Los Angeles Times Thursday, March 8, 2001

Beleaguered Idealab Needs to Hatch a Plan for Its Survival

Internet: The start-up incubator has fallen on hard times along with many of its dot-coms.

By GREG MILLER, KAREN KAPLAN, Times Staff Writers


Bill Gross     EToys Inc., one of the Internet's flagship companies, filed for bankruptcy protection Wednesday, becoming the biggest online company yet to fail amid the devastating dot-com shakeout.
     More than the demise of a single company, the collapse of EToys shows just how far Bill Gross and his Pasadena-based Idealab Inc. have fallen.
     Besides EToys, Idealab churned out early Internet hits such as Web search engine GoTo.com, free Internet service provider NetZero and online guide CitySearch, generating at its peak more than 6,000 jobs and billions in shareholder wealth.
     All that activity put Southern California on the "new economy" map and made Gross a high-tech celebrity, entrepreneurial hero and paper billionaire. But the dot-com decline has left Gross and Idealab in a precarious and unfamiliar position.
     With an Internet turnaround nowhere in site, Idealab has been forced to slash spending and lay off more than half its employees just to make it through this year.
     After pouring $800 million into a virtual black hole, Gross now finds himself in the humbling position of fending off investors who recently tried to seize control of his company. Gross also is facing several lawsuits from a growing list of disenchanted former executives.
     "We go through these cycles where we think there's a suspension in the rules of business and we learn--pretty painfully--that there isn't," said Frank Baxter, chairman of the Los Angeles investment bank Jefferies Group. "There was a certain suspension of reality, and Bill responded to it. It changed abruptly and maybe he couldn't adjust as fast as he might have."
     Gross' top lieutenant and girlfriend, Marcia Goodstein, acknowledged that many of Idealab's ventures over the last few years amounted to garbage and that the company's decline has cast serious doubt on Gross' fundamental premise: In the right setting, Internet start-ups can be hatched like eggs.
     The incubator concept "is being torn apart, laughed at, degraded and derailed," she said. "We need to prove that this model works."
     Indeed, after thriving in an era that scorned business fundamentals, Gross' survival now depends on his ability to do something he's never done before: create a sustainable, profitable enterprise.
     None of this appears to discourage Gross, an incurable optimist who expresses no regret for leading his company into this trouble. True to form, he still believes he can pull Idealab to safety by doing what he does best: generate ideas.
     "We have really, really great companies coming out," Gross, 42, said recently. "Very, very bold, world-changing."
     As recently as a year ago, Gross appeared to be churning out successes at a record pace. EToys was his biggest hit, and many believed it could push Toys R Us out of business.
     Instead, EToys will shut down its Web site today after it was unable to find a buyer or additional financing. The company, which lost $189 million last year, listed debts of $416.9 million and assets of $285 million. Its shares, which last traded for 9 cents on Feb. 26, will be delisted by Nasdaq today.

     Entrepreneurial Bent

     That is a far cry from 16 months ago, when Idealab's publicly traded offspring were worth a total of $10 billion and dozens more start-ups were in the pipeline.
     It was all almost effortless for Gross, the son of an Encino orthodontist, who has been hatching moneymaking schemes since he was a child. His first venture came in middle school, when he discovered he could buy candy in bulk and resell it to classmates at a markup that still undercut the local drugstore.
     As a student at Caltech, he built stereo speakers and sold them to classmates. He made his first real fortune when he started an educational software firm, Knowledge Adventure, and sold it in 1996 for $100 million.
     Then he had what many thought was his best idea of all: Idealab.
     The premise was simple: maintain a staff of entrepreneurs, programmers and managers who could swiftly convert Gross' inspirations into companies. His first hire was Goodstein, who is as pragmatic and tough-minded as Gross is starry-eyed. Though both were married at the time, their professional relationship evolved into a romantic one.
     Gross' companies enter their larval stage in the "pen" just beyond the plexiglass wall of his office in the converted Old Pasadena warehouse that serves as Idealab's headquarters.
     The payoff comes when ventures go public or are sold. For a while, the payoff was huge, as the stock values of EToys, CitySearch and other offspring soared.
     Gross made $7.6 million to $10.2 million selling his personal shares in Idealab companies, according to First Call/Thomson Financial, a company that tracks insider trading. He bought a Ferrari and began work on a custom-built house overlooking the Rose Bowl, where he now lives with Goodstein. He bought his own airplane and told friends of his ambition to give Caltech such an enormous endowment that no student there would have to pay tuition again.

