The <I>TSC</I> Streetside Chat: Venture Capitalist Gary Morgenthaler

Morgenthaler Ventures has recently attracted $850 million in new funds. What's it doing with them?
Publish date:

Citing history and borrowing from some basic anthropology, venture capitalist Gary Morgenthaler believes that tech will rise again. He's banking on a repeat akin to 1999.Sometimes it pays to be quasiscientific when you are running against an angry tide of investor disappointment. Morgenthaler Ventures has recently attracted $850 million in other peoples' money, so now the Silicon Valley-based venture capital shop is in the hunt for important emerging technologies.In the wake of the speculative tech-investing spree that vaporized billions of dollars in the rise and collapse of the Nasdaq, you'd think damn the torpedoes would be the last thing most investors would be saying. But Morgenthaler offers evidence to the contrary. Clearly, there are some folks that believe him when he says downturns are, if inevitable, fleeting in the larger scheme of things. Join us as Morgenthaler shares his sunny outlook and his investment philosophy, focusing on communications technologies.

How have your day-to-day duties changed from this year to last?

Gary Morgenthaler:

Last year, I was hearing four or five presentations a day from companies on the cusp of going public. This year is much more about making sure the good companies in our portfolio are adequately financed. And trying to find time in the midst of that to decide which companies will emerge from this period as important companies. Trying to be contrarian and aggressive in a time when everyone else is pulling back.

We are more than adequately capitalized to continue to support our companies. We just raised a new $850 million fund that closed in July. We want to keep our companies adequately financed to scale back their operations to meet a less optimistic business environment over the next 12 months. But we want to be positioned for an inevitable rebound 12 months out.

What leads you to believe we'll see a rebound in 12 months?

Gary Morgenthaler:

My hope is it will be sooner than that.

There's good historical data that suggests the two past economic downturns, in 1990 and 1981, took six quarters from beginning to end. Given the

Fed's aggressive easing, given the fiscal stimulus-package upcoming, given the successful conclusion of the war against the terrorist network -- all of that will bring a return of confidence both among businesses and consumers. Excess inventory has dropped out of the pipeline; marginal producers have been shaken out of the business. So there's an inevitable strengthening that comes at the end of that period.

And I think the 475 basis points of reduced interest costs translates directly into increased profits for large corporations. Companies with significant debt are able to refinance at much lower prices, and the difference comes back as profits. Those profits translate into the ability to invest more in business. There continue to be great opportunities here.

We will see a return to a much more normal business environment in the second quarter next year, and I think it may be one or two quarters after that when we see the telecommunications market return in full.

'We will see a return to a much more normal business environment in the second quarter next year, and I think it may be one or two quarters after that when we see the telecommunications market return in full.'

Let's hope you are right. So what areas of tech are getting the most attention?

Gary Morgenthaler:

We look for pressure points in networking that have unsolved problems, and, specifically, that means the local loop. Voice and data travel together in a converged form on fiber-optic cable over long-haul networks, but when it comes to the last mile, they split out into a separate network for voice and a separate network for data. That's not economical, so we are looking at companies that address that and offer converged solutions for the last mile.

Another area we look at is the differing economics of the phone network and the enterprise network. Enterprises are built around Ethernet and Internet protocol, called IP, a dramatically cheaper way to carry traffic than phone systems. And this is building up to what will be an epic struggle in the next two to five years over which architecture will win out.

Carriers charge between $700 to $1,500 for T-1

a conventional data line that carries information at 1.5 megabits per second business lines. For the same amount of money, you can get a 100-megabit per second Ethernet service from some of the emerging new carriers. That's a 60-to-1 cost advantage. That's discontinuous economics. Carriers can ignore that for a while, but the incentives for business to adopt these new technologies are very strong. This is building up to be a major showdown in the next few years.

Gary, let me push you on that a little bit. We are all somewhat familiar with technology's steady progress and the great advancements in speed and capacity. It's essentially the mantra that helped fuel the Internet building boom of 1999. But that, of course, led us to an oversupply of capacity, gearmakers and service providers. Would chasing these new technologies only cause us to repeat that process?

Gary Morgenthaler:

For 30 years people predicted we had created more computing cycles than anyone had a use for. The notion, early on, was that no one needed anything more than a word processor. Well, people found new uses for greater computing cycles. The same thing will happen to communications. It just doesn't happen in linear terms, but rather in discrete chunks. New capacity and demand come to the market in lumpy fashion, which creates excesses of supply at times and excesses of demand at other times.

New uses will emerge for communications just as they did for computing. We are at our very core a social species, and communications is what we do as a species, so the need for this is not finite. The ability of humans to absorb information and communicate with others in more media-rich ways is nearly infinite.

We have the luxury with a 10-year fund cycle, so if we are building businesses that emerge as important businesses in that time cycle that create favorable returns to our investors, we've done our job. So we can look beyond the 12- to 24-month turndown in the markets and ask if we are doing the right thing: building for markets that will be there. Building companies that will be the leaders of their respective industries when the dust settles.