Where’s Value Heading?

Posted: 01/1999

Where’s Value Heading?
By John T. Mulqueen

Summarizing the multibillion-dollar communications venture capital (VC) industry is
like asking a blind man to describe an elephant. The beast is too big and has too many
unique appendices to be depicted easily. Besides, it is moving all the time.

Still, one piece of the giant does seem to be taking shape. A group of investors is
growing with more interest in content-oriented or service-oriented Internet companies than
in hardware or network providers. Scared off by the collapse this fall of the junk bond
market and steep declines in competitive local exchange carrier (CLEC) stock prices, these
VCs are looking for potentially richer returns in less capital-intensive industries.

"It is like the flavor of the year," says Perry Ha, a principal in Athena
Technology Ventures, a relatively new fund located in Palo Alto, Calif. "I am finding
that other venture capitalists are interested in more service-oriented business
models."

Why invest in a CLEC that will burn up $150 million to build its network over three
years? Ha asks.

"The networks cost a lot to build and the public markets and the high-yield debt
financing is soft at best," he says. "Trying to fund them is going to be tough.
They all look very similar. There are very few front-runners, and the risk is great."

Ha says investors are looking at startup firms that use the Internet to provide
services, that can build customer loyalty, that are paid for transactions they handle and
that can build a revenue flow immediately. They must have more than just content, and the
business model is not based on banner advertising or measuring click-through streams, he
says.

As examples, Ha mentions businesses such as Milpitas, Calif.-based GRIC Communications
Inc. and North Brunswick, N.J.-based ITXC Corp.–two companies that are selling
clearinghouse services to carriers offering voice over Internet protocol (VoIP)
services–and Acton, Mass.-based Bright Tiger Techno-logies, which offers resource
management software for building and managing websites.

One company Ha would not identify by name is another good example. This firm helps
online securities trading companies to keep an audit trail of customer transactions, as
the Securities & Exchange Commission (SEC) requires. Trading firms now print out
orders that have to be warehoused. Storing the orders digitally would make it easier to
access them. The idea can be applied to other online ordering businesses, Ha says.

"It is a transactional model," Ha says. "The more people you get to use
it, the more revenue you receive. You can ride the wave of the growth of the
Internet."

Other investors agree. Larry Kubal of Labrador Ventures, Redwood City, Calif., says
that his firm invested in iSyndicate Inc., a San Francisco company that syndicates and
sells content from 100 media companies, because it liked its transactional business model.
"The banner advertising model has proven that it does not work," Kubal says.

Todd Dagres, a partner in Battery Ventures, Wellesley. Mass., says a new class of
service bureaus is emerging. "You are starting to see companies called ASPs,
application service providers. Instead of building networks, they are adding valued
services such as hosting supply chain applications, licensing [enterprise] software from
SAP or BAAN, or doing [virtual private networks (VPNs)]," Dagres says.

One such company is USinternetworking Inc. (USi), Annapolis, Md. The company bills
itself as the first Internet managed application provider. Founded in January 1998, USi in
November added data centers in Amsterdam and Tokyo to the centers it already had in
Annapolis and Milpitas, Calif. The centers are connected over the public Internet. The
company offers outsourcing of sales-force automation using Siebel Inc. Enterprise
Relationship Management Solu-tions; human resource and financial management using
PeopleSoft products; electronic commerce (e-commerce) based on Microsoft and Broadvision
products; data warehousing using Sagent and USi’s own website management software and
Internet connectivity.

US WEST Inc., Denver; Venrock Associates, New York; Grotech Capital Group, Timonium,
Md.; Blue Chip Venture Co., Cincinnati; and Massey Burch Capital Corp., Nashville, Tenn.,
have invested $42 million in USi.

Dagres says that he also has seen companies planning to resurrect the idea that IBM
Corp., Armonk, N.Y.; Lotus Development Corp., Cam-bridge, Mass.; and AT&T Corp., New
York, tried unsuccessfully a few years ago–putting groupware on a network as a shared
service.

"If you are talking about doing transactions on a network [as a service], you have
to realize that a corporation will keep the transaction processing system in the core of
its own network," Dagres says. "They will put pictures of sweaters or other
product out on the edge closer to the user, but they will not distribute the crown jewels
to the edge."

There is beginning to be the sense of a glut of bandwidth, especially in the long
distance networks, Dagres says. "You don’t need many more Level 3s (Level 3
Communications Inc., Omaha, Neb.) or Qwests (Qwest Communications International Inc.,
Denver). But you will see more networks built overseas."

Jim Hynes, group managing director for Fidelity Capital, Boston, also sees overseas
markets as prime areas for network development. In addition to advising Fidelity on
telecommunications investments, Hynes is chairman of London-based COLT Telecommunications,
an alternative telecommunications company. He says he is investing in a new fiber optic
network in South America and is looking at building the same type of network in the Far
East. The Internet service provider (ISP) market in the United States is too crowded, but
there might be opportunities in that sector also overseas, he says.

One of the largest VC funding this past summer was for Viainternet Inc., an Englewood,
Colo., international ISP that raised $51 million. Blair Whitaker of Norwest Venture
Partners, Palo Alto, Calif., says the consolidation that has taken place in the domestic
U.S. ISP sector has not happened yet in foreign countries. Viainternet could benefit from
that, he says.

Ravi Mahatre of Besssemer Venture Partners, Menlo Park, Calif., says Viainternet is
using its funding to strike deals with ISPs in Europe, the Pacific Rim and soon in Latin
America. Verio Inc., also based in Englewood, is a strategic partner of Viainternet that
uses Verio’s asynchronous transfer mode (ATM) backbone to give ISPs high-speed access to
the Internet, he adds. The business model is similar to the plan Verio used to acquire
regional ISPs serving smaller companies and connect the local networks over a
corporate-wide high-speed backbone to become a national powerhouse.

Through its partnerships, Viainternet is providing connectivity, hosting, VPNs and
turnkey network and application solutions to small and medium-sized companies in Europe
and Asia, he says. Latin America will be a huge market when it develops, he adds.

Viainternet is headquartered in the United States because it is easier to raise VC
funds in this country, he says. The company is moving its headquarters to Reston, Va.,
from Colorado.

Galileo Communications Ltd., Annapolis, Md., has just raised funds from some of
Europe’s largest firms to finance its e-commerce services offering for the Fortune
1000 companies in Europe. Rick Kozak, the firm’s founder and former president and CEO of
Annapolis Junction, Md.-based CLEC American Communi-cation Services Inc. (ACSI) (now
e.spire Communica-tions Inc.), says Galileo is providing intranet and extranet services
and managing billing and other support services for its customers.

Another major international player is StarMedia Inc., a New York-based company that
raised $80 million in October, bringing to $96 million the total investment in the
company. StarMedia provides e-mail, e-commerce and content for Latin America in Spanish
and Portuguese. It claims to be the only ISP providing service across the region. In
November StarMedia announced it is expanding its service to the U.S. Hispanic market.

But don’t write off the U.S. network providers or equipment manufacturers just yet.
They have their followers and resources. Roland Van der Meer of Communications Ventures,
Palo Alto, Calif., says "the big deals– $20 million to $50 million–are being done
in big iron companies building infrastructure equipment."

Cupertino, Calif.-based Pluris Inc., the terabit router company, raised $20 million in
November. And New York-based WinStar Communications Inc. recently received a $2 billion
line of vendor financing from Lucent Technologies Inc., Murray Hill, N.J.

John T. Mulqueen is freelance writer based in New Rochelle, N.Y. He can be reached
at [email protected]