Feasting on Failure - Part I

We're strolling through the cavernous Weird Stuff warehouse in Sunnyvale, Calif., when Chuck Schuetz spots one of his, well, weirder acquisitions. "That's a used satellite dish," Schuetz says, gesturing toward the huge device lying like a beached whale, high above us on a warehouse shelf. "One guy offered us $50 for it. He wanted to make it into a hot tub."
I blink. It does kind of look like a hot tub. "You didn't sell it to him?" I ask. Schuetz gives the dish/tub a shrewd once-over and shakes his head. "Nah, it's worth $500 to $600."

He should know. Schuetz, Weird Stuff's president, makes his living selling off Silicon Valley's roadkill. When a company dies, he's one of the professional buzzards who swoop in and pick over the remains. Those remains then end up in graveyards like this warehouse, a nondescript building in a Sunnyvale industrial park where everything is for sale. "Make us an offer," Schuetz says with a laugh. "Everything is negotiable."

The place is the size of half a football field, with aisle after aisle of high-tech gear. Picture shelves filled with aging 386, 486 and Macintosh computers; monitors; keyboards; baskets of mice ($5 each); circuit boards; software (yes, there's an "adult" collection); and heaps of stuff that stumps even a seasoned engineer like Schuetz.

In Silicon Valley's overheated economy, where startups are treated more like Hollywood starlets than the ultimate high-risk enterprise, no one likes to discuss the dark underbelly. Few people will utter the word liquidator in polite society. But even as VCs invest billions in high-tech startups (a staggering $7 billion last year alone, according to venture analyst Venture One Corp.) and the Dow surges past 9,000, fueled partially by the high-tech boom, companies are failing all the time.
In absolute numbers, probably more startups are failing than ever before, ironically because the boom is creating more of them, says Charles Federman, managing director of the venture capital firm BRM Group in Fort Lee, N.J. Federman, however, believes the percentage of startup failures is probably lower than it was a few years ago. "Opportunities are greater, and companies have more places to get adult guidance," he notes.

Nonetheless, when a company is going down, someone has to step in and chop up and recycle the pieces. Welcome to the most hushed business in high tech. These folks are Silicon Valley's bottom feeders. But even in that morbid subculture, they adhere to their own pecking order. Explains Kevin Otus, one of the Valley's more polished liquidation specialists, "It's like this: The king lion makes the kill, takes what he wants, then his pack is allowed to come in. Then, when they're done, in come the hyenas and finally the ants." Otus, founder and president of Emerald Technology Valuations LLC of San Carlos, Calif., refers to this as the Valley's "liquidator food chain."

These people know how to make a buck from every workstation, disk drive, conference table and cubicle wall. And a truly great liquidator is a virtuoso who knows how to turn broken dreams--millions of lines of unfinished software code--into a multimillion-dollar deal.
The trick for a distressed company is knowing whom to call when the investors pull the plug and everything must be sold in two weeks. Many investors and shell-shocked CEOs blow it. They throw away millions by resorting to an emergency fire sale where the vultures feast cheaply. Even worse, they never bother trying to sell their intellectual property--their most valuable asset--mistakenly believing that an engineer's still-incubating idea has little or no value.

"Venture capitalists typically cut and run. They see a bunch of code that's worthless without the guys who created it," explains Mark Radcliffe, a prominent intellectual property Valley attorney who has presided over many startup deaths. "But in the past three to four years, we've gotten a wake-up call that there's still life in the corpse." Radcliffe got that wake-up call in 1995 when his Palo Alto, Calif., firm, Gray Cary Ware & Freidenrich, helped Samsung Electronics Co. Ltd. purchase a bunch of long-forgotten 13-year-old patents for a price considered absurd at the time. Observes a chastened Radcliffe, "There's now a recognition that a technology company isn't a pile of sludge when it goes into bankruptcy."

Because distressed CEOs who've never walked the liquidator road are easy prey, Upside is here to help. And because the subject is rarely discussed at dinner parties in the better Palo Alto villas, Upside has decided to lay out the food chain. Savvy entrepreneurs may want to lock this article in the company safe, along with a copy of their résumé.

