Cash infusion for the optical market

One venture capital firm that's taking a laser-beam focus on optical technologies is Morgenthaler Ventures, a Silicon Valley-based firm that at one time staked the likes of Apple Computer, Vivo Software and VeriFone. But now that the computer industry has hit the skids, Morgenthaler is turning its attention to what it thinks will be a white-hot market for years to come: optical components.

“The vision is bandwidth, bandwidth and bandwidth, and not only more and more but throughout the networks,” said Bob Pavey, general partner at Morgenthaler Ventures. Founded in 1968, Morgenthaler has funded more than 170 companies and has about $1 billion under management (see table). Last year the firm raised Morgenthaler VI, a $570 million fund now 75% invested. The firm plans to raise another fund in 2001.

Morgenthaler raised its first fund with limited partners in the early 1980s, though at one point, the firm was as much as 60% invested in health care. “The [telecommunications] industry was pretty stable, highly controlled and wasn't growing all that rapidly,” Pavey said.

Of course, then came the Internet, and the heavy demands that stretched the capacity of the copper communications infrastructure to its limits and helped push fiber communications from a one-signal-per-strand business to a dense wave division multiplexing business. “The implication was we would have to move from an [electrical-optical-electrical] world to a world where you could deal with photons,” Pavey said.

Besides seeing a large market opportunity, Pavey and his partners saw the optical components market as being subject to some of the same market “laws” that govern the semiconductor industry. They recognized that winners in optics would not only have good technology but would understand volume manufacturing and the marketing of products whose cost would be driven down while their performance increased. “The advantage is we've seen the play before,” Pavey said.

While early optical innovation has produced significant growth in performance in the LAN and in the backbone, the bottleneck between the two is in the metropolitan network, Pavey said. “A lot of [companies] are still focusing on 20-channel solutions, but the agility that's needed in the metropolitan area with all the signals you're trying to carry—and dedicated lines—is going all the way up to 100 signals, and that's driving the need for new optical components,” Pavey said.

Fortunately for Morgenthaler, as with the semiconductor industry in the 1970s, there are many entrepreneurs already toiling in obscurity, finding ways to deal with photonic networks. One of them is Milton Chang, an engineer-turned-entrepreneur whom Gary Shaffer, general partner at Morgenthaler, has called the “Pied Piper of technical talent.”

Chang is the founder of New Focus, an early optical components “home run” for Morgenthaler. New Focus was turned away by many venture capitalists because its components catalog business was boring, Pavey said. But that was the same base from which optical components giants JDS Uniphase and SDL started, Pavey said. Morgenthaler invested $10.5 million in a couple of rounds.

“In the world of optical components, operations skills—the ability to produce products in volume—is a critical component,” Pavey said. “The fact that you are doing it with some less exciting products initially gives you a major leg up on the raw start-ups.”

New Focus, the first public liquidity event of Morgenthaler's strategy, debuted in June 2000 and traded at about $53 a share recently. “We made the investment out of a $300 million fund, and it has largely returned the entire fund,” Pavey said.

Perhaps more important, Chang helped turn Morgenthaler onto Agility, a vendor trying to optimize the mass production of widely tunable, high-powered lasers, and LightConnect, a maker of MEMS-based fiber optic components.

From there, Morgenthaler further developed a kieretsu of optical component start-ups. For example, the firm has high hopes for Lightwave Microsystems, a developer of array wave guides (AWGs)—a way to do multiplexing and demultiplexing on a single component. “[Lightwave] is producing on a single silicon chip multiple AWGs and over time driving down the cost and driving up the performance,” Pavey said.

One of Morgenthaler's latest investments is fiberSpace, a developer of high-performance laser sources. The fledgling company says it can improve the accuracy of a laser's frequency by adding an opto-electronic circuit to help keep it stable. The benefit is that the signals can travel farther without optical regeneration. Morgenthaler participated in a $12.1 million series A round in mid-January, but fiberSpace doesn't expect to be in beta testing until the end of the year.

Morgenthaler's optical component start-ups

	Latest financing round	Description
Agility	$70 million	Widely tunable, high-powered lasers for DWDM networks
FONS	$15 million	Fiber optic connectivity hardware, fused technology- based optical components and packaged modules including splitters, taps and DWDMs
Innovance Networks	$75 million	Next generation platform for long-haul photonic transport
LightChip	$60 million	Low-loss optical multiplexer/ demultiplexer products
Lightwave Microsystems	$75 million	Optical integrated circuit platform for passive and active components
Peregrine Semiconductor	$37.5 million	Communications integrated circuits for broadband fiber, wireless and satellite markets
Terawave	$73 million	Access solutions using passive optical networking technology
Zolo	$18 million	Optical subsystems including multiplexers for DWDM networks
Source: Morgenthaler Ventures

The funding candidates that make it past the first round of scrutiny by Morgenthaler partners usually have a core technology that gives the company some “technology protection” and a business plan for converting that technology into a meaningful product, Pavey said. “Communications has significant requirements in terms of reliability and performance, so to the technology has to be added a strong dose of strategic planning in the operational sense and the ability to build the kind of management team that can win,” Pavey said.

But Pavey and his partners at Morgenthaler also are moving up the optical equipment food chain, starting to take nibbles of system-level companies. However, because most of the next generation technology in optical components comes from young VC-backed companies, system makers have to rely on financially shaky vendors, which compounds investors' risk, Pavey said.

“Virtually every system play at this stage is doing what is usually a mistake for venture capitalists—they're small companies leveraging other small companies,” Pavey said. In this way, Morgenthaler's knowledge of optical components can be an advantage. “We have a sense of what technologies are stable and what companies are reliable. That's been a key to making some very interesting system-level bets,” Pavey said.

Critics might say that by having such a large stake in the optical components sector, Morgenthaler is putting too many of its eggs in one basket, but the opposite actually is true, said Jeff Matros, president and CEO of Tachion Networks, a Morgenthaler portfolio company. While other VC firms and corporate investors often openly invest in direct competitors, Morgenthaler doesn't, Matros said. “They haven't placed all their bets on one type [of company]—it's across the board,” he said. “A switch maker like us could buy from all its portfolio companies.”