Where's The Funding? Episode 3: Intro to the capital stack: How will you structure the capital invested in your company?

Gary Bolton: And we're live.

Gary: Well, good morning everyone and welcome to Where's The Funding, hosted by the Fiber Broadband Association and sponsored by Broadband.Money. I'm Gary Bolton, the President and CEO of the Fiber Broadband Association and this is our third episode of 2023. This is a 12 part series designed to help you understand, navigate, and obtain matching funds for broadband grants. The NTIB program requires broadband applicants to come to the table with a minimum of 25% matching funds and a letter of credit upfront with the applications. For many smaller providers and non-traditional providers in communities, this may sound daunting, but it doesn't have to be. This 12 part series is designed to help you understand how and why meeting these requirements can be straightforward. So last month we had a great session and did a deep dive into BEAD with Evan Feinman, the director of the $42.45 billion NTIA Broadband Equity Access and Deployment BEAD program. If you missed this episode, I highly recommend you watch the replay as Evan is very forthcoming in his answers and discussions on some of the gotchas on the BEAD Program. It was an extremely informative and instructive session.

Gary: Today on Where's The Funding? We're gonna focus on the capital stack with our guest, David Hartin, the president of ITC Holding. During this episode, you'll learn how to identify the right sources of capital for your business and how to structure these sources to secure the necessary funding. David Hartin is the president of ITC Holding Company. ITC invests in telecom, technology, financial services, transaction processing and real estate. Prior to ITC, David was the co-founder and president and CEO of Notora, a RF engineering firm, and he has extensive history in telecom. David graduated from Auburn with a BS in Electrical Engineering. So welcome David, and for audience please put your questions in the chat and we'll work those into discussion as we go. So to start off, David, ITC is a really interesting company with a really rich history that dates back to 19... Excuse me, 1896. Can you share with our audience how a train conductor ended up as a telephone operator, then an ISP, and then where you are today? 

David Hartin: Yeah, absolutely. Well, first, thanks for having me Gary. It's an honor to be here. I'm sitting outside, actually in Alabama State Grant meeting in Monroeville, Alabama today. So hopefully there won't be any background noise. But ITC does date back to 1896. Our chairman Cam Lanier his great-grandfather was a train conductor and he would take a group of people from West Point, Georgia to Atlanta in the morning and then take them home in the evening. So he had a lot of downtime during the day and during that downtime he was at a state fair one day and saw a booth where they were selling telephones. So he bought 32 telephones, I believe, brought them back to West Point, Georgia and started Interstate Telephone Company. So the Lanier family ran that from 1896 to the 1990s when they broke up the bells and sold the business then, because they were a little concerned about competition coming into the market. And then from there they started a long distance carrier that was sold to MCI and don't worry they were paid in cash for that. So we didn't get caught up into any of the MCI mess, but from there we started looking a lot more like private equity. So when I was first introduced to ITC as a co-op student at Powertel, we had three publicly traded companies right there in West Point so ITC Deltacom, Knowledgy and Powertel. And we've continued to invest in and help grow broadband and other technology companies since.

Gary: So David can you maybe... You've had a pretty interesting career as well. Can you share with us how an RF engineer ends up as a financier? 

David: Well, I'd love to say I had a grand plan for all that, but really I think it's divine intervention and dumb luck, a little bit of all that. But I started my career at Powertel as a co-op student while I was still getting my engineering degree. Right at the time I was graduating, Powertel was being sold to VoiceStream, so all the corporate employees that were being retained from West Point were being relocated to Seattle. I really had no interest in that. So I took a job with Nextel in Chattanooga, Tennessee which was great because I think we had 3 cell sites when I started. So we got to grow that from about 3 to over 120. And then we were moved to Atlanta to start an in-building program, which focused on coverage indoors. Nextel in particular because they're a B2B company. We found quickly that we couldn't close accounts if we didn't have coverage in their main office. So we would do... Commit certain number of units for a certain number of years. And so my job was to design those systems and bring in contractors to install them.

