Dangerous Liaison

By SmallBusinessComputing Staff | Posted June 01, 2001
by Micheal Grebb

Annette Spector keeps a one-page Indian parable in her desk drawer. In the story, a cracked pot feels guilty that it can't hold its water but is redeemed when it discovers the leak has nourished flowers on the ground. "It means that everyone is unique," Spector says. "You have to find the good in everyone's flaws." Spector's outlook has been tested lately. Her McLean, Va.-based company, Diagnostic and Educational Resources (DER), which offers educational consulting, counseling, testing, and course preparation services for educational institutions, is now recovering from a merger that eventually fell apart. The plan was to bring quality educational resources to the Web. "People ask me if I have any regrets," she says in her thick Brooklyn accent. "I say, 'no.' I knew it was a business risk. And now I can go through anything. Sock it to me, and I can do it."

Spector doesn't fit the dot-com profile. Her background involves more chalkboards than boardrooms. She was a teacher before starting her own educational consulting and tutoring business. "I'm not really a businessperson first," she says. "I'm an educator. This was my first real experience with the corporate world, and I was shocked at how people are treated. The only thing that drives the corporate world is money. That's the least thing that drives the educational world."

When it comes to mergers and partnerships, especially in the volatile dot-com environment, some businesses were eager to get on line fast, often glossing over the potential consequences. But now prudence has taken on new importance. The key, say experts, is for small businesses to make sure that everything -- from business goals to chain-of-command to exit strategies, in case things don't work out -- be considered up front. The alternative can be disastrous for small businesses not attuned to the volatility of the high-tech world.

An Enticing Offer
Spector's adventure began in August of 1999 when she got a call from one of her 200 subcontracted tutors who had done some work for a new online educational company called TutorNet.com. "She called me and said she saw a perfect match here," Spector says. Within days, TutorNet contacted Spector to explore a partnership; within a week, it proposed a merger. Spector says she had been thinking about the Internet for months before TutorNet's overtures, especially as a way to extend her educational services to a larger audience and improve upon what she saw as mostly shoddy educational offerings on line. "I was really excited about providing top-quality content on the Internet," she says.

Spector hired some lawyers to examine the deal and eventually agreed to the merger. She burned hours of midnight oil making preparations to merge operations. Then, the day before the merger was to close in December 1999, Spector says a TutorNet lawyer left her a voice mail calling the merger off. "I never really figured out why," Spector says. Perplexed, she got in touch with Keith Edwards, TutorNet's director of marketing, to see if he could shed some light. "Keith told me that he was going to leave TutorNet to start his own company," she says. "And he wanted to work with me. He said nothing that happened with TutorNet would happen with him." By March 15, 2000, Edwards' new company Educata (now CATA Technologies) merged with Spector's company and combined with yet another tutoring firm, Tutorfind. "We were all joking about the Ides of March," Spector recalls, half a smile curling into her cheek.

A Dose of Reality
Within weeks, those Shakespearean jokes were already starting to take on renewed meaning. Spector signed the merger documents and left a few weeks later for a three-week vacation to Europe to see her two daughters. While Spector was abroad, air began to seep out of the Internet bubble. The latest batch of earnings worried increasingly skeptical investors, who began to punish publicly held companies. Private capital dried up almost overnight.

"Originally, my role was going to be huge, but when I got back from vacation that had changed," she says. "The focus was changed from business-to-consumer to business-to-business." Spector had been working to develop tutoring Web sites and to build an advisory board of educational experts. But now her employees were asking questions, and she didn't know what to say.

Edwards says he had no choice but to change strategy. "After the market correction, we saw that some of the business models were not gaining traction," he says. "Being savvy managers and having a lot of experience in planning and the Internet, we had developed a technology that was supporting our educational prospects," he says.

Still, he believes it was a good decision. "We had a sense that there was innate value there," Edwards says. "We saw the opportunity to provide infrastructure services to the educational service providers using that platform. We decided to reposition the company to refocus on that area. Within that context, we brought it to the attention of the other participants in the company that we were going to go through that refocusing and repositioning."

In May, only a few weeks after Spector had returned from vacation, she says Edwards held a conference call. He talked about the tough market environment and outlined the company's new focus. Instead of aggregating educational services, the company would concentrate on technology and software. After the call, Edwards called Spector and offered to sell her company back to her, essentially undoing the deal they had executed in March. "In fairness to these folks, I offered them the opportunity to buy their assets back," Edwards says. "I could have shot those businesses down, but because of my sense of commitment to these people, because of my innate fairness -- I wanted to say, 'Hey, we all had a vision here and this vision is not being realized in the way that we thought it would. This company needs to go in a new direction. I'm offering you the opportunity to take the assets back.' "

Spector says she didn't give him an answer right away. "I still hadn't told my employees what was going on," she says. "Over the months, they had trusted me. Telling them what had happened was the hardest thing I ever had to do in my life."

Starting Over
What happened next is up for debate. Spector says her staff starting getting termination letters, but Edwards says any claim by Spector that he fired her employees would be an "inaccurate statement." (Spector later clarified that the letters were from the human resources director, whom she assumed took direction from Edwards.) In any event, the de-merger occurred on June 30, and Spector struggled through the rest of the summer. "How did he expect me to buy back a business with no employees?" she says.

Eventually, Spector worked out a deal to get her company back, or at least a shell of it. Her entire tutoring business had been folded into Tutorfind, which had become a separate unit of Educata after the mergers. "It would have taken too much time and created too much confusion to pull it back into my business again," she says.

