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Bubble Time Makes Silicon Valley VCs Smile -- Everyone Else, Beware

Depending on who you ask, the consumer tech sector is either a very smart investment or a bubble getting ready to burst. Reading between the lines of a report on Silicon Valley venture capital confidence by Mark Cannice of the University of San Francisco, however, suggests that ordinary investors and entrepreneurs should proceed with caution.

According to the report, Silicon Valley VCs are growing more optimistic about high growth investment in the San Francisco Bay area over the next 6 to 18 months. That's a significant jump over last quarter and an indication of "an increasing upward momentum in confidence," as Cannice's graph below shows (click to enlarge):

What's making the VCs smile their cat-and-canary smiles? The very same thing that made them grin just over a decade ago: a bubble. Some VCs insist in interviews that there is no bubble because high valuations come only for companies that display solid fundamentals.

And yet there's been a 35 percent year-over-year spike in VC investment, which is a pretty sharp jump. Some investment darlings like Twitter have yet to show solid revenue models and levels that would justify the level of investment they've received. According to Reuters, a group of early Facebook investors and employees plan to sell $1 billion in stock. Someone is clearly getting nervous. You can practically hear the crack as the parachutes snap open.

According to the report, the main thing driving VC confidence is the convergence of social, mobile, and gaming technologies. Twitter, Facebook games, smartphone apps, and all the variations you can think of. They're all hot areas that the interviewed VCs described as torrid" or "almost frantic," with "the rest of the entrepreneur ecosystem -- either incredulous or envious of what's going on in social-mobile-gaming."

Bubble, bubble, toil and trouble
But heck, "bubble" works just as well to describe what's going on. What else do you call soaring valuations with what one VC called "the best exit market in a decade?" The "greater fool" theory of investing is alive and well in the economy-sized version.

The exit scenario is dangerous for new investors. To recoup their investments, they have to find even greater fools, and what are the chances that the overheated valuations of Facebook will continue to go up indefinitely?

However, the greater fool theory is even more treacherous for entrepreneurs, who can become cannon fodder for VCs that want to score big and don't care what happens after they walk away. The entrepreneurs are left to deal with the mess afterward.

There is a second problem, as well. According to Bob Ackerman of Allegis Capital:

Venture Capitalists have invested almost $15B more than they have raised over the past three years. This trend is not sustainable and will have negative impact on the ability of start-ups to raise capital if it is not reversed.
VCs are so anxious to catch the gravy train that they're dumping everything they have on the Twitters, Facebooks, Foursquares, and other high fliers. But they're not bringing in money at the same rate, so there's going to be far less cash for new ventures that haven't yet hit superstar status and the promise of an easy exit.

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Image: morgueFile user fiona_adam, site standard license.
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