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Cogent's Dave Schaeffer on how he'll succeed where others have failed and why he chose JVP. Cogent Communications founder and CEO Dave Schaeffer had already known, from previous high-tech ventures, terminal situations like the one affecting Cogent. He decided he would not give up this time. "Cisco told us, 'We looked at your balance sheet and we don’t want to put any more money in this sector. We want out.' I told them that would force me into bankruptcy, and they said, 'We don’t want to make any promises. We've already invested $290 million in Cogent and supported you until now, but the analysts are slamming us for putting money in a competing communications provider. Let's work something out'," he relates. A few weeks ago, following almost six months of negotiations, Schaeffer and Cisco reached an agreement that lifted the threat of bankruptcy from Cogent. Under the agreement rescheduling Cogent's debts to its suppliers, Cisco wrote off most the money owed it in exchange for 18% of Cogent, $20 million in cash, and $17 million in promissory notes, due from 2006. The agreement slashed Cogent's debt from $380 million to $27 million. In order to enable the company to meet its cash payments and give it breathing room, JVP led a $41 million financing round, with the participation of existing investors Broadview Capital Partners, Oak Investment Partners, Worldview Technology Partners, Boulder Ventures, and Nassau Capital. JVP increased its stake in Cogent from 20% to 23%, becoming the largest shareholder. Vision in face of the abyss On the face of it, Cogent's connection with JVP seems rather odd. What do an ambitious US company that aimed to become the largest data communications provider in the country and an Israeli venture capital company have in common? A study of the two companies' histories and collaboration, shows an ideal match. Neither Schaeffer or JVP founder and managing partner Erel Margalit is the kind of guy who gives up. It may be an obvious trait for an entrepreneur, but in the case of the Israeli venture capital fund, an over-protectiveness toward its portfolio companies is a common criticism in the local venture capital industry. JVP has taken great risks in the past. Its investment in Precise Software Solutions was a great success, but JVP's portfolio also includes a number of failures. However, the risk taken with Cogent is unprecedented. As the lead investor in Cogent's seed round, JVP has maintained a large stake in the company, which has raised over $200 million altogether. JVP is a full partner in Cogent's grandiose ambitions. Schaeffer believes they are achievable, despite the collapse of the similar ambitions of the CLECs. Cogent, says Schaeffer was founded with the aim of providing business data communications services in the metro sector though its own network, as a way to compete against the large veteran communications providers. "When the demand for data communications grows," he says, "the existing players will be pressed to provide these services efficently. When the Internet service providers (ISPs) built their data communications networks, they simply added them onto the existing telephony networks. The model turned out to be problematical, because as the networks expanded, managing the multiple layers became complicated, a capacity problem was created, and greatly raised costs." In contrast to most of Cogent's competitors, Schaeffer's concept relied on building a nationwide optical communications network. He says, "We now have 12,500 miles (20,000 km) of fiber optics connecting 22 US cities, plus Toronto, Canada. We have 74,000 miles (118,000 km) in metro area linking over 800 buildings. Only AT&T (NYSE:T), Sprint Corporation (NYSE:SDE), and MCI have a more extensive metro network. We have more capacity and more linked buildings than any other provider except for the Baby Bells: SBC Communications (NYSE:SBC; SBT; LSE; XETRA:SBC), Verizon Communications (NYSE:VZ), BellSouth (NYSE:BLS), and Qwest (NYSE:Q)." Schaeffer attributes most of Cogent's growth to its business model, which offers enterprises, mostly small and medium-sized businesses, Internet access at 100 Mbps for $1,000 a month. "We grown to a size we didn’t originally expect," he says, adding that the result is that Cogent is now the second largest ISP in the US in terms of traffic (after MCI's UUNet), with 10% of US Internet traffic. Testimony to Cogent's presumption is its acquisitions of bankrupt competitors. Cogent acquired NetRail in September 2001 for $11.9 million, followed PSInet for $10 million, Onsite Access for $150,000, Fibercity Network, and FNSI. In February 2002, Cogent acquired public company Allied Riser, and has been listed on Amex ever since. "Organizations move slowly" Despite statistics indicating impressive growth in Cogent's activities, its acquisitions brought it to the verge of bankruptcy. Schaeffer nevertheless believes that the company's focus on providing Internet access services, instead of the CLECs' model of providing complex data communications and voice services, will be the road to success. "The large providers have almost $1 trillion worth of communications equipment in the US. They financed these assets from telephony revenue, and have no debts. When someone builds a $1 trillion asset, it's almost impossible for a venture capital-backed company to compete. Furthermore, the large providers control over 90% of the voice services market. The highest entry cost for a new competitor is acquiring customers, i.e. sales and marketing. When you challenge the large providers while suffering from these two handicaps, all the money entering the sector couldn’t help the new competitors overcome their disadvantages. That is why so many companies went bankrupt and vanished. It was irrational." "Globes": Why will you succeed when so many others have failed? Schaeffer: "A vast amount of outside money was invested in the telecom market that generated an unreasonable degree of competition. When the bubble