Reader,

This is the third edition of BlueLake Partners' Newsletter - The Perspective from BlueLake©. The Newsletter is published periodically and focuses on and analyzes trends in the sectors we follow: Software, Semiconductors and Materials, Enterprise Storage Networking, and Communications. We hope you find it informative and thought provoking and we welcome any suggestions or thoughts you might have on the content. Please feel free to pass it along to others that you think would find it interesting. To Unsubscribe or Subscribe, please click here.

Sincerely,

BlueLake Partners, LLC

No one was surprised when the ‘dot.com’ industry became the ‘dot.bomb’ industry. However, few foresaw the dot.bomb's first derivative, which is the compression of the telecom sector, both in services and equipment. The sector became flatter than road kill; we expected a down cycle, not obliteration.

While the ‘man on the street’ will not shed a tear for those affected by the venture capital claw backs, or the layoffs at Wall Street firms, we are concerned by these cascading downward trends.

The image that appears in my mind is that of Yellowstone National Park after the devastating 1988 forest fire, which burned 1.2 out of 2.2 million acres of the Park plus an additional 400,000 acres of adjacent U.S. Forest land. We are all praying that the economy, financial markets, and the world will rebound as Yellowstone has revived.

The first question BlueLake is asked is "are we at the bottom?” We don’t know. You have to start trending up to know that you’ve hit bottom and we won’t have proof of that until 90 to 180 days after the fact.

The second question we are asked is "how long will we stay at this unproven ‘bottom’?" Currently, companies have absolutely no visibility for revenues or earnings from quarter-to-quarter. Unfortunately our feeling is that it will be a long time—up to two to three years - until we see the any signs of growth.

The signs are all there, in a historic sense, that we are at a bottom. Corporations are closing and selling off their in-house venture groups and selling off their positions in outside venture capital groups in the secondary markets.

• Lucent Technologies sold an 80 percent stake for $93 million to London based Coller Capital Ltd;
• Accenture Technology Ventures sold to CIBC World Markets;
• Hewlett-Packard hired Credit Suisse First Boston to sell its venture portfolio;
• Quantum Technology Ventures was sold to Pantheon Ventures;
• 3Com looked for buyers and backed off;
• Von Wagoner Funds are rumored to have sold off its venture portfolio;
• E.W. Scripps Co. and Palm Inc. both sold off their venture portfolios;
• Oracle Ventures and Dell Ventures have slowed their investing.

Virtually no IPO's have been completed in the past 12 to 18 months, though a few hardy souls have filed S-1’s with the SEC. PIPES (Private Investment in Public Equity) are becoming much more difficult to complete. PIPES were popular in first quarter 2002 in the semi capital equipment sector when people believed we were on the way back from the bottom. Private placements, or late stage financings, are few and far between. Three years ago companies went public one to two years before being profitable, now investment banks are looking for $5million in Net Income - Aldous Huxley could not have predicted this in the Brave New World.

We saw a spate of IPO filings in May; none of those deals have priced as of October 1st:

No one is forecasting a resurgence in the IPO market over the next 60 to 90 days. Additionally, it is not only the IPO market that is hurting, secondary offerings are slowing as well. In second quarter 2002, 106 secondary offerings priced, in the third quarter only 23 secondary offerings were priced. Even adjusting for the ‘seasonal summer slowdown’--say that five times fast--a significant drop.

On the private placement front, BlueLake has seen few do-able private placements and few interested buyers. Unfortunately, both supply and demand are weak in this market.

Venture Capital Investing
According to PriceWaterhouseCooper’s MoneyTree, venture capital investing continued downward in the second quarter, although nothing like the IPO market. Total disbursements fell to $5.7 billion, an 11 percent decrease from the previous quarter and the lowest level since the third quarter of 1998. A total of 819 companies received funding, as opposed to 826 in the previous quarter. Life Sciences accounted for 27 percent of all venture capital investing, the highest allocation in the last five years.

