PARTNER CHANNEL: Are You at Risk?

Posted: 06/2002

Are You at Risk?
Assessing Your Partners' Survivability

By Khali Henderson

BERNIE EBBERS RESIGNATION AS CEO of WorldCom Inc. was a pivotal juncture in telecom's collapse. Good or bad, his exit personalizes the industry's fall from grace. And what a fall it has been. WorldCom was trading at less than $2 in May, down from a high of $64.50 in June 1999. And rumors of bankruptcy for the No. 2 long-distance carrier are rampant. That prospect would be unfathomable were it not for the precedents. In the first four months of 2002, Global Crossing Ltd., Williams Communications Group Inc., Network Plus Corp. and Yipes Communications Inc. were among the companies that filed for Chapter 11 bankruptcy protection. These are just the latest in a string of filings to tarnish the industry since 2000. Others like XO Communications were struggling to avoid a similar fate. 

"The majority of carriers -- big ones and small ones -- today are in some financial difficulty. Most of them -- over 50 percent -- will have to do some sort of restructuring," says, Roland Van der Meer, co-founder and partner, a Palo Alto, Calif., venture capital firm.

He says restructuring is happening this year for good reason. "They have to start expanding again because there is fundamental growth going on and they don't have the balance sheets to go buy more things and to go raise some financing to expand," he says.

PricewaterhouseCoopers (PwC) expects telecom industry bankruptcies to continue throughout 2002 with greater activity during the first half and slowing in the second half, says Carter Pate, managing partner of Financial Advisory Services for PwC, in a March 2002 report.

"Not as many telecommunications liquidations are expected to occur in 2002 as in 2001 when many companies that filed were smaller and less stable," he writes. Pate notes many of last year's filers were among the more highly leveraged, smaller companies with significant operational problems. "The expected 2002 bankruptcy filings will include some of the bigger, more stable emerging carriers that generally have larger customer bases and more stable operations but yet due to stage of development and poor market conditions are experiencing negative cash flows and are over-leveraged," he reasons.

PwC's predictions already are being realized with the April Chapter 11 filing by Williams Communications and XO's ongoing restructuring negotiations.

Man Overboard

For sales agents, news that their carrier partner may require court-sanctioned restructuring comes especially hard. Agents are unlikely to have a seat in the lifeboat when the carrier's vessel shows signs of sinking. "Customers and lenders first." Even if an agency does not go down with the proverbial ship, it may struggle to keep its head above water.

"I don't necessarily worry about circuits going down. I worry about that accounts receivable and that collectible that is in jeopardy when they go under and restructure," says Van der Meer, who estimates agents are likely to lose 45 to 60 days of accounts receivable this year. Some can be out many months of commissions if the contracts are canceled, as is often the case in a bankruptcy.

Adding insult to injury, the damage can go beyond AR losses to the agent's reputation, says Tony Parella, executive vice president, Allegiance Telecom. "Here are people who pride themselves on delivering personalized service, that really handhold the customer [and] suddenly their customers are getting a letter, with no prior knowledge of the agent, saying you have 30 days to get off our network or you will be without dialtone," he explains.

Parella admits this is a worst-case scenario. But, he says, it has happened to a few of the agents that have since turned to Allegiance to pick up their business. The company's push into indirect channels beginning last fall coincided with financial troubles of some of its CLEC competitors, including Teligent Inc., WinStar Communications and Network Plus.

To be fair, not all reorganizations put the agent on the short end of the stick. RSL Com USA, for example, was set for its asset auction May 23, 14 months after it filed for bankruptcy protection in March 2001. In the intervening months, RSL Com continued to pay its agents and claims to have maintained relationships with 99 percent of them.

"RSL (Com) went into Chapter 11 expecting a positive outcome," says David Schwartz, vice president of Alternate Channels. "We realized that it would be difficult to garner new producing agents in Chapter 11 so we focused our efforts on retaining the agents and customers we had. This was absolutely the right thing to do because our agents and customers have continued to be very loyal."

One of RSL Com's largest master agents, Alex Phillipov, general manager, Long Distance Post agrees: "They never missed a check. Customer support never got worse. We kept giving them business. At the beginning, we were hesitant because of what happened with PGE (Pacific Gateway Exchange). After the first check came, it was apparent they had something else in mind. We didn't move any accounts."

In contrast, Phillipov claims his company lost nearly a million dollars in commissions when its contract was terminated in conjunction with PGE's bankruptcy. He tried to sue to recover the loss, but the bankruptcy court dismissed the claim.

