Crash Of The Web 2.0 Titans

June 5, 2006

This article has been inspired by a post by Erik Peterson in the OnStartups Forums titled simply “Crash 2.0?” (Erik has a talent for title brevity that I clearly lack).  With Erik’s permission, I thought it might be interesting to dig into this “Crash 2.0” concept a little deeper.   [Shameless plug:  If you’ve not yet registered for the OnStartups forums, it’s free and easy.  The group is now 300+ members strong and there have been about 480 posts, a lot of them quite interesting].
For purposes of this article, I’m using the word “titan” in the dictionary sense (defined loosely as “a person of exceptional importance and reputation”).  You’re probably going to argue that very few of the current Web 2.0 startups are “important” – and you’d be right.  However, to really get a good “crash”, it’s helpful to be big and important (i.e. a “titan”).  Besides, “Crumble of the Web 2.0 Titans” as an article title just wasn’t as catchy.
In any case, in the forum post, Erik made the following comments (edited slightly): 
I've become slightly worried as of late with the amount of venture capital pouring in to some really bad ideas, or decent ideas put into overly crowded market niches. I can't really see more then 5-10 feed service companies surviving for the long haul- I can think of about 15 off the top of my head.
So in the next year, we're inevitably going to be hearing about dozens of web 2.0 startups that fail for one of the following reasons:

1) Bad execution
2) Bad idea
3) Bad market

When the first set of web 2.0 companies start to go sour- will people start to panic?   There are some things that lead me to believe that a second crash would be a lot less severe than the last, mostly the lack of IPO's- Venture Capitalists are a lot less susceptible to panic than Wall Street, and their holdings in private companies are a lot less liquid than some shares of publicly traded stock.
I mostly agree with what Erik has to say.  The world only needs so many companies in a given product category (I’d argue 3 or 4) and as a result, many of the “me too” companies will likely fail and shut-down for one of the reasons he has cited (and a fourth, which same later in his post:  “bad revenue strategy”).  For the record, a non-existent revenue strategy qualifies as a bad one.
But, I don’t think we’re going to see a Crash 2.0.  With the lack of a robust IPO market, VCs have little incentive to fund Web 2.0 startups at exceptionally high valuations and with large blocks of money.  As a result, the amount of capital being invested in these new Internet startups is nowhere near the levels we saw during the last bubble.  Further, the current generation of startups are simply not consuming capital at the rate that we saw last time.  Gone are the Super Bowl ads, the fancy offices and startup founders focused more on throwing launch parties than actually launching a product.  This time around, it seems that the “geeks are back” and people are working hard and actually creating something.  Of course, the question still remains as to whether they’re creating anything of value, but that’s a different problem.  In reality, though we’ll probably see a few of the current individual titans “crash”, most of the Web 2.0 startups will simply crumble and fade into oblivion.  
I think the Web 2.0 startups most likely to shut-down are the venture-backed ones.  The reason is that though it is much cheaper to run a Web startup today than it was in the first bubble, investors still have a limited time horizon within which to achieve liquidity.  As a result, though the founders could conceivably run the company “indefinitely” (while sustaining themselves on minimal cash), there’s little reason for VCs to stay involved.  They’d rather just “exit” at whatever they can get and move on with their lives.  I think we’ll see a fair amount of this in the next few years as the early rounds of capital start to get depleted and revenues don’t catch-up to meet expenses. Some of the better startups will probably get some follow-on capital (assuming there’s some hope for profit or exit someday), but most won’t.   I’m not saying anything brilliant here, that’s just the way it is.
I personally tend to be mostly an optimist – and on bad days, a realist.   As such, I don’t usually short stocks.  But, there are times that I wish the private equity markets (particularly in the venture world) allowed me to short-sell some of these current venture-backed Web 2.0 startups.  I simply do not see how they will ever create a return for their investors.  My best guess is that some of these VCs are applying some sort of warped “portfolio optimization” theory and attempting to diversify away some risk by sprinkling in one or two Web 2.0 startups into their lineup.  They don’t want to be left out of the game should this become really, really big.  However, as has been the case in the past, the money will likely be made by the same VCs that always seem to make the money (the top quartile) and the rest will be writing off most of their investments without a “high flier” in the bunch to compensate. 
Summary of my point:  Clearly many of today’s Web 2.0 startups lack the revenue models and paths to profitability that would allow them to become “real” businesses someday – and even well-funded ones have a limited lifespan.  However, we’re likely not going to see a real “crash” like we did last time, because there’s no real bubble to burst with one single prick of reality.

Written by Dharmesh Shah

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