Small Business Financing December 22, 2009, 1:54PM EST

Five Lessons from the eBay-Craigslist Fight

Entrepreneurs considering a strategic alliance can learn from the legal battle between the online auctioneer and the online classifieds site, says Tom Taulli

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Back in 2004, eBay (EBAY) purchased a 28.5% stake in Craigslist for $32 million. The online auctioneer and the online classifieds company planned to expand into global markets in a joint venture as well as share best practices. However, the relationship quickly deteriorated and eBay launched its own classifieds service, Kijiji, in 2007. EBay claims that there was a lack of seriousness to work together, whereas Craigslist says it wanted to remain in control and continue its mostly free services.

Now, the parties are embroiled in dueling lawsuits: EBay says that its stake was unfairly diluted and wants to get its original equity amount back. Craigslist says it's the victim of unfair competitive practices and violations of confidentiality. It wants to get all its shares back and receive damages for lost profits and malicious actions.

Such disputes are often settled out of court because of the expense and distraction involved, but the lawsuits are moving forward. EBay wants to maximize its ownership in Craigslist, which is a valuable asset (with 50 million unique monthly visitors and 19 billion page views) and continue to learn from its operations. As for the Craigslist, it is in the awkward position of having one of its largest competitors as a major shareholder.

As a result, we can get an inside look at big-time dealmaking—gone wrong and wild—that offers some valuable lessons for any entrepreneur contemplating a strategic agreement with another company. Let's take a look:

1. When issuing stock, include shareholder restrictions. The eBay-Craigslist dispute got its start because of a disgruntled shareholder who wanted the venture to focus much more on increasing profits. The shareholder owned a 28.5% stake in Craigslist and was actively shopping the shares from 2003 to 2004. There was nothing Craigslist could do because the shareholder agreement did not have resale restrictions. It would have been advisable for Craigslist to have insisted on a right-of-first-refusal clause, which gives the company and current investors the right to participate in any share sales before others.

In a similar vein, when transferring equity from your own company, make sure you hire a qualified securities attorney to craft strong resale restrictions. These clauses can get extremely complicated. Check out my previous column for what to consider when choosing a lawyer to help you do this.

2. Spell out the responsibilities of each of the partners. The eBay-Craigslist arrangement was a classic strategic relationship. To keep growing, eBay wanted to enter adjacent markets, such as classifieds. By having a board seat and significant equity stake, the company would be in a position to learn about the dynamics of a successful classifieds business. Ultimately, this could lead to joint ventures or even an acquisition, which is what eBay really wanted, according to the legal briefs.

Craigslist also received benefits, such as learning about running successful online marketplaces, dealing with illegal activities in online forums, putting together professional financial forecasts, and operating in foreign markets.

Then why did this relationship break down? It's far from clear. But there are hints. For example, Craigslist did not want to maximize profits or sell out to eBay. It also appeared that the initial share purchase was rushed by eBay to try to prevent Google (GOOG) from gaining a foothold in the classifieds market.