By Jessi Hempel
June 1, 2010

As investors swoon over the latest crop of hot startups, consider what happened to the last round.

It’s been seven years since tech guru Tim O’Reilly used the term “Web 2.0” to describe a crop of social-networking startups that let users publish and share information. As Twitter and Facebook ascend, many of the category’s icons are crumbling. The shakeout has come quickly.

Five years ago Rupert Murdoch was hailed as a visionary when he shelled out $580 million for MySpace. In 2006, Google (GOOG) put up $1.65 billion for a nascent YouTube. Then Time Warner’s AOL (AOL) paid $850 million for Bebo in 2008. Meanwhile, from 2002 to 2007, venture capitalists pumped almost $4 billion into startups building online communities around everything from pets to banking. Sure, the business models were weak, but IPOs for unprofitable companies were out of the question anyhow. The money would come later.

Well, it’s later — and there’s still no money. As the IPO market slowly opens up, the pressure is on to show a profit — particularly for those that received such sky-high valuations. The problem, in part, is that the category has lost its singularity; nearly every site is now adopting social tools, but most come from just one company — Facebook. Says Gartner analyst Ray Valdes: “A lot of these sites are falling by the wayside in the face of the Facebook juggernaut.”

The site Mark Zuckerberg started from his linoleum-tiled college dorm is likely to be one of the few that will keep their promise. Facebook should bring in an estimated $70 million in (Ebitda) profits on $1.4 billion in revenue this year, and its IPO, not expected before 2012, is one of the most anticipated since Google’s.

Far more social-networking startups stand to disappoint. MySpace was responsible for most of the $150 million loss reported by News Corp.’s (NWSA) Digital Media Group in the first quarter of 2010, prompting Murdoch to admit, “We made some big mistakes.” AOL’s Tim Armstrong plans to sell or shutter Bebo, which has seen traffic fall 52% in the past year. And although Google CEO Eric Schmidt says he is bullish about YouTube’s future, analysts predict that significant profits are still years away.

Meanwhile, a slew of Web 2.0 companies such as Ning, Hi5, and Digg are replacing CEOs, eliminating free services, whacking employees, or becoming social-gaming companies. Just last summer Ning raised money at a $750 million valuation. This spring, however, it named a new chief executive officer, cut 40% of its staff, and announced plans to start charging users. New Ning CEO Jason Rosenthal says the goal is to “build the best service for the most active group of users.” Not the most users, as once was the goal, but the users willing to pay. It’s a shift that companies like Tagged don’t have to make, because they took far less investor money and have more flexibility about how they run their business.

Even if the companies remake themselves, it’s unlikely they’ll ever live up to the expectations of early investors. But memory can be short in the Valley. Already investors are pumping large sums into the next round of startups — iPhone apps and social-gaming companies. With acquisition rumors flying and VCs hot to invest, Foursquare, which lets users “check in” to places they visit, reportedly is valued at around $100 million with just over a million users. Here we go again.

You May Like