Sealed Bid

The market has tightened, especially for a few cas

Which is the most powerful Internet company today? America Online? Or does Yahoo! win that distinction? Actually, says George Zachary, a partner with influential Silicon Valley venture capital firm Mohr, Davidow Ventures, it's neither of those. Nor does the nod go to any other consumer-driven Internet brand.

The 400-pound Internet gorilla, Zachary asserts, is networking giant Cisco Systems, the leading manufacturer of the switches and routers that are helping to build out the Internet's infrastructure. Cisco's technology helps direct Internet traffic and enables Web sites to run more efficiently. What about AOL's 22 million paying users and its merger with media titan Time-Warner, or Yahoo's encompassing search engine and worldwide name recognition? Impressive, Zachary concedes, but not the measure of stock-market success. For that, he explains, just look at each company's market capitalization America Online in early October commanded a $142 billion market cap; Yahoo, $46.5 billion. And Cisco Systems? $405 billion.

Why should Cisco retain a market cap nearly three times that of AOL, a company that has made it simple for the masses to access the Internet? Infrastructure, says Zachary. After all, you can drive a Rolls-Royce, but you still need a road underneath.

"Companies that are supplying the basic building blocks of the Internet infrastructure are getting capital and being highly valued precisely because no one knows how to value the things that are closest to the consumer, like AOL," Zachary explains. "They're viewed as 'safe bets' because no matter what, people will want bandwidth and infrastructure. I don't know who's going to survive on the top, but I know that people who sell picks and shovels are going to win."

Companies with unique technology that can't be duplicated easily will have the strongest shot at success, says Zachary, a Massachusetts Institute of Technology graduate who managed the consumer products business of Silicon Graphics before making the leap into venture capital. "While we look at great teams and great technology that solve real problems," he adds, "we also have to have a sense of how highly valued these problems will be by the end market. The interesting businesses are ones where you can defend a 50% gross margin. The way you do that is through some kind of differentiated technology where you can claim to have an unfair advantage."

The stakes are high. Mohr, Davidow, founded by veteran technology investors Geoffrey Moore and Bill Davidow, certainly isn't the only venture capitalist to put its muscle behind Internet infrastructure plays. And this is no "Field of Dreams" story: building it doesn't mean they'll come. Venture capitalists do tend to take a long-term view of their seedling investments, with three to seven years being a usual holding period. Over this time they supply management with money, contacts, and advice in exchange for an equity stake. Once a company is deemed ready - and timing obviously depends on market conditions as much as maturity - the venture firm orchestrates an "exit strategy," a sale or public offering.

Until this year, public-market investors had been extremely receptive to new technology offerings, to say the least. And private-market venture firms had no problem attracting institutional and high-net-worth investors to their funds, which can be highly speculative. Venture capital firms invested a record $35.6 billion in 4,006 companies in 1999, compared with $14.2 billion in 2,849 companies in 1998, according to the latest PricewaterhouseCoopers study. Most of the investments, averaging $8.9 million per company, were channeled to Internet firms and technology providers.

A key area of Internet infrastructure that has captured Zachary's attention is optical networking, a technology that transmits information and data via the Internet at light speed. The commercial implications for optical technology are staggering: downloads that now take hours over a cable modem would take seconds. Music and movies over your computer - so-called "streaming media" - would require no more effort than turning on a radio or a video player does now.

"Five to 10 years from now, we're going to see broadcast-quality video and audio available on the Internet," Zachary predicts. But only, he cautions, if the network that links Internet data providers and consumers is fortified. "We've been making investments in the networking and infrastructure space because we believe that the underlying infrastructure doesn't work well enough," he says.

Indeed, using the Internet now is similar to traveling in America before Interstate highways. While Detroit in the early 1950s built bigger cars to move Baby Boom families from suburb to suburb, the nation's older roads were unable to handle the crush of new traffic. Similarly, anyone today with a home computer and a telephone line can obtain high-speed Internet access, but existing connections can be frustratingly difficult and slow.

Faster computers and wider Internet adoption will bring more people onto the network. They will cruise an Internet - the electronic Interstate - that is always on and always available - the "Evernet." But unless the infrastructure itself becomes stronger, traffic bottlenecks and incomplete downloads will mar the experience. Broadband technology essentially widens the highway, allowing greater amounts of data to flow quickly over transmission lines. Optical technology takes innovation even further, enabling telecommunications companies to deliver information and entertainment at unparalleled speed, a Diamond Lane for the Internet.

At least, that's part of the thinking behind several of the Internet infrastructure investments that Mohr, Davidow has made. "There are still interesting boxes, switches, routers, and underlying services that will continue to create more credible bandwidth," says Zachary. "There's a huge demand for bandwidth and it's not going to be satisfied. I don't see that trend going away for a long, long time."

For example, Mohr, Davidow was an early backer of ONI Systems, which manufactures optical equipment for the Internet service providers and local telephone companies that picks up the Web's long-distance traffic and transmits these signals directly to subscribers in metropolitan areas. Mohr, Davidow put roughly $15 million into the startup. Says Zachary, "We funded it because we saw fundamentally important and differentiable technology for a huge market, with a great founding team."

Good call. ONI Systems went public last June at $25 a share and within three weeks was trading at $142 a share. By early October, shares had tumbled to $58, but ONI Systems, which counts mutual fund giants FMR Corp. (Fidelity Managment & Research Corp.) and Invesco among its largest institutional shareholders as of September 30, still wielded a respectable $7.3 billion market cap.

