Telecom Strategist

 
 
 
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    Thoughts and reflections on strategic issues facing the telecom industry.
 
You’ve Got to Survive to Thrive November 2nd, 2005

This article was originally written in October 2003 for the January/February 2004 issue of Success magazine.

“Successful telecom startup.” Isn’t that an oxymoron? Looking at the hundreds, if not thousands of companies launched between 1996 and 2000, you’d be tempted to think so. Hundreds of billions of dollars raised in debt and equity markets, with nothing to show for it except empty office buildings and unlit fiber networks.

Thankfully, Covad Communications stands as a shining light amidst this doom and gloom. Not only has Covad survived the sequential bursting of the Internet and telecom bubbles, but the company has a fully funded business plan that is expected to carry them to profitability in the second half of 2004.

How have they done that?

Much of the credit must go to Charles Hoffman, Covad’s CEO who hired on at the company’s lowest point, and who has steered the company through treacherous waters to today’s position of strength. However, Hoffman is quick to share credit with wise decisions made in the company’s earliest days.

Chuck McMinn, Covad’s chairman and one of the company’s founders, describes three things they did right from the very beginning: they built the right team, they built an infrastructure for long term growth, and they focused on a growth plan that was fully funded.

“The first person we hired was a great salesperson,” Chuck recalls. “We didn’t yet have a product to sell, but we needed someone who could spend time with customers and listen to their needs instead of talk about our capabilities. What we learned from these buyers turned our plan for the business upside down.”

Chuck and his co-founders, Chuck Haas and Dhruv Khanna, came across a technology that had been lying dormant in telephone company labs for years. That technology, Digital Subscriber Line (DSL), could deliver information over existing telephone lines at speeds twenty-five times faster than conventional analog modems. These three envisioned a killer application for the technology of connecting remote and home-office workers back to their corporate headquarters at speeds that would rival in-building local area networks (LANs).

But that’s not the application that got corporate network buyers excited. What customers wanted was an inexpensive way to gain high-speed access to the Internet. And DSL could accomplish that task for a small fraction of the cost of existing telecom services.

Thus, the broadband Internet industry was born. But Covad wasn’t alone in chasing this market opportunity. The cable industry had formed @Home to begin delivering broadband Internet services to residential customers over their coax infrastructure. Meanwhile, dozens of startups formed around the DSL opportunity, with two main competitors, Rhythms NetConnections, and Northpoint Communications, joining Covad as the market leaders.

Rhythms, Northpoint, and the vast majority of Covad’s startup peers have long since gone out of business. What enabled Covad to survive?

“Our second critical hire,” continues McMinn, “was our Vice President of Engineering. He began putting in place the automated software systems that would allow us to add lots of customers without adding lots of employees, and to turn up those customer orders quickly. That makes the customers happy and gets the revenue in the door.”

It also proved to be the difference between corporate life and death for Covad.

“Rhythms and Northpoint are gone because they didn’t have the systems that would allow them to scale the business while drastically cutting operational costs when all sources of funding dried up,” says Patrick Hurley, broadband analyst for TeleChoice, a telecom consulting firm that closely tracks the industry. “From day one, Covad focused on execution, quality, and efficiency, and when the cash disappeared, only Covad could quickly implement a plan to both rapidly reduce burn rate and steadily grow the company to reach break even and profitability.”

And that’s exactly what the company did.

When Covad was formed in 1996, the founders knew they only had enough cash amongst them to build out and serve the San Francisco Bay area. So, that’s all they focused on. In 1998, when they landed their first outside funding, they were fully funded to build out and serve six cities, so that’s what they did. They continued this disciplined approach through their IPO in January 1999 and additional debt financing in the first half of that year, cautiously expanding their plan to only include the 16 cities that were fully funded with their existing financing.

Unfortunately, even Covad got caught up in the go-go telecom spending days of 1999 and 2000. Customers wanted nationwide coverage, and Covad’s competitors were rapidly building out additional cities, so Covad followed suit, assuming that the cash that had flowed so freely into the industry would continue as long as they needed it.

Obviously, that was a bad assumption. By the second half of 2000, it was clear that the company’s existing capitalization plan wasn’t going to happen. In short, the company would run out of money before reaching profitability.

Covad’s board and management team huddled and agreed that a financial restructuring was required. Bob Knowling, Covad’s CEO at the time, stepped aside and the board brought McMinn out of semi-retirement to serve as chairman while they began a CEO search. That search uncovered Hoffman, a seasoned telecom executive who proved to have what it takes to navigate these stormy seas.

As Hoffman came on board, he recognized that there were four critical stakeholders that would need to be managed through the process.

To have a sustainable business, of course Covad would require employees and customers. Even though these groups are merely passengers in a financial restructuring, it was critical that Hoffman and Covad keep them totally on-board through the entire ride.

Similarly, since Covad’s path would involve bankruptcy, existing stockholders were clearly not in the driver’s seat. However, the company hoped to deal fairly with these investors or risk alienating Wall Street and cutting off potential future funding sources.

