VCs Need to Rethink SMB VoIP Valuations

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billion sale to eBay Inc., SunRocket Inc.s ability to raise more than $30 million for its consumer VoIP play and Packet 8s (8×8 Inc.) current valuation despite significant losses. Add to that Vonage Holdings Corp.s IPO filing, which may yield an even higher multiple. While these developments in the consumer space might seem promising for other nextgeneration service providers, raising investment capital remains surprisingly challenging for VoIP companies targeting small and medium businesses.

The market has reached the proverbial tipping point. Every credible market research report promises exponential growth over the next five years in VoIP-related services and equipment sales yet many traditional venture capital firms still remain on the sidelines or cling to CLEC-like valuations of proposed investments. The big question remains: Wheres the cash and what ultimately defines the value drivers?

Over the past 12 months, I have had the opportunity to speak and meet with many executives from smaller service providers that have deployed, or are in the process of deploying, new VoIPenabled networks and services. Their experiences attracting funding and building shareholders face some common challenges.

The first challenge is while many investors and VC firms understand the ultimate SMB value proposition, they are not convinced service providers have broken the code and have the ability to scale the business. Their trepidation is not unfounded as nearly every service provider has experienced significant challenges with the complexities of commercial VoIP deployments. (Just ask Covad Communications Group how its GoBeam meets DSL strategy has panned out to date. Inconsistent broadband, softswitch architecture, CPE interoperability and other assorted LAN-related issues have been problematic.) The key to scalability is and always has been found in broadband network ownership. The ability to provide and own high-quality broadband is paramount; it is the ultimate Trojan horse as service providers move toward a true managed services model. SMBs are not necessarily buying broadband to use VoIP, but they are clearly more and more receptive to cost savings and productivity-enhancing features derived from broadband. Remember: VoIP, as an industry friend often reminds me, is a technology, not a service, and is the application du jour. The takeaway here, then, is prospective investors must see an executable path to other ARPUboosting services that create a real managed services environment.

Valuations and investor interest will increase as service providers evolve their VoIP strategies into viable managed services business plans that include other important services like managed network security. VCs correctly believe successful managed service plans need to come out of the closet and derive a greater percentage of revenue from the desktop.

VC firms are right to question service providers abilities to execute on such plans, especially those calling for broad geographic reach. Investor confidence in business plans that go deep in specific geographies typically is much higher than in those that dont. This is with good reason. For smaller providers, in particular, geographic customer density allows for a more manageable, quality broadband product as well as local smart hands. Several companies are following this strategy successfully. Cbeyond Communications has built a $150 million revenue stream following this strategy in its core markets. While its valuation is still dragged down by traditional CLEC bias, its go deep approach is working. After experiencing the challenges of a broad market approach, Broadvox recently launched a subsidiary, InfoTelis, to accelerate its managed network service provider model. The pilot test in Ohio resulted in immediate traction, and additional markets will be rolled out in the next 12 months.

Another apparent bias among VCs is their preference for companies that own the softswitch technology or have developed models based on proprietary technology. This, I believe, is a shortsighted objection. Whether a managed network service provider owns or resells the technology is a nonissue. The real value driver should be a companys ability to successfully integrate and manage the multiple technologies and vendors needed to create the converged solution SMBs require. According to recent research from Ovum and commissioned by Cisco Systems Inc., managed VoIP and managed network security are in demand. The study found that managed VoIP services will see a 65 percent compound annual growth rate over the next three years, growing to a $41.5 billion market by 2009.

In practice, New Global Telecom Inc., CommPartners Inc. and other service providers are successfully wholesaling hosted IP, trunking and other associated VoIP applications. Their platforms allow Tier 2, Tier 3 and emerging providers to focus on customer acquisition, deployment, service and OSS. While its true there may be a point when their customer bases become so large that reselling no longer makes economic sense for these companies, their ability to drive top-line revenue while mastering the complexities of commercial VoIP deployment are more critical now and should warrant considerable attention from investors.

Another common experience among smaller CLECs migrating to VoIP models is that even with viable plans for transitioning end users to new services, they are still considered CLECs. Their valuations are tied to current public CLEC valuations which, with some exceptions, range from 0.3X to 1X annual revenue. They also are not helped by the fact that many UNE-P CLEC bases can be bought for as little as 1X to 2X monthly revenue. We all know CLECs were not created equal. Some clearly are experiencing a post-UNE-P disadvantage, but those with SMB customer density in specific geographies should be viewed in a different light because network efficiencies can be achieved faster with far less expense. For example, STS Telecom in Florida has nearly 10,000 accounts in one Florida LATA, has deployed its own softswitch infrastructure, has leased an OC192 with BellSouth Corp., and is well-positioned to provide existing customers new services while pursuing an aggressive managed network service provider model for new business.

I have a difficult time rationalizing valuations of Skype or Vonage with models that generate $20 consumer MRCs that hang perilously on limited control of the broadband connection and face increasing cableco triple-play momentum. I do, however, have hope that service providers executing VoIP as part of an overall managed service provider model will attract smart investment dollars and drive much greater and sustainable valuations. For this to come about, it is critical for these service providers to go market deep, make broadband ownership a priority and scale now. Industry consolidation will reward those companies that execute on these strategies over the next 12-to-24 months.

Gerry DeHaven is the president of Iridius Management Group, a management consulting firm based in Princeton, N.J. He also is managing director with Blue Beacon Capital, a technology telecom media investment banking firm based in Malibu, Calif.