Given recent developments in the telecom sector, equipment makers are faced with a tough decision: Stop selling to emerging telcos — and risk putting their own prospects for the future on hold indefinitely — or bankroll an industry engulfed by hard times.

As capital markets have dried up — eliminating funding sources such as IPOs, private equity, bank financing and high-yield debt — many emerging carriers have become more aggressive about asking vendors to share their risks by becoming a primary source of the funds necessary to complete network buildouts, which can run to hundreds of millions of dollars.

In fact, start-ups are demanding more than just equipment-related loans. They want suppliers to help cover installation costs, provide working capital and, in some cases, supply investment capital. Given current market conditions, it is not uncommon for an emerging carrier to get commitments from telecom equipment manufacturers for 150% to 200% of the purchased equipment's value.

What can go wrong in such deals is the stuff of recent headlines: The high-profile bankruptcies of 360networks, e.spire Communications, GST Telecommunications, ICG Communications, NorthPoint Communications, PSINet, Teligent and Winstar Communications have made news alongside the corollary multibillion dollar write-offs of Cisco Systems, Lucent Technologies, Nortel Networks and other suppliers. Not surprisingly, these developments have only intensified the sector's demand for capital — and made financing considerations the defining component of more deals.

In recent years, the majority of suppliers have financed equipment with emerging carriers. There are significant risks to such arrangements — consider the $10 billion lawsuit Winstar filed against Lucent, which had agreed to serve as Winstar's supplier and financier. Among other things, Winstar alleged that Lucent failed to meet its contractual obligations, including a scheduled cash payment of $90 million.

Yet despite these risks, vendor financing is not going away. The challenge is to limit exposure wherever possible.

Risky business

With credit risk escalating and equipment makers now reserving billions on their balance sheets to cover investments in emerging carriers, it is clear to many vendors that their sales and marketing departments can no longer maintain sole control over the decision-making process.

Indeed, the current climate dictates that before manufacturers enter into any financing agreements, they must conduct a careful screening of all prospects. This should be done by cross-functional teams with members drawn from sales, marketing, finance, strategy and treasury, with further support and guidance from experienced outside advisers with backgrounds in corporate finance, strategy, market research and due diligence.

By drawing upon these team members' diverse and strategic vantage points to gain insights into industry trends and capital market developments — and by thoroughly applying a host of rigorous analytic tools — equipment makers can create a clear framework for determining which emerging carriers offer the most viable investments and which investment structure will be the most opportune. This process also will allow them to benchmark how much risk they are willing to assume (Figure 1).

The starting point for building a vendor risk-sharing framework is to conduct a detailed market evaluation. What market space does the target operate in? What has competition done to pricing? Equipment makers will want to know as much as possible about the sector's customer base, as well as the scale and capacity of the competitive networks.

Similarly, manufacturers must consider recent capital markets developments. What do the capital markets think of such deals? If no one else is buying into this sector, should a vendor proceed? If others are going forward, how are comparable transactions being structured? What are the benefits and risks inherent in vendor financing in relation to the target industry?

A thorough market analysis also requires vendors to take a close look at the target industry. How robust are a target's market size and growth prospects? What are the underlying demand/capacity drivers? This is particularly critical in the long-haul carrier space, for example, where supply has significantly outpaced demand for bandwidth in recent years, causing prices for dark and lit fiber to plummet. Vendors must develop a solid methodology for estimating market size.

Next, vendors should compare recent market transactions with current financing trends. How are financing arrangements being structured? All alternatives (debt vs. equity, senior debt and preferred stock, among others) must be studied. But information on vendor-financing transactions often is not disclosed publicly, making it far more difficult to obtain and adding to the due diligence team's burden.

Finally — and perhaps most important — even before an analysis of the target company begins, vendors must design a viable exit strategy. Determining how and when an investment will pay off is the most important — and often the most overlooked — detail in a vendor-financing agreement.

Final exams

Due diligence efforts must involve close examination of the target company's business plan, including analysis of its projected income and cash flows, customer/prospect base, network scale and competitors. Such analysis must be considered in the context of where the target is in its life cycle. For example, is it an early or later stage company? What is the revenue-generating quality of its customer base? How does it stack up against competitors?

Central to this analysis is determining whether or not an emerging telco can generate sufficient cash flows from its operations for a vendor to earn an adequate return on its investment. How likely is the telecom operator to maintain its customer base and grow revenue consistent with its business plan? Vendors should make every effort to interview a targeted telecom's current and prospective customers to determine how well services are delivered.

The due diligence process also should consider a wide range of environmental issues such as current business trends and developments; opinions on the depth and experience of the management team; and market research, including studies of customers, suppliers and competitors. In addition, manufacturers should examine the quality of a telecom's operational execution as it pertains to market expansion, customer growth and gross margins, among other factors. It also is important to thoroughly review significant supplier and customer contracts.

And finally, no due diligence is complete without a detailed financial analysis of the target, encompassing historical and projected results. Quality of earnings, working capital, liquidity, cash flows and burn rate — as well as all items on the balance sheet — must be analyzed closely. Furthermore, financial projections should be analyzed forward, at least until that point in time when the target company is expected to become free cash-flow positive, able to maintain operations and grow on the strength of internally generated cash flows.

Gregory E. Wolski is a partner at Ernst & Young LLP Chicago. His e-mail address is gregory.wolski@ey.com.