US ONE Communications A Case Study of a Failed Start-up

US ONE Communications A Case Study of a Failed Start-up

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US ONE, against which an involuntary petition was filed in June 1997, was a start-up tele-communications company hoping to capitalize on the regulatory changes in the industry. The challenges faced by US ONE provide insight into the problems tele-communications companies, especially start-ups, face in the rapidly changing regulatory environment and capital markets.

Industry Overview

The telecommunications industry can be divided broadly into two segments: long distance service and local dial tone service. Since the AT&T divestiture of its local telephone subsidiaries in 1984, local dial tone service has generally been monopolized by the seven regional Bell operating companies (RBOCs) and other incumbent local exchange carriers (ILECs). However, the market for long distance service has become increasingly competitive, as a result of actions by the Federal Communications Commission (FCC) and certain state regulators. More than 1,000 long distance carriers and telecommunications resellers are providing service today.

Company History

US ONE (the "company") was formed in May 1994 around a core of network engineering and information technology personnel who were responsible for the development and operation of the LDDS/WorldCom network and IT systems from 1990-1994.

US ONE’s strategy was to build a national value-added telecommunications services company to capitalize on the trend toward increased competition in the telecommunications industry. US ONE’s service offerings were to include national Carrier Controlled Switching (CCS), exchange access service and wholesale and retail local dial tone services. These services would have enabled US ONE’s wholesale customers to control and customize their own long distance transmission networks, as well as to offer local dial tone service with minimal capital. The company’s targeted wholesale customers included long distance carriers, telecommunications resellers, out-of-region RBOCs and large corporations with branded private networks.

The initial deployment of the company’s nationwide tele-communications service included Lucent 5ESS-2000 switches—which control the delivery of CCS services, exchange access services and local dial tone services—deployed in major cities throughout the United States. The company’s management believed that the switches and related information technology would be the central components of its value-added tele-communications network. US ONE was configuring its switching and information technology systems in an "open systems" format, which would have allowed them to be partitioned among multiple users. This would have afforded customers, such as inter-exchange carriers (IXCs) and out-of-region RBOCs who do not have a full range of customer services and products in a specific geographical area, the opportunity to design, control and monitor their own networks and to offer customized services and products to their customer base without incurring the expense of installing and operating their own switches.

Business Strategy

The company’s goal was to utilize state-of-the-art information technology and intelligent network systems to take advantage of the opportunities afforded by the Telecom Act of 1996 to build a nationwide telecommunications company. The principal elements of US ONE’s strategy were:

1) Establish Nationwide Presence. US ONE’s nationwide network build-out was designed to offer fully-integrated CCS service, exchange access service and wholesale dial tone service to customers who would have been able to control and customize their portion of the network. Management believed that the ability to originate and terminate telecommunications traffic in major markets throughout the United States would have facilitated rapid revenue and cash flow growth as the company would have provided an attractive alternative to major long distance carriers for nationwide network services. Furthermore, the company believed that a nationwide presence would have provided the following competitive advantages over ILECs in the market for wholesale local dial tone: (i) US ONE would have been a single-source provider of dial tone in multiple markets, thereby eliminating customer’s need to negotiate inter-connections and resale agreements with several different ILECs to offer national coverage; and (ii) the company would have offered uniform, state-of-the-art information technology systems in the form of systems interfaces, customized billing, traffic monitoring and network element management across all local dial tone markets.

2) Continue to Invest in Intelligent Systems. Management intended to achieve national market coverage by concentrating its investment on the information technology and intelligent network systems, such as switches, network management, customer care and back office systems that control, integrate and make operational all the elements of a full service telecommunications business, rather than investing in transmission capacity such as fiber-based systems and local dial tone loops. US ONE was configuring its switches in an "open switch" format, which would have allowed each switch to be partitioned among multiple users. In addition, US ONE was designing its information technology systems to support a similar "open systems" configuration. Together these capabilities were to allow wholesale customers to control, monitor and customize their own products and services.

3) Provide Services on a Wholesale Basis. The company initially was going to provide its services on a wholesale basis to carriers and telecommunications resellers, allowing the company to put its capital investment to use quickly. The company already had begun to exploit this advantage by obtaining early commitments from telecommunications resellers and other customers to use US ONE’s services.

