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EarthLink Connects

Title: EarthLink Connects
Date: Thursday, 28 May 1998
Author: Michelle V. Rafter
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The Southern California Internet Service Provider has defied conventional wisdom just by surviving. Now Dayton and Betty are betting the company on a $180 million deal with Sprint.

Driving down a steep mountain road after a weekend on the slopes of Big Bear in Southern California, EarthLink Network (ELNK) founder Sky Dayton and his promising COO candidate, Charles "Garry" Betty, had an unexpected chance to see how well they worked together. A storm the previous night had covered the road with a slick layer of ice and snow, and the way ahead was obscured by a swirling blanket of fog.

Although an avid snowboarder, Dayton hadn't brought chains for his BMW M5. He remembers thinking he wouldn't make it off the mountain. But Betty took charge from the passenger seat and coached Dayton through every mile of icy, hairpin curves.

The 1996 ski trip was the then 24-year-old Dayton's idea of a final interview for Betty, a Georgia native 15 years his senior. Betty got the job at the fledgling ISP and rose to CEO six months later.

Dayton and Betty may be nearly a generation apart, but their close working relationship lies at the heart of the company's success. Dayton, an ambitious GenXer who never went to college, started EarthLink on little more than a dream, but it was the industry-wise Betty who took Dayton's vision and ran with it.

At a time when most consumer ISPs still counted customers in the thousands and analysts regularly issued dire warnings of telephone companies and cable operators engulfing the industry, the two men transformed EarthLink from a small Southern California outfit to a national powerhouse. In three years, EarthLink has amassed more than 500,000 subscribers, seen revenue more than triple to $79.2 million in 1997 and watched its stock price soar. Since the company's January 1997 initial public offering, EarthLink stock rose from $13 to a high of $77 before slipping lately to $58.375, giving it a market capitalization of $610.9 million.

The secret of Dayton's and Betty's success has been equal parts intuition, luck, timing and moxie. Colleagues and analysts credit Dayton with a keen ability to act early on trends: He leased bandwidth rather than build his own network infrastructure and dropped prices to $19.95 a month for unlimited access before other ISPs saw the wisdom of flat rates.

Time and again, Dayton and Betty have also found ways to raise cash from public markets and private investors just when they needed it most. This week, EarthLink expects to close a deal with Sprint that analysts calculate is worth about $180 million in cash, credit lines and new subscribers. EarthLink is looking to raise another $174 million in a secondary stock offering set to take place later this month. Fueled by the new funding, analysts believe EarthLink could become the nation's No. 2 consumer gateway to the Net by 1999.

But questions remain about the future of the EarthLink Sprint (dossier) deal. EarthLink has yet to make a nickel, and won't for at least another two years because of write-offs associated with the deal, according to analysts who follow the stock. Likewise, Sprint could prove more of a hindrance than a help to EarthLink. A latecomer to the consumer dial up business, Sprint has seen its Internet Passport service flounder while the company invested in other areas. And executives at both companies won't rule out the possibility that Sprint could buy EarthLink after a three-year hands-off period spelled out in their deal.

If Dayton has his way, though, EarthLink will still be independent in the future - and he'll still be running it. "Somebody has to be out way ahead saying we have a long way to go," he says. "It doesn't keep me up at night, but I do worry. Are we talking to customers? Is our present technology palatable? Our bread and butter for many years to come will still be getting people connected."

The Internet was relatively unexplored territory when Dayton first caught wind of it in 1993. As a teenager, he had tinkered with computers - his grandfather was an IBM fellow - and had worshiped motorcycles and fast cars. He hung out with a crowd in Los Angeles' Los Feliz neighborhood that vowed to be millionaires by the time they were in their 20s.

A practicing Scientologist, Dayton graduated at age 16 from the Delphian Academy, a Scientology-affiliated boarding school in Sheridan, Ore. But ambition moved him to choose entrepreneurship over college. His first venture was a money-losing coffeehouse named Cafe Mocha, located on trendy Melrose Avenue in L.A. Dayton's next business was a graphic design shop, started with long-time friend Adam Walker.

When another friend introduced him to the Internet, Dayton says he spent more than 60 frustrating hours attempting to establish a TCP/IP connection. The experience sparked an idea for a business: An Internet access provider that would make it as easy as possible for novices like himself to log on.

To fund the venture, Dayton talked to anyone who would listen, eventually hooking up with two Scientologists who would become his first angel investors. He raised $100,000 by selling a 40 percent stake to Kevin O'Donnell - the father of a school friend and founder of Government Technology Services Inc., a Chantilly, Va., computer reseller - and Reed Slatkin, a Santa Barbara, Calif., stock trader, financial manager and long-time friend of Walker's family.

