September 6, 2005 4:00 AM PDT

Boom times ahead in networking?

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and Internet carrier networks. After only 18 months, the company was bought by Sycamore Networks for $2.9 billion.

Reeves' current start-up, Mangrove Systems, would have been dead on arrival four years ago, after the telecommunications industry collapsed.

It's a different story now.

With venture capital flowing, the value pegged to hot start-ups is jumping. Valuations on second-round investments for highly sought-after start-ups have gone from a range of $10 million to $15 million several years ago to $25 million to $30 million today, said Venky Ganesan, a managing partner at Globespan Capital Partners. Valuations have also doubled for third-round investments, going from $35 million and $40 million two years ago to $70 million and $80 million today, he said.

"It's different from five years ago, when nothing more than a PowerPoint presentation could get you a million dollars. That won't even get you in the door nowadays."
--Kirk Wallden, national director of venture capital research, PricewaterhouseCoopers.

But the rising tide has not lifted all boats. In aggregate, valuations have remained flat from a year ago, according to the Money Tree survey.

"VCs are looking for some assurance that the company will make it," said Kirk Walden, national director of venture capital research at PricewaterhouseCoopers. "It's different from five years ago, when nothing more than a PowerPoint presentation could get you a million dollars. That won't even get you in the door nowadays."

Venture capitalists and entrepreneurs naturally are happy about the rising valuations. But big acquirers like Cisco say they are worried that some deals are getting too expensive.

"We've definitely seen valuations on top start-ups go up substantially in the past 12 months," said Ned Hooper, vice president of corporate business development for Cisco. "Both as an investor and acquirer that's disturbing to us. Maintaining rational valuations is critical. If they're too high we just won't do the deal."

IPO or M&A?
While it's always been true that start-ups have a better chance of getting acquired by a company than having an initial public offering, the trend toward acquisitions is even more pronounced today.

"Today, it's much more realistic for a start-up to get acquired or partner with a larger player than to go public," Reeves said. "It's very difficult to have an IPO these days, so I think we'll see a lot more acquisitions in the next 12 months."

One of the biggest deterrents for small companies with IPO aspirations is the 3-year-old Sarbanes-Oxley Act, which requires publicly traded companies to include in their annual reports a review of the company's internal control over financial reporting, and a related auditor's rundown. The cost for complying with the law is expensive, anywhere from $1 million to $4 million annually, say experts.

Smaller companies also face tough scrutiny from bankers who favor larger companies.

"Being a public company is not a thrill these days unless you have a predictable revenue stream," Baloff said. "The economics in the banking world have changed and bankers don't make the same fees on companies with market capitalizations under $200 million that they used to. So these smaller companies suffer from a lack of trading volume."

Despite these hurdles, CEOs of start-ups say they're still thinking big.

"Companies that are building themselves to be bought by another company are destined to be small," said Selina Lo, president and chief executive of a home networking company called Ruckus Wireless. "You get what you wish for. And if you're not going to try to build a sustainable business, why bother building a company in the first place?"

Cisco executives agree that they aren't interested in companies that are deliberately on a quest to be bought.

"The most interesting companies to us today are ones with strong sustainable business models, good revenue run rates and sales channels" said Hooper. "These also happen to be the same attributes that are necessary for companies going for an IPO."

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