Tech Industry

Investors see nothing hatching at Net incubators

Analysts are pulling the plug on Internet incubators, the high-risk businesses that discover and nurture fledgling e-commerce companies.

Investors are pulling the plug on Internet incubators, the high-risk businesses that discover and nurture fledgling e-commerce companies.

Many incubators are trading at or near their 52-week lows, and analysts are skeptical that they will soon rebound. The market has so severely punished the niche that Pasadena, Calif.-based Idealab postponed its initial public offering Wednesday, casting blame on market conditions.

"Over the past several months, we have seen dramatic shifts in the market and determined that it is in the best interest of the company, its employees and investors that we not proceed with the offering during this volatile time," Idealab chief executive Bill Gross said in a statement Wednesday.

Last year, when investors rushed to purchase any Web-related stock, Internet incubators seemed like a great idea. They funded and helped develop a wide range of Internet companies, from Web portals to business-to-business marketplaces, and their market capitalizations soared.

But shares of e-commerce companies took a beating in the general market downturn that began in April. Now the incubators that fund and help develop them are also showing cracks.

Experts say that Wall Street's renewed emphasis on profits and sustainable growth has been a bitter pill for incubators, which try to discover interesting start-ups with long-term potential--most of which burn cash for years before making profits.

"Sentiment went away from business-to-business, business-to-consumer, and essentially all things dot-com and Internet, and these (incubators) were essentially Internet holding companies," said Luke Fichthorn, an analyst at Lazard Freres.

Leading incubator Internet Capital Group traded as high as $212 in the past year, but it set a new 52-week low of $9 on Wednesday.

CMGI also set a new 52-week low of $12.88 on Wednesday, after reaching a 52-week high of $163.50. San Francisco-based Stonepath Group, formerly Net Value Holdings, traded Thursday at $1.13, a 97 percent drop from its 52-week high of $39.31.

Shares of Rare Medium Group, a New York-based incubator and consulting company specializing in e-commerce, traded Thursday at $4.22. That's a 14.41 percent improvement from Wednesday's closing price, but it's a 95.5 percent decline from the company's 52-week high of $94.75.

The drubbing of e-commerce stocks isn't the only factor contributing to the cooling market for incubators.

The downturn in the market for initial public offerings of all kinds also means trouble for incubators. Numerous technology companies have recently pulled their IPOs, including Net consultant Zefer, set-top TV box maker ReplayTV, incentive-to-surf start-up AllAdvantage.com, electronics retailer 800.com, and Linux services company Linuxcare.

"The idea was to provide more value than just money and advice," said Safa Rashtchy, an analyst at U.S. Bancorp Piper Jaffray. Rashtchy was referring to the potential payoff to incubators, which typically own large percentages of the companies they nurture and capitalize when their clients go public or get acquired.

Ending, not mending?
Experts say the market for incubators is unlikely to improve in upcoming quarters. They predict that many will not survive because of their high "burn rates"--the amount of cash that companies must spend before profitability to pay employees and otherwise operate the business.

ICG has three to four quarters of cash left, while CMGI has about five, Fichthorn estimated.

Facing an uncertain future, many incubators are rushing to revamp their own business models. Some are betting that they can make more money as turnaround consultants for troubled companies than as feast-or-famine gold diggers looking for one big payoff.

"Incubators are trying to move away from their inability to get (IPOs) out the door by becoming more of an operating company than a venture capital firm," Fichthorn said.

In an effort to help speed changes to their business model and restore faith among investors, many companies are shunning the label "incubator" altogether.

"It wasn't the right metaphor for us," said John Brine, vice president of marketing and communications at Stonepath.

Brine insisted the semantic shift was meaningful. The word "makes you think it's for sick babies and it's a short-term fix, and we're not (investing) for the short term," he said.

Another option for beleaguered incubators is to focus on a particular niche of e-commerce and get a reputation as a specialist in a specific investment field. ICG focuses on getting business-to-business companies off the ground and hopes that in-depth experience in that field will help it dominate.

But even that plan has snags. ICG owns a stake in more than 70 companies and owns a majority stake in 13 of those entities, making it tough to wrest command of one niche of e-commerce.

"ICG needs to be able to dictate behavior, not just influence it," Lehman Brothers analyst Patrick Walravens wrote in a recent report.

ICG plans to "focus our resources on our most promising and strategic companies," said Michelle Strykowski, a public relations manager at ICG. It is also considering a plan to consolidate its holdings and raise its stake to more than 50 percent in a few select entities.

Shifting strategies
The company gave no specifics, but Walravens calculates that ICG will cut its ownership down to 20 to 25 companies through mergers of complementary companies and the sale of nonstrategic assets, which will also strengthen the company's cash position.

But the strategy could take as long as two years to execute, Walravens predicted, partly because chief executives in ICG partner companies may hold out for better merger terms. Some may not want to merge at all.

While ICG is increasing its stake in partner companies, Stonepath prefers to hold minority stakes in companies. It owns a majority stake in only one of nine businesses it funds.

"There's less control, but there's also less risk," Brine said.

The method might suit smaller players like Stonepath, which has about 20 employees and $40 million in cash, according to Brine. ICG has about 150 employees globally.

CMGI does not consider itself an incubator and highlights its activities as an operator of 17 Internet-based businesses including publicly traded Engage, uBid and NaviSite, as well as privately held search portal AltaVista.

The company has changed its investment strategy over the past few months in response to internal initiatives and market conditions.

@Ventures "is slowing down investments in e-tailers and business-to-business companies," said Lior Yahalomi, a managing partner of CMGI @Ventures, the independently operated venture capital arm of CMGI. "We're diversifying the fund into emerging technologies."

@Ventures generally looks to shift investments more into technology powering the Internet or Internet businesses. One example is 2Roam, a company that helps Internet businesses deliver content and services to wireless devices.

The markets also instilled more discipline in the company's investment decisions. "The fundamental correction in the market brought us back to basics," Yahalomi said.

Many incubators insist money is still available. Christian Gunning, spokesman for privately held incubator eCompanies, says the company has funded seven start-ups since the market correction in April.

In the past, eCompanies would put $1 million to $1.5 million into a company before financing its first round of external funding. The market correction has forced the company to seek outside investors earlier for the first round.

"The public markets will always influence venture capital," Gunning said. "At the end of the day, companies with a good idea, good management and a good business model will get funded."