The Need for Development Capital

Somebody asked me the other day what one critical element is missing from the rural broadband landscape. My response was developmental capital – money that does the early leg work to turn conceptual projects into shovel-ready projects. Communities and small carriers everywhere struggle with the lack of easy funding aimed at identifying projects and getting them ready to seek funding.

Communities everywhere decry the fact that nobody is investing in new broadband in their community. More times than not, this is due to having nobody willing to spend the development costs needed to define a viable broadband project. There are a few key elements that are needed for any new telecom project. First is feasibility engineering that is done in enough detail to understand the cost of a network needed in a community. Next is market research to understand the potential market demand for buying broadband and other products. Also needed us a financial business model that looks to see if a project can be successful and meet investor requirements. The final part of the development effort is finding the funding needed to make a project work, be that grants, equity, bank loans, or municipal bonds. These development steps are not inexpensive, and it can easily cost as much as several hundred thousand dollars to create a project that can be considered as shovel-ready.

There was a time in the past when this role was played by big banks. Cities or carriers could borrow the money for the developmental costs of a new telecom or other infrastructure projects. But over time this changed. For several reasons banks lost interest in funding infrastructure – not just telecom networks but everything else like roads, electric grids, you name it. The municipal world took up this slack by moving almost all municipal funding to bonds. But in doing so, it became harder to fund the development stages. Assuming a community is credit-worthy, it’s relatively easy to raise bond money to build a new telecom network or a highway – but it’s hard to fund the development work to make such projects shovel-ready to go for bonding.

This had even bigger consequences for commercial companies. Big companies like AT&T or Verizon self-fund project development. They internally fund the engineering effort to consider new projects. The ones that pencil in with good results get built and bad ones are scrapped.

Communities always ask me why nobody comes and builds fiber in their community. They look at me with puzzlement when I tell them that it’s the lack of development capital for ISPs. Small and medium ISPs don’t have a budget for project development where they can spend a few hundred thousand just to see if they should build in a new community. Most small ISPs simply chase low-hanging fruit where it’s easy to identify a profitable opportunity rather than to look at half a dozen projects to identify the most profitable one.

There are a few funding sources that cover part of the cost of development. There are foundations grants or government grants from agencies like the EDA that will fund feasibility studies to look at some of the aspects of project development. Local communities sometimes directly fund feasibility studies to look at some aspects of project development. But funding a feasibility is generall half or less of the total effort required to turn a concept into a shovel-ready project.

Lack of development funding doesn’t just affect broadband projects, but almost all infrastructure. Where it might take $150,000 or more to enable a broadband project, the cost of building new roads, dams, or other infrastructure can cost a lot more. Without an easy way to pay for the project development costs, I’ve seen communities do ridiculous things like pay for the engineering for a big road project over five or ten years to be able to afford it out of annual tax revenues.

I groaned earlier this year when I read that a few states offered to provide funding from CAREs Act monies for shovel-ready broadband projects. By that, they meant projects that could start spending money immediately since some of the pandemic-related funding has to be spent by the end of this year. They quickly found what anybody who works on broadband projects already knew – there were practically no shovel-ready projects sitting around that could launch immediately. At best there are projects at some stage along the project development timeline.

I’ve wracked my brain for years trying to find a workable solution to the lack of development capital. Some grants will pay for the most obvious parts of project development such as funding an engineering estimate of the cost of building broadband. But I’ve never seen any grants that fund the whole project development process.

Connecticut’s Call for a Fiber PPP

Fiber CableA large number of municipalities in Connecticut have banded together and let it be known that they would love gigabit fiber. They’ve recently made numerous announcements about the initiative as well as assembled a list of the things that each municipality is prepared to contribute to somebody who will build fiber for them. This list includes the typical sort of things that cities offer to potential commercial partners – expedited permitting, real estate and building access, access to existing conduits or other sorts of existing telecom infrastructure, etc.

What these cities are doing is not unusual, but it’s by far the biggest such initiative I have seen. I have no doubt that these cities would love gigabit fiber, and they clearly understand the benefits and implications of getting it. But unfortunately, I see very little chance of their approach working. The Connecticut group is calling this a PPP (public private partnership). I love the ideas of PPPs and I have worked with some successful ones. In addition to being a telecom consultant I also am on the Board of Directors for a PPP financial consultancy firm that works across a wide range of infrastructure projects.

Numerous cities have taken this same approach to try to find a private partner. The first one I recall was the city of Seattle nearly a decade ago, a project that I helped with. The city made the same sort of appeal to investors to build fiber in their city and they had no takers. Since then I have regularly seen similar appeals made from cities all over the country. And except maybe for a few small cities that might have found a small local ISP or telco to partner with, I am not aware of any of these attempts that has ever been successful in attracting a partner. There are a number of reasons for this:

