Want to go into the local phone business? You need a new technology or a new customer base. Allegiance went for the customer base.

By Phyllis Berman

THERE WAS A LOT TO TALK ABOUT at the raucous telecom industry meeting at Disney World in late 1996. Bill Clinton had just signed the Telecommunications Act of 1996, taking the local phone business out of the world of regulated monopolies and into the world of free-wheeling competition.

Royce Holland and Thomas Lord got away from the crowds by climbing aboard the monorail. Holland had campaigned for the law. Now, says he, "I wanted to take advantage of it." Would Lord help him start a company?

Holland had cofounded the first competitor to regional Bell operating companies, MFS Communications, in 1987. He and James Crowe, now head of Level 3 Communications, started it as a division of Peter Kiewit Sons', the construction firm. It went public in 1993 and four years later was sold to Bernard Ebbers' MCI Wor ldCom for $13 billion. Ebbers and Crowe wanted Holland to stay on or at least sign a noncompete but he refused. A nasty lawsuit followed, but they reached a settlement where Holland was vindicated. Lord, a senior managing director at Bear Stearns, was instrumental in raising billions in junk bond financing for the nascent industry starting in 1992. His customers included MFS.

The duo's experience helped them spot an opportunity. Allegiance Telecom would neither develop new technology nor bury fiber in the ground. It would take advantage of what others had done and would concentrate on sales and service. They knew that they didn't have this idea to themselves. So-called competitive local exchange carriers, or CLECs (pronounced cee-lecks), were springing up all over the country. To distinguish Allegiance, Holland and Lord targeted small and medium-size businesses with 5 to 24 phone lines and offered them a range of services, including Internet connections and Web hosting.

Plan in hand, they approached venture capitalists with a most unusual proposition: If the venture capitalists put up $95 million and Holland and Lord put up $5 million, they would get only a proportionate share of the equity, or 5%, a stake that they would, moreover, share with managers they recruited.

A giveaway to the founders? No, there was a big kicker. If they achieved a goal of taking the company public with a valuation at least triple the $100 million starting point, the insiders' 5% stake would balloon to 33%.

One year and three months after startup, in April 1997, Allegiance went public with a capitalization of $780 million. The founders got their third. After dividing that among 29 other employees and taking some dilution, the two now share a stake of 7.6% in the company. That little stake is worth $632 million. Today Holland, 51, works out of Dallas as chief executive officer; Lord, 43, is in Atlanta as chief financial officer.

When Allegiance goes into a market it begins its operations by leasing space in the central office of the incumbent Bell and installing its own switches. Then it leases lines on which signals can travel. Meanwhile, its sales force is out calling on potential customers. Customers who commit to two years of Allegiance service get a 20% discount.

Selling was the easy part. Much more difficult was getting the Bells, which still have 97% of the market, to transfer accounts in a timely way. The process initially took 45 days or more to complete.

Solution? Allegiance hired software developers MetaSolv and DSET to work with its employees to develop a program to put electronic interfaces between Allegiance back offices and the systems of the Bell companies. Now an account from Bell Atlantic, for example, can be transferred to Allegiance in 18 days. Allegiance likes the fact that the software company took on the development costs. "If a telecommunications company starts talking about developing its own software, you will hear a loud sucking noise, which is the sound of greenbacks going down a big hole," Holland says.

Allegiance has cut similar deals with 13 other software vendors, all with products made to its specifications to make Allegiance's back office run smoothly. One piece of software handles customer calls, reducing the average time before a phone is picked up to between 11 and 12 seconds and the call-abandonment rate (the industry term for a hang-up by a frustrated customer) to a low 3%. Allegiance makes it worthwhile for the software developers. They get not only fees but also the right to sell the software to any of Allegiance's competitors.

Allegiance starts generating revenues 6 to 9 months after it enters a city, versus the 18 to 24 months it took the first CLECs. Within that time Allegiance usually picks up enough customers--as it's doing in 19 markets--to move its business from the Bell's leased lines to the fiber-optic wires thrown under sidewalks by all manner of telecom ventures. Allegiance signs 20-year contracts with the wires' owners, companies like Metromedia, Level 3 and Brooks Fiber, at fixed rates. There are two to five vendors of so-called dark (uncommitted) fiber in each of Allegiance's markets.

Allegiance expects to be in 36 U.S. cities by the end of 2001. Reed Hundt, former head of the FCC and an Allegiance board member, is a real believer. Allegiance, he says, can make a fine business dressing up plain telephone service with extras like Web hosting and software delivery to help small businesses do business-to-business over the Web. Wall Street is a believer, too. Even after the crash in speculative technology stocks, Allegiance commands an $8.4 billion market value on meager fundamentals--it lost $49 million last year on $100 million in sales. But there's no denying the momentum here. Allegiance added 72,600 lines in the first quarter of 2000, bringing the total to 314,300. Good thing Thomas Lord has translated this success story into hard capital. Allegiance has $1.2 billion in cash, enough to fund all 36 markets in its business plan. "Loading up on high-yield debt is heroin for some companies," says Lord. So in January he raised $660 million for the company (and $340 million for insiders wanting to sell) in a stock offering at $105. (Recent price: $77.) Three weeks later he got a $500 million bank loan. Allegiance has lofty goals: revenue approaching $1 billion by 2002, which would give it 1% of the local phone market for business customers. The ten-year objective is $6.5 billion. Could CLECs ultimately pick up half the local business, just as AT&T's competitors took half of long distance? "You bet," says Holland. By the Numbers

The race is on for Allegiance to pick up a piece of a huge market.
$300 Billion: Total size of U.S. telecom market.
$113 Billion: Size of market for business lines.
97%: Market share held by the regional Bells.
1%: Market share Allegiance wants by 2002.