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Ativi – Telecom Net: A VC-Backed Brazilian Success Story

LAVCA 2008 LP/GP Roundtable16 October 2008

Kevin G. Lee, CFOkglee@ativi.com.br

Tel. + 55-11-5213-1024Cel. + 55-11-9319-2662

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Opportunity

• Illiquid, indebted, informal, friendless – in a word: “bankrupt” in every meaningful way.

• This was Telecom Net in mid-2005. The company that had been responsible for the first electronically-delivered

pre-paid cellular credit in Brazil had reached its nadir.

• It must have been incredible vision (or a pair of exceptionally-tinted rose-colored glasses) that convinced Darby

Technology Ventures, Intel Capital, and Mifactory to open their checkbooks and assume responsibility for a

company that by that time had become a financial albatross for its founders.

• The company had been founded in 1999 upon the idea that it would be more efficient (and more profitable both

for the telecom carriers and its independent distribution partners) to distribute pre-paid cellular credits to end

users electronically rather than via physical scratch cards. (The logistics and security issues involved in the

manufacturing and distribution of scratch cards makes them considerably more expensive for the cellular carriers

vs. electronic distribution). The company’s “business model” was based on having contracts with all of the

principal cellular and fixed-line carriers to distribute pre-paid credits electronically through third-party, retail

points-of-sale (e.g., pharmacies, supermarkets, newspaper kiosks). The company provided the technological

platform and retail point-of-sale channel relationships necessary in order to connect the cellular carriers with their

pre-paid end users.

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Opportunity (cont.)

• At the time (1999), Brazil had 13 MM cellular subscribers (approx. 30% of which were pre-paid).

• Now jump ahead to early-2005: Brazil has approx. 65 MM cellular subscribers (more than 80% of which are

pre-paid). While Telecom Net has grown quietly (27% 1Q 2005 vs. year-earlier period), over 50% of its

sales volume is accounted for by one cellular carrier through one distribution channel (i.e., through

government-owned lottery houses). One fine day, the carrier and lottery houses awaken and realize that

they do not really need Telecom Net to act as an expensive middle-man for this distribution channel.

• By July 2005, monthly top-line sales had fallen by 75% since the beginning of the year to US$ 750,000 and

the company was effectively bankrupt.

• Enter the VC white knights who, notwithstanding their pink-hued spectacles, did clearly see that the

company had one incredibly valuable, difficult-to-replicate asset not to be found on its besmirched balance

sheet: signed distribution contracts with all of the major cellular and fixed-line carriers.

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Investment

• This asset, together with the vision that Brazil pre-paid telephony (and pre-paid products in general) were

still in their infancy, gave the three VCs the “confidence” (if that’s the right word) to place a small bet. Mind

you: this was not a bet of chance (or luck), but rather an “educated bet” that value could be realized at the

confluence of market demand, possession of an asset representing a significant barrier to entry of

competitors, a bit of capital, and a professional management team.

• An experienced management team would prove invaluable in undertaking the myriad operational and

financial changes necessary for realizing the vision. My colleague, Glaucon Pereira, was hired as the CEO

and I as the CFO and we both formally joined the company simultaneously with the VC investment.

• As might be expected, within six months over one-half of the financial “bet” had been consumed by buying

out the founders, paying off mountains of debt to the carriers and other suppliers, and writing off what we

will politely call “impaired assets”.

• These six months (and many, many more) were also witness to the herculean task of fiscal, financial, HR,

and operational house-cleaning and restructuring that is sine qua non to a VC-backed investment.

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Restructuring

• What, specifically, was done to “put the house in order”?

• All of the following were undertaken simultaneously:

1. Commencement of re-establishing credibility with the telecom carriers: this entailed both paying off debts

and embarking on a now 3-years-and-running policy of maintaining a pristine payment history.

2. Establishing relationships with first-tier commercial banks who would be willing to approve (admittedly,

initially miniscule) lines-of-credit based not on a robust balance sheet, but rather on a compelling story

well told, a management team with deep experience, and the brand recognition of Darby Overseas and

Intel Capital.

3. Implementation of good corporate governance structure.

4. Resolution of contingent liabilities: especially fiscal and workers’ comp.

5. Expeditious phasing out of “old guard” management and personnel .

6. Definition and implementation of day-to-day operational policies and procedures so as to redefine

company’s modus operandi from ad hoc reactive to a kind of “standardized” proactive.

7. Establishing key operational and financial metrics to help measure both our progress in cleaning house and

our ongoing financial health (e.g., net adds, net revenue per point-of-sale).

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Keys to Success• The foregoing fairly summarizes the company’s first 18 months post-investment, namely: the quotidian tasks of

digging the company out of its financial hole and operational quagmire, putting it on a solid foundation and providing

it with a fighting chance to survive.

