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The Dealmakers - Terence O'Hara

Tracking Signs Of a Rebound In Telecom

By Terence O'Hara
The Washington Post
Monday, December 20, 2004; Page E01

Investing in early-stage telecommunications companies in the past three years took a strong stomach. But a few local venture investors who have stuck with the sector are beginning to see signs that the indigestion may have been worth it.

It's nothing like 1999 and 2000, when telecommunications companies with no revenue and untested technology were at times valued in the billions of dollars. But after three years of dormancy, 2004 was the year that venture capital investing in telecommunications equipment, software and wireless gizmo firms became respectable again.


Optinuity's Scott E. Stouffer could boost its fortunes. (Justin Sullivan For The Washington Post)

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"We feel very sanguine about our telecom portfolio," said Tom Smith, a partner at Mid-Atlantic Venture Funds of Reston. "All of our companies are meeting or exceeding their plans."

Sanguine may not rival "ecstatic," the word most often used in 2000 when early-stage telecoms were white hot, but Smith has a few reasons to be genuinely happy about his telecoms.

First, merger-and-acquisition activity is increasing. For example, large telecommunications equipment companies, squeezed by the drop in spending by the large phone companies in recent years, pulled back on expensive research and development. That left early-stage telecom companies that have cool technology, and patient investors, an opportunity to develop a real product that the bigger equipment vendors might want now.

Second, spending by carriers on enhanced broadband services and voice over Internet protocol (VoIP) -- where a number of local companies want to play -- is increasing.

Third, some telecom companies have been able to sell stock in initial public offerings, including InPhonic Inc. locally.


Smith and other VC investors in the telecom industry point to three local examples why early-stage telecom could become profitable again for investors: Sentito Networks Inc., Optinuity Inc. and Covega Corp. It is important to note that none of those companies is profitable, nor is it clear that any will ever make money for their VC investors. But each has raised new venture money this year from some of the most experienced investors in the business, and they are prime examples of where the bets are being made. (This is a sampling. There are other examples, of course.)

Sentito Networks, in Rockville, raised $28.5 million this year in a third and fourth round of VC funding. The most recent, in August, was led by Core Capital Partners, a District firm with a number of local telecom companies in its portfolio. Sentito had a $14 million second round in spring 2003, and its first round in 2001 was for $9.3 million.

Mark Levine, Core's lead partner on -- and a board member of -- Sentito, said Core invested in the company in its first round of financing in 2001. Sentito makes Internet protocol equipment that can be attached to old-time telecommunications networks, allowing carriers to offer VoIP without tearing up their hardware.

"You could offer it to a customer without turning your back on trillions of dollars of infrastructure," Levine said.

For much of the downturn -- in 2001 and 2002 -- Sentito did not have a product on the market and was focusing on developing its technology, Levine said. Although he can wax rhapsodic about the company's technology, Levine is more measured in describing its business prospects. Sentito has competitors, after all. "With any of these companies, you have to continually monitor the marketplace and have a realistic view about their value proposition," he said.

Sentito's other investors include Inflection Point Ventures of Massachusetts , Kodiak Venture Partners of Massachusetts, Mid-Atlantic Venture Funds, Technology Venture Partners of Minneapolis, and Telus Corp., a Canadian telecommunications company.

Optinuity, another Rockville company, presents another promising trend: the "recycling" of proven entrepreneurs. In this case, it is Scott E.Stouffer. Stouffer, the founder of Visual Networks Inc. (and its current chairman), recently became Optinuity's chief executive as the company landed $6.5 million in first-round venture financing from Mid-Atlantic, Silicon Valley's Venrock Partners LP and Baltimore's New Enterprise Associates.

Optinuity makes software to monitor information technology systems over telecommunications networks. Stouffer's Visual Networks produces similar software to monitor telecommunications networks. And it was Stouffer's success at Visual -- it went public in 1999 and made tons of money for venture investors, though its revenue has shrunk significantly in recent years -- that made Optinuity bankable.

Mid-Atlantic's Smith said VC investors always go with someone who has made money for them in the past. "We liked [Optinuity] first and foremost because of Scott," he said.

Covega is the most ambitious of the three companies, and if it becomes successful, it would reward more than five years of expensive patience for its investors. It is one of the region's surviving optical equipment start-ups of 2000. In that year of folly, nearly $1 billion was invested in Washington area telecommunications network technology companies like Covega. Many crashed and burned, mostly because it takes so much money and time to get a technology working and on the market, a reality that was compounded by the collapse of spending on new broadband technology in 2001.

Covega of Jessup is the result of a March 2003 merger of two such companies, Quantum Photonics Inc. and Codeon Corp., producers of highly specialized gear that makes telecommunications signals more efficient and faster. Covega's products are sold mostly to other large fiber-optic equipment makers, such as Ciena Corp., which then sell their gear to large telecommunications carriers.

All told, including the predecessor companies, Covega has raised about $100 million in venture capital since 2000. It is now raising more. According to a filing with the Securities and Exchange Commission, it closed on $3.8 million (of a planned $7 million) in venture financing in November.

"As a component provider, Covega will probably be one of the first ones [to benefit] once demand picks up again," said Core's Levine. Along with Core, investors in Covega include Optical CapitalGroup, a private equity firm founded by Corvis Corp.'s David Huber. New Enterprise, Boulder Ventures in Colorado, Siemens AG's venture capital arm and North Carolina's Intersouth Partners are also investors.

Joseph Dixon, a telecom equipment veteran, was brought in to turn around Covega in November 2003. He cut costs, laying off staff and taking some strategic whacks at the senior management structure.

When Dixon took over, Covega had 14 customers, all in the telecommunications sector. Now it has more than 60 customers, about a quarter outside the telecommunications sector.

Dixon declined to give a revenue figure other than to say that Covega would book 70 percent more revenue this year than in 2003 and would probably double its revenue in 2005. The goal is to become cash-flow break-even -- taking in as much cash as it burns -- by the end of 2005.

"We grew our revenue and bookings so rapidly this year that we outsold our capacity," Dixon said. "The market really started coming back in the middle of this year."

Covega was, to some extent, lucky, Dixon said. Products that it began developing four years ago are now in demand. That wasn't a sure thing a year ago.

The payouts for Covega's partners are likely to come from a merger with a larger equipment provider, probably within two years if all goes according to plan.

"I never say I'm 'high' on anything anymore," said Don Rainey, Intersouth's Reston-based partner and a board member at Covega. "But I'm comfortable saying 'very positive.' The signs are encouraging."

Terence O'Hara's e-mail is oharat@washpost.com.


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