Let there be more light
Real Deals, 25 July2002
With telcos strapped for cash, life is tough for many photonics start-ups. But few investors deny that this sector has good long-term prospects, and it continues to attract venture funding. Which areas will light up the future?
Maurizio Vecchione, chief executive of Microwave Photonics, promises nothing less than a revolution. The company's technology is aimed at effecting the biggest change in the operation of radio networks for a hundred years, by replacing the electronic systems used to amplify and transmit signals with systems based on light. "There is effectively the same kind of paradigm shift that occurred when the valve was replaced by the transistor," Vecchione says.
Microwave Photonics' proprietary Green Radio technology converts light signals directly into radio signals and back again, and allows the radio base stations which make up the infrastructure of wireless communication networks to be powered by the same optical fibres that carry its signals. According to Vecchione, that could cut the costs of some systems by a factor of eight.
Based on a unique semiconductor developed over the past decade by BTexact, the technology wing of the UK telecoms giant, Green Radio is compatible with virtually every wireless protocol used today or likely to be used.
"It can be disruptive to virtually every area of the wireless market including next generation networks and mobile infrastructure," Vecchione says. "That includes 3G, and also existing networks which are moving away from what one would call coverage limited networks - where the focus is on installing infrastructure and providing coverage - to capacity limited networks, where some suppliers are dividing themselves into ever smaller cells which are becoming more expensive using other technologies."
Based in Santa Monica, California, and at BT's Adastral Park research centre in Ipswich, Microwave Photonics is being nurtured by Brightstar, BTexact's corporate incubator, which brought in Vecchione as CEO designate in May. An experienced entrepreneur and VC with over 20 years experience in the telecoms industry, Vecchione is currently raising a first round of $15m to pave the way for the company's first commercial market launch early next year. Initial products will target the enterprise wireless LAN market, one of the key areas for the many businesses scrambling for a foothold in the crowded photonics and optoelectronics arena.
As an active investor through his own telecoms consultancy Synthetica, Vecchione has observed the optoelectronics market for years. "I would say it's still a very active area of VC investment, though there are clearly concerns about where photonics businesses in general are going, particularly in the core infrastructure market which appears to be somewhat saturated," he says. "There's clearly been a significant slowdown in capital investment in the photonics area. However it probably remains as the single most active area of VC investment in the technology sector.
"Generally, the opportunities for liquidity have become much fewer which means VCs are focusing on the quality of investment. What I find attractive in nurturing Microwave Photonics is we have a technology rooted in fundamental science, covered by a whole host of patents that we have had issued and which has had almost a decade worth of systems tests and R&D, and it is disruptive to a very large market which already is worth more than $1bn. These are the ingredients that a VC would be looking for, and certainly we're looking at it that way."
Microwave Photonics is not the only optoelectronics start-up chasing funding in what is probably the busiest time in the sector since 2000. London boutique FirstStage Capital is currently advising an academic spin-out looking for initial funding. "It has a breakthrough technology which potentially significantly reduces the cost of manufacturing certain types of optical components," says FirstStage director Hazel Moore. "It's a very exciting opportunity."
Investor interest in optic opportunities is split, Moore observes. "There is strong interest from people who know about the optics market and recognise some of the unique aspects of this particular company. There is obviously scepticism from certain parties given the current very weak state of the market. One thing specific to the optoelectronics market is that the meltdown in their end product market happened more rapidly than most people expected.
"Optoelectronics companies have to have very specific propositions," Moore emphasises. "They really have to be targeting an area of the market where there's genuine need and where there are realistic prospects of demand within a reasonable time frame. There are certain areas where there is still growth and if you get the right proposition for that market there is still strong investor interest."
Some investors active in the previous wave of optical activity remain dubious. In June 2000, Amadeus Capital joined in the £37m first round for Southampton Photonics', a producer of optical components for telecoms networking applications.
"It was very high quality technology with a deep and broad set of applications and a pipeline agreement of continuous collaboration with the Optoelectronics Research Centre at Southampton University, which is one of the leading centres in the world for optics," recalls Amadeus managing director Anne Glover. "The product development is moving to plan, but obviously the market has been delayed considerably across the whole telecoms sector."
