The telecommunications pipeline has dried up. Even the largest players are swimming in red ink and layoffs. Yet in a market that is arguably among the most depressed in the tech sector, Internet Machines, a one-and-a-half-year-old company in Agoura Hills working on a high-speed semiconductor, managed to secure $41 million in equity capital last month. How they did it goes to the heart of what’s happening not only in the technology sector but in the financing environment as well. “This is really next-generation stuff,” said Brian Marshall, senior semiconductor analyst at JP Morgan H & Q; in San Francisco. “This is going to be a ramp from zero because the market doesn’t exist now. So when it takes off, it will be significant growth.” Internet Machines received $40 million in July from Exar Corp., a Fremont, Calif.-based designer and marketer of communications infrastructure solutions, and $1 million from Banc of America Securities. The investment was made on a pre-money valuation (the amount at which the business was valued before the equity investment) of $209 million, 19 percent more than the $175 million it was worth prior to its last funding round in July 2000. Companies seeking funding hope for the highest valuation possible because the greater the value assigned, the smaller the stake they must give up for the financing. But the way the company is valued is a reflection of the way its business is seen by the marketplace. “They are pre-revenue, but there’s a lot of excitement around the company,” said Marshall. “Exar invested $40 million for a 16-percent stake. It’s a rich valuation, so it’s higher than most, but these types of companies command a premium.” The semiconductor Internet Machines has in development is only just becoming available on the market. When it does, much like what happens in the PC market when higher speed versions supplant older models, it will be cheaper and more cost-effective for telecommunications companies to use Internet Machines’ OC-192c than earlier connectivity solutions. “It’s basically a new market, and what typically drives purchases is the economies of scale,” said Chris Hoogenboom, president and CEO of Internet Machines. “To buy 10 gigabytes worth of bandwidth costs less than to buy one gigabyte. It makes more sense to buy the higher speed interface.” Unlike the Internet, which is undergoing a fundamental change as companies redefine the potential of e-commerce, most believe what has happened to depress the telecommunications industry is temporary. Rather than shy away from the semiconductor category, equity investors are looking for companies positioned to take advantage of the turnaround when it happens. “While the word is that it’s so difficult to get funding and the sky is falling, that’s just not the case,” said Dave Lavinsky, president of Growthink, a Los Angeles consultancy which has just released a report on funding for the second quarter. “We’re at the same level we were at in 1999, which were better than ’98 levels, which were better than ’97 and so on for 20 years.” Among the deals revealed in the Growthink report are 14 semiconductor companies in the greater Southern California area that raised a combined $150 million in the most recent three-month period. “You look at the semiconductor space and the market is so enormous that, if you really have an advantage, the implications could be multi-billion dollars,” Lavinsky said. That doesn’t mean getting the money is easy. While it took only a few weeks to secure its last round of funding, Hoogenboom said that this latest round took months, not just to identify potential investors but to convince them that the company’s future was sound. “The fundamental difference is last year it was a sellers’ market and this year it’s a buyer’s market,” said Hoogenboom. “Last year people were frequently either doing very minimal checks or none at all. In this year’s market, we’re seeing far greater due diligence efforts being put in. It meant we had to be very patient with potential investors. We had to make sure we articulated very clearly what our value proposition was.” Exar looked at companies for nine months before deciding on a short list of three firms that included Internet Machines, said Susan Hardman, vice president of corporate marketing at Exar. Its ultimate decision was based not only on the way it viewed Internet Machines’ prospects, but also on how the company’s product could advance Exar’s business. “With the expertise we have and the product portfolio we’re developing, we believe we could drive this company to be a $300 million company,” said Hardman of Exar, which reported sales of $113 million in its most recent fiscal year. “We think that’s good but not great. We’ve been looking for opportunities to drive the company with revenues north of $500 million.” Exar considered an acquisition, but in the current marketplace, with profits depressed, such a move would have taken a big bite out of its bottom line. And like a lot of investors in today’s market, the company believed that the current telecom troubles will be short-lived. “It is a challenging year for semiconductors,” Hardman said. “Our revenue year to year is certainly going to be down over last year, but we think it’s important to focus on two things. One is our R & D; spending, and the other is looking at longer-term futures and making these investments.”