Cover Story: VoIP –

Steve Jurvetson is an electrical engineer by training and a savvy investor by practice, and by most accounts a pretty smart guy. Yet Jurvetson, the Jurvetson in Draper Fisher Jurvetson, confesses that until recently, he’s always felt intimidated by conference calls. “Oh sure, I’ve been on millions of them, but I’ve never set one up. It’s too complicated,” he says.

What’s changed for him is Skype, the wildly popular Voice-over-Internet Protocol (VoIP) startup that allows even Jurvetson to set up a five-way conference call, simply and easily. Jurvetson sees this feature as a breakthrough in his work life, the kind of simple thing that can make entire new markets develop-and one of the reasons DFJ has invested in Skype. He sees VoIP as something that will create room for a number of Skypes over the next five or 10 years. “What I see for quite a while is layers of new communications opportunities where you might not have had them,” he says. “There’s a lot of technology that will arise around VoIP, both in the U.S. and abroad.” In part, that’s because VoIP is not just about voice. It’s become a form of shorthand for the conversion of analog communications of all forms

to digital packets. This conversion in turn will create new ways of handling music, videos, video-conferencing and other types of multimedia.

Certain that the conversion will happen sooner rather than later, venture capitalists have dramatically ramped up their VoIP investments this year, putting more money to work than they did in the previous two years combined. As of Nov. 10, they plunked down $355 million for 18 companies, according to the MoneyTree survey conducted by PricewaterhouseCoopers, Thomson Venture Economics (publisher of VCJ) and the National Venture Capital Association.

The most active investor in the space this year has been 3i Group, which put money into three VoIP-related deals: Kineto Wireless Inc., Sonim Technoligies Inc. and Vonage Holdings Corp. Another five firms have done two deals each in 2004: Accel Partners, BCE Capital, Enterprise Partners Venture Capital and Storm Ventures.

The year’s biggest round went to Vonage, an Edison, N.J.-based startup that lets people make local and long distance phone calls over the Internet. After pulling in a $40 million Series D round in February, it hauled in $105 million in August. The Series E round was led by New Enterprise Associates and joined by Institutional Venture Partners, Meritech Capital Partners and 3i.

All this talk about the future of VoIP might spark cries of “hype” from investors who remember similar talk from four years ago. Flush with capital-remember billion-dollar funds? -VCs over-saturated the space in 2000, dropping $685 million on 28 VoIP startups. Investments declined in the following years, hitting a low in 2002, with $160 million invested in just 12 companies.

While there are early sectors of the market that no longer leave much room for venture investors, the likelihood that the traditional phone system will be made over into a digital packet-switching environment will create huge potential for returns.

“Communications over IP is enormous,” says J. Sanford Miller, managing director of 3i US. “This is one of the big trends for the next 10 years. … Once there’s millions and millions of VoIP users, there’s going to be a variety of software and equipment needs that will be met not only by the likes of Cisco, but also by startups.”

It might seem odd to think of VoIP as a hugely successful technology in the voice world. It was only a few years ago that its quality was so poor that it seemed unlikely ever to gain widespread consumer adoption. In fact, where consumers did use it was more of an arbitrage opportunity for companies that wanted to take advantage of extremely high costs for overseas calling. But packetizing the network itself gave enough advantages that there was healthy potential for IP equipment firms.

Longtime VCs acknowledge that a lot of the venture-backed startups of five years ago were mostly too early, or were victims of the downturn in the telecom market. Many of the investments have been a bust. While this year has seen the sale of at least eight venture-backed VoIP companies, five of those companies were sold for less than they raised from VCs. The biggest bust was Vertical Networks, which raised $124 million from top firms such as Accel Partners and Kleiner Perkins Caufield & Byers. Back in June 2001, the VCs gave it a $258 pre-money valuation. All that was just a bitter memory when Artisoft came along in September and snapped up Vertical for $19 million.

Still, VCs have to be encouraged by two big exits this year: Lucent’s purchase of Telica for $296 million and Alcatel’s purchase of Spatial Wireless for $250 million. The Telica deal returned 2.5X to its venture backers. Telica had previously raised $117 million from Bessemer Venture Partners, Highland Capital Partners, Oak Investment Partners, Prism Venture Partners and others.

The biggest win for VCs came from Spatial, which returned 4.3X their money. Spatial had raised about $58 million from ComVentures, Sprout Group, St. Paul Venture Capital, VantagePoint Venture Partners and others.

The number of startups that have been sold at a loss shows that VoIP is still a difficult market to call, but several of these companies simply ran into stubbornly weak markets that had not turned around enough to keep them cash-flow positive. There are stronger companies out there.

