June 23 (Bloomberg) -- When Jeffrey Citron rang the opening bell at the New York Stock Exchange on the first day of trading in his Vonage Holdings Corp., he was supposed to have formally put his past of Securities and Exchange Commission fines behind him. Instead, he opened up a new chapter of suspicion.

The Internet phone company's $531.3 million initial public offering May 24 now holds the distinction of being among the worst this decade. Issued at $17 a share, the stock has fallen 49 percent, the twelfth-biggest drop of any new issue since 2000, according to data compiled by Bloomberg. The shares rose 10 cents to $8.75 in New York Stock Exchange composite trading today.

Compounding the price drop is a bungled attempt by Vonage to dun phone customers who agreed to buy shares at full price, a lawsuit charging patent infringement from Verizon Communications Inc., and a business model that relies on ever-larger discounts and costly, ubiquitous television ads. It adds up to making ``financial distress a distinct possibility,'' says Qaisar Hasan, an analyst at Buckingham Research Group in New York.

``It's like watching a train wreck,'' says Alex Motola, manager of the $850 million Thornburg Core Growth Fund in Santa Fe, New Mexico. He read the prospectus but passed on the deal. ``Customer investors have lost more money on the IPO than they were saving on the service.''

In the aftermath of the debacle, the question asked among investors and analysts is why Vonage, based in Holmdel, New Jersey, was taken public in the first place. With accumulated losses of $467 million, and the expectation of more as the company pursued growth at the expense of profits, Vonage was an unlikely public stock, says Mark Mowrey, an analyst at Al Frank Asset Management, in Laguna Beach, California.

`No Business Model'

``I don't even know how the company went public,'' says Mowrey, whose firm's $850 million in funds includes shares of Verizon and AT&T. ``With big companies trading at the valuations they're trading at, I don't know how an upstart that's stolen customers from them and has no defensible business model should be valued more highly.''

Adding to the controversy is the generous pricing of the deal, which was $7 more than the $10 or less Pali Capital Research managing director Richard Greenfield thought the stock deserved. Greenfield has since put a $5 target on the stock as growing competition from cable companies puts pressure on prices.

``Despite the stock being down 50 percent from the IPO, overall competitive dynamics are getting more severe instead of less severe,'' says Greenfield, who has a ``sell'' rating on the shares.

Priced Like Ebay

Although Vonage had just 1.6 million subscribers, the investment bankers valued Vonage at $2.6 billion, the same amount EBay, based in San Jose, California, paid last September for Luxembourg-based Skype Technologies SA, which claimed 54 million ``members'' in 225 countries at the time. The underwriters--which include Citigroup Inc., UBS AG, Deutsche Bank AG, Bear Stearns Cos., Piper Jaffray Cos. and Thomas Weisel Partners Group Inc.-- earned $31.9 million in fees from the IPO, according to the May 23 prospectus.

The company couldn't find a buyer to pay a high enough price, so it raised capital on the market, say people familiar with the matter. The people, who declined to be identified because talks were confidential, say BellSouth Corp., which is being bought by AT&T Inc., considered paying between $1 billion and $1.5 billion, too little to get Citron, 35, to agree to a deal. Vonage's market value now stands at $1.35 billion. BellSouth's director of media relations, Joe Chandler, said the company doesn't comment on ``rumors or speculation concerning mergers.''

Commodity

Lawyers suing the company blame insiders and early-stage investors: ``With no public market, and with the company's primary service quickly becoming a very low priced commodity, by the spring of 2006, company insiders were desperate to execute an exit strategy for themselves,'' said a lawsuit filed against the company on June 2 in U.S. District Court in New Jersey by Mount Pleasant, South Carolina-based Motley Rice LLC.

``They used their customers to prop up the price of the stock,'' says Motley Rice attorney Stuart Guber. ``If you're a sophisticated institutional investor, this is not an attractive IPO for you. They've never shown a profit, and their marketing expenses are extremely high compared to their competitors.''

All of the underwriters declined to comment. Citron and Vonage declined to answer a detailed list of e-mailed questions. In response to the shareholder lawsuits, the company said in a statement that it ``will contest the allegations vigorously.'' Early-stage investors such as New Enterprise Associates and Meritech Capital Partners, didn't respond to requests for comment.

Banks Declined

Several investment banks, including Credit Suisse Group, Morgan Stanley and JPMorgan Chase & Co., passed on the Vonage underwriting business, and Goldman Sachs Group Inc. chose not to participate, people familiar with the matter said. One person cited Citron's past. In 2003 he paid $22.5 million to the Securities and Exchange Commission to settle fraud charges when he ran Datek Online Holdings Corp., a small trading company. He didn't admit or deny guilt.

Citron and early investors have profited handsomely from the IPO, if only on paper. With a cost basis of just $3.29 a share for their 78 percent stake, Pali Capital's Greenfield said in a May 25 research note there is a ``high likelihood'' the investors will sell when their 180-day lockup expires November 20. On June 15, he downgraded the stock to ``sell'' after learning that Vonage was cutting prices to retain customers.

Tanzer Suit

Unlike many company founders who give up much of the equity in exchange for venture capital financing, Citron acted as his own venture capitalist. He made a series of early loans to the company that were converted into his 33 percent stake following the IPO.

Vonage ran into legal challenges well before the IPO. One of the company's early fund raisers, investment banker Joshua Tanzer filed suit against Vonage last October 16 in U.S. District Court in the Southern District of New York, for unpaid fees.

Seeking damages of $26.7 million, Tanzer claims he brought in $320 million of outside equity for Citron and Vonage starting in 2003, yet he received fees of only $2.1 million, representing 5 percent of $42 million raised.