Equally important, O'Donnell and Slatkin acted as Dayton's management and financial advisors, filling gaps in his limited experience. Both O'Donnell and Slatkin remain on the board, and although EarthLink's subsequent private and public offerings have diluted their stakes, they still hold 7.9 percent and 8.8 percent of the company's shares, respectively. The only shareholders whose stakes are higher are Dayton, who owns approximately 10 percent of EarthLink shares, and billionaire financier George Soros, who has acquired approximately 10 percent through several private placements.

In 1994 EarthLink introduced its first sign-on software kit, an all-in-one bundle with TCP/IP, e-mail, a Web browser and other Internet software that was among the first of its kind. To help run the business, Dayton hired friends and drew on management courses he'd taken at L.A.'s Hubbard College of Administration International, another Scientology-affiliated school.

Dayton acknowledges the role his Scientology training played in his career: He says it helped him learn new subjects quickly, think for himself, manage people and structure a growing company.

"I've found that the approaches I started with were totally common sense," Dayton says. "Every good manager applies them anyway."

In EarthLink's early days, some employees objected to the company's Scientology techniques and the company drew suspicion after the Church's controversial role in cases involving free speech on the Internet.

But EarthLink's Scientology influence waned as the company grew, according to people who worked there at the time. The change became most apparent, they say, after Dayton hired Betty, a veteran corporate exec who had run networking-software company Digital Communications Associates and had held management posts at modem-maker Hayes Microcomputer.

Acquaintances such as Linwood A. "Chip" Lacy, an EarthLink director and investor since 1995, credit Dayton with a maturity beyond his years, comparing him to computer wunderkind Michael Dell, who started Dell Computer while an undergraduate. The best indicator of Dayton's maturity was his decision to hire Betty when the company was still small, says Lacy, former co-chairman of computer distributor Ingram Micro.

"We've all dealt with founders who can't make that transition, but he wanted this company to fulfill its destiny," Lacy says.

Dayton's admirers also credit him with the prescient decision not to invest in building his own Internet network. While other ISPs were spending precious capital erecting modem banks and high-speed fiber-optic lines, Dayton figured EarthLink was better off buying access from IP backbone wholesalers and spending its money snagging customers.

In 1995 EarthLink signed a wholesale bandwidth agreement with UUNET, instantly transforming itself into a national provider and giving itself an endless supply of bandwidth. EarthLink immedately cut its monthly fee to $19.95 for unlimited access, the first ISP in the country to offer a cheap, all-you-can-eat dial-up plan. Later EarthLink signed a similar wholesale access contract with PSINet, bringing the number of dial-in numbers it offers to 1,100. As part of the Sprint deal, Sprint will become EarthLink's third access provider, adding 200 access numbers.

By 1997 most consumer ISPs had gotten out of the once-novel Internet backbone business and leased capacity from major providers such as UUNET (dossier) or MCI. With high-speed cable modem and digital subscriber line (DSL) technologies around the corner, it now makes more sense than ever for consumer ISPs to be "network agnostic," says Forrester Research analyst Kate Delhagen.

In many ways, Dayton and Betty are opposites. Tall and lank, with close-cropped brown hair, Dayton, now 26, is guarded in conversation and is well known as the company's resident worrier. "I worry about everything," he says. Betty, 41, is more jovial and open.

For the past two years, Dayton has played Mr. Outside to Betty's Mr. Inside. Dayton represents EarthLink on the Internet conference circuit while Betty handles the company's day-to-day operations. One week in April found Betty in his office while Dayton flew to Washington, D.C., to lead the president and first lady through the EarthLink sponsored Webcast of the White House's annual Easter Egg Roll.

"I'm the original user of our service," he says. "I go home at night and use it. I dial in via modem. I use ISDN. I worry about all of the long-term stuff, the high-speed access and R&D stuff."

These days Dayton, whose stake in EarthLink is worth about $100 million, is enjoying the fruits of his labors. He bought himself a silver 1997 Porsche Twin Turbo last fall and recently gave his mom a Toyota RAV4. In February Dayton and his wife, Arwen, a budding screenwriter and novelist, paid $1.9 million for a 6,400-square-foot, 1920s-era mansion in Pasadena, Calif.

But financial success hasn't left much time for hanging out with his old buddies. "A lot of the guys he used to spend time with wonder what happened to him," says Walker, Dayton's one-time business partner. "He's joined the big-business gang. That's one of the sacrifices anyone has to make."

When Betty joined EarthLink in 1996, the company had 30,000 subscribers and was growing at a rate of 15 percent to 20 percent a week. Despite Dayton's best efforts, the frantic pace made for virtually nonexistent financial controls, Betty says.

"They didn't know how much cash they had," he says. "They didn't know how much they needed, how much they owed."

Over the following six months, Betty installed the kinds of accounting and financial systems he'd used to manage larger, public companies like Hayes Microcomputer. The corporate makeover helped EarthLink tap investors for the capital it desperately needed to continue growing.

