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The Silicon Valley machine is still going, for now

Here in Palo Alto, the Silicon Valley machine is still going strong – entrepreneurs are still starting companies, angels and VCs are still investing, and engineers are still coding. In the last 3 months, I’ve had half a dozen friends get their companies financed, which is great. Certainly things are more difficult, but deals are still happening, and there’s still a lot of companies growing.

But I’ll say that I’m still quote worried, because of my belief that the worst has yet to come. There is a large group of 2004-2007 self-described Web 2.0 companies which haven’t hit bottom yet, and I’d like to discuss this possibility in this post. I hope this blog will spawn off useful discussions for entrepreneurs thinking about where we are in the boom-bust cycle.

So first, some thoughts about Web 2.0 and how that category has played out:

Web 2.0 isn’t cool anymore
In the 2004-2007 era, many companies in the “Web 2.0” space received a tremendous amount of funding. You can debate what the term means, but generally I would classify them as companies having some of the following qualities:

• Consumer internet destinations (or widgets!)
• User generated content and activities
• Advertising-based revenue models
• Appealed strongly to the early adopter audience

Yet ultimately, it turned out that most of these startups didn’t work out as real businesses. The reasons hinged primarily on the difficulties of monetizing user-generated content based on ads that I’ve written about. As a result, to be a VC-backable business, you either need to be a top 50 internet property (good luck on that!) or have a well-defined monetization backend that probably wasn’t advertising.

My guess is that the # of companies describing themselves as Web 2.0 has dramatically decreased over the last year, as these business model problems have been rapidly discovered and popularized.

And yet, now the difficulty of course, is that there are dozens of Web 2.0 startups funded in the 2004-2007 timeframe that have a meaningful amount of cost, and not enough revenue. It’s these startups that I’m worried about.

Venture financings as a lagging indicator for the economy
The problem is, VC financings tend to be a lagging indicator for the economy. We haven’t seen the established startups who are trying to raise Series B or C rounds get turned down by the market. The reason is that it’s too early, and these companies failures will lag the downturn in the economy by a year or possibly more.

Lots of smart companies and entrepreneurs did a great job of getting their financings done last year before the economy really fell apart. As a result, these lucky ones have cash in the bank right now and can continue iterating on their model to hopefully figure things out. But if they haven’t figured things out and the economy is still bad, then ruh-roh, that’s no good. But we’re unlikely to see the effects of these sick companies with dysfunctional business models until later this year.

Who are these startups that might be in trouble? Let’s discuss:

Characteristics of startups in danger
I’m not going to call anyone out ;-) But I think that there are several startups out there which are now in the precarious position of either finding their model ASAP, or collapsing.

These companies might include the following characteristics:

• Started in 2004-2007, and self-described as Web 2.0 startups
• Have grown to lots of headcount, let’s say >40 people, which can burn through a $5M Series A in under a year
• Substantial traffic, let’s say >5 million uniques per month, which drives up the cost structure
• Ad-based business models, which rely on big sales teams calling up agencies (whose pockets are now reduced, if not closed)
• Low-context advertising inventory, with low CPM in sectors like communication and entertainment
• Mature internet sectors, where the upside is now established, and acquirers are less likely to pay up as a result
• Not a leader in their category, where they may be #5 or higher, and investors may be unlikely to keep supporting their growth
• Media content hosting, where they allow users to upload, host, and stream content without charging a dime, which also drives down the cost structure

I will leave it as an exercise to the reader to pick out companies that might fit the bill.

The point is, I think this cycle is going to get a lot worse, and a downslide will likely be caused by one or a number of 2004-2007 vintage classically Web 2.0 companies hitting the skids. I am hoping that the slope down will be gentle.

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