Stormy Seas

If agents find themselves in Phillipov's shoes -- facing a supplier bankruptcy, what can they do? Master agent Vince Bradley, president and CEO of World Telecom Group, who has been through Chapter 11 with three vendors, says that it's important not avoid a knee-jerk reaction. "To me it's more about understanding what your suppliers are going though," Bradley says. "Agents don't seem to differentiate between Chapter 11 and Chapter 7. They seem to think both are the same, equating them with the worst-case scenario when there are huge differences between the two."

As an example, he cites the successful reorganizations of companies like McLeodUSA Inc., which emerged from bankruptcy protection in April after only 75 days. He says agents should take some comfort if their supplier is submitting a pre-negotiated reorganization plan. "If it's not, that's when you need to worry [because then] it's not a business plan, it's a 'stop the bleeding' plan. If it's prepackaged, they are saying, 'We can make it work if we do these things.'"

Van der Meer says it is very likely that a company going into the Chapter 11 is trying to remanage its balance sheet and come out the other side. "That is the intent of a lot of 11s that will be happening shortly," he says. "Some of them do it in front of it and some do it during it and some of them might not make it through the process."

In fact, PwC estimates of the 11,000 public and private companies in all industries that file for Chapter 11 protection this year, slightly more than a third (3,600) will emerge successfully within 18 months.

So how does an agency protect itself? "You really can't," says Van der Meer. "All you can begin to do is maybe hedge a little with another carrier or reseller or just tighten up your collection policies and have a cushion in your business model so you can sustain through."

Bradley agrees and recommends agents maintain a cushion of one month's AR and to diversify their sources of supply. "It's a good argument for [working with] a master agent," says Bradley, taking the opportunity to plug a model that often includes a stable of suppliers. "We spread it out really thin. I don't think more than 15 percent of our business comes from any one company. Our average agent does business with three to five carriers."

Van der Meer cautions: "Don't make the assumption that master agents are any better than anybody else." He says the decision should consider that by working through a master agent you are reducing commissions. Separately, there is the question of whether you are protected better. "You probably are, but I wouldn't guarantee that at all," he says.

Consultant Phil Jacobson, founder and general partner, Network Conceptions LLC, a business planning and development company for the communications industry, says that however agents do it, they need to diversify. "The problem right now is recognition that this is not the growth business that everybody made it out to be. It may be nothing more than a cash management business for the next 10 years or the next five years or whatever. To the extent that there is concern about it, anyone who is trying to mitigate this, you want to deal with suppliers who are as diversified as possible," he says.

Warning Signs

In this market, an agency must be vigilant in order to recognize warning signs about its suppliers' declining stability. "The obvious would be to look for deviation from the norm," says Casey Freymuth, president of Group IV Inc., a business strategy-consulting firm. "Has the service staff or service hours been cut? Are my commission payments starting to run late?" He says problems that you are told are isolated glitches should not happen across the board. "I would be especially concerned with recurring problems. Okay, so a batch of mail may be lost in February, which impacted my payment. What are the odds of that happening again in March?"

Allegiance Telecom's Parella also advises agents to pay attention to changes in the agent channel relationship. "If they don't have the same level of support to the agents, if they see a lack of support either from a collateral standpoint, getting the orders entered, any change in intervals for the worst, it should be a red flag."

Steve Hesling, vice president of marketing for data reseller American Telesis agrees. He says there is cause for concern if "yesterday you could call in or speak to a real live human being and today you find yourself always leaving a voice mail asking for a return call."

Hesling says alarms should sound if your supplier reduces your commissions, removes the Evergreen Clause or indicates that you need to maintain a $50,000 minimum to continue getting paid. "All of these are signs of recession either in their financial health or simply changing their market focus in a way that does not benefit the agent," he says.

Not all the warning signs are going to be so obvious, however. Sources say to look for general changes in the business, such as layoffs, particularly within the direct sales force, which is usually the last to go. This kind of information may not be easy to come by if the company is held privately, so agents need to be proactive.

"I wouldn't be the least bit shy about making inquiries throughout the company, or with other agents for that matter," says Freymuth. Parella adds that listening to your customers is another way to find out about degradation in service levels, account plan changes or cutbacks.

If an agency can confirm problems or if their supplier files for Chapter 11, what should it do? "This is a tough spot to be in because none of the remedies for the company you are representing are within your control," notes Freymuth. "What I can say is that if the company is able to clear debt and was a good partner in the past, they probably will be a good partner in the future. If they hit financial difficulties with no warning or discussion with you, have been hard to collect from, etc., there is probably not much reason to stick it out with them."

