The IT Hot List: Leading VCs Say Where the Smart Money is Headed –

Every venture capitalist invests in information technology companies, right? Well, maybe not – but at times it certainly seems that way. New IT-focused venture funds seem to sprout up as quickly as Internet start-ups once did. Meanwhile, VCs, formerly relegated to the background of the financial services world, have marched into the national consciousness in lockstep with the growing fascination among everyday Americans with technology companies, tech stocks and the get-rich-quick possibilities of initial public offerings. For most people, VC equals IT and IT equals money. It seems to be a fairly simple equation, but as with most things, the devil is in the details. And in this case the chief detail is staring VCs in the face: what companies to invest in – which one’s a sure thing and which one’s a dud?

Finding the next big thing in the IT universe is not easy. The process is made more difficult by the constantly evolving nature of the sector, VCs say. “Typically, new areas of focus develop every one to two years,” says Jennifer Fonstad, a managing director at Draper Fisher Jurvetson (DFJ), an early-stage, IT investor. DFJ deals with the inherent fluidity of the IT sector by factoring this into their investment philosophy, so the firm looks for companies that are changing the rules, rather than companies responding to those changes. “We strive to invest in revolutionary, rather than evolutionary companies,” she says.

The IT sector is currently experiencing another period of change, as what was the next new thing – business-to-consumer Internet plays – has, with the recent untimely ends of several dotcom companies, suddenly become old news. “The obvious shift in the sector is that lots of people were throwing money into B-to-C deals. There was a lot of consumer-oriented focus to IT investing. Now, there’s a business focus,” says H. Dubose Montgomery, a managing director at Menlo Ventures. In July, Menlo held a $1.5 billion first and final close on its latest vehicle, Menlo Ventures IX (VCJ, September, page 22). At the same time, the firm decided to stop investing in health-care deals and, instead, focus solely on early-stage communications, software and Internet companies. “We made this decision because the returns in the IT sector are so good,” Montgomery said.

“There has been a shift from B-to-C to infrastructure plays,” adds Sean Dalton, a general partner at Highland Capital Partners, a backer of early-stage Internet, communications and medical companies. VCs are now looking to back companies providing the picks and shovels that are enabling the Internet and communications revolution, he says. Not only is this the smart bet, it’s also the safe bet, Menlo’s Montgomery says. A VC who invests in an infrastructure company will win, even if the e-commerce business utilizing the infrastructure company’s technology does not fare so well, he adds. “We prefer stuff that wins, regardless of who wins on the end-user side,” he notes.

Simple Themes, Huge Possibilities

“We’ve identified simple themes: broadband – the more you have, the more you want; wireless communications – everybody wants to cut the cord; and the ubiquity of the Internet,” says Alan Salzman, a founding partner at VantagePoint Venture Partners. “When you take these themes and look at today’s world, it means you have to rip out all the existing communications infrastructure of the whole world, because it was not built for this,” he adds. VantagePoint, a backer of data networking, communications services and technology, enabling technology and Internet infrastructure companies, is positioning itself to profit from this gigantic rip-out and rebuild process by having cash on hand. In early August, the firm closed on its fourth vehicle, the $1.5 billion VantagePoint Venture Partners IV LP fund.

Other VCs, who are drooling over the opportunities presented by this impending change, are betting that optical networking is what will make the brave new world of communications work. “There is an unlimited demand for faster and faster networks,” Montgomery says. “Every generation of optical transport is two to four times faster than the previous generation,” he notes. Menlo has backed several optics companies to date and has realized some breathtaking returns. In 1999, Menlo invested $10 million in Sunnyvale, Calif.-based Xros Inc., an optical switching company. In June, Nortel Networks Corp. purchased Xros for $3.25 billion, yielding a $1 billion profit for Menlo. The firm believes the optics industry holds even more opportunities, and in late August it added a new managing director to its investment team to help scout out optics deals.

Sierra Ventures has also bulked up its investment team for the purpose of trying to identify potential optics category killers, says Peter Wendell, a general partner and founder of the firm. He says optical networking companies will be a key focus in Sierra’s networking and telecommunications practice. The firm, which also backs early-stage software and Internet companies, held a final close on $500 million for its newest vehicle in late August.

Highland’s Dalton, while noting that his firm has backed optics companies and believes in their growth potential, does wonder if the marketplace might be a little too enthusiastic about them. “The market may be a little overzealous – there is a lot of existing equipment out there,” he says. “The fervor surrounding optics is a bit like how people used to feel about B-to-C companies. Sure, some of these companies are great, but some are not so great.”

