Posted 10/01/2001

Survival of the Fittest
Vendor Startups Decline But Cash Abounds for Winning Ideas

By Paula Bernier

Technological innovation is a beacon to investors in the now-cloudy tech sector environment. Even as startups fail and stalwart vendors struggle, significant funding is available for equipment vendors that can persuade wary investors their products are unique and their business plans hold water.

In essence, it's "survival of the fittest" telecom style.

"Probably companies that are getting started and getting funded now are in very good shape because it's [tough] getting funding in this market," says Irfan Ali, president of CommWorks Corp. He says it typically takes about 18 months for a vendor to get its initial product out, so the telecom economy could improve by then.

Not long ago, venture capitalists seemed to be handing cash to just about anyone with a business plan. As a result, the true innovators found themselves surrounded by copycats.

"My guess is the number of companies that copy others will slow down," says Vivek Ragavan, the new president and CEO at Atrica Inc., who previously served as CEO of Redback Networks Inc.

With fewer new copycats getting funded, struggling startups falling by the wayside and larger vendors focused on internal streamlining and maximizing profits, many industry watchers believe vendors, in the near future, will take a harder look at any M&A activity.

Hilary Mine, executive vice president at Probe Research Inc., expects vendor mergers and acquisitions this year to be based more on specific business requirements, such as meeting a certain customers' needs. That wasn't always true of mergers during the boom years.

"Vendors were getting a lot of bad advice," Mine says. "[Some analysts were] advising companies to buy other companies, even [those] without products, for greatly overpriced prices. Most of the major vendors paid billions of dollars for companies they couldn't even get a product out of."

Tom Nolle, president of consulting firm CIMI Corp., doesn't buy the conspiracy theorists' line about big vendors buying startups just to kill what looked like promising technology. He does say that many acquisitions in recent years were speculative and didn't result in significant new lines of business for the companies that did the buying.

Of course, one of the most recent examples of that is Lucent Technologies Inc.'s acquisition of Chromatis Networks. After laying out $4.5 billion for the Israeli firm last spring, Lucent late this summer fired the 150 Chromatis employees and said it was pulling the plug on the Chromatis MSX product, which Lucent spokesman Ray Zardetto describes as product that aggregates voice and data traffic onto metro optical links.

Lucent instead will focus its metro optical networking efforts around its Metro EON DWDM and Metropolis DMX metro SONET products, which handle data and voice, respectively, says Zardetto, adding those are the products customers are asking for.

While Zardetto concedes that the price tag Lucent paid for Chromatis was signficant, he explains "as we go through the restructuring process, we have to make some tough decisions." Expenses related to the shutdown of Chromatis are part of the $7 billion to $9 billion writedown for the fourth fiscal quarter that ended Sept 30, which Lucent already had announced, adds Zardetto.

Another prime example is Cisco Systems Inc.'s acquisition of optical switch vendor Monterey Networks Inc. in September of 1999, a competitor of still-independent Sycamore Networks Inc.

"I think Cisco bought Monterey as a hedge that there would be a play, and there wasn't," Nolle says. "Large companies, instead of waiting for a startup to prove itself, start buying on the rumor. So you end up with more acquisitions that don't play out. There have been a lot more deals that didn't pan out than those that did."

Other examples of disappointing returns on acquisitions include Marconi Corp. plc's (then General Electric Company plc) purchase of Fore Systems Inc. and Lucent Technologies Inc.'s absorption of terabit router player Nexabit Networks, he says.

Nolle notes Cisco was the most speculative buyer among the big telecom/data vendors. The company tended to acquire companies earlier, says Nolle. "You don't make conservative investments when you are a speculative player yourself," he adds.

Having completed dozens of acquisitions in 1999 and 2000, Cisco so far this year has announced only two such deals. Of course, companies like Cisco, Lucent and Nortel Networks Ltd. that did much of the acquiring in the past couple years are less interested in M&A today, because they now are forced to focus on the bottom lines of their core businesses. They no longer have the buying power that high-flying stock prices once gave them. And an accounting rule change that went into effect this year, related to asset pooling, also has dampened interest in acquisitions, says Mine and Nolle.

Basically, asset pooling had enabled larger companies to bring up their P/E [price to earnings] ratios by acquiring smaller companies with larger P/E ratios, explains Nolle.

With those factors in mind, it's likely that most of the innovation from these large players in the immediate future will be homegrown. These companies' research and development budgets (even if cut due to current business realities) dwarf R&D at startups. The large vendors also tend to preserve financially viable markets until the threat of competitors breaks the log jam, says Nolle.

While smaller vendors will continue to offer that challenge, the outlook also has changed significantly for startups. Getting rich quick -- by being acquired by a larger vendor or going public -- was the apparent mission at many start-ups. There are now few prospects of being acquired; anemic tech stock valuations; and a capital market that has become extremely skeptical of the sector.

Still, most small companies in the equipment space either will fail or will be acquired by one of the larger players with bigger pockets and better distribution and marketing channels, Nolle says.

"Most startups were not started up to ever survive, they were started up to be flipped," he says, "It's called the burger phenomenon."

Everyone is looking for core markets with great growth potential, says Janey Hoe, director of business development at Cisco, whose acquisitions this year consisted of 10gigabit metro silicon vendor AuroraNetics Inc. and VPN company Allegro Systems Inc.

"The rationale behind those two deals is similar to the rationale of all the other acquisitions we do," Hoe says. "What we do is focus on key markets that will be explosive -- storage networking, optical, wireless."

CIMI has identified three service provider equipment markets it considers to be strong going forward and in which startups are key players:

• Fiber remote, which includes next generation digital loop carrier/DSL type products, with Alcatel and Marconi being the incumbent vendors in this space;

• Service switches, in which Aplion Networks Inc. appears to be alone;

• And, service management software, in which CPLANE Inc., Mantra, Syndesis Ltd. and Trendium Inc. are the four players.

Probe's Mine says, "this year anything with the word Ethernet has been very popular." Products that bring quality of service to the Internet, making the "best effort" network more predictable, and the mobility market still are considered attractive, she says.

As evidence of that, Integral Access Inc., which describes itself as an intelligent MPLS access company, recently secured $45 million in a fourth round of financing. Meanwhile, Celox Networks Inc., an edge aggregation and IP service switch company, raised $80 million in a third round of funding.

Even the hard-hit packet voice arena is attracting money. Voice over DSL vendor CopperCom Inc. just received $65 million and General Bandwidth Inc. recently announced the completion of $66 million in additional funding.

Although significant money still is rolling in from the capital markets, Hugh Kelly, Celox Networks' senior vice president of marketing and business development, says it's not easy to win investors.

"The investor today takes an extraordinarily deep look at you, your technology, your business plan," he says. Kelly says he's heard of deals being done in a week. But for Celox Networks, due diligence for its most recent round of funding took more than six weeks. "If they (venture capitalists) take more time, they can't do as many deals," says Kelly.

Although funding continues to roll in for Celox and others, CIMI's Nolle says most of the money coming in is for vendors in subsequent rounds of raising financing. "There's not a whole lot of money going into new ventures right now," he says.

Even those companies that manage to garner initial or additional funding, however, are probably going to innovate at a slower rate than in the recent past.

"Acceleration of innovation within these companies won't happen as fast because these companies will have less money," says Joe Kowalczyk, vice president and chief financial officer for Integral Access.

But that innovation will be more meaningful, adds Kelly of Celox Networks. "In a more rational market customers won't buy things if there are small improvements in small time cycles," he says. "Now carriers are buying more slowly and incrementally."