In The Zhone

A startup with a pedigree goes up against the giants

As president of Ascend Communications in the early 1990s, Mory Ejabat had to hustle to help the networking startup scrape together $19 million in venture-capital funding over four years. Ejabat pitched the idea 10 times before he could persuade the first investor to write him a check. What a difference the Web makes. Now, as chief executive of Zhone Technologies Inc. in Oakland, Calif., Ejabat is swimming in greenbacks. After word spread about Zhone's plans to build a new type of networking gear, investors started calling him. Last November, just five months after co-founding Zhone, Ejabat raised $500 million--believed to be a record for a private placement.

Zhone's investors are wagering that the company's promising market, unique technology, and seasoned management will deliver a rich payoff. It's a good bet--but Zhone needs to get big pronto. And that's where the money comes in. The company's stash of cash is allowing Ejabat to compress a project that normally might take years into a matter of months. The goal: to put together a soup-to-nuts system of specialized networking gear that can handle voice, Internet, and television signals in the so-called last mile of telecommunications networks that lead to homes and businesses. Right now, local phone companies must install and manage different gear for each type of signal, which can be costly and confusing. "We want to be one of the four largest networking companies on the local-loop side," says 49-year-old Ejabat.

The nascent market is expected to grow rapidly. It was just a $90 million field last year, but it should hit $1 billion in 2004 and keep soaring from there, according to RHK Inc., a telecommunications research firm in South San Francisco, Calif. To get ahead of the competition, Ejabat is buying small companies that have nifty technologies and then stitching them together in addition to creating products from scratch. That "build-and-buy" strategy is what appealed to C. Richard Kramlich, who invested in Zhone as a general partner at venture-capital firm New Enterprise Associates.

Zhone is on a buying binge. In the past six months, it has spent $150 million to snap up four companies, each of which brings a particular piece of technology to the Zhone package. Premysis Communications developed voice networking systems, CAG Technologies specialized in hardware design, Roundview developed Internet networking software, and OptaPhone Systems made wireless telephony gear. Meanwhile, Zhone's own engineers have been concentrating on cable-TV technologies. In February, Zhone released its first product, which connects data networks with voice networks. "We have all the pieces, but we have to integrate everything together now," says Ejabat.

They had better do it fast. "Right now, they've got a lot of competition," says RHK analyst Claude Romans. Rivals include Jetstream Communications, Copper Mountain Networks, CopperCom, and networking's Big Three: Cisco Systems, Lucent Technologies, and Nortel Networks.

So far, Zhone has a technical edge. Although most of these competitors have developed products that let local phone companies offer voice services over data networks, few are going as far as Zhone is to also offer cable TV and wireless. Yet even analysts who believe Zhone has the technology lead say it won't easily crush the competition. "Execution is 90% of the success potential," says analyst Hilary Mine of Probe Research Inc., a communications research firm in Cedar Knolls, N.J.

Early customers give Zhone's products a thumbs-up. At local-exchange carrier AMC Communications in New Orleans, La., which is testing Zhone's equipment, CEO Michael Henry is so pleased with its performance that his company has agreed to purchase and use the gear by the end of this month. "There are a lot of products in this space, but the majority of them don't work," says Henry, who is tearing out Cisco equipment to install Zhone's boxes. "Zhone's product actually works."

That is sweet music to Zhone's investors, who are betting that Ejabat will be able to repeat the success of Ascend, which he sold to Lucent Technologies Inc. last June for $24 billion. "The fact that he created $24 billion in value in five years puts him in a class that very few people have achieved," says Frank Quattrone, a managing director at Credit Suisse First Boston, which managed Zhone's private placement. To fund Zhone, Ejabat tapped a mother lode of private equity from two leveraged buyout firms, raising $150 million apiece from Kohlberg Kravis Roberts & Co. and Texas Pacific Group. The rest of the dough came from former Ascend employees, pension funds, and venture capitalists such as New Enterprise Associates, which ponied up $55 million.

Zhone's backers are not just writing a blank check. In what may be another Silicon Valley first, the terms of the deal specify that the investors must quadruple the value of their investment before the founders can sell their 50% ownership stake. That means Zhone must be valued--either through an initial public offering or a sale--at $2 billion before Ejabat and his co-founders can cash out. Ejabat isn't opposed to selling early. "We are trying to build a business, but we are a very opportunistic company," he says. "So if somebody comes along and hands me a $30 or $40 billion check, I'll take it." If Ejabat can pull that off, he'll probably set another record.