burst, the competition shrank to almost nothing, and the new providers vanished. When Cogent was founded, there were over 100 start-ups doing similar things, and we're the only survivor. We were the first in the market, we built the largest data communications network in the US, and we proved to our investors that we could do it better, faster, and cheaper than everyone else." There used to be a lot of talk about the convergence of communications networks. Why do you think the market is heading the other way? "When you look at the two types of products - voice and data - you'll see something interesting. When deregulation was started 20 years ago, one bit of data on public communications networks created 1/15 of the revenue generated by one bit of voice. That created a fantastic opportunity to take money from the highly profitable voice business to subsidize the data business, which began to grow rapidly. That worked until the revenue from voice services began to decline and the subsidy became harder to sustain. Today, 80% of revenue still comes from voice, compared with over 90% 20 years ago, which means the operators are reaching the technological limit of their networks that were designed for voice and converted to data. "The large operators can build new parallel networks for data communications. But such bureaucratic organizations move slowly, which creates opportunities for operators that provide only data communications services to achieve economic efficiency. We're doing this not just be keeping network costs low, but by providing a small number of products. We currently have only eight products, whereas AT&T has almost 9,000 and MCI 6,500. It's impossible to profitably train teams, formulate business procedures, and build a technical support network for so many products in the current business climate." "The only mistake is to lose focus" Schaeffer admits that the model separating voice and data communications networks - divergence - is "debatable", but he believes that it will prove itself. He has believed in divergence since the day he founded Cogent. That was one of the reasons he contacted an unknown venture capital fund (in American terms) like Israel's JVP. "When we opened the financing round and met venture capital funds, some funds offered us more money at higher valuations than JVP. This was my seventh start-up, and I've had previous successes, so I was able to obtain such offers quite quickly. "Some of the VCs criticized me for my divergence idea. The claimed, among other things, that customers wanted a single bill that included everything. I disagreed with this thesis. A single bill puts customers at a disadvantage, especially in the small and medium-sized business market segment, because if they are late in payment, they lose all the services provided by the operator. There was also a technical aspect: if all the communications services come through the same telephone jack, there is only one point of failure for your entire communications network. One of Cogent's most important advantages is that we're independent and unconnected to the telephone companies, both in terms of billing and equipment. "After managing six companies before Cogent, I can say that the only big mistake a venture capital-backed company can make is to lose focus. The board of directors must challenge the company's managers. That's one of the abilities we seek in our investors. We also sought something else. VCs always say one of the things they look for in an entrepreneur is the ability to listen. After six companies before Cogent, I became the man who asks the questions. I wanted a VC that would listen." In JVP, Schaeffer says he found someone to listen to his divergence model. "That was the main reason I chose JVP. I knew, especially during the 1999-2000 boom, that I could do it faster and better that I had in the past, but I needed someone who wouldn’t fight me, but help." There was another reason for choosing JVP. "The large venture capital companies forgot the company-building dimension," says Schaeffer. "There is technology creation, which is the relatively easy part, but there is also the part of hiring people, formulating business models and marketing strategies - the things that people take for granted in companies. I think that JVP added a lot of value to us because they understand this." Cogent's current performance has not yet brought to the operating break-even point, despite its impressive presence in the US market. Schaeffer says, "We plan to slow our building down in order to switch from cash burning to cash creation from operations. I think we'll make the transition quickly. Cogent's current market cap on Yahoo! doesn’t reflect our company value because it only reflects the value of Allied Riser shares from before we acquired the company. Cogent has a market cap of $850 million. I don’t care about the erroneous report, because we decided to keep a low profile, so as not to get calls from analysts. Our market is consolidating rapidly. We played a major part in that process so far, and one day we might be a part of someone else's consolidation plan, I don’t know." Your business model requires many acquisitions to win customers and keep prices competitive. What resources do you plan to use? "We might not buy anything. We've been very disciplined in our acquisition strategy. Cogent has conducted due diligence studies on 82 potential acquisitions to date. We bid for 11 companies among them, and won seven. We're looking at numerous acquisition possibilities right now, but we can stay profitable with our current balance sheet and assets, without the need for acquisitions. If we find a suitable opportunity at the right price, we'll buy, but we avoided many deals in the past because the price was too high. We'll stick to this policy. Our business model doesn’t dictate that we must make acquisitions to survive. We consider acquisitions as an opportunity to accelerate our business model." Published by Globes [online] |
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