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Imagine that someone comes up to you and asks you for money to buy two bicycles. He is nicely dressed, in an expensive suit. Perhaps he is a professional financier. He tells you that if only you give him enough money for the two bicycles, you'll get to own one of them.

Great deal, huh? Well, that, more or less is what Espernet is proposing to do.

Espernet is an Internet service provider, a fairly straightforward and -- unless you're America Online -- money-losing commodity business. Well, that's not quite right, Espernet is going to be an Internet service provider. As soon as investors give it the money.

Here's how it works: Espernet plans to buy 43 smaller ISPs, with a total of 274,000 subscribers. To buy the ISPs, it will spend about $173 million in cash and stock. Where will all that money come from? You guessed it: an initial public offering for a company that for all practical purposes doesn't exist.

Espernet is the ultimate evolution of what in the financial world is known as "roll-up" strategy. A company pursuing a roll-up strategy grows by buying smaller companies, usually paying for the acquisitions in stock. The idea is that the whole is worth more than the sum of its parts.

In this case, Espernet is planning to raise up to $172.5 million to pay for its acquisitions. It sounds good -- after all, the end result will be a company that owns 43 ISPs, for which it will pay $173 million. But the important thing to remember is that investors in the public offering won't own the whole company. They put in $172.5 million for only a piece of it. The rest would be held by current investors and management.

Espernet has yet to disclose the exact percentage of the company investors will get for their $172.5 million -- that will come in later revisions of the company's SEC documents. But the prospectus does say, in boilerplate legalese, that investors in the public offering will "suffer immediate and substantial dilution." That's the legal way of saying that Espernet will use the investor's money to buy two bicycles and the investors will get to own one. Of course, what's involved here isn't two bicycles but 43 ISPs, and the fraction that new investors will own won't be exactly half -- it could be a whole lot more, or a whole lot less, but the principle is the same.

Even if it were certain that the whole would be worth more than the sum of the parts, this would be a very iffy proposition. But even that is by no means certain. Other Internet service providers, such as Onemain, have found that hooking up a bunch of disparate ISPs just gets them a lot of incompatible equipment and mismatched systems. And running small Internet service providers is a very expensive proposition indeed. Onemain lost over $45 million in the six-month period that ended in September 1999. (Onemain.com's stock rocketed to $46 a share and now languishes below $20.)

Taken together, the 43 ISPs that Espernet plans to buy lost $33 million in the first half of this year alone. So in some ways it's a good thing that Espernet will have plenty of money in the bank.

In the IPO game, no one is wholly innocent. Even some avid dot-com investors figure that when the music stops playing, someone will be left holding a bag full of stock in failing companies. They just hope it won't be them.

So who really benefits? Most of all, the management and early backers in the truly doggy dot-coms. Sure, the stock is going to drop sometime in the future, but by that time, in many cases, top management will have sold part of their holdings and made an easy fortune. The worst dot-coms will go public with a bang -- but eventually some of them will go broke with hardly a whimper.
salon.com | Dec. 9, 1999

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