VCs stay stingy toward net start-ups

Venture funding of network start-ups continued its record slide in the fourth quarter last year, as the poor economy and a lack of corporate and carrier IT spending took heavy tolls.

Venture capitalists invested $2.2 billion in 352 network start-ups in the fourth quarter, down roughly 8% and 4%, respectively, from $2.4 billion and 367 companies in the third quarter. That’s according to a special analysis of the quarterly MoneyTree Survey compiled for Network World by PricewaterhouseCoopers, Venture Economics and the National Venture Capital Association (see complete survey results at https://www.nwfusion.com/bg/vc3/vc.jsp).

The quarterly funding number was the worst in about four years, and the number of companies receiving investments was the fewest in about five years. The fourth quarter marked the 10th straight quarter in which funding in network companies and number of companies invested in dropped. Overall funding in network companies last year reached its lowest level – $13.2 billion – since 1998 and was off a whopping 77% from the record high $57.4 billion invested in 2000.

Tracy Lefteroff, global managing partner of the venture capital practice at PricewaterhouseCoopers, doesn’t see a turnaround anytime soon.

“The pattern should continue in the short term till there’s a pickup in capital equipment orders and we see liquidity returning to the marketplace through an increase in M&A or IPO activity,” he says.

Lefteroff says venture capitalists are shying away from funding new companies, choosing instead to stick with existing companies they think can make it in the long run. Customers should expect to continue seeing new companies in areas such as security and storage, though they might  notice fewer in areas such as Internet applications, he says.

Steve Baloff, a general partner at Advanced Technology Ventures, says that in addition to having to deal with more conservative investors, network start-ups are facing a tougher crowd of potential customers.

“Customers are showing an appropriate degree of skepticism,” he says. “They want to look at balance sheets and talk to investors.”

That’s not to say there aren’t any positive signs. Whereas the biggest round of funding in the fourth quarter went to Atlanta-based service provider Cbeyond Communications, which scored $43 million, at least two companies have already topped that number this quarter. Carrier equipment makers Axiowave Networks and Calix Networks have announced funding rounds this quarter of $45 million and $50 million, respectively, no mean trick given the widespread reduction in capital spending by service providers.

“Carriers are still spending tens of billions of dollars,” says Mukesh Chatter, CEO of Axiowave, which started trialing its core and metropolitan network equipment “at more than one carrier” late last year. “The market might have shrunk from what it used to be, but it’s not chump change.”

Chatter, who sold a start-up called Nexabit Networks to Lucent in 1999, is keeping mum on specific product plans. But he says the company will address carrier concerns such as lowering capital and operational expenditures, and increasing revenue and earnings. The key to carriers returning to health is for them to find a way to charge customers for premium services, says Chatter, whose company has raised $96 million in three rounds of funding. “Relying entirely on best-effort services won’t do it for them,” he says.

Another recent funding recipient is Q1 Labs, which got $3.3 million to further develop and market its software for helping companies cut down on network misuse. While many start-ups have yet to realize the sales boost they expected when network security awareness reached new heights following the 2001 terrorist attacks on the U.S., Q1 Labs CEO Brian Flood says he is hopeful that companies will start investing this year.

“It usually takes a good year for something like that to cycle through,” he says. “Our strategy has been to really understand the concept of ROI, especially in light of customers not seeing a significant return on investment from products like traditional [intrusion detection] systems.”