The first thing to remember is that Silicon Valley's undertakers are highly specialized--you need to know who sells what--and there's a lexicon associated with liquidation. Some liquidators sell just the brains--the intellectual property, better known as IP. Others, like Otus, sell the hard assets. We're talking guts here. Otus knows where to get top dollar for a fleet of used Silicon Graphics Inc. workstations.

It's also easy to get taken by aggressive scavengers--we'll talk about that later. "Have a contingency plan for this occasion, even if it's a remote possibility," urges Bruce Bauer, who was thrust into the grisly liquidator world when, as a board member of Interactive Network Inc., he had just weeks to sell off the property of the once high-flying interactive-TV technology company.
Upside's guide for avoiding liquidator hell--how to get the maximum dollar for every asset--is gleaned from interviews with scavengers at every level of the food chain. Upside spoke with specialized investment bankers, bankruptcy lawyers, asset-valuation artists, intellectual property experts and the hard-core liquidators who dispose of a company's chairs, phones, unsold software and even leftover promotional T-shirts and coffee mugs.

Know your Predators

Lesson No. 1 for financially distressed entrepreneurs: Know who's knocking on your door.
The fact is, a liquidation predator may appear on your doorstep in a deceptively friendly form. But you can't trust anyone in this food chain. For example, take the friendly "turnaround" or "work-out" guy or gal dispatched by panicking investors--the banks, venture capitalists or your financial "angels." Cautions Michael St. James, a bankruptcy attorney with the San Jose-based firm Rosenblum, Parish & Isaacs, "Turnaround guys aren't always what they seem to be. They're often just a kinder, gentler liquidator."

Sometimes turnarounds are exactly what these people will do. But here's a tip: If one of your investors or board members cans the CEO and then introduces you to a "temporary CEO," it may be time to dust off the résumé. Respected venture capital firm Accel Partners of Palo Alto employs two full-time executive partners, Jim Flach and Joe Schoendorf, who spend part of their time working out problems at troubled startups. For example, a few years ago Flach was dispatched to Teleos Communications Inc., a networking company funded by Accel. Teleos was in trouble, and the board had fired the CEO. Flach came in as temporary CEO, did some housekeeping, "hired a bunch of new managers and then sold the company to Madge [NV of the Netherlands] for $150 million," says Jim Breyer, Accel's managing partner.

Often unbeknownst to the entrepreneurs, their temp CEO has specific marching orders. "[The temp CEOs] start off seeming warm and caring. Once they're signed up and locked into place, the relationship shifts to working a liquidation on behalf of the banks or VCs," St. James explains.
Surely, entrepreneurs aren't this naïve? They must have a clue that the vultures are closing in when the "turnaround" consultant arrives. St. James shakes his head: "In this business, you need to be a gambler who believes he can make it work if given another chance. You're hoping the turnaround guy can beg the banks for another million."

In fact, selling a startup has become a lot more common than taking one public. According to BRM Group's Federman, former chairman of the M&A firm Broadview Associates LLC of Fort Lee, N.J., a tech company is eight times more likely to be sold than it is to go public. This figure is based on a 1997 Broadview study. However, Federman cautions, "The worst time to try to sell a company is when it's going through bad times."

Bad times are Jerry Klein's forte. But he's an unusual turnaround guy. Unlike many in his line of work, Klein admits that frequently his mission is to prepare a company for its demise. "My charter [in some deals] was, 'Go out and kill everyone. Put their heads on sticks,'" says Klein, president of the Los Altos, Calif.-based Chatham Group, technology hired guns brought in by troubled companies or to aide attorneys preparing litigation. "But sometimes when I've been called in as an angel of death, I've come back and said, 'Hey, you've got something here.'"
If Klein can convince investors that they're fools to give up, then he's got a shot at resuscitating his gasping client. If not, it's time to move down to the next rung on the food chain.

Lion kings--Silicon Valley's "remarketers"

If a company can't be saved, even after someone like Klein has shored up the bottom line by axing top managers, slashing the workforce and possibly repositioning the product, the next step is to try to sell the company lock, stock and barrel--and do it fast. For this you need a "remarketer."

"It's not a furniture store; technology grows stale quickly," warns investment banker Norm Hall, one of the Valley's veteran remarketers. "You have to know the technology and understand where the fit is, know the players out there buying and how to keep the deal quiet."