Last August, Mohr, Davidow showed continued confidence in optical communications technology with a $6.5 million first-round investment in Trillium Photonics, a Canadian startup involved in building a new means of handling Internet data traffic. The Internet today routinely hauls optical signals over long distances, but these transmissions must be amplified periodically to ensure that a user receives the data in the same way it was originally sent. So far, fiber optic amplifiers designed to work with electrical switches have been responsible for creating the Internet as we know it.

But supplying the video games, movies, books, and other information that people want to download, and doing so quickly and efficiently, requires enormous amounts of bandwidth. As demand for bandwidth soars, network providers are using speedy optical switches to transport data from point to point. Yet the current generation of amplifiers does not perform well with optical switches. Trillium makes fiber optic amplifiers that are geared specifically for these new devices, and hopes to gain a sizable share of what it expects will be a $3 billion market as telecommunications providers retool.

These types of venture capital efforts are 180 degrees from the consumer-and-content Internet craze that showered millions of dollars in seed capital on just about anyone with a dream, an advertising-based business plan, and a chance to grab first-mover advantage. "The investing environment has stabilized," says Zachary. "There's a real focus now on what earnings look like in three or four years. That implies some ownership of the market."

The highly specialized technology and equipment companies that Mohr, Davidow and other venture firms are funding represent the bricks and mortar of the Internet economy - the glue that holds the network together and allows us to check stock quotes, read e-mail, and bid on secondhand merchandise. Some of these promising enterprises will be more successful than others, of course, but at least their financial backers are requiring them to demonstrate how they intend to become profitable. And that's a big change from how many business plans were considered not long ago.

Not that the consumer side of the Internet is being marginalized. Consumer-focused Internet giants like Yahoo! and AOL have been extremely aggressive in strengthening their own infrastructure: namely, building brand awareness and user traffic. A new chapter is unfolding in the battle for Internet users, also known as capturing "eyeballs," says Zachary. He adds, "The next thing that Yahoo! and AOL are thinking about is how do we get our margins to grow even bigger?"

Mergers and alliances form one proven route. The AOL merger with Time-Warner seems likely to be completed, and could create a predominant mass-media Internet company - if these two disparate corporate cultures can integrate smoothly. That's an open question, Zachary says. "AOL has exactly the right thought," he adds, but "the reality of doing it is going to be very sticky and difficult."

Meanwhile, Yahoo! is taking a more conservative path that is easier to execute, Zachary claims. "Yahoo! is showing some smart strategic and tactical elements," he observes. As an example, he points to Yahoo!'s agreement last September with the Recording Industry Association of America over royalty payments for music performances broadcast over Yahoo! sites, including the popular Yahoo! Radio. "Instead of trying to buy the biggest media company or music company, they announce a deal with the RIAA to license all the music so they can stream it from their site," Zachary says approvingly. In one move, he explains, Yahoo! outmaneuvered rival broadcasters - like AOL-Time Warner. "That to me was proof that there is strategic thinking going on at Yahoo!," Zachary notes.

But the most serious showdown that Zachary foresees coming between the Internet consumer giants will involve a bid to dominate online auctions - the most profitable and successful area of e-commerce. Auctions are appealing to companies like Yahoo! that largely depend on advertising dollars to generate revenue. Advertising spending is unpredictable; auction revenue is recurring. "It's a real business with defensible margins," Zachary says.

The main obstacle for Yahoo!,, and other budding auction sites is eBay, which created the marketplace and dominates all challengers. Yet eBay has a challenge as well, Zachary says: it needs more customers. To boost traffic, he observes, eBay has undertaken a major campaign to expand outside of the U.S., most recently in France. eBay already operates sites in Canada, Australia, the United Kingdom, Japan, and Germany, and has announced plans to enter Italy. But Yahoo! is also branching beyond its borders, and is growing its own traffic more quickly. "The problem that eBay is experiencing is that the total number of listings on their site is not really growing," Zachary explains. "People are asking, 'Is that because they don't have the customer traffic, or is it because they've saturated the amount of people who want to be involved in auctions?'"

As often happens, uncertainty could spell opportunity. Yahoo! has voluminous traffic but needs additional sources of solid revenue. eBay has solid, high-margin revenue but needs traffic. "eBay is a cash machine," says Zachary. "Yahoo! looks at that and says, 'Wait a second; we have a huge, rapidly expanding amount of eyeballs on our site. How do we monetize them?'"

How, indeed. Rumors about a Yahoo! and eBay merger were rife early in the year, but speculation had cooled by fall. Zachary says he believes that Yahoo! will pursue the auction business in dramatic fashion, either by spending considerable time and money to build an operation internally, or by acquiring eBay. "The Yahoo!-eBay combination, if you could work it out organizationally, would be incredible," he adds. "Yahoo! is in a space where they can innovate and provide energy to auctions."

But if Yahoo! decides to build its auction presence aggressively rather than buy, Zachary says, that would up the ante. "Then," he suggests, "AOL will have to buy eBay. AOL is at the top of the pyramid on the Internet. New revenue streams that would continue to increase their earnings would be great for them."

What's the next big Internet story on your nightly news? Try "How much am I bid for eBay?" What's the more lucrative story that you're not likely to hear? "How much for that pick and shovel?"

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