Hardly any discussion of Homestore lasts more than a few minutes without mention of "the deal," some $200 million in Homestore cash and stock promised to AOL in exchange for a "distribution alliance" with the leading Internet service.

The "usual understanding" works like this:

• Homestore gave AOL $20 million as well as almost 3.9 million shares in exchange for the right access to AOL's millions of members.

• On May 1, 2000, when the deal was announced, Homestore shares were priced at $22 7/8.

• Homestore also promised that if company shares were worth less than $65 at certain times in the future, Homestore would make up the difference to AOL in cash. Thus, it is explained, if the stock is at $20 at the end of the guarantee period, Homestore would owe AOL $175,500,000. ($65 less $20 = $45. $45 x 3.9 million shares = $175,500,000).

• The requirement to pay out $175 million, if it happens, will overwhelm Homestore.

In reality, the "usual understanding" is largely wrong. There are no circumstances under which Homestore will need to pay AOL $175 million -- or anything close. And Homestore has already set aside sufficient funds to pay off whatever it owes AOL.

So what was the deal and what's really happened?

In early 2000 the stock market was booming, Internet stocks were golden, and the most golden name of all belonged to AOL. If you wanted the world to see you as a serious Internet player, if you wanted to reach 24 million online subscribers via AOL and Compuserve, you had to cut a deal with AOL.

AOL, however, was not selling ad space in a manner similar to a local newspaper or TV station. Rather than selling space for cash, AOL often sought a combination of cash and stock from advertisers. The attractions were money up front, the potential for appreciation, and the creation of long-term relationships.

The mechanics of the deal are explained in the friendly archives of the Securities and Exchange Commission. There, in Homestore's 10-Q report for August 14, 2001, the guts of the transaction are laid out in a few paragraphs:

"In April 2000," says Homestore, "we entered into a five-year marketing and distribution agreement with AOL. As part of this agreement, we paid AOL $20.0 million in cash and issued to AOL approximately 3.9 million shares of our common stock. In the agreement, we have guaranteed that the 30-day average closing price per share of our common stock will be:

• $65.64 per share with respect to 60% of AOL's shares on July 31, 2003;

• $68.50 per share with respect to 20% of AOL's shares on July 31, 2004; and

• $68.50 per share with respect to the remaining 20% of AOL's shares on July 31, 2005.

"This guarantee," explains Homestore, "only applies to shares that continue to be held by AOL at the applicable date.

"If there is a shortfall between the guaranteed price and the 30-day average closing price per share on the applicable date, we would have to make cash payments to AOL. The aggregate amount of cash payments we would be required to make in performing under this agreement is limited to $90.0 million. To the extent that the aggregate shortfall exceeds $90.0 million over the course of the agreement, AOL can shorten the term of the agreement. We have placed $90.0 million in restricted cash on our balance sheet, which represents a letter of credit in favor of AOL for this obligation. If we are obligated to pay AOL less than $40.0 million at the first guarantee date of July 31, 2003, then we will have the right to reduce the restricted cash to $50.0 million, which will then represent our maximum aggregate cash payment we would make in performing under the agreement after July 31, 2003."

And sure enough, if you look at the latest quarterly balance sheet, a statement rendered according to generally accepted accounting principles (GAAP), you will see under "restricted cash" the sum of $90 million.

Gary Gerdemann, Homestore's Senior Director Corporate Communications, says Salomon Smith Barney explained the deal this way in a report issued June 4th.

The agreement with AOL also includes a kind of 'make good' provision against the value of the equity stake issued to AOL. In April 2003, 2004 and 2005, Homestore has guaranteed AOL that the trading value of the shares issued to AOL will be $68.50 each (on a 30-day avg.). However, if HOMS shares are trading at a price less than that $68.50 value, Homestore is responsible to pay AOL the difference in cash. The agreement applies to 60% of the shares in 2003, and another 20% in each of 2004 and 2005. Homestore has reserved $90 million on its balance sheet to fund a possible cash payment requirement in 2003, and we note that if AOL draws more than $40 million of cash "make good" in 2003, the term of the agreement can be reduced (and the rest of the deal cancelled or renegotiated). The AOL deal is complicated, but not at all threatening in our view.

So is Homestore out $90 million in the worst case? Or is it out less?

Homestore has $90 million in cash it can't touch until 2003. But this money isn't in a mattress. Assume that from 2000 to 2003 Homestore sticks its $90 million in an account that pays 5 percent interest. It has $94.5 million at the end of the first year, $99.2 million at the end of the second year, and $104.2 million at the end of the third year. Or, it simply has another $4.5 million in annual revenue.

Alternatively, what happens if share values rise and Homestore doesn't owe AOL a dime? Then the company has some or all of a $90 million nest egg.

In essence, the idea that Homestore somehow owes AOL more than $90 million now held in reserve is simply not true. And while that may not be the "usual understanding" it has the benefit of being real.

For more articles by Peter G. Miller, please press here.

Published: September 6, 2001

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