This is the first in an ongoing “Venture Files Classics” written by former Venture Files Editor Steven Fisher. The selections are chosen for historical reference as well as a notorious ability to be right. The original post from January 12 of 2007 can be found here

Being a serial entrepreneur I have been through many business cycles, but the Internet boom of the late 1990’s was an extremely heady time. People were so enamored with what the Internet could do, every one really believed that the old rules didn’t apply.

The reality was that those rules applied more than ever and with the crash in the early part of the century we have tried to learn our lesson.

With these new companies deemed Web 2.0, everyone is expecting another bubble. So many of the same types of companies have been funded so there are bound to be consolidation and just plain failure.

According to Michael Arrington, his entry “Bubble, Bubble, Bubble“, the despite the fact that some companies are failing, the sky is not falling.

In fact I would call this time around the ol’ startup track “saner, saner, saner”.

Despite many of these companies basing their success on being an aftermarket for Google, the smart ones I think many people know that you have to be in this to create a real enterprise and one that makes money. It is not so much about the VC’s but about the ability to use the low cost and barrier of entry to innovate.

But the Dead Pool is not cool

I think that the blog A VC gets it right his counter points on “Building It Up and Then Knocking It Down” are right. He says “over hyping young companies where people are working their butts off and then throwing them overboard quickly into a “dead pool” when they fail is not healthy.

I believe it is dead wrong to put this up there. It just feeds the fire for the chicken little’s of the world. Mike Arrington has known successes when he co-founded helped flip Achex and sold it to First data. I don’t know if he has experienced building a company from scratch and having it fail, many times from circumstances out of your control.

But there is a bubble developing and not where you think…..

The bubble is not with companies it is in the private equity market itself. The model of funding and the way people are evaluating companies is changing. The way investors look at companies is not based on a fast IPO but aligning it to be a sweet acquisition target.

This is helped in no small part since most VC’s invest like they are teenage girls. “Oooo, you invested in a video sharing site, I want one too! You put $5 million into social networking for eco-friendly baby boomers? Find me one so I can get one too!!

Here is how I got there:

1. The amount of money chasing deals have lightening strike twice to find that repeat of unrepeatable past returns is growing rapidly
2. The number of opportunities are declining and there are too many copycats plus the cheap money is pouring out to fund them.
3. Not enough VC’s to serve on boards effectively and make the existing investments get to a proper exit
4. IPO market is still not there and there is and there are only so many acquisition partners
5. Higher prices of entry and lower returns

What I don’t know:

1. When the IPO market might be friendly to tech stocks
2. If investors will broaden their portfolio choices to get their money working in unique ways
3. If funds might start giving their money back

Only time will tell if this comes to pass. If you have a good idea, the money is out there but might not be for very much longer.

Crystal Ball? 2-3 years or mid-2008 this is gonna come to a head. Only time will prove me right or wrong.

Editors Note: At the end of 2008, we do now know that the economy has imploded, not simply from web valuations. In fact, web valuations hardly played any part like they did in 1999-2000.

In fact, the web sector has seen much less damage, than the rest of the economy. In fact, there are still investments taking place, if devalued. A series investments for web companies typically range in the $1-2M range which in the larger picture is fairly small. Biotech companies, for instance, typically pull in around $20M for a Series A round.

That does not make the web sector immune, and in fact, Steve is correct in recognizing that there would be a bubble coming, and that it has arrived.