Internet, 12/27/99

The Internet: influence most powerful

Industry experts keep trying to position the Ciscos, Lucents and Nortel Networks of the network industry as the last, unseatable emperors, and the market keeps proving them wrong. As an incredible round of initial public offerings (IPO) by network vendors in the last six months clearly shows, the Internet economy isn't just about dot-com ventures gaining astronomical valuations through what looks suspiciously like smoke and mirrors.

Even in the network infrastructure market, start-ups have never had it so good.

Look at the extraordinarily successful IPOs of network product companies such as Juniper Networks and Copper Mountain Networks, for example. Juniper, which makes Internet backbone routers, closed its first day of trading at $97.88 per share, or 188% over the $34 offering price. Copper Mountain, which makes digital subscriber line (DSL) products, closed its offering day at $68.44, or 226% over its $21 asking price.

What is the Internet economy bringing to late '90s network companies that counterparts formed earlier this decade or before didn't benefit from? For one, it levels the playing field by imposing standards and providing easy access to markets and resources. That increasing competitiveness, in turn, speeds the rate of innovation and gives greater advantages to nimble start-ups. Now, established players use start-ups as external laboratories, often providing seed money, and buying them outright if they succeed.

In fact, within the big companies, it's getting harder and harder to distinguish R&D from M&A.

"It's a natural cycle, and it's a very positive thing," says Jim Flach, a partner at Accel Partners, a venture capital firm in Palo Alto. Start-ups have ultrasharp focus and complete dedication, and they spend a much higher percentage of their total budgets on R&D. Once they have products, they get bought and leverage the distribution power of the acquiring company.

"The big company gets the product and technology and - for a short time - the people. Then the people move on and start the next new thing," Flach adds. The result is that new technology makes its way into the market much faster.Brain drainThis trend feeds upon itself as start-ups become rallying points for the best and brightest. Cream-of-the-crop college graduates no longer set their sights on the big names in networking. Today, they want to help create a hot start-up and become the next Marc Andreessen.

In Cisco's salad days, start-ups had to earn their valuation the hard way, by racking up several quarters of solid earnings before going public. The company got its start when Sequoia Capital gave it $2.5 million - a whopping sum in the mid '80s but mere pocket change these days. Its IPO produced a market cap of $225 million, but Cisco didn't go public until it had achieved $6.1 million in cumulative profit for the previous four quarters.

"Today, capital markets are willing to finance companies that are still losing money, as long as they are growing fast and going after big markets," says Amnon Shohan, principal partner with Cedar Fund, a venture capital firm in Tel Aviv. "Valuation is based on revenue growth, not earnings per share. And because Wall Street is rewarding start-ups the way it is, start-ups can attract the best talent."

The result is a brain drain that is making big companies distribution-rich and product-poor. "That's why the bulk of the new products the big guys have been introducing lately are the result of acquisitions," Flach says.

Traditional network companies are also hindered by the large installed bases they've spent years cultivating, for in the Internet economy, a big installed base is very much a mixed blessing. While one can help buffer an established player from rapid change, it also can create some disadvantages for economies of scale.

"The big companies have customers they have to bring along, and product trajectories that can be difficult to revector," says Russ Siegelman, a partner with venture capitalist star Kleiner Perkins Caulfield & Byers in Menlo Park, Calif. While start-ups have only windshields, larger companies have much bigger rear-view mirrors, which they are constantly checking. They have less time to look at where they are going and respond to market changes. They also face new R&D challenges.

"Large groups of people have two problems: They don't move fast, and they can't innovate," says Cliff Higgerson, a partner with ComVentures, a venture capital firm in Palo Alto. It's hard to design products by committee, and the increasing pace of technology change makes the process even more difficult.

"Size does not carry anything like the momentum that it used to," agrees Peter Alexander, vice president of enterprise marketing for Cisco. And Cisco's size has increased from 4,000 employees in 1995 to more than 23,000 today. "With the lowering of barriers to entry, big companies have to earn their continued success every day," Alexander says.

Big companies' customers are being pursued relentlessly by newcomers such as Vertical Networks, a Sunnyvale, Calif., start-up that is using $55 million in venture backing to develop its InstantOffice line in the emerging voice/data switch market.