4) Exploit First-to-Market Advantages. The company was seeking to become one of the first to offer national CCS service as an alternative to compete against the bundled wholesale offerings of the major long distance carriers and to be one of the first to offer extensive national wholesale dial tone services in competition with the RBOCs. The company believed being among the first to market would have provided it with an attractive opportunity to capture market share as customers react to their new ability to obtain improved service from an alternative provider and lower their monthly telephone bills.

5) Use Proprietary Network Optimization Model to Reduce Customer Costs. US ONE had developed a proprietary network optimization model that develops optimal network configurations and routing systems to generate line cost savings. Management believed that US ONE’s optimization model would have offered it a competitive advantage in marketing its services to wholesale customers due to the potential line cost savings they may realize. Management also believed that its experience in developing optimal network configurations using sophisticated applied mathematical techniques would have also allowed it to optimize the capital expenditures related to its networks.

Capital Structure

US ONE was initially capitalized in 1994 with $1.6 million in equity financed from individuals, some of whom were founding executives of LDDS/WorldCom. In early 1996 the company raised $6.6 million and $1.8 million, respectively, in separate preferred stock offerings. In April 1996 the company raised an additional $13.8 million in a third series of preferred stock. The last funding was in August 1996 for $50 million of preferred stock by institutional investors.

By the end of 1996, the company had $23 million in cash after it had deployed only four switches plus funding ongoing losses. In January 1997, US ONE was in the process of raising another $75 million of convertible preferred shares and $150 million in debt in the form of a senior secured credit facility. The company planned to use the net proceeds from the placement, together with cash on hand ($23 million as of December 31, 1996) and $100 million of borrowings under the first tranche of the senior credit facility, in the following manner: (i) approximately $83 million for capital expenditures relating to the continued deployment of its national CCS and exchange access network, in addition to the approximately $15 million that had been expended at December 31, 1996, for the deployment of the company’s switches in Denver, Chicago, Tampa, Fla., and New York City; (ii) approximately $27 million for capital expenditures relating to the development of a local dial tone network in New York City initially covering approximately seven million local dial tone lines, in addition to the approximately $8 million that had been expended at December 31, 1996 for the development of such market; (iii) approximately $33 million for corporate level capital expenditures, including information technology systems and software development, computer hardware, and furniture and fixtures; and (iv) approximately $53 million to fund operating losses primarily consisting of start-up costs relating to the development of certain elements of the company’s organization, including customer service, sales and marketing, operations and engineering, and information technology from December 31, 1996 to December 31, 1997.

Subsequent Events

In April 1997, the company announced it had entered into a letter of intent to merge with Phoenix Network Inc., and in June 1997 Resurgens Capital Corp. (Cherry Communications) was added to the proposed merger. During the pendency of the merger, Phoenix traded in a range giving US ONE an implied equity valuation, based upon the merger consideration, of approximately $130 to $160 million. On July 16, 1997, the proposed merger, which was subject to availability of public financing, was canceled as the parties were unable to raise the $225 million in high yield notes for the combined entity. The collapse of the $75 million placement effort for additional preferred stock and $150 million of notes, as well as the inability to complete the Phoenix merger, culminated in the termination of services by the company.

On June 6, 1997, three of US ONE’s creditors filed an involuntary petition under the Bankruptcy Code. Among those creditors was Lucent Technologies, the company’s vendor of switch equipment, who had provided more than $40 million of unsecured trade debt to US ONE. This forced the company to discontinue the modest level of service carried on its network and to layoff the bulk of its employees. On July 24, 1997, US ONE and its two subsidiaries sought protection under chapter 11 in Wilmington, Del., received a debtor-in-possession loan in the amount of $8 million secured by the switches and was forced to seek a speedy sale. An auction process was established, which culminated in the company selling the bulk of its assets to WinStar Corp. in October 1997, for $100 million.

What Went Wrong?

