Year in Review: Internet

You can’t turn your back on the Internet. It has this nasty habit of evolving faster than investors, entrepreneurs and strategic acquirers can keep up with. Last year proved to be a year of massive disruption that has left everyone in the innovation ecosystem off-balance.

Start with Google. The Internet giant is shaking in its shoes about the rise of the “real-time Web,” a term that describes the constant data flow kicked off from companies such as Twitter and Facebook. Google is great at archiving and retrieving static pages, but hasn’t mastered the new speed at which Internet users can create posts, updates and swap links.

Building an ecosystem of companies to capitalize on the fast-forward Internet is Ron Conway’s new investment thesis. The hyper-angel that backed Google sent around a memo explaining how important the real-time Web is going to be and that he would invest in 40 to 50 companies focused on the sector. Conway has backed companies such as news aggregator Scoopler, search engine Topsy and video-sharing company Vidly, to name a few.

Even Conway, who can seemingly turn on a dime, will have competition from at least one incubator that has tackled the Twitter universe. New York-based Betaworks has backed companies such as URL-shortening service Bit.ly, Twitter software company TweetDeck, RSS-publishing service Twitterfeed and others. It’s a rare group that can force Conway to play catch-up.

Of course the real-time Web wouldn’t be possible without the ubiquitous Internet access afforded by Apple’s iPhone, which every teenager shuffling around the mall seems to be glued to. All those Lady Gaga YouTube videos put a heavy load on the AT&T’s telecommunications network. In fact, AT&T is contemplating charging users for the bandwidth they use, a move it hopes will save it from having to spend more on infrastructure, according to reports. One of the company’s senior executives reportedly said that just 3% of its smart phone users gobble up 40% of the company’s bandwidth.

Bandwidth Brouhaha

But if variable pricing doesn’t fly, the major U.S. telecoms may need to do the same thing they did over a decade ago: go shopping in Startup Land. That’s one of the reasons why an investor group that included Accel Partners and Redpoint Ventures bought a majority stake of NextG Networks this September for $360 million. The company, which pulled its proposed $150 million IPO, makes distributed antenna systems designed to improve wireless network coverage, capacity and performance. Other investments in the space included Tower Cloud, which collected just shy of $20 million in its second round of financing from El Dorado Ventures, Sutter Hill Ventures, Noro-Moseley Partners and others for its technological improvements working with mobile backhaul.

Still, AT&T may take the net-neutrality debate to the mobile Internet and you can bet that venture capitalists will have something to say about it, especially firms such as DCM, which recently invested $4 million in “augmented reality” company Tonchidot. The Japanese startup uses the iPhone’s camera and GPS to show users—quite literally—more than meets the eye. It is one of several companies aiming to blend the cyber world of tags, hyperlinks, search capability and e-commerce with real life spaces and places. Will it use bandwidth? Like a Hummer guzzles gas.

While augmented reality is a fun way to hog bandwidth on the mobile information superhighway, other companies are looking to expand into the business end of the Internet. LinkedIn announced last winter it would be opening its application programming interface (API) to developers looking to make business-centric social networking applications.

M&A Mania

It could be a lucrative new opportunity, especially after Electronic Arts reeled in social gaming company Playfish for $300 million in cash and stock with a shot at another $100 million in earn-outs. The Playfish deal was certainly a big acquisition, but by no means the biggest in the Internet startup pond. The largest acquisition for 2009 was online shoe seller Zappos, which sold for a whopping $928 million to Amazon. The deal was a big pay day for VC-backers Sequoia Capital and Venture Frogs, an investment vehicle controlled by Zappos CEO Tony Hsieh.

Following close on the heels of Zappos was Google’s $750 million acquisition of mobile advertising company AdMob. It was a deal that didn’t particularly surprise industry watchers. After all, Google CEO Eric Schmidt told Reuters in September that the search juggernaut would be making one acquisition per month. “Acquisitions are turned on again at Google and we are doing our normal maneuvers, which is small companies.” If AdMob is what he calls “small,” that could spell great news for VCs selling companies to Google this year.

Even Yahoo says it is hot to cut checks for social networking startups. “It’s a good time to be buying now,” CTO Ari Balogh told Reuters in May. The No. 2 search engine company had some $3.9 billion in cash and equivalents at the end of the third quarter and its shares are up nearly 30% on the year.

Other potential startup buyers have yet to show their cards. An AOL that is now separated from Time Warner could be primed to acquire technology to help it make up ground on the field, but it will need more than the $77 million sitting in its war chest before it can go shopping. IAC/InterActiveCorp seems to have stabilized as a buyer after its August 2008 stock split and massive one-time dividend sent shares down and depleted its cash reserves. It managed to buy Internet advertising company Sendori, which had raised $1.25 million from Felicis Ventures, First Round Capital and Maples Investments, for $25 million last January. It also paid $57 million for People Media, an online dating company backed by American Capital Strategies.

Early stage investors are optimistic about deal making in the coming year. In fact, optimistic may be an understatement. “Mergers and acquisitions are back!” declares Jeff Clavier of SoftTech VC.

Big Question Mark

His excitement is understandable. Perhaps what is confusing is that venture capitalists are not talking about the IPO market for Internet companies. Just two of the 11 VC-backed companies that went public last year were Internet-related. Still, both of them performed well in the aftermarket. Online reservation service OpenTable hearkened back to happier days when it enjoyed a 59% first-day pop on its IPO in May. And LogMeIn, which provides remote Internet access to mobile professionals, priced at the top of its range and gained 25% on its first day of trading in July. Both OpenTable and LogMeIn continued to trade above their IPO prices as of mid December.

Clearly, investors are hoping more than a couple more Internet companies will go public this year. “LinkedIn, Facebook, Zynga—I hope all those companies go out at some point, so the public has interest in what we do,” says Clavier of SoftTech. “It also gives those companies currency to become acquirers.”

The market may be salivating for a Facebook IPO, but it seems unlikely that it would go public this year. Accel Partner and Facebook board member Jim Breyer tells VCJ that the social networking company is focused on growth and long-term product initiatives, and “we are spending no time today debating whether we should be thinking about a public offering or not.” Of equal importance, Facebook doesn’t appear to need the cash. It sold just under 2% of its equity to Russian investor Digital Sky Technologies for $200 million last May.

Everyone has a prediction for what 2010 will hold for the Internet sector. Investors foresee the rise of location-based social networking games, the demise of banner ads, a growing importance of virtual goods and a diminishing role of user-generated content.

“The definition of the Web and the mobile Web are starting to blur, and it presents lots of interesting investment opportunities,” says Sharon Wienbar of Scale Venture Partners. “We’re spending time in synchronization and sharing, backup and lightweight collaboration. There are a ton of companies in each area, and it’s not clear who the winner will be.”

Deven Parekh of Insight Venture, whose investments include online textbook seller Chegg.com, sees e-commerce continuing to gain ground and creating new opportunities. “E-commerce is continuing to take market share from the off-line world,” he says. “If you want variety, you’re now forced to look online.”

One thing is certain, whether it’s the rise meteoric rise of a startup such as Twitter, or the appearance of surprise new power players such as venture firm Andreessen Horowitz, the Internet sector in the coming year will be predictably unpredictable.

—Additional reporting by Deborah Gage