"The big companies are dealing with a lot of legacies, which restrict the kind of physical infrastructure you can build, and limit the kind of partnerships you can form, and sometimes force you to eat your young," says Alan Fraser, president and CEO of Vertical. "What you have, you kind of have to stick to and not destroy. Existing relationships can hinder you from thinking about new ways of doing business."

Start-ups keep the network industry more in tune with business needs, because they are making decisions closer to the customers. The level of participation by customers in the product development process is much higher than at established companies.

"As a start-up, you spend more time with early adopters, and they almost envelop you and bring you in," says Gordon Payne, executive vice president of sales, marketing and operations for Tundo Corp., a venture capital-funded pioneer of packet-based telephony. "Your success is their success." That said, start-ups do have to guard against over-customization and keep their sights on solutions that can be sold to a sizeable customer base.Catching the WAN waveIf the enterprise market that companies such as Vertical and Tundo play in is good to start-ups, the service provider arena is even better.

"Service providers are so desperate to get leading-edge capabilities that they will trial with anyone," reports Michelle McLean, director of strategic marketing for Pluris, a start-up in Cupertino, Calif., that is developing terabit routers for service providers. Pluris has attracted $60 million in venture backing.

While service providers make technology decisions, McLean says, enterprises make business decisions. Technology is third or fourth on an enterprise buyer's list, behind such considerations as vendors' staying power, ability to deliver services and support, and pricing. Enterprises are conservative, and more reluctant to buy from emergent companies.

It wasn't always this way. During the LAN revolution, enterprises were the infrastructure sweet spot, and carriers were the bastions of conservatism. Carriers took too long to make up their minds, depreciated equipment over 20 years and were under less competitive pressure to adopt new technology.

"Deregulation has created an explosion of new carriers that are a lot more likely to buy from start-ups," Higgerson says. "That's what has really opened up opportunities. And now the established carriers are forced to keep up and are more receptive to buying from smaller companies."

At the same time, carriers are more demanding and risk-averse than enterprises because their network infrastructures are much more closely tied to revenue streams. It's a measure of the competitive pressure they are under that they are throwing the door open to start-ups.

Industry watchers point to three waves that are breaking over the network infrastructure market at the same time and forcing the issue: the transition of tens of billions of dollars in circuit-switched equipment to packet technology over the next few years; the deregulation that has spawned legions of carriers that are themselves start-ups with a bust-the-trust mentality; and all the green-field opportunities in less-developed countries.

"There is an enormous sucking sound all over the world from people who want to buy this equipment," says John Boyle, a general partner with Worldview Technology Partners, a venture capital firm in Palo Alto. "We even have international carriers coming to us and asking to be hooked up to our start-ups, telling us, 'We can't get their attention.'

"It's a spectacularly unique situation to have three waves like this coming together at the same time," he adds.

Meanwhile, the enterprise market is stronger than ever, but it looks anemic by comparison. There hasn't been the same infrastructure shift that the Internet economy's open systems thrust on the carrier market. The existing enterprise infrastructure has turned into a commodity and become relatively standard across vendors. There are almost no green-field opportunities, and manufacturing efficiencies and economies of scale become more important. Consequently, start-ups don't bring as much to the table.The Internet advantageThe Internet favors start-ups in many ways. "It is an information economy that is pushing power out to end users, to individual consumers," says Ajit Medhekar, president and CEO of Lara Technology, a San Jose start-up developing carrier-class voice products that use IP instead of ATM or SONET in the service provider core. "It's becoming more of a pull than a push economy, so the big players with all the pushing power have less of an advantage."

The Web provides easy and inexpensive access to information, so new companies can become known much more quickly around the world, and attract that critical mass of first customers a lot faster. The Internet also fosters a lot more cross-pollination of technology development.

"There is no monopoly on good ideas anymore," says Bill Hawe, chief technology officer for Nortel in Billerica, Mass. "There used to be a lot of compartmentalization of information, with certain companies working in certain areas and coming up with all the ideas for those areas. The Internet economy broke that down, and everything is connected in a single bazaar."

This free flow of ideas is benefiting the big companies, too. "We are now seeing a lot of things starting up in big companies that would ordinarily be funded by venture capitalists," Hawe says. He offers as proof three products Nortel introduced for the service provider market this year: the Versalar 15000 multiservice switch for the edge of service provider networks, and the Versalar 25000 and Optera Packet Solution series of optical switches for service provider cores.