David: So I hung around there until Sprint acquisition and a few years after that. And then Sprint just made it really advantageous to leave. So based on the severance they were giving people and it was a voluntary plan, myself and a couple other guys at Sprint decided if we're gonna start a company now would be a great time to do that. And so we left there and started Connectivity Wireless. I really loved the entrepreneurial environment of writing big proposals when you're just 3 guys in a basement. But we grew that company until... From 2008 to 2014 when we brought in a private equity firm that created an opportunity for me to leave and start my own thing. So I sold my piece of that, started Notora. We grew that successfully. Sold it in 2019. I hung around as the CEO until a private equity firm came in and bought the majority of the company that had bought Notora. So that gave me a chance to check all the way out and I really thought I was going to start another business. That was my goal. And so I met Cam Lanier, he's our chairman, really thinking I was lining up an investor, but Cam had other designs, so he brought me on as president. It's been a huge learning curve. But I love it, I'm enjoying meeting with entrepreneurs. Having done it twice myself, it's really rewarding to get to help invest in and coach up and advise companies in our portfolio.

Gary: I can't think of who would be better to help operators than someone who's been there, done that, and built these networks, so thanks, David, for sharing that with us. So let's talk about the capital stack, and let's start with defining what is the capital stack and why is it important for operators to understand the different kinds of funding available.

David: Well, the capital stack is just what you said. It's the funding you use to get your business off the ground. And a mentor shared this with me, and I can't emphasize enough that ultimately for all successful businesses, your customers will be your main source of funding for your business, right? Banks, private equity firms, folks like us, our main goal is to help you get to a point where your customers are your main funding source. So we're really bridging that gap. But in the stack, you've got bank debt. That's probably considered your cheapest form of funding. The challenge that you're gonna have as entrepreneurs though is banks have pretty strict metrics that they use. Most commonly it's gonna be 3-4 times your EBITDA, your cash flow. If you're not profitable yet, that's not gonna be an option for you. And if you are profitable, it's capped at a fairly... I won't say small amount, but small relative to say a big fiber build. But as a private equity firm, we certainly don't look down on companies that have a reasonable amount of bank debt because it is a pretty low-cost source. After bank debt, you have mezzanine debt, which is a little bit more risky for the lender, so it's gonna cost you more interest rates in the 15 to 20% range most of the time. And for mezzanine debt, that's really gonna be... As an entrepreneur, you gotta decide if your growth is gonna outpace the high-interest rates that you're paying.

David: There's a big debate amongst CFOs if mezzanine debt is cheaper than say an equity investment. And my personal opinion is gonna be that really again just depends on how fast you're gonna grow and can you sustain that. One downside to debt is the debt payment's gotta go every month. If your business is lumpy on the revenue, you may not actually ever realize your full potential because you gotta make that payment regardless of what's coming in on your end. On the other hand, if you are a steady monthly recurring revenue business and it's going, it may make all the sense in the world to do something like that. And then the next step in the stack is what I would call a convertible note. That's a bridge between debt and equity.

David: We use convertible notes a lot for two reasons. One is on our side if you need cash, you can say in the next 30 days, that's really not enough time for us to do all the homework we need to do to decide if you're a good investment, but we'll do a convertible note because it's fairly low risk. It's debt. It's usually a smaller amount. It gets you funding that you need to continue the equity conversation with us. The other reason... The other thing we use convertible notes for is evaluation gap. A lot of times, the owner thinks they're worth X. We think they're worth Y, but we still think apart from the valuation gap, this is still a good investment. We like the CEO. We like where they're headed. We like the markets they're in, so we'll use a convertible note to bridge the conversation on how much you're worth because... And normally there's some components to that. There'll be a cap that says, all right, well, if you really are worth X, then we can convert the equity of that at a later date or the true test of what you're worth is what somebody's willing to pay.

David: So if another investor comes in, there'll be a function of that note that says we could convert at a discount to what they're coming in at because we took the risk with you earlier, or it can just be paid out as debt. So that's probably the third spoke of the stack. And then the next one would be just straight equity, and that's where we play mostly. And equity, some people say it's expensive. I don't think about it that way. I think about what you gain as a partner and what the doors that a company like ours can open for you to help you go further faster, it's totally worth it in a lot of cases. So as a CEO, my advice would be when you look at equity partners, really decide who do you want to partner with and there's better fits for different firms. Some are more hands-on. Some are more hands-off. Some are more industry knowledge. Some are more purely financial. My recommendation there would just be as you're going through the process, make sure that the private equity firm you're talking to fits your culture, agrees with your vision of where you want to take the company, and the rest generally tends to work itself out.

