Posted: 01/1999
The End of an Era
These Days, There's No Such Thing as Easy Money
By Ken Branson
Just because a competitive local exchange carrier (CLEC) has built a better mousetrap doesn't necessarily mean investors will beat a path to its doors.
Especially these days.
Until last spring, according to market analysts, finding money wasn't all that difficult for a CLEC with a good presentation and a decent business plan.
"Until May, investors were indiscriminately throwing money at anything that said 'telco,'" says Leslie Rogers, general manager of vendor funding at Lucent Technologies Inc., Murray Hill, N.J. "Then, the last two weeks in May, there were 50 high-yield deals, 20 priced on the same day, so investors could cherry-pick. There were companies with good business plans that didn't get picked. It's starting to come back now, but it was pretty dry last summer."
In May, the yield curve started to shift, says Peter Kennedy, a telecom analyst with Morgan Stanley Dean Witter & Co., New York. "It started to get expensive for CLECs to raise money. Then, in the summer, it got nearly impossible. And on the equity side, there was nothing in the IPO (initial public offering) pipeline. Now, we're seeing some selective growth in high-yield where some of the more mature CLEC companies have been able to tap into the marketplace--like McLeodUSA Inc., Cedar Rapids, Iowa, and ITC DeltaCom Inc., West Point, Ga. But it's still selective."
It was in this environment that Michael Viren, Oscar Williams, Vince Rocca and Charlotte Baker set out in the summer of 1998 to raise $10 million--and did it. The four worked together as senior executives at Intermedia Communications Inc., Tampa, Fla. It had been fun, but the thrill was gone.
"Once you get the entrepreneurial spirit in you, you never lose it," says Williams, a finance specialist and now chief financial officer of 2nd Century Communications Inc., Tampa. "We were sitting there at Intermedia, vice presidents, and we weren't having the same impact any more."
"The steering wheel wasn't as tight," says Viren, 2nd Century's CEO and the former operations vice president at Intermedia. "It was getting to be so big--4,000 people, $800 million in revenues, all kinds of senior vice presidents, executive vice presidents. Things didn't happen as fast."
So it's still possible to draw from the traditional financial wells if you have the right management team and the right business plan. There are venture capitalists who will take a piece of a CLEC in return for their investment; vendors who will finance CLEC equipment purchases; and investment bankers, large and small, who will guide CLECs through private placements, debt issues and IPOs. None of these sources is free, of course.
The Brass Ring
At all stages of the money-raising game, competent, committed management is the very first thing potential investors look for.
"We look for a strong management team," says Chris Rodskog, vice president of Fourteen Hill Capital Partners, a San Francisco-based venture capital firm. "We look at what they've done before and who they've worked for. But it's more than just their resumes. One of the ways you know it's a strong management team is that it really is a team."
Rodskog, whose firm has backed data carriers and international long distance carriers in the past few years, says the only way to gauge that team is to visit the company in person. In fact, at all stages of a carrier's funding life, potential investors say personal relationships are very important.
Williams, in the line of duty at Intermedia, helped raise money for that company and came into contact with venture capitalists and investment bankers. When he and his colleagues went to see their venture capitalists--Accel Partners, Palo Alto, Calif.; North Bridge Venture Partners, Boston; and Venrock Associates, New York--they were dealing with people who knew them personally or by reputation.
"There are investments that walk in off the street, but we pay most attention to entrepreneurs that we've worked with, who have a relationship with one of our partners, or who have worked with a venture capital firm we partner with," says Alex Wilmerding, a principal in Boston Capital Ventures.