"These products were started in an incubator within Nortel," Hawe says. "The teams were given special incentives and a free reign."

In general, though, the Internet lets companies focus on what they do best and outsource everything else. Start-ups typically have great focus, so they are a better fit for this new value-chain paradigm. They can become major players a lot faster by creating partnerships and using extranets to create virtual companies that have all the capabilities of big, traditional enterprises.The main advantage start-ups have, though, is their ability to operate in Internet time.

"Because of the speed and changes, companies make decisions that may not be fully informed and checked, and they have to be able to absorb any resulting mistakes," Cedar Fund's Shohan says. "It's harder for big organizations to operate this way."Survival strategiesIt's not impossible though, insists Cisco's Alexander.

"The Internet economy has skewed the market in favor of companies that can display superior agility, but agility doesn't have to be a function of size," he says. Properly applied, "I-business" can optimize the processes, communications, productivity and costs of the industry behemoths, too. Because of the Internet, Cisco executives have a complete, up-to-the-minute picture of customers and their needs, and can make decisions quickly.

Cisco even has a self-assessment test called the Internet Quotient that other companies can use to measure their potential to create an "Internet ecosystem" and leverage it.

"The secret going forward is to scale agility," Alexander says. Companies that do so - even big, established players - can continue to grow their market caps rapidly and offer new recruits and investors returns that are similar to the ones associated with start-ups.

And an acquisition strategy is a lot less risky than developing everything in-house. People often ask why Cisco pays $200 million for a technology that could have been developed internally for $10 million. But they are forgetting that this acquisition approach lets the venture capitalist community absorb a lot of the risk - the 19 out of 20 start-ups that fail. Cisco can wait and buy the one that succeeds.

"That's how the established players retain and expand power today, by buying the innovators after the pudding has been proven," says William Schrader, chairman and CEO of Internet backbone giant PSINet in Herndon, Va. The pressures of the Internet economy have made the big companies so desperate for cutting-edge technology that they will pay whatever it takes, and they have the means to do so.

"Small companies will have great difficulty staying independent," Schrader concludes, and the start-ups acknowledge that the lure of lucrative buyout offers makes it difficult.

"We want to stay independent and become the next Cisco, but we have no control over whether someone comes along and offers so much that our owners say, 'Take it,'" admits Vertical's Fraser. The financial backers may well decide that a bird in the hand is worth two in the bush.

And the venture capitalists admit confidentially that it is not unheard of for major customers to force the issue by agreeing to buy a product only if the start-up in question becomes a unit of a bigger company with which the user organizations are already dealing.

Start-ups that evade suitors and make it through a successful IPO face new obstacles. "They have the toughest job," Alexander says. "They have their market cap, and now they have to prove they are worth it by staying on track with revenue growth. There is less upside for new hires because the big boost has already gone by."

The secret to maintaining independence is having a value proposition so compelling large customers can't live without it. As Lara's Medhekar puts it, this proposition "has to be something radical with a reasonable possibility of success." A better mousetrap that provides an incremental improvement over what the Ciscos and Nortels can offer - even a fairly substantial one - won't suffice.

Start-ups have to make either a quantum leap forward in a particular product category or, better yet, invent a brand-new one.

Related links

Breijdenbach is a freelance technology journalist and consultant. She can be reached at sbreidenbach@usa.net.

Internet Quotient
From Cisco.

The money guys
A look at today's venture capitalists and their networking picks. The Power Issue.

Venture Capital Database
Search through more than two years' of data from the quarterly PriceWaterhouseCoopers/Network World VC survey.

Recent reports from that survey:

Q3 funding tops $6 billion
VC firms heaped money on business-to-business e-comm, 'Net infrastructure firms. Network World, 11/22/99.

Internet start-ups still rolling in venture dough
Network World, 8/23/99.

Where has all the cool net gear gone?
Innovation has slowed to a crawl in the enterprise network equipment market as money flows into dotcoms. Network World, 8/2/99.

Dispatches from the heart of venture capital country
Network World Fusion, 6/30/99.

VCs still nuts about nets
Network World, 5/24/99.

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