Venture Capital's Hidden Calamity

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The fallout is still being felt, even in what are considered hot sectors. Take Web 2.0, where exactly one company, YouTube, had a $1 billion-plus outcome when it was purchased by Google (GOOG). Only a handful has sold in the hundreds of millions. And because the costs of starting these businesses are so low, venture investors own smaller stakes than they did in the last Web bubble.

Paper Gains

Clean-tech companies have seen a few exits, with two IPOs this year and three in registration. Still, the deals have been small. Most of the Clean-tech market is still experimental, in both technology and market opportunity.

Meanwhile, venture investors are paying more to get into the best deals. A recent study by Valley law firm Fenwick & West showed that valuations are on the rise. Valuations are an important barometer of who holds more power at any given point in the Silicon Valley economic cycle. The higher a valuation, the fewer shares a VC's dollar buys, and the more leverage entrepreneurs have.

High valuations aren't all bad news for the venture set. Step-ups in valuations between rounds, for instance, mean that on paper, early-stage investors are showing gains. But so far, that's just on paper. Typically, valuations are driven up by the prospect of a big acquisition or IPO. Now, they're mostly being driven up by the piles of money looking for the next hot deal. Venture investors are getting all the drawbacks of a hot market, with competition to get in on deals and high prices, without the benefits—a rash of blockbuster IPOs and acquisitions.

Oodles of Cash

Heading into this year, a study by the National Venture Capital Assn. found that almost half of venture investors surveyed predicted a decrease in the number of VC firms even as returns improve overall. "The pundits were correct about the reduction in venture capital firms—they were just a few years too early," Mark Heesen, head of the NVCA, said at the time of the survey.

Indeed, other studies have shown that terms between venture guys and their investors are getting harsher, as limited partners increasingly demand lower management fees and so-called "key man" provisions, which give investors an out if certain rock-star partners leave a firm. The most staggering example of the tension was the recent news of Yale getting kicked out of top Valley firm Sequoia Capital's newest fund after refusing to invest in the firm's less-proven overseas and late-stage funds.

There is a bright side. With so much cash floating around the Valley, entrepreneurs have never had it so good. Sure, a lot of dumb ideas are getting funded, but nearly any great idea has a good chance of getting funded, too. There is likely a trove of new experiments being started on the sly. And ultimately, VCs will fund these deals, and that top 10% will continue to have huge hits with returns that the NASDAQ, bond markets, and even buyout firms can't match.

The question is, in an industry that has gotten this big and this bloated, how long do the other 90% and their investors keep hoping for the next winning lottery ticket?

Lacy has been a business reporter for 10 years and is currently writing a book on global entrepreneurship. Her first book, Once You're Lucky, Twice You're Good: The Rebirth of Silicon Valley and the Rise of Web 2.0, was published by Gotham Books in May 2008. She also blogs for TechCrunch.