Big Firms Find New Way to Spin Value From Web Business

In the awkward dance between cash-rich Fortune 500 companies and dot-com start-ups that promise incredible potential if harnessed, a strategic consensus is beginning to emerge.

Many big companies, entrepreneurs and Internet professionals now say that in most cases, the traditional giants should incubate a Web version of their business inside the company, then sell shares in the new entity to the public or give them to investors in the bricks-and-mortar business.

That approach is contrary to the popular methods of buying a ready-made Internet start-up competing for the same customers or growing and keeping a Web business inside. But the new strategy has two main advantages, industry veterans say.

First, the promise of a publicly traded stock allows the company to issue options--the surest way to lure and keep management talent in the fiercely competitive Internet labor market.

Second, it places a market value on the Internet operations, which may lose money for years, and it avoids mixing in those losses with the parent company’s profits.

“It reassures senior management,” said John Hagel, who heads the e-commerce practice at management consulting firm McKinsey & Co. “Equity spin-outs create currency for retaining talent and for doing deals.”

Hagel predicted that in the next four years, 200 of the biggest 500 U.S. companies will spin out Internet progeny.

Already, the pace is quickening, with companies ranging from brokerage Donaldson, Lufkin & Jenrette to bookseller Barnes & Noble joining the race.

And last week, travel reservation system Sabre Group said it would spin off its Travelocity Web site after merging it with publicly traded Preview Travel, a move that follows last month’s filing by Microsoft to sell a $75-million public stake in No. 1 online travel agency Expedia.

As competitors take steps toward spin-outs and some of the biggest Internet companies threaten to buy bricks-and-mortal rivals, “traditional companies will increasingly develop a sense of urgency,” Hagel said.

Perhaps the most serious warning to adapt or disappear came when Qwest, an Internet communications firm, bought regional Bell operating company US West. “That was kind of a shot across the bow,” Hagel said.

Most of the early spin-outs are already successes, at least if judged by their value in the stock market. Even though Barnes & Noble’s forced response to Internet triumph Amazon.com remains a runner-up in the online book-selling field, Barnesandnoble.com has a market value of about $3 billion--50% more than its parent, which benefited by keeping a sizable stake in the online venture.

In May, Donaldson, Lufkin & Jenrette sold 16% of DLJDirect to the public and watched the stock soar 50% its first day, valuing the fledging company at $3 billion despite earnings of less than $10 million in the first quarter.

And last month, office supply chain Staples Inc. said it would issue tracking stock for its Internet holdings, a possible prelude to a spin-out.

Despite enthusiasm for this approach to online ventures, companies remain wary following a major stumble by giant Toys R Us.

Under pressure from online retailer EToys, the once-dominant toy seller vowed to fight back with its own Web sales. The company negotiated with smaller online toy retailers and then with Silicon Valley venture firm Benchmark Capital to create a hybrid company.

But the creation floundered when Toys R Us refused to allow the series of potential partners as much control as they wanted. Benchmark, for example, was told it couldn’t end up with an equity stake should the effort go public. The effort has yet to get off the ground, and in August, Toys R Us Chief Executive Robert Nakasone resigned.

Still, the Toys experience provides lessons for the clicks-and-mortar set.

First, the online operation has to start out with both strong support from the top of the old-line company and a path toward real autonomy.

“The CEO of the company has to make it a priority and, structurally, the group has to report to him, because the issues they’ll be dealing with will cut across every part of the organization. Only the CEO can cut though all of that,” said Jake Winebaum, former head of Walt Disney Co.’s online efforts and now CEO of e-commerce incubator ECompanies.

In the early days at Disney, he said, “I’d spend three to six months resolving internal disputes.” After he started reporting to the CEO, it would take an hour.

In addition, companies need to avoid worrying about cannibalizing their own off-line operations. Toys R Us expressed concern that its retail stores would be upset if the same products were offered at a discount over the Web, adding to the sluggishness in the site’s development.

The CEO should have overruled those objections because, as Net experts say, someone is going to take away the offline business, so it might as well be you.

“It’s easier to dance with the devil now than later,” said Jim Clark, founder of Silicon Graphics, Netscape Communications and Healtheon, a new health-care Web venture. “If you wait until someone takes your industry, you’re going to lose out anyway.”

Clark said he backs the spin-out approach in most cases because it lets companies leverage the brand name without encumbering the operation with legacy parts of business.

And perhaps most important is the basic premise of working out the details before jumping.

In the case of Toys R Us, announcements started coming before an agreement with Benchmark.

By contrast, Dan Nordstrom, who is leading retailer Nordstrom’s Nordstrom.com Web venture, labored over an agreement on possible conflicts between the online department store and the traditional retail stores.

The document ended up addressing everything from how to use the Web to sell products not offered in stores to whether merchandise purchased over the Web could be returned at physical sites.

Without the careful delineation of the agreement, “human nature will create an ‘Us versus Them’ mind-set,” Nordstrom said.

With no advertising, Nordstrom’s site is already doing $1 million a month in revenue. It plans a major ad campaign for its best seller so far--shoes. Nordstrom.com is going to stock 40 million pairs.

“The elephants have arrived,” he said.

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Times staff writer Joseph Menn can be reached at [email protected].