Buy cheap, the saying goes, and you get cheap. In what is shaping up as a dismal year for the Internet sector, at least 450 Internet companies closed their doors during the first nine months of 2001, nearly twice as many failures as in all of 2000.¹ As valuations plunged, failing dot-coms have become acquisition targets for better-positioned companies eager to take advantage of bargain-bin prices. Investors, many of them traditional, off-line companies, have poured billions into acquiring almost 1,000 different Internet assets and properties so far this year. In comparison to the same nine-month period last year, the average dollar value of each transaction has dropped, but the total number of transactions has actually increased by about 40 percent—and the figures are projected to grow by year's end.²

But acquirers rummaging through the Internet's bargain basement should temper their enthusiasm with caution. The spectrum of options to choose from is much broader than typical M&A, and there is much less data to help sort it out. Think about how many start-ups there were in each major e-tail category alone, for example. How does a potential acquirer know it is picking the one deal that has real assets? Unfortunately, these acquisitions are relatively small and can easily fall below the radar of established M&A departments. Most targets do not have I-banks, either, to shop their assets in this fire sale. More than in typical M&A, it is critical that potential buyers thoroughly understand the complexities of an opportunity before completing a deal, both in valuing intangible assets and in capturing potential synergies.

Shop carefully, even when time is short

Companies looking to take advantage of the bargains must guard against allowing a feeling of urgency to lead them into a bad investment. With sources of funding disappearing and companies on the brink of insolvency, Internet companies hurrying to liquidate may not be entirely candid about their financial status. Acquirers should be on the lookout for hidden liabilities that would destroy the value of an acquisition. For example, close examination of one dot-com found that more than half of its accounts receivable were to other cash-strapped dot-coms, and it had hidden liabilities in ongoing service contracts, equipment leases, and software licenses. Combined, the company would need 60 percent more cash than it had estimated to return to profitability.

Moving fast may make sense in some cases, for example to reach an agreement before a potential acquisition heads into insolvency, but companies must not give short shrift to standard M&A best practices. This is especially true when it comes to evaluating tangible and intangible assets. The few tangible assets an Internet company may have, such as customized e-commerce hardware and software, are often too difficult and expensive to integrate with existing systems. Key personnel may leave before an acquirer can convince them to stay, taking with them crucial knowledge of software codes.

Intangible assets are even more difficult to value and may be worth little or nothing to an acquirer. Brands, customer relationships, and talent have been among many Internet companies' core assets. But how can an acquirer evaluate an Internet brand, for example, when so many are suddenly available and so few have been around long enough to build up solid brand equity?

Similarly, while acquiring existing customer relationships may be tempting, the usefulness of customer lists is questionable. Privacy groups fighting to prevent companies from selling customer information are not the only concern. Factors such as nontransferable customer contracts, poor customer quality, or low visitor-to-buyer conversion rates are also obstacles. For example, one on-line health player purchased a major competitor expecting to broaden its customer base. However, postmerger analysis revealed significant customer overlap, dramatically decreasing the value acquired.

Thoroughly understand where value will come from

In order to understand clearly the value of a potential merger, companies must incorporate postmerger management planning from the beginning, just as in more traditional mergers and acquisitions, including critical input from the teams that would be responsible for integrating assets. They must also structure each deal to minimize the potential risks that often accompany bankruptcy, such as talent flight, deterioration of customer relationships, or lawsuits by creditors or other parties.

Particularly in the Internet sector, success hinges on the acquirer's ability to be creative in considering the full slate of deal options. For example, one travel start-up headed to insolvency seemed at first glance to have little to offer. But a closer look by an opportunistic incumbent uncovered favorable terms for reservation processing that the start-up had been granted by an established player. Since the contract was transferable, it was worth $10 to $20 million to the established acquirer—well above the actual purchase price for the company.

Plan an Internet strategy

Established incumbents that carefully identify and pursue specific assets to support a strong existing Internet strategy are the most successful acquirers. Targeting specific assets rather than buying an entire company increases the chance of success by minimizing risks associated with costs, complexity, personnel, vendor relationships, and other potential liabilities. Many successful deals have not only reduced time-to-market or development costs but have also generated a unique and proprietary advantage that increased entry barriers for competitors.

Electronic commerce—one of the first sectors to collapse—has yielded several successful transactions. For example, one major retailer acquired specific key assets of its bankrupt on-line competitor in a series of separate transactions, improving both its off-line and online operations. More than $40 million of inventory was purchased for $5 million; the trademarks, logos, URLs, and other intellectual property were purchased for $3 million, and several months later the distribution and fulfillment operations were purchased for a fraction of the original investment.

By focusing on complementary assets rather than on trying to acquire and fix the failed company as a whole, the retailer was able to improve its chances for success.

The acquirer was able to leverage these bargain assets almost immediately into incremental sales and profit. And by focusing on complementary assets rather than on trying to acquire and fix the failed company as a whole, the retailer was able to improve its chances for success and increase its return on investment. In fact, the company felt the brand name of the defunct e-tailer to be so valuable that it relaunched the brand less than a year later. The relaunched site already represents 40 percent of the retailer's total on-line sales, and the retailer expects to break even on the investment in less than a year.

Another successful strategy has been to acquire all the specific assets necessary to create a complete, market-leading offer. For example, Homestore.com, a leader in the on-line real estate market, carried out a systematic acquisition program or "roll up," targeting weaker players to build economies of scale and expanding the company's service offering and revenue sources. Homestore identified real estate listings as a critical, scarce resource in its industry's value chain. Its control of listings, bolstered by key acquisitions of languishing dot-coms, provided improved control over an expanded range of listings to close future deals on attractive terms.

The results have been impressive. Homestore.com has grown into one of the Web's top 25 most-visited destinations, leading its industry segment in visitors for more than two years.³ This market leadership has translated into significant sales growth—expected to grow over 100 percent in 2001—and positive operating cash flows.⁴ Unfortunately, Homestore has not been immune to the events of recent months, and its market valuation has declined significantly.

Distressed assets are usually cheap for good reason. Finding companies that retain value in the midst of the Internet stock collapse is not easy, but it is possible. The key to finding the best values is a rigorous application of M&A fundamentals combined with a thorough understanding of the Internet's distinctive characteristics.