• Survive it has.

• Top-line sales have grown from US$ 750,000 monthly to US$ 34 MM. That is, on average, growth of 10%+ per

month for the past 38 months.

• Average productivity (i.e., monthly sales) per retail point-of-sale has tripled since the time of the investment.

• EBITDA will more than double from 2007 to 2008 and should double again in 2009. FY 2008 EBITDA will be

US$ 8 MM, and this is on a total VC investment of US$ 5.6 MM made just over three years ago.

• But what has allowed Telecom Net not merely to survive, but to positively thrive? What are the keys to our success?

• As much as I may hate to admit it, as it tended to make my job more difficult, this successful investment began

(once getting past the initial hurdle of not egregiously overpaying for the asset acquired) with VC parsimony

with capital injected into the company (accompanied by the requisite admonition to management: “these are the

scraps you’re getting, and you’re not getting any more”). This went a long way to quickly focusing

management’s attention that matters are urgent and time is not an ally.

• With this “rule-of-the-game” engraved on our foreheads, we were afforded the opportunity to get on with the

business of delivering on the VC vision.

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Keys to Success

• This said, the day-to-day keys to our success are largely a by-product of limited capital and the imperative

of the disciplined allocation of scarce capital resources:

• Focus: identify and relentlessly focus on the company’s bread and butter core business. Do not

become distracted by “sexy” businesses or products that can beguile management into sub-optimal

allocation of resources. Don’t try to do it all – or even a lot of it. Do a few things exceedingly well.

• Discipline: instill a culture of corporate self-discipline whereby strategies once decided upon and

decisions once made are subsequently executed on and not continually second-guessed. In short,

have conviction of your convictions. Stay true to that strategy you understand maximizes the

probability of success, without being distracted by the vagaries of competitors’ divergent business

models and tactics. Perpetually revisiting issues that have, in principle, long since been decided

breeds doubt, confusion, and lassitude in day-to-day execution, thereby resulting in sub-optimal

returns on capital invested.

• Execution: get it done!

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Keys to Successand Lessons Learned

• Cash generation: in our case, proactive management of working capital allowed us to continue growing

without requiring new capital, even during 18 months of operational losses.

• On the subject of growth, in our case it was essential that we not get ahead of ourselves with the goal of

growth for growth’s sake. We did not seek to grow our network or acquire market share at the expense of

profitability.

• Lessons Learned

• Of course, no success story would be complete without at least a few (difficult) lessons learned. First, in

the name of partially-full disclosure, many of the aforementioned keys to success were transformed into

such after starting life as “lessons learned”.

• Robust pre-investment due diligence is essential. Start-up informality is often synonymous with contingent

liabilities. Negotiate a sufficiently long indemnification period so as to have time to unearth all of the

skeletons.

• Quickly substitute out inadequate human resources, especially those who do not share the investment

vision and sense of urgency required to realize it.

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VC Value-Added

• What, in practice, has been the venture capital firms’ true-value added to Telecom Net?

• Other than the obvious initial injection of capital, I see three principal sources of value:

1. First, the VCs hired a professional management team and then let us manage. We were

empowered to do all that we viewed as necessary to restructure the company and realize its

economic potential, unfettered by VC attempts at micro-management. This has been extremely

important in our case, as explosive growth requires agility in negotiating with creditors (among

others) that is not compatible with plodding decision-making by committee (e.g., with regard to

corporate cash utilization, levels of indebtedness, credit guarantees)

2. Second, particularly in credit line negotiations with banks and carriers, valuable “political

capital” was gained by being associated with the Intel Capital and Darby Overseas brand

names. While the VCs have not, either explicitly or implicitly, backstopped any of our credit

lines or other obligations, having these names as controlling shareholders undoubtedly lends

credibility and comfort.

3. Third, corporate governance: from monthly board meetings to consolidated USGAAP-based

audits, Telecom Net has been formally structured to maximize corporate discipline and

facilitate an eventual exit from the investment.

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Exit Prospects

• I thought it interesting that one of the headlines on the cover of the September issue of LatinFinance

magazine was: “Brazil VC Awaits Success Story”. We obviously believe that Telecom Net is a great model

of such a success story.

• Note that we do not view “success” as contingent upon already having realized an exit from the

investment, as the investment success story has largely been written over the past 31/2 years. Only the

story’s denouement is yet to come.

• What are the prospects for a successful exit?

• Given recent equity, credit, and FX market volatility, my view today is rather different from that of just six

weeks ago; but principally in terms of “timing” of a “home run” exit rather than the real prospects for its

eventual realization.

• The company currently has several interested suitors, both financial and strategic, whose indicative

valuations yield returns in the range of 12x money invested.

• Telecom Net is a VC-backed Brazil success story. The only real question remaining is how big a success it

will be for the VCs on exit.