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Optical/IP

Choosing Light

Optical networking has a lot more in common with physics than just photons. There’s a little thing called the Uncertainty Principle, known to venture capitalists and quantum mechanics alike — except, while the eggheads are chasing down quarks, neutrinos, and other subatomic particles, the VCs are trying to track the speed and trajectory of optical equipment vendors.

The VCs have the tougher task.

Companies that build optical communications gear are increasing their valuations by hundreds of times annually (ONI Systems Inc. [Nasdaq: ONIS] and Corvis Corp. [Nasdaq: CORV] being recent examples). That sort of growth has venture capitalists throwing money in the direction of almost anything optical: Startup valuations can top $1 billion in the third round.

The gold rush is on. Dozens, possibly hundreds, of private companies have been pushing to deliver the market’s next stellar IPO or multibillion-dollar acquisition.

Where does this leave the VCs? Competing to participate in funding rounds for companies they understand only to a limited degree — all within weeks of a first meeting. The problem is particularly acute in the optical components marketplace, where esoteric technologies typically succeed or fail, with very little in between. Networking systems offer similar challenges, as datacom and telecom systems blend into compelling, complex hybrids.

Further complicating matters, this is one gold rush that could go on for years. Optical networks will completely replace today’s network. That’s what makes them so attractive to investors. The optical buildout will grow from innovations in optical components, systems engineering, and software, creating huge opportunities for vendors over the next decade.

Which brings us back to the Uncertainty Principle: How do VCs pick winners in this market?

The basics still apply: Look for a great team of founders and world-class engineers, bearing in mind a target market that’s forecasted to expand at least 20 percent per year, eventually into the billions.

That’s a good start, but VCs will understandably need a bit more when deciding to put $10 million behind a company, especially when so many look so good and act so confident. VCs need to be assured that a viable solution is in the works.

P.G. Menon of Atoga Systems says it well: “What is a startup but a rich environment for problem solving?” And there will always be plenty of problems in search of a solution, no matter how sophisticated optical networks become. In fact, since optical networks create opportunities for more advanced application development, they also lay the foundation for their own obsolescence. That creates a growing demand for faster, nimbler solutions.

The challenge for vendors and VCs alike is predicting the slope of the technology curve and staying at its edge. Are companies developing systems that actually improve networks, simplifying them while enriching possibilities? Technology looking for a home may get lucky some of the time, but solutions to real-world problems don’t need luck, just timing.

It’s easy to be swayed by a vendor’s vision. Companies work hard on their presentations; often there’s little else to go on before a product is ready to be powered up and tested.

But VCs are not flying blind. Even if all they have to go on is paper and a PowerPoint presentation, they can still decide if a product appears plausible or sustainable. A minimum of information only means that minimal requirements must be met. Here are my top four criteria to consider:

  • Bottlenecks Never forget the basic rule of bottlenecks: Relieve one and others appear. Broadband access leads to metro optics, which in turn leads to optical switching, routing, and core transport. This raw bandwidth points to packet processing, which opens the door to scaleable switches and scaleable, intelligent routers. Solutions that address these bottlenecks have an immediate appeal.

    The key here is to have a team strong enough to see into the future and perceive not merely an isolated bottleneck but a solution that improves overall network performance and economies.

  • Integration Another common theme: Consolidation of network elements improves service velocity, provisioning, and network management, while conserving space and power.

    The trick is in knowing what to integrate. Some carriers are wary of too much consolidation, believing it compromises their ability to choose best-breed products. Others insist on integration, because it allows the rapid creation of networks that can be managed via a common software platform. And that means shorter time to revenue, which is the one value that CLECs (competitive local exchange carriers) will never argue over.

  • Scale Networks will always need to scale; startups that facilitate scaling — whether in distance, capacity, size, or dimension — will be positioned to succeed. In the Internet era, products that can be deployed to create widespread networks, serving diverse customer groups over a broad geographical area, have more potential to succeed than so-called point products.

  • Service creation Many startups position products by pointing out how they’ll save carriers money. The trouble is, most carriers can’t justify product choices based on possible lifecycle costs that can’t be proven even in beta trials.

    With so many carriers competing for so few customers, the key is service creation, which equals differentiation. That’s why we’re seeing a shift away from investments in companies that supply raw bandwidth to those that offer either intelligent networking or “high-touch” packet processing. The lesson for VCs: Make sure the startup can hire the requisite software programmers. Those code jockeys will make the real difference.

    If a startup can pass all these tests, there’s one more consideration: the team. True, every startup is unique, but founders tend to come from one of two camps:

  • Skunk works A group inside a larger organization is charged with building a new platform, based on customer feedback or perceived emerging demand. For whatever reason, that work is not supported well enough or does not result in a product that fits with the company’s existing product line. So the group decides to spin off a startup, sometimes with the parent company’s blessing (think Metro-Optix Inc. and Ericsson AB [Nasdaq: ERICY]), often without (consider Alcatel SA [NYSE: ALA] and Nortel Networks Corp. [NYSE/Toronto: NT] suing various startups for various reasons).

  • The impossible dream A few key players come together based on shared entrepreneurial spirit and the notion they can do things better than status quo. The smart dreamers talk to carriers first before they start building the box.

    The more input from carriers the better, though it’s wise to be wary of big RFPs from ILECs (incumbent LECs), which may look like long-term endorsements of a new market but are little more than sound and fury. ATM VP rings are a good example here: Endorsed by carriers and specified by Telcordia Technologies Inc., they led to the formation and dissolution of a handful of well-intentioned startups. Besides, building equipment for ILECs alone is no way to form a startup; no one should wish 24-month sales cycles on themselves.

    The final ingredient is the unquantifiable, ineffable gut feeling that these folks know what they’re talking about. They’re an A team. They’ve done their homework.

    If they seem preoccupied with their future IPO, that may be a problem. It’s difficult to remember sometimes, but Wall Street is not the startup’s customer. Carriers will deliver the ultimate validation of an equipment vendor and in the end will be the prime beneficiary of this optical gold rush. A carrier’s biggest concern is not whether its problems are being solved by the vendor community, but whether it has the time and wherewithal to determine which solution is appropriate. Sound advice to any startup is to come prepared with training, professional services, and customer support. Make it easy on the carriers; they’re trying to pick winners too.

    Scott Clavenna is president of PointEast Research and director of research at Light Reading http://www.lightreading.com
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