Venture capitalists form new rules for investing

TRENDS

By MEGHAN FULLER

While it is clear that last year's spending spree is becoming a distant memory, the current venture capital market remains a puzzle to many. On the one hand, several startups have changed direction or closed shop as their funding resources have evaporated. On the other hand, companies such as Santera Systems Inc. (Plano, TX) can still close $110 million funding rounds. Speaking at the recent Startup and Emerging Companies in Optical Communications Conference in Boston on August 13-14 sponsored by ElectroniCast Corp. (San Mateo, CA), several venture capitalists (VCs) listed the new rules for investing in today's environment.

The current landscape began to emerge in late 1999, according to Stephen Montgomery, ElectroniCast's president. Carriers who had deployed tremendous amounts of fiber during the boom of the previous five years realized network costs that far exceeded their revenue. A gap appeared between carriers' points of presence and potential subscribers, and by the fourth quarter of 2000, VCs were leery of funding this gap. Meanwhile, carriers were forced to cancel equipment orders, and equipment vendors canceled their component orders.

The resultant economic downturn has forced VCs to change their investment strategies, which makes raising capital a more arduous process for startups and emerging companies. According to the VCs on the August 13 panel, due diligence periods are now much longer, with potential investors conducting extensive background checks and often turning to key industry analysts and experts for advice.

The dynamic of the process has changed 180 degrees, asserted Thomas Smith, a partner at Mid Atlantic Venture Funds (Bethlehem, PA). In the past, the onus was placed on one partner to explain why a startup shouldn't receive funding. Today, the onus is placed on one partner to explain why a company should be funded.

Such statements beg the question: just what, exactly, are VCs and potential investors looking for? According to Michael DeRosa, vice president of Enertech Capital Partners (Wayne, PA), entrepreneurs should keep two things in mind when approaching VCs. First, he said, it is important to differentiate your company and product down to the minutest detail. Make clear distinctions between yourself and the competition, and be sure that your intellectual property is defensible. Second, today's venture capitalists place a premium on companies that already have some customer traction.

Smith agreed that customer validation is an important metric for his firm when deciding which companies to fund. Early customer involvement is critical, he asserted, for customers can help guide product development.

Practical, "must have" products that address an immediate need and are easy to manufacture stand a better chance in today's market, argued Smith. "Brave new world" technologies and products are increasingly relegated to the back burner, as startups are realizing that the world isn't as brave as it used to be, he added. Subra Narayan, vice president of Crescendo Ventures (Palo Alto, CA), stressed that companies should focus on one product line instead of working on multiple products. Do one thing, and do it well, he urged.

The panelists also argued that a good business strategy is just as important as a solid, marketable product. "Two years ago we were investing in technologies," explained Atul Madahar, vice president of Keystone Venture Capital (Philadelphia and Chicago). "Now, we're investing in businesses." A business is only as good as its weakest link, he asserted; therefore, good management is critical. He also stressed that startups should have addressable milestones for every round of funding. Narayan claimed that his company also likes to see a solid downside protection plan. New companies should try to create value in the event that they can't bring the products to market themselves.

Across the panel, the VCs agreed that they generally do not favor component-based companies over systems-based companies and vice versa. The bottom line, said Madahar, is to differentiate your end product in the eyes of your customers.

When asked which market segments are most exciting to potential investors, DeRosa cited 40-Gbit technology, polarization mode dispersion (PMD) and chromatic dispersion (CD), and automated manufacturing technologies. According to Madahar, the "fun areas" include OC-768 and new components based on off-the-shelf technologies.

Startups are taking such advice to heart. Among the emerging companies represented at the conference was Boston-based startup Twin Photon, whose founders are still looking for first-round funding to cover product development, patents and licensing, and administrative costs for the company's first 12 months. President and CEO Bill Wilson admitted that his startup faces a difficult challenge trying to attract the attention of VCs who may be distracted by the existing investments they've made in the past few years.

For their part, the folks at Twin Photon have done extensive surveys of the market, interviewing competitors, potential customers, network operators, and key industry analysts. They are focused on bringing to market optical characterization products and subsystems, an industry that could be worth more than $3 billion annually, according to a recent report from Salomon Smith Barney. The management team features several Boston University professors, whose research on twin or "entangled" photons will form the basis for the company's intellectual property.

The company's founders seem to have heeded the advice of VCs, and they hope to have funding in place by next month. While Wilson is optimistic that his company can attract potential investors, he is also realistic. After all, a cat that sits on a hot stove may never sit on a cold one again, he joked, causing scattered laughter in the conference room. But for startups that cannot attract the requisite funding, it's no laughing matter.

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