Most investment bankers want little to do with troubled high-tech companies because their worth isn't in hard assets like furniture or cars. It's tough to calculate an operation's value with little more than unproven technology, the intellectual property.

However, this is Silicon Valley. A special breed of investment bankers smelled opportunity and seized the challenge. Two M&A firms, Broadview Associates and Alliant Partners of Palo Alto, have carved out a niche business by coming to the rescue of hemorrhaging Valley ventures. "When they come to me, they have four months' cash left; they're in panic mode and must sell," says Hall, a managing partner with Alliant. "At this point, it's tough to get as good a valuation. They should have come to me sooner."

Often, Hall is the final stop before the bankruptcy attorney. "We're the last guys to sell it as an ongoing business. Or we may have to break it up."
Hall knows that the technology alone may have almost zero value. The key to unloading the Valley's failures often hinges on the employees: Hall must deliver the engineering team, which can then deliver the technology. No small trick in a Valley with almost negative unemployment rates. As soon as word leaks out that a company's investors are pulling the plug, headhunters start circling. Hence, Hall works under a cloak of secrecy.

Selling half-baked ideas

Either with or without the bodies, remarketers also sell intellectual property, which typically falls into two categories: trade secrets and patents. There are remarketers for each type. Here's the general rule of thumb: Investment bankers like Hall often handle deals that aren't in formal bankruptcy proceedings. The IP in such cases may be trade secrets and pending patents. Startups often haven't won patents yet. Hall's job, then, is to capitalize on his industry knowledge and extensive contacts until he finds someone interested in, for example, a chip design, even though it's not a finished product or producing revenue. Bankruptcy attorneys only enter the picture when a company has enough assets, including patented IP, to merit a formal Chapter 7 liquidation. The court then appoints a trustee who helps dispose of the intellectual property.

In both cases, the game is the same: getting top dollar for old or unproven technology.

Take the case of Gulbransen Inc., a small musical-instrument and audio-chip company. The investor was refusing to pour more cash into the San Diego-based venture. "The value went down because they never got product out the door," recalls Hall, who was contacted by Gulbransen's investor. He'd heard of Alliant Partners from another company president who'd worked with Hall. (As Hall likes to say, "You don't get these calls out of the Yellow Pages. This business is about relationships.")

Hall headed to San Diego, looked over the technology and "immediately knew who would benefit from owning it." After drawing up a list of likely buyers, he started making calls, including one to National Semiconductor Corp. The huge chipmaker bit, agreeing to come to San Diego.
National thought Gulbransen's audio chip was a good fit. But there was one potential deal breaker. "National wanted the engineering team," he says. "They couldn't get the intellectual property to work without the people."
Negotiations started. "The key," says Hall, "is to get more than one bidder, get some competition going. Then the price goes up."
I ask, "Did you have any competitors as you negotiated this deal?" Pause. "Well," Hall says, clearing his throat, "having it and having the perception of it is just as good."
In January, Hall made the deal with National. The final price was about $6 million--for a package that included the IP, engineers and some of the physical assets. (Gulbransen still manufactures musical instruments.)

Patent Peddling

The big money in high-tech liquidation? Patents. Hence, entrepreneurs who fail to sell off patents are like culinary ingenues refusing to sample sweetbreads in the Provence region of France.
Regrettably, this lapse was commonplace until what we'll call the "Banquet at Orca Technology Inc." in 1995. The Orca feast began as a desperate nibble by San Diego-based Orca's bankruptcy trustee, who was searching for ways to pay off the more than $2.5 million owed to Orca's creditors. The estimated value of Orca's assets totaled only about $1.3 million, and that was on a good day.

"Orca had left everything in a storage locker so it colored how those [hard] assets could be liquidated," recalls David Jaffer, the IP specialist who worked for Orca's court-appointed bankruptcy trustee, Robertson & Associates of Los Altos. (Jaffer works for Rosenblum Parish & Isaacs.) It's tough to get top dollar for computers when potential buyers can't boot them up.
So Jaffer and Orca's founder started reviewing the value of the unsold intellectual property, especially an old packet of patents and other assets the company had purchased in 1990 from San Jose-based Priam Corp. for about $500,000.

