Fears of Dot-Com Crash, Version 2.0

Times Staff Writers

Is the bubble about to burst -- again?

Investment in Internet companies has climbed so steeply since the dot-com crash of 2000 that some Silicon Valley veterans worry that too much money is again pouring into too many unproven, unprofitable ideas -- setting the stage for another high-tech shakeout.

Watching venture capital firms invest hundreds of millions of dollars in new Web companies last year, longtime Internet executive Richard Wolpert branded the upswing "a mini-bubble." But "about a month ago," he said, "I started dropping the word 'mini.' "

In the first three months of this year, venture investors funded 761 deals worth about $5.6 billion. That's up 12% from the same period last year and the highest first quarter since 2002. One sector in particular is heating up fast: online media and entertainment.

The $254.9 million invested in blogging and online social networks in the first half of the year already exceeds such spending for all of 2005, according to research firm Dow Jones VentureOne. The $156.3 million pumped into online video is on pace to surpass last year's investment.

The popular success of MySpace, a social networking site bought last year by Rupert Murdoch's News Corp. for $580 million, and YouTube, a video sharing site, has inspired scores of imitators. In online video alone, there are nearly 180 new companies -- not to mention big players such as Yahoo Inc., Google Inc. and CBS Corp. -- vying to be the next YouTube.

There's also VideoEgg and Video Bomb, Blinkx.TV and Blip.TV, Guba and Grouper.

But MySpace and YouTube, the industry leaders, have yet to make big bucks, and some skeptical investors wonder what hope there is for all of the copycats.

"YouTube has been a cultural phenom," said Mike Hirshland, a general partner with Polaris Venture Partners.

"But how many YouTube knockoffs have been funded in the last six to nine months? The market has capacity for a certain number of successful winners. Whether it's one, two or, if it's really exciting, three -- you can debate. But eight?"

Venture capitalists say they're being more responsible this time. Alan Patricof, who provided early funding for America Online, Office Depot Inc. and Apple Computer Inc., said the investment community probably wouldn't reach the late 1990s level of irrational exuberance.

But, he added, "it certainly is the beginning of a heightened frenzy developing."

The current run-up does differ from the late-1990s bubble that began to implode in 2000, wiping out within two years $5 trillion in paper wealth on Nasdaq, the stock market on which the shares of many tech companies are traded. The market value of Nasdaq companies peaked at $6.7 trillion in March 2000 and bottomed out at $1.6 trillion in October 2002. It has since rebounded to $3.6 trillion.

One key difference is that the volume of venture investment is much lower than it was during the first Internet boom's height. The amount invested in the first quarter of this year was just one-fifth the $28.1 billion spent in the first quarter of 2000, according to PricewaterhouseCoopers' MoneyTree report, which tracks venture investment.

Also significant is the lack of investor appetite for initial public offerings. Unlike the last round of online exuberance, small investors aren't likely to buy shares in an online pet store with a sock-puppet spokesman.

And the range of companies sprouting this time is narrower. In the 1990s, entrepreneurs tried adapting any number of business ideas to the Web. Now, the focus is more on free services supported by online advertising, which has been growing sharply.

Some investors argue that there won't be another dot-com implosion, that the investment boom in online media companies is part of the natural ebb and flow of venture capital: Money plows in to unproven start-ups, winners emerge and investors move on to the next popular collection of start-ups.

"There are going to be a lot of flameouts and some spectacular winners, because even in bubbles some enormous companies that have lasting value were created," said Gary Little, general partner in Morgenthaler Ventures.

Nevertheless, overinvestment carries potential consequences. If Silicon Valley again disappoints the pension funds and college endowments that bankroll venture capital, it could find itself spurned next time, stifling the next round of innovation.

"When there is a crash or implosion, it makes investors -- both private investors and public investors -- just reluctant to go into these categories, even if there are good investments there," said Josh Lerner, a Harvard Business School professor and co-author of "The Venture Capital Cycle."

Nasdaq's malaise is contributing to the interest in the start-up gold rush. Shares of Dell Inc., Intel Corp., Microsoft Corp., EBay Inc. and others are either stagnant or near multiyear lows. Fast-growing Google is a big exception, but when its profit growth slows -- as its chief executive has warned that it inevitably will -- investors could flee.

With the public markets soft, money managers are desperately seeking other ways to get the returns needed to fund their pension plans, including hedge funds, buyouts and venture capital. The prospect of finding the next Google when it's still young holds great appeal, and money managers are willing to fund 10 venture-backed fledglings in hopes that one hits it big.

Putting bundles of cash into the hands of venture capitalists causes what the investment community refers to as "overhang" -- too much cash chasing after too few brilliant ideas. That can disrupt the delicate courtship ritual between entrepreneurs and investors, producing too many bad pairings.

To veterans like Wolpert, it all seems familiar.

"If you screw up once, it's an accident," said Wolpert, former president of Disney Online who now serves as an advisor to online media software firm RealNetworks Inc. and venture investor Accel Partners. "If you screw up twice, it's a trend."

