New Alliances in the New Economy
Willkie Farr & Gallagher
Eugene A. Pinover, Esq., Chairman of the Real Estate Department
Steven A. Seidman, Corporate Partner
Andrew Abramowitz, Corporate Associate
Erin E. Smith, Real Estate Associate
The success of Internet and new media
companies in the public markets has fostered a new set of
partners - building owners and start-up telecommunications
companies. These new alliances have been formed in order
to rewire office buildings for high-speed Internet access
and other telecommunications services and with the hope
that the start-up companies can take advantage of the hot
initial public offering market. The building owners are
offered equity and a percentage of sales in the fledgling
companies in exchange for the right to rewire their buildings
and offer a broad range of services (such as local and long
distance access, Internet access and satellite accessibility)
to tenants. The tenants, in turn, are offered cutting-edge
technology at affordable prices.
In addition to the red-hot public markets,
there are two primary forces driving these transactions.
First, the increased demand for ever-faster access to the
Internet and other technologies requires improvements to
existing office buildings. The telecommunications companies
(TCs) can provide a complete bundle of high-speed Internet
access, voice and data transmission and other services.
Second, changes in telecommunications regulation in recent
years have opened up local telephone service to competition,
thereby allowing the TCs to challenge the dominant local
carriers.
Many tenants, particularly small ones,
prefer the all-in-one package of services offered by the
TCs, giving the TCs an advantage against the dominant local
carrier. The deals made by the TCs are rarely exclusive,
but the TC that can establish a beachhead in a given building
is better able to market to tenants than its competitors.
As for the building owners, they want
to be able to present their buildings to potential tenants
as being technologically up to date. In addition, the owners
consider the equity stakes in these fast-growing, soon-to-be-public
TCs to be a potentially lucrative investment. Given the
large size of many of the building owners, it is the equity
rather than the revenue share with these small TCs which
is likely to significantly impact the building owners' earnings.
EQUITY ACQUISITION
AGREEMENTS
The TCs set aside a portion of their ownership for the various
building owners with whom they contract. The amount of equity
reserved for each owner depends on the amount of building
space provided by the owner and the owner's degree of commitment
to the TC. Most frequently, the equity will take the form
of warrants, giving the owners the right to purchase the
TC's stock at a certain time in the future at a certain
exercise price.
The time at which the warrant may be exercised
can be tied to the amount of space provided by the owner
for rewiring, if that amount has not been set initially.
For example, the warrant agreement could provide that the
warrant may be exercised once the TC and the owner execute
license agreements allowing for the rewiring of 50 percent
of the building space. The amount of space provided by the
owner for rewiring also can be tied to a vesting date (i.e.,
the owner will become full owners of the warrants upon the
execution of license agreements relating to a certain amount
of building space). In addition, a building owner's failure
to cause the execution of a sufficient amount of license
agreements can lead to a forfeiture of warrants.
Similar to venture capitalists, building
owners must keep a watchful eye on their "exit"
strategy since they are acquiring securities containing
strict transfer restrictions and no trading market. In general,
securities that are not registered under the Securities
Act of 1933 (the Securities Act) at the time of issuance
are "restricted securities" and may not be resold
except pursuant to a registration statement filed under
the Securities Act or pursuant to an exemption under the
Securities Act. Unlike venture capitalists, however, building
owners (in part because of the smallness of their equity
stake) need not rely so heavily on contractual "registration
rights" that allow the holder of stock to freely sell
the stock to the public pursuant to a registration statement.
Building owners often are able to plan on selling pursuant
to Rule 144, the principal exemption under the Securities
Act.
A building owner that holds a small equity
stake in the TC will rarely obtain so - called demand registration
rights (i.e., the right on one or more occasions to cause
the TC to file a registration statement), though sometimes
a group of stockholders will be permitted to band together
and exercise demand rights. More frequently, owners will
receive "piggyback" registration rights. This
allows the owner to sell its stock only in conjunction with
the TC filing a registration statement to sell new securities
in an offering at the TC's discretion or in a registration
statement filed to allow other existing holders to sell
their securities. Often the owner can obtain a "most
favored nation" covenant from the TC such that if the
TC grants registration rights to another similar stockholder
in the future, it will be obligated to also grant these
rights to the owner.
