Is the VC depression lifting?

After living through the greatest tech bust in memory, shell-shocked venture capitalists are understandably reluctant to get back into the game.

But the prevailing gloom is slowly clearing, according to David Witherow, chief executive of VC research firm VentureOne.

While the industry may not recapture the exuberance of 1999, he believes a rebound is nonetheless under way. That would be welcome news indeed for cash-starved entrepreneurs. Start-ups have been forced to fight for crumbs in the last one-and-a-half years after venture investment in young technology companies slowed to a trickle.

Indeed, VentureOne found that funding declined every quarter since peaking in the first quarter of 2000 at $27 billion. The upshot: Many young companies simply lacked the funds to survive, let alone thrive.

But Witherow says VCs have begun to tip their toes back in the water and are selectively making investments. Venture funding in the fourth quarter fell only slightly in the third quarter, which suggests the worst may already be over. On the eve of the company's annual summit for venture capitalists, corporate investors and start-up outfits, CNET News.com checked in with Witherow for an update.

Q: Where do you think investment in the Internet will go in the future?
A: Many of the great e-businesses of the future already exist today--quietly.

As in, most of the great e-businesses are private?
As in, they are either private or they're the scorned public ones. The issue (that a surviving e-business faces now) is that it's probably a real business, perhaps not a massive business, but just a real good business. But bringing in either professional venture capital or going public was predicated on these businesses being massive--and inevitably, massively profitable. And that, I would say, seems unlikely.

Does that go back to Priceline.com once having a market cap greater than many of the most major airlines combined?
Priceline is a great service, and it's probably a very good business at a (certain) level. Is it multi-multibillion? I personally think not. Is it a real business that will probably be profitable that creates customer value and could become a way that people shop for excess travel and lodging? I would say very likely. The issue is the difference between expectations and realism. That is probably not a multibillion-dollar, industry-destroying revolution, but rather, just a cool business which will find its own size. But I do believe that in 20 years, Priceline or its successor, Amazon or its successor, and eBay or its successor will be businesses, and that 20-year-olds will have no concept (of when) they never (existed).

So if you think that most of the great e-business and content companies already exist today, then there's probably little room for investment in new companies?
Most of them exist today, or at least are being tried. There will be many innovations around different ways to establish those businesses or ways to monetize those businesses.

Sort of tweaks on the model?
Yes, tweaks on the model. But most of the spaces got named in the bubble. Most. There will be brand-new markets that were not even considered, but I think most of those markets have already been considered, experimented in, and are maybe being tried even as we speak. Therefore, there's great room for investing either in the one that's already been tried or has yet to be (improved). I think that those investments, at least in the near term, will be tempered with much more moderated expectations--hopefully on the part of the entrepreneur and certainly on the part of the investor.

What were the signs of excess among venture capitalists?
The boom was

"The best way to make money is let an area get overfunded. Let it collapse and become unfashionable, then pick the real gems in the wreckage."

characterized by a remarkable disconnect from the practical reality of building a sustainable business. (This) was pervasive, even (among the) private equity investors who are specifically chartered to assess the viability of new enterprises. That disconnect seemed to get embodied by (everyone), from the 20-somethings to management, who believed their own hype and believed that (these were) sustainable model(s) and that they should be amply paid and rewarded for what they were doing.

They drank the same Kool Aid?
Yes, so you had title inflation, personal spending inflation, salary inflation and expectation inflation, and you (were) poised for disappointment.

Is there any one instance or event that sticks out in your mind that summed all this up?
Well, there's been no end of examples that name the online pet companies, which brought the commonly used venture capital adage "Will the dog eat the dog food?" to its logical conclusion. But for me, the great examples of this period are when you tried to check up on the reality.

Ten to 30 years from now, I'm likely to remember being at a start-up sponsored beer outing around the Fall of 1999, surrounded by well-dressed, articulate 20-somethings. I asked a business development professional at the start-up, "What does your business do?" "We sell college text books online," she said. "Isn't that space commercially dominated by (one company)?" I asked. "Yes, they're well known," she replied. "Well, what is it about your business that is going to compete and be differentiated from that competitor?" I asked. She paused, looked at me, reached in her pocket, then she said, "Do you have one of our stickers?" I remember taking the sticker and thinking, "This is not a good sign." You certainly had to accept that the mania was pretty all-encompassing at that point.

Who deserves most of the blame? The investment bankers? The VCs? The kids with business plans on cocktail napkins?
(You can blame) every individual who succumbed at any point to greed over reason. By the top of the bubble, that applied to about every person I knew. Because it became so pervasive, everyone wanted to be a part of it. The public market investor, the investment banker, the entrepreneur and the venture capitalist all held hands and helped shape this mania. (We could also) blame the Internet itself for having such promise of changing the way that our world works...Like other technology waves, we got excited about the possibilities--and those possibilities are absolutely real; we just overestimated the rate at which they'd occur. It was a timing mistake.

We've talked about content and e-commerce, the lepers of the Internet space...
There's always been money in lepers, by the way.

"Like other technology waves, we got excited about the possibilities...We just overestimated the rate at which they'd occur."

How so?
In my view, the best way to make money is let an area get overfunded. Let it collapse and become unfashionable, then pick the real gems in the wreckage and invest in them when no one else has the courage to do so, and watch those become great companies. Quietly.

Sort of stealth investing?
Call it humble investing. Where can you find more fertile ground than to look at the thousands of future carcasses...and find the gems within them? Because clearly--with lots of experimentation--some of it is great. You can't take an out-of-favor sector and say there's nothing good there. When it's unfashionable, that's when it's really good; insightful investors have a great opportunity because they're not competing.

When do you think venture capital investment will start to grow again?
I think a leveling off is going to happen in 2002 and may have already occurred in the fourth quarter of 2001. Our expectation is that the leveling off will precede a period of growth and--to editorialize--hopefully moderate growth. The worst future includes another big bubble. People get burned in a big bubble. Here's the issue for me. If a professional investor gets burned in a bubble, well, that's unfortunate, but not a tragedy. But if it's the nonprofessional investors, like the parents of children who have lost life savings, retirement savings, college education savings--the very real people who are being affected--that strikes me as an absolute tragedy.

So, is it harder to feel bad for the professional investor who got burned because they should have known better?
I feel bad for everyone who loses something, but it's the nature of the business if you're a professional investor, so you should know what you're doing. The less informed public investor who is supporting a family--that is more tragic. But, again, I am not saying that I do not care about the institutional investor.

Let me play devil's advocate: If the mom-and-pop investors are betting their savings on funds that invest in Enron or Pets.com, just to use some examples, shouldn't they have known better?
Well, mom-and-pop investors invested in a fund managed by a professional that they trusted. Yes, those risks were always there--whether they knew it or not--and you can blame them for either not understanding the risk or not acting correctly. But it's still pretty painful.

Is that similar to putting your money in a checking account and then having the bank go under?
Many people lost sight of the fact that investing in the stock market is risky instead of bank-like, albeit bank-like with outrageously good upside potential...Years and years ago, a great truism was: Never allow yourself to say "reward" without putting "risk" in the same sentence. Period.