Spector says that before the merger, her firm generated annual revenues of about $400,000. But after losing the tutoring portion of her business, revenues are now about $165,000 per year. "And I'm still paying back attorneys' fees from the de-merger," she says.

Spector says she never had to put up any cash to get her firm back, but other concessions included forfeiting her rights under an employment and severance contract and giving up half of her Educata equity. And while she retained the rights to content she had developed prior to the merger, any content development work that took place afterwards stayed within Educata. Spector says things have gotten better. She has hired an office manager and a course coordinator, who ironically is the same tutor who first approached her in 1999 about TutorNet. Although she understands the tough fix Educata was in last year as the markets retreated, she still wishes she had been more involved in the decision-making process. "I think Keith was a victim of circumstance," she says. "I give him credit for having the vision, but I just can't feel sorry for him because of the way he handled it." Edwards still runs the renamed CATA Technologies from his offices in Orlando, Fla. He says he has no regrets about how the merger and de-merger occurred and was simply fulfilling his obligations as CEO. He also rejects the notion that his relationship with Spector ended badly. "It's not a difficult situation," he says. "It's business."

Stepping Back
Mergers aren't marriages. They're business deals, plain and simple. Small-business owners should leave their emotions at the door when they partner with dot-coms or any other entities. "For small entrepreneurs, often it's not about business, it's a passion," says Brent Habig, a consultant at New York City-based Tigris Consulting. "But if you're trying to partner, you have to distance yourself from that." Furthermore, Habig says that while merger partners may expect their ally to keep them abreast of strategy changes as they occur, top management doesn't necessarily have an obligation to share every detail as it unfolds. "If someone just shows up one day and drops a bomb, maybe there wasn't enough communication on both sides," he says. One idea, he says, is to agree upon periodic status meetings before the deal has closed.

Indeed, that idea of airing everything up front may be one of the most important -- and most overlooked -- aspects of such deals. "It's almost the equivalent of doing a pre-nuptial agreement," says Mitch Marks, a San Francisco-based management consultant and author of Joining Forces: Making One Plus One Equal Three In Mergers, Acquisitions, and Alliances (Jossey-Bass Publishers, 1998). "If you don't come to a meeting of the minds before the deal, you're not going to be able to do it later," Marks says. Too many times people at small organizations overlook culture. You have to listen to your gut."

One mistake to avoid, Marks adds, is letting third parties such as lawyers and investment bankers rush the deal before everything is worked out. "Keep in mind that the advisors get rewarded for the deal getting done, not for the deal working," he says. Of course, even meticulous planning may not avert a separation based on outside factors or changing market conditions. And that's okay, as long as the process was fair. Often, a failed merger is simply a function of timing or marketplace dynamics, but it can also stem from a failure to think the deal through before jumping at the chance to get in on the Internet. While that may be less tempting now that tech markets are in a malaise, experts say it's still a common mistake. "Don't check your common sense when you enter cyberspace," says Harvey S. Jacobs, managing partner at Jacobs & Associates, a corporate law firm in Washington, D.C. "If you wouldn't sell your company to someone who runs a lunch wagon, then don't sell it to someone who sells sandwiches off of a Web site."

Getting the Facts
Jacobs suggests calling for client references to make sure they're satisfied. And check the dot-com's Web site to see if they're hiring. "If they're looking for liquidation experts, that's one thing," he says. "If they're hiring business development people, that's another." It might also be a good idea to buy a financial report on the would-be partner from Dunn & Broadstreet, which usually costs between $100 and $200.

Jacobs also suggests that would-be partners adopt a due-diligence checklist to review all pending lawsuits, existing contracts, employment agreements, bank lines of credit, leases and deeds, tax returns, bank statements, and incorporation documents. If the company's main assets are intellectual property (often the case with dot-coms), a quick check at the trademark and patent offices may be in order as well.

Jacobs says owners should also ask for non-dilutable shares that won't lose value as new mergers occur. "Otherwise, if they keep selling 50 percent of the company, you'll end up with one percent," he says. In addition, small merger partners should ask for specific liquidation rights in the event the business fails. "Maybe you don't want the file cabinets, but you want to own the records that are in there," he says. "Be specific."

The bottom line is that allying with dot-coms remains risky. "A lot of the dot-com companies have come into business without any experience," says Nirmal Pal, executive director of the e-business research center at Pennsylvania State University. He suggests small-business owners strongly consider whether selling the business outright would be a better option, especially when dealing with larger entities. "A lot of companies try to be your partner, but they really want to take over," he says. "It can be psychologically torturous for a small-business owner. It's better sometimes to sell out and make a lot of money."

Of course, entrepreneurs like Annette Spector have a hard time separating their personal passions from the business. In her case, that may have worked to cloud her judgment. "When I got that conference call, I just fell apart emotionally," she recalls. "Looking back, I would have done a little more homework." She says she now wishes she had checked to make sure that the company had worked out all of its long-term funding arrangements before she signed on the dotted line. "That was my error," she says. "I assumed they had already done that. I'm much wiser now. I would definitely have done more research into their long-term goals to get a better indication of whether the company was in a state of flux."

The reality of the world is that markets change rapidly, investors are fickle, and business plans are fluid. Spector isn't letting her bad experience turn her off to the Internet, though. She has begun developing coursework that she is aready marketing for online instruction -- but strictly as a consultant, not as a merger. And Spector says she wouldn't rule out walking down the merger aisle again if the deal was right. "I'm very open to it," she says. "But I'm just going to wait for someone to come to me. I'm too exhausted to go out looking." Indeed, Spector, who has spent her life teaching others, may have just learned a lesson of her own: Like a cracked pot, business deals have the potential to leak water. The hard part is finding those flowers underneath.

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