Hundreds of Internet companies have emerged since the dot-com crash, looking to capitalize on a resurgent online advertising market. Companies in this new wave -- known as Web 2.0 -- have focused on online collaboration and sharing among users. They hope to attract millions of users and become the next YouTube, which was acquired by Google Inc. earlier this year for $1.65 billion.
Venture capitalists, who fueled the previous Internet bubble, are pumping money into the new crop of Web startups. In the first nine months of 2006, VCs sunk $455 million into Web 2.0 companies, according to research firm VentureOne. (VentureOne is a unit of Dow Jones & Co., publisher of this Web site.) That's three times as much money as such startups received in the same period last year.
There were no blockbuster Internet IPOs and just one Web deal (Google's purchase of YouTube) valued at more than $1 billion in the past year. But the flood of money and flurry of activity prompts the question: Is Web 2.0 another bubble or are the startups getting funded today more sound than ones created in the run-up to the last bust?
The Wall Street Journal Online invited two technology venture capitalists, who were active in the dot-com days and have invested in the current crop of startups, to debate the topic. Todd Dagres spent nearly a decade at Battery Ventures before starting Spark Capital last year. David Hornik, a partner at August Capital and a former Silicon Valley attorney, writes the popular VentureBlog. Their conversation, carried out over email, is below.
Mr. Dagres begins: Web 2.0 is a bubble for 3 reasons: 1) There is far too much money chasing Web 2.0 deals. Too much money means too many companies getting funded at higher valuations. 2) There are virtually no barriers to entry in Web 2.0 and therefore the ability to develop a unique solution and sustain a competitive advantage is virtually nil. Therefore, it's difficult for Web 2.0 companies to build long term value. 3) There is very little liquidity in the market for Web 2.0 companies. The Dow was recently at a high and still no liquidity. Without liquidity, Web 2.0 companies must rely on acquisitions to achieve liquidity and this will put a lid on the potential exit options and ultimate valuations of these companies. In short, they will be playing a musical chairs game in which there are far too many players and too few chairs.
There are some similarities between the current "bubble" and the last one that burst in 2000: Lots of incomplete and under-experienced teams, business models based more on eyeballs than cash flow, and a rash of incremental and "me too" deals.
Mr. Hornik responds: I do not believe that the existence of too much venture capital money chasing too few interesting ideas constitutes a bubble. The Web 1.0 bubble inflated because the public markets were willing to bet on unproven ideas. Public markets are ill suited to evaluating such risks. On the other hand, the venture capital community exists precisely to take on that risk. While many Web 2.0 companies will fail, they will not likely fail in significantly greater proportions than has been the case with other venture investments historically. So it is hard to imagine how this so-called bubble will over-inflate. Venture capitalists will rationally stop investing in ideas that don't bear fruit. Those that do bear fruit will gain traction and either be acquired or go public. Those are the traits of a rational market in my mind.
Mr. Dagres: Not really. Private markets are far less efficient than public markets. Private companies don't publish results, trade on exchanges or comply with a number of SEC rules that protect the individual investor. They are inherently illiquid and risky. Of course, where there's more risk, there is often more reward. I see irrational pricing occurring right now in the venture market with private companies receiving venture money at valuations of over $200 million (Spot Runner, LinkedIn) and $500 million (Facebook). I have seen private Web 2.0 companies with negative cash flow and little revenue valued above public companies with stronger operating results. There's a reason why the average American doesn't have access to venture capital and it's not because it's more rational.
Mr. Hornik: I was not suggesting that private markets are necessarily more efficient or more rational than public markets. Merely that private market investors are trained to assess the risks involved with speculative and illiquid investments. While I am not on the boards of Spot Runner, LinkedIn or Facebook, my understanding is that each is cash flow positive and making real money. They are each excellent examples of real businesses that are being built in this Web 2.0 era. Whether $200 million or $500 million is the appropriate price tag for those investments isn't important. What is important is that each of those businesses appears to be on track to be strong, stand-alone entities that will likely get public or be acquired. Those sound like good investments to me.
