Encouraged by the success of VMware and Xensource, venture capitalists invested a record amount in virtualization software companies last year and are eager to do more deals

Virtualization startups are undeniably hot these days. VMware's spectacular IPO last year cast a bright light on all things virtual. In the blink of an eye, this once-obscure startup became the fifth largest software company in the world with a market cap that currently stands at about $23 billion.

That's the kind of debut that grabs the attention of the venture industry. But does VMware's stunning success mean that the real money in virtualization has already been made?

For the most part, VCs say VMware is a harbinger of even greater things to come. Investments in virtualization startups hit an all-time high of $309 million last year, eclipsing the $291 million VCs pumped into such companies in 2006, according to Thomson Financial (publisher of VCJ).

In the first two months of this year, U.S.-based VCs have pumped $47 million into seven virtualization upstarts: Agami Systems, AutoVirt, CiRBA, Pano Logic, Terracotta, Virtual Iron and VKernel (see table).

New virtualization startups have pretty much ceded the server market to VMware. Instead, they are targeting untapped pieces of the IT ecosystem, including desktop virtualization, file virtualization, storage virtualization and virtual network security.

"Virtualization is fundamentally a disruptive technology that has the potential to transform the entire IT ecosystem," says Ashmeet Sidana, a general partner at Foundation Capital. "VMware targeted the server space, but the technology itself has much broader potential for other markets, such as the desktop."

Foundation Capital is an investor in Pano Logic, a desktop virtualization company that recently secured a $12 million round led by Goldman Sachs. Pano has developed a technology that "virtualizes" the desktop so that none of the client computers within an organization needs a CPU, an operating system or memory, thus reducing the total cost of ownership by around 70 percent.

Pano competes against a host of other desktop virtualization startups. For instance, NComputing raised a $25 million Series B round led from Menlo Ventures and Scale Venture Partners in December, and Desktone closed on a $17 million Series A round co-led by Highland Capital Partners and SoftBank Capital last summer.

"Virtualization is just about the most exciting thing out there these days," says Peter Bell, a general partner at Highland. "If you're an Internet guy, you want to be involved in Web 2.0 stuff, but if you're an enterprise guy, virtualization is it. This is as big a wave as I've ever seen in enterprise computing. This is where the next batch of great companies will come from."

Compelling cost savings

Corporate America is embracing virtualization companies because of the big cost savings they promise. Research firm IDC estimates corporate spending on virtualization software and services will balloon to more than $15 billion worldwide in 2011, up from $6.5 billion last year.

Numbers like those are a good reason to give virtualization a long look, but VCs who are new to the space should be careful, say experienced investors. For one thing, many startups are now calling themselves virtualization companies, whether they actually leverage the technology or not. What's more, the noise in the marketplace is amplified by the sheer volume of companies each claiming to do the same thing.

With many companies making similar claims, it's difficult to figure out which ones will be the eventual winners, admits Jim Jones, a managing director at Scale Venture Partners who invested in NComputing. He's currently evaluating virtualization startups targeting data center management. "This is not an easy space to spot clear differentiations," Jones notes. "With virtualization, there are lots of ways to skin the cat. It's hard to say which way will achieve the most benefit."

The key, as with most investments, is figuring out how real those differences are—and whether corporate buyers are in enough pain that they are willing to take a chance on a startup with a new technology.

Highland's Bell takes a hands-on approach. Before making a virtualization investment, he makes sure to introduce the startup to several large potential customers. "I have them lay out their product vision and roadmap for the customer just to see how it resonates," he says. "I want to see firsthand how they map to the pain points of corporate buyers and whether their product will integrate well with the technology already in place. This is a big part of the process for me."

Despite the hype surrounding virtualization, at least one experienced venture investor isn't sure about the prospects. About seven years, Cameron Lester of Azure Capital Partners took a flyer on little-known VMware. He was the only VC to invest in the company. With the success of VMware, you'd think Lester would be all over the new crop of virtualization startups. But you'd be wrong.

Shortage of real companies?

"We've looked at a number of startups here since VMware, but we just haven't found a real business yet," Lester says. "We've seen derivative plays and feature/function plays, but we haven't seen anything that could eventually become a $100 million or $200 million business. We like to invest when we think a company can become a large, independent entity. So when we see a company that looks like a product feature or an add-on rather than a real business, it's hard for us to move forward."

Still, Lester says there are intriguing things happening in virtual security and management, so he's still keeping his eyes open. "Five and 10 years ago, you had all these interesting mobile companies that never went anywhere, but today they are resurfacing in a way that's making sense," Lester notes. "The same thing might happen with virtualization. Maybe it's just a matter of time before the market becomes big enough."

In the interim, there are plenty of new companies popping up nearly every day. "I feel very good about the deal flow," says Foundation's Sidana. "This week [in February] alone, I saw three new companies related to virtualization that I never heard of before. This is a very fertile area for innovation."

"We've looked at a number of startups here since VMware, but we just haven't found a real business yet. We've seen derivative plays and feature/function plays, but we haven't seen anything that could eventually become a $100 million or $200 million business."

Sidana's most recent investment in the space is a stealth startup called Altor Networks, which raised a seed round of about $1.5 million and is now wrapping up a bigger round led by Foundation and Accel Partners. Altor focuses on improving the security of virtual servers in datacenters and streamlining administrative overhead so that companies can maximize their virtualization investments.

Perhaps the best news for venture investors is the established exit path for virtualization startups. After VMware went public in August 2007, competitor XenSource was snapped up two days later by Citrix for $500 million. The XenSource acquisition proved that large technology companies have a growing appetite for virtualization technology. They are increasingly willing to pay large amounts for startups rather than develop the technology themselves.

"We believe Microsoft is the likeliest buyer, with potential interest in nine of the 10 [virtualization] sub sectors," Rachel Chalmers, an analyst with research firm The 451 Group, writes in a recent report. "Judicious acquisition could help the Windows giant catch up." She adds that other public vendors likely to go on a virtual buying spree include BMC Software, Hewlett-Packard, Novell, Sun Microsystems and Symantec.

"We have not seen any real consolidation in this market yet," says Bell. "It's hard to imagine that five years from now there will only be one or two companies providing the infrastructure, security and management around virtualization. I believe there will be many companies here, not just one or two."