VCs Ponder the Future of Broadband and Bet Big on PON –

While most venture capitalists are playing it safe, a cadre of respected VCs have placed a $45.1 million bet on a technology that once tripped up their peers. It’s called passive optical networking (PON), and despite its dullard name, it is poised to give other broadband technologies a run for their money.

VCs thought they had PON figured out four years ago, but they picked the wrong business model. This time, it looks like they’ve picked the right one, but their portfolio companies face competition from entrenched players.

The beneficiaries of renewed interest in PON are Salira Inc. of Santa Clara, Calif. and Wave7 Optics Inc. of Alpharetta, Ga. They are direct competitors. Salira closed on a B round of $22.1 million, with backing from Sofinnova Ventures, Mobius Venture Capital, Vertex Management and WI Harper. Similarly, Wave7 closed on a B round of $23 million in a deal that included Advanced Technology Ventures (ATV), Mellon Ventures, Morgenthaler Ventures and Lucent Venture Partners.

Salira and Wave7 have “a product to solve the last-mile bottleneck because DSL [digital subscriber line] is not enough,” says Sofinnova Principal Eric Buatois. “DSL is not profitable for the carrier – it only has 2 million to 5 million users in the U.S while cable modem users in the U.S are 9 million or 10 million. The carrier wants technology which is cheaper and cheaper to maintain and has high bandwidth for the business user.”

PON is a last-mile technology that extends optical bandwidth, but it’s one that doesn’t require expensive active components like lasers or amplifiers. It contains no electronic devices that require external power, and use the physical characteristics of light to separate different carriers or colors of light, making PON systems easier to maintain and cheaper to install than lasers or amplifiers. PON is a carriers’ alternative to laying miles and miles of fiber within a metropolitan network. Instead of laying fiber out from the central office to each customer. With PON, a single cable runs from a carrier’s central office to a box close to a cluster of customer sites. There, the PON system splices the signal and delivers all that electronic information to each customer through a short piece of fiber. It’s almost like a bridge – every car is funneled across San Francisco’s Bay Bridge. But when they get to the other side, the road splits. To go east, get on 80. To go south, get on 880.

It’s a solution that can make it cheaper to deliver broadband to homes and businesses. For the carrier, PON conserves fiber and port space at the central office by coupling several units into a single fiber and then spread the cost of expensive active components over multiple subscribers.

Overall, the PON sector has garnered $676 million worth of attention from venture capitalists. The rage for PON began in 1998, surged in 2000 and waned in the last year and a half. Salira and Wave7 are the first PON players to secure venture funding since May of last year when Luminous Networks Inc. of Cupertino, Calif. closed an $80 million Series C round.

Salira and Wave7 focus on Ethernet-based PON (EPON), a space that’s attracting more and more attention. Since 1998, EPON companies have reined in more than $115 million. Livermore, Calif.-based Alloptic Inc. has raised more than $11.7 million from the likes of Athenian Ventures, the Blackstone Group and GMS Capital Partners. Meanwhile, OnePath Networks of Princeton, N.J. has secured $52 million in venture backing – and a post-money valuation of $145 million – from investors like AIG Capital Partners, Apax Partners’ U.S. and Israeli teams, CIBC Capital Partners and Genesis Partners.

The first generation of PON companies venture capitalists seeded in the 1998-1999 cycle are either languishing or have changed their business models. OnePath Networks of Princeton has abandoned the technology altogether to focus on fiber-based satellite links. The problem is that companies like OnePath were built and funded with the intention of passing fiber into the home.

In the late 1990s, when the demand for Internet bandwidth surged, carriers did not have the systems in place to supply hungry audiences. Servers slowed and crashed as the last-mile bottleneck became all too obvious. While DSL providers came to the fore and the phone companies morphed into big bad broadband titans, venture capitalists took their first steps into the PON sector, with investments in companies like Terawave Communications of Hayward, Calif.

Terawave built its technology around ATM, the standard that the Baby Bells demanded. But the phone companies soon discovered that passing fiber to the home was costly and inefficient, especially since the cable companies and competitive local phone companies – known as competitive local exchange carriers, or CLECs – found ways to bring broadband into the home with existing copper technologies. So the ATM standard they demanded was outdated even before it could be implemented. And those that had set their sights on the residential market by selling to the Baby Bells, like AllOptic, changed their strategies to target alternative carriers and enterprises that had their own communications networks.

Since Baby Bells are the only ones asking for ATM-based PON – and they’re not rushing to bring the technology into the home – demand for that particular technology is limited.

For now, the action lies with those that control the local loop: utilities, cable companies, CLECs and anyone with unlit fiber. And they’re demanding Ethernet, the most commonly used communications protocol, as a standard, not ATM.

The technologies themselves are similar. With cell-based, or ATM-based architecture, you can predict how long it will take for a parcel of data to travel from one point along the network to another. While Ethernet-based systems are not as deterministic, both can carry and deliver high-speed data, video and voice services.

Indeed, who’s willing to put down the cash to roll out new EPON systems is going to determine whether or not the sector is for real, or just another over-hyped optical play.

Salira, for its part, will use the recent capital infusion to launch equipment trials with carriers in the second quarter. In the third quarter, it plans to start shipping its system, begin an aggressive push into China and ready itself for a $20 million Series C offering.

In September 2000, the company closed an initial round of venture funding. It raised $6.9 million – a sum that allowed it to develop and test its product suite and ready it for market. Now, with 85 employees and a monthly burn rate of $1 million, Salira needs another $20 million before it can reach a cash-positive position. Following the close of its C round, its burn rate will increase to $1.25 million a month.

Wave7Optics Inc., on the other hand, closed its $23 million Series B round after six months of talks with investors. When the syndicate finally closed, ATV led the deal with an $8 million commitment, while the remaining slices went to Mellon Ventures, Morgenthaler Ventures, Armanda Venture Partners, and Lucent Venture Partners. The company plans to use the capital to continue field trials of its system, build up its inventory as well as its sales and marketing efforts for a formal launch of its PON technology in April. Although the company already has purchase orders from two public utilities that are looking to become service providers, the company has yet to build traction with the international customers that are central to its strategy.

It’s going after international and domestic cable companies that provide business and residential services, as well as public utilities providing those services, says Jack Harrington, a general partner with ATV. “We like that because companies in those areas are spending money.”

Wave7 could only hope that Salira was its only competitor, and vice versa. Alas, optical components makers like Alcatel SA, Marconi PLC and Quantum Bridge Communications Inc. are all said to be developing Ethernet-based PON systems. Looking on the bright side, Salira and Wave7 have that many more potential acquirers if they find it too difficult to go public.