Investing in a start-up

Most people dream of investing in a successful start-up company. With visions of turning $1 into $100 or more, professional investors and venture capital firms flood the networking industry with hundreds of millions of dollars per year.

Cisco snaps up Granite Systems for $220M Network World, 9/9/96. Wireless start-ups draw heavy venture money A look at where the VC money went in Q1. Network World, 5/20/98.

But it's not just investors pouring money into these start-ups. IT managers also invest hundreds of millions of dollars in to start-ups each year - somebody is actually buying all the products these companies turn out (unless they're one of those lucky companies that gets bought up by Cisco before they ever actually ship anything).

Why do IT managers take a chance on a start-up? Unlike investors, they're not seeking out risks that could pay out big and quick. In fact, they don't like risk - they want for cost-effective, manageable products that help them in their core day-to-day business, ideally with continued support and room for future upgrades. Venture funds look for assets to appreciate; users purchase assets that will depreciate.

I bring this up because the increased pace of technology deployment, the increased amount of venture funding and the increased rush to remain competitive in networking industry have all resulted in users buying product sooner (and thus increasing their own risks) from emerging technology companies. Unfortunately, it has become increasingly difficult for the average end user to differentiate between the risky startup company and the promising startup company. Here are several reasons why:

1. Increased up-front funding. The amount of investment that start-ups get has increased from the $3 million to $5 million range in the 1980s to $7 million to $15 million today. At first, this seems that the start-ups are better supported financially, and so more likely to survive. But it's not always the case. Venture firms are increasingly looking for fewer, but bigger, investment opportunities. Second, the reality of today's technology market is such that it simply takes more money up front to get a startup going.

2. Seasoned management teams. Everybody likes to bet on a winning team, and venture funds are no exception. Users too like to purchase from proven winners - people that have delivered solid products for them in the past. But having "name" management is no guarantee. With their bank accounts secure from their first jobs, big-name execs might be more likely to depart a new start-up if problems develop.

3. Large initial product sales. It used to be that a start-up with a couple of large clients up front could use that as a momentum builder with smaller clients. Today, however, having only one or two major customers could spell serious trouble for the start-up if it loses one of them.

   Case in point: Dense Wave Division Multiplexing manufacturer Ciena Corp. While Ciena is not exactly a startup, it has emerged rather rapidly in a hot-growth market. Ciena saw its stock drop 45% last week when it announced AT&T would not become a customers - its current customer base is basically limited to just two other concerns (which account for 90% of its sales). The result? It now looks like the planned $7 billion acquisition of Ciena by Tellabs will be worth about zero.

So how should a user look to evaluate the risks of "investing" in a start-up vendor? I'd suggest starting with the following:

1. A diversified customer list. Look for those firms that have (or will have) a strong appeal to a large group of users and will likely not suffer if one or two clients become non-clients during the first few years.

2. Strength of funding. A press announcement that a firm has raised $5 million to $10 million means nothing unless you know just how far that funding will take them. If you're planning on a major purchase, one that will serve your network for several years, insist that the vendor disclose some level of detail about their funding (and spending) plans. Firms that won't disclose some level of detail (even under strict non-disclosure) should be viewed cautiously.

3. Diversified management team. Look for a mix of seasoned managers and hungry new blood (team members that are experienced, but still looking for their first big payoff).

4. Presence of competition. Only half of all start-ups are considered early to market, with the other half being late. Make sure you understand the general state of the market and don't get caught with a start-up that can't possibly carve out a niche in an already crowded market. Equally important, you may want to avoid firms that have no competition yet - as the market may not develop and the first players in any market tend to take the most arrows in the back (and can be leapt over technically by the second wave of startups).

5. Alternative products or technologies. One way to minimize risk with a startup is to make sure that there are alternate technologies that can be used as backup in the event that either the technology or startup fails.

In the end, it all comes down to how comfortable you are taking a risk on a start-up. Before any final decision is made, before any large dollar amount is committed to, talk to the vendor's management - and even some of its investors. If you don't like what you see, it's not worth taking the risk. Leave the risk to the venture funds (who by the way fund a whole lot of second-rate startups just to find that one big "next Cisco" winner).