“You have to go through these stories individually. Some of these companies were making progress, but were probably still losing quite a bit of money,” says Michael T. Fitzgerald, managing general partner of Commonwealth Capital Ventures, which has made several VoIP investments, including one in Pactolus Communications Software. Fitzgerald says that as the market continues to develop, there will be more revenue and better results for investors. He cautions, though, that VoIP is not a sure thing. “The market is potentially vast, but it may also be a bust for investors. Users will certainly benefit.”

There are signs that parts of the VoIP market are strengthening. Improvements in VoIP quality have yielded a small but rapidly growing consumer market for voice calls, while packetizing communications is sweeping through the telecommunications industry.

The Yankee Group projects that the worldwide market for packet voice equipment will grow from $3.3 billion this year to $13.8 billion in 2007. “It’s definitely a sustainable trend,” says Danny Klein, an analyst at Yankee. The key driver, he says, is that VoIP improves worker productivity, by making it easier for end users to do things like organize conference calls and for administrators to manage their communications.

Despite this growth and potential for productivity, it’s also clear that there are already a number of VoIP markets unlikely to draw new investors. Softswitches for enterprise and carrier class networks, for instance. Session border control companies. And of course, with more than 40 VoIP service providers, including some of the largest traditional phone companies, funding another Vonage makes little sense.

BCE Capital, a venture capital firm funded by Bell Canada, has in the last year put money into IP softswitch maker Sylantro, Voice-over WiFi provider Bridgeport, and NexTone, all three of which it says exceed plan on a quarterly basis. This though the firm retains reservations about whether VoIP has passed the point of investment potential for VCs.

“Voice over the net is happening in full force in three different areas, each of them well beyond the point where you’d invest in them for venture,” notes Jim Orlando, managing director of BCE Capital in Ottawa. But all that activity means, “If this is happening now, in three years what problems are going to emerge as VoIP is proliferating? As venture investors, how do we make successful investments … when this thing goes from 1% penetration to 50% penetration?”

Orlando thinks that areas like VoIP security, Voice over WiFi/broadband, and mobile VoIP infrastructure all have potential. He also thinks that as VoIP-enabled switching continues to spread, significant markets will emerge for applications that integrate phones with contact databases, or devices that include streaming MP3 players and the like. “It isn’t new, but the infrastructure now being put into place is making it become reality,” he says. In fact, Orlando thinks that voice is just the tip of the iceberg-the broader markets are video over the Net, entertainment over the Net, “all the stuff people pay money for.”

It’s Different Now

Several things have changed since 2000 to create what appears to be a strong foundation for VoIP. One is that the basic technology has improved. Where once making a phone call over IP meant very poor quality sound, dropped calls and latency issues-if in fact the network would let you connect your IP call to the person you wanted to reach at all-after several years of work the quality has improved greatly. As proof, 3i’s Miller notes that Vonage, which is a 3i portfolio company, now sees 60% of its users port their phone number to the Vonage service, which implies that they’re going to use it as their primary phone line. He says 3i did not expect such behavior, and sees it as a huge underscore for the market potential of VoIP.

Another piece of the VoIP puzzle is the development of standards. Where once it was difficult to connect two IP calls to each other, let alone to the regular phone network, this has become much easier, thanks to the rising popularity of protocols like Session Initiation Protocol (SIP).

Jaime Robertson-Lavalle, director of the communications infrastructure sector at Intel Capital, said on a panel at the VON Conference in Boston in October that standards-based telephony means that telecommunications will become a standards-based industry in the same way that computing shifted from proprietary platforms to a standards-based industry, yielding the PC industry and ultimately the Internet.

“We will see the disaggregation of a horizontal industry into standards-based open-architecture building blocks,” Robertson-Lavalle said. “For the first time, the network will be a platform. Siebel could start a CRM business because he didn’t have to think about infrastructure. For the first time, that will be true of the network.”

Time itself is a factor in VoIP’s favor. Earlier failed VoIP companies have made errors that followers could avoid or correct, and that’s helped markets to develop. Where four or five years ago startups had to basically invent everything they needed to make their product work, now there are emerging standards, practical experience based on five years of early adopters screaming bloody murder, and a sense of how to distribute these new products.

Even in the last year, concerns have been alleviated, says Yankee Group’s Klein. “Twelve months ago, the concerns still had to do with the technology: Is it mature? Is it carrier class? Can you build a real network using these small vendors’ equipment, and will it be as reliable as equipment in place today?” he says. Successful deployments and the ongoing advance of technology has alleviated many, though not all, of these concerns.

Earlier this year, the FCC removed another potential roadblock, ruling that VoIP phone calls cannot be taxed by state regulators.

“The market is ripe now to start coming up with things that can piggyback on what’s there,” says Jim Laird, vice president of investments at Covington Capital in Toronto. Covington has invested in SIPQuest, which is working on several technology projects, most notably bringing VoIP to the mobile platform.

