Meritage is pleased to announce our recent investment in NewPath Networks. Based in Seattle, NewPath is engaged in the construction and operation of Distributed Antenna Systems (“DAS”) for wireless carriers.  DAS provides wireless carriers with an alternative to traditional communications towers as a mechanism for improving the capacity of their networks.  DAS networks are particularly valuable in high-density population areas where construction of communications towers is not feasible because of zoning and other regulatory restrictions.

Existing cellular networks were originally optimized for voice traffic only.  With the recent proliferation of wireless data services, these networks have become overloaded in many areas with a resulting degradation of signal quality.  (Meritage has pursued mobile data content and services as an investment theme for some time, with representative investments including MCN and Crisp Wireless.)  To accommodate the increasing demand for capacity, wireless carriers are making massive investments in infrastructure to convert their networks from 2G to 3G and 4G.  In fact, nearly all carriers confirm that their 2009 infrastructure spend with be in line with 2007 and 2008 despite the current economic crisis:  they simply can’t slow down because their customers are consuming more and more content and demanding better performance.  To address this need, fiber-fed DAS networks provide wireless carriers with a quickly-deployable and cost-effective solution for wireless networks that are capacity-constrained.

NewPath is an excellent fit with Meritage’s network-enabled services investment focus.  One of the key elements of our investment focus is the recurring nature of our companies’ revenues. In today’s environment, recurring revenue is more valuable than ever. NewPath has excellent revenue visibility and stability because its network services are provided under 10-year contracts with its carrier customers and the company has a significant backlog of business under contract. As with the tower industry, contract renewals are virtually assured as it doesn’t make economic sense for a competitor to overbuild an existing DAS network.  Meritage’s operating expertise and sector knowledge is also an excellent fit with NewPath, as our partners have both run and invested in fiber network companies, tower companies and cellular carriers.

We believe the DAS industry is on the cusp of explosive growth, as DAS has recently become a strategic part of the carriers’ network architecture.  More and more neighborhoods are resisting the addition of unsightly communications towers, yet these same residents need and want better cell phone coverage and capacity.  We believe DAS is the answer, and NewPath is leading the charge as one of only three independent providers of DAS services in the US.  NewPath differentiates itself from the competition through its selection of high quality opportunities: NewPath works primarily with the leading wireless carriers such as AT&T and Verizon and is very selective about the markets it pursues.  Last year, in a highly competitive process, AT&T selected NewPath to build the largest outdoor DAS network in the United States in Scottsdale, Arizona, a testament to the company’s capabilities.  As with the tower business, multi-tenant lease-up is critical for maximizing profitability in DAS networks.  NewPath has demonstrated strong historical lease-up performance and believes that demand for its networks will continue to grow.

Needless to say, we are excited about the growth prospects for NewPath and are encouraged by the quality of business opportunities the company has recently been awarded.  Given the limited competition in the DAS market and the fact that mobile telephony and data services are one of the few areas of the economy showing growth, we believe NewPath will be a dominant player in this segment.

Telephony ONLINE recently offered an insightful opinion article exploring the strategic positioning of network owners and their long-term strategic alternatives for monetizing their infrastructure. Network owners have historically monetized their assets by selling transport services and by offering self-managed services on their network. For example, telecom network operators offered voice services; cable network operators offered video services. More recently, service providers have bundled multiple services; voice, video and data services.

The trend toward multi-service networks is the leading edge of what we see as a long-term trend; consumers and enterprises are demanding an increasingly diverse set of services that enable them to communicate, to interact with content and to move money. The emergence of Internet protocol based networks - which enable services to be separated from the networks over which they are delivered - has only accelerated the trend.

We are dubious that incumbent network operators have the requisite skills and organizational flexibility to respond to the increasingly complex needs of their customers. But if network owners do not build and control these new services, they risk being relegated to providing highly-commoditized transport services. The threat, while long-term, is considerable. The typical network operator reaction is to erect “walled gardens” of services and content to abstract other IP-based service providers away from the network operator’s customers. But that didn’t work for AOL, it hasn’t worked in the wireline world and the walled garden is predictably and rapidly crumbling in the wireless world as well.  So what is a network-operator to do?

