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Networkers seek survival strategy as cash thins

Networking component start-ups were one of the last safe havens for venture capitalists as the economy sputtered, but now the future is less certain.

BURLINGAME, Calif.--Networking component start-ups were one of the last safe havens for venture capitalists as the economy sputtered, but now the future is less certain.

Start-up component makers, which cater to equipment giants such as Cisco Systems and Nortel Networks, received huge amounts of cash last year. Venture capitalists felt that this sector, with its growth prospects, was a safe place to invest while other technology industries struggled.

This networking start-up niche includes little-known companies with names such as Genoa, CyOptics and Agility Communications, among hundreds of others. More than $6 billion was invested in optical-related equipment companies and component start-ups in 2000 alone, according to VentureOne.

But with the telecommunications boom gone bust, as evidenced by Cisco being forced to swallow $2.5 billion in components inventory this week, the future is less certain for the market. And with giants such as Cisco falling on tough times, smaller companies are truly beginning to sweat.

Trillions of dollars have evaporated during the economic downturn so far, according to venture capitalists. For private companies with little cash, the game has changed from one of strategy to one of survival.

VCs say optical and networking component companies without money--and a viable product--will find they are up against tough times.

"It's no longer a question of first to market; it's first to money," said Richard Prytula, president and managing partner of TechnoCap, a $250 million fund based in Canada.

Companies big and small gathered at the Next Generation Networks Ventures here this week to seek that cash grail from newly conservative venture capitalists.

"There has never been a more challenging time in our industry to make informed business decisions," said John McQuillan, president of McQuillan Ventures. "An event of this magnitude does change everything."

Take it where you can get it
Prytula advises tech entrepreneurs to take any amount of funding under any terms because the heyday when start-ups could dictate terms have gone, and they are not coming back.

Component makers must also figure out their place in the market--if they do not know it already--because they're part of a food chain that goes from the equipment makers to the carriers, analysts said.

Richard Parry, chief technology officer at networking equipment maker Sycamore Networks, believes component makers must always keep in mind that their products will ultimately be influenced by the design of communications networks built by the carriers.

see Special Report: Assessing the carnage A company might have a great product that will go nowhere if it does not fit into the network architecture of the future. "The downturn will hinder start-ups that do not have a clear understanding of the application of their technology innovation," said Roderick Randall, general partner at St. Paul Venture Capital.

This makes investing in components a risky proposition because component makers must satisfy the equipment makers, which must then satisfy the carriers. Such a long food chain separates the component start-ups from the end customer and resigns them to a less profitable business.

But others see things differently. "I like selling bullets to the warring parties," said Bob Pavey, a general partner at VC firm Morgenthaler. "If these guys are going to shoot each other, that's fine as long as they use our bullets."

Opportunities still abound
Pavey is betting that significant component innovations will find a niche at this stage in the optical industry's development.

Of the 20 communications companies Morgenthaler invested in within the past three years, Pavey says about two-thirds were component makers. Pavey says his firm will most likely invest in more equipment makers in the future, but he thinks the component makers will play a large role in determining the evolution of communications networks, much like semiconductor component makers in the 1970s.

Carriers have laid miles of fiber-optic cable that remain unused because of the high cost of the equipment needed to light the fiber. Component makers that can help equipment makers--and ultimately the carriers--increase the efficiency of their networks or dramatically slash operating costs will find a following.

"There will be less funding of stuff that's incremental," said Rick Gold, CEO of optical start-up Genoa. "Who wants to be the 15th guy with a me-too solution in a market that's not capacity constrained anymore?"

The task for industry executives, engineers and VCs is to figure out the technologies that will win out, which is still very unclear.

But VCs will continue to put their chips on the table. Bruce Sachs, a partner at Charles River Ventures, which has $2 billion under management, likens the optical communications industry to the early days of the car industry when a wave of car companies entered a war, and only a few survived.

Sachs points out that just because hundreds of start-ups with limited prospects saturate the market does not mean there are no opportunities.

VCs will most likely spread their bets and wait to take advantage of the final winners because investing in this climate can resemble prospecting for oil wells.

"At some point we'll know where the oil wells are, and we'll cluster around them," said Andy Rappaport, a Partner at August Capital. "But for now we'll drill a well here and drill a well there and reassess in the future."