     Idea Loop

     But the Internet mania that fueled Idealab's rise also masked its flaws and, Goodstein acknowledged, clouded Gross' judgment.
     Many of his companies started to have a cookie-cutter quality. After EToys, Idealab launched start-ups selling cookware, cars, pet supplies, homes and jewelry. His next idea sometimes seemed to reflect his latest purchase.
     While shopping for fixtures for his Pasadena mansion, Gross decided the Internet needed a home furnishings store. He hired his builder, Steve Jennings, as chief executive of the start-upMyHome.com. Jennings, who spent four months at Idealab, describes the experience as chaotic.
     Then there were the notorious strategic flip-flops. Three months into MyHome.com, Jennings recalled, "I got a call from Bill in his car. He said, 'Steve, I want you tonight to shut down the e-commerce Web site. Have your tech team put up a basic portal page with links to other furnishing companies.' "
     The next day, Gross called back, upset that the site hadn't been overhauled overnight. "It was flabbergasting," said Jennings, who quit a month later, only to see Gross reverse course again and convert MyHome.com back to an online store.
     Last May, Gross brought in retail consultants from Meridian Ventures to evaluate his e-commerce empire. The group, which had led turnarounds at Macy's and Barney's, concluded the outlook was hopeless and advised Gross that his only chance for profitability would be to fold all of his e-tailers into an Amazon.com-style juggernaut.
     Chagrined, Gross decided it was worth a try. But within months, as the stock market cooled on e-commerce, the mega-site was shut down.
     Gross acknowledges that he relies on others to point out the flaws in his ideas. Much of that pressure falls on Goodstein.
     "He's yes, I'm no," said Goodstein, 36, Idealab's president and chief operating officer. In the midst of the market run-up, she now says, Idealab needed more no's: "We lost all our filters. When the market was investing in crap, we came out with crap."
     Gross still has plenty of supporters and powerful allies, drawn by the always distinct possibility that his next idea could be worth billions.
     But Gross also confronts a growing list of detractors, including many current and former executives at his companies. Their most common complaints: Gross takes too much credit for ideas and Idealab takes a larger stake in its companies than its assistance merits.
     Toby Lenk, chief executive of EToys, resents Gross so deeply that the two have not been on speaking terms for years, according to associates. David Hoddess, chief executive of the struggling Cooking.com, said there's "not a chance" he would replicate his deal with Idealab.
     More than half a dozen former Idealab executives have sued the company over what they say were deceptive practices. Richard Katz, who headed Tickets.com, one of Idealab's first ventures, said Gross stole his idea for a ticket-selling Web site and then simply fired him. The suit was settled out of court and its terms weren't disclosed.
     Gross said the suits and complaints by executives are both predictable and unwarranted. Idealab has given dozens of unproven executives their first crack at running a company, he said, and though they may wish the terms were better, none of them joined against his or her will. "It was completely opt-in," he said.
     Such frictions were easy to overlook while Idealab's prospects were soaring. By the end of 1998, the stock market was so receptive to Internet companies that Gross started to consider taking Idealab itself public.

     Structural Flaw

     But deciding to sell stock to the public set Idealab on a disastrous course. In preparing to go public, Idealab discovered a glaring oversight in its corporate structure. Under a securities law, Idealab's holdings would cause it to be classified as a mutual fund instead of an operating company, potentially blocking its plans.
     "Nobody ever told us" about the law when Idealab was set up, Gross said.
     To comply, Idealab would have to either completely divest itself of many of its companies or buy back enough shares in them to regain operating control. By then, those shares had become quite expensive, and Idealab needed cash.
     In early 2000, Idealab found a group of investors willing to fork over $1 billion. Idealab used $800 million of the proceeds to buy shares in such offspring as GoTo.com and CarsDirect.com at what turned out to be top-of-the-market prices.
     By the time Idealab filed plans to go public in April, the market for Internet stocks was on the front end of a harrowing decline. Gross waited months for the market to turn around, but it only got worse. In October, Idealab withdrew its plans.

     New Investors

     Chasing billions had put Idealab in a huge bind. The company was spending cash so fast it was on course to run dry by the end of this year, Goodstein said. Fearing that Idealab was about to collapse, the outside investors tried to seize control of the company in November, wielding a clause in their contract that guaranteed their investment could not be diluted.
     Gross said he offered to boost the investors' stake in the company from 10% to 25% if they would agree to drop the clause. The investors had another proposal: They would give Gross two of his favorite start-ups--CarsDirect.com and Internet name registrar DotTV--if he would give the rest to them for liquidation.
     Gross and Goodstein rebuffed the offer, and they maintain that their control of the company is not in jeopardy unless they raise new money. Which means "we have to make this model sustainable without ever raising new capital, ever," Goodstein said.
     To conserve cash, Gross decided to scale back Idealab's four satellite offices and slashed company spending rate from about $10 million a month to $2.5 million. At that rate, Goodstein said, Idealab has enough cash to operate for two years.
     All of which leaves Gross essentially back to square one, with the survival of his company dependent on his next crop of ideas. But the market is looking for something that has never been Gross' forte: new technologies that can be protected by patents or would be hard for competitors to duplicate.
     Among Gross' new offerings are companies to provide wireless Internet connections in coffee shops and self-service laundries and to turn PC monitors into TV sets.
     "Within the next six months," Gross said, "we will have major announcements of companies that will be dramatic, great companies."
     

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     Spinning Down

     Idealab has spun off several companies since its inception, but stock prices for these once-highflying tech firms have quickly returned to earth.

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     Idealab companies Ticker IPO All-time Wednesday
that have gone public symbol price high close Ticketmaster* TMCS $14.00 $80.50 $9.03 GoTo.com GOTO 15.00 114.50 9.41 Centra Software CTRA 5.00 40.38 6.38 NetZero NZRO 16.00 40.00 0.72 Tickets.com TIXX 12.50 32.00 0.69 EMachines** EEEE 9.00 10.00 0.34 EToys*** ETYS 20.00 86.00 0.09

     *--*

* * *
     * Formerly known as Ticketmaster Online-CitySearch.
     ** EMachines acquired Idealab start-up Free-PC.com in November 1999.
     *** Stock ceased trading Feb. 26.
     Source: Bloomberg News
Copyright © 2001 Los Angeles Times