We believe that the answer starts with understanding that network operators control considerable assets and capabilities that go well beyond their networks. Telephony ONLINE mentions subscriber information, payment infrastructure (billing), quality of service management capabilities and the ability to make services available on multiple networks as key leverage points. To this list, we would add a list of the unique capabilities and data elements that are inherent in network infrastructure, like location data, presence, usage history, and latent data on the social graph their networks connect (who calls who, emails who, etc.). Some of this will give privacy advocates nightmares, and telcos and cable operators have already been chastised by privacy advocates with dire consequences for packet sniffing enabling technology vendors like NebuAd. Privacy issues aside, the opportunity for the network operator is to expose these services through a service oriented architecture to a community of application developers who can leverage the assets inherent in networks and innovate at a rate and at a level of quality that network operators could never hope to achieve on their own.

The operational and strategic challenges facing the network operators are non-trivial. Adopting a service oriented architecture to open their billing, consumer data, location and other “services” to a community of application developers requires skills and a business philosophy that runs counter to command and control history of network operators. Network operator back-offices are typically a mess with multiple billing, customer resource and other systems all managing the same group of customers. But with no viable path to control the third-party services delivered over their networks and lacking the capabilities to innovate on their own, we see little choice for network operators in the long-term. They must open up their infrastructure and allow others to innovate on top of it; they must become a platform.

Does this mean that network infrastructure is no longer valuable? No, not entirely; network assets will always have inherent value, particularly in geographic markets where network capacity is constrained so that raw transport is still valued. Despite that, the trend is clear; value is moving away from networks toward the services that are delivered over them. Network operators can either leverage their strengths to facilitate the delivery of these services by third parties, or face the prospect of service innovators cannibalizing the network operator’s proprietarly delivered service business for years to come.

From an investors perspective, the dilemma of the network operator is our gain. We actively seek opportunity to innovate using the network assets of others without having to pay for access to the capabilities of their networks. Likewise, we are always on the lookout for ways to leverage data that the network operators may be opening up; location data being a good example. We encourage you to share your thoughts on this trend and to share any business plan ideas that align with the concepts outlined here.

The Catalyst Code by Dave Evans and Richard Schmalensee is dominating the water cooler talk at Meritage. It’s rare that a business strategy book really hits the mark, but The Catalyst Code does as it was written for the 21st century VC and entrepreneur.

With unprecedented levels of broadband connectivity and the widespread adoption of the Internet, businesses today are able to bring together different sets of customers to allow them to interact in ways never before possible. This is what the authors call a multi-sided business platform. Getting customers to interact on such a platform is a catalytic reaction. Rather than creating new products or services, catalyst companies figure out how to allow participants in an ecosystem to interact more efficiently (or in some cases to interact for the first time), creating enormous value within the ecosystem. Meritage has invested in five catalyst companies to date and is a huge believer in the premise that multi-sided businesses have the ability to transform industries. A perfect example is our portfolio company Pipeline Financial Group. Pipeline is an electronic securities trading platform that allows institutions to trade large blocks of shares directly with one another: no more need for a broker. By doing so, institutions avoid the $20 billion annual cost resulting from brokers “front running” their orders.

Catalyst companies offer tremendous opportunities as they’re often rooted in huge industries; however, they also have special challenges. First and foremost, the company must attract the various participants into the ecosystem at the same time – you can’t conduct one sided transactions in a catalyst company! Pricing also becomes very tricky: do you charge all customers using the platform or do you consider subsidizing or even (gasp) paying a key customer group for its participation? The idea of subsidizing a customer always gives VCs the chills: Pets.com and Vonage spring immediately to mind. But these infamous companies were single sided businesses subsidizing their only customer with no second-side of their market. In a catalyst company, there are at least two and sometimes more distinct customer groups, and it may be necessary to incent the customer group that can start the catalytic reaction. Our mobile search company Mobile Content Networks is doing just that. MCN has numerous distribution agreements with leading wireless carriers and hardware manufacturers including Sprint, DoCoMo, Nokia, Yahoo! Japan, Tele2 and SMART. MCN does not charge these distribution partners to implement its search technology. These partners are the key to reaching the consumer, and MCN now reaches over 365 million mobile subscribers. This reach is a huge asset and one that MCN is monetizing through advertisers. Had MCN charged either the carrier or consumer for search, it likely would have failed. Instead, MCN charges the participant in the ecosystem who is the most motivated to reach the consumer: the advertiser.

