What Happens Next?
By Mark E. Evans and Mark D. Taber, Great Hill Partners

As the summer of 2001 ended, entrepreneurs and investors looked around and wondered what could possibly happen next to make the business environment more challenging. Questions on the health of the US economy turned from "is it slowing?" to "how deep will the recession be and when will the recovery begin?" Entrepreneurs had to wonder how the business climate could have deteriorated so quickly.

The investment environment for communications companies continued to worsen, as the NASDAQ Telecommunications index, which was already down 28% year to date, dropped an additional 25% between July 4th and Labor Day. Once high-flying broadband service providers, such as Covad and Rhythms NetConnections sought bankruptcy protection in the dog days of August, while many other companies struggled for survival. Venture capitalists spent the summer focused on rescuing their current portfolio companies instead of making new investments. Everyone hoped the end of the summer doldrums would bring some positive change: perhaps the economy would stabilize, the much talked about bottom would be behind us, and optimism might return.

Dramatic change did come just a week after Labor Day, but it was a change that no one could or would have imagined possible. The tragedies and terror of September 11th have changed our world in many ways and will continue to do so for the foreseeable future. While the country slowly begins to rebound from the initial shock of these events, a heightened sense of uncertainty pervades almost every aspect of our professional and personal lives. Uncertainty is a four-letter word in the business world. The normally challenging task of strategic planning, budgeting, and forecasting becomes much more difficult during uncertain times. Entrepreneurs, employees, bankers, investors, and government officials now had to look at a changed world and wonder "what happens next?"

While no one can accurately predict what might happen next, entrepreneurs and executives in the communications industry might want to consider reviewing near-term tactical and strategic options in light of current market conditions. Key areas to consider include:

· Scaling back existing operations and/or plans for growth;
· Revisiting current assumptions upon which a business plan is premised;
· Finding an appropriate merger partner; and,
· Fixing balance sheet issues.

While many companies were addressing some of these points already, we believe the impact of September 11th increases the urgency of examining these possibilities.

First, both management and investors need to reset their overall expectations. While this does not necessarily mean that all existing strategies need to be abandoned, we do believe that every company needs to take a fresh look at what is realistic in this environment and adjust its business strategies accordingly. An important aspect of that process is making sure that entrepreneurs and their financial partners agree on what those revised expectations are, particularly as they relate to the availability of capital needed to support the company's strategy. Uncertainty wreaks havoc in financial markets, often causing sources of financing to suddenly dry up for extended periods. Public and private investors might decide to sit on the sidelines until a better assessment of the situation becomes available. The need to minimize financing risk and preserve precious capital is only magnified in the current market.

Revise Business Plan

Scaling back a business plan often allows management to focus its talent and other resources on the smaller universe of challenges that are inherent in trying to grow a business. Simply put, trying to manage the growth of people, networks, and other assets across three markets is easier than across six markets. If a company is fortunate and has capital available, then focusing that investment across a smaller operational base can leverage the capital more efficiently. A company that needs to raise capital may find that investors are more receptive to a business that can clearly demonstrate that it requires only a small amount of capital to achieve profitability. Similarly, entrepreneurs financing a new venture will also find that investors are more receptive to a plan that calls for a smaller amount of capital to validate the business plan. Scaling back your existing business or new venture in the near term does not mean that you will have to forego a larger plan in the future. However, it may allow your company to eliminate additional execution and financial risk in an extremely challenging environment. Demonstrating your company's abilities on a smaller scale today should allow you to gain investor confidence, and better position the company for future opportunities when a more promising environment returns.

Revisiting the underlying assumptions of a company's business plan should be done on a continuous basis - and especially in these tumultuous times. Scrutinize business practices that might cause diminished financial performance, and don't be afraid to challenge established assumptions. Management teams should not be afraid to walk away from an unprofitable line of business or revenue. Sometimes in the rush to build a business quickly, decisions are made based on what was once considered a reasonable premise, such as selling a particular product at a loss to build market share, or because it would lead to more profitable revenue from another offering. Be honest in determining whether that outlook still makes sense. Of course, with the constant pressure to grow a company's revenue base, it may be difficult for a CEO or manager to walk away from any revenue, but this is an example of a difficult decision that must be made in today's market.