It isn't surprising that we aren't seeing a whole lot of Web 2.0 companies going public yet. The public markets have appropriately adjusted to the irrationality of the Web 1.0 ascendancy and are looking for companies that have operating histories with quarters of profitability, large top-line revenue, and predictability going forward. That takes time. But I have no doubt in my mind that there are interesting businesses being built that will meet those criteria in the coming years.
Mr. Dagres: I agree that there will be interesting companies coming out of the Web 2.0 wave. Every wave has its winners and losers. The notion of a bubble, however, is that a particular market gets overdone, i.e. over-hyped, over-invested, and ultimately experiences a high mortality rate. I think the Web 2.0 space will have a higher mortality rate than other segments of the overall media and technology industries. There are far too many MySpace and YouTube genetically challenged clones. All but a few will fail. The winners are generally the ones that get in early and out before the bubble bursts. There are rare examples of bubble companies making it through the bust and going on to become successful and valuable companies. By the way, the combined cash flow of Spot Runner, LinkedIn and Facebook is less than that of one Costco store.
Mr. Hornik: I would reckon that the margins of Facebook, LinkedIn and Spot Runner are a whole lot better than that of a Costco store.
Even assuming that the vast majority of the Web 2.0 companies fail, the amount of capital that is going into all of them combined is a pittance compared to the Web 1.0 bubble. In fact, it is even a relatively small portion of the overall capital being invested by the VC community on an annualized basis. How many Web 2.0 companies do you think you can build for the same amount of capital it takes to build a single medical device company? And unlike a medical device company, the power of the Web 2.0 model is that investors get very quick feedback about how well the company is doing. So the likelihood that investors pour tens of millions of dollars into Web 2.0 companies that will never be self-sustaining is very low. VCs may lose their capital invested early in Web startups, but the amount of capital sunk into failed businesses will never snowball the way it did in the late 90s.
Mr. Dagres: I'll take cash flow over gross margin -- I can eat cash flow. I think there will be billions lost on Web 2.0 companies when all is said and done. The real money hasn't even gone in yet. The hedge fund, corporate and family offices are coming in as we speak. The good news is you can generally only lose 1.0 times your money. I agree that medical device and drug companies consume much more capital than a Web 2.0 company but they can build advantages based on patents and substantial R&D, which limits the competitive threat. R&D in a Web 2.0 company = rummage & duplicate.
That said, the life sciences venture environment has its own issues.
Mr. Hornik: I think that you aren't giving Web 2.0 entrepreneurs enough credit. Sure, there are some "me too" sites out there. There always are. But the amount of rapid innovation in online services has been staggering -- from Skype to Digg to Six Apart to YouTube to Flickr to Facebook... The list goes on. They aren't microprocessor companies with years of patent-protected intellectual property. On the other hand, they are innovating around things that matter to consumers today. And I believe they are being appropriately valued, not just by potential acquirers but by the consumers themselves.
You say that billions are going to be lost. I think that overstates the potential problem. Certainly billions haven't been invested to date. It takes a whole lot of companies to get to billions when investing a few million dollars at a time. On the other hand, if a few billion dollars are lost in the face of exits like Skype and YouTube, and others that I see making hundreds of millions in the future, then the market is doing well and investors and entrepreneurs alike will emerge decidedly net positive. That doesn't sound like a bubble to me. That sounds like a vibrant market for innovation.
Mr. Dagres: Aha! We agree on what may be the most important point -- great entrepreneurs are the key to building valuable companies. If you invest in great people, you have a good chance of making money. In the current market there are gifted entrepreneurs that will benefit and thrive. These people will start disruptive companies that look for what will be hot rather than what is hot. They won't be lumped into the Web 2.0 category; they will define their own categories. This is what will separate the few winners from the many losers. So in closing, I am leery of Web 2.0 but I am always going to invest in great people pursuing big ideas.
Mr. Hornik concludes: I was recently asked by an entrepreneur what I thought would be the next great technology in the coming year. I told him I thought it would be the Internet. We have just started scratching the surface of the enabling power of the Internet. Whether it is called "Web 2.0" or "New Media" or "Enterprise 2.0," Internet services are going to drive the world's economies for the foreseeable future. To me that doesn't spell bubble, that spells opportunity.
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