Feature: Optics Update – Is this High Flying Sector Headed for a Fall? –

Hot investment sectors in the venture capital industry seem to come and go in a flavor-of-the-month manner. Business-to-consumer Internet plays, business-to-business deals, infrastructure companies and nearly as many wireless deals have all had their 15 minutes. And once a sector heats up, VCs are sure to follow, lest they miss out on the next big thing.

Last year, optical networking became the VCs’ newest best friend. Everyone, it seemed, was talking about optics and touting the benefits of their most recent investment in the sector.

In 2000, VCs pumped $3.8 billion into 118 optics companies, according to data from our VentureXpert database, a dramatic increase from 1999, when VCs invested $993 million into a mere 42 optics deals. The fervor around the sector grew so intense that investment activity in the fourth quarter of 2000 – $1.27 billion invested in 48 companies – outpaced all of 1999.

But then, nearly as quickly as it came, VCs’ activity in the sector dropped off. In the first quarter of 2001, VCs invested just $475 million in 32 companies, less than half of the previous quarter’s total disbursements.

The rise and fall of the optics sector is reminiscent of the dotcom roller coaster, albeit with some notable differences.

“Over the past two years, too much money was invested into too many optics companies,” says Chris Schaepe, a general partner at Lightspeed Venture Partners.

“We, venture capitalists, overdid it,” adds Sanjay Subhedar, a general partner at Storm Ventures.

In short, too much capital flowed into the optics sector a little too quickly because of the enormous opportunity it presented, a number of VCs say. “When you see such a huge market involving users all over the globe, you need to be playing there because the aggregate market is so large,” notes Christopher Kersey, a partner at Blueprint Ventures.

Lightspeed’s Schaepe agrees. “I think, in general, VCs like to back companies in emerging growth markets, which is what optics is,” he says. Moreover, VCs who are not involved from the beginning risk having to play a futile game of catch-up later on. “The danger is, if you don’t place any bets you will be left behind and you won’t have the knowledge to compete down the road,” says Schaepe. Lightspeed recently came out ahead, when Intel Corp. agreed to buy one of its optics portfolio companies – Newark, Calif.-based LightLogic Inc. – for $400 million.

However, the one problem with a potentially super-sized market is that VCs, awed by the possible returns a successful company could generate, sometimes have the self-control of lemmings running toward the edge of a cliff. “Because the opportunity was so great, there was a huge rush,” Subhedar says. “This has happened with every new technology, like the early days of the PC or disk drives…everybody thought, all I need is 5% to 10% of this big market. But usually this isn’t enough, because as a market matures it will only support two or three companies in the long run.”

A Case of Indigestion?

As a consequence of this over-funding, VCs now spend more time scrutinizing the optics deals that are coming across their desks and digesting their performance.

“You still see a bunch of companies out there, but the bar for funding is higher now because of the fact that there is so much inventory there,” Schaepe says.

“Some of the luster may be gone now,” adds Subhedar. “People are being more careful. Not every professor will get funding and a $30 million valuation for his idea and a couple of PowerPoint slides.”

Indeed, Highland Capital Partners, a backer of early-stage Internet, communications and medical companies, decided not to do any more communications equipment deals in the second half of 2000 and only recently began investing in optics again, says Sean Dalton, a general partner at the firm. “I was presenting the case for two optics companies at a partner’s meeting and one of my partners asked a question about the companies, and I realized they were basically the same company going after the same market, so we decided to take a step back for a little while and wait to see how the sector would develop,” he explains.

The majority of optics investors seem to be employing a similar strategy, says Jeffrey Yu, a principal at Crescendo Ventures and co-leader of the Crescendo Ventures Research Group, which in January authored a report about the opportunities in optical components and subsystems. “Right now the slowdown is people understanding what they have done, where they are,” he notes. “So VCs have to spend some time digesting what the opportunities that exist are and what technology addresses those opportunities.”

The digestion process will spawn a minor shakeout among optics companies, says Steve Krausz, a general partner at U.S. Venture Partners. “Because the capital spending by major telecom carriers has decreased dramatically due to current economic conditions, a lot of companies will find a difficult time locating buyers for their product,” he says. “So it is probably going to be a very challenging 2001 as people sort out what will happen.”

Companies that lack the wherewithal to respond to this changing business climate are going to struggle. In April, for example, Patricof & Co. Ventures Inc. portfolio company OnePath Networks laid-off 50 of their 165 employees in response to a general softening of market conditions, said David Stehlin, the company’s chief executive officer.

“Much like you saw huge write-offs in people’s portfolios for Internet companies, this will happen as well for optics companies,” Dalton says.

Not the Next Dotcoms

Despite the seeming parallels, VCs don’t expect another dotcom-style meltdown. “Fundamentally, there is a real difference between optical component companies and b-to-c or b-to-b e-commerce companies – many of the early optical companies really had products that were new with proprietary, breakthrough technologies,” explains USVP’s Krausz.

“Optics companies have real business models,” says Michael Duran, a general partner at Patricof. “This is not an Internet business versus an Old Economy business situation.”

Blueprint’s Kersey points to the investment his firm recently made in Tunable Photonics Corp., a fiber optic components maker, as proof of how real optics companies are. “This company is different from a dotcom because it has proprietary technology that if you drop it will break your foot,” he adds. And unlike an online pet store, Tunable Photonics’ technology – the company makes a wavelength locker and wavelength mapper for widely tunable lasers – means that the company has established real barriers to entry in its market place.

Optics companies not only have legitimate business models, but they also service a market that will continue to grow, a number of VCs say, which means the sector will continue to attract VC interest. “The drivers are still there. The Internet is still there and traffic will increase,” Yu says.

However, not every VC is convinced. In the short term, Promod Haque, a general partner at Norwest Venture Partners, says there will only be some selective opportunities in optical component and subsystems. “I’m fairly negative on that space. The game is over,” he says. “The action is somewhere else now,” Haque says. “Five years from now there will probably be some space here, because the technology will change.”

Duran disagrees, arguing that optics is a very young industry and there is still a tremendous amount of innovation to come. “In the semiconductor domain, a chip today has tens of millions of circuits. An optical component has 10 functions, so it is a million times more complex in electronics than in optics, which means there are decades of advances ahead,” he says.

Moreover, investing at a time when the sector seems to have slowed can be a winning strategy, says Lightspeed’s Schaepe. “Now is not a bad time to be looking at optical companies…because 10 VCs probably will not be there, maybe only two or three others will also be interested.”

“It is the cyclical nature of markets that there will be heightened periods of frenzy and times of lesser activity,” Crescendo’s Yu says. “It is the VCs that are making smart investments now, who will be ahead in two years.”