Venture firms are pouring money into Web 2.0 startups in hopes of funding the next MySpace. But is the frenzy getting out of hand—again?

Venture capital investors have finally found something they're excited about.

After a sharp decline in investments following the tech bust of 2000 and 2001, venture firms are beginning to pour money into a new crop of Internet companies, in businesses such as social networking and online video. Together, they're called Web 2.0 companies. Venture firms have put a total of $455.5 million into 79 of them during the first nine months of the year, according to a study released on Nov. 7 by market researcher VentureOne, which is part of Dow Jones & Co. (DJ). That's more than twice the amount of money that was invested in such companies during the same period in 2005.

One of the reasons for the surge is the success of several high-profile Web 2.0 companies. Last year, News Corp. (NWS) bought the parent company of MySpace for $580 million, and the surging growth of the social-networking leader has since made the deal look like a bargain (see BusinessWeek.com, 7/19/05, "News Corp.'s Place in MySpace"). Then in October, Google agreed to pay $1.65 billion for YouTube, the online video sensation (see BusinessWeek.com, 10/10/06, "YouTube's New Deep Pockets" and "Google Competitors Beware").

Flurry of Deals Questioned

Venture firms may envy the success of some of the early investors in such deals. The sole venture-investor in YouTube was Sequoia Capital, a prominent Silicon Valley firm led by Michael Moritz. The firm put $11.5 million into YouTube, largely because Sequoia's Roelof Botha had worked at PayPal with the video site's founders, Chad Hurley and Steve Chen. Sequoia ended up reaping about $500 million after the Google acquisition.

Sequoia has been one of the most active investors in Web 2.0 companies. According to VentureOne, the firm has put money into 14 such deals between 2001 and this year. Only Draper Fisher Jurvetson and Benchmark Capital have had more, with 15 each.

Yet, might the Web 2.0 frenzy be getting out of hand? Some think so. "Obviously there are too many companies being funded in the area," says Todd Dagres, a longtime venture investor who worked at Battery Ventures and started Spark Capital last year. "What we're seeing is inflation similar to back in the bubble."

Dagres is a believer in the future of Web 2.0 opportunities and has invested in several. One of the highest-profile is his stake in Veoh, an Internet site that plans to deliver TV-quality programming. Its backers include Time Warner (TWX) and Michael Eisner, the former chief of Walt Disney (DIS). Yet he's worried that many of the Web 2.0 companies won't be able to offer strong products and services to attract customers. "It's still a competitive market and the consumer is fickle," he says. "You've got to do a great job of satisfying the customer."

Care to Venture a 1% Success Rate?

He's not the only one with bubble déjà vu. "This is scarily like 1998 in some ways," says David Card, a senior analyst with Jupiter Research. "There's easy money out there, and there are some bad ideas getting funded."

In particular, he points to the dozens of social-networking sites that are popping up, in imitation of MySpace. "I'm highly skeptical about social networking," he says. "I think it's a feature. It's not a business." MySpace, he points out, isn't even that good as a social-networking site. Rather, "it's building itself into a youth portal," he says. "It's a Yahoo! (YHOO) for youth."

Certainly, many Web 2.0 companies will simply go under, for lack of an audience or funding. Booms and busts are part of the venture business. Typically two or three big hits will be plenty to pay for seven or eight clunkers. But the number of Web 2.0 companies getting started has raised concerns that the percentage of losers this time will be much higher than in the past. "For every one that works, another 100 will fail," predicts Dagres.

Venture investments in Web 2.0 companies certainly aren't high enough to push funding back to bubble levels. Some $19.5 billion was invested during the first nine months of this year, according to VentureOne, indicating that total investments for the year will come in at around $26 billion. That would be up slightly from the $24 billion last year. But it's still a far cry from 2000, when the venture firms threw $95 billion into companies.