Betty logged 80 to 100 hours a week and claims he was hooked on the company's pace from the moment he stepped into the company's first office. "I go in to meet Sky, and there's 200 people in this little bitty building, and the electricity is just incredible," Betty remembers. "There's nothing like being in the excitement of a start-up."

Before Betty's arrival, EarthLink had raised $4.4 million from existing and new investors to promote its national status after the UUNET deal. But the company burned through the money in a five-month marketing blitz.

In subsequent private placements, EarthLink raised $22.7 million, including investments from Soros, before its $26 million public offering in January 1997. In September the company raised another $15.4 million in a private placement, with $5 million coming from Soros' investment arm, Soros Fund Management.

To continue its expansion, however, it needed more funding. Betty and Dayton spent the first half of 1997 talking to the Baby Bells about marketing partnerships but came away empty handed. Then, in September 1997, EarthLink director Sidney "Sam" Azeez, asked his friend Carl Peterson, president and general manager of the Kansas City Chiefs, to pass the word to Sprint Chairman William Esrey, another Peterson buddy, that EarthLink was looking to do a deal.

Esrey liked the idea and set the wheels in motion for a meeting between top EarthLink and Sprint execs, which took place in Sprint's Kansas City, Mo., headquarters on Halloween. Within a month, Esrey and top Sprint Internet managers were in Dayton's office finalizing negotiations, and the deal was announced Feb. 11 of this year.

"They had the scale we were looking for and the strategy and direction right in sync with where Sprint wanted to go," says David Owen, Sprint's Internet marketing director. " #91;Sprint] customers will be very happy because they'll get a better product than what we provided and equal to one we thought it would take us 12 to 18 months to get to."

Sprint will pay $4.2 million for 10 percent of EarthLink stock, extend it a three-year, low-interest $100-million credit line and become EarthLink's third access provider. Sprint will also hand off to EarthLink its 130,000 Sprint Internet Passport customers. Sprint promises to deliver another 750,000 customers over the next five years through a joint marketing program.

In exchange, Sprint also picks up 4.2 million restricted, nonvoting shares (in addition to EarthLink common shares), giving it an aggregate 30 percent stake in the ISP, as well as two seats on EarthLink's board, to be filled by Esrey and Patti Manuel, head of the $14.8 billion company's consumer long-distance division.

Once the deal closes, Sprint's 2,000-person telemarketing staff will pitch "EarthLink-Sprint" Internet access to long distance customers and prospects. Beginning in the fourth quarter, EarthLink-Sprint Internet access will be featured in Sprint TV commercials, possibly including those starring celebrity pitchwoman Candice Bergen.

Analysts expect additional subscriber revenue from the deal to kick EarthLink's operations into the black by year-end. But because EarthLink will write off an undisclosed amount of goodwill associated with assets exchanged in the pact, the company will continue to show a net loss for another two years, analysts and company officials predict. In the quarter ended March 31, EarthLink lost $6.4 million on revenue of $29.2 million, compared with a $8.4 million loss on revenue of $15.7 million in the same period last year. In 1997 EarthLink lost $29.9 million on revenue of $79.2 million, compared with a $31.1 million loss on revenue of $32.5 million in 1996.

To keep up with its growing customer base, EarthLink has invested more than $23 million in a 10,000-square-foot data center at its year-old Pasadena headquarters, which can handle the needs of up to 3 million subscribers. EarthLink's customer-support department is in perpetual hiring mode, and the department accounts for 600 of the company's 1,000 employees.

Ultimately, the big winner in the deal could be Sprint, which had been a distant third behind competitors ATT (T) and MCI in the consumer ISP business. As part of their agreement, Sprint could buy EarthLink outright at the end of 39 months, if the companies agree on a price. Sprint officials refuse to speculate on the likelihood of such an acquisition.

"It's a great scenario for Sprint," says Forrester's Delhagen. "Two or three years from now if they realize owning Internet customers is a valuable proposition - whether they make money or it's a feeder for their core [long-distance] business - that's a lot of customers for Sprint."

But some question whether Sprint is up to the challenge. "I don't think [adding 150,000 subscribers per year] is a large threshold to meet. From what they've done in #91;the last] 18 months, they have to be more serious," says Joe Bartlett, a Yankee Group (dossier) analyst.

Expect to see EarthLink announce more marketing partnerships in the coming months. EarthLink recently unveiled a marketing pact with the Discover Card unit of Morgan Stanley Dean Witter (MWD) to offer cobranded Internet access to 30 million Discover Card holders. In an upcoming agreement with the Los Angeles Dodgers, EarthLink will offer "" vanity e-mail addresses to baseball fans.

"This is so fun," Betty says of the Sprint deal. "They've put us on the map."