Bucking the recent downturn in venture-capital funding, Morgenthaler Ventures is scheduled to announce today the closing of an $850 million fund, a third of which will likely be directed to optical networking startups.

Though the Menlo Park, Calif., firm's seventh fund will add more emphasis on health care and software investments, Morgenthaler general partner Gary Shaffer says the firm will continue its bullish belief in the optical systems and components markets, a space other venture firms are fleeing (see Kleiner Perkins Scales Back).

"Components are definitely not dead," says Shaffer, who estimates that as much as 35 percent of the new fund could end up in startups with photonics-based business plans. In recent history, Morgenthaler has been one of the most active VC firms in the optical components space, counting Agility Communications Inc., Ignis Optics, LightConnect Inc., and Zolo Technologies Inc. among its recent deals. Morgenthaler also recently invested in switch startup Xebeo Communications (see Xebeo to Build a Service-Aware Switch).

What Morgenthaler looks for in a components startup, Shaffer says, is strong intellectual property and functionality beyond a single purpose. "[The technology] has to be something that's hard to copy, and something the customer cares a lot about," he says.

Morgenthaler general partner Bob Pavey says that raising a new fund in the current down market may seem counter-intuitive, but it reflects his and the firm's belief that optical technologies are still at the beginning of their lifecycle.

"I think we're in the early stage of a five- to 10-year technology run," Pavey says. "There are still a number of interesting ideas, and I don't think we can anticipate yet where the [successful] trends are going to be."

Known for its conservative nature (stodgy, by another name), Morgenthaler doesn't expect blockbuster returns from this fund, according to Shaffer: "The days of triple-digit returns are gone." But Shaffer notes that at even at returns of 20 to 40 percent, VC funds on average outperform public stocks.

"If you can get 30 to 40 percent return, that's very good, and that's what the limited partners are looking for," he says. Pavey and Shaffer say the firm expects to fund one optical deal per quarter, over an expected 10-quarter active funding lifespan for the new fund.

Morgenthaler, which shied away from flashy dotcom investments, missed both the explosive upside and the nasty meltdown of pure-Internet investments. But even conservative firms have flameouts, as evidenced by the current disintegration of Tachion Networks, which was a portfolio company in Morgenthaler's fifth fund (see Crunch Time at Tachion).

Still, Shaffer says that people who are afraid of risks or long-term commitments shouldn't play the venture-capital game.

"We really don't expect [equity] results until 2004 and later," Shaffer says, believing it will take that long for the communications market to turn around. But he believes it will turn around.

"Historically, every other investment sector -- biotech, computers -- has gone through a downturn, then come back. The end demand in communications is going to be major. And anyone who doesn't believe the market will be on extremely solid footing by 2004 should get out of the business."

- Paul Kapustka, Editor at Large, Light Reading
http://www.lightreading.com