To understand Orca's tale, you need to understand the three reasons Siliconers buy patents:
1. They want to use the technology.
2. They don't want competitors to get the technology.
3. They want to use the patent as a weapon to fend off another company's patent-infringement claim.

More and more, companies are buying patents because of reason No. 3--to arm themselves in the increasingly heated patent war. This war was fueled when the courts reinterpreted patent law in the 1980s, making it easier to defend a patent, even if it's in the more abstract world of software. "Because of these legal changes, people started applying for more patents--even in software--in the late '80s," explains attorney Radcliffe. "So, by the '90s we saw patents becoming more valuable."
"People assumed that old technology didn't hold any value," says Jaffer, as he launches into the Orca tale. Even though Orca and Priam, the company that originally developed the disk drive patents, didn't do well, over time other businesses adopted technology related to these patents. Jaffer and Michael Warner, Orca's founder and former chairman, drew up a list of hard drive manufacturers and IP attorneys, then pared the list down to possible buyers. About 30 companies and 30 attorneys were notified that the patents were for sale.

Almost immediately, someone offered $110,000. Orca's legal team smelled more money and, after some legal wrangling, set up a blind auction--all bids would be anonymous--with an opening bid of $225,000 and a minimum of $5,000 increments. For more than two hours, the bidding was heated: Increments shot up to $100,000 with bids jumping from $1.2 million to $1.3 million to $1.4 million.

Jaffer admits he was stunned. Samsung beat out competitors with a bid of $3.65 million. With the creditors paid off, Orca officials still are haggling about how to disperse the unexpected windfall. In retrospect, Jaffer realizes that Samsung needed "an arrow in its quiver" to fend off competitors taking aim at it. "The value wasn't to the big players like Seagate [Technology Inc.] because they usually have huge portfolios of patents," Jaffer says. "But to [a company] like Samsung just entering the disk drive market, this allowed them to build a patent portfolio."

Bankruptcy attorney St. James saw immediate ramifications. "After Orca, all of our bankruptcy trustee clients were focused on intellectual property. We got calls [from] our competitors asking for pointers on liquidating intellectual property."

Hyenas: "industrial auctioneers"

Once the lions have feasted, the hyenas move in. These folks size up the value of the tangibles--that's everything except intellectual property.

Says Emerald Technology's Otus, who prefers the more refined term "industrial auctioneer" to liquidator, "I consider myself as taking the 'white collar' approach to our industry." Before starting his own business, Otus worked for the Valley's premier industrial auctioneer, Dove Brothers of Foster City, Calif. Like other liquidators, he emphasizes that distressed companies constitute only about 10 percent of his business.
At this rung on the food chain, high-end hyenas like Otus offer an array of services, ranging from full-blown auctions to advertising items piece by piece. "We're the worst-case scenario," he acknowledges, "but there are times when I can get more for the tangibles than if the whole company was sold."

Otus often works with bankruptcy attorneys or investment bankers, helping to size up a company's value. If someone's offering $7 million for the company's IP and physical assets, but Otus estimates he can auction off the physical assets for $9 million, then the bid is rejected.

From the entrepreneur's point of view, reaching this point in the food chain can feel like witnessing the dismemberment of a loved one. "It's like a murder scene with shrinkwrapped technicians' tables" was what Bruce Bauer thought as he toured the warehouse containing the remnants of his investment, Interactive Networks, the much-hyped interactive-TV pioneer that promised to revolutionize broadcasting. Interactive had been troubled for some time, but the venture collapsed when its major investor, cable giant Tele-Communications Inc. (TCI), abruptly demanded repayment of its loan. Interactive was forced to close its doors as it was preparing for its first big rollout with NBC.

"Have you ever lost a parent?" asks David Lockton, Interactive's founder and CEO, in response to questions about how it felt to shut down his dream enterprise when engineers were midproject. "It was devastating. We had to vacate our building immediately so we shrink-wrapped workstations, put numbers on them and moved everything into the warehouse."
Interactive's gear filled all 27,000 square feet of the Sunnyvale warehouse, all the way to the 40-foot ceilings. Lockton installed a new board of directors and, at the board's urging, gave them a tour of the warehouse.
"I was aghast!" Bauer says. "All those dollars gathering dust. You see all your dreams, your kids' college future in those boxes, a stock that once had been $15 dollars, now 20 cents," he says, wincing at the memory.