Tanzer met Citron while working for Credit Suisse Group's technology group from 1996 to 2003, where he raised $700 million from private equity funds which acquired Datek by buying out Citron.

100 Investors

In his complaint, Tanzer said that he agreed in 2003 to help Citron raise money for Vonage. This would prove to be an ``extremely challenging'' assignment due to Citron's ``checkered past'' and ``meltdowns'' in the telecommunications sector such as WorldCom Inc. and Global Crossing Ltd., Tanzer claims in his complaint.

As a result, Tanzer alleged he contacted a ``higher than usual'' number of potential investors totaling 100 on behalf of Vonage, ``necessary in light of the overall condition of the market and the legal issues surrounding Citron.'' Of that pool, he raised $12 million from New Enterprise, a Baltimore, Maryland- based venture capital firm that oversees $6 billion. New Enterprise ended up becoming the largest holder behind Citron, with a 19 percent stake.

That was followed in 2004 by a third-round offering that raised $30 million from Meritech Capital of Palo Alto, California, and 3i of Menlo Park, California. Tanzer also claimed credit for bringing in Bain of Boston for a later stage investment. Meritech has a 10 percent stake, while Bain and 3i each hold 8 percent.

Citron's Vision

In its answer and a separate counter complaint filed against Tanzer in February, Vonage said Tanzer's arrangement with Vonage was invalid since he didn't have the proper securities license at the time. Tanzer, now working in Beverly Hills, California, for Boston-based Revolution Partners, an investment bank, didn't return calls seeking comment. His lawyer declined to comment.

Despite Citron's lack of telecommunications experience, early investors touted his vision, which saw that the Internet could provide a cheap way to make voice calls. New Enterprise said in a November, 2003, press release that Vonage's management ``brings a wealth of experience to the table, enabling them to be the early market leader.'' Yet until Vonage, Citron had never worked in the industry.

Colorful History

Left out of the announcement was Citron's colorful history. According to the prospectus and legal filings, Citron didn't attend college and went to Datek in 1988. His breakthrough came when he learned how to exploit NASDAQ's Small Order Execution System, which was supposed to allow small investors greater access to the market. Called ``S.O.E.S bandits'' on Wall Street, Datek and other firms used the system to instantly execute big trades ahead of the rest of the market, bypassing market makers.

The money Citron earned from selling Datek in 2000 to the private equity funds came in handy in 2003, when he and other Datek traders were accused by the SEC of participating in a ``massive fraudulent scheme'' to execute proprietary trades on the S.O.E.S. system by hiding behind dozens of bogus accounts. Citron settled the charges for $22.5 million and agreed to a lifetime ban from the securities industry.

He picked up some controversial friends during his time at Datek. They included Robert Brennan, the penny-stock promoter notorious for his 1980's ``come grow with us'' television ads that urged investors to do business with his First Jersey Securities, which ceased operating in 1985. Datek principal Sheldon Maschler introduced Citron to Brennan in 1996.

Brennan

Brennan was sentenced in 2002 to 12 years in prison for money laundering and bankruptcy fraud. Citron bought Brennan's riverfront house in New Jersey and socialized with Brennan. Vonage discloses much of Citron's legal history in its prospectus, including his association with Brennan.

After birthing Vonage in 2001, Citron developed his strategy of marketing Internet phone services directly to consumers, instead of through cable companies, which now represent his biggest competitive threat.

The go-it-alone strategy has been costly. Marketing expenses more than tripled last year to $243 million, while sales doubled to $269 million. Losses almost quadrupled to $261 million from $70 million in 2004. The company expects to spend as much as $380 million on marketing in 2006, according to the prospectus, more than any other expense.

In addition to funding Vonage's memorable ``People do Stupid Things'' television commercials, the money has gone into a variety of sponsorships, paid surveys and events. This year, the company is sponsoring horse racing's most recent Preakness Stakes and English broadcast rights to the World Cup.

`Love to Make Love'

For Valentine's Day in Canada, the company backed a survey that revealed Canadians ``love to make love on the phone.'' It held a ``Pimp That Phone'' contest last July, awarding $2,000 and a year's worth of Vonage service to the best-looking modification of a touchtone phone.

Although the spending has gained Vonage customers, they've become less profitable. Subscriber lines jumped to 1.6 million by the end of March, from less than half that amount in 2005, while average monthly revenue per line was $27.65, less than the $33.37 the company received in 2003.

Vonage won't break-even until 2011, says Buckingham's Hasan, and will need an additional $1 billion through 2012 to keep customers coming in the door.

`Survival Options'

``I doubt the company will completely collapse,'' says Hasan, ``but none of the options for survival look particularly appealing.'' There aren't any natural buyers for Vonage's subscriber base, he says, and raising more money would be difficult and dilute existing shareholders. The company's most likely road is to cut spending -- and growth -- to create profits.

``Vonage won't succeed as a standalone company,'' says Mowrey. ``You can't be in communications as a one-trick pony.''

If dicey economics weren't enough, New York-based Verizon on June 19 alleged Vonage had infringed seven of the patents that allow the New Jersey telecommunications giant to send Web-based calls over traditional phone lines. Vonage said it would fight the suit.

Notwithstanding the problems, the company says the offering was oversubscribed, at least among its customers, who were allocated 13.5 percent of the shares. In hindsight, some consumers turned shareholders consider that a blessing. Marc Eisner, 41, a consultant to law firms in Kenmore, Washington, says he requested 100 shares in the IPO.

``When I found I didn't get allocated any shares, I was disappointed. But that changed. You can't be disappointed with not losing money,'' says Eisner, a Vonage customer for 18 months. ``It was probably the luckiest day of my life.'

To contact the reporter on this story: Seth Lubove in Los Angeles at slubove@bloomberg.net.

Last Updated: June 23, 2006 16:59 EDT