VC funding is naturally selective: venture capitalists focus on the fittest

There is, supposedly, an inherent balance in the VC market, a bit like the ecological balance seen in nature. Observers argue that not only are VCs and the start-ups they fund part of an ecosystem, it is one that is becoming increasingly complex.

One of the main issues in the market, according to this ecosystem argument, is that the business of telecom operators--who are no small part of the food chain--is, itself, an increasingly complex proposition. If they simply truck capacity from A to B, or even Z, they become utility providers. That, in turn, means keeping margins as fine as a razor and resigning oneself to low growth, which is not an option that--at least if their public statements are to be believed--appeals to many. "We need to innovate quickly, but we don't have sufficient human resource to do that," says Francesco Caio, the CEO of Cable & Wireless, who spoke at the recent European Technology Investment Forum, in London. This need to innovate, Caio explained, is why large carriers like C & W are interested in small start-ups.

There are, however, VCs who do not see telecom operators as significant innovators. "Some telcos do actively look for new ideas--Telecom Italia, for example. However, there is no great fit between what telcos want and what start-ups can offer. [Wireless] telcos don't need differentiation. They are pipe guys. They need networks that function and a brand," argues Jean Schmitt, a partner at Sofinnova Ventures, a Paris-based VC that focuses on start-ups in the wireless market. "Handset manufacturers, however, are a great way for start-ups to get into business," he adds.

Many wireless operators would strongly disagree that they are just 'pipe guys'. They certainly spend a great deal of money on trying to mould the individual user experience. Vodafone, for example, has its own portal, Vodafone Livel, that offers users a 'Vodafone' look and feel. Schmitt, however, is not convinced that this sort of approach equals differentiation. "There is no real competition between [European] wireless operators. They have done a great job, however, in creating an impression of competition. New handsets [for example] are a way for them to get more traffic on their networks, not a real way of setting themselves apart," says Schmitt.

Other VCs have a less jaundiced view of the operator/start-up relationship. "Now they will go and buy software and systems that start to drive revenue, though that's got to be demonstrable. They are also willing to consider smaller, venture-backed companies," says Martin McNair, a partner at Advent Venture Partners, a London-based VC that manages over [pounds sterling]450 m and is in the preliminary stages of launching a new fund. "They invest and are happy to invest in trials. They do it very gradually. It can take a year. They are also happy to look at revenue models that link the sales to the rate of use, to the number of handsets. There aren't very many examples of this, but there are enough within the European operators to signal a change," adds McNair.

However, even if one accepts that telcos, whether fixed or wireless, want to innovate and that they have to turn to other companies to do that, there are still not necessarily rich pickings for start-ups. According to research from Forrester, CIOs, CTOs and CMOs have cut supply lists by up to 95 per cent, with the most serious knock-on effects being faced by the smaller and unquoted vendors. Around 90 per cent of CIOs, CTOs and CMOs, in both Europe and the US, will not consider a deal size above US$100,000 if the vendor has less than US$20 m a year in revenues, Forrester found. It is estimated that over 90 per cent of start-ups would fall at this hurdle.

A further difficulty for small companies is that the established vendors "are being very selective in acquiring feature/function to boost their offerings," J Carl Allen, director of the VC program at Forrester Research, points out. This means that getting a foot in the door via a big vendor--whether through having the business acquired, or through finding a partner--is no easy task. The VCs that invest in startups need to help them market effectively, Allen believes.

Complex food webs, simple propositions

VCs are quite pragmatic about what the pressing issues for operators are. Revenue assurance is a recurrent theme, as is making the services that are already in place user-friendly. "Mobile operators are starting to look at systems that will make access to these mobile data services more appealing. That, I think, is where smaller, VC-backed companies can begin to move the needle. At the moment, it is just a drop in the ocean," says McNair. In selecting good ideas, VCs are also wary of straying too far into the wrong niche--that is the one inhabited by the dominant animal. "Either you get stamped on by the gorilla because what you are offering is core to their business and they are doing it themselves, or you get picked up, and it is either or," says Martin Cheeseman, a partner at Advent Venture Partners

Allen believes that VCs have good prospects if they focus on investing in business intelligence software, business process management and web services, managed security services, financial planning tools, speech applications or storage management software. Of course, within each of these broad headings there are numerous subsets, each of which is linked to its own ecosystem.

This complexity can make it difficult for individual players to know where to focus their energies, but, it is argued, it also provides some opportunities. "The world is not following a simple, direct sales model any more. Small companies can reach large ones through partnerships," argues Ann Glover, the chief executive of Amadeus Capital Partners in the UK, though she adds that the balance of power between a big partner and a small company requires the start-up to have something unique.

The need to have a proven product is one of the reasons why start-ups may not find the present climate particularly kind. "On the technology side we have shifted our focus--like many others in the industry--toward later stage. One of the reasons for this is that it is more interesting to pursue later stage companies for the sort of valuations that early stage companies used to have than invest in the smaller players," says Machiel Papousek at ABN Amro Capital, the investing arm of the Dutch bank, and which has relatively large sums to play with as it uses the bank's money, rather than drawing on a fixed fund. "Cash flow generative companies are the most interesting. Our transactions are generally in the [euro]10-50 m range, with a minimum of [euro]5 m and a maximum of [euro]100 m. We have no formal upper limit on the exposure to one particular company," adds Papousek. Given its financial clout, ABN Amro Capital spreads its net wider than components, or applications. "Smaller telecom and cable operators would be of interest to us, as would vendor spin-offs and some SMEs in the equipment or software area with a clear niche that they can defend," says Papousek.