Lockton acknowledges that he was suffering from a common founder malady--denial of the situation's desperate nature. Instead of concentrating full time on liquidating Interactive's possessions, Lockton was preoccupied with filing a lawsuit against TCI to win back the company's crown jewels--its patents for two-way TV technology. TCI had laid claim to the patents as repayment of its loan. This spring they settled in principle, although the details were still being hammered out at press time. TCI agreed to return the patents to Interactive and pay the company $10 million, plus $2.5 million in attorney's fees. At press time, Interactive's board had yet to decide what it would do with the money and patents.

On the day I visit the warehouse, Lockton admits the place is filled with ghosts for him. "I loathe walking through it. The warehouse is a visual representation of what's happened. It's so depressing," he says, pointing to hundreds of brown boxes filled with about 50,000 brand-new TV settop units. They were the key to Interactive's promised fortune; they would have allowed customers to play along with TV game shows and sporting events.

Bauer took over the liquidation and quickly learned that the situation was a full-blown crisis. Interactive was three months behind in its warehouse rent. "We'd gotten a sheriff's eviction notice," he says. If Interactive didn't raise the necessary cash in just two weeks, the sheriff was threatening to slap a padlock on the warehouse, locking up almost all of Interactive's hard assets.
By his own description, Bauer was a liquidation novice. As owner of Unlimited Services in Belmont, Calif., a building services and supplies company, he'd never worked the high-tech liquidator food chain. With the eviction date ticking down, Bauer became a quick study.
"I called everybody--scrap metal and electronics [dealers], used-computer [resellers]--[asking] where they buy and sell merchandise," Bauer says. He also went on the Internet, where he found Weird Stuff's Web site.

Bauer researched each liquidator then invited the better ones to submit ballpark bids on the value of Interactive's goods. One liquidator after another walked the warehouse, eyeballing the floor-to-rafters inventory, which included TVs, monitors, communications and computer networking gear, pricey test equipment and even a custom-made $30,000 mahogany conference table. Also for sale: Interactive's catchy red-on-black promotional jackets, T-shirts, fanny packs, gym bags and water bottles.
"When you're liquidating a large amount, the liquidators will test you about the value of what you've got," Bauer says. For instance, one guy said he couldn't handle everything, claiming "lots of it is junk." But he then generously offered to take everything off Bauer's hands for $50,000 in cash, on the spot.

Bauer figured he could do much better. He'd spent a day making careful notes about what was on each pallet, in each box. To gauge prices, he purchased tech magazines that advertised new and used equipment. By his calculations, "the stuff was worth at least $120,000."

Enter Weird Stuff's founder, Dave McDougall. From the start, Bauer liked the engineer-turned-liquidator. "He was honest, and a trust was established," Bauer says. Even so, he didn't tell McDougall or any of the other liquidators about Interactive's impending eviction. "You don't want to go out there with your hand in your pocket and look desperate."
McDougall looked over the vast inventory and estimated it could be sold for $100,000. But there was a catch. Liquidating it would take time, and Weird Stuff didn't have enough storage space in its cramped facilities.

Three short days before the sheriff arrived, Bauer and McDougall struck a deal. Weird Stuff would do the liquidating, paying a cash advance on future consignment percentages and taking over Interactive's lease on the Sunnyvale warehouse, providing Weird Stuff with the extra space needed to handle this and other large liquidations. Depending on the liquidation method, the commission structure they agreed on would give Interactive between 65 percent and 75 percent of any sale, with Weird Stuff getting between 35 percent and 25 percent.

Dining With the Ants

"Lots of people are trying to play liquidator," warns Herb Hershfield with a flash of his large teeth as he shows me around the retail store for Herb's Discount Software. "But it's a dangerous game."
I'm not sure where the danger lies, but I'm sticking close to Hershfield as I take in the hundreds of boxes of software lining the showroom shelves.

