The End of Web 2.0?

Sam Gustin writes: By the time the dust settles, the global financial crisis might end up producing one final casualty: the easy money that venture capitalists have poured into internet start-ups with, at best, vague plans how to make money.

In the frothy internet phenomenon known as Web 2.0, when user-generated content and community sites were the name of the game, venture capitalists barely ratcheted up expectations for revenue beyond their low or non-existent hopes during the boom of Web 1.0.

Instead, they took expensive stakes in companies such as YouTube, MySpace, Facebook, Digg and Twitter -- many of which prioritized building an audience over a revenue plan. But now, VC fundraising is dropping amid an economic slowdown.

Just this week, Thomson Reuters and the National Venture Capital Association released data showing that only 55 venture capital funds raised money in the third quarter, a drop of 29 percent from one year earlier. The total amount of money raised dropped 6 percent to $8.1 billion. And while VC's are feeling squeezed on the amount of money they're able to raise, their exit options are diminishing too, as the I.P.O. market drops out (just six this year in technology and health care versus 55 last year). Returns through acquisitions of their investment are also taking a nosedive -- just 58 in the third quarter of this year compared to 102 in the same quarter last year, according to the N.V.C.A.

Should the trend continue -- and venture capital funds operate on 10-year cycles, so they don't shift direction all that rapidly -- companies will need more than just a clever idea to get funded.

The good news is that tough economic times will put pressure on entrepreneurs to develop businesses driven by real innovation, not just iterative or cosmetic improvements on existing products. There is an emerging consensus that everyone -- from major internet companies to media giants to venture capitalists to start-ups -- will have to tighten their belts and better demonstrate how they plan to make money. What this means is fewer I.P.O.'s and costly acquisitions, as well as less investment in start-ups.

In a widely read essay, Jason Calacanis, the chief executive of Web directory Mahalo, predicted that as many as 80 percent of internet start-ups will "shut down or go on life-support" during the next year and a half. Furthermore, investor Ron Conway last week cautioned his portfolio of internet companies to cut their spending because venture capital was expected to become less readily available for awhile. Similarly, Sequoia Capital held a meeting with its portfolio companies last week, warning them to brace for lean time ahead.

Others have seen this coming for awhile. In January of this year, Fred Wilson, the New York-based tech investor, told me that the U.S. was on the brink of a recession that would affect Web start-ups. He said a dearth of initial public offerings would slow the VC process and put more pressure on entrepreneurs to prove their businesses. In the months following that interview, venture capital activity shriveled to its lowest level in a decade. Meanwhile, market research firms and Wall Street analysts repeatedly scaled back their estimates for online ad spending.

My colleague Kevin Maney rightly points out that the cost of starting an internet company has decreased dramatically in recent years. But moving forward, start-ups will need more than two people and $100,000 in funding to succeed. They'll need to bring real innovation to the table and add real value for users.