Startup Death Spiral

No customers - no cash - no new products. There are few ways out of that power dive to oblivion. One is Powerball

The chances of a lucky New Englander winning the recent $295 million Powerball lottery were about 1 in 80 million, or so say lottery officials. As fantastic as it might sound, an increasing number of startups in the network-equipment space seeking late-stage funding could be facing even greater odds.

While that might be a bit of an exaggeration, little doubt exists that the venture capital community is being much more discriminating than in the past when it comes to replenishing the coffers of fledgling network-equipment providers.

"People are doing real due diligence work now," says Joe Kennedy, the chief executive at router startup Pluris. "It used to be rubber-stamped based on what lead investors had done."

As might be expected, a byproduct of the increased scrutiny is that startups looking for additional funding, in some cases to complete product development, are beginning to hear "no" from the same folks who have been saying "yes" for the past two years.

As the dozens of startups that were founded 18 months to 2 years ago increasingly encounter additional funding difficulties, analysts and industry experts are predicting that the anticipated consolidation of the network-equipment market will begin to accelerate over the next few months to a year. Symptoms can already be seen among the dozens of startups that have announced workforce reductions and other cost-cutting measures.

"You havent see the half of it yet," says Todd Dagres, general partner at Battery Ventures. "Over the next couple of years, youll see a lot of these guys sold for pennies on the dollar or close their doors."


While there is nothing unusual about market consolidation in a new technology space, the winnowing of this crop of players could be especially bloody for several reasons, say experts.

Foremost is the large number of startups that poured into the market in 1999 and 2000, during the peak portion of the dot-com craze and the stratospheric rise of the stock market. Money was plentiful at the time, and dozens of entrepreneurs raised tens of millions to launch dozens of companies within markets that traditionally support three or four players. The metro optical space is one of the most crowded. There are currently more than 40 companies working on gear for the access portion of the public network, says Dagres.

As is often the case in times of expansion, investors were not as careful with their money as they would have been during periods of retraction or slow growth. Many companies that were funded had poor business plans. While those startups are now finding it difficult to impossible to find additional funding, the sheer number of players in the space also means that many companies with solid business plans are running into rejection from the financial community.

"If you cannot articulate your differentiation right now, youre in real trouble," says Kennedy. "People are not getting money right now for two reasons. It could be because you had a bad idea or because you had a good idea — but so did 35 other companies."

Two other factors, directly associated with the downturn in the industry, are also contributing to the likely number of failed startups. The first is the disappearance of the public market as a source of funding. In the past few months, only a handful of companies, such as Tellium and Riverstone Networks, have lunched IPOs. Meanwhile, dozens have pulled back or stalled public offerings in anticipation of the clouds lifting over Wall Street.

Directly related to the crash of the public market is the steep loss in valuation of network-equipment giants, which had previously been acquiring fledgling companies left and right as a strategy for growth and a substitute for internal research. Even new companies, such as Sycamore Networks, crashed the acquisition party. A little over a year ago, Sycamore shelled out close to $3 billion in stock for startup Sirocco Systems. Before the ink on the contract was even dry, the market started a precipitous fall. Incredibly, Sycamore itself is now valued at about half of what it paid for Sirocco. A similar scenario played out with Redback Networks and others.

While a few companies have managed to find suitors, such as the recent acquisition of Amber Networks by Nokia, being absorbed by a larger company for an eye-popping sum is now an artifact of telecoms glory days.

Perhaps the most vicious, or at least the most ironic, contributor to the growing number of struggling startups is the rapid deceleration of next-generation technology deployments. The slowdown in capital spending and the receding challenge to incumbents from competitive carriers have conspired to elongate the path to profitability for many startups. Funded to bring new products to market in 2001 or early 2002, many startups are discovering that the anticipated demand for these products, such as pure MPLS switches, has been pushed out by a year or maybe more.

"Investors are looking for a payback in the next 12 months or sooner," says Dagres. "Products must be much more tactical now then they every had been in the past."

Duck and Cover

The spending slowdown and the resulting push-back of cash-flow-positive status has forced nearly every startup in the networking space to slam the brakes on their burn rates — the amount of cash that goes out the door each month. Dozens of companies have either announced or quietly executed workforce reductions and other cost cutting measures. Alidian Networks, Equipe Networks, Mayan Networks, Coree Networks, Tenor Networks and dozens of others have announced layoffs recently.

