Web 2.0 and VCs: Is the Gold Rush Over?

A Dow Jones VentureSource report released Tuesday indicates that Web 2.0 investment may be peaking in the United States despite an 88 percent increase in money investment in 2007 over 2006.

Even though venture capitalists threw a record US$1.34 billion into 178 Web 2.0-related deals in 2007, the Dow Jones data reveals that the number of deals has finally slowed after several years of rip-roaring activity.

In 2007, the number of Web 2.0 deals rose to 178, up from 143 deals in 2006 — only a 25 percent increase. While 25 percent is hefty on its own, it’s a decrease compared with the period from 2002 to 2006, when the number of Web 2.0 deals had doubled every year.

The report broke out U.S. Web 2.0 investment into regions, which revealed some surprising nuggets.

Bay Area in Decline?

“On the surface, the numbers look fine for the Bay Area — $720 million invested in 72 deals — but take Facebook’s $300 million out of the statistics and you see a very different picture,” noted Jessica Canning, director of Global Research for Dow Jones VentureSource.

“Web 2.0 deals in the Bay Area actually dropped from 74 deals in 2006 to 69 last year, and investments were down 3 percent from the $431 million invested in 2006. It’s clear that the real growth in the Web 2.0 sector is happening outside of the Bay Area,” she added.

New England, Southern California, New York Metro, and the Pacific Northwest regions all saw solid gains in both the number of Web 2.0 deals and the value of the deals. New England went from 15 deals valued at $79 million in 2006 to 20 deals valued at $158 million in 2007; Southern California went from 10 valued at $41 million to 14 at $115 million; New York Metro went from 9 deals at $18 million to 25 at $58 million; and the Pacific Northwest went from 6 at $35 million to 13 at $140 million.

Big Deals

Still, the largest deals occurred right where most would expect. Facebook, based in Palo Alto, Calif., raised $240 million from Microsoft that included at least another $60 million more from individual investors. Ning, a Web 2.0 solution that lets users create their own niche social networks, secured a cool $44 million deal.

While a couple of companies grab most of the headlines, most Web 2.0-based companies negotiate deals that involve less money than most other venture capital investments. According to the Dow Jones VentureSource data, the median deal size for these companies reached a record $5 million in 2007, up from $4.1 million in 2006 … when the overall industry median for a venture capital deal in 2007 was $7.6 million.

Advertising Engines

“The beauty of Web 2.0 companies is that they can do so much with so little. A few million dollars and they’re not only up and running but attracting eyeballs and advertisers,” noted Canning.

“But 2008 may be a make-or-break year for many Internet companies with business models relying on advertising. The slumping economy, coupled with a slowdown in click-through rates for online advertising, is going to pose a real challenge to their ability to generate revenues and position themselves for an exit,” she added.

The Economy Barometer

Might a slowing U.S. economy have played a role in the slower rate of deals? Might venture capitalists have been more in tune with economic indicators, leading them to tighten their investment plans in 2007?

“The current economic outlook certainly plays a role in the slowdown in the rate of investment not just in Web 2.0 companies, but the overall VC (venture capital) environment,” Gina Chan, research manager, Dow Jones VentureSource, told the E-Commerce Times.

“The VC environment will always be linked to the economy — VCs look to institutional investors to raise money and rely on investment banks for a liquidity event, such as an IPO (initial public offering) and M&A (mergers and acquisitions), where the VCs hope to see a large return on their investments,” she explained. “With investment banks and private equity firms — Bear Stearns, Carlyle Group, etc. — making headline news because of the credit/mortgage mess, this will no doubt have an effect on VC investments.”

Great Ideas Gone?

Could the slowdown in the number of deals also reflect a lack of innovative Web 2.0 ideas and business plans? Even some of the highest profile Web 2.0 businesses haven’t come close to generating revenue that reflects their heady market valuations. One has to wonder whether investors could also be slowing down because advertising-related profits have been harder to create.

“There will always be good companies and great entrepreneurs to invest in, whether they are Web 2.0 companies or another type, so the slowdown in investments is likely not due to the lack of great business plans,” Chan said.

“Advertising-related profits being harder to create may be one reason why investors have been slowing down in this sector, but also because investors are looking at other industries as well as other geographies,” she added. “The clean tech sector accounted for more than 8 percent of total U.S. venture capital investment in 2007, whereas in 2005, clean tech accounted for roughly 4 percent. Investors are also looking at developing markets such as China and India, which have been experiencing significant growth in the past few years, particularly in its business-consumer-retail sector.”