InfoSpace (Con't Part 1 of Taking the Investors for a Ride"....
"A very awkward position"
InfoSpace's revenue shortcomings were turning out to be far worse than finance director MacLeod had feared.
From: Naveen Jain
To: Garth MacLeod
Subject: European wireless revenues down
"This is not good. How do we fix it?"
From: Garth MacLeod
To: Naveen Jain
Subject: Saraide board meeting
"Saraide's revenue ... is significantly lower..."
From: Joni Hanson
To: Naveen Jain
Subject: Analyst day
"Better talk to him about what exactly he thinks he's going to say" to analysts.
By August 2000, MacLeod reported that wireless revenues from InfoSpace's Saraide purchase would limp in at $4 million in the fourth quarter, a far cry from the $17.5 million needed to "beat the street." In fact, InfoSpace's wireless business was such a bust that company insiders sarcastically called it "wireloss," a former company executive said.
"The drastic size of the [Saraide] reduction has put us in a very awkward position," MacLeod wrote in an Aug. 4 e-mail to Jain, Halstead, Alben and others. "This is the main reason for our 4Q '00 revenue challenges, as analysts were clearly primed to expect major wireless revenues."
Senior management — in a flurry of e-mails — discussed the need to try to conceal the revenue figures as they prepared to meet with stock analysts in early September to talk about InfoSpace's financial picture.
"Knowing that wireless revenues are not coming in where forecasted — I think it would be a mistake to provide [figures] at this time," chief accounting officer Halstead wrote on Aug. 31.
Investor-relations officer Joni Hansen agreed: "Better talk to [the chief financial officer] about exactly what he thinks he's going to say. The wrong thing will kill us."
Jain added, "We need to be very, very careful on what we say about historical information especially on revenue breakdown. I will prefer to avoid it all together. Let's focus on the future."
During the meetings with analysts, InfoSpace executives refused to give precise answers about how much revenue the wireless business was bringing in. However, they did focus on the future, forecasting spectacular 2001 revenues — a 70 percent increase to $360 million.
Jain's claims in these meetings disturbed Rick Thompson, the executive vice president of product development who was new to the company.
"I had observed Mr. Jain making unsupportable comments to InfoSpace investors, regarding financial results to be expected and products in development," said Thompson, now a vice president at Microsoft, according to an unsealed court record. He declined to comment for this story.
How to hide the shortfall
With the company's wireless business failing to meet expectations, InfoSpace relied on accounting gimmicks and questionable deals to make up the shortfall, records show.
Desperate to make up for the lost revenue, Jain turned to his younger brother, Atul, who lived in Virginia, where he had started a small software company called TEOCO. InfoSpace had paid Atul Jain's company $400,000 a year earlier to develop software that would later become the nucleus for another Atul Jain company, netgenShopper.
NetgenShopper's concept was to allow people to go online and seek competitive bids for services or to buy merchandise. A customer could look up landscapers in online Yellow Pages, for instance, and click on a link to ask for bids for a back-yard project.
Jain and InfoSpace each invested $1.5 million in Atul's startup. Within a few months, InfoSpace announced that it would offer netgenShopper's auction services on its network of Web sites.
However, Jain later renegotiated the deal with his brother to try to dramatically boost InfoSpace's struggling revenues.
From: Atul Jain
To: David Shipps
Subject: Amendment to agreement
"Here are my thoughts on how to move forward."
They came up with a plan: InfoSpace would buy an $8 million interest in netgenShopper, which in turn would send $5 million of it back as payment to InfoSpace for promotional services. Specifically, InfoSpace agreed to send out e-mails to potential customers and guaranteed an enormous number of hits on netgenShopper's online ads.
It was the kind of deal that InfoSpace insiders referred to as "buying revenue" or "a lazy Susan" because the cash the company gave out came right back to it as revenue.
Experts say that these types of deals are suspicious because of the inherent conflict: one company doing business with another company it owns. The American Institute of Certified Public Accountants advises auditors to scrutinize such deals because they can "improperly inflate earnings by masking their economic substance or distort reported results through lack of disclosure."
Lazy Susan deals are illegal when they're not genuine business deals but instead merely a fraudulent way for companies to convert their own cash into revenues.
When it became clear InfoSpace wasn't generating its own revenue, Jain used several types of deals to create the illusion of revenue.
Atul Jain — seemingly mindful of the suspicious nature of lazy Susans — wrote an e-mail to his brother, cautioning him about the appearance of the deals. "We should separate the investment from the business deal. We will do them at the same time in separate transactions."
Atul Jain declined to comment about netgenShopper for this series.
Even though it called for a long-term relationship, the new netgenShopper deal was loaded to provide most of the $5 million in revenue in the fourth quarter — the quarter with the huge revenue shortfall.
Frontloading the netgenShopper payments to InfoSpace in such a short period was strange, according to Ajay Shah, former CEO of a leading auction company, Handshake.com.
"When you have $8 million to spend, marketing should never cost 50 percent of your complete budget [nor] be exhausted in four months," Shah said in an interview. "There's no way to justify that. You'd have to be a really, really bad business person to think that deal was good."
Shah said InfoSpace was one of many dot-coms doing lazy Susans. In fact, they "were so common at the time, I thought it was completely legitimate," Shah said. Even so, he said he always considered these kinds of deals to be misleading to shareholders.
Lazy Susans were not the only accounting trick Jain and the company used. He knew another way to show more revenues from the deal he made with his brother's startup.
