How To Pick Through the Optics Fire Sale –

When you look at later-stage optics deals, it’s easy to assume it doesn’t require much savvy for venture capitalists to snap up troubled companies at Wal-Mart clearance prices. But as the failed Pluris deal shows, these investments are fraught with risk. How do you avoid costly failures? Venture Capital Journal (VCJ) spoke to the VCs who play the high-stakes game to get their insights.

In the first half of the year, 63 optical networking companies pulled in about $950 million from more than 260 venture firms, according to market researcher Venture Economics, publisher of VCJ. Of those deals, 86% were later- or expansion-stage investments. At the height of the optics craze, VCs poured $7 billion into 890 companies in 2000. Just about everyone got burned, and many abandoned the space altogether. But others are trying to take what they learned from failure and turn it into success.

Among the deals that have been done at fire-sale prices are Caspian Networks, which raised $120 million in March from a syndicate that included New Enterprise Associates, Oak Investment Partners and U.S. Venture Partners; Mahi Networks, which closed a $75 million Series D round led by St. Paul Venture Capital in early June; and Pluris, which raised a $53 million round in February in a deal led by ComVentures, Crescendo Venture Management and JPMorgan Partners.

Drop Zone

The collective pre-money valuation on those deals alone collapsed from $1 billion to less than $100 million. When you’re dealing with numbers like that, you tread very carefully. “It takes two or three months now for due diligence, whereas before it sometimes took as little as two weeks,” says a later-stage investor who requested anonymity.

During that extended due diligence process, VCs are looking for very specific things. Steven Bird, a general partner with Focus Ventures, a 5-year-old later-stage VC, says his firm wants to see specific benchmarks before it opens its wallet. ” p says.

Sales by themselves aren’t enough. The company must be growing. “Shy away from a company that has revenue that isn’t increasing,” Bird says. “That’s a sign that a company may stall. Two years ago, we thought all revenue was good revenue. We didn’t realize the dot-coms and CLECs were going away.”

Customers are the critical element that Catherine Lego wants to see. Now is definitely not the time to be talking to “three professors who are doing a science project,” says Lego, a general partner at The Photonics Fund of Woodside, Calif. The $25 million fund, raised a couple of years ago, focuses on communications. “If a company is talking to its customers it will know that customers want higher integration at a lower cost,” Lego says.

Taking Names

But make sure you know exactly who those customers are, warns Bird. “It’s easy to get in trouble if you are not selling to substantial businesses,” he says. “Right now it is so hard to sell these products to new customers, so having strong customers gives you more potential to sell more to them.”

For Columbia Capital, whether or not to invest in a later-stage optics deal comes down to a very basic question: Does the management team have what it takes? “You can’t get past the management,” says Matt Newton, a partner at the firm, which is investing from its vintage 2000 third fund of $850 million. “Later stage deals have to have good management in place. And they can’t be building at that point. But I do see a lot of deals that are later-stage and the company is in the middle of restructuring. That doesn’t work.”

There appears to be some slight differences of opinion on this last point. Bob Kondamoori, a partner with Charter Ventures, is of the opinion that an established company can be refocused and succeed-if it has the right plan. That means that it is crucial that you have a management team that is willing to be flexible and listen. Kondamoori insisted that Charter, an early stage investor, would only invest in Maple Optical Systems if it changed its business model. The company agreed to abandon its all-optical switch in favor of an ATM model and eventually netted $25 million in a Charter-led July deal that brought its total Venture financing to almost $100 million.

One Trick Pony

“They were taking on multiple challenges,” Kondamoori says. “Two weeks after we joined, we killed some projects and decided it was better to get just one product validated. We had to pull the reins in fast, because we knew that they were going to run out of money if they kept this up.”

The painful reality was that “instead of focusing on 115 things, we wanted to just focus on two,” he says. “Instead of 400 employees, we brought the number to 100. We knew what had to be done, but lots of these companies are in complete denial, won’t scope down and will run out of cash.” With the tighter operation, Kondamoori is confident that 2-year-old Maple will start shipping product in the third quarter.

Even when you do your homework, success isn’t guaranteed. Look at what happened with Pluris. In February the company closed on a Series E deal at a $75 million post-money valuation from lead investors ComVentures, Crescendo Venture Management and JPMorgan Partners. It looked like a good deal for investors, given that the Cupertino, Calif.-based router maker was valued at $626 million when it raised a $104 million fourth round in Q3 2000. But the new cash wasn’t enough to get Pluris over the hump. It closed its doors in June, because management and investors couldn’t see the company hanging on until the telecom market rebounded.

No Takers

If there is a silver lining for the VCs, they didn’t lose their entire investment because they structured the deal in two parts. They gave Pluris $27 million to start but wouldn’t put in the remainder of the $53 million until more money come in from other investors. Try as it might, Pluris couldn’t get anyone else to participate.

Bob Stearns, an early-stage communications investor, says getting later-stage money these days is very difficult. On top of having a product that works, customers and strong growth, a company must show that it can stand on its own and be able to go public or get sold within 12 to 18 months, says Stearns, a managing director at Sternhill Partners, a Houston-based firm that’s investing a $100 million fund. “Even if everything is going right, if the company can’t have a liquidity event for market reasons, or because it’s not a good acquisition candidate, then a later-stage VC might even not bother,” Stearns says. “It’s not a science.”

Contact Danielle Fugazy