We all know how difficult the venture capital business has become, but do you understand that it’s going to get a lot worse before it gets better? In some cases as many as 40 venture-backed companies are chasing $100 million markets that can support just two or three players. Overall venture capital returns will be negative in 1999 and 2000, and more than 80% of the companies funded in those years will be shut down or acquired at rock-bottom prices.
Venture-backed companies in sectors like networking will probably fare even worse. Telecommunications carrier capital spending has been declining every quarter since the end of 2000 and will continue to fall until the end of 2002. Spending will be flat next year and won’t increase until 2004.
How did we get mired in the Technology Ice Age? It boils down to the impact of deregulation, as well as the explosive growth of the Internet and inflated expectations about the new business opportunities that it would create. Another contributor to the mess was the unprecedented herd instinct among venture capitalists.
Deregulation in 1996 fostered competition for the first time in the local cable, landline and wireless markets. In fact, it created a whole new class of service providers called competitive local exchange carriers (CLECs) that successfully raised venture capital, public equity and debt to build networks to compete with the Baby Bells. The CLEC model got oversized to the point that it created different classes of specialists. Some CLECs offered only high-speed data services, such as DSL, to homes and small businesses. Others provided high-speed connections solely to buildings. Far more companies were created than were needed, creating enormous competition. In the wireless world alone, many metropolitan areas quickly jumped from being monopolies to accommodating up to eight wireless service providers each.
The explosion of the Internet and false notions about how it changed the rules of doing business also significantly contributed to the bust. One of the first successful new entrants in this marketplace, Amazon.com, built the world’s largest bookstore, completely virtual, and soon thereafter virtually every sizable retailer jumped on the Internet bandwagon. “Clicks” and “eyeballs” soon became the rage in retailing. Traditional bricks-and-mortar retailing, meanwhile, was supposedly teetering on the edge of obsolescence. All of this created enormous demand for Internet servers and bandwidth connectivity to those servers. The myth was born that a paradigm shift from bricks-and-mortar to Internet-based sales was underway, one that would dramatically reduce selling and distribution costs. Order backlogs at major suppliers of Internet infrastructure gear, such as Cisco Systems and Nortel Networks, soared in some cases to as much as three years. But then, of course, the fallacy of the Internet-only business model quickly began unraveling along with the fortunes of these companies.
Venture capitalists also contributed mightily to the dot-com and Internet infrastructure bust. VCs, like other investors, have long followed a herd instinct, or the belief that a relatively small handful of sectors, such as the Internet, are particularly ripe for investment. After all, they come out of the same industries, think largely the same way, commonly syndicate deals together and tend to be unbridled optimists, a requirement for people who invest in emerging technologies. This excessive optimism extends to the individual companies that venture capitalists back. Most are steeped in a culture that says the companies they choose to finance can compete with the best and often execute better. Examples of this were ubiquitous during the dot-com boom, and it didn’t help that many relatively unseasoned entrepreneurs simply wanted to make a quick buck. In one of many examples, 40 companies were funded to develop Gigabit Ethernet, a new technology for LANs. At most, the market can support three such companies.
Now we find ourselves mired in a Technology Ice Age or almost certainly the worst downturn in the history of information technology and one that will continue to persist for another two years. But while many startups will die, some will survive and even ultimately thrive. Those in the most dire straits (many funded in 1999 and 2000) have their products in beta tests today. They are ready to go to market, but the market is not ready for them. Some will try to survive by going into hibernation – keeping expenses very low while waiting for the market to rebound. The problem is that this makes it extremely difficult to keep their products fresh. When the market does fin ally turn, their technology is likely to be leapfrogged by newer technology that produces better, faster and cheaper products.
Startups in the best position today are still in the middle of developing their products and will not be ready to introduce them for beta testing until late 2003 or early 2004. Their technology is newer and better. Because fewer startups are being funded today, they will also have fewer competitors, and they’re able to recruit stronger development teams at a lower cost amid the information technology depression. In addition, they may be in a stronger-than-average position when IT spending rebounds because established companies are investing substantially less in research and development and are likely to be bigger buyers of startup technology in 2004 and 2005.
Some companies that have placed products in beta tests, including some Storm Ventures-backed companies, will also manage to weather the Technology Ice Age and ultimately fare relatively well. It won’t be easy, but they have the opportunity to transform themselves into better fighting shape. Highly disciplined companies will find ways to trim expenses further and revamp their products to keep them technologically fresh when the market finally rebounds. They also will continue to outsource as much as possible, focusing their spending solely on core competencies.
It is only a flicker right now, but there is light at the end of the tunnel foreshadowing a sustainable resumption of growth in information technology. We won’t see a repeat of the 30%-plus annual revenue growth we saw in the mid to late 1990s, but we will certainly see solid growth of 10% to 15% a year lasting through the rest of the decade. Such growth was common before the late 1990s boom. The recession has also showed American business the substantial benefits of aggressive corporate IT investments over the last decade. Productivity, the ultimate engine of prosperity, rose throughout 2001 and continues to post huge gains in 2002, mostly because of IT investments. Corporate profits have taken a terrible beating, but the picture would be far worse if companies had not been reaping unprecedented efficiency gains.
For now, the Technology Ice Age will continue, and only the hardiest companies will survive. Many will be hamstrung by unusually small orders over short time periods and hence minimal order backlog and visibility. At some point, however, this difficult backdrop will fade away. Young technology companies that run a super-tight ship and maximize every opportunity to improve their competitive posture can still look forward to a promising future.
Sanjay Subhedar is a general partner at Storm Ventures, a seed- and early stage venture capital firm based in Palo Alto, Calif. The firm, founded in Otober 2000, manages a $310 million fund. Prior to co-founding Storm, Subhedar was the founding CFO of Stratacom (bought by Cisco) and the COO of optical component maker Etek Dynamics. He sits on the boards of Chahaya Optronics, a contract manufacturer for optical componentry, and Dowslake Microsystems, an optical component maker.