Optics Startups Give Up Frothy Valuations for Cold, Hard Cash –

Although funding of optical networking startups ground to a virtual halt in the second half of last year, no less than three core optical technology companies scored follow-on financings in a single week in February. All told, the trio – Caspian Networks Inc., Innovance Networks and Chiaro Networks Ltd. – raised a total of $250 million.

At first blush it may look like the optical networking bubble is re-inflating. But VCs say that’s not the case. They say the overall sector is still over-funded, and while they are keeping a vigilant eye on emerging technologies, they aren’t likely to chase the “next big thing” in optics. Instead, they’re looking to invest in VC-backed startups that have delivered on significant milestones. Like working products.

It’s no coincidence that all three of the recently funded optics startups compete in one of the only telecom niches market analysts still seem to believe in. “This core router transition space may be the only thing I’m not down on right now,” says Stephen Kamman, executive director of Networking Equity Research at CIBC.

The reason that core router companies are so important is that carriers have to replace their core routers every 18 to 24 months, due to a lack of capacity. With voice and data traffic expected to keep rising, Internet Protocol (IP) traffic is to increase annually by at least a factor of two on major network backbones. That creates major bottlenecks at backbone nodes, causing carriers to look for less costly and more scalable technology.

Analysts and VCs say they expect widespread adoption of core routing technologies in 2003. (See related story on passive optical networks on page 14.)Granted, carriers currently are bleeding red ink, but if the economy bounces back in the latter half of this year, as many predict, carriers are likely to have a bit more discretionary money to play with next year. If so, it’s also likely that new core optical technologies will be in heavy demand.

Thus, those companies with products ready for market when carrier demand does soar are the ones that are most likely to garner the lion’s share of their business. Of course, should the economy emerge from its slump, another potential upside for VCs is the companies that are fully funded and able to bring products to market over the next few months may be ready for initial public offerings as early as next year if they are successful.

Right now, the startups are just happy to be able to raise more venture capital. Caspian had no problem taking a major haircut in its valuation in return for $120 million, the largest single round raised this year. Its pre-money valuation fell to less than one-quarter of the $304 million valuation it was given in its Series C round in late 2000, sources close to the deal say.

Caspian is working on a super-router that promises to scare the likes of Cisco Systems Inc. and Juniper Networks Inc. VCs breathed a big sigh of relief when the company recently started shipping working boxes to beta customers.

“They hit a milestone in engineering,” says a source close to the deal. “Before that, there were a lot of questions about whether they could continue [as a company]… We were on the edge of our seats. Now we are able to sit back and be comfortable.”

That milestone accomplishment spurred a rush of VC interest in Caspian’s Series D offering, which was originally launched last fall with a target of $50 million to $60 million. The deal offered such attractive terms that existing investor U.S. Venture Partners (USVP) bought into Caspian’s latest round at more than five times its pro rata option.

The transaction was co-led by a syndicate of existing investors like USVP, New Enterprise Associates and Merrill Lynch & Co., in addition to new buyers such as Morgenthaler Ventures and Oak Investment Partners. To date, Caspian has raised more than $260 million in venture financing.

Like Caspian, Innovance appealed to VCs because it has delivered a working core router device to trial customers and is poised for a commercial product launch in the second quarter.

It netted $55 million in a Series B round in February that was led by inside investor Advanced Technology Ventures (ATV). The Piscataway, N.J.-based company is developing a photonic networking technology that promises to let inter-exchange carriers to turn up their bandwidth capacity between any two cities in a matter of seconds.

New investors JDS Uniphase and Corning provided strategic financing for Innovance, and as two of the largest components providers in the optical industry, will likely serve as suppliers to the company down the road. Previous backers that re-upped are Morgenthaler, Thomas Weisel Capital Partners, Azure Capital, Banc of America Securities LLC, KPL Ventures and Archery Capital. All of the company’s prior investors exercised at least their pro rata rights, says James Frodsham, the company’s chief operating officer.

Innovance commanded a pre-money valuation of $45.4 million before closing its $77.5 million Series A round in November 2000, according to Venture Economics.

Its latest capital infusion is expected to carry Innovance through its initial product launch, but it will likely need at least one more venture round for working capital, says Jack Harrington, a general partner with ATV and the company’s newest board member.

He’s optimistic about Innovance’s financial prospects. “These contracts for large carriers [can translate] into millions of dollars per year in spending,” he says. “It might be $1 billion over a contract period of three or four years.”

Of the three router startups that raised money, Chiaro appears to be the farthest away from launching a commercial product. A company spokeswoman says Chiaro plans to launch a full-scale product trial effort in the second quarter of this year.

VCs say they’re satisfied that the company is moving forward. “We expect continued customer progress that will turn into concrete, measurable commitments,” says John Adler, a venture partner with InterWest Partners. “Successful trials with customers will lead to revenue, which then leads to profitability.”

Besides InterWest, four other prior investors stepped up to co-lead the new round, including CenterPoint Ventures, Rho Ventures, Sevin Rosen Funds and Star Ventures. The Richardson, Texas-based company raised $80 million, bringing its total venture backing to $210 million.

Chiaro also attracted the attention of a few first-time supporters such as Delta Ventures, Landho Ventures and Poalim Capital Markets.

The round was oversubscribed. Chiaro set out last August to raise $40 million, but it ended up doubling the figure because interest was so strong. A few unnamed investors were left out, and they won’t likely get another chance, as Chiaro expects this round to take it to profitability.

The company was worth nearly $300 million before raising a $101 million Series C round in September 2000, according to Venture Economics. Based on the mini-feeding frenzy surrounding the latest round, it’s safe to assume the company’s valuation declined like those of its peers. But there’s no shame in that. The key issue is whether or not you have a strong enough story to get venture backing. If you don’t, your valuation is just a number on a piece of paper.

Additional reporting by Dan Primack and Lawrence Aragon.