Nearly all are cutting back, some to conserve funding and others to demonstrate fiscal responsibility to potential investors. Some, however, are cutting back more than others.

Coree, for example, essentially pulled the plug on its current business plan. According to Michael Zadikian, Corees founder, the maker of high-speed routers has trimmed down to a few engineers and will essentially relaunch product development so that completion of the product corresponds with a need for the type of equipment Coree is building.

"We were aiming for 2001 or 2002 and then things moved out," says Zadikian. "We thought we should revisit the whole project."

Zadikian actually believes that the startup was in a fortunate stage of development when it retrenched. Having launched not that long ago, the company can do a restart of sorts, without having squandered huge sums of money and time.

"The worst place to be right now," he says, "is having gone through beta with the product ready to ship and no takers. That means you are at the maximum burn rate possible."

While its impossible to say with certainty which companies will survive, most experts agree with Zadikian, in that the biggest determining factor is the ability of a startup to show investors that potential customers are within a short reach.

"In the present climate, the most vulnerable will be those who have yet to establish a good customer base," says Yum Petkovic, an analyst with U.K.-based Ovum. "Investors today expect a very short payback period."

Both investors and startups say that the key to securing additional funding is to have customers in hand or at least be able to produce a couple of carriers that are willing to vouch for the equipments potential. Dennis Rainville, chief executive at startup Equipe Communications, which is seeking third-round funding, says that investors will think long and hard before pouring more money into a product that doesnt have an addressable market for a year or more.

"VCs are being cautionary on that side," says Rainville, adding that Equipe is targeting the ATM market. "If youre a startup thats standing on that lily pad of a probable market, thats a tough place to be standing."

Dagres, who is involved in Equipes funding, refers to companies that are still living on investments but cant find a market for their products as "dead men walking." He estimates that maybe as many as a hundred startups — across all segments of the telecom industry — are in this zombie-like state.

"They have plenty of cash but no compelling product," he says. "Its just a matter of time before they go under."

Its actually a little more complicated than that. In addition to requiring the startup to have a compelling product that is close to completion, VCs also insist that the product is relevant to a currently addressable market. In other words, startups sitting on top-notch products that no one is likely to purchase for a year or more are in just as much trouble as startups with a clunker.

As part of the due diligence being done by potential investors, VCs are quizzing carriers that are conducting field trials to make sure that they are, one, interested in purchasing the product and, two, able to pay for the product.

"Once you have a predictable revenue stream with customer reference accounts," says Laura Howard, vice president of startup Gotham Networks, "that gives investors a lower risk."

Howard says Gotham, which is currently seeking funding, is in a good position because its product was designed with the capabilities to address both the existing ATM market and the still-burgeoning MPLS and IP market. The deceleration of the move to MPLS and other IP-based technologies among incumbent carriers is reflected in the way Gotham has adjusted its marketing message over the past year or so.

"A year ago, I was all about optical strength," says Howard, referring to the promotion of Gothams product on the bases of its IP and MPS capabilities. "Now, what is in the RFP [from potential customers] is How can you give me a better ATM switch?"

As part of the shift from a buildout mentality to one of leveraging current assets, carriers are now interested in products that will generate money now but also provide a bridge to next-generation technologies, say both Howard and Rainville. Startups that looked past already funded markets, such as ATM, they say, are the ones that are in real trouble.

Indeed, startups with finished products in advance of a serious market are in an unenviable state of suspended animation. They have basically shut down all life support systems, hoping that a cure (a rash of customers) will be found before they burn through whatever cash is remaining.

The major flaw with that system, says Kennedy, is that while these companies are doing a high-tech Walt Disney, the rest of the development community is moving ahead with even more cutting-edge technology. "When you do come out of hibernation, youre going to emerge into a different market sector and a different sector of competition," says Kennedy.

Kennedy says the key to managing the slowdown in the market is to cut back slightly, but not to divert resources from field trials and other development milestones. Although he says each startup should be looked at on a case by case basis, companies that have made drastic cuts to conserve costs are likely to be delaying the inevitable visit from the Grim Reaper.

"Look at the companies that are making cuts of 30 and 40 percent," he says. "Most of those guys are going into a death spiral."

Looking at the bright side, however, there is always the next Powerball lottery.