Up-and-down quarter for network company investments

Venture capital funding in network start-ups declined for the first time in 18 months, dropping 13% from a record-breaking $15 billion in the second quarter of 2000 to $13.1 billion in the third quarter, according to the most recent PricewaterhouseCoopers/Network World Venture Capital Survey.

Despite the downturn, third-quarter investments remained slightly higher than in the first quarter and more than double the amount spent in the third quarter of 1999. Altogether, 870 network hardware, software and services start-ups received an average of $15 million each during July, August and September.

Much of the decline was related to dot-coms, with investments in Internet content, e-commerce sites and related services plunging $2.2 billion -- or 30% -- from the previous quarter. Among the start-ups that had trouble attracting funds were business-to-consumer e-commerce sites, business-to-business e-commerce sites and consulting firms offering Web site design.

However, venture firms remain optimistic about network equipment, with investments in this segment more than doubling to $2.48 billion. Indeed, half of the third quarter's 10 largest deals were for fiber-optic equipment, while the other half were for Internet collocation facilities and service providers.

Fiber optics "is hotter than a pistol," says Kirk Walden, national director of PricewaterhouseCooper's MoneyTree survey. "When you're talking about laying fiber-optic cable or building a piece of optical equipment, you're talking about notably more money than you need for software or services."

Interest in a safe bet

Bill Collatos, co-founder and managing general partner with Spectrum Equity Investors, says venture firms are interested in Internet infrastructure start-ups such as fiber-optic and wireless companies because they seem like a safer bet than content or e-commerce providers.

"If you think of this entire space as a network . . . what you find is a lot of traffic always runs over the core, regardless of whether some small tributary of the network is slowing down," Collatos says. "There's more reliability in the infrastructure opportunities, in the hardware and software that actually manage the network."

With hot areas such as fiber optics picking up the slack for weak areas like e-commerce, Walden predicts that year-end figures will show network investments in 2000 being twice the amount made in 1999.

"We are sticking to our guns on the prediction that we made earlier this year . . . that overall venture capital investments are going to double to $70 billion in 2000, compared with $35 billion in 1999," Walden says, adding that the same trend will hold true for the network segment of the economy, which should reach $46 billion by year-end.

"We are slowing, methodically plateauing to a sustainable level of venture-capital investment," Waldden says. "But the bottom is not dropping out of this market."

However, the key statistics were down this quarter for network investments:

The number of deals dropped 9% from 960 in the second quarter to 870.

The average size of these deals declined 4% from $15.65 million to $15 million.

The largest deal of the quarter -- a $207.5 million investment in Internet data center operator Relera -- is about half the size of last quarter's $402 million investment in Carolina Broadband.

The 10 largest deals of the third quarter ranged from Relera's big prize to a $100 million investment in Chiaro Networks, a Richardson, Texas, start-up that's developing an optical router for Internet backbone carriers.

Fiber optic push

Investments in fiber-optic start-ups are expected to remain strong for the next few quarters because of several recent billion-dollar acquisitions by Nortel Networks and Cisco of companies building fiber-optic products.

"There used to be only a handful of players in fiber optics," says Tracy Lefteroff, managing partner of PricewaterhouseCoopers' Venture Capital Practice. "With the Internet deals slowing down, everyone wants in."

Lefteroff predicts the market for fiber-optic equipment will remain strong even though the stock values of most telecommunications carriers are down this fall, and big players such as AT&T and British Telecommunications are splitting up.

"The fiber-optics market is fundamentally more solid than many Internet investments," Lefteroff, says. "[Telephone companies] around the world are all going to modernize their systems [with] fiber optics because of the capacity advantage they can get."

That's what the folks at Chiaro Networks are banking on. Chiaro raised $100 million last quarter from 13 investment firms led by Polaris Venture Capital and Koor Corporate Venture Capital.

Chiaro is using this windfall to build a large Internet router that has an optical switch fabric and provides a large number of ports and fast speeds for backbone transmission systems. Chiaro plans to have beta-test systems available for customer trials next fall.

"The carriers and the market in general are still going to invest in infrastructure," says Ken Lewis, CEO of Chiaro. "The amount of Internet traffic is at least doubling every year . . . and that's a disruptive thing for carriers. If they don't keep up, they will lose to somebody else that has the capacity."

Lewis says Chiaro's router will let carriers provide a more reliable Internet infrastructure to corporate customers. He predicts the carrier market will remain strong for the next two years.

"One of the things that we're hearing from our customers is that the largest increases in capital expenditures will be for core routing and switching," Lewis says. "There's room for several core players."

Aerie Networks is focused on the same trend. A Denver wholesaler of fiber-optic bandwidth, Aerie raised $115 million last quarter from a group of investors that includes Vantage Point Venture Partners and Wolf Venture Fund. Aerie also raised debt financing to pay for its network rollout.

Aerie is using the money to build a 15,000-mile nationwide backbone network, with construction scheduled to start in December. Aerie will sell so-called dark fiber to backbone carriers as well as offer outsourced network operations services to corporations.

"The reasons we've attracted so much money are pretty simple," says Peter Geddis, CEO of Aerie Networks. "We have a very clear and focused business plan and a strategy that yields operating cash flow and profit in a relatively short period of time."

Geddis says Aerie benefits from earlier venture capital investments in last-mile technologies such as DSL and cable modems that are bringing broadband capabilities to the home and remote office.

"The backbone systems are not adequate aand don't offer an economic model to carry all that traffic," Geddis explains.

Although the 'Net's traffic patterns point to a fiber-optic future, not all fiber-optic start-ups will succeed, warns Cliff Higgerson, a general partner with ComVentures. He says the best opportunities may be for component suppliers rather than bandwidth or system suppliers.

"In the optics business, the value is as much in the components as in the systems. It looks more like the PC business where the value is in Intel, and Hewlett-Packard and Dell are glorified value-added distributors," Higgerson says.

In addition to fiber optics, venture firms also like wireless start-ups. For example, EveryPath, which provides Internet services over wireless devices and telephones, raised $70 million, and Ensemble Communications, which offers wireless broadband access, raised $63.8 million.

"We like both mobile and fixed wireless. We believe they both have enormous growth potential," Spectrum's Collatos says. "On the fixed side, the challenge is simply getting the networks built. On the mobile side, the challenge is getting the networks built but also getting the applications built that can use the network to the fullest capacity."

Higgerson favors carrier-grade wireless equipment, pointing out that the "infrastructure has to be dramatically upgraded for the carriers to be able to support mobile services."

Venture capitalists agree that investment in Internet infrastructure start-ups is good news for corporate IT managers.

"The long-term benefit is increasingly sophisticated networks with bigger pipes," Collatos says. "Enterprise customers are experiencing exponential growth in data distribution and consumption. They're looking to the future and saying: I'll forever need bigger and bigger pipes."

"Corporate users are going to be the big beneficiaries," Higgerson adds. "With more companies being formed, the level of competition goes up, which provides a combination of lower prices and higher-performing services."

This story, "Up-and-down quarter for network company investments" was originally published by Network World.

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