Some venture capital investors, once burned, are twice as skeptical this time around. For example, Hummer Winblad Venture Partners, which backed one of the poster children for the dot-com implosion, Pets.com, is studiously avoiding next-generation Web companies.

"The VC community has gotten very much more savvy," said Skip Paul, former chairman of iFilm, one of the original Internet video sites, who arranged its sale to Viacom Inc.'s MTV Networks Co. If there is another bubble, he said, "I think it will be a much smaller bubble, and it will be populated by people who didn't go through it the last time."

But for all the presumed restraint among early-stage investors, plenty of money is pouring into businesses preening to be the next MySpace or YouTube.

Consider Facebook Inc., a Palo Alto company that has raised $38.2 million by running a social network for college students. It's not to be confused with Affinity Engines Inc., a Mountain View start-up that is helping about 50 colleges create their own Facebook clones.

Other online teenage and college-student hangouts funded by venture firms include Bebo ($15 million), Doppelganger ($11 million), Gaia Interactive ($8.9 million), TagWorld ($7.5 million) and Tagged.com ($7 million).

MySpace has been growing at a furious pace, attracting 52 million Web surfers in June. But its corporate parent, media giant News Corp., has struggled to convert that traffic into advertising revenue. The software that underpins the service has also labored to keep pace, threatening to saddle MySpace with the slow-loading pages and other technical glitches that doomed Friendster, a social networking site that preceded it.

Other networks have sprung up, seemingly for every demographic: Latinos, professionals, travelers, women -- even pets and their owners.

The online video world is also crawling with venture capitalists looking to fund a competitor to the early leader YouTube, which itself has raised $11.5 million. Revver, a Hollywood company that attaches ads to amateur videos, got $17.3 million. Metacafe, another site that plays homemade videos, landed $15 million this month from blue-chip firms Accel and Benchmark Capital Management Co.

In a sense, the Internet has matured from geeky fad to a real medium. And advertising is following the audience. Research firm Emarketer Inc. projects online ad spending to reach $16.7 billion this year, a 34% increase from last year's $12.5 billion. So it's no surprise that investment capital is following the ad money.

"There is a risk that we're going back to the marketing of eyeballs without a business model," said Jim Lussier, a general partner with Norwest Venture Partners in Palo Alto. He has kicked the tires on nearly two dozen online video companies but said he couldn't find anything unique.

Afraid of being left behind, traditional media companies such as News Corp. and NBC Universal Inc. have paid hefty sums for a few Internet companies. Inspired by those acquisitions, new companies have sprouted, making the competition to attract a deep-pocketed suitor even more intense. Google, Yahoo and other new media giants are cultivating their own services to rival these start-ups, and they've put away their checkbooks for the time being.

The public markets aren't much of an option now, either. The Nasdaq is sputtering, down 7.6% in 2006. One of the rare Internet IPOs since the dot-com crash belonged to Google, a once-in-a-generation powerhouse whose market value now rivals that of Time Warner Inc. and Walt Disney Co. combined.

The last popular Internet service that went public was Vonage Holdings Corp., which allows phone calls over the Internet. Its stock has fallen 50% since its May debut on Nasdaq.

Until an acquirer comes calling or the IPO frost melts, these social networking and Web video companies are all trying to attract audiences in hopes that advertisers will follow.

The "online dress-up and makeover community" Stardoll.com, for example, is on the prowl for sponsors. Liisa, a Finnish artist, began the service, originally known as Paperdoll Heaven, in 2004. It began to catch on among girls ages 8 to 17, who liked to dress virtual dolls of Johnny Depp, Madonna and other celebrities, said Danny Rimer, the company chairman.

Rimer, a partner at Index Ventures, invested $4 million last year and recently joined with Sequoia Capital -- the firm that backed Google and Apple -- to inject $6 million more in Stardoll.

"You're assembling the key things girls seem to be interested in at that age: namely fashion, music and celebrities," Rimer said. "While it was a wacky-sounding idea, the beauty of the Internet is you actually don't decide what's wacky or not -- the community does."

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Networking for dollars

Many young tech companies rely on venture capitalists to supply the cash they need to grow. Here's how the process usually works:

* A firm establishes a fund, often with a theme: consumer Internet, alternative energy, biotechnology. Limited partners -- including pension funds, colleges, wealthy individuals and companies -- provide most of the investment capital.

* The venture capital firm hunts for promising companies. The companies get money to hire employees, market services and buy equipment; in exchange, the firm gets a stake in the companies and some say in strategy.

* To cash in on its investment, the firm needs what's called a "liquidity event": a sale of its stock through an initial public offering or a sale of the entire company.

* Most young companies fail. As in the movie business, one big winner in a portfolio can more than offset a dozen losers.

* When the returns from all the companies in its portfolio are tallied, the firm divvies up the proceeds and distributes them to its partners. Returns of 20% a year are not uncommon.

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