Restricted securities may be sold in accordance
with the volume and manner of sale limitations of Rule 144
under the Securities Act after the securities have been
held for one year from the time they were acquired (that
is, fully paid for) from the issuer. The volume limitation
under Rule 144 provides that the maximum volume that may
be sold in any three months by any person is the larger
of one percent of the outstanding shares or the average
weekly trading volume during the four calendar weeks preceding
the filing of a notice under Rule 144. The manner of sale
limitation under Rule 144 is, essentially, that all sales
be in "brokers' transactions" and that a person
selling the securities shall not solicit or arrange for
solicitation of orders to buy in anticipation of such transactions.
Sales pursuant to Rule 144 require a notice of a proposed
sale filing with the Securities and Exchange Commission
if the amount sold in reliance upon the Rule during any
three month period exceeds 500 shares or has an aggregate
sale price in excess of $10,000. When making a sale pursuant
to Rule 144, the broker should be made aware that the transaction
is in accordance with that rule.
As a result of the one year holding period,
it is important to structure the warrants so that the one
year period is not inadvertently restarted. The holding
period starts at the time of exercise if the shares of common
stock are received upon exercise of warrants. If shares
are received upon cashless exercise of warrants, the holding
period begins at the time the warrants are issued. Since
a sale into the public markets pursuant to Rule 144 may
very well be the final exit strategy, negotiating the ability
to engage in a cashless exercise is crucial for the building
owner.
The warrant agreements usually will contain
strict transfer restrictions. For a certain period of time,
the owner often will be allowed to transfer the warrants
only to its affiliates. From the TC's perspective, it has
chosen to accept certain building owners as its investors;
it wants to preclude transfers to unknown stockholders.
However, in some cases the owners have already agreed to
transfer some of the warrants to other real estate partners
who are not affiliated with the owners. In such a case,
the owner must be careful to add the partners to the list
of permitted transferees.
Start-up TCs are not obligated to publicly
file financial statements. Without this information and
with no right to attend meetings of the Board of Directors,
building owners have little ability to monitor their investments.
Therefore, building owners and TCs often negotiate the owners'
right to obtain financial information about the TCs on an
ongoing basis. Venture capitalist investors frequently are
able to persuade the TCs to provide financial information
to them on a regular basis (either through their Board representative
or otherwise) as a result of their significant capital investment.
When building owners attempt to negotiate this sort of provision
with TCs, the TCs frequently reject the owners' request
on the theory that the owners do not have the large equity
stake that the venture capitalists have and thus should
not hold these rights. The TCs also use this argument to
deny the owners other "venture capitalist"-type
rights.
However, the building owners usually can
use the TC's line of reasoning for their own benefit. The
TCs often request that the owners be subject to a lockup
period following a public offering. During this period the
building owners and other stockholders are precluded from
selling any shares. The TCs' justification for a lockup
is that the TCs and the underwriters for the public offering
do not want the TCs' stock trading market to be adversely
affected immediately after the public offering as a result
of too many sales by large stockholders. If the TCs deem
the owners to be too small to be entitled to financial information,
their stake also should be too small for the sale of their
stock following an offering to have a significant impact
on the overall trading market for the stock. Therefore,
the owner should be able to convincingly request the removal
of the lockup requirement as a corollary to the TC's refusal
to grant financial information rights.
TELECOMMUNICATIONS
LICENSE AGREEMENTS
From both a legal and practical standpoint, building owners
are concerned about assuring tenants that they will be provided
with top quality service at competitive prices. They also
are concerned with controlling access to the building, where
that access is granted and at what price. Those priorities
dominate the negotiation of a license agreement with a TC,
just as they do any lease or service agreement.
Cost of Access Building owners typically
eliminate the cost of installation, maintenance and repair
of the cables and related equipment by requiring the TC
to perform those functions. Further, building owners should
eliminate potential liability from claims concerning service
issues by requiring proper indemnities from the TC (or TC
parent, if possible). As noted above, for the benefit of
providing services to the building tenants, the TC often
(i) pays the owner a percentage of the revenues derived
from the sale of services to the building's tenants, with
a minimum base monthly fee protecting the owner's downside
and (ii) if a large portfolio of buildings is committed
by the building owner, provides a stock and/or warrant deal
with the TC. Such large portfolio owners, especially if
among the telecommunications pioneers in a particular region
or the first to sign up with a particular TC, should demand
the protection of a "most favored licensor" provision.