Amadeus is not looking for further investments in the area. "The area at the component level has stopped with the number of competing component technologies that have to sort themselves out," Glover says. "There's lots of new investments in existing companies, but there are no opportunities for a new company unless it's an obviously unique technology. It would be too hard for a start-up company to sell into such an uncertain environment."
The dead zone
Other investors have retained their appetite, however. 3i previously backed the highly favoured Kymata and Bookham Technology, both of which have seen their fortunes fall dramatically from their 2000 heights.
"3i has been investing in the optical industry since the early 90s," says head of telecoms Ian Lobley. "We've benefited from the first phase of the industry, and we've seen a period of excitement where leading edge R&D was productised and equipment vendors consumed all that could be produced. That phase is obviously over and we are now in what has been described as an optical dead zone.
"What we're now looking at is the move towards much higher levels of functionality at much lower levels of cost, to drive the economies of the industry to something like what the electronics industry has enjoyed for many years. A key part of that is the integration of active devices into monolithic structures."
Recent 3i investments have dealt with the basic building blocks of optical systems. The group's latest optics investment is in OmniGuide Communications, a US-based spin-out from MIT. OmniGuide's hollow fibre technology guides light signals through air rather than the traditional silica, potentially removing the need for expensive optical amplifiers. "It's a real disruptive technology, with the tremendous quality of technology coming out of MIT, and a couple of world-class business angels seeding the business," Lobley says. "We were tempted to invest in that because of the quality of all those things. I think we will see a return of demand, and optical systems will have a very important role to play as networks are replaced and improved. We will not see a massive spiralling of valuations but there is something very revolutionary about the migration from electrons to photons."
Going the last mile
The market for photonics businesses is inextricably bound up with the wider telecoms and ICT markets. The reverse is also true, which is why corporate venturers have been some of the most consistent investors in the field.
Intel Capital, the equity investment arm of the ICT giant, has backed around 40 optical businesses from its $500m Intel Communications Fund. "We invest to grow the markets we serve and to bring new knowledge into Intel," says director Tim Keating. "We believe in the internet and the need for more and more bandwidth."
Getting usable bandwidth to the end user is now the key challenge for networks. Telecoms operators have invested heavily in recent years in the fibre networks linking cities and countries, but much of this infrastructure is lying unused because the local metro networks have been much more expensive. It's the telecoms equivalent of a road system with eight-lane motorways and no junctions.
"There's a lot of dark fibre out there, but there's no low-cost photonics to connect to that," Keating says. "The last mile and metro networks that will take advantage of that are not built out. What we're looking for is how to get very low cost photonics - lasers, amplifiers, modulators, and background technologies around these devices - that will enable this next generation of low cost equipment."
Intel's investments include Zurich-based Avalon Photonics, which produces a low-cost form of laser called VCSEL for the local access market; and quantumBEAM, a spin-out from the Generics Group in Cambridge developing fibre-free ultra-high bandwidth links.
In December 2001, Intel also joined a $5m second round in Compound Semiconductor Technologies, a Glasgow-based foundry specialising in the preferred semiconductor for optoelectronics applications, indium phosphide. "We made that investment to help enable the ecosystem of young companies building on new technologies," Keating says. "There's not a lot of places in Europe that you can get indium phosphide fabricated. It doesn't make sense for every company to need its own foundry in the early days so we thought this was a good proposition."
Keating agrees that the integration of optical components onto single chips is the key to the sector. The photonics industry is currently at a similar state to the electronics industry 20 years ago, when integrated circuits were first becoming economic for mass applications, he suggests. The difference is the physical difference between electrons and photons.
"It's easier to work with electrons - they go round corners, while light goes in straight lines," Keating points out. "The only way you can bend light easily is through a fibre - you can get it through a chip using waveguides but you have to physically structure it. The tendency to integration is much more difficult for photonic devices - they are more expensive but people are finding good companies to do it."
One such company is ThreeFive Photonics, a spin out from Delft University of Technology, which won a Euro7m first round from Atlas Ventures and Gilde IT Fund in September 2001. The scientific team is highly regarded for its work with indium phosphide, including the creation of a chip with an integrated optical switch that measures just 3mm across.
"It's a technology that's perceived as the only way to create a full optical system combining optical and electronic components on one chip, which is perceived in the optical space as the holy grail," says Atlas investment principal Gerry Montanus. "This has not been done before so there is significant technical risk in this venture, which we accept."