As Bill Gates comments in the book, this is “how breakthrough businesses can be built in today’s economy”. We agree. Catalytic investing is one of the most promising investment areas and we continue to aggressively pursue these ideas. If you haven’t read The Catalyst Code – do it and join the 21st century!

Recently, we had the pleasure of visiting with many of our Limited Partners and friends of our firm during our Annual Meeting. To those of you who attended, we thank you. A special thanks to Royce Holland, Executive Chairman of Masergy Communications and Fred Federspiel, President of Pipeline Trading, both of whom presented during the session. Also thanks to Chip Kahn, CEO of IP Commerce, who joined us for our annual family-style dinner.

Given the current macro-economic turmoil, we felt it appropriate to discuss the impact of the credit crisis and equity market dislocation on venture capital investing. This proved to be prescient as the Dow Jones Industrial Average dropped over 1,400 points during the week preceding the Annual Meeting. The question we posed to ourselves was: “What is the impact of the current markets on venture capital?”

The Venture Capital Value Chain
In order to answer that question, one must first understand the key functions of the venture capital business. We believe that Venture Capital investing is comprised of five key functions; Fundraising, Investment Sourcing, Investment Selection, Value Creation and Exiting. In the graphic below, we’ve outlined these functions in a value-chain like construct. We have color-coded the “chevrons”; red signifies a “negative impact”, green signifies a “positive impact”. Full credit to my Partner Jack Tankersley for the construct.

We’ll work our way backwards through the chain.

Exiting – An External Dependency
There can be no doubt that current markets are not exit friendly. I will not be the first, nor the last, to quote the fact that the third quarter of 2008 was the first in 33 where there was not an initial public offering of a venture-backed company. To compound this, with credit markets tightening, strategic buyers are more focused on cost-containment than expansion. Those few strategic buyers which are willing to pursue strategic acquisitions are valuation conscious.

Impact Assessment: Negative

Venture capitalists can (and will) lament the exit markets all day long, but that won’t change the fact that we don’t control them. Only with the long-term view that building a successful company is a five to seven year proposition can one see that today’s exit market is not particularly relevant to the overall process of building value. With that in mind, lets move on the core venture capital functions where a venture capitalist should be able to make an impact.

What We Can Control - Value Creation, Investment Selection and Investment Sourcing
In our nomenclature, Value Creation is the process of working collaboratively with a management team to shape, guide and ultimately, enhance the value of an investment. The value creation process never sleeps; it is not dependent on capital markets. What we have found over the years is that human capital is the fuel that powers the engine of value creation. In difficult macro-economic markets, talent tends to be more available. When the biggest companies in the World are failing or struggling to raise capital, no-one’s job is safe. It may be counter-intuitive, but there is less relative employment risk working for a well-capitalized early stage company in this economic environment.

Regarding Investment Selection, we similarly see some strong positives for firms that have a deep sector orientation and domain expertise. Venture capitalists are expert at pattern recognition. We observe exits, investments by competitors, and news of companies expanding and we assemble this information into a composite view of the investment landscape. But in a slow market, there are fewer external signals to rely on. With fewer external signals, what is required for success is a more fundamental understanding of where value is being created in a sector and a deep level of understanding of the dynamics at work in that sector. This works to the advantage to those among us who have deep sector knowledge.

Finally, regarding Investment Sourcing, I’ll quote Warren Buffett, who in an October, 17 Op-Ed piece in the New York Times, wrote:

“Be fearful when others are greedy and be greedy when others are fearful.”

