Venture funding continues to slide

After a brief rally late last year, venture capital investments in network start-ups continued a precipitous decline during the first quarter of 2002, dropping to their lowest level in three years.

Venture capital firms invested $3.2 billion in 387 start-ups, down 29% from last quarter's $4.5 billion invested in 517 companies. The average investment was $8.2 million, down from $8.6 million in the previous quarter.

Today's investment level is one-fifth of what it was at the network industry's peak in the second quarter of 2000. At that time, venture capital firms poured a record-breaking $15.8 billion into more than 1,000 start-ups, many of which have since gone out of business.

These network industry statistics were compiled for Network World by three organizations that compiled the quarterly MoneyTree Venture Capital Survey: PricewaterhouseCoopers, Venture Economics and National Venture Capital Association.

Despite the downturn, industry observers say venture financing for promising technologies such as Internet backbone routers, metropolitan-area Ethernet and voice over IP remains high from a historical perspective.

"The conventional wisdom is that the sky has fallen, and we're in a virtual depression," says Steve Bengston of PricewaterhouseCoopers.

"But 2001 was the third-biggest venture year ever," Bengston says. "And even if we stayed at this same level for all of 2002, we'd still have the fourth-biggest venture year. That's hardly a depression by anyone's standards."

The top 10 deals of the quarter all surpassed $40 million. One deal - a $120 million investment in IP switch manufacturer Caspian Networks - is reminiscent of the industry's glory days of 1999 and early 2000. Caspian has raised $262 million in four rounds of financing since its launch in February 1999.

Caspian attracted so much money because it offers a breakthrough, cost-saving technology for service providers, says Faizel Lakhani, a vice president at Caspian.

"Even the most conservative estimates show IP traffic growing at 100% a year," Lakhani says. "Service providers are now recognizing that they need to invest in an IP infrastructure . . . that reduces the cost of IP networks."

Caspian isn't the only Internet infrastructure start-up to get funding. Indeed, six of the top 10 deals are for companies building backbone routers or switches. Two more companies offer software for service providers.

With these investments, venture capital firms seem optimistic about the service provider market despite the current financial woes facing top-tier carriers such as AT&T and WorldCom.

"Given that service providers are in trouble today doesn't mean the traffic is going away. Somebody will carry this traffic," Lakhani says. "There's an opportunity for solutions that reduce the cost of ownership and increase revenue [for carriers.]"

Another IP infrastructure start-up that attracted major investment last quarter was Chiaro Networks, a developer of large-scale backbone routers. Chiaro raised $80 million last quarter in its fourth round, bringing its total venture financing to $210 million.

"All the top-tier carriers are seriously studying how to replace their IP cores with the next-generation platform," says Ken Lewis, CEO of Chiaro. "What's going on now is [requests for information] and lab trials. They're looking for the new platform to be deployed next year."

Venture capitalists say investments won't start rising again until the IPO or merger/acquisition markets improve, which isn't expected until next year.

"Short term, the network industry is going to remain traumatic [and] very uncertain," Bengston says. "But long term, we have to say that the network business looks great. All the money that went into the network industry was not wrong. There will be some huge winners."