Laird sees a major shift coming to the VoIP market, as well. What’s driven much of its early growth is price. IP has been cheap to use for voice, and there’s always a market for the lowest-cost version of anything. So both telecom and enterprise deployments have occurred. The same value held true for VC favorites like Vonage and Skype. But bringing packets to the analog realm ultimately will generate other kinds of companies, says Laird. “There’s a lot of things coming down the pipe that aren’t just about being cheaper,” he notes.

Laird adds: “What’s interesting about voice over IP is not the voice part, but that it can make for a much richer user experience.” IP remakes the field of video conferencing, for instance, making it easier to do, and more likely that people will use what has been a somewhat daunting application.

Laird thinks such a shift will drive mass adoption, a much different venture-investing model than developing high-priced applications that will appeal primarily to large companies. Not that those markets will be irrelevant. He just thinks there will be plenty of profitable niche markets for VoIP technology providers, but that the best returns will come from broad adoption of technologies.

Critical Thinking

Add it all up and even VoIP skeptics-like Bart Schachter, managing partner at Blueprint Ventures-acknowledge that VoIP has looked stronger than expected. Schachter continues to think that consumer VoIP services such as Vonage will wind up as fodder for traditional telecom vendors, and not at premium returns to investors. But he is not a skeptic about other facets of the market for voice-over-network. Blueprint has two VoIP investments, Atreus and Bay Packets, and Schachter says he could see making more investments. “There are absolutely startup opportunities,” he says.

What Schachter likes about VoIP is that “this is an established technology. It’s a 10-plus-year-old technology. We’re not skeptical about the technology. We’re just skeptical about how investors make money on voice over IP for last-mile applications.”

He even likes other parts of the consumer market, particularly for consumer electronics. He thinks the spread of IP into voice and other analog applications will be a boon for things like wireless speaker startups and other ways of transmitting multimedia into new types of devices.

He also likes the related field of Voice over Wireless, which he thinks is a still-emerging area and open to investments. There are Voice over WiFi phones already out from companies like SpectraLink, and Hewlett Packard, Motorola and NEC all plan to release dual-mode phones that can accept calls both from the cellular network and WiFi LANs. The market for such handsets is expected to grow rapidly, since it offers companies a way to reduce their overall telecom costs.

But no venture-backed business is a no-brainer. VoIP and the broader market for packetized communications will see plenty of competition, both from other startups and existing companies. “One of the things that scares me about VoIP is that there are so many companies in different categories,” Anthony Marino confessed to the audience at the VON conference. Marino, a partner at Venrock Associates, also expressed concern about how easy it is to scale the technology.

Marino thinks wireless LANs and converging data networks with cellular networks will present substantial opportunity for VoIP vendors, both on the transport and service layers. He thinks the nation’s aging emergency services infrastructure could present an opportunity for entrepreneurs. And he sees a market for SIP equipment inside enterprises.

Other issues, and opportunities, will present themselves internationally. Some regions of the world are further ahead of the United States, others behind. Products that sell for telecommunications carriers here will also likely have global markets. But consumer products may find spottier potential. In the meantime, as more kinds of media get packetized, there’s an opportunity for startups, like companies that make semiconductors to support the handoff of different kinds of signals.

“The whole category of mobile phones is increasingly becoming more sophisticated,” Rod Randall, a senior managing director at Vesbridge Partners, said at VON. “Look at the power that’s in a cell phone: the connection, the distribution, the processing, the storage. It’s a platform for innovation.” Much of that innovation will focus on VoIP functions, particularly chips that can handle multiple kinds of signals, or can limit content access.

Randall said he’s actively looking for things that will take advantage of VoIP infrastructure. He’s watching the VoIP-ization of the cellular industry, driven in part by push-to-talk features that are moving to SIP. “If you get your cell phone punch button, and you have instant access to speak into it, and you combine your idea with the idea that 411 is a $9 billion business area, you start to see what you can do with VoIP over cellular,” Randall said.

Another opportunity: making video connnections happen more easily. “If you’ve got a way to do it, come see me,” Randall said.

How big is VoIP? Venture capitalists say it won’t likely be as big an investment opportunity as the PC or the Internet because it doesn’t create entirely new ways of doing things. But they think that taking familiar things and making them cheaper and more powerful will offer plenty of room for investors to make money.

The potential for converting cellular networks to VoIP is clearly high, with all of the related opportunities around handsets and services. In the interim, there will be companies offering a variety of ways to give cell phones IP-like capabilities, and connect them to universal mailboxes and the like. Another intriguing, if vague, area is the chance to create applications for the emerging telecom platform-video conferencing in particular is one that intrigues venture investors, but anything to do with digital video and audio is also there. If Steve Jurvetson is organizing his own conference calls, it may well be that anything is possible.

Michael Fitzgerald is a freelance technology writer based in Boston. His email is