Identifying further opportunities in the currently well-funded optical space demands great selectivity, Montanus emphasises. "You have to make a distinction between the short term and the long term. In the shorter term, what the telcos are looking for is probably less disruptive and more an extension of existing assets - they want to have equipment which is more efficient, cheaper and smaller. I don't think they're in the mood now for completely new applications."
Atlas' latest optics investment is OptoVia, a US-based start-up developing novel amplifiers for next generation optical networks. Like ThreeFive, OptoVia is a fabless semiconductor business, with manufacturing operations outsourced. "One of the things that has changed in the optical market is that some early investments were really science projects that had a lot of research to be done," says Mike Feinstein, investment principal with Atlas in the US. "You're now seeing companies like ThreeFive and OptoVia that are using existing manufacturing facilities and outside foundries, so they're focused on the technology. It focuses the investment where the company can really add some value."
Optoelectronics is one area where Europe and the US are roughly level in terms of original research and start-up rates. "From our perspective, I would say the number of deals we do in this space is about 50:50," says Montanus. "The technologies we see are very comparable. I think if you have to make a distinction between the US situation and the European, there's still the difficulty to build a management team in early stage companies in Europe. It's improving but we're not to par with the US yet in terms of management teams approaching VCs, or in the likelihood you can fill a management team with very strong candidates."
Lobley at 3i agrees that Europe stands good comparison with the US. "The big difference in the European situation is the lack of indigenous OEMs and systems houses," he notes. "That does give the US companies some advantage in getting their products specified and integrated into networks."
The UK can boast one of the world's leading optoelectronic clusters, based around the universities of central Scotland. Recent start-ups such as Essient Photonics, an integrated component supplier which closed a $7m first round led by Pond Ventures in March, have followed companies like Terahertz Photonics, Kamelian, and of course the Livingstone-based Kymata.
"Scotland receives approximately 40% of the UK's university funding for optoelectronics," says Gary le Sueur of Scottish Equity Partners, which has backed Terahertz and Photonic Materials. "Overall, six universities in Scotland cover the area, making the country a fairly major league player in the global marketplace. That core research, coupled with the growing entrepreneurial culture, the availability of risk capital and the support from economic development infrastructure in Scotland such as Scottish Enterprise, provide some of the key ingredients required."
The quality of optoelectronic business proposals has improved significantly over the past two years with only a slight dip in volume, le Sueur notes. "With the turbulence in the technology markets, only the most committed, motivated entrepreneur, with the strongest of cases, is successful in fundraising," he says. "This is actually a good thing for us, as the more unrealistic proposals are not taking up much of our time. We will tend to prefer companies that have a suite or family of devices based on one core technology, rather than just one end application. That said, there is an issue with some companies that try to do too much with limited resource - now, more than ever, there is a need for focus."
Photonics: a lightweight
The scientific field of photonics covers a range of areas dealing with the transmission and manipulation of light on the level of its individual photons. Commercial applications are focused on the use of photons rather than electrons to carry information in telecoms and IT networks. Optoelectronic devices convert optical signals to electronic signals or vice versa, and the term is often used synonymously with photonics.
The connections in an optical network are made by optical fibres, very thin strands of pure silica glass surrounded by a cladding of low refractive index. Fibres carry information in the form of pulses of light generated by a laser. These lasers are tiny semiconductor devices which produce intense light at one specific wavelength when an electric current passes through them. Most optical networks operate at infrared wavelengths.
Networks also need nodes where optical signals can be processed and switched between fibres. These nodes can contain a variety of devices, which are usually produced separately. Integrating all the devices needed at a node into a single chip is a major challenge for the photonics industry. Optical chips may be made of silicon or the technically superior but less established indium phosphide.
Common devices include transponders, which electronically boost an optical signal; optical amplifiers, which boost a signal without any conversion into an electrical signal; and optical switches or crossconnects, which move optical signals between different fibres without conversion. A waveguide is a material that guides the optical signals through the devices.
Optical fibres can carry much more information than electrical cables thanks to a technology called dense wavelength-division multiplexing (DWDM), which allows signals at many different wavelengths to be transmitted simultaneously on a single fibre.
Until recently, fibre optics have been mainly used over long distances. Currently emerging applications centre on the local area network (LAN) connecting a small area such as an office suite, using either cable or wireless connections.