Honeymoon in Las Vegas –

LAS VEGAS – In the dizzying crowd of this frenzied conference, industry professionals and venture capitalists rushed from one display to another. Packed tightly against each other, they discussed the latest devices, services and business models for the year ahead. They took every networking opportunity and scheduled hour-long follow-up meetings in well-healed hospitality suites at Mandalay Bay.

But the Adult Entertainment Expo, the pornography industry’s mainstay event, had nothing to do with the real reason hundreds of venture capitalists landed in Las Vegas in early January. Across the way, at the Las Vegas Convention center, the much larger Consumer Electronics Show (CES) spread from its humble beginnings to overwhelm the city’s convention infrastructure. It was here that venture capitalists from across the land were truly fawning over the latest gadgets.

CES has become the largest technology show in North America, usurping several computer conferences including Comdex and PC Expo. For industry and venture capital digerati, gracing the halls of this conference immediately upon the start of the New Year has become de rigueur. Readers of Venture Capital Journal should not be surprised: For the last several months the merits and opportunities of consumer electronics have been widely touted in this magazine and in other investment and industry publications. With the collapse of so many other technology sectors, why not seek solace in the impressive volumes and steady growth of the consumer electronics industry? It has proven itself impervious to the vicissitudes of other technology markets.

Fueled by the insatiable appetite of the global consumer and riding the wave of unprecedented growth in wireless devices, digital imaging and personal multimedia, consumer electronics have delivered steady growth. Rich Templeton, the charismatic CEO of Texas Instruments, delivering his keynote address to a standing-room-only crowd on a late Friday afternoon at the Las Vegas Hilton, summarized it best in his recognition award to the “global consumer,” who has sustained his company and the industry through the worst downturn it had ever known.

And so it is that the “convergence” of consumer electronics and computer devices has finally arrived. As a side note, judging from the show’s keynote speakers, the convergence is not simply a “marriage of equals” between two industries but a radical acquisition of the consumer electronics sector by the titans of PC-based computing. TI’s Templeton, Bill Gates of Microsoft, Craig Barrett of Intel and Carly Fiorina of HP were the only keynote speakers at the conference. Bypassing entirely their traditional consumer electronics partners, the tech execs chose as podium mates actors Robert Redford and Matt Damon, rockers Gwen Stefani and Steven Tyler, late-night talk show host Conan O’Brien and Hollywood kingpin Jeff Katzenberg.

Proving once again that Hollywood has more in common with Silicon Valley than with Tokyo, content providers mingled even with stodgy semiconductor companies. As another side note, this convergence was probably not lost on the “content providers” across the way at the Adult Entertainment Expo. It was their content, after all, that fed succeeding generations of consumer electronic appliances, beginning with the VHS players of a generation ago, then the DVD, high-speed Internet and, more recently, high-definition television.

Taking in the dizzying array of product announcements at CES, one could not help but feel a nostalgic sense of optimism for the consumer electronics industry. Many of us remember when the computer industry, and later the telecom industry, shared the same sense of unbridled optimism. But whether this industry will reward venture investors with similar returns remains to be seen. In fact, what privately troubled most of the VCs swarming about at CES this year was a sense that this War of the Worlds may be fought among industry titans without obvious participation by venture-backed startups, or at least those unwilling to spend hundreds of millions of dollars of venture capital to establish a foothold in this marketing-driven industry.

Why this predicament and how can the venture industry make money on it? Leaving aside the world of consumer services, a bet on the future on consumer electronics is a bet on two fairly simple things: devices and components. But only components are likely to reward the venture investor. Why? Because for all his endurable spending habits the consumer is a highly unpredictable actor. For the last several years, device manufacturers have tried hard to predict the right combination of product functionality and cost to appeal to various consumer segments. This is not a challenge that “above average” companies can easily meet. Consumers are fickle and their tastes change frequently, often in response to industry offerings. The challenge is not simply one of market prediction (a challenge that most VCs should be able to manage) but an expensive proposition of market timing that takes years of R&D followed by years of expensive broad-based marketing. No surprise that Apple, rather than a venture-funded startup, took the hill as the dominant provider of digital music devices.

Take cell phones for example. Few would have predicted 10 years ago that a “must-have” feature of a cell phone this year would include a digital camera. Yet today, Nokia is the largest provider of digital camera technology in the world. At least two devices have unpredictably merged, for now, into one. This unpredictability is one that venture investors should be loath to chance. Why? Because its cost is unbearable by the economics of venture capital today. The successful marketing launch of a consumer electronics platform can easily exceed $100 million. To the extent that venture investors and their limited partners believe that capital efficiency is the last bastion of profitability for the venture industry, taking risks on devices that each take hundreds of millions of dollars of risk capital to launch may be more than LPs bargained for. It is almost impossible to predict the combination of device features that consumers may ultimately adopt.

Components, Young Man

While consumer electronics devices are a risky proposition to venture investors (in fact they are risky to all investors but presumably $100 million of risk capital means less to Nokia or Apple than it does to most readers of this column), technologies needed to power all these devices remain in the realm of venture investors. As consumers continue their dance with the latest form-factor innovation, several requirements are clear. Consumers desire more portable devices (lower power consumption, smaller footprint), which provide a better experience (improved displays, better prediction software), which cost less (less expensive processing, interconnects) and connect wirelessly (faster wireless networking) and communicate better with the analog world (improved mixed-signal processing).

These ingredient technologies, for the most part, remain in the domain of venture-fundable companies and allow any combination of devices to prosper in the uncertain world of consumer tastes. Most (though not all) of these components and ingredient technologies should hopefully take rational amounts of capital to develop. PortalPlayer, the poster child for venture-backed ingredient component companies supplying the brains of Apple’s iPod, is but one example of a company delivering a relatively sane capital efficiency investment to investors who were rewarded by a profitable IPO.

Other examples abound. We recently backed a company called WiSpry. A provider of RFMEMS components for mobile handsets, the company’s semiconductor technologies provide a cost and time advantage to device manufacturers looking to shorten their design cycles and improve the performance of their mobile phones. A fairly modest capital requirement is needed to execute on WiSpry’s plan. Why? The company doesn’t need to wow millions of consumers with flashy advertising campaigns. Instead it has to focus on the dozen or so device manufacturers that care about handsets.

WiSpry wouldn’t be seen on the floor of CES where most VCs were ogling the latest multi-million dollar devices. Most “interesting” startups stayed away from the expensive show floor and chose targeting presentations to peddle their gear to consumer electronics buyers.

Meanwhile, outside the convention center, single engine airplanes dragged banner ads announcing the latest consumer devices and brands. VCs shouldn’t look too longingly at those banners. Not long ago, we wrote off the Internet sock puppet and Super Bowl advertising as untenable for venture-backed companies. Today, the sock puppet may be creeping back into venture portfolios under the sexy rubric of consumer electronics. Let’s not forget why the sock puppet went by way of eBay and remember that intellectual property, capital efficiency and rational business models are the way to make money in this industry. This is what LPs are paying us to do.

Bart Schachter and George Hoyem are managing partners with Blueprint Ventures. Schachter focuses on communications and IT infrastructure, wireless technologies, nanoelectronics, software and communications chips. Hoyem focuses on software, wireless, securitiy and IT and communications infrastructure. Schachter’s email is bart@blueprintventures.com. Hoyem’s email is george@blueprintventures.com.