  • I saw several quotes from Connecticut officials that said that they are hoping that some venture capitalist will see this offer and become interested. That is not the way that venture capital works. Venture capitalists don’t invest in ideas for good projects; they invest in management teams that they trust. And they expect those management teams to have a strong track record and to bring them shovel-ready projects. Venture capitalists never go and seek opportunities, but instead wait for fully fleshed-out opportunities to be brought to them. For the Connecticut opportunity to be shovel-ready someone will have to expend significant millions up front to perform the engineering to determine the cost of the build, undertake market research to understand the potential for customer interest, and then create financial business plans to demonstrate that the project can make the kind of returns that venture capitalists or other financial sources will find acceptable. For just one decent sized city, that development work can easily cost half a million dollars or more, and for the 40+ towns in this consortium this would be a huge outlay. There are probably not many companies around willing to take a multi-million dollar risk on doing this upfront development work without knowing for sure that they can get it financed.
  • I have done several recent financial analyses of large fiber PPPs. These studies show that the kind of contributions that these cities (and most cities) are willing to make to a fiber project are not worth very much to a potential builder. One of the few benefits that might get somebody’s attention would be if a city already has a significant network of empty conduit through which fiber could be pulled. The other things these cities are offering don’t change the potential IRR (internal rate of return) of a project by much at all. Sadly, cities are overvaluing the benefits they can bring to a commercial fiber partner as part of a PPP. If a city really wants to attract a private builder they ought to be thinking about providing an economic development bond to pay for some significant portion of the fiber – a bond that they would repay out of tax dollars. That would be real skin in the game that would create a real partnership opportunity which might attract investors.
  • There are not many companies building fiber that would be large enough and have the ability to respond to the Connecticut group. To build to the fifty plus communities in this group must be a billion dollar venture and there are not many companies that have the wherewithal to raise that kind of money to build fiber. Only a company with deep pockets and a proven track record of building and operating telecom networks would have any chance of raising this kind of money. Even for companies with deep pockets this kind of construction is going to require at least 30% to 40% equity and there are not many firms sitting on the cash and equity needed to pay for this.
  • The various announcements said that since fiber is profitable that they ought to able to attract the needed money, But is it that profitable? Venture capital investors normally seek risk-adjusted returns of 30% or better and since fiber is a capital intensive undertaking it’s hard to achieve returns that high. It’s not impossible, but if building fiber was really that lucrative there would be fiber projects everywhere.

I hope these communities prove me wrong, because I think what they want is terrific. I really don’t want to be throwing a wet blanket on this because I am a huge believer in the benefits of fiber networks. But this sounds to me like wishful thinking on the part of economic development people who do not understand the market reality of how large amounts of money are raised in this country today. These cities are basically wanting somebody else to bring the money to build fiber in their communities, and you can count the firms who are capable of doing this on one hand – and most of those are the giant telcos who are no longer building fiber at all.

Lessons Learned With Gigabit Squared and Seattle

Hollow-core_photonic_bandgap_fiberChristopher Mitchell of the Institute for Local Self-Reliance recently wrote a 3-part article talking about why Gigabit Squared (“G2”) failed in Seattle. His articles talk about the challenges that any competitor has when going head-to-head with a large competitor like Comcast. I would take that discussion one step further and talk about why G2 specifically failed in Seattle. I think there are valuable lessons to be learned from their experience for anybody entering a new market.

The biggest problem faced by G2 is that they had a hard time raising development capital. This is an issue faced by almost every new infrastructure project in the country, both private and public. The US investment community no longer has much taste for the high-risk involved in funding the first step of a project. I call this development capital, but when this capital comes from private sources it is often called angel investing.

Up until a decade or so ago new start-ups were able to find angel investors who would take a chance on a new venture that had promise. For taking that early risk the angel investors got really large returns and a piece of equity in the business. But today it seems nearly impossible to get enough money to get a project to the point of being ‘shovel-ready’. I think a lot of this reluctance comes from the last few decades that saw the implosion of a lot of tech start-ups. There were a lot of start-up telecom and web-based businesses that failed since the late 90’s and a lot of angel investors lost their entire investments.

Second, G2 planned to launch the business in phases, probably due to the hard time they were having in raising money. They planned to raise $20 million to first build around the University of Washington campus. Then they planned to raise a little more and build a little more and repeat until they built most of the City. In the investing world this is referred to as raising the money in tranches.

The problem with raising money in tranches is that it makes it even harder to raise the early money because the early investors can’t understand the big picture. They can’t know how any equity they get from the business will be diluted by future waves of investors. This approach also makes it nearly certain that the business will fail at some point, because every time the company needs to raise more capital they end up on a financial ledge. For example, even if they raise two rounds of money, they will probably fail when they can’t raise the third.

There is a general understanding among people that raise money that it is far easier to raise $100 million than $5 million or $20 million. I know that sounds non-intuitive, but G2 probably would have had an easier time raising the money to build the whole City than they did in trying to do something smaller. Investors can understand the big picture a lot easier than they can understand a project done in phases.

The third issue that killed G2 is that they didn’t hoard their early money. They had raised some early money and they did some of the right things with that money like doing engineering and building relationships with the City and with other carriers. That is the sort of developmental steps you should do with early money, and I would characterize those steps as getting the business shovel-ready and ready to raise the construction money.

But before G2 was funded they put enormous pressure on the business by announcing a timeline for when they were going to launch retail service. They announced products and prices and even went so far as to launch a website where customers could get on a waiting list for service. They created a lot of public expectation. They opened shop and hired a few employees in the market. The company began eating into their very limited cash with operating expenses rather than sticking with pure development of the project.

It’s fairly easy to see why G2 did this. They were having problems raising money and I think they were trying to create a stir about the project by showing community support. They hoped that public support would make it easier to attract the needed angel investors. But all this did was to cut short the amount of time they had to raise money.

G2 is not the first start-up to fail in a market, and they failed for some of the same reasons that have sunk other ventures in the past. Anybody thinking of opening a new market or new venture should look at the lessons to be learned from this. First, never underestimate how hard it is to raise developmental capital. It is probably the hardest thing there is to do in the business world. Second, have a business plan that contemplates the full build. I think G2 might have had more luck if they were trying to raise money to build the whole City than in trying to build a neighborhood at a time. And third, never spend money on operations until you are fully funded. If you have some seed money use it only for raising the bigger money.

And who know, maybe Gigabit Squared is not quite done in Seattle and can take another shot at it.