The final group to be managed was the company’s creditors. In a bankruptcy proceeding, the court is primarily focused on ensuring that the debtor is doing all that can be done to pay back outstanding debts. In virtually every bankruptcy coming out of the telecom industry over the past few years, creditors have ended up with a significant equity stake while existing shareholders have been wiped out.

Thankfully, Covad was blessed with two tremendous assets in working through these issues.

First, the company actually had a significant amount of cash on hand. Hoffman put this cash to work, both as working capital in operating the business, and as one of the currencies for satisfying the company’s debt holders.

Second, Covad enjoyed a great relationship with its creditors and that group still believed in the company’s opportunity. The creditors actually presented a plan that would allow Covad to eliminate all the existing debt by exchanging it for a combination of cash and equity that would still leave existing shareholders with majority control of the company.

However, Hoffman and McMinn couldn’t kick back and coast. The plan presented by the creditors would get the company through bankruptcy, but wouldn’t leave Covad with a fully-funded business plan that would carry them to profitability. Chuck and Charles didn’t want to be back in that position again. For the plan to work, the company needed to work out three additional components to the plan.

The emotionally hardest change would be a reduction in headcount. The company’s new plan would not support the existing level of staffing. Since Covad had beefed up operations primarily to support an aggressive nationwide roll-out, scaling back the expansion plan eliminated significant capital expenses and made it possible to scale back the organization. Of course, the early engineering decisions to automate processes played a key role as well.

Covad also needed to rationalize its customer strategy. The company’s early growth had largely been on the backs of other startups that were growing as rapidly as Covad to provide high speed bandwidth to the explosion of Internet companies. As those Internet startups stopped paying their bills, and eventually shutting their doors, Covad’s customers stopped paying their bills, and eventually started shutting down as well. Covad had to work through complex legal issues to extricate the company from serving non-paying customers while, whenever possible, retaining the subset of end users who were financially stable.

Covad shifted their focus from primarily growing through wholesale deals to other start-up service providers, to selling directly to small and medium businesses while establishing strategic partnerships with top-tier wholesale customers. Covad established and strengthened relationships with companies like AT&T, Sprint, and MCI Worldcom while strengthening their own direct sales capabilities. Needless to say, this was no easy task.

However, perhaps most challenging of all, Covad would need to raise additional funding as part of the restructuring process.

What was needed was an investor who could spare about $150 million in cash, who clearly understood the DSL value proposition, and, in a best case scenario, could become a strategic partner – working side-by-side with Covad to ensure each company’s success.

They found that perfect partner in SBC Communications, the parent company of Pacific Bell, Southwestern Bell Telephone, Ameritech, and a handful of other household-name telephone companies. SBC has been one of the most aggressive incumbent telephone companies in introducing DSL services; the company clearly sees broadband as the future of the telecom industry. However, SBC’s customers want end-to-end solutions, and SBC struggles to deliver broadband connections out of its regional footprint. Covad provides an excellent network extension solution to meet that need. Similarly, Covad’s greatest reliance is on companies like SBC who own the telephone wires into customers’ buildings. A strong relationship with SBC could provide easier access to approximately 40% of those lines.

That’s not to say the negotiations were easy or smooth. But, through the combination of McMinn’s creativity and Hoffman’s focus on getting the deal done, Covad and SBC were able to come to terms in a true win-win relationship.

On August 15, 2001 Covad Communications submitted a pre-packaged Chapter 11 filing in the U.S. Bankruptcy Court for the District of Delaware. On December 20 of that year, the company emerged from Chapter 11 with all existing debt eliminated, its network intact, its customer base generating revenue, and with $150 million in new funding from SBC. That new cash is expected to be enough to carry the company to profitability. Covad also emerged to a drastically simplified competitive space, with most of their traditional competitors eliminated.

What did it take to make it through?

Charles Hoffman makes it sound simple: “It was critical that we have a clear plan for how we would, not only emerge from bankruptcy, but emerge with a fully-funded plan that would carry us to profitability. We took that plan to our key partners and customers, to our vendors, to our employees, and to our investors. The plan was clear and it was compelling. We then began execution on that plan and continued to communicate every step of the way.”

Vik Grover, a Wall Street analyst with Needham and Company who has followed Covad since the telecom boom days describes the company’s rebound this way: “By 2001, in a miraculous comeback, Covad performed a prepackaged Chapter 11 filing, eliminating its entire debt load through the payment of cash and 15% of its equity to creditors. This reorganization plan positioned common shareholders to salvage their investments and enjoy the upside offered by Covad’s revamped plan. The company also made needed corrections to its account management and sales growth strategies. Overall, we believe these maneuvers positioned Covad for long-term success and could make the company the comeback story of the year.”

The fact that Wall Street is pleased with Covad’s progress is a testament to the company’s ability to continue to tell the clear and compelling story. Communications, after all, is the company’s business. Unfortunately, for many in their industry, it hasn’t been the practice.

Hoffman sees communications as a critical component for success for any technology startup. “You’ve got to get the right people and develop them into leaders. You have to have a clear, well communicated plan. You have to build the company with a long term focus and never stop improving how you serve the customers.”

“And, you’d better be fully funded,” adds McMinn.

One Response to “You’ve Got to Survive to Thrive”

  1. Telecom Strategist Says:

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