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Year in Review: Internet

Venture investors’ fascination with Internet startups continues unabated, but their love of consumer-facing companies with elusive business models began to cool by the spring of last year and remains chilly.

These days Internet startups with a clear path to profitability—including cloud computing companies that save large corporations big bucks by acting as outsourced data centers—are the belles of the ball.

As of last month, venture capitalists were on track to surpass—or at least match—the amount they invested in Internet companies in 2007, according to preliminary data from Thomson Reuters (publisher of VCJ). They had invested $13.4 billion in 1,752 Internet companies as of Dec. 7, compared to $14.8 billion invested in 1,793 such startups in all of 2007.

Even before the world became mired in an economic crisis with no end in site, Internet investors were looking at depressingly few IPO opportunities and less-than-dazzling mergers and acquisitions. Unlike 2006, when Google gobbled up YouTube for $1.5 billion, or 2007, when Google bought DoubleClick for $3.1 billion, 2008’s M&A activity will be remembered for being wholly unremarkable.

Balderton Capital (formerly Benchmark Capital Europe) enjoyed the year’s biggest Internet exit when social networking site Bebo was acquired by America Online last March for $850 million. Bebo had raised just a single round of $15.4 million from Balderton prior to the acquisition.

More typical were sales like Affinity Labs, an online community sites startup that had raised $6.2 million and sold last January to classifieds giant Monster Worldwide for $61 million. Affinity produced a decent return, but it did little to move the needle for its big venture backers, Mayfield Fund and Trinity Ventures. Mayfield invested in Affinity from its $375 million 12th fund and Trinity backed it from its $300 million ninth fund, according to Thomson Reuters.

Little wonder consumer Internet investors began some time ago to look for greener pastures. Individual investor Mike Maples, who was an early and active backer of consumer Web 2.0 startups, switched his primary focus to business software and services early last year. “How many social networks are people going to sign up for?” he asked at the time. Today, Maples, who raised a $33 million fund last spring from institutional investors, spends 75% of his time on business software and services.

Likewise, First Round Capital, which was among last year’s most active Internet investors, has also moved away from consumer Internet deals and is focusing more on enterprise Internet investments. “We’re not abandoning consumer, but, historically, 40% of our investments have been made in enterprise and 60% in consumer,” says Managing Partner Josh Kopelman. “Looking at this past year, we were 60% enterprise.”

One First Round investment that Kopelman is particularly excited about is AppNexus, which has developed a cloud computing platform tailored for online advertising applications. The company—which has raised $8 million from First Round, Khosla Ventures, Kodiak Venture Partners and Venrock Associates—represents a “massive trend across the board,” says Kopelman. “The concept of installing desktop software individually is fundamentally changing.”

Kopelman is also trying to diversify from startups that rely heavily on ad dollars, which have been cut dramatically during the recession. “In 2006 and 2007, about 25% of the companies we added to our portfolio were either selling ad tools or ad infrastructure, or generating revenues through advertising,” he says. “While we’re still investing in that space, the bar has gotten a lot higher for us.”

Bob Ackerman, a managing director at Allegis Capital, says his modus operandi is to ask: “In this environment, does this business need to be created today?”

Though Allegis has backed its share of consumer Internet companies, including the chat messenging startup IMVU, Ackerman, like many of his peers, is also focusing more than ever on the enterprise. “People are saying enterprise budgets are going to be slashed next year [in 2009] and there will be reductions, but in all likelihood, they will continue to be interested in security products and legal information,” he says. “They will continue to be interested in connecting demand and supply where it’s inefficient today. If a company immediately addresses pain in the marketplace, then we think launching them today is the best time.”