Eerily familiar frothiness worries investors

The numbers for the first quarter seem innocuous enough, but don’t be fooled. VCs in the trenches say that they are seeing a number of unnerving, all-too-familiar trends, including a shortage of serious innovation combined with skyrocketing consumer Internet valuations.

“It definitely feels a little bubblicious,” says Sharon Wienbar, a managing director at BA Venture Partners. “A few weeks ago, an entrepreneur came to see us wearing Teva sandals and shorts, if that’s any indication.”

The number of deals rose only slightly over the first quarter of last year (786 from 710). But there was a much bigger jump in the average investment per firm. It leapt 17% from $6.7 million in Q1 2005 to $7.8 million in Q1 2006. The number underscores that firms are raising bigger funds and deploying more capital per deal as a result. Consider that venture funds as a group raised $6.5 billion in the first quarter, up 20% from the same period last year.

Bill Ericson, a general partner at Mohr Davidow Ventures (MDV), says the increase in funds is not a good development at all. “Our industry’s biggest challenge, and one that will affect returns, is that there’s a lot of capital continuing to flood into VC, and it’s not clear that there are any greater number of Grade-A projects [to justify that flood], and I mean across all sectors—from life sciences to IT.”

The obvious problem created by ballooning rounds, and funds, is overinvestment, particularly around the consumer Internet applications made popular by a healthy economy and greater broadband penetration.

‘Mind blowing’

David Hornik, a general partner at August Capital, recently wrote in his popular VC blog that August has backed four Web 2.0 companies—LiveJournal, Technorati, Trumba, and Video Egg—and that those four companies face 33 competitors in their respective verticals of blogging, RSS, calendaring, and digital video posting and sharing.

“This is mind blowing,” Hornik wrote. “[Those 33 competitors do] not even include Yahoo, Google, Microsoft, InterActive Corp., Fox, Vivendi, eBay, and Amazon, all of which are likely competitors of each and every [Web 2.0] company.”

With the price of Web deals skyrocketing, maybe going off the beaten path and investing in deer-deterrent technology isn’t such a bad idea (see story, page 6).

George Zachary, a general partner at Charles River Ventures (CRV), would certainly welcome an investment off the beaten path.

“It really seems like the quality of deals has nosedived in the last three to six months. We’re seeing a lot of superficial innovation and repeat stuff. There’s a lot of ‘I’m building a YouTube meets MySpace meets a better version of Web-based email.’”

Count me in, too

Me-too technologies notwithstanding, VCs are also grappling with soaring valuations. VentureOne reports that median pre-money valuations across all stages have shot up 72% to $16 million in the past two years.

“Deals are absolutely getting bid up,” says Wienbar. “I was just shown two new Web 2.0 companies, and in the first round they were both expecting to get $25 million pre-money.” Zachary has a similar complaint: “Lots of things are being priced at a $10 million pre-money valuation that should be a $3 pre, and that’s gone up significantly in recent months.”

Ericson has seen it, too. “The Internet has generated, in a small set of cases, outsize returns,” he says, “and because of them you’re seeing much, much higher valuations in the Internet consumer world than the average outcome would suggest make sense.”

Venture firms insist that they are done being squeezed. To get away from the high valuations of Series A deals, BA Venture Partners is trying to do more Series B and C deals.

“It’s sort of an adverse selection” strategy, Wienbar offers. “Conventional wisdom suggests that people don’t want to show you good deals and that the risk isn’t entirely gone with mid-stage deals. But we’re focusing on subsectors, and we feel like if we pick the right markets and the right companies, we’re doing our job well. Plus, the pricing is far more rational. On a Series B or C, you can see that a company is doing $3 million in revenue. It can’t ask for $100 million pre-money.”

BA Ventures is also shying slightly from the consumer Internet, having most recently funded a new enterprise software-as-a-service startup and two semiconductor deals. (None of the deals was ready to be announced as of press time.)

Stay focused

MDV’s strategy right now is to “stay for the most part very early stage,” says Ericson, who adds that the firm has been “spending a lot of time at universities, trying to find innovation at that level and ideas around which you can build more protective barriers than around some other areas.”

MDV is also “doing a fair amount of incubating companies” in its Menlo Park, Calif., offices, a tack that has already produced a number of portfolio companies, including Proofpoint, a Cupertino, Calif.-based networking startup, and Medio, a Seattle-based mobile search company.

Over at CRV, some general partners are looking for opportunities abroad. One of the firm’s recent deals was an undisclosed investment in Beijing-based, which Zachary characterizes as “American Idol meets the Web.” He says the company has 3.5 million users and is profitable.

Not all VCs say that the environment has grown alarming. “We’re clearly in an environment where certain sectors are particularly exciting, as well as one in which people are chasing the latest fads, creating overvalued situations,” says Cameron Lester, a general partner at Azure Capital Partners.

Still, VCs have been known to invest too heavily when times are good and under-invest when things crater. The best returns come from spreading investments over multiple years in a consistent fashion, he says.

Azure has been spending a lot of its time on open source over the last year or two. According to Lester, the firm decided in 2002 that there was plenty of opportunity to sell proprietary software into installed bases like the telecommunications industry and the government.

“We developed investments early in the funding cycle, and I think that’s key to being successful.” Among Azure’s open source bets was VMWare, which sold to storage company EMC in 2004 for $625 million in cash.

Azure has also made some bets in the mobile 2.0 space, including handheld computer maker OQO and, more recently, Limbo, a San Mateo, Calif.-based startup that takes auction bids for prizes over cell phones. “We still see great opportunity in the mobile space, considering the power of the device and its growth, especially in Europe and Asia,” Lester says.

Tempered criticism

As critical as he has been of Web 2.0 investments, Hornik, of August Capital, says Web investments remain as intriguing as ever.

“There’s been a whole lot of competition and a lot of these startups face a lot of competition in and around their verticals,” he said in an interview with VCJ. “But finding great teams that are building interesting products in the consumer space will always be appealing. I’m not of the belief that we’ve run out of good ideas or that there’s nothing new to do on the Web.”