As market grows, so does VC interest

By most standards, the optical communications market shows renewed life. Besides the immediate benefits of increased revenues, the increased health of the space should improve the industry’s strained relationship with the financial community. Some public companies already have seen a bounce in their stock prices. For companies who are still positioning themselves for an initial public offering (IPO) or some other exit for their bedraggled investors, the relationship with venture capitalists (VCs) and other sources of capital is of more immediate concern. On a scale of 1 to 10, with 10 being a return to bubble euphoria and 1 being “I’d rather set my money on fire-it would be a more efficient way of getting rid of it,” how do the VCs view the market? Conversations with financiers and company executives who recently have sought funding reveal that the answer depends on the part of the optical communications market in which a company operates and how far along on its path to profitability it has come.

Sources in the financial community appear aware of optical communications’ improved fundamentals. But a lingering skepticism remains, particularly when talking about the components space. Asked to evaluate the market based on the 1-to-10 scale outlined above, Morganthaler Ventures (www.morganthaler.com) General Partner Drew Lanza responds, “It’s probably a 5 or a 6 in the systems side of the space. And it’s probably a 2 or a 3 on the components side of the space. And it’s probably a 0 in the carrier side of the space.”

“Probably like a 3 or a 4,” replies another investment manager, who prefers to remain anonymous. “I think anything in the optical component space is still really challenging. There are still too many companies going after too few opportunities.”

That said, both sources say those relatively low numbers represent improvement from confidence levels 12 months ago. “The systems side is pretty straightforward. There are some survivors, companies that were started before the crash, that have done very well,” explains Lanza. He cites Calix, Force10 Networks (in which Morganthaler has a stake), and Infinera as burgeoning success stories, which he describes as companies that have achieved $100 million to $200 million in annual revenues and that could be in position for an IPO in the next 12 to 24 months. “Those are real companies, man,” he says.

Systems houses have benefited from an overall increase in carrier spending, a combination of capital expenditures recovering from what Lanza calls “a steep depression or recession” as well as a change in how carriers view their infrastructure requirements. “The shift to Ethernet services has kind of woken up a lot of carriers,” he adds.

Improvements in the components space have come via a trickle down from the improved prosperity of the systems houses as well as consolidation, Lanza feels. Still, the components community faces continued pressures. The other VC contacted for this story believes that components and subsystem companies have found themselves saddled with the extra burden of doing R&D that the systems companies would have performed before they shed engineers. “The optical component vendors still in my opinion are not able to recoup the cost of that R&D required to keep pace with the innovation that the industry requires,” the VC says.

Executives who have gone to the financial markets in search of new investors report that VCs no longer brandish crosses and drape their doors with garlic when they hear the words “optical communications.” Still, the reception one receives often depends on the financier’s previous experience with optical communications.

BTI Photonics (www.btiphotonics.com) announced in January that it had closed $12.25 million in Series C funding. Approximately 60% of this round came from new investors BDC Venture Capital and GrowthWorks Canadian Fund, reports company president and chief executive officer Lance Laking.

“It’s always an ambition of mine to bring in a new investor,” Laking explains. “It certainly helps in terms of private equity metrics, setting valuations, and building a stronger confidence factor around the investor base in that there’s a continuing, objective, fresh set of investor eyes and ears that are interested in the company.”

Laking wanted new investors who knew something about the markets in which BTI Photonics participates. However, large VC firms with existing positions in the optical communications market proved hard to interest. “The investors who were very active and got badly burned in the previous wave of 1998 to 2001, those investors in my opinion are still quite gun-shy entertaining new investments in optical,” he says. “A lot of them have existing portfolio companies that are being supported. But the appetite to entertain new investments in optical is still a pretty difficult sell.”

A company executive from an optical subsystems vendor whose most recent round of funding had not been announced at press time says there is one condition that piques the interest of such heavily leveraged financial companies. “What we found was that most larger VCs had already significant investments in the optical space,” the executive relates. “So their interest wasn’t so much in investing in another optical company; it was more in bringing other companies together [with us]. Saying, ‘Well, you know, I have invested in Company X, I like what I hear from [you]-why don’t you guys come together and we’ll give you another $5 or $10 or $15 million?’ That was probably 80% or 90% of the scenarios I came across.”

Laking finds this sentiment familiar. “Consolidation is always one option to kick-start a liquidity path,” he agrees. “That was certainly a discussion in one or two occasions, but it wasn’t prevalent for us.”

Laking says that his desire for Series C funding, coupled with a demonstrated track record of revenue and customer traction, helped significantly in conversations. “Very much, the conditions today are around capital efficiency and a fairly pronounced amount of market success and customer engagement. It’s never not been a condition, but the barriers are as high as ever now,” he explains. “I think that a lot of companies that haven’t seen the traditional four- to six- or four- to seven-year turn time for an investment are starting to feel that pain of carrying some of the 1998 vintage investments without exit. So by the law of averages, I guess, if they can get into some later-stage deals now and see some exits in the next couple years, that helps their overall portfolio.”

Lanza and the anonymous VC source both report that they are looking at more opportunities with established companies. “The bulk of the ones I see are companies that already exist, that have had a couple of rounds of funding,” Lanza says. “It’s very unusual to see a brand new optical component company.”

This may be because of the difficulties the current environment present to startups. “I think it’s a totally different equation for those companies that are going out for early stage and Series A money. They face a tougher barrier to entry to VC money than ever before,” Laking theorizes.

However, Laking believes that overall the prospects for funding will continue to improve. “I predict that there will be a return. And the investors that have been participating in the last 6 or 12 months I think are ones that have really been able to lock in some sweet deals. The space is definitely heating up, and I’m extremely optimistic on both the prospects of optical networking space and the prospects for BTI, that’s for sure.”

Laking may be right. The anonymous VC reveals that he’s just made a new investment in an optical communications company. “Frankly, it was something that I would not have even remotely thought I would have invested in 6 months ago or 12 months ago,” he admits.

For his part, Lanza says he’s still looking as well. “I’m game-I’m open-minded,” he asserts.

“It’s nice to see after a couple of tough years where it was maybe the better strategy to keep your head down in 2002 and 2003,” Laking concludes. “It’s very much now a time to go and get it.”

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