“Welcome to the VC world. Don’t expect too much money. You can’t be the next IBM, EMC or Hitachi. But of course, you can build great technologies. And we’ll get you acquired. We’ve been there done that!” VCs are chanting the what-is-in-store mantras to the storage startups.

In the new millennium, storage sector alone has garnered about $6 billion in investment and VCs are raising eyebrows on how so much money went in there. Not a single startup since 2000 has reached the IPO benchmark, but still concepts like virtualization, Information Lifecycle Management, mirroring and snapshots are hot property.

And the good news—companies with such disruptive technologies will see money raining on them as their behemoth peers acquire them. However, the bad news is more interesting—no matter how disruptive your technology is, the possibility of a large funding is miniscule. Because VCs believe that currently there is no such alien technology in the horizon to replace existing storage equipments or components. Second, VCs think investments of large amount is bad practice in today’s acquisition rate-card which doesn’t match a return of investment for anything invested above $30-$50 million.

But this lurking thought among VCs is true. As Barry Eggers, General Partner at Lightspeed ventures notes, “Revolutionary ideas are most admired. But in the storage market, which has been around for a long time now, there is an averse towards revolutionary ideas. Perhaps, the customers are happy with what is already there and are reluctant to change.” This mindset of customers has made VCs averse towards capital-intensive projects. But this is not the only reason. VCs like Sunil Dhaliwal, Principal at Battery Ventures, think the crown jewel of an enterprise has still been the data.

And no CIO would like to mess with data unless they are really sure that a technology or equipment can store their data better. “So if a startup comes with a new data storage technology product then the possibility of marketing it is really grim,” says Dhaliwal. However, both Eggers and Dhaliwal believe, technologies around data storage concept could fetch entrepreneurs funding. Few such concepts are security software, replication, commodity servers’ platforms and compliance software.

While all these software and servers have little to do with the actual storage unit where the data is, they help in enhancing storage requirements like backups, data protection, and easy accessibility. And such requirements yield good returns. “This is like deploying the CRM software. If GRM works then keep it or else return back to your older software. And there is no scourge of losing data,” says Dhaliwal. For Duncan McCallum, General Partner at Bessemer Venture Partners, the best models for any storage company currently are concepts that can add value to the storage existing infrastructure. “These concepts should be so unique that you don’t get from the large companies in the next four months time frame,” he says.

Chris Balmer, General Partner at Charles River ventures, metaphors storage investment as a wave—there are ups and downs, he says. “The wave of storage investment has perhaps passed. I think the existing companies will continued to be funded and there will be very little new funding in 2005.” In the years, 2003 and 04, the two most funded storage concepts are virtualization and ILM.

As virtualization—a process of direct wiring of the host systems into storage area—became the buzzword of storage industry in 2004, entrepreneurs started mounting ideas over it.

But, Balmer says, people soon discovered that virtualization in principle was a nice idea but it scurried by inserting an active element in the data path. For some like Dhaliwal, virtualization is a lot of hype and more so a feature than of a product that could create a company.

However, the concept of ILM is perhaps the most admired storage technology lately. Many VCs believe ILM is a great long-term concept. But the murkiness surrounding ILM implementation is yet to clear. “Unfortunately, like virtualization, ILM means 50 different things to 50 different people. And there is really no good standard today of how ILM actually involves,” says Dhaliwal.

“Who knows how ILM puts information away and is aware of the hierarchical information? Is it a smart approach?” are questions VCs and entrepreneurs are digging answers for. As ILM makes way for success, veterans believe it would also bring in the issue of compliance with the Sarbanes Oxley document management or record retention question. Important thing for startups is such developments have blocked investments in the storage sector. “There were lot of investments in 2003-04 in this space as a result there is nothing new in 2005,” says Eggers.

Less investment does not mean less activity for VCs. VCs in storage who funded technologies in the last three to four years are now looking for exit opportunities. And perhaps the latest trend now is acquisition.

Since most distribution and customer controls are in the hands of large companies like the EMC, IBM, Hitachi, Cisco there is probably very few ways to get the end customers.

However, disruptive a company’s technology may be, it can never challenge the customer traction, account and component control of larger companies. And since new equipments from a startup is not easily accepted in the market. So, most VCs don’t see IPO as an alternative exit for their portfolio companies.

Interestingly, even larger companies are opting to buyout small companies pursuing disruptive technologies than investing in R&D. Recently some companies like Pirus and Rhapsody were bought based on their technologies, but Eggers disagrees to say, “Large storage companies are more concerned about the distribution channels and customer traction of the small company than its technologies. Some of the companies that had the best technology lost out in the market due to little customer traction and partners.”

For VCs in Storage sector 2005 may not be an activity hotbed, but for companies pursuing unique innovative technology with a great team; really trying to solve customers’ problems in spaces unseen, it is an emphatic time. But the hardest thing for entrepreneurs is to go find those unseen problems and fix them.