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Boom times ahead in networking?

After a dismal couple of years, networking start-ups are coming back, but the rising tide of venture funding isn't lifting all boats.

Jonathan Reeves, a three-time start-up founder, says it's a good time to be an entrepreneur.

When Reeves went looking for a second round of funding earlier this year for his current company, a telecommunications equipment maker called Mangrove Systems, he landed $21 million, bringing the total capital raised to $42 million. And more than six months after it closed its latest round of funding, new investors are still trying to give the company money, he said.

"It's not so easy for everyone," Reeves said. "But for the start-ups with solid teams who have done this before and who have a strong business plan, there's plenty of money available, and no short supply of people trying to invest it."

Venture capitalists and entrepreneurs agree that the technology start-up market has come back to life during the past year. Valuations for top-tier companies are on the rise and large companies, particularly big networking equipment makers such as Cisco Systems and Juniper Networks, are once again shopping for good acquisitions.

Cisco, traditionally one of the most prolific acquirers in all of tech, bought nine companies in the first half of 2005, including Wi-Fi switching player Airespace, for which it paid $450 million. It's continuing a buying spree that started the year before, when it bought 13 companies--up from just four the year before.

The Cisco indicator
"Our overall acquisition strategy has not changed," Cisco CEO John Chambers said during the company's fiscal fourth quarter conference call with analysts and investors in late July. "There's no magical number. It's more opportunistic. We still prefer small acquisitions with geographic proximity, usually a private company with about 100 employees."

That Cisco is comfortably back in acquisition mode should make entrepreneurs think about taking the plunge into networking and communications, say venture capitalists.

"Cisco is a good indicator of the market in terms of creating a belief set that there will be light of end of tunnel," said Steve Baloff, a general partner at the venture capital firm Advanced Technology Ventures. "You can see things are getting better. The quality of opportunities has gotten noticeably better and the venture capital community is responding."

That exuberance is not yet showing up in overall venture capital data, however. Venture capitalists invested $811 million in 91 networking start-ups, and $926 million in 114 communications start-ups in the first half of this year, according to a PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association Money Tree survey. That's about on par with investment last year.

Nonetheless, a research report that was set to be released Monday by the research firm The Carmel Group predicts substantial growth in California's communications sector thanks to increasing interest in so-called convergence technologies such as Voice over Internet Protocol, or VoIP. In California alone, the report predicts $5 billion to $7 billion in venture capital will be invested in the sector over the next three years.

Reeves, a veteran who should know a good start-up environment when he sees it, says the anecdotal evidence is already there. He has been through the start-up game twice in the last decade with companies that together sold for more than $3 billion. He founded his first, Sahara Networks, in 1995. Two years later, he sold the company to Cascade Communications, which later became a part of Lucent Technologies, for $216.5 million in stock.

In 1999, Reeves was back at it with Sirocco, a company that developed optical-edge switches used in building telephone and Internet carrier networks. After only 18 months, the company was bought by Sycamore Networks for $2.9 billion.

Reeves' current start-up, Mangrove Systems, would have been dead on arrival four years ago, after the telecommunications industry collapsed.

It's a different story now.

With venture capital flowing, the value pegged to hot start-ups is jumping. Valuations on second-round investments for highly sought-after start-ups have gone from a range of $10 million to $15 million several years ago to $25 million to $30 million today, said Venky Ganesan, a managing partner at Globespan Capital Partners. Valuations have also doubled for third-round investments, going from $35 million and $40 million two years ago to $70 million and $80 million today, he said.

"It's different from five years ago, when nothing more than a PowerPoint presentation could get you a million dollars. That won't even get you in the door nowadays."
--Kirk Wallden, national director of venture capital research, PricewaterhouseCoopers.

But the rising tide has not lifted all boats. In aggregate, valuations have remained flat from a year ago, according to the Money Tree survey.

"VCs are looking for some assurance that the company will make it," said Kirk Walden, national director of venture capital research at PricewaterhouseCoopers. "It's different from five years ago, when nothing more than a PowerPoint presentation could get you a million dollars. That won't even get you in the door nowadays."

Venture capitalists and entrepreneurs naturally are happy about the rising valuations. But big acquirers like Cisco say they are worried that some deals are getting too expensive.

"We've definitely seen valuations on top start-ups go up substantially in the past 12 months," said Ned Hooper, vice president of corporate business development for Cisco. "Both as an investor and acquirer that's disturbing to us. Maintaining rational valuations is critical. If they're too high we just won't do the deal."

IPO or M&A?
While it's always been true that start-ups have a better chance of getting acquired by a company than having an initial public offering, the trend toward acquisitions is even more pronounced today.

"Today, it's much more realistic for a start-up to get acquired or partner with a larger player than to go public," Reeves said. "It's very difficult to have an IPO these days, so I think we'll see a lot more acquisitions in the next 12 months."

One of the biggest deterrents for small companies with IPO aspirations is the 3-year-old Sarbanes-Oxley Act, which requires publicly traded companies to include in their annual reports a review of the company's internal control over financial reporting, and a related auditor's rundown. The cost for complying with the law is expensive, anywhere from $1 million to $4 million annually, say experts.

Smaller companies also face tough scrutiny from bankers who favor larger companies.

"Being a public company is not a thrill these days unless you have a predictable revenue stream," Baloff said. "The economics in the banking world have changed and bankers don't make the same fees on companies with market capitalizations under $200 million that they used to. So these smaller companies suffer from a lack of trading volume."

Despite these hurdles, CEOs of start-ups say they're still thinking big.

"Companies that are building themselves to be bought by another company are destined to be small," said Selina Lo, president and chief executive of a home networking company called Ruckus Wireless. "You get what you wish for. And if you're not going to try to build a sustainable business, why bother building a company in the first place?"

Cisco executives agree that they aren't interested in companies that are deliberately on a quest to be bought.

"The most interesting companies to us today are ones with strong sustainable business models, good revenue run rates and sales channels" said Hooper. "These also happen to be the same attributes that are necessary for companies going for an IPO."