Preventive Measures

While there may not be much an agency can do to mitigate losses from existing carriers that founder, there are a few due diligence exercises that can help them to protect themselves in relationships with new suppliers.

"When I look at a new supplier, I always ask questions like how are you backed? What do you have? What is your financial situation? What is your revenue? How much capital do you have? How much working capital do you have? When does cash flow burn out happen for you? You can ask questions like that. You have every right to ask it to figure out are you going to be around," says Van der Meer.

Freymuth adds that it is important to avoid the trap of hearing what you want to hear or pursuing a higher commission level from a riskier company. He argues that it's better to draw a lower commission from a company that is funding itself from operations than a greater commission from one that is banking on future funding, or that it will become cash flow positive based on current reserves. "Remember that revenues and net income can be manipulated, but cash flow is hard to fake and is generally a solid measure of management's effectiveness. This is especially true in the current climate wherein funding has dried up," he says.

When evaluating available financials, make sure there is not too much debt, says Jacobson. "What you want to do is compare [operating income] against the debt to make sure they aren't going to go under because of debt problems," Jacobson says. He cautions a company's debt should not exceed one year's worth of revenue.

He also suggests the company should be examined to determine if it might of had sufficient cash or open bank facilities to fund operating losses that it has had for at least 18 months. "What you want to look for is a funding gap," he says. "Make sure there is no issue in funding [such] that they are going to have to raise more money in the next year or year and a half because if they do have to raise money in the next year or year and a half, they probably won't be able to do it."

There's only so much an agency can do to protect itself, especially if it is working with private companies, notes Kevin Emahiser, president, KEI Communications LLC, a startup local service master agency. "Our research is only as good as the numbers that are available."

That doesn't mean agents need to leave their business to chance. He advises them to look at the supplier's executive management team. Where did the personnel come from? If they come from failed ventures that can tell you a lot, he says. He also suggests interviewing a provider's master agents to find out how prompt it is paying and what its install intervals average. "If [intervals] are 60-90 days, that's a sign of trouble."

Bradley suggests investigating a company's investors' backgrounds and track records can provide a comfort level if financial statements are not available.

Similarly, if the supplier is a reseller, it makes sense to look at what companies it is buying from. "It's basically understanding who is the ultimate supplier of the capacity. Who owns the network assets?" says Jacobson, explaining that with so many companies selling to other companies, somewhere in that chain you might have a problem.

Van der Meer says that while it is nice to know how strong the whole chain is, the underlying carrier is not as important as the company that pays the agent. "It's all revenue to the carrier; the last thing they are going to do is cut off people who are paying them. So the reseller is the most vulnerable and the most relevant [entity] from the agents' point of view," he says.

If the reseller is private, which most are, then the best an agent can do is to check its credit. "As an agent you are a vendor and you are providing a service and you have the right to collect on that service. If they don't want to give you the information you need to properly act as a vendor to them, then I guess it's up to you if you want to take that chance or not," says Jacobson.

Agents also should find out what their recourse is if their provider runs into financial trouble or files bankruptcy, Van der Meer adds. "I know that I will lose my accounts receivable. I know that, but I will have the right to move my client to another network or to direct bill my client?"

Contract Provisions

These kinds of arrangements typically are solidified at the contract stage. Telecom attorney Neil S. Ende, founder and partner in Technology Law Group LLC, says an agent should make sure that, in the event that payments are not being made in a timely manner, it has a mechanism to obtain security in the customers it has brought to the debtor, or in other of the debtor's assets.

He also says that in the event of bankruptcy (or other breach or termination for that matter) an agent needs to be sure that it is entitled, as a matter of contract, to its CDRs and related customer databases and, if possible, to re-PIC those customers. Similarly, it should be sure to be named as the RESPORG for any 800 numbers, including 800 numbers that are used to access customer service. In his experience, Ende says he has been able to negotiate such provisions for his clients.

Finally, he says, you want to do anything you can to put yourself into a preferred class in a bankruptcy. "For example, if there are hard assets at issue, you want to take a security interest in those assets from the outset. If the only assets are accounts receivable or customers, you also want to try to get some kind of security interest in them from the outset -- or at least one that kicks in, in the event of financial distress, so that you are a secured creditor in bankruptcy."

Ende adds, "You can attempt to write those provisions into the agreement, but it's a matter of the leverage the agent has and the quality of the negotiator."

Startup agency KEI Communications tried to negotiate similar protections, but it came up empty-handed. "The contracts are pretty ironclad," says Emahiser, particularly for a new company like KEI. "Once we start producing, we can leverage that business to renegotiate some provisions."


Telecom Service Provider Chapter 11 Filings - 2000-2002