TCS Daily

Dialing for Dollars

By Dominic Basulto - September 14, 2004 12:00 AM

Venture capitalists -- the "rock stars" of the late 1990s who brought you the likes of Amazon, eBay, Yahoo and Google -- are back in business. There may no longer be the same end-of-the-millennium-type froth that existed five years ago, but the recent $105 million investment in VoIP pioneer Vonage could presage a return to glory for innovative Internet-savvy startups and the re-emergence of billion-dollar market opportunities. By all accounts, VoIP (Voice over Internet Protocol) is one breakthrough technology that could disrupt the existing telecommunications market and lead to the next great Internet boom. Based on traditional approaches used to evaluate VC deals, the recent investment in Vonage should have been the best VC investment of the summer - but was it?

Even skeptics agree that Vonage is offering a truly disruptive technology (VoIP) that could quite possibly revolutionize the telephone business by enabling customers to make and receive voice calls over existing broadband Internet connections. Like any disruptive technology, VoIP offers the type of value proposition that customers love -- cheaper costs, increased functionality and ease of use. By some estimates, a Vonage subscriber could save 40% or more on monthly phone calls by routing phone calls over the Internet and in a recent Smart Money survey, the Vonage VoIP service actually performed better than traditional land lines, garnering the highest overall rating for voice quality.

The company also has an A-list executive management team led by CEO Jeffrey Citron, who founded The Island ECN in 1995 before selling it for $503 million to Instinet Group. He also helped build Datek Online Holdings into one of the giants of the online trading space before it was acquired by Ameritrade in 2002 for a whopping $1.3 billion. That's the kind of track record that venture capitalists love. That's not all -- the CTO of Vonage has more than 20 years of experience in Internet technical engineering and architecture, while the chief marketing officer is a former senior executive at with a wealth of experience at traditional consumer packaged goods companies and advertising agencies.

Finally, the company has the type of "Get Big Fast" mentality and nearly-vertical hockey stick growth curves that cause MBA grads to start salivating uncontrollably. The company now has more than 240,000 subscribers, making it the largest pure play VoIP provider. With its new $100 million war chest, the company plans to expand worldwide to Canada, Latin America, Asia-Pacific and the UK. The future's so bright, you gotta wear shades -- research firm Gartner predicts that there will be more than 6 million VoIP subscribers by the end of 2005, while research firm IDC predicts that VoIP could become a $7 billion market opportunity by 2008. Starting September 1, Office Depot will offer Vonage products, giving the company a highly-visible nationwide brick-and-mortar presence.

Yet, for all of its advantages, the company has a number of disadvantages. For one, VoIP is, and always has been, a legal and regulatory nightmare. For now, VoIP startups have managed to avoid the tax and regulatory burden of traditional phone companies, but that could change at the drop of a hat. In addition, a number of deep-pocketed competitors like AT&T, Verizon and Qwest are aggressively bidding for VoIP subscribers in certain geographic markets. (AT&T is aggressively peddling its CallVantage VoIP offering to residential customers, offering, among other perks, free long-distance.) Since these companies own their own networks, Vonage could be facing a nasty, brutish pricing war as it races to acquire customers -- the company is essentially relying on potential competitors to provide it access to future customers.

That's just for starters. Some VoIP experts, such as Tech Central Station's Kevin Werbach ("Not Your Parents' Phone System"), point out that telecom giants like AT&T and Verizon are not even the true competitors of Vonage. Instead, it is companies like Microsoft and Sony (online gaming with real-time voice capabilities) or Yahoo and AOL (voice chat), which represent the biggest competitors in the VoIP landscape. Notes Werbach, "Going forward, there will still be things that look like phones, activities that look like phone calls and companies that look like phone companies... Viewed in perspective, though, these will be a small corner of the VoIP market."

Take Skype, for example, which bills itself as the global Internet telephony company. It's a bare-bones VoIP service from the inventors of KaZaA using P2P software that's, well, free. Even FCC Chairman Michael Powell was bowled over by the potential of Skype to transform the world of communications forever. The free software has already been downloaded more than 21 million times, giving it a potential subscriber base that would be impressive by any standard. Moreover, the company has an enviable cost structure, thanks to minimal marketing costs and low-cost Estonian programmers.

It will be interesting to see how things shake out in the world of VoIP. Remember that at one time, Google was not considered a slam dunk investment. Search was a "commodity business" with "low barriers to entry" and few, if any, visible revenue streams. And look at what happened. VoIP is a huge -- make that gigantic -- market opportunity. The only question for venture capitalists, though, is who do you back? The broadband phone pioneers like Vonage -- or the VoIP startups in far-flung places like Scandinavia that are fundamentally reconsidering the very notion of the telephone?

Dominic Basulto is a TCS contributor.


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