Is There a Bubble in Web 2.0 Startups?

Over the past 18 months, angel investors have leap-frogged over VCs to offer seed funding to startups seeking very small chunks of capital. Since the term “angel investor” simply means anyone who is an accredited investor according to the SEC, we’ve seen a ton of ignorant people get into the high-risk startup funding game.

Of course, this isn’t much different than all the ignorant people who invest in public stocks or real estate. However, angel investing is much more challenging and the odds of winning are about the same as going to the race track. As super-angel Naval Ravikant says, “Each year only 10 startups matter.” So, if you don’t have access or didn’t get into those 10, you can bet you’re probably in one of the hundreds of thousands on the road to perdition.

Unfortunately, it looks like a lot of people will watch their angel investments go bust. As the Nasdaq rebounded and Silicon Valley got its groove back, a huge wave of wannabes have started tossing bets at any Web 2.0 company with a sweet deck or glossy user interface. As with all investment cycles, once the “dumb” money starts piling in, it’s only a matter of time before smart money bolts like lightening and the newbies feel the thunder.

“But,” you say, “Web 2.0 has so much potential! How can it burst?”

First, if the stock market goes sour or the economy slows, revenues will decline and M&A will slow (or cease). Therefore, the creative destruction phase will wipe out more investors.

Second, and this is the one I believe will hit hardest, many Web 2.0 businesses will crash in value because they are merely features (Cf. defensible value-adds). For example, all of these are features which you too can compete with by simply hiring someone on ODesk (for an inexpensive wage and no equity): comment plugins, URL shorteners, social feed aggregators, analytics platforms, productivity solutions, etc.

If you don’t have a barrier to entry (e.g., patent, trademark, complicated engineering, high startup costs, etc.), the Invisible Hand is on its way to bring 10 more copycats into your niche.

So long as there’s profits, entrepreneurs will smell them and compete. And Web 2.0 startups are more vulnerable than most because they are super-cheap to copy, mostly unprotected IP because they can be “deduced by a person with average knowledge“, and can be created by a bunch of caffeinated college kids or widely available independent contractors.

The Renaissance for Web 2.0 features is still strong, but I don’t see a moat for investors:

In the last week I’ve already been invited to 2 “personal splash pages” (e.g., about.me, flavors.me). Seriously? I already have a homepage on Facebook, Linkedin, my website, etc.

That doesn’t mean you can’t win in the very short term. Like a day trader, you can throw $30,000 into Web2.0 Co. at the seed stage and exit for a win during a subsequent round of early-stage funding. But liquidity is anemic insofar as investing markets go, so you’re strategy will need a category entitled “Prayers”.

I am not a hater. I LOVE startups and am actively growing one (Wall St. Cheat Sheet) that only recently transitioned from the garage phase to the small business phase (via the ‘ole bootstrap). However, I am a savvy investor and have seen lots of family and friends get slaughtered in two market meltdowns over the past decade. So, I am simply reminding accredited investors to meditate on this:

Before you attempt to stroke your ego and become a personality in the very small and visible angel investing space, understand the risks and the market landscape. Everything that applies to being a successful large cap investors also matters with startups:

  • Know the company’s market.
  • Find trustworthy founders and management.
  • Size your investment positions with a risk-reward model that won’t ruin your life.
  • Find a mentor with a winning framework.
  • Ignore what you perceive as glamorous so you can …
  • Avoid slick talking schmucks and beware the legal con artists.

(Also Check Out: “The Top 3 Reasons Andreessen Horowitz Invested in Foursquare – with VC Ben Horowitz“)

If you think I’m making this up, don’t take my word for it. In a recent keynote speech, super-angel Naval Ravikant noted some of the dangers in the over-heating market:

All’s well that ends well. And I’d like to see a happy ending for the angels.

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