Another business strategy assumption that should be assessed in this environment is the desire to be all things to all customers. Strategically, bundling services with the goal of maximizing revenue derived from each customer is still very strong. However, it's time to recognize that revenue should be profitable and leverage a company's core skills. For instance, instead of investing in additional personnel and assets to provide your broadband customers with a managed firewall services, consider partnering with a managed security services company that would allow you to provide these additional services through a private-labeled partnership with a complementary company. While, the margin on a 'resold' service may be less attractive than an internally operated service, current markets call for maximizing financial performance today, and limiting the number of challenges a company's management and employees undertake.

Consider a Merger, Acquisition, or Recapitalization

Financial success in the communications services industry is premised on a relatively straightforward equation: drive operating leverage by building a critical mass of customers that are served across a largely fixed-cost infrastructure. There are two primary methods to accomplish this: acquire the customers through sales and marketing or acquire a broader customer base through a merger. While many entrepreneurs craft their business plans around a strategy of out-selling their competition, the current environment calls for examining whether there is a more prudent path to success that includes combining efforts with the competition.

Merging with a competitor might mean that the one merged company survives and flourishes, instead of both companies floundering and failing on their own. Obviously, if the customer constituency of each of the merged companies can be served over one network, then the goal of driving operating leverage becomes more readily attainable.

Another possible merger strategy is to combine companies that offer complementary services that can be sold to the same customer base, improving the combined company's customer level margins. Done correctly, a merger should also allow the combined entity to drive a better bottom-line margin, by eliminating redundant overhead expenses and improving operating efficiencies.

Many well-known public and private companies have recently announced balance sheet restructurings to better reflect the operating profile of their underlying business. Unmanageable debt loads are the typical reason that a company seeks to restructure its capital base. Having a business that is not meeting expectations is one problem, but having a business that is not performing to plan and has burdensome debt service obligations obviously complicates matters further. An over-leveraged company's problems are magnified, because potential providers of new capital understandably are hesitant to invest in a company with acute balance sheet issues.

To alleviate the pressures brought on by excessive leverage, many companies are seeking to negotiate transactions with their creditors, whereby the existing debt holders exchange their credit instruments for an equity position in the company. Faced with the alternative of liquidating the business or filing for bankruptcy, the company's existing shareholders should be willing to accept a diluted ownership interest in the surviving company in exchange for the debt burden being eliminated or decreased. Historically, creditors have not always been as willing to negotiate debt-equity exchanges, because they believed they could recover the principal by forcing a sale of the company or its underlying collateral. With today's depressed asset prices, particularly in telecommunications, creditors are not assured of recouping their principal through a foreclosure so the opportunities to negotiate with creditors are a lot greater.

While we are not suggesting that all companies need to or should seek to restructure their debt loads, we do believe it may be best to take a proactive approach to potential debt-related problems. Focal Communications, a publicly traded competitive local exchange carrier, is an example of a company that took a proactive approach to looming balance sheet issues. Focal and its existing investors structured a $430 million recapitalization that allowed the company to decrease its outstanding debt through a $280 million debt for equity exchange and to raise an additional $150 million of growth equity. In addition, with $280 million of debt obligations removed, the company's senior lenders have agreed to increase Focal's borrowing capacity, which will also be used to fund the company's growth plans. By taking a proactive approach, Focal's management team avoided having to put the company through a Chapter 11 bankruptcy proceeding. In addition, the team eliminated further management disruption and loss of customer confidence that accompany a bankruptcy filing.

Despite current market conditions, the demand for communication services is, in fact, likely to increase in the months and years ahead. Business and residential customers continue to demand more services and bandwidth, and all signs are that growth trends will continue. While businesses in almost every industry face new challenges of sustaining success, it can be done, even in the most difficult sectors, including telecommunications, by paring back aggressive plans and trying to work a little smarter. Success is relative, and in today's environment, survival is, indeed, victory. The companies that make difficult decisions today will be among the most successful and valuable companies in the long term.

About the Authors

Mark E. Evans is a partner and Mark D. Taber with is a senior associate with Great Hill Partners (www.greathillpartners.com), a private equity investment firm based in Boston that was formed as a successor to Media/Communications Partners in January 1999. The partners at Great Hill Partners have invested in more than 35 companies in the communications, media/information and IT infrastructure services sectors and has over $1 billion under management. Our recent investments in broadband services include CityNet Telecommunications, Edge Connections, and ManagedStorage International. Great Hill Partners is currently pursuing investment opportunities in several segments of the broadband services market including wired and wireless voice and data services and next-generation carriers.