RECENT MAJOR CLEC FINANCING DEALS
| Company: McLeodUSA Inc., Cedar Rapids, Iowa |
| Funding Type: Private placement |
| Description: Offered $200 million at 9.5 percent, due November 2008. Offer was oversubscribed. Raised $300 million. |
| Reason: Expansion of fiber-optic network, possible acquisitions |
| Lead investment bank: Salomon Smith Barney |
| Company: NEXTLINK, Bellevue, Wash. |
| Funding Type: Private placement |
| Description: Offered $500 million at 10.25 percent, due November 2008. |
| Reason: Expansion of existing networks and acquisition of new ones |
| Lead investment bank: Salomon Smith Barney |
| Company: ITC DeltaCom Inc., West Point, Ga. |
| Funding Type: Private placement |
| Description: Offered $125 million at 9.75 percent, due November 2008. |
| Reason: Purchase of equipment and systems |
| Lead investment bank: Morgan Stanley Dean Witter & Co. |
| Company: WinStar Communications Inc., New York |
| Funding Type: Vendor financing |
| Description: Obtained $2 billion in vendor funding from Lucent Technologies Inc. over five years. Lucent will sell WinStar's debt to banks. |
| Reason: To finance purchase of telecommunications equipment and systems from Lucent and other vendors |
| Lead investment bank: N/A |
The unstated assumption among venture capitalists and other investment managers is that a strong management team is one whose members are telecom veterans; such people will have run across a venture capitalist or investment banker from time to time during their careers. Therefore, a management team whose members cannot produce the name and number of a venture capitalist between them is a suspect management team.
Nonetheless, there is a first time for everything. Investments do occasionally walk in the door. They may be accompanied by David Rhodes, or someone like him. Rhodes is an investment banker with Daniels Associates, a small Denver-based firm that introduces venture capitalists to potential opportunities. Rhodes says he and his colleagues have gone so far as to approach telecommunications people who have day jobs and may not have considered going out on their own. But usually, he says, such people come to him.
"We look for the same thing venture capitalists look for," Rhodes says. "These days, the things that are constant are an experienced management team that has done this before, a specialized market niche and a well-defined strategy. Not long ago, a strong team could lay out a fairly general strategy and get funded. No more. That's why you see CLECs talking about 'smart-build' strategies where they own the switches but not the transmission. They want to build in a market, prove in that market and then go on from there."
But venture capitalists are not just faucets providing an initial flow of money. They begin by owning a piece of the company, and most enter into a relationship with an exit strategy. There are three good exits--a merger, an acquisition and an IPO. In between entrance and exit, a good venture capitalist is like an extension of the management team, giving encouragement and advice. Some venture capitalists are in for the long haul, however, and aren't interested in an exit after one of the major CLEC milestones.
"Some people see an IPO as an exit," Wilmerding says. "But for long-term investors, it's one way to create an infusion of capital for development."
Most CLECs use initial capital for equipment to get their networks started. In some cases, the vendor of the equipment itself will finance that purchase.
The most spectacular recent example of vendor funding was a $2 billion, five-year deal between Lucent and WinStar Communications Inc. Rogers, who negotiated the deal for Lucent, says the agreement was unique in many ways.
Indeed, the two companies went to extraordinary lengths in announcing the deal to emphasize their "strategic partnership." WinStar, well past the point of being a startup, has made Lucent the effective arbiter of its technology; Lucent has committed itself to provide WinStar with "best-in-class" equipment, whether it's Lucent's or not.
But there are some aspects of the deal that are typical, not least of which is the high value Rogers and her colleagues place on the skills of WinStar's management team. In addition, Lucent will "sell" WinStar's debt to other companies--to banks, mainly.
"There is a core constituency of about 65 banks that lend to the telecom industry," Rogers says. "There are five or 10 that 'agent' loans, and then maybe 25 who take major roles in loans."
Rogers says Lucent is busy negotiating with several banks to take a piece of the WinStar deal. She says she has no trouble attracting banks to a deal like this--WinStar's management team is known and admired by bankers and investors.
Like most of her counterparts at other vendors, Rogers is a professional banker. And most of her work is less spectacular than $2 billion deals with high-profile clients. CLECs come to her, sometimes introduced by their venture capitalists, but mostly through Lucent salespeople.
The role she and her colleagues play goes beyond the checking of credit ratings. Rogers and her counterparts are even less likely than venture capitalists to be seduced by a business plan. She also considers the carrier's existing capital and investors.
