April 16, 2004

BayStar pulling out $20m investment in SCO Group; PIPE deal falling apart?

Author: Chris Preimesberger

A major investor in The SCO Group wants out of its financial relationship immediately. BayStar Capital, the Larkspur, Calif.-based investment firm which funded $20 million of a $50 million cash infusion to SCO Group only last October, has notified SCO Group by letter that it wants to cash out of the deal and redeem its 20,000 shares of Series A-1 Convertible Preferred Stock in the Unix sales and service firm.

The 20,000 shares are valued at about $20 million. SCO Group's stock (SCOX) ended trading Friday at $8.37, down $1.29 (13 percent) on the day.

BayStar spokesman Bob McGrath told NewsForge Friday afternoon that the company had "no comment" at this time. "No words, other than 'no comment,'" he said.

Royal Bank looking at its options

Spokesman Paul Wilson of the Royal Bank of Canada, which funded the remaining $30 million of the private investment in public equity (PIPE) deal, said the bank "has not yet requested a redemption, but we are reviewing the investment and will arrive at a decision shortly."

Melanie Hollands, OSDN's IT stock analyst, told NewsForge that "it is possible that the (whole) PIPE deal is about to fall apart. ... I certainly think that Royal Bank of Canada may have cause to ask for a cash redemption Monday or soon."

In the letter, dated April 15, BayStar contended that the Lindon, Utah-based SCO Group has violated specific sections of the exchange agreement between the two filed with the Securities and Exchange Commission on Feb. 5. The sections are 2(b)(v), 2(b)(viii), 2(b)(viii) and 3(g), which spell out mandates of the original purchase agreement, issues involving disclosure, and how that information is publicly filed. In other words, BayStar is implying -- but not stating directly -- that SCO Group hadn't told BayStar everything it needed to know in advance of the deal.

"BayStar's letter did not provide specific information regarding SCO's alleged breaches of the Exchange Agreement," SCO Group spokesman Blake Stowell said in a statement. "SCO is attempting to obtain specific information from BayStar and is evaluating its obligations and options with respect to the redemption notice."

"However, SCO does not believe it has breached any of the referenced provisions of the Exchange Agreement. As a result, SCO does not believe it is obligated to redeem BayStar's shares of Series A-1 Convertible Preferred Stock."

Stowell told NewsForge: "We're puzzled at what this is about. We believe we have been completely forthright in our disclosures to BayStar all along."

Stowell said that no substantial conversation with Royal Bank of Canada has taken place about the BayStar letter. "Because this was a material filing, we were obligated to disclose that to the bank, which we did," Stowell said. No further communication took place, he said.

"We believe this (situation) is limited to BayStar, and BayStar only," Stowell said.

Because SCO Group is, at least at the outset, refusing to redeem the 20,000 shares, BayStar will have to make the next move. A court order is possible.

BayStar, a privately held investment firm, funded $20 million and Royal Bank of Canada the remaining $30 million in the package to SCO Group in October, keeping the wobbly Unix company above water. Later, BayStar changed the arrangements of the deal in a separate SEC filing.

How Microsoft is tied in

Last month, BayStar confirmed that several highly placed Microsoft executives initiated the idea of the PIPE fund transfer to SCO Group. Chairman Bill Gates and CEO Steve Ballmer were not among those executives, McGrath said.

The admission was additional evidence of an alleged Microsoft-SCO Group cash pipeline for many members of the open source community, who believe Microsoft is quietly backing SCO in its many lawsuits against companies that use Unix and Linux in their enterprise IT systems. SCO Group is suing a number of companies, including IBM, Novell, DaimlerChrysler, AutoZone, and others for allegedly using its proprietary Unix System V code in open source Linux IT systems.

The most credible evidence of Microsoft's involvement thus far is a memo from a former SCO Group contractor, Mike Anderer, who described details of the transaction to SCO Group executive Chris Sontag in what later became the "Halloween X" document after being leaked to open source community leader Eric S. Raymond on March 3.

"I look at this as bad news for SCO," Dion Cornett, an analyst for Decatur Jones Equity Partners-Soleil told TheStreet.com. "I don't think BayStar is going to be very successful in getting their money back. It's very difficult for a private equity investor to force a redemption on a company that doesn't want to redeem. But it makes it very difficult for SCO to raise future financing."

SCO needs plenty of cash to keep litigating

SCO has been spending a high percentage of its resources on researching, filing, and enacting litigation against corporations such as IBM -- many of which are former or current customers. SCO Group is seeking $5 billion from IBM for alleged intellectual property and licensing violations.

"SCO will certainly need lots of money if it wants to fight the likes of massive IBM," Cornett told TheStreet.com. "I think they'll need all the $65 million they have in the bank to fund this fight. This is going to be a multi-year, very protracted lawsuit, if it's not dismissed."

Editor's note: For a closer look at the investment implications of the BayStar move, see a more detailed version of this story at IT Manager's Journal.

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