Raiding the dot-com piggy banks

As the Internet economy crashed, his Skiritai Capital investment firm started looking for companies that still had plenty of cash left over from stellar stock offerings. Many of these companies' bank accounts were larger than their stock market value, an unusual phenomenon called "negative enterprise value."

It seemed like a natural way to pick up bargains. Silvestri combed through his research and finally invested in a company called Cotelligent, a once-ambitious wireless Net consulting company.

But one unsuccessful proxy battle and several difficult months later, he--like other investors who have sought similar bargains--now has words of caution for anyone who might be contemplating the same path.

"The idea works," Silvestri said, "but you have to do a lot of work to find management that's going to rebuild. (Otherwise) you're battling against management, and they're spending your money."

Silvestri is one of a few who retain some optimism about parts of the dot-com sector. While not many believe in the billion-dollar promises of the bubble years, a small number of firms and investors still see some opportunity in the form of negative enterprise value companies.

Since the collapse of Enron and WorldCom, Wall Street critics have called on boards of directors to take more responsibility for company direction, while shareholders have been increasingly vocal about their concerns about corporate plans. Silvestri and his peers take this shareholder activism to an extreme, putting their message to directors in no uncertain terms: Prove the company can make money, or stop wasting shareholders' funds.

Breaking into the piggy bank
Some investors see these companies simply as piggy banks to be broken open: If they take enough of a stake in the company, the management might be persuaded to shut down the business and hand out the cash to shareholders. Some companies have done this without a struggle. Others have done so only after bitter proxy battles led by the investors.

One of the most active investors in this category has been Jim Mitarotonda, chief executive of the New York-based Barington Capital Group. He and investing partner Seymour Holtzman applied the strategy to Musicmaker.com, an online compilation-CD manufacturer that proved to be one of the very early casualties of the dot-com shakeout.

After a hostile proxy battle that saw the election of Mitarotonda and Holtzman to Musicmaker's board, the company closed its doors and redistributed much, but not all, of its cash to shareholders. Mitarotonda and Holtzman are now pressing music technology company Liquid Audio, in which they own a near-7 percent stake, to do the same thing.

Their pressure on struggling businesses has prompted bitter words from employees of the companies they're targeting. Critics say investors like Mitarotonda are nothing but corporate raiders, hungry for quick dollars at the expense of a company's value.

"It would appear that they have their own agenda, which isn't necessarily driven by what is best for all Liquid Audio stockholders," said Liquid Audio spokeswoman Kim Strop, following a recent shareholder vote that saw Mitarotonda and Holtzman placed on that company's board. Liquid Audio has sued Mitarotonda's group and another investment firm, Steel Partners, which pursues the same investment strategy somewhat less aggressively.

Mitarotonda, at least, doesn't mind.

"Boards of directors have a fiduciary responsibility to their shareholders if their business plans aren't working," Mitarotonda said. "They can't just deplete cash on the future hope that something might turn around."

Not that the investing strategy always leads to both sides drawing battle lines. Some of the companies with negative value do have real business models, when they're forced to make a realistic balance between costs and revenues, investors say.

Despite his as-yet-unsuccessful fight over the direction of Cotelligent, Silvestri says it's best to find small companies that actually have a potential business, and work with management. Feeling burned by his recent experiences, he says his firm will take this tack in the future.

"We spend a lot of time going in to meet managements to find out if they're going to be shareholder-friendly," Silvestri said.

Shareholders' rights? Or wrongs?
The fight waged over the future of these struggling companies ultimately comes down to a philosophy of ownership. Does a public company have a right to keep using its cash if shareholders have lost faith?

Mitarotonda, Silvestri and others think the answer is no, at least in extreme cases. But many of the companies they target have "shareholder rights" plans, or "poison pills," written into their corporate documents, which prevent activist shareholders from deep influence on the direction of the company.

Companies adopt these terms of governance in order to fend off hostile buyout attempts and short-circuit the influence of hostile minority shareholders. Typically, such terms require that in order for changes to the corporate charter or other actions not supported by the board of directors to go through, a large percentage of all outstanding shares, such as two-thirds or 70 percent, be voted in their favor.

These provisions have helped Liquid Audio and Cotelligent fend off Mitarotonda's and Silvestri's most dramatic proposals for change, and the two say the clauses are anything but shareholders' rights plans.

"Why should they have a protective mechanism if they're doing a good job?" Mitarotonda asked. "It protects the entrenchment of poor management. If you've got an outstanding CEO and a board acting as outstanding managers...why would you need a poison pill?"

Despite the post-Enron moves to improve shareholder scrutiny of corporate action, the poison pill is likely to remain a useful tool against more conventional corporate raiders, however.

Certainly, the growing caution of negative-value investors faced with the power of shareholders rights plans is dimming enthusiasm for the investment strategy. Moreover, the simple weight of ongoing business failures and buyouts is shrinking the number of negative-value companies available to investors.

A survey taken in early October by National-Louis University Assistant Professor Scott Larsen found 67 companies in that position, compared with 233 in the third quarter. The list included Internet and tech companies such as Quepasa.com and Deltathree.com.

"These companies have a negative value for some good reasons," said Charles Bolton, a hedge fund manager for WestEnd Capital Management who has little interest in negative value companies. "The bottom line is they aren't great businesses."