"We'll want to see their business plan, their marketing plan and their revenue projections," she says. "We run customer financing, as our competitors do, with a fiduciary responsibility to our shareholders. You don't just want to give equipment away, you want to get paid for it. So there is a considerable bit of due diligence that goes on before we send the looking-forward-to-doing-business-with-you letter."
The biggest mistake CLEC managers can make with Rogers is to give her the impression they don't have a specific plan with specific costs.
"I just want to see if they know what they're doing," Rogers says. "I've talked to some people who said, 'Well, uh, I didn't really run the numbers on that.' Then you get worried."
Lucent isn't alone, of course. Most vendors offer some sort of financing to their customers, and most take a proprietary interest in how the financing is used.
"We have a history of working with our customers in a very, very close manner," says Eric Warren, director of public relations for Ascend Communications Inc., Alameda, Calif. "That means we really tend to get inside their network to understand what they're trying to do."
Warren adds that Ascend has its roots in the world of Internet service providers (ISPs), so it is familiar with startups.
Financing, Round Two
Once a CLEC has been through a round or two of venture capital funding, and perhaps some vendor funding as well, it may be interested in raising money by a private placement--essentially, the offering of interest-bearing debt to select investors or a qualified financial institution. There always is new equipment or software to buy, a sales staff to hire, customers to service.
Depending on how large a carrier has grown, this placement might be done by a really large investment bank--a Bear, Stearns & Co Inc. or a Morgan Stanley Dean Witter. Williams, of 2nd Century, says anything less than $100 million is probably not worth the time of a large investment bank. For smaller carriers, firms such as Commonwealth Associates, of New York might be more likely agents. Common-wealth Associates, its CEO Michael Falk explains, also acts as a venture capital firm and "may take a company from startup to the point at which they would need $15 million in capital."
A private placement may involve a debt that would run for 10 years with interest in the 8 percent to 20 percent range. Of course, interest rates depend upon the company's track record and market perceptions of that company.
ITC DeltaCom recently raised $125 million in a private placement at 9.75 percent, due in 2008.
"We were just doing it to fund the business plan, to make sure we stayed liquid," says Douglas Shumate, ITC DeltaCom's chief financial officer. "In this business, you never, ever want to be short of capital."
Shumate says his company will buy switches and transport gear with that money. He was pleased with the placement, to put it mildly. "We did it in five days, and it was oversubscribed," he says.
McLeod, meanwhile, raised $300 million in a private placement this year, also for expanding its network and funding its business plan. The debt, offered at 9.5 percent, sold at 10.25 percent and is due in 2008.
Investment bankers also will help a carrier float corporate bonds, which may be offered at similar terms, but to the general public. Shumate believes that one reason ITC DeltaCom's private-debt interest rate was so low was that the company had offered bonds to the public before, and those bonds were trading at about 9.25 percent when the private placement was made.
The Holy Grail
If a carrier executes its business plan and establishes itself as everything an investor would want, the IPO is the Holy Grail of fund-raising. Of course, to reach this plateau, a carrier must first execute its business plan.
For entrepreneurs, venture capitalists and investment bankers, the IPO represents payday. For entrepreneurs and many venture capitalists, it also represents a psychological high-water mark, a vindication of their vision and, occasionally, of their sanity.
Of course, sometimes it represents the high-water mark in the history of a carrier. USN Communications Inc., for example, went public in early 1998 at $15 and its stock was trading at $23 in early March. The company was a total-service reseller--an aggressive seller of access lines--opening offices and hiring salespeople across the country.
But the bottom dropped out this summer. Hundreds of staffers were laid off, the company went through several changes in senior management and the stock was trading at about 37 cents a share in mid-November. On Nov. 12, a class action suit was filed against the company in New York, alleging the company's managers and the underwriters of its IPO failed to inform potential investors of material facts that might have caused them to put their money elsewhere. Those underwriters include many of the most distinguished names on Wall Street--all of whom, presumably, examined the business plan and thought deeply about the management team.