There was a time, of course, during the boom, when small start-up companies supposedly marked a new stage of economic evolution. A website run from a back-bedroom would, it was said, take on established corporate leaders and trounce them. However, when the tide of cash receded, it was not the 'dinosaurs' who were left stranded. "A lot of the dot-com disasters were down to VCs going into market models that they just couldn't fund," argues Hans-Guenter Schreck, a partner at Techno Venture Management, in Germany. Schreck gives the example of consumer-led products that require massive up-front investment. Only large electronics companies, he believes, have the cash and economies of scale that enable them to produce competitive and innovative handsets. What start-ups can do, he argues, is be part of the ecosystem that enables a finished handset to be manufactured, but providing a specific component, or application.

That does not mean, however, that smaller companies do not have scope to pick up business that might be expected to go to larger players. For example, Microsoft and Symbian (which is soon to be controlled by Nokia) are considered to be the leaders in the nascent mobile handset operating system market--where they focus on the development of operating systems for smartphones. Neither Nokia nor Microsoft are names to tangle with, but that does not mean they will, necessarily, have the OS market to themselves. "I am actively looking for a company that can produce a mass-market handset OS. At present, the OSs being developed are extremely resource-demanding and could well struggle on mass-market devices because of the dramatic increase in the bill of materials they trigger. This increase in cost is not warranted as, at the end of the day, people don't care where the OS comes from," says Schmitt. Existing venture-backed mobile operating systems include SavaJe, which has funding from Orange Ventures and Vodafone Ventures, the VC arms of the respective mobile operators.

Pterodactyl or real flier?

Though they might be looking at different subsections of the market all of the VCs are agreed on at least one thing: "The deal-killing criterion is the core management, the people who set the DNA," says Glover. They also say that they are taking their time in sizing up the managers. "Judging management is the hardest thing before you invest," says von Freyberg. The typical lead time is 3-4 months, according to Papousek. All of the VCs would rather back a strong management team than a hot market, though some set more stringent criteria than others. "We hire CEOs who can talk to other CEOs. All of the CEOs in my portfolio companies are over 50. The brute reality is that you are either 'in' or you are 'out' and creating relationships from scratch just takes too long," says Schmitt.

There are other deal-makers or breakers. Market acceptance and routes to market are much more important elements in the evaluation process now than they were during the boom. Comverse, for example, the US-based supplier of messaging, billing and call management solutions, got its fingers burned with investments in unified messaging and voice activation for which there was little end-customer demand. Now, says Tzipi Ozer-Armon, vice president of corporate strategy and corporate business development at Comverse, who spoke at the European Tech Forum, they are "more conservative". "We can scale up a 'B' technology and make it an 'A' technology if there is demand," says Ozer-Armon of Comverse's approach.

The herd mentality that marked some investment during the late nineties seems to have given way generally to considered conservatism. Given that fixed/mobile convergence is considered an inevitability, it might be expected that many VCs would follow the example of Sofinnova Ventures and focus on wireless. Schmitt believes that there are some very good opportunities in the present market. "Why wireless? It is a huge industry and has many fragmented sub-sectors that are growing very fast, such as embedded software for mobile phones. This means that a start-up in one of these sectors can become a market leader," he says. However, many other VCs are more cautious.

"We are not keen on mobile technology, simply because there is a lack of clarity on what will win. We see a lot of propositions on SMS and on the content delivery side, with very low barriers to entry. We haven't seen anything that is unique yet," says Geoffrey Doyle, of SE Growth Fund, a government-backed VC based in the South East of England. The complaint that many business plans in mobile are generic and easily duplicated is a common one. VCs are also not necessarily enamoured of value-added service propositions.

"These added value services for mobile phones are something we have been leery of for quite a while, where there is an awful lot of activity on the development side--start-up companies, software gurus perceiving that the operators need additional sources of revenue and one of the ways of getting that is VAS. We have kissed an awful lot of frogs," says Cheeseman. He points out that operators actually make their money from voice or from text messaging and that data services are still a relative drop in the ocean. "If I'm an operator and can spend a million dollars putting in a software system that assures, say, my roaming revenue, that is going to put far more to the bottom line than a million dollars spent on some fancy, added value data service. That is their view-point. The paradox in this is that they are going to have to do something to get additional revenue streams, but it is all a question of when," adds Cheeseman.

Table 1 Investment in European venture-backed communications companies
([euro] m)

Year         Q1           Q2            Q3            Q4          Total
2000         71           64            57            57           249
2001         51           49            44            40           184
2002         28           24            24            22            98
2003         25           17            16            20            78

Source: VentureOne and Ernst & Young

written by Ouida Taaffe

Ouida Taaffe, features editor (otaaffe@horizonhouse.co.uk)

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