Gary: So when you're looking at equity partners, some of the... You mentioned... I did a couple startups, and we probably raised between 2 startups about $300 million. And it was really important that we really had the right partners. Now, everybody... I mean you can get money from a lot of places, but is that... [0:12:41.6] ____ you just went through the whole history of all the networks that you've built in the past, is that what you bring to the table is kind of your expertise and you really know this industry, or what is it that you guys bring to the table as equity partner? 

David: Yeah. I would say ITC is really more focused on being an operational partner. If it's connections you need, if it's experience standing up customer service organizations and things of that nature of knowing contractors, relationships, things like that, I think we bring that to the table.

David: I'll take a step back. The other thing I'd recommend when you're looking at financial partners is, the financial partner needs to be this the same size that you are. So if you're looking at banks and you're a startup, I would find a small bank, right? A bank that you could go play golf with the CEO and talk about growth and talk about problems. Same thing with private equity, right? There's sweet spots. For us it's about $10 million to about $500 million. That's where we play, there are firms that they don't start until you're at least $100 million and then there's also more venture funds that work with you on a purely startup basis. So probably size and fit matter there as well.

Gary: Now, let's talk about grants. So not all grants are good grants, so what should an operator be looking at when they're choosing which grants to... And what the funding purpose is? 

David: Man, am I glad you asked that question? Because we see this all the time, tragically, is that somebody may have won a $50 million grant but when you look at the unit metrics, when you dial it down to the cost per passing the grant still doesn't make sense. So for us we like to see somewhere between $1,200 maybe up to $1,500 of passing that you're paying for after the grant if you think about it the real intent of the grant is to cover the gap between what it's really gonna cost and what you would've paid for it to get a reasonable ROI as an operator. So be thinking about that because if after the grant you're still at $4,000 of passing, that still won't work. So it's very important. And you're exactly right. Not all grants are good grants they've got to be grants that get you to a reasonable ROI or in some cases better. And we've worked with companies that maybe the first grant didn't get them there, but they've been able to stack a federal and a state and a county grant that do get them to that $1,200 benchmark or below but you definitely have to make sure you've done your homework, you've done your cost estimates before you sign up for taking on grants.

Gary: I mean, in RDOF we saw some people bid down to 1% of their reserves, so they're basically taking on some very high cost area for very little subsidy, is there... When you're looking at the strategic value of claiming or trying to attack certain locations and maybe it's there... As you go to what a prime location you might be going pie and you don't want competition, is there a time when you would for strategic reasons go much higher on a cost per home past? Or is it... I mean, do you look at this in the aggregate or do you look at every location on its own? 

David: I'd say you look at it in aggregate, and you're right, there are strategic reasons. So if you're to fit in your territory that may make sense. If you... Maybe you turn down the federal grant because you know you're gonna get a local grant to do it that's the case. I know of one company that they bid RDOF, but their cost per passing is actually not what it would cost to construct because they're a software upgrade away from actually delivering the speeds that the grant requires. So say they're running a wireless network at 25/3, but they know the network's capable of doing 100 by 20, they just haven't been running that hot that might be a case to do it, but those are the exception and not the rule, right? The rules should be disciplined in your financial analysis.

Gary: Now, I know you're an RF guy and I'm a fiber guy but when you look at investments fiber seems to be very creative. Do you tend to encourage fiber investment or do you think is fixed wireless and other technologies fine or what do you look at when you look at the actual network they're building? 

David: I think all the technologies out there are just tools in the toolbox and there's a appropriate tool for each application. For me putting my financial hat on though there's definitely a multiple higher for fiber companies. So if you are wireless even if you can deliver a 100 by 20, you've got to think about if the requirements are raised, how are you gonna get there? And also think about... Just as an entrepreneur who wants to exit one day, a wisp is gonna sell from 5 to 8 if it's strategic and might get as high as 10 times EBITDA, fiber companies north of 15. So you're getting more value for your investor. The more hard asset, the more fiber assets you have.