The third quarter 2008 version of the Silicon Valley Venture Capitalist Confidence Index, performed at the University of San Fancisco’s Entrepreneurship Program, has reached an all-time low. So there is clearly fear in the venture capital community. Anecdotally, what we see is venture capitalists backing away from earlier stage opportunities, dropping venture valuations and stranded companies with fatigued syndicates. But despite the doom and gloom, embedded in the report is a nugget of light:

“While the Index has hit its lowest point to date, this quarter’s respondents had the widest range of confidence since I began this survey nearly 5 years ago with responses ranging from very confident (5) to quite cautious (1).”

This implies a small contrarian view in the venture markets; a Buffetesque view. We share that view. It is a fabulous time to make new venture capital investments.

Impact Assessment: Positive, Positive, Positive

What is required in this investment environment is a long-term view to value creation, an ability to fundamentally identify areas of emerging growth and an ability to build strong syndicates early in a company’s lifecycle to mitigate future capital formation risk. With that view, attractive new investment opportunities abound.

Fundraising – The Other External Dependency
Finally, on to Fundraising. There are two problems plaguing venture capitalists trying to raise new funds in this market. Those of you who are LPs or are venture investor are all too familiar with them. The first is known as the “denominator” problem. At the beginning of every year, most institutional limited partners set a target for their private equity portfolio (including buyout and venture) as a percentage of their total assets under management. For those investors with significant public equity investments in their portfolio, the total value of their portfolio (the denominator) has dropped significantly in value. As a result, many institutional limited partners are “over their limit” in terms of the size of their private equity and venture capital portfolios. The second problem has to do with liquidity. Most institutional limited partners rely on distributions from their private equity fund managers to fund new private equity commitments. With the slowdown in the leveraged buyout market in particular, many institutional limited partners are reporting private equity distributions of only 25 – 33% of what they modeled at the beginning of the year. The last thing an institutional investor wants to do is sell public equity securities at down valuations to fund private equity commitments.

Impact Assessment: Negative

The denominator and liquidity challenges facing institutional LPs make this a very difficult market for venture capital fund formation.

Putting it all together, what does it mean?

In the end, venture capital is and always has been about creating long-term value in a portfolio. For the things we can control - Value Creation, Investment Selection and Investment Sourcing - now is a great time to be a sector focused venture investor and to be an entrepreneur. Fundraising and exit markets are cyclical; they will come and go. But as The Great One, Wayne Gretzky once said:

“I skate to where the puck is going to be, not to where it has been.”

The puck that our most recent investments are skating to is the exit market in five to seven years. There is no telling where the market will be at that time. But it is more likely than not to be more exit-friendly than the market today.

What came first? Without a blog, there can be no audience; but without an audience, what is the point of having a blog? The whole idea is to create a platform for communicating ideas and gathering feedback; a rich duplex exchange of ideas. But where to begin?

Our team has a can-do spirit, so we’ve always thought that the chicken and egg problem is self-defeating; it is circular and interdependent; it is the wrong question really. One of our portfolio company CEO’s, Chip Kahn, at IP Commerce is fond of saying “forget the chicken and the egg, its all about getting a hen and a rooster in the same place at the same time”. Being the highly intelligent and introspective CEO that Chip is, he is of course right.

This reframing of the issue is empowering and has application well beyond what it takes to get a blog started. It applies equally well to what it takes to build a successful business in our chosen area of investment; Network-Enabled Services. Our investments connect things and we monetize those connections by delivering a service that is of value to the multiple sides of a multi-sided market. With great entrepreneurs as partners, our mission is to harness innovation in services to build companies with enduring value.

Innovation in services and our unique view of the process of building great companies are but a few of the topics we’ll discuss in this blog. You will also find information on our new investment activity, goings on in our portfolio, our view of emerging themes that are driving innovation and investment opportunities in services and our assessment of issues facing the venture capital industry today.

Whatever your role, we hope you will contribute your views, making this blog better in the process.

The Meritage Team