802 Chapter 11? –

In an otherwise bleak venture-financing environment, a recent slew of fund-raising announcements in the 802.11 (Wi-Fi) sector appear to signal the beginning of a long-expected recovery. But is Wi-Fi sector investment supported by rational expectations of returns by venture capitalists? The answer may be surprising.

Intel’s Andy Grove has billed the Wi-Fi phenomenon as the greatest technology “inflection point” since the Internet in 1994. Not satisfied merely to witness yet another “greatest legal creation of wealth in history,” Intel set out to define and capture this wave with its ubiquitous Centrino branding campaign. This “Intel-inside”-like marketing blitz has put Centrino on trains, planes, buses, automobiles and in the hearts and minds of grandmothers everywhere. Centrino, a catchall brand for everything Wi-Fi, quickly has become synonymous with wireless laptops across the world. After literally buying its way into a sponsored Wired Magazine special issue entitled “UnWired,” Intel moved to quickly secure its defining position in this new untethered universe, which, quite conveniently, imagines a wireless world built around Pentium-based laptop computers. As history buffs would know, for many years Intel had actually opposed the Wi-Fi standard before embracing it wholeheartedly about two years ago. Meanwhile, buoyed by the Centrino euphoria, venture capitalists rushed to wire money to the infrastructure needed to build the new Wi-Fi world, which many enthusiasts and service providers began to view as an economically superior model to the 3G world that wireless service providers touted and funded by the billions in the late 1990s.

Wi-Fi entrepreneurs quickly stratified into semiconductors, systems and software. Like the famous land-grab-turned-PC- industry in the 1980s, some sought to create the “building blocks” of semiconductor circuitry, others to build the “IBM compatibles” of Wi-Fi, including access points and systems, and others to build the “application layer,” which would provide ease-of-use, management and security support to the new network. A dozen companies were funded to build communications ICs to support several of the new standards in Wi-Fi in 2001. Two years later, half of those companies are beginning to ship product.

Exit Ahead

Fortunately for them, few if any of the large semiconductor companies (including Intel) have built any such technology internally. Quite likely, 2003 will be the year of several profitable exits in the Wi-Fi chip area, and most, if not all of the half-dozen players, will find homes among the several dozen semiconductor companies looking for technology in this area. The key reason for this happy outcome is a classic venture capital adage: These companies have solid intellectual property claims, competitive technology advantages, and time-to-market benefits which accrue to all with “over-the-horizon radar.” These companies were started before Wi-Fi was a household name and stand to benefit from that foresight.

Unfortunately, the same does not hold true for the hundred or more startups funded in recent years to build systems-level and software Wi-Fi products. Systems-level Wi-Fi companies are being funded at breakneck speeds, with some of the largest deals in the networking equipment space focused on Wi-Fi systems plays. It is unlikely that most of the investments made in these companies can provide a venture-style return to their investors. Unfortunately, that reality has not stopped VCs from chasing the latest hot Wi-Fi deal.

Small and successful networking companies delivering Wi-Fi or wireline systems suffer from a fundamental reality: The world values them at anywhere from 0.1X revenue to about 2X revenue. These companies include very successful, profitable and high-growth companies. Take, for example, Proxim Inc., one of the leading providers of Wi-Fi equipment and as close to a W-iFi “pure play” as one could have. The reward for Proxim’s market leading position: a 1X revenue multiplier. As shown in Figure 1, other examples abound. Even with sizeable revenue bases, networking systems companies are simply not valued much above their revenue rate.

Suspending Disbelief

Most venture capitalists will recognize the famous “Year 3” financial projection. Without specific regard to the product, market or economy, the average entrepreneur fancies a $25 million revenue run-rate in Year 3. VCs, in turn, will “rightsize” that number with the expectation that the company won’t ship product or won’t ship as much product in that time. The Wi-Fi entrepreneur is no different. Of the approximately 75 Wi-Fi startups that Blueprint Ventures has evaluated over the past 12 months, most of them projected $25 million in revenue in their first or second year of shipping product (Year 3).

Of course, building a company to $25 million in revenue takes a fair amount of money. A rough guideline for a networking systems company is approximately $25 million. And herein lies the investor’s dilemma.

Thorny Roses

If the rosy-eyed VC believes the entrepreneur will deliver $25 million of revenue in Year 3, understands that it will take $25 million to build a company that will succeed in delivering that revenue, and believes that no other company will compete effectively for the market in three years, then that same rosy-eyed VC might also believe, based on fundamental valuation metrics of 1-2X revenue, that the company might be worth $25 million to $50 million in three years. On a good day, one might assume a dramatic increase in the NASDAQ, leading to a valuation of over $50 million. How exciting is that?

After management incentives, it’s likely that a very successful investment in the Wi-Fi systems space could return 1-2X to its investors. Taking into account the many expected failures, that is hardly a prize to compete for. The competition is quite fierce, commoditization quickly sets in and margins dissipate rapidly. Also, there isn’t much intellectual property protection available to networking systems players. In fact, the exact same Taiwanese companies building product for Proxim, Cisco, DLink and others are available to build product for the new entrants. Fundamentally, the race is one of sales and marketing. By way of example, Linksys (recently purchased by Cisco for approximately $500 million at 1X revenue) was rumored to have just one dozen engineers out of a 200-person headcount. Engineering is done in Taiwan by one of the many highly successful design and manufacturing houses. Systems-level companies are effectively sales and marketing channels for Asian manufacturers. Companies promoting special features to differentiate are scrambling for something that might transform “features” on the next Cisco/Linksys box to “companies” in their own right. That is not a successful differentiation strategy.

So why are VCs racing to put money to work in Wi-Fi systems companies? One poor answer might be: “Because they can.” Faced with continual pressure to put money to work (or to reduce fund sizes) VCs have gotten hold of a “hot” sector. For the time being, nobody can be faulted for backing the latest and greatest Wi-Fi deal. As one venture capitalist recently put it: “We can’t afford not to invest in this sector.” We will soon find out if that is not the case. Meanwhile, let the party continue.

Bart Schachter is a founder and managing partner of San Francisco-based Blueprint Ventures and George Hoyem is a partner. Their investment focus includes communications infrastructure, wireless technologies, and software.