BayStar Capital told the software company that it might be able to keep a $20 million investment--if it makes changes in management and focuses more on its lawsuit against IBM.

Larry Greenemeier, Contributor

April 22, 2004

6 Min Read

SCO Group Inc.'s strategy of publicly taking on Linux users and vendors may have cost the company a large investment from BayStar Capital. The venture-capital firm Thursday insisted that the company might be able to keep the $20 million investment, but only if it makes changes to its management team, focuses more on its intellectual-property lawsuit against IBM, and/or tones down its aggressive behavior toward Linux users and vendors.

BayStar contends that since it first made the investment in October, it has expressed three primary concerns numerous times--both in writing and verbally--to SCO Group's board of directors. This is the first time in BayStar's history that the company has asked for an investment to be returned.

First, BayStar wants SCO Group to "strengthen and enhance" its management team with people skilled in the areas of intellectual-property management, litigation, and the overall running of a public company, a spokesman said Thursday. BayStar denies it was involved in SCO CFO Bob Bench's decision to step down Wednesday.

The second area of concern for BayStar has been SCO's unwillingness to focus on its greatest area of shareholder value: its year-old lawsuit against IBM. "We believe that when we invested there was a strong and valuable asset in the intellectual property case" against IBM, the spokesman said. "We still believe that SCO has the chance to prevail," he said, adding that SCO needs to focus its resources on the court case in order to do this.

Although SCO president and CEO Darl McBride said in an October news conference revealing the investments that the money would go toward the enhancement of its Unix operating system and software, toward the development of Web services, and to fight its ongoing legal battles against companies that infringe upon its intellectual property, the BayStar spokesman said SCO's other investments don't have the potential return that its lawsuit against IBM does.

The third area of concern has been SCO's undisciplined approach to communications with the media and the public. In the time between its investment in October and its request for the money back, BayStar saw a number of communications issued by SCO that the VC firm questioned the value of, although the spokesman wouldn't specifically cite any of those announcements.

BayStar is still open to resolving its dispute with SCO, but the spokesman wouldn't say if the company would have to address all of BayStar's concerns to keep the investment.

BayStar's move comes across more as a negotiating tactic than an ultimatum to SCO Group, says Dion Cornett, managing director of Decatur Jones Equity Partners LLC. BayStar is realizing that redeeming its investment in SCO is going to be difficult, so "it looks like they're trying to cut a better deal for themselves," he says. "They've certainly gotten SCO management's attention."

But BayStar's request could actually benefit SCO--if the company is able to negotiate an investment redemption worth less than the original $20 million. "BayStar is baggage for SCO moving forward," Cornett says. This means they might be willing to write off a portion of their investment. "Venture-capital firms would rather have 50 cents on the dollars than 0 cents."

SCO, which is suing IBM and several Linux user companies, last week filed an 8-K report with the Securities and Exchange Commission stating that BayStar Capital wants SCO to redeem all of the VC firm's 20,000 shares of SCO's Series A Convertible Preferred Stock.

In October, BayStar agreed to invest $20 million in 20,000 SCO Series A Convertible Preferred Stock shares. BayStar's share was part of a $50 million investment, with the Royal Bank of Canada contributing $30 million in 30,000 shares of the Series A Convertible Preferred Stock. At the time, this pushed SCO's cash position to $61 million. A Royal Bank of Canada spokesman earlier this week wouldn't comment specifically on the future of his company's investment in SCO. "We're aware of what BayStar is doing and are reviewing all of our options," he said.

BayStar's investment in SCO was structured as a private placement of nonvoting Series A Convertible Preferred Shares, convertible into common equity at a fixed conversion price of $16.93 per share, which was the average closing bid price for the company's common stock for the five trading days prior to and including the date of closing.

BayStar has accused SCO of breaching four areas of their agreement. One area of representations and warranties that BayStar accuses SCO of breaching came with the issuance of a Feb. 6 news release announcing the exchange of the preferred stock issued in connection with BayStar's $50 million in private financing. A SCO Group spokesman says his company was obligated to let BayStar review such releases before their distribution. SCO was also obligated to file a Current Report on Form 8-K within two days of the date of the Exchange Agreement. The SCO spokesman says the company agreed to write a news release at the time of the exchange and send that release to BayStar for review before issuing the release. He says SCO followed these procedures.

SCO would have breached a second provision if there were "a material adverse change or development in its business that had not been disclosed" in its annual report on Form 10-K for the fiscal year ended last Oct. 31. According to SCO, BayStar hasn't provided specific information about any "material adverse change or development" that might have occurred between Oct. 31 and the close of their deal on Feb. 5.

SCO also states that as of Feb. 5, there was no information about SCO that hadn't been publicly disclosed, but would be required to be disclosed, in its annual report. SCO would have breached this portion of the agreement if it provided BayStar with false information or if it hadn't disclosed information required to be disclosed in its annual report. Again, BayStar hasn't provided SCO with details as to how it has allegedly breached this representation.

SCO would have breached another section of its agreement with BayStar if any representations and warranties it made on Oct. 16 as part of the original Series A stock financing transaction were not true on Feb. 5. SCO says it doesn't know which representations and warranties BayStar claims SCO allegedly has breached.

Decatur Jones' Cornett says this is a tough way for BayStar to get its money back. If BayStar's claims against SCO are true, SCO could have to return the investment amount, plus an 8% dividend. But a legal battle over the investment is hardly what BayStar wants--particularly because SCO would be fighting the suit with BayStar's money.

Cornett speculates that IBM's plans to have SCO's case dismissed could have shaken BayStar's confidence. "Common sense tells you something spooked" BayStar, Cornett says. "Something tells them this isn't the home-run investment that they though it would be, and you don't make an investment you don't think is a home run."

BayStar's move to withdraw its money from SCO's coffers isn't likely to change the perspective of Linux users because "the Linux community always thought SCO was blowing smoke," says Evan Leibovitch, president of the Linux Professional Institute.

BayStar denies that its effort to withdraw support for SCO indicates that the company's case against IBM is weak. But to Leibovitch, the move says that "SCO has not adequately been making its case, either in front of a judge or with regard to public opinion."

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