In this provision, the TC must offer the owner the same
benefits (i.e. revenue sharing percentages, subscription
fees and warrant rations) as other portfolio owners, when
taken as a whole, are potentially more favorable to the
owner.
Location of Access In the world of telecommunications,
riser space is the equivalent of liquid gold. Thus, owners
must be very protective of the amount and location of riser
space committed to each TC. The TC may need access and time
to determine whether the facilities can be installed in
already crowded pathways and risers. This is typically provided
through an option arrangement called a "glue agreement,"
which generally is a diligence period of 30 days. Typically,
the TC will be required to provide proposed plans outlining
the proposed riser as well as the location of all other
TC cabling and equipment. The owner approves or rejects
the plans in its reasonable discretion. While that approval
right gives the owner control at the initial installation
point, a building owner also should insist upon a relocation
right, which in the future may be important in facilitating
the optimum number of TCs in a building. Further, some building
owners require TCs to install additional empty conduits
in the risers while the TCs are performing the initial installation,
at the owner's cost.
Limitations on Access
Exclusivity Covenants Obviously, any building owner would
desire to avoid exclusivity with a single TC. The ability
to allow additional TCs in the building can generate additional
service fees and increase the options available to tenants,
a marketing plus. Typically, building owners are successful
in avoiding an exclusive relationship. Relatedly, building
owners must use care in defining the scope of marketing
support they provide to a TC since the practical effect
may be an exclusive TC in the building if that support is
too favorable.
Transfer Rights The ability to assign
the license agreement is of paramount importance to both
building owners and TCs. On the building owner side, the
owner must retain the right to assign in the event of a
sale of the building. Controversy surrounds whether the
owner should be obligated to cause the purchaser to assume
the license agreement with the TC. TCs argue that, due to
their capital infusion in the building, they need the protection
of the minimum terms negotiated. Building owners employ
market-chilling arguments, as many potential purchasers
may have similar broad-based agreements with other telecommunications
providers. Typically, the building owner loses this battle.
However, some providers, confident in the value and superiority
of their system and services, will accept a mere covenant
to use good faith efforts to have the purchaser assume the
contract.
On the TC side, since many TCs are start-up
companies searching for equity to expand their business
and bolster their earnings, the ability to transfer to affiliates
and others in connection with corporate transactions is
a must. Many TCs also will argue for transferability in
the event an assignee meets certain minimum net worth requirements
and has some limited background in the same service field.
TCs also maintain that they will be severely hampered in
contracting with tenants if their service agreements can
be canceled because the building owner sells the building.
The flexibility of the building owner on transfer rights
is largely a matter of institutional policy: for the most
conservative of owners, a TC with any no-consent assignment
right may be unacceptable, especially since building owners
view the TC as a mere service provider. Other owners may
be satisfied as long their tenants are receiving the expected
service and they have adequate termination rights in the
event things are not going so smoothly.
Co-location Concerns Building owners need
to be wary of the potential for TCs to use their building
riser space to provide services to parties outside the building
(whether through wireless communications or otherwise) with
whom the Building Owner has no relationship. While the building
owner may benefit minimally from the share of revenues it
derives by the increased traffic over the lines (provided
the revenue-sharing provision is broadly defined), most
owners prefer to eliminate the possibility of co-location
services, together with the potential related liability.
Additional Concerns
A few additional issues for building owner consideration
in negotiation of a telecommunications license agreement:
(i) a commitment by the TC to respond to any building occupant
complaints within very short time frames, as insurance for
the maintenance of good tenant relations; (ii) a termination
right in the event the TC's system is inoperable or dysfunctional
for some extended period of time, otherwise fails to provide
high-quality services at a competitive price, and/or fails
to generate certain revenue levels within the first few
years of installation; (iii) a commitment by the TC to install
and be operational within a set number of months (which
varies depending on the size of the real estate portfolio
provided by the owner), to install first in specifically
identified markets and to install in that building owner's
buildings first or contemporaneously with the owner's competitors.
CONCLUSION
The issues highlighted above are among those a building
owner must consider in navigating the telecommunications
service world. While the medium discussed may be relatively
new, the traditional concerns - satisfying tenant demands
while maintaining control of real property on the real estate
front and flexible ownership of equity on the corporate
front - remain the focal points. Indeed, building owners
stand in the enviable position of profiting from the tenant
demand for vastly increased bandwidth and types of telecommunications
services, while at the same time keeping their office buildings
competitive and technologically up to date.
