Most startups will not start

Despite all the venture capital floating around, we don't expect even 20% of startups to get to the public market.

BY KEVIN SLOCUM AND ROBERT MANDRA

Last month, we mentioned that if the correction in optical communications stocks in 2000 meant anything, it was that investors were going to have to buckle down and get to know their companies better. We also mentioned that the days of near-overnight tenfold returns were probably over. By coincidence, only a couple of weeks later, we found ourselves out visiting several venture capitalists that had made several investments in the sector over the past two years. Their comments were interesting. Clearly, the expectation that things had changed was etched in their minds. The biggest issue we heard was that the same reality of a more normal venture-capital lifecycle and the valuations that should accompany that longer path to success had not sunk in with startup companies.

The week after our return, the record one-day rebound by the NASDAQ occurred and the sector staged a strong rebound. While the gains only erased the prior three weeks of losses, we worried that with too hasty a comeback, nothing healthy would have come from the correction. There are still important risks to the optical communications opportunity.

One of the biggest, and the one where we believe a lot of money will be squandered over the next few years, is in the venture investment arena. Wit SoundView is attempting to track over 200 startups today. Given our modest size, we are probably not doing an extraordinary job on that count. There are easily over a hundred others that have not hit our radar screen as hard as maybe they should have because we are not staffed to reach them. We do not believe that even 20% have much of a chance of success from the standpoint of getting to the public market. Maybe another 20% can be sold for intellectual property that might advance the prospects of the cadre of public companies. That leaves 60%. Amazingly, many of these companies are teeing up private deals that are larger than many companies raise in an initial public offering.

Last year, virtually every mutual-fund complex we deal with entered the venture investment market. Most professionals charged with deciding what opportunities to pursue have great judgment about management talent; however, very few have any background in the technology of optical communications. That may have been plausible with semiconductors, electronic systems, and software, but we believe it is a formula for disaster in the photonics market. The successes of the past few years have been based on developments of the past 10 years. Many of the emerging opportunities facing private investment fund managers today involve delivering solutions in materials and manners that have already tried and failed.

The other interesting aspect is that up until recently, there has been such a hunger to have investment exposure in the area that too much money has been chasing the available pool of ideas, no matter how numerous we may tell you they are. That has put pressure on many of the money suppliers to make speedy and less informed decisions than they have been comfortable making.

By the time you read this column, the Federal Reserve Board's actions may have erased some of the bad memories of the fall of 2000. And we hope not because important lessons should have been learned. We believe it is important that a more balanced relationship between investors and entrepreneurs returns to the photonics sector. The advances that are necessary to make optical communications the pervasive bandwidth-enabling technology that it can be will require more time and understanding by all parties than what we have been treated to since 1998.

In that vein, we will make a few general observations. At the broadest level, we believe that the era of huge windfalls in capacity plays is over. The best example of what we mean by that can be summed up in what happened to E-Tek Dynamics. We haven't spent time looking at other investments to see where venture backers may have done better, but management and their sole venture investor, Summit Partners, could not have played the optical-component shortage environment any better.

Not only did Summit make their largest investment in the firm's history, but it hardly sold any of its position until after the sale to JDS Uniphase. Senior management even exercised positions early and sold much later in the process of the market understanding the shortage dynamics that overhung the vendor community. Perfect environment and perfect execution on a capacity shortage.

Other companies such as Optical Coating Laboratory, Avanex, Oplink, New Focus, and Alliance Fiber Optics attempted and, to varying degrees, succeeded in what we believe are only moderately differentiated capacity plays. We believe it gets much harder for this type of story to get valuations different than a price earning multiple that is near their expected growth. For many, we believe the best option may actually be to consider selling to companies with a more unique vision of where they are headed that also calls for the technology of the seller. Good execution should produce respectable investment performance, but if you are looking for anything like we witnessed in 1999 and early 2000, our guess is that particular period is over.

There are other concerns we harbor, as well. At the top of the list is metro DWDM. There are more boxes being built to attack this market than we care to think about. All claim important differences, but most seem to be built in hopes of possibly achieving that fortunate combination of features and functions that captures the customer's imagination and takes off. There are too many box suppliers and too amorphous an understanding of what will be necessary to address the market opportunity. In our view, a very limited number have a chance of going public and even fewer have any chance of being sold for the merits of their proprietary design features. The balance will go away.

The "all-optical switch" is another opportunity we question. Over 30 companies are developing some sort of micro-electromechanical systems (MEMS) concept that either aims to be the all-optical switch fabric or the switch itself. We would rather have money invested in the switch-fabric side of the ledger, but even there, we feel there is quite a crowd with the chances of standalone success modest and a fair number of captive bets already made. We worry for those headed down this path that the semiconductor industry will be able to make substantial strides in performance that delay a substantial move to all-optical technology for longer than many believe. Even if we are wrong, there are an awful lot of companies pursuing the opportunity.

Kevin Slocum is a managing director and communications research analyst for Wit SoundView (Stamford, CT). He has more than 18 years of financial industry experience, including equity research, sales, and analysis. He can be reached at (203) 462-7219 or kslocum@witsoundviewcom.