Amazingly, 2002 is likely to be the fourth largest year ever for venture investing, which may appear contradictory. However, when we look at the amount of money raised by Venture Capital firms over the past few years, this phenomenon is not nearly so breathtaking

Given the rapid pace of early stage investing in the late nineties it is not surprising venture capital investments are now focusing on existing portfolio companies. The venture capital investment trend has shifted from investing in early stage companies, anticipating an IPO financings in two years, to husbanding dollars for follow-on investments in portfolio companies. For every dollar invested in a new company, Venture Capitalists are investing five to seven dollars in existing portfolio companies. Currently, the larger venture capital funds are seeking lower risk deals by focusing on larger, more viable companies with growth capital opportunities. According to PriceWaterhouseCoopers’ MoneyTree, expansion stage companies attracted the most capital with 468 companies, accounting for 66 percent of the money raised. Early stage companies attracted 19 percent of the total dollars, at 233 companies. Fewer companies received later stage financings, with 73 companies receiving funding versus 132 in the first quarter.

Mergers & Acquisitions
According to Mergerstat, 5,381 deals closed year-to-date with a value of $343 billion, down from $551 billion for the comparable period in 2001. The middle market was not as affected as other areas, with 763 deals valued at $60.6 billion from $74.2 billion for the comparable period in 2001. Following the trend in VC investing, healthcare topped the list with 400 deals totaling $77.3 billion, followed by Internet at 842 deals valued at $28.5 billion, Telecommunications at 217 deals and $12.6 billion and Semiconductor-related at 44 deals valued at $2.0 billion.

While the sellers seem to have adjusted their valuation expectations to the ‘new’ reality, buyers have become more aggressive. Some buyers have become opportunistic, proposing term sheets, where the buyers could best be characterized as bottom-feeders. We have seen proposed deals at valuations half of what would be expected, even in this more sober current environment.

Some of the bottom feeding is being rewarded. We have seen some stunning purchases. Cereva was shut down after raising $137 million; Sanrise, which raised $200 million has filed for Chapter 11 and EMC has bid $2.5 million for the IP; Telseon which had raised $206 million, sold its assets, assessed at $85 million, to OnFiber for between five and twenty cents on the dollar. Some of these sellers feel fortunate to have been able to complete a deal. And then there are the companies that were unable to find purchases at any price, many with over $100 million of venture capital invested. Cereva, a case in point, was shut down after raising $137 million.

Silver Linings
While Rick Pitino, former coach of the Boston Celtics, rightly said "all of this negativity sucks!" we are looking for the silver lining. And we think we found something for those with a longer term perspective. We compiled a list of significant technology companies and sought data such as date founded, date of IPO, and funding information. We were pleasantly surprised with what we found.

Many of the companies on the list were founded in very difficult times. In particular, the late 1970's, early 1980's, which as you may or may not recall was a period of double digit inflation and high unemployment. Unfortunately we actually lived through it, which only makes us old. Frankly, we think the environment was much tougher in the early 1980’s we are hoping not to retrace those steps.

These companies were able to establish themselves, take time to build a strong base platform from which to grow. While they may have experienced extraordinary growth in the outer years, where growth capital was essential, these companies were able to finance themselves from their founders’ savings, internally generated funds and in some cases, angels.

Of the companies listed Broadcom, Cisco, DELL, eBay, Intuit, JDS Uniphase, Microsoft, Qualcomm, and SAP either didn’t raise venture capital or delayed raising venture capital until one to two years prior to the IPO, in preparation for the IPO.

• Avoid capital intensive industries;
• Husband resources;
• Shun fixed costs/outsource;
• Hire judiciously;
• Achieve early sales; and
• Expand with caution.

As opposed to the companies founded in the late 1990’s and early 2000 that got caught in the crunch, where financing capital suddenly dried up. Far better to know the rules of the game going in, than to have the rules change mid-way through the product development stage.

Another benefit of bootstrapping to the entrepreneur and the founding employees, is that they are able to stay in control of the company for a far longer period of time and hold on to a larger ownership share of the company. If a company raises money early on, typically management and employees are fortunate if they own 15 to 20 percent of the company by the IPO. In a company is able to bootstrap, management has the time to get their sea legs and try different approaches and strategies to see what works, without the pressure from venture capitalists for hyper-growth. As a result of this incubation period, we would forecast that you will see some very interesting and important companies emerge from this period when all is said and done.

- Margaret Johns, Ron Rossetti

If you have any comments or observations, we are very intereseted in hearing from you at Newsletter@BlueLakePartners.com.