Menlo’s Montgomery agrees that perhaps not every optics company is going to have a $20 billion market cap one day, but he does not believe his colleagues are showing any sort of irrational exuberance in their reaction to the industry. Unlike B-to-C plays, the optics industry features strong, defensible positions because of large barriers to entry, he says. Meanwhile, it’s hard for established companies like Nortel Networks or Cisco Systems Inc. to keep up with smaller companies that are more nimble and focusing on one product instead of a number of products. “Companies which are market leaders will have strong positions and value in the public markets or as acquisitions,” he says.

As optical networks continue to develop, and end-users continue to scream for more bandwidth, these advances will add to the functionality of the Internet, Montgomery says. “The Internet drives the need for bandwidth and as you get more bandwidth, you can do more with the Internet. This means you can provide new types of solutions, which people could not do before because they didn’t have the bandwidth,” he adds. This results in a growing interest among VCs for the new crop of application service providers, or ASPs, which can provide software solutions that are hosted off-site and accessed via the Web, he notes. Sierra’s Wendell agrees: “Optical offers a tremendous leap forward in capacity of transmissions and this opens up applications, which did not make sense to try even a year or two ago.” For proof, he points to a portfolio company, Again Technologies Inc., which provides an enterprise software solution that manages variable compensation systems and is offered via an ASP implementation.

A World Without Wires

If optics companies are hot because they can move data through their backbones faster than it has ever been moved before, imagine the potential value of companies that will move your data through thin air. VCs active in IT investing see the future and that future is dominated by wireless communications. A businessman will be able to think outside the box, literally, while still having access to his contacts file stored on his desktop computer’s hard drive.

“Wireless was always thought of as voice communications, but now, increasingly, we are seeing data applications,” says Dave Hathaway, a managing general partner at Venrock Associates, an early-stage IT, health-care and life sciences investor. Venrock puts about 70% to 75% of its funds toward IT deals, he adds.

“Wireless is moving to areas where it can move large chunks of data effectively,” adds William Marshall, another founding partner at VantagePoint. The firm is seeing its involvement with wireless companies pay off. In early September the firm closed on the sale of one of its portfolio companies, Santa Rosa, Calif.-based Alantro Communications to Dallas-based Texas Instruments Inc. for somewhere between $300 million and $500 million, Marshall says. Alantro makes chip sets that enhance wireless connectivity.

“Now that carriers see the potential of the wireless Internet, there should be a whole spurt of applications opportunities here,” adds Hathaway. In addition, he says, there will be a number of wireless infrastructure deals on the horizon for willing VCs because the majority of that infrastructure still needs to be built. In this arena, VantagePoint has high hopes for another of its portfolio companies, Boston’s Netmorf, which is in the business of allowing companies to quickly extend their e-business initiatives to wireless devices.

Montgomery says Menlo is intrigued by wireless and has done some deals in the area, although he does not think wireless is quite as exciting as some other VCs do.

“It is a broad area, ranging from new cell phones for the Web to the software behind them,” he says. “Plus there is more than one kind of wireless: there is wireless from your cell phone to fixed point wireless at home, wireless in metropolitan areas, long haul wireless – so there are lots of pockets of activity. Some areas are interesting, some are less so.” Moreover, wireless is complicated to a certain degree by regulatory issues, he says. “It is not quite the free frontier of building equipment to make a computer faster,” he adds. “You do not need government approval to use a piece of equipment in your office for higher broadband access, you do need it [to use the wireless spectrum].”

Looking Ahead

Even while they are working to identify what is hot now, VCs in IT are keeping one eye on the future. VantagePoint’s Salzman and Marshall even believe they have already been working on the future hot item for over a year now: Semiconductors – because underlying all the advances in communications are newer, more powerful semiconductor chips, they say.

DFJ’s Fonstad says nanotechnology and peer-to-peer networking are poised to become the next big thing. “Peer-to-peer networking will allow more than file sharing; you will be able to share bandwidth and break computations into thousands of modules and farm them out to a bunch of computers to work on the modules and then re-aggregate the modules into a whole,” she says. “This will change the Internet fundamentally, because it takes bottlenecking and latency out of the network.”

Highland’s Dalton says he thinks there will be a large market opportunity for software that ties together heterogeneous networks. But whatever does develop, Dalton says it is an interesting time to be working in IT. “Overall, there’s just as much excitement in IT as there has ever been,” he says.