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Venture funding continues its slide

By John Fontana
Network World, 08/20/01

Network start-ups are bearing the largest brunt of the continued drop in overall venture capital investing, according to a new survey.

The $4.7 billion invested in 423 network companies in the second quarter was down 35% from the $7.3 billion put into 527 companies in the first quarter. This drop accounted for nearly the entire decline in venture capital investments for the quarter across all industries.

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The funding total represented the lowest amount since the first quarter of 1999, and the number of companies invested in was the fewest since the fourth quarter of 1998.

These findings are part of a special analysis of the PricewaterhouseCoopers and VentureOne Money Tree Survey conducted exclusively for Network World.

"This is a normal contraction after a very, very hot period," says Tracy Lefteroff, global managing partner of the venture capital practice at PricewaterhouseCoopers. "We are still above historical levels. The start-ups that survive will be strong and will be a solid base for the next step of growth."

Funding is shrinking as venture capitalists - bruised or worse as a result of the Internet and telecom busts - take more time to evaluate the business plans and revenue potential of start-ups.

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The falloff in network industry funding hit all sectors, including business services, software and hardware. The most dramatic investment hit was taken in fiber optics/photonics, where investment plummeted $800 million from the previous quarter.

Still, observers are optimistic about the industry turning around.

"Fiber optics and photonics, those areas are still very positive and a lot of people still look to that as the future of the whole communications and networking section," Lefteroff says.

"In the short term we are reaching saturation, but in the long term venture capitalists think this is an area where there will be a lot of big winners, " he says. " A lot of long-distance carriers need to overhaul fairly antiquated systems, and it will be the suppliers of those products that are going to benefit in the long term."

Gus Tai, general partner for Trinity Ventures, says there isn't one hot area but that there are good areas, including security, user and access management, storage and wireless.

"What we are looking for are opportunities that address some pain point in the enterprise but that don't require big budget dollars for IT to roll out," Tai says. "We see that enterprises are looking for products that improve what they already have."

The top deal of the quarter was the $115 million second round of financing for managed data storage services vendor Sanrise, though others, such as Celox Networks, also fared well.

"Our focus on Tier 1 carriers is one of the reasons we were able to get such a large round of funding during this downturn," says John Rogers, CTO for Celox, which secured $80 million to fund its IP services creation switch business.

Rogers says the company has remained attractive to investors because it avoided the pitfalls of branching out into the now-struggling competitive local exchange carrier market.

"We are seeing a flight to quality among the venture capitalists," Rogers says. But he adds it also is getting harder to move to later rounds of funding where companies must show a competitive market position and the potential to generate revenue. "We spent three times the effort to get our third round of funding as opposed to the other two," he says.

Top 10 deals for Q2 Unlike in Q1, when nine of the top 10 deals were each worth $100 million or more, only one Q2 deal hit that mark.
1.	Sanrise Dublin, Calif. $115 million Managed data storage services.	6.	CopperCom Boca Raton, Fla. $65 million Products that let local exchange carriers offer new services.
2.	Celox Networks Southborough, Mass. $80 million IP services creation switch.	7.	2Wire San Jose, Calif. $65 million Broadband products and services for residential market.
3.	Luminous Networks Cupertino, Calif. $80 million Gigabit IP-over-fiber optical access switch.	8.	Broadslate Networks Charlottesville, Va. $60 million DSL-based Internet access for small and midsize companies.
4.	Diveo Broadband Washington, D.C. $78 million Facilities-based Internet infrastructure.	9.	Movaz Networks Norcross, Ga. $52 million End-to-end optical products.
5.	General Bandwidth Austin, Texas $66 million Telecommunications equipment for voice infrastructure.	10.	TrinTel Communications Irving, Texas $50.3 million Site development, tower construction for wireless service providers.

Whereas companies in recent years have typically collected two or three rounds of funding before going public or getting bought, the survey identified several that were on their fifth or sixth round as venture capitalists looked to pay for actual performance. The number of seed and first-round deals was down about 50% from the first to second quarter.

Looking ahead, PricewaterhouseCoopers' Lefteroff says the third quarter is likely to be flat or down compared with the second quarter. "I don't see the activity picking up until the first quarter of next year," he says.

But overall, investing this year is forecast to be well above historical norms represented in 1998, when $10.7 billion in investments was the yearly record to date. The total for 2001 to date is $12.1 billion, and is expected to hit $30 billion by year-end.