Hershfield, a former record-industry marketer, has created a prosperous business feasting off scraps. Everything he buys for his San Jose operation is new but castoff, unloaded for a variety of reasons including excess inventory, outdated software versions and businesses in distress. For penny-pinching customers, the shop is a great place to pick up popular software at a discount, but don't count on finding a copy of a particular title. Hershfield never knows what he'll have in stock.
Here at the bottom of the food chain, the scavengers are crustier. And proud. "That's what we are, liquidators," Hershfield says. "I play the game because I know what sells. I don't try to screw anybody, and I stay out of trouble." Someone's got to service garage-sale customers who are unwilling to pay retail.

According to Hershfield's business card, you save at Herb's because "we pay ourselves less, we think 60 watts is bright enough, we married gals with cheap taste, we run little cheap ads."
Actually, Hershfield rarely bothers to advertise. After 17 years in the liquidator game, the software finds him. Calls come in from all over the country. On the afternoon I visit, he's at his desk looking over the latest fax, which is offering 30 software titles (about 9,000 pieces), including popular educational software such as Freddie Fish and the Case of the Missing Kelp Seeds. The distributor--someone higher in the food chain, like a Weird Stuff or a wholesaler--wants $6 apiece. I figure Hershfield will snap up all the Freddie Fish programs he can get.
Hershfield sagely shakes his head. "Nah, I'll pay $2, maybe $2.50 in a worst case. At that price, I could double my money."
A lean, graying man with a tough edge, Hershfield circles back to the dangers at his rung of the food chain. "There are traps all over," he cautions, advice he passed on to a friend who wanted to get into low-end liquidating, thinking he'd make a fast buck. "He didn't realize this stuff doesn't turn over fast, the price erodes and the market becomes saturated. And you must know who you're dealing with."

Has Hershfield, who often buys pallets of merchandise in boxes without being able to look at everything inside, ever been burned? He laughs. "Yes, and I have my methods of correcting it." Such as? "Methods unknown," he chuckles and leads me to the storeroom, where he picks up a box of something called PC-Xware for Windows.
"I took a flyer on this," Hershfield says with a grimace. When the boxes of software arrived, one of Hershfield's assistants looked them over and advised, "I think we have a piece of lead here." That's liquidatorese for "It's a dud." Says Hershfield, "I paid $5 apiece before thinking--I'll be glad if we can [break even] on these."

When somebody screws Hershfield, he never forgets. Like the time he got stuck with unsold inventory a distributor had promised to pick up. When the guy refused, leaving Hershfield with 600 titles in his warehouse, Hershfield did nothing. Until the guy called with another deal. Hershfield ordered 600 pieces. A couple of months later, the distributor demanded payment, and Hershfield refused. So he paid Hershfield a visit. "I [told] him, 'I'll pay with the merchandise you stiffed me with!'" Hershfield says. "It's a treacherous business."

Liquidators do have a heart

"The really distressed situations are the nasty ones. We feel sorry for those guys," confesses Weird Stuff's Schuetz. In his line of work, Schuetz witnesses some of the Valley's worst abuses--entrepreneurs ripped off by investors or competitors who sue them in court, driving them out of business. "We see those things happen in this Valley, and then suddenly we have to sell their assets."

Schuetz no longer asks about the circumstances behind a business's death. "You get to feeling sorry for them," he concedes, "and that influences how much you'll pay."
Schuetz looks around at the huge warehouse of high-tech remnants. Three years after taking over Interactive Network's lease, most of its goods have been sold, bringing in about $160,000. A few fanny packs and water bottles are still for sale. And those 50,000 never-used TV control devices tower over the warehouse from their perch on the top shelves. With the TCI lawsuit settled, Interactive's trying to figure out whether the technology still has any value and whether the company can be resurrected.

"This is a serial-port extender," Schuetz says as he picks up a heavy gray metal device with connecting prongs. "But I don't know what board it's made for. Sometimes, there's only one person who will buy some of these things." Price: $5. It's a steal for the one geek who knows what the hell to plug it into.
Schuetz picks up another guts-of-a-computer-looking gizmo, a kind of a prototyping board that a dream-building engineer would purchase for hundreds of dollars. But in this graveyard, the asking price is $5.

At Weird Stuff, Silicon Valley's life cycle comes full circle. For every Valley death, another birth is under way. Schuetz taps a bin filled with computer innards and says with a smile, "This is a great place for startups."
 

Source: Tia O'Brien, Upside Today, June 28, 1998