through dot-com companies like Amazon.com, Buy.com, and Ideamall.com. The dot-coms sell the product and forward the sales order to Santa Ana, California-based IM, which then ships the order to the end user and bills the dot-com company.

IM realized it had to do business with the dot-coms because that’s how its end users wanted to buy its products, says Michael Newcomb, vice president of credit strategies. The most critical task, he says, is to determine which dot-coms represented a reasonable credit risk.

Like DoubleClick, IM conducts a thorough due diligence, the focus of which is to determine a company’s cash burn rate. IM has set a cash burn threshold of at least one year before it will accept business from a dot-com customer. Still, when it first started doing business with dot-coms, says Newcomb, IM treated them like other customers, extending net 30-day credit terms.

“But as the capital market has changed, it has changed our relationship with dot-coms,” he says. “We realized that we were funding their lack of profitability.” The company changed standard credit terms for dot-coms from net 30 days to an early-pay discount, says Newcomb. “There’s a significant amount of product that moves through the Internet. The key is to participate in it while trying to minimize one’s risk.”

HEDGING STRATEGIES

But that doesn’t insulate IM from bad-debt losses. When a customer looks marginal, IM will also accept letters of credit or on-account deposits against which the customer can make purchases. The company will also consider taking an interest in a customer’s tangible assets. IM sets up another safety net against customers’ business failures by assigning internal credit “specialists” to each of its customers. The specialists make frequent visits to those customers to learn their businesses and to look for signs of impending failure.

One hedging strategy that IM does not use is to take equity stakes in its dot-com customers. “We’ve absolutely stayed away from that,” says Newcomb. “The only way we’d consider taking an equity stake is if we were already extending credit to a customer and we saw it as a short- term solution to cover our credit risk.”

As a lender to dot-com companies, Silicon Valley Bancshares (SVB), based in Santa Clara, California, relies heavily on a dot-com’s backers for its credit risk mitigation strategy. The banking industry is often the first place that economic downturns become apparent, as banking customers of all types begin to default on loans.

Several major banks, including Bank of America, have announced major bad-debt write-offs in recent months. SVB itself was recently downgraded by two of its analysts. The cause: a drop-off in deposits and a drop in the value of the warrants it holds in more than 1,000 companies, which are a mix of technology- related businesses. Ironically, bad-debt write-offs have not been one of the bank’s problems, says CFO Chris Lutes, primarily because SVB does business only with dot-com companies that have some sort of intellectual property, whether it’s proprietary software or patentable processes.

“A traditional bank will look only at a company’s cash flows,” says Lutes. “But for dot-coms, there often aren’t any. If there’s underlying intellectual property, and a company goes under, the venture capital backers will look to quickly merge or sell the company’s assets. If there’s no intellectual property, there’s nothing for them to sell.” This means that SVB’s loan exposure is mostly to early-stage Internet- related technology and software start-ups, not business-to-business or business-to-consumer dot-coms.

CREDIT METRICS

When evaluating a company’s creditworthiness, Lutes says, SVB also looks at the company’s other assets, such as accounts receivable (backing out foreign receivables and past-dues). In addition, it closely examines the amount and source of a company’s venture capital funding, and lends only a portion of that. Lutes says that SVB is more likely to lend to companies that are funded by firms with which the bank has a prior relationship. And, he adds, “We always look to make sure that the venture capitalists have some skin in the game.”

SVB also generally sets a $500,000 limit on loans it makes to Internet-related companies. As a result, SVB’s total loans outstanding to these companies are just $30 million on a $1.6 billion loan portfolio. As a bank, SVB has a unique risk advantage over other businesses, because the loans it makes are secured, and it is the first in line during bankruptcy proceedings.

MORE STRATEGIES FOR SURVIVAL

Experts stress that before extending credit to a dot-com company, it is important to understand the structure of its funding. Many start-ups receive their venture capital in stages after they hit certain performance milestones. “Often at the first glance at a company’s balance sheet, it looks like it is going to run out of money in two months,” says Benjamin Wilner, senior economist with LECG LLC, an economic and financial consulting firm in Evanston, Illinois. “But there could be another milestone it’s going to hit in a month and a half. You need to know what those milestones are and if the company is going to hit them.”

But most important, say experts, is to hold to the fundamental methods of evaluating a company’s potential. “Do not get caught up in metrics like market share and eyeballs,” says Wilner. “You need to use your business acumen to come up with a model to determine whether or not you think the business model makes sense, and whether or not you trust that the people running the company have the ability to implement the model.”

If your company is already overexposed to dot-com risk, Moody’s Konefal suggests taking the most conservative position possible when recognizing revenue from those customers.

“Don’t book that revenue at full value,” he advises, “and create a meaningful bad- debt reserve. From where we sit, diversification of customer base is what we like to see.”

Kris Frieswick is a staff writer at CFO.

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