Venture capitalists warm up to Internet again

Venture capitalists swore off Internet companies after dot-coms tumbled like dominoes in 2000 and 2001, but in recent years enthusiasm for this sector has been renewed.

This restored confidence from early-stage investors has allowed entrepreneurs to develop a new wave of online services that have hit it big with users while providing sustainable business models for their startups. Social bookmarking, social networking, blogging, online video, photo sharing, content syndication, and podcasting have all recently changed online communications among consumers and organizations.

Along the way, venture capitalists and entrepreneurs have learned valuable lessons from the dot-com debacle. The result: a healthier investment and entrepreneurial climate that again supports Internet innovation. Although some worry that this renewed optimism could yield a new Internet bubble, experts say some principles have taken hold for good.

For starters, venture capitalists today claim to better understand the products and services offered by startups they fund and apply stricter principles when evaluating whether to back a company. In the dot-com heyday, venture capitalists often poured money on companies without giving their business plans rigorous reviews and without grasping the startups’ core technology.

“In the late 1990s, VCs had a sense of the promise of Internet services but no real understanding of how those services got built, differentiated, defended and became businesses,” says Brad Burnham, a partner at Union Square Ventures, a New York venture capital firm. “Now people have a better appreciation for what makes for an attractive user experience and a sustainable business.”

Meanwhile, entrepreneurs now build useful online services and companies that require modest startup investment. This contrasts with the excesses of the late 1990s, when startups often spent millions of dollars before launching services. Many point at Google Inc. — a survivor of the dot-com carnage — as the company that set the example for this now popular formula of spending moderately while focusing on delivering an online service that generates mass appeal and attracts online advertisers.

Startups that came after Google have embraced its formula and mixed it with the so-called Web 2.0 approach: fostering interaction among their users by letting them tag, describe and share content. This has allowed them to generate a sense of community among their users known generically as “social” computing. These startups also promote open architectures so that external developers can build applications and extensions for their services, the so-called “mashup” phenomenon that has been adopted widely by larger companies.

Prime examples of this successful Web 2.0 approach are photo sharing site Flickr and social bookmarking pioneer del.icio.us, both acquired last year by Yahoo Inc., and video sharing site YouTube, bought recently by Google. These startups brought their services into the mainstream and rewarded their venture capitalists.

Union Square invested in del.icio.us because it provided a useful service, it could change a market’s structure — search in this case — and it used IT to get a substantial advantage. “Del.icio.us was supporting 300,000 users with six employees when we were investors,” Burnham says.

Portage Venture Partners, in Northfield, Illinois, invested in TicketsNow because it exemplifies how an Internet company can change the character of a traditional industry like event ticket brokerage, said Matt McCall, the venture capital firm’s managing director.

Still, although entrepreneurs have learned from the mistakes of the past and venture capital is flowing more freely, new challenges and dangers exist. For example, too many Internet companies these days depend solely or heavily on advertising. “All it takes is a recession or a pullback in ad market and you’re going to see carnage everywhere,” McCall says.

Another danger is the relatively small amount of capital required to fund a Web 2.0-type company, which has started to crowd markets with competitors. “This week alone I’ve seen four different plays with a social net model for distributing music online,” McCall says.

Meanwhile, it’s clear that entrepreneurs who relax in this climate of optimism will not get much attention from venture capitalists. “I am looking for entrepreneurs with the drive and vision to take on the enormous challenge of competing with companies many times their size with far more resources. I want business models with clever plans to win over the long haul, and I want markets big enough to justify a DFJ investment,” says Timothy Draper, founder and managing director of venture capital firm Draper Fisher Jurvetson (DFJ) in Menlo Park, California, in an e-mail interview.

McCall also sees some venture capitalists, giddy with optimism, overfunding companies, relaxing their due diligence process and lowering the return expectations. “There’s an enormous opportunity,” McCall says. “But it’s critical for startups to have a legitimate business model, understand the domain they’re playing in and understand why your customer needs to buy, and buy often and a lot.”

While venture capitalists must avoid past mistakes, they can’t get overly conservative either. “With the constantly changing environment we face, we cannot get locked into any pattern recognition, since what works keeps changing,” Draper says. “If we don’t make mistakes we are not ‘venturing’.”