Network equipment start-ups feel financing pinch

Venture capital investments in network equipment start-ups slowed to a trickle during the third quarter of 2002, reaching the lowest level of early-stage investments recorded in seven years.

That was one of the key findings of a special analysis of the quarterly MoneyTree Survey compiled for Network World by PricewaterhouseCoopers, Venture Economics and the National Venture Capital Association.

Venture firms made only six first-round investments in network equipment start-ups during the summer -- the fewest since the fourth quarter of 1995, according to Tracy Lefteroff, global managing partner of the venture capital practice at PricewaterhouseCoopers.

Venture capitalists are skittish about investing in next-generation routers, switches and other network hardware components because potential carrier customers aren't buying new gear, experts say.

"Capital budgets have been cut back," Lefteroff explains. "(Buyers) say that the first thing they need to do is implement everything they've purchased over the last 10 years. It's only when they see their technology falling behind that they'll upgrade to increase productivity. That cycle could take a couple of years."

Altogether, the third quarter 2002 MoneyTree survey recorded 39 investments in network equipment start-ups that totaled $341 million. That level of investment is about half the amount invested during the second quarter of 2002, when venture firms invested $633 million in 57 network equipment start-ups.

Even more sobering is the fact that the current investment level is down more than 70% from the second quarter of 2000 -- the peak of the Internet boom -- when 80 network equipment start-ups received a total of $1.2 billion.

The lack of venture funding is making it harder for entrepreneurs to find financing for innovative ideas in network hardware, experts say.

"The pace of innovation is a lot less variable than the financing cycle," says Bob Grady, managing director in venture capital with the Carlyle Group, a Washington D.C. based investment firm. "There are a lot of good ideas out there. There are a lot of good companies out there."

The six early-stage network hardware start-ups that successfully raised funding last quarter received a total of $39.4 million. The largest of these deals was $17.8 million invested in Covaro Networks, a Richardson, Texas, provider of carrier-grade equipment for converged networks. The second largest was $6.9 million invested in Actona Technologies, a Los Gatos, Calif., provider of wide-area network storage systems.

Meanwhile, venture capitalists spent significantly more money shoring up their investments in more mature network equipment start-ups. The survey reports seven investments that were fifth or later rounds of venture financing that totaled $67.7 million.

The largest of these deals was $34.5 million invested in LuxN, a Sunnyvale, Calif., maker of optical access network platforms for service providers. This was the seventh round of financing for LuxN, which was founded in 1998 and has raised more than $150 million.

Another large later-round deal was $20 million invested in Infirea, a Sunnyvale, Calif., maker of optical components. This was the sixth round of financing for Infirera, which was founded in 2001 and has raised $90 million.

These aging network equipment start-ups are still receiving venture financing because the initial public offering and acquisition markets are dormant. Venture capitalists have no exit strategy for these investments and must keep them alive until the overall economy turns around.

"The silver lining here is that there's still a lot of interest in this space," Lefteroff says. "This market isn't going away, but it has to readjust to more normal levels."

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