Cashing in favors
InfoSpace required netgenShopper to pay partly in "stock warrants," which gave InfoSpace the right to buy netgenShopper shares at a predetermined price. By doing this, InfoSpace could count the value of netgenShopper stock as if it were cash coming in. In the days of exploding stock values, this enabled InfoSpace to balloon its revenues.
Counting warrants as revenues is allowed under accounting practices, but putting a value on stock warrants is tricky. As a small private company, netgenShopper didn't sell stock on the open market. So the value of its shares was anybody's guess.
In those situations "any valuation would be suspect. It's about as far as you can get from a real asset," Eugene E. Comiskey, an accountant and co-author of "The Financial Numbers Game: Detecting Creative Accounting Practices," said in an interview.
Comiskey believes auditors should not allow public companies to give private-company stock warrants any value at all, which would eliminate their worth as a revenue booster.
Jain had a different way to make the stock warrants valuable: If he could get outsiders to buy shares of netgenShopper at a vastly inflated price, he might convince auditors at Deloitte & Touche that the stock warrants were worth millions.
Jain had a difficult sales job because the dot-com stocks were falling and the torrent of venture capital was drying to a trickle.
From: Jed Smith
To: Naveen Jain
Subject: Jed Smith - Catamount Ventures
"I cannot do an investment as a favor. I believe that I could go to jail."
From: Marc Belzberg
To: Naveen Jain
Subject: InfoSpace investment in Netgen
"For friends, I am willing to stretch the rules."
From: Ellen Alben
To: Steve Crosetti, Christina Balkan, Naveen Jain
Subject: OpenAuto deal (timing)
"It disturbs me that they are essentially just paying us back our own money."
From: Garth MacLeod
To: Naveen Jain
Subject: yr 2000 forecast
"Even the realistic estimate will prove to be a challenge (unless we buy revenues)."
Jain decided to cash in some favors. He e-mailed Marc Belzberg, who ran a technology company based in Israel. InfoSpace was one of several investors who had pumped $9 million into Belzberg's company, e-Sim, the year before. Now, Jain asked Belzberg to buy netgenShopper shares at an inflated price, even offering to give him the cash he needed to make the investment.
"Please let me know if I can count on you for this," Jain wrote in an e-mail. "I can buy some of your e-Sim shares to give you cash if you need some cash to fund this."
Belzberg responded that he was generally prudent in his investment decisions, but "at the same time for friends I'm willing to stretch the rules." Even so, Belzberg passed on Jain's invitation.
Jain tried another investor, Catamount Ventures, in which he had already agreed to invest his own money. Now he tried to use that as leverage to get a favor.
Jain asked the managing partner of the venture-capital fund to buy shares of netgenShopper. "I would have led the round myself," Jain wrote, "but it does not seem appropriate given my relationship with" Atul Jain.
Catamount's manager Jed Smith was incredulous at the value Jain proposed for netgenShopper's stock, making the company worth more than $100 million.
"My feeling, Naveen, is that Atul is great, but I'm seeing deals across my desk that are at a similar stage that are jamming" — having trouble — "and at $10-$25M valuations."
Jain pleaded with Smith, "I can't believe that you can't help me out. I will return the favor back to you."
At that, Smith sent a blunt response:
"You never told me that your investment in my fund was conditioned on my investing in your brother's company. Naveen, no matter how much I want to, I can't do an investment as a personal favor. I would get sued by my limited partners and I believe that I could go to jail."
In the end, a lazy-Susan deal saved the day for Jain. Lycos, the search-engine company, agreed to put $8 million into Atul Jain's tiny company. In exchange, netgenShopper agreed to pay Lycos $10 million, over three years, for ads on Lycos Web sites.
NetgenShopper had the extra $2 million to spend on the one-sided deal because InfoSpace, under Jain's direction, had given his brother's company $8 million but took only $5 million back. In effect, Naveen Jain overpaid his brother's company, so that it in turn could pay Lycos, which then bought part of netgenShopper at an inflated price.
As a result of this financial triple-bank shot, InfoSpace was able to convince auditors that its netgenShopper warrants were worth $2.8 million in 2000, using that figure as if it represented cash revenue. The maneuver was a huge boost for a company desperate to beat Wall Street's revenue projections.
InfoSpace's lazy Susan and stock-warrant arrangement with netgenShopper were not the only questionable deals the company crafted during volatile 2000 as a way to create revenue, thereby fooling investors and shareholders.
InfoSpace had another trick for boosting revenues: Swapping free advertising with other Internet companies. Known as "barter revenue," such swaps were allowed at the time by accounting rules, though the maneuver was controversial because no cash is exchanged.
By the end of 2000, InfoSpace counted at least $22 million in 2000 revenues from stock warrants and $32 million from "related party" and lazy Susan transactions. Together with barter advertising, these deals accounted for more than a quarter of InfoSpace's revenues that year.
These accounting gimmicks fulfilled the forecast of finance director MacLeod, who had warned earlier that hitting revenue targets will be tough "unless we buy revenue."
And just how real were the numbers? Again, MacLeod said in an e-mail to Jain that the stock-warrant deals "are driving revenues artificially high."
But the investing public had no idea at the time. Only InfoSpace insiders knew the extent to which their dot-com was built on artifice. They also knew what they had to do next.
David Heath: 206-464-2136 or dheath@seattletimes.com
Sharon Pian Chan: 206-464-2958 or schan@seattletimes.com |