Gary: So that's what brings up a good point. With... Right now there's over 1100 fiber providers across the country with all these investment. There's gonna be a whole lot more in the next couple years, so there's got to be some market consolidation here in the next few years. So when you're taking money and people... And you're investing, how should operators look at that? Should they... You don't wanna end up in a poison pill situation, right? How do you... Do look at what an M&A situation's gonna be down the road and what's makes sense there versus what you need today? 

David: Yeah, well, that's a mistake I see when entrepreneurs pitch to us I see that mistake made all the time is they don't have a great vision, they're... Their pitch might be [0:19:07.6] ____, we're just gonna be opportunistic, that's really hard for a private equity firm to get behind, right? We expect that you know your business way better than we do. So when we meet with you we'd love to talk about all right, well this funding is gonna be used for building fiber or for the matching portion of this grant to build here, right? We need a narrative. And so you will often ask, well, beyond that how much bigger could you get? You are there... Are there neighboring companies that you could acquire and consolidate? What does that look like? And so what we're looking for is just a thoughtful, reasonable answer from CEOs. We fully understand that the future may not turn out the way you predicted to be. But we really wanna see that you've got a plan you've got a vision, because that's how private equity makes money, right? We're gonna pay market value for your business today in anticipation that it's, we're gonna grow together and then exit down the road...

David: So Yeah, you absolutely need to be thinking about consolidation, both from what could you acquire that would make you more valuable and also who'd be a likely suitor for your network.

Gary: So... That's a good point, David, is the, not necessarily that you would sell out, but private equity loves to be able to take a lot of fragmented markets and then build into a much more accretive value by adding some operators together. Is that... Do you think when you talk to your CEOs, is that what they're looking at is how could they big be big? Or do they just kinda say, "Hey, I'm in my a hometown, this is kind of my comfort level and... "

David: I would say that's all over the place, Gary. What we look for are the entrepreneurs that want to grow their business. But there's nothing wrong with wanting to be a lifestyle business. And you're in a small town, you're fairly isolated from competition. There's certainly nothing wrong with that. But when we talk about capital stack and investment, probably not a partner for us. If that's the mentality that you're running your business by it doesn't mean it's wrong. It's totally fine. It's just not gonna be something we would want to get behind.

Gary: So What are some of the common issues that operators run into? When you're... When someone comes to, I would have to think cash flow's up the top, but as you're... The challenge is there's all this money coming, but if you have to have a 25% match and you have to bill before you get reimbursed and you have to have a letter of credit, what are the things that you're seeing? 

David: All the above. And I would just pause for a little bit. We're targeting this conversation to network owners. If you're a services company, this is probably not... You may or may not need private equity because your payroll is your likely your biggest expense, except for tools and trucks and things like that. But when network is your biggest expense, I think you've gotta think about owning a smaller piece of a bigger pie 'cause you're gonna need capital from outside. And whether that's from us or anybody. So you gotta be thinking that that's the ultimate direction of your company. But yeah, letters of credit are tough for people because that's just cash sitting in the bank. They've maxed out bank debt, that sort of thing. So We see that. And if that's you, just know that that's not uncommon. You're not alone in those issues, but there are folks like us that can come alongside you and help.

Gary: So What are... Well, I guess I... I even hesitate to bring this up, but I spent the weekend studying the whole of Silicon Valley Bank they were a partner with us with in my first startup. And it's just shocking, that you wouldn't think that a bank like Silicon Valley Bank would have a run on it and just the repercussions that that's having. How should people think about the current environment with the Fed cranking up interest rates and some of the volatility that we've seen of... Even kind of places like SVB? 

David: Yeah, I think inflation is probably the bigger issue, but markets are tightening. We've seen a lot of the big guys miss their build numbers because of lack of labor and because equipment's going up so As you're doing your cost analysis for builds, you probably need to build in a factor of things costing a little bit more. As far as Silicon Valley goes, and this is just a personal opinion, no insider information. But I feel like that's gonna be more of a one-off example of bad management. So I think the local banks that you're with now is a business probably just fine serving you for the purpose that they are. But I do think the overall economy is continuing to worsen. And so that means capital's gonna cost more. Some of the deals that were happening two and three years ago with really high multiples is probably gonna bed tempered a little bit. But I think as long as you're going into it with realistic expectations, there's still good opportunities for you to find a partner that can help you grow.

