Here's some bad news for infrastructure startups: Telecom network equipment vendors are not good investment prospects these days, because companies that rely on carriers for their revenues offer too little potential for a "liquidity event."

So says Jean Schmitt, managing partner at European venture capital firm Sofinnova Partners, which recently raised a €385 million ($513 million) investment fund (see Sofinnova Grabs €385M).

The firm is now sizing up the technology markets, looking for early stage firms that offer decent prospects for a profitable return on investment, either through an acquisition or an IPO.

Sofinnova has a history of backing telecom hardware and software companies such as photonic switching systems vendor Calient Networks Inc., broadband access equipment firm Narad Networks Inc., PON systems vendor Salira Optical Network Systems Inc., and billing software firm VoluBill (see Narad Networks Raises $17.5M, Calient Networks Raises $20M, and Salira Secures $7 Million More).

But Schmitt says that telecom network equipment and OSS firms are no longer attractive to VCs. "With our previous fund we invested in a few telecom software companies, but we quickly stopped, as operators haven't really been investing much there. Companies that rely on telcos as their customers make me very nervous. On the network side, it's possible to create exciting companies, of course, but not the kind of companies that will attract VCs," he says.

The main problem is that the operators are not willing to invest in innovative technology, he says, and it's hard to determine how much they will spend, and when. "And if you're landing big deals with Tier 1 operators, they are squeezing your margins so hard it's tough to make money. If you are winning contracts with Tier 3 carriers and a competitor is winning the Tier 1 contracts, then you're dead," adds Schmitt, cheerily.

He says Sofinnova has looked at a few companies in the video equipment and triple-play systems space, but "we didn't see anything that would crack the market."

He adds: "We still look at the infrastructure market but we don't see many opportunities, as there aren't any real opportunities to grow a company to very quickly become a $100 million [annual revenues] player. It's a big issue -- how to build a business model with carriers as customers. It's possible to build a company that has revenues of $20 million, but that's not enough for a liquidity event. The bar is going higher," says Schmitt.

Instead, Schmitt and his colleagues see greater opportunities in companies that are developing software and hardware components for mobile handsets.

He notes one such company in which Sofinnova has already invested, California-based fingerprint authentication technology vendor Upek Inc.. Sofinnova led the company's $20 million Series A investment in March 2004, and Schmitt claims the company is already experiencing financial success.

Embedded technologies for mobile phones are "a big growth area," reckons Schmitt. "Feature phones are growing in terms of market share, and there are opportunities for companies developing embedded systems that provide functions such as location services, and security. The handset market is still very nascent in terms of embedded software," says the VC.

"We're looking for the missing pieces, and there's a lot of work to be done on download technologies and creating good user interfaces. There's also some amazing battery technology that is being used in other industrial sectors that hasn't been applied to mobile phones yet. And machine-to-machine technologies, allowing machines to communicate with each other for maintenance, downloads, upgrades, stock control, and so on, is also a very interesting area."

He also sees investment opportunities in companies developing IP Multimedia Subsystem (IMS) client software for mobile phones that would connect back to the network-based application servers delivering services such as presence, instant messaging, and other SIP services. IMS is one of the hot telecom topics of the moment (see IMS Tops 3GSM Agenda, HR Says Wireless, Wireline Converging, and Urgence and Convergence).

But he believes that Europe is falling behind in terms of its innovation potential, while the U.S. is becoming more of a hotbed, especially in wireless. "The U.S. is waking up. There are a lot more interesting technology startups there now. Many of them have naïve business plans, but they are very innovative, and they are being helped and supported by the U.S. carriers. But in Europe I see the opposite happening. The carriers here are not interested in innovation."

Schmitt believes carriers should do much more in promoting and developing their own new technologies. "A lot of operators don't invest in technology – they're only interested in milking the cow instead of helping to create wealth. Sure they have R&D teams, but often they're looking outside their own companies at what other companies are producing, and they're not creating anything themselves. That's not good for them or the economy. The telcos are reluctant to innovate, but they shouldn't forget that they're technology companies themselves."

He says this "plays into the hands of the large vendors, such as Alcatel (NYSE: ALA; Paris: CGEP:PA) and Siemens Communications Group. They will take control. I would rather see an innovative France Telecom SA (NYSE: FTE) or Orange SA (London/Paris: OGE). But these operators are only interested in making money from their intellectual property, and they're just giving away their R&D. That's not a good move," concludes Schmitt.

— Ray Le Maistre, International News Editor, Light Reading