From...

1/6/00
Web posted at: 11:02 AM

by Susan Breidenbach

(IDG) -- Industry experts keep trying to position the Ciscos, Lucents and Nortel Networks of the network industry as the last, unseatable emperors, and the market keeps proving them wrong. As an incredible round of initial public offerings (IPO) by network vendors in the last six months clearly shows, the Internet economy isn't just about dot-com ventures gaining astronomical valuations through what looks suspiciously like smoke and mirrors.

Even in the network infrastructure market, start-ups have never had it so good.

Look at the extraordinarily successful IPOs of network product companies such as Juniper Networks and Copper Mountain Networks, for example. Juniper, which makes Internet backbone routers, closed its first day of trading at $97.88 per share, or 188% over the $34 offering price. Copper Mountain, which makes digital subscriber line (DSL) products, closed its offering day at $68.44, or 226% over its $21 asking price.

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What is the Internet economy bringing to late '90s network companies that counterparts formed earlier this decade or before didn't benefit from? For one, it levels the playing field by imposing standards and providing easy access to markets and resources. That increasing competitiveness, in turn, speeds the rate of innovation and gives greater advantages to nimble start-ups. Now, established players use start-ups as external laboratories, often providing seed money, and buying them outright if they succeed.

In fact, within the big companies, it's getting harder and harder to distinguish R&D from M&A.

"It's a natural cycle, and it's a very positive thing," says Jim Flach, a partner at Accel Partners, a venture capital firm in Palo Alto. Start-ups have ultrasharp focus and complete dedication, and they spend a much higher percentage of their total budgets on R&D. Once they have products, they get bought and leverage the distribution power of the acquiring company.

"The big company gets the product and technology and - for a short time - the people. Then the people move on and start the next new thing," Flach adds. The result is that new technology makes its way into the market much faster. This trend feeds upon itself as start-ups become rallying points for the best and brightest. Cream-of-the-crop college graduates no longer set their sights on the big names in networking. Today, they want to help create a hot start-up and become the next Marc Andreessen.

In Cisco's salad days, start-ups had to earn their valuation the hard way, by racking up several quarters of solid earnings before going public. The company got its start when Sequoia Capital gave it $2.5 million - a whopping sum in the mid '80s but mere pocket change these days. Its IPO produced a market cap of $225 million, but Cisco didn't go public until it had achieved $6.1 million in cumulative profit for the previous four quarters.

"Today, capital markets are willing to finance companies that are still losing money, as long as they are growing fast and going after big markets," says Amnon Shohan, principal partner with Cedar Fund, a venture capital firm in Tel Aviv. "Valuation is based on revenue growth, not earnings per share. And because Wall Street is rewarding start-ups the way it is, start-ups can attract the best talent."

The result is a brain drain that is making big companies distribution-rich and product-poor. "That's why the bulk of the new products the big guys have been introducing lately are the result of acquisitions," Flach says.

Traditional network companies are also hindered by the large installed bases they've spent years cultivating, for in the Internet economy, a big installed base is very much a mixed blessing. While one can help buffer an established player from rapid change, it also can create some disadvantages for economies of scale.

"The big companies have customers they have to bring along, and product trajectories that can be difficult to revector," says Russ Siegelman, a partner with venture capitalist star Kleiner Perkins Caulfield & Byers in Menlo Park, Calif. While start-ups have only windshields, larger companies have much bigger rear-view mirrors, which they are constantly checking. They have less time to look at where they are going and respond to market changes. They also face new R&D challenges.

"Large groups of people have two problems: They don't move fast, and they can't innovate," says Cliff Higgerson, a partner with ComVentures, a venture capital firm in Palo Alto. It's hard to design products by committee, and the increasing pace of technology change makes the process even more difficult.

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"Size does not carry anything like the momentum that it used to," agrees Peter Alexander, vice president of enterprise marketing for Cisco. And Cisco's size has increased from 4,000 employees in 1995 to more than 23,000 today. "With the lowering of barriers to entry, big companies have to earn their continued success every day," Alexander says.

Big companies' customers are being pursued relentlessly by newcomers such as Vertical Networks, a Sunnyvale, Calif., start-up that is using $55 million in venture backing to develop its InstantOffice line in the emerging voice/data switch market.

"The big companies are dealing with a lot of legacies, which restrict the kind of physical infrastructure you can build, and limit the kind of partnerships you can form, and sometimes force you to eat your young," says Alan Fraser, president and CEO of Vertical. "What you have, you kind of have to stick to and not destroy. Existing relationships can hinder you from thinking about new ways of doing business."

Start-ups keep the network industry more in tune with business needs, because they are making decisions closer to the customers. The level of participation by customers in the product development process is much higher than at established companies.

Start-ups that evade suitors and make it through a successful IPO face new obstacles. "They have the toughest job," Alexander says. "They have their market cap, and now they have to prove they are worth it by staying on track with revenue growth. There is less upside for new hires because the big boost has already gone by."

The secret to maintaining independence is having a value proposition so compelling large customers can't live without it. As Lara's Medhekar puts it, this proposition "has to be something radical with a reasonable possibility of success." A better mousetrap that provides an incremental improvement over what the Ciscos and Nortels can offer - even a fairly substantial one - won't suffice.

Start-ups have to make either a quantum leap forward in a particular product category or, better yet, invent a brand-new one.