In the early spring of this year, Niloo Howe, founder of Internet pet site AllPets.com, sat in a hotel room in San Francisco, took a deep breath, and made a phone call to Steve Dempsey, chief executive of publicly traded Internet pet site PetQuarters Inc.

Would he be interested in talking merger? At the time, the prospects for the already saturated market of online pet sites were looking bleak. Sites like Petsmart.com and Petopia.com. were offshoots of large brick-and-mortar companies and consequently better financed than AllPets. Moreover, Pets.com, with its cute sock-puppet television ads that debuted during the Super Bowl, had generated a tremendous amount of buzz. Pets.com had gone public on Feb. 10. After moving up from its initial public offering price of $11 a share to a high of $14 the next day, the bottom dropped out. Within a week it was trading around $6 a share and falling. Suddenly, the long-term outlook for Los Angeles-based AllPets looked even more challenging. “After Pets.com went public and was tanking, we all knew that no one would be going public for a long time,” Howe said. “Things got really crazy really quickly, and the economics of our space changed.”

So she and her backers primarily Zone Ventures, the L.A. arm of Silicon Valley venture firm Draper Fisher Jurvetson considered their options. AllPets had only raised about $2 million in venture financing, and more money could be sought. But valuations were coming down rapidly, and the space was increasingly seen as a dubious place to put one’s money. Merging with a larger operation seemed the best way to go.

So Howe called Dempsey. Three months later, on May 31, Arkansas-based PetQuarters announced it had acquired AllPets in an all-stock deal, one that would combine the retail and catalog strengths of the former with the content-driven assets of the latter.

Challenging courtship

The deal prolonged the prospects for survival for both. But each company wanted to get the best deal possible, in a courtship where everyone agreed on the ultimate goal but had different perspectives on how to get there. In addition, both had financial backers to consider PetQuarters as a public entity traded over the counter, had shareholders to please. AllPets, as a Zone Ventures company, had its venture backers to satisfy. Satisfying everyone would obviously be a challenge.

For PetQuarters, the ground rule for striking any deal with AllPets was basic: no cash. “For any startup, cash is king,” Dempsey said. “We need it to run operations. Our (merger) currency is the stock itself.”

That was agreeable to Howe, a former lawyer at O’Melveny & Myers who had worked on large corporate mergers herself. But she needed to convey a position of strength even as she solicited a takeover of her company. Based as it was on content and chat rooms, AllPets hadn’t garnered a lot of revenue since its Web site debuted in November 1999. But it quickly won recognition as a very “sticky” site, with visitor traffic rising between 100 percent and 200 percent in the first several months of existence. By March, daily traffic was averaging 10,000 unique visits a day. That loyalty had caught the attention of larger sites in the same space, which had expressed some interest in acquiring AllPets. The combination of loyalty and competitor interest, along with the possibility that Zone Ventures might consider leading another round of venture financing, was raised in conversations with PetQuarters to stress that AllPets wasn’t without options. And PetQuarters’ site and brand name weren’t as recognizable as AllPets. “We said, ‘We bring economies of scale to the table,'” said Melainie Mansfield, a senior associate at the law firm of Milbank Tweed Hadley & McCloy, which represented AllPets during negotiations. “(The position of AllPets was), ‘Go with us, or go out and do it yourself.’ It’s basically how good you can bluff.” Bluff or not, the perception that AllPets was relatively strong resonated in the corporate offices of PetQuarters, which had recently bought a catalog company to strengthen its offline business but recognized that its brand name was weak.

“We lacked one element to complete what we thought was a truly robust company, and that was a content and community-driven Web site, and that was AllPets,” Dempsey said. “I’m sure they had offers from other suitors. We both said, if we could agree on a price, the deal made a tremendous amount of sense.”

Revenues on the rise

Determining how much stock to exchange when venture capitalists are involved can be tricky, since they can haggle to get as much return on their early investment as possible. But Mansfield praises Zone Ventures for sticking with the company instead of focusing solely on its exit strategy.

“There was definitely some give and take,” she said. “But Zone helped, not hindered” the process. “We were very happy with the deal,” Zone Ventures partner David Cremin said. In the end, PetQuarters agreed to buy AllPets for slightly more than 3.6 million shares of common stock, valued at that time at $1.87 a share. In addition, the company agreed to grant additional stock if certain milestones were reached within a year. So far, however, those benchmarks (which Dempsey declined to identify) haven’t been attained. With little duplication between the two businesses, AllPets only had to lay off three employees in the wake of the buyout, bringing its staff down to 12. Howe took the titles of president and “Top Dog” at the new PetQuarters, with Dempsey retaining the CEO title. The reconstituted company now employs about 100 people.

The catalog and Internet businesses are increasingly using the AllPets brand name, and revenues if not profits are growing. The future of the company is by no means certain: PetQuarters stock was trading over the counter at around 60 cents a share late last week (about the same price as Pets.com on Nasdaq). In other words, the company’s value has plummeted by about two-thirds since the acquisition.

The stock market doldrums continue. But it’s better than the alternative. “The market changed and you have to be able to adapt,” Howe said. “We weren’t as strong before the merger.”