As if waking from a dream, Silicon Valley has suddenly realized that the collapsing economy means trouble for tech companies, too. Especially at risk are the new startups created in the wake of the last dotcom crash in 2001. The signal traits of these Web 2.0 companies are cutesy logos, odd-sounding names—Twitter, Zooomr, Digg, Ning, Loopt—and flimsy business plans based on a vague notion of luring millions of people to free Web sites and someday selling advertisements. Most lose money. Some have raised enough venture-capital funding to survive for a year or more. Some may be able to raise more from venture backers, albeit at onerous terms. But many are going to flame out.

The correction is long overdue. Over the past two years, valuations on some Valley startups have soared to ridiculous levels. Facebook, the social-networking site, last year raised money at a $15 billion valuation despite being profitless and only three years old. Ning, another social-networking site, has raised $104 million and was most recently valued at $500 million. (Cofounder Marc Andreessen, a Valley veteran, said earlier this year he was raising money to ride out a coming "nuclear winter.") Slide, a maker of software widgets that let Facebook users "Poke" and "SuperPoke" each other, earlier this year raised $50 million at a $550 million valuation. Just as in the original dotcom boom of the late 1990s, Valley types claimed these valuations were perfectly reasonable, and insisted there was no bubble. Those who have raised war chests remain upbeat. "Not to sound obnoxious, but this downturn could be good for us," says Max Levchin, founder and CEO of Slide, in San Francisco. "Some of our competitors are going to go out of business."

To get an idea how crazy things have been, consider that Twitter, a "micro-blogging" site launched in 2006, earlier this year raised a reported $15 million in venture funding at an undisclosed valuation—even though the company hasn't made a dime so far and its managers aren't trying to. "We're prerevenue. We're focused on growth," CEO Jack Dorsey says, although he adds that Twitter intends to start generating revenue next year. How it will do that remains to be seen: Twitter lets people send 140-character bursts of text to a list of friends, telling them where they are and what they're doing at any given moment. That's it. That's the whole idea. Like Levchin, who was a cofounder of PayPal, Dorsey says others will suffer in this downturn, but not him. "It's going to be painful," he says. "There's going to be a lot of fallout." Some of that fallout might involve the dozens of firms that make software that works with Twitter. There are also loads of companies doing some or all of what Twitter is trying to do, including Tumblr, Publr, Chatterous, Posterous, Yammer, Streem, Pownce, Spoink and Plurk.

Not everyone in the Valley is looking forward to that fallout. Sequoia Capital, a leading venture-capital firm, reportedly hauled the CEOs of its portfolio companies into an emergency session early this month and warned them to start cutting costs and preparing for hard times. (Sequoia would not comment.) Entrepreneur Jason Calacanis, founder of a Web startup called Mahalo, recently posted a blog item warning that "50-80% of the venture-backed startups currently operating will shut down or go on life-support (i.e., 3-4 folks working on them) within the next 18 months." Ron Conway, a prolific and successful early-stage investor based in San Francisco (he backed Google and PayPal, among others) is less apocalyptic—he thinks 10 to 15 percent of Valley startups will go under. Last week, Conway sent an e-mail to his 130 portfolio companies warning them to find ways to make their money last longer. "Raising capital will be much more difficult now. The name of the game in this environment … is survival," he advised.

Conway says companies most at risk are those with less than one year's worth of funding in the bank. About 20 of his portfolio companies fit that description. "I'm spending all my time with those CEOs, trying to figure out how we're going to hunker down and weather this storm. These guys are victims," he says. "The storm is on Wall Street, but it's rippling out to Silicon Valley and causing investors to be more cautious." On the bright side, Conway says he continues to see five deal proposals a day, and he's still making investments. But he admits, "I am being a little pickier."

Public markets are practically shut down to new offerings. Even the chance of being acquired has grown slimmer. Without the prospect of a hefty "liquidity event," as it's called in the Valley, a lot of these former high fliers don't seem so sexy anymore. Facebook attracted top talent with the promise of a public stock offering that would create loads of overnight millionaires (and a few overnight billionaires) the way Google did when it went public in 2004. Now Facebook employees are jumping ship, including Dustin Moskovitz, a company cofounder.

While online advertising is expected to grow this year, according to researcher eMarketer, it remains a tiny piece of the overall advertising market. And advertisers are cutting back like everyone else. With so many Internet companies chasing so few dollars, the Web 2.0 (pronounced "Web two-dot-oh") craze now may be moving into a new phase: Web two-dot-over.

© 2008