One lesson learned from US ONE is that in order to succeed as a start-up in a competitive environment that requires huge amounts of up-front capital investments for technology that is changing rapidly, you must have strong financial and business leadership in addition to strong technical capabilities. US ONE simply ran out of cash. Money was spent developing the technical and administrative infrastructure faster than customers and funding could be obtained. Management refused to accept a lesser goal of partial implementation of fewer switches.

Management banked on the ability to always be able to go to the market for more capital, a trend that, until recently, has been true for telecom start-ups. It has been said that the telecom industry has reached a point where deals happen just to happen and where companies rush to buy someone so that they don’t get left behind. Hiring was based on the business plan of national service. With the failed offering that was needed for continued capital expenditures, as well as ongoing operating losses, the management relied on its trade vendors who had seemed more than happy to keep supplying credit. In fact, claims filed in the case originally exceeded $100 million (although this number is now closer to $75 million). When the revenue projections did not materialize, the market backed away from the company. The company had no contingency plans in the event it could not raise additional funds in the market.

What Were the Warning Signs?

There were two early warning signals that are clear in hindsight. Although they may have been obscured at the time by other factors, we certainly can improve our strategic thinking by analyzing these warning signs after the fact.

The first warning sign was an overly aggressive business plan. The US ONE business plan was based on engineering assumptions of what was technically possible. It was based on the assumption that if you build it, customers will buy it. There was little input from the financial side to control for financial risks and cash requirements. Marketing drove the business plan from the point of view of what might be achievable, not what conservatively could be achieved. Business plans created in the atmosphere of "what if" scenarios are frequently very mis-leading. Those considering investments in telecommunications start-ups should be very hesitant of untried marketing teams and revenue-based business plans.

The second warning sign was the fact that the company attempted to build 14 switches almost simultaneously, spend-ing more than $100 million of investor capital and vendor credit, without a single switch ever becoming fully operational. Likewise, the company also built an administrative overhead structure to support levels of activity on these switches that were never realized.

The third warning sign came when the company started to miss its revenue targets. The money had been spent, and overspent, on the network and infrastructure.

The revenue was projected to grow exponentially. But every day that revenue fell short of projections, it was the loss that grew exponentially. The company was in the process of seeking investors. The search became impossible when it started to miss projections by an increasing margin. With the collapse of its financing plans, US ONE was left with no choice but to shut down operations and liquidate assets.

What Is Next?

Of note is the fact that during the eight-week auction process, of the 16 entities who signed confidentiality agreements and started due diligence, four of them were merged or purchased during the period. Perhaps of equal interest is the fact that four more of these entities have since filed their own chapter 11 cases, including Resurgens. The high capital investment of switch-based resellers, coupled with the savage competitiveness of the industry and the "need to be first," augers for many more mergers, as well as more disasters, to occur. This is especially true as more of the long distance transmission companies and the equipment vendors find their customers in bankruptcy and they become less willing to extend large amounts of credit to the industry start-ups.

This is an industry where investments are often made as multiples of revenue. Literally, billions of dollars have been raised for companies whose local dial tone and/or long distance networks are not yet built, who do not have a firm customer base (or, for switchless resellers, have a customer base that churns daily), and which have never shown a profit or positive cash flow. And, all this money is being invested in an industry where the average margins run around 5 percent. The industry is so accustomed to supporting operating losses through new equity infusions that the joke is that the first cash flow positive quarter is a company’s kiss of death! The real question becomes: Once the hype has died down, will the company have the revenue growth to support the huge prices being paid? For investors, this means that extreme caution is called for and recognition that successes such as Worldcom will be difficult to find.

On the other hand, telecom companies, like US ONE, are betting that the future profits in this industry will be developed through selling a conglomerate of services, including local dial tone, long distance, cellular, voice mail and Internet access. The name of the game becomes building traffic (customers) quickly, and the fastest and most efficient way to reach that end is to start by becoming a competitive local exchange carrier (CLEC) and owning a local dial tone. As a result, buying or merging with a CLEC makes economic sense—and that is what every CLEC is betting on. In the end, the risks are high, but so may be the rewards if the players are smart enough to back the right horse in this ever-quickening race.

Journal Date: 
Sunday, February 1, 1998