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Can cable capture limited VC?

Sat, 11/30/2002 - 7:00pm
Craig Kuhl, Contributing Editor

In the year 2000, venture capitalists and much of the investment community at-large were tripping over their portfolios to lend money to start-up companies extolling the next greatest technological advancements–business plans, management teams and growth strategies be damned.

Figure 1: Fourth quarter venture capital investments (in $billions).
Ideas, however whimsical, and a PowerPoint presentation could usually muster millions in Series A financing for companies with no product, no business plan and no clue how to execute on either one.

That year, much of the breathtaking $105 billion in venture capital (VC) and other investment money was shoved at any company remotely associated with the Internet or the technology that would ultimately connect a consumer to myriad revenue generating services–from the Web to home networks.

Now comes the reality. This year, just $18 billion in venture capital will be invested in entrepreneurial companies, with investments in networking and telecommunications down 34 percent over last year and even further from the year before. Overall, VC investments in all sectors are down a staggering 80 percent. In one state alone, Colorado, third-quarter VC funding is down to $45 million after its peak second quarter in 2000, when it totaled $1.2 billion, reports a PricewaterhouseCooper/Venture Economics/National Venture Capital Association Money Tree survey.

The lack of VC investment in new technology companies, based on a host of economic and market factors, is forcing some entrepreneurial upstarts to re-define their strategies for innovative technologies or abandon them altogether, and pressuring the VC community itself to tighten its criteria for lending, especially to technology-driven companies that can't produce a clear, definitive business plan. The result, experts maintain, could mean fewer technological advancements and innovations.

"The VC funding richness of great liquidity and flow is gone," says Ted Henderson, senior vice president for Stifel, Nicolaus and Co., an analyst firm in Denver. "It's hard to attract money for the next great business or technology. It was easy for start-ups to get into the business a few years ago when ventures were funding ideas, not businesses. Now, no one knows if consumers want all these technology-driven services or if there's even a business. The VC industry is just a tough market today. It's dried up in general and is more focused. Every dollar is scrutinized."

The effects of a parched VC market are being felt throughout the broadband industry. Far fewer start-up companies are finding first round financing, while funding for technology-related businesses is mercilessly scrutinized and the telecommunications/dot-com hangover is embedded in venture capitalists' minds. Add to the mix a floundering economy and a painfully cautious spending mentality at cable MSOs, and the near-term future of VC investments in new technology companies gets really cloudy, as does the crucial R&D budgets to advance them.

Figure 2: Annual venture capital investments
(in $billions).
"There's so much turmoil in the VC community. People gain and lose interest in the cable space and its technology. But at-large, people are funding cable technologies and companies. The types of business models are just different, and entrepreneurial companies are changing all the time," maintains Samuel Schwartz, senior managing director of Comcast Interactive Capital (CIC), a $400 million VC fund that has invested in 55 companies over the past four years as part of Comcast Corp.'s investment strategy.

With VC investments at 1998 levels, and a fundamental shift in how VCs invest in upstart companies, particularly those in the cable-related technology sector, many entrepreneurial, technology-driven firms are morphing to the cable industry, and distancing themselves from the ill-fated telecom, CLEC and ILEC segments. In the meantime, they're re-tooling their technologies to fit cable's space. And quickly.

"It became very clear that we had to refine our strategy and move from several different markets to one market–cable," says Greg Nicholson, CEO and co-founder of EGT Inc., a signal processing company currently moving through a $5.5 million first round of financing. "We were too broad and too thin. It's completely different now (getting VC funding). They want a focused, developed entry into market, based on fundamental and reasonable estimates. We've had to change and validate our value proposition more than once."

Figure 3: Number of Q3 2002 venture deals done by sector.

The new VC mantra, experts suggest, is: Show me the business plan, management team and a compelling technology, and I'll show you the money. Maybe.

"We always look for cutting edge capabilities to deliver real-world solutions, and the VC criteria has certainly changed. VCs seek companies that are funded through each round of financing and have fully funded business plans. The money people were paying for early stage companies was absurd. So now, it's much harder for those companies to raise money," explains Gary Lauder, managing partner of Lauder Partners LLC, a venture capital company specializing in Internet and cable TV-related technologies.

Despite the harsh environment, the cable industry is attracting plenty of new VC investment, Lauder and others are finding. "The VC industry generally recognizes that cable operators are healthier (than other related industries), and it's causing greater interest. But, others have had bad experiences with technologies and services such as @Home, and cable's consolidation is a deterrent to new VC investments in technology and innovations because of the large corporate staffs who all have to say 'yes' to get things done. But on balance, there's more interest in cable-related technologies," he notes.

The list of VC firms currently investing in cable technology isn't exactly a who's who in the VC community. In fact, only a handful are seriously committed to that space. Yet the list is likely to grow. "It's one of the more attractive places to invest," says Tony Abate, general partner for Battery Ventures, a top-tier, early-stage venture capital provider. "The telecommunications industry is in a free fall and cable's services are at reasonable penetration levels with reasonable prices for four services. And it won't go out of business soon. Technology investment opportunities remain as strong as two years ago. It's a good scenario to invest in technology companies."