Gary: So what are some of the lessons that you've learned? There's a number of things that could, as people come to take on financing, what are the kind of the things to look out for? 

David: Yeah, if I were coaching a CEO who's going to pitch to anybody, I would say first just make sure you know your numbers. We're looking at you to know your business better than we do. So just make sure you know number of subscribers, your annual revenue, your monthly revenue, your EBITDA, make sure you know those things going into the meeting. The other thing I would say is just make sure your valuation expectations are right. So many times we meet with entrepreneurs and they're thinking that they heard a valuation that somebody got a couple years ago and just make sure that's applicable to your business. Because as you... The smaller you are, the smaller the multiple's gonna be because the less the upside. So if you're at a a $100,000 annual revenue, you're not worth the same as a $10 million dollar company that's throwing off 3e or $4 million dollars in EBITDA, not yet. So having the expectation that say the bigger company you've heard about sold for and what yours is worth today, probably not apples to apples. So just make sure that you're coming in with similar sized businesses and that your expectations are kind of set accordingly.

Gary: Now, what about... The big issue now, you mentioned inflation and the construction costs. So when you're taking on the risk of the build and you don't know what the availability of labor and construction costs and the timing and permitting and there's a lot of risk. So how should... What should she be building in on that and how do you look at that? 

David: I would try to get as many real quotes as you can when you're doing your analysis bake in a 10% contingency factor, something like that. Because we don't know what the future's gonna hold there. And the good news though, I guess it's good news, is that everybody's feeling that same pressure. It's not unique to us or any one company that construction costs are going up, guys that are skilled at building fiber networks and wireless networks too. They're in high demand and short supply.

Gary: So I just had Joey Winder from Treasury on my fire for breakfast this morning, and I asked him about the 2 CFR Part 200. How are you guys looking at this? 'Cause I mean, if you have some, take on some federal money, and it limits your ability to use revenue that's generated from the project, and also limits your where you actually, your potential future ownership of that investment. How are you guys looking at this? 

David: Well, that kind of circles back to our earlier conversation of not all grants are good grants. So just make sure you fully understand all the details, and you're comfortable with the downside of that. There's a big question about how much of the network do you have to own to retain value? I think that's where you're going with this one. We've seen most fiber providers today don't do all their own middle mile. They have a partner to do that. So that's okay. We've seen lease models come out where the provider owns the drops and really nothing else in the network. So the question is, the answer to that question is, I don't really know, Gary. It's really going to depend on how much value is retained in owning the customer versus how much is owned in the network itself. And each grant is a little bit different. So just make sure you understand all of it before you sign up for it.

Gary: So June 30th is the big date, right, when the NTI is going to do the allocation, and every state's going to get whether Alabama gets a billion and Texas gets three billion and so forth. And then they've got their five-year plans. And so that money's going to start flowing here. And when I hear from like Louisiana and others, they're going to be right after June 30th, they're going to start launching their grant programs. So what should, today's March 15th. What should operators, anybody that wants to participate and be, what, when should they be calling you and what should they be preparing for to get ready for this money? 

David: At first stage, just make sure you're reaching out to your local state broadband offices so that you understand all the requirements ahead of time, as many as you can, so you have an idea of what the letter of credit you might be required looks like, whether the grant's on a reimbursement basis and how often that reimbursement happens, so that you can have a good picture of what you need. And then once you have that, it's really not too early to start talking to private equity so that we can wrap our head around the market, do our diligence. And if you don't win, then no harm, no foul. We learned some things and you did too. But if you do win, you can go in confidently that you've got a partner that can help see you through the build. So I would say as soon as you understand the requirements that are on you, come see us.

Gary: Well, David, thanks so much for taking the time to meet with us. And good luck at the state broadband meeting there. Say hello to my good friend, Maureen Naber, the state officer. And I really appreciate your sharing your insights on the capital stack and all the work that you and your team are helping to get operators to take advantage of building out our nation's critical broadband infrastructure.

Gary: And I want to thank everybody for joining us today and look forward to getting back together on April 19th, the next episode of Where's the Funding? We're going to be discussing the intro to private sources, banks, family offices, foundations, and more. So you're not going to want to miss that. So thanks, everyone. Have a great day.

David: Thanks, Gary.

Gary: See you