Chewing on the Internet bubble

Is the Internet market headed for another bubble? That’s the question on every investor’s mind these days. But nobody knows, because the terminology is outdated.

For example, what is an “Internet company” in 2005? Is it just online retailers, Internet search providers and social networking companies, or do broadband phone companies, mobile gaming companies and Comcast also count?

What about news publishers, which distribute products online, but also rake in cash off print ads? Are they Internet companies?

One definition is that an Internet company is one that has a main product that is identifiably obtained/consumed by end-users via the Internet. So eBay is an Internet company, because all eBay users must use the Internet to use its auction services.

Vonage, however, doesn’t qualify, because the service is used on a traditional telephone.

So for a bubble to occur, the following must be true: (A) There has been a significant increase in Internet company investments; and (B) The valuations of those investments has been artificially inflated due to unreasonable optimism.

Recent venture disbursement data from The MoneyTree Survey – published by PricewaterhouseCoopers, Thomson Venture Economics (publisher of PE Week) and the National Venture Capital Association – suggests that there was a substantial decrease in Internet investments between the second quarter of 2005 and the third quarter of 2005. Specifically, it dropped from about $840 million in Q2 to about $613 million in Q3.

A major reason for this decrease is that the operative terminology is the aforementioned catch-all – a definition whose organic overgrowth caused it to become too many things to too many people.

I went through all PE Week Wire issues for Q2 and Q3, looking for disclosed VC fundings in Internet companies as I’ve defined them. The result is a 60% increase in the number of Internet investments from Q2 to Q3. Even more staggering is the actual amount of capital invested, with about $492 million disclosed for Q3 companies compared to just $208 million disclosed for Q2 companies. This is a significant increase, even after you consider that my parameters exclude such companies as Vonage.

But we just don’t know yet about the valuations. We don’t yet have a large enough valuation sample to prove a substantial increase and, even if we did, it is too early to suggest that such an increase is artificial. It is easy to jump on Web 2.0 companies, but the reality is that most Internet companies raising VC funding in Q2 and Q3 were not of the Web 2.0 variety.

Believe me when I say that I’d like to have an affirmative or negative conclusion. I’d like to be the seer who accurately asserts that today’s Internet frenzy equals folly, and that some Silicon Valley VCs will soon remember the lessons of CMGI.

Or to become head cheerleader for the next generation of revenue-producing innovation. But to do so today would be premature, so we must all resist the temptation a bit longer.