Manic-Depressive Technology Business

As I read this article about local (to Ottawa) technology firm Dragonwave, I couldn't help but empathize with their plight. It is a common one for small firms whose market is comprised of large companies, which in this case are the telecommunications carriers. Let's look at their difficult situation to understand it better.

During the dot-com boom, the two types of startup that always attracted attention were the web companies and the telecommunications product and service companies. Due to its engineering pedigree, Ottawa startups most often fell into the telecommunications product category. Entrepreneurs and investors knew that even a single sale, if you could achieve that critical milestone, could make everyone rich. The reason is simple: a modest investment would pay huge returns since any sale to a behemoth like a carrier promised a solid and lucrative revenue pipeline. That first sale could fund the company's operations for a long time and also attract the acquisitive eyes of a Cisco, Nortel or one of the other large equipment vendors.

After the dot-com bust, it once again became important to consider the ebb and flow of such a business since the carriers slowed their capital expenditures, the acquisitive stopped acquired and investors held tightly onto their money. In this more normal business environment, the challenges of selling to carriers could not be ignored. It was still true that a sale would be windfall, just not as wonderful since there were no exits. Startups had to get to work right away on the next sale.

In the public markets, small companies selling to large companies can lead investors on a frightening ride. Full quarters can pass without any significant revenue. The question then becomes whether the company can pull another one out of the hat. There is also that dreaded 10% rule, the one that states that a company that get more than 10% of its revenue from one customer is a high-risk investment. Dragonwave is in this very situation (Clearwire), and the one they have to pull out of the hat is Verizon or AT&T. The pressure is building, as represented by the reported 25% short position on their shares. These are investors betting against their ability to deliver that next sale, or at least not in the near future.

I've worked in this type of environment. Except in a startup (Dragonwave is beyond that, though still of modest size) that carrier can represent 90% or more of revenue. The discussion isn't public, but you can be sure that there are some tense meetings between management and the sales team, and between investors and management.

When the sale actually materializes, the company goes through a remarkable overnight transformation. While everyone is cheering and passing around cases of champagne it comes out that the company was mere weeks away from shuttering the doors; the bank account is empty and investors would not put up any more money. Now with the purchase order in hand, the bank will loan the company large sums to bridge the gap between P.O. and the first payment on product delivery, while investors and management are all smiles once more.

The company then hires more people to service the new customer's needs -- which tend to be large, in line with their size -- and money is freely spent. As the champagne loses its fizz, the sales team goes back to work because the clock is ticking again. Everyone knows that the next big sale is needed within a couple of quarters or trouble will again loom in the boardroom.

This manic-depressive cycle continues until there are enough customers that the revenue lumpiness is no longer a threat to the company's survival. Done right, that's the time to go public and pad the bank account. Dragonwave will likely survive their still very lumpy revenue, even though they are unlikely to do issue more stock, but their share price will continue its roller-coaster ride for some time.

It's no surprise that investors over the past decade have steered more towards web startups. Unlike telecom startups, these companies can get to revenue with less money up front and the revenue, while typically very small at the beginning, is not lumpy. Smooth revenue plots, both past and present, are great for giving investors confidence in the business prospects. Lumpy revenue, even when the lumps are very large, always makes investors feel as if they're in a casino, where the next spin of the wheel or pull on the arm will hit the jackpot.

The appetite for the casino approach to investing is long gone. Carrier-focused, telecom startups are therefore, not surprisingly, not ones that are likely to attract investors in either the private or public markets. Manic-depressive revenue cycles are no long acceptable.