Some of the leading VC funds for cable technology include AOL Time Warner Ventures, Cedar Fund, Charles River Ventures, Pilot House Ventures and Redpoint Ventures.

Yet Abate and others are taking a close look at cable's ability to monetize its technologies, and the operative term is "return on investment." "It's all about hard ROI. If the technology has a soft ROI and takes a large investment to deploy, we'll wait for the economy to turn. But if there's hard ROI, we'll invest in it now. The bar is very high to invest in the technology," he says.

High indeed, especially for technology companies that have run the VC gauntlet. "Our last round of financing required that we have everything clicking in a strong market. The willingness of the investment community to take a risk has been reduced significantly, so being focused was a requirement. I don't think we could have invented this technology if we had to start today," admits Ed Huguez, president and CEO of Midstream Technologies, a developer of video-on-demand servers and solutions which recently closed a $26 million series C round of financing.

A growing number of entrepreneurial technology companies are re-defining themselves to fit the cable industry's needs, a go-to strategy that for many is a make-or-break shift from their initial telecommunications-focused business plan.

"When we decided to go after the cable space, we had to build to its requirements," says Ted Griggs, CEO of Syndeo Corp., a provider of voice-over-IP softswitch/call management server technology which recently raised $75 million in third round financing. "We weren't pitching to ILECs or CLECs anymore, so it was hard to turn around from telco to cable and the immersion was risky. But it was the most likely path to success."

Syndeo's path, Griggs adds, included an investment in DOCSIS 1.1, security and new features that would make its technology deployable in a cable environment. And lots of listening. "MSOs know what it takes to be successful, so when you look at things like PacketCable, you have to listen to what the MSOs are saying from a business perspective. You can't have a big ego."

Syndeo is part of a Comcast trial, which Griggs admits could damage his and the company's ego for a long time to come if it's not successful. "Our biggest worry is now on execution. We have the resources and capital. Now it's got to be put together. We've been handed a great opportunity to be successful. If we can't execute, we're sunk. But I'd rather have to execute than get funding," he says.

Securing the funds to develop advanced technologies and the R&D crucial to make them happen is at issue, experts believe. How will the drastic reduction in VC funding affect the entrepreneurial spirit of technological innovations and the companies that foster them?

"There will be continued investments by the VC community in the technology sector of cable, and as long as it moves down the path to new services, entrepreneurs will have good ideas because they know the industry and are focused on solving cable's problems, and investors will validate those. But cable must perform more efficiently," says Paul Pishal, principal at HIG Ventures, one of the largest VC firms for early stage technology companies.

For many VCs, the emphasis is not only on the technology, but on efficiencies and execution. Adds Pishal: "If a product or technology makes an operation more efficient, they'll get funding. People are very reluctant to put $100 million to work and wait two years to see if it works, so we look for significant innovations, not just technical, but operating efficiencies."

Opportunities for start-up technology companies will be in network infrastructure, service delivery and provisioning, Pishal says.

Yet for a growing number of service providers, the opportunities and challenges differ from those of their vendors. "We've always been focused on our technology investments because that's what it takes to grow our business, but now we look at how much cash the technology companies have, and not just the start-ups, but the established ones, too. VCs want to see a strong business plan and the management that can execute on the plan and the ROI, and we look for the technology to leverage our existing assets," says Bill DeMuth, vice president and CTO of Surewest Communications Corp., a triple-play service provider with 244,000 customers in the Sacramento, Calif. area.

CIC, which Schwartz refers to as Comcast's ambassador to the VC community, is in a unique position to understand the opportunities and challenges of both the VCs and technology companies. "Like any other VC, we want to be sure that emerging technology companies have a solid business plan, but there are fewer of these companies servicing the cable industry because of consolidation," he admits.

Nonetheless, entrepreneurs and their upstart technology companies continue to surface. Adds Schwartz: "There's a pretty efficient entrepreneurial market out there. People realize where cable's money is being spent, and they're morphing into cable-targeted companies from Internet and telecommunications. There are fewer operators, but money is still being spent."

Much of that money, industry experts say, is now beginning to flow from VC funding, albeit not at 2000 levels. "I don't think VC funding is low at all. The reduction has been in me-too companies who aren't innovative," concludes Seth Kenvin, vice president of corporate development for BigBand Networks, a provider of broadband multimedia routing systems which has secured $60 million in venture capital from a number of leading VC funds. "The race to gain revenues and enter the market was so fast it soured the VC community. But VC is a long-term commitment, and they want companies that sustain themselves. Now, the promise of innovation and growth in the cable industry is attracting VCs."

Just how active the VC community becomes in cable-related technology companies is likely to have a lasting effect on advancing technologies and how they address cable's operating environment. In the meantime, emerging entrepreneurial companies are expected to flourish, albeit with a whole different attitude toward the process of securing funds from VCs.

Concludes Nicholson of EGT: "It was trying (getting VC money), with only shreds of our egos left. So if you can stoop down and rebuild, it can become a reality."

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