Surge in VC Funds for Tech Not All Rosy

NEW YORK ( TheStreet) -- Each new tech IPO announcement and report of rising early-stage funding furthers the cheery proof that finally, following the recession, young tech is back.

But inevitably, with the good comes the bad. In this case, as the market for venture financing heats up to pre-recessionary levels, a few troubling investing trends have emerged that are impacting both entrepreneurs and investors -- some for the worse.

First, let's set the stage. Around 67% of start-ups in the first quarter of 2011 raised money at a higher valuation than their previous funding round, according to a new study from Silicon Valley law firm Fenwick & West, which surveyed 122 companies. And only 16% of these companies raised financing at a lower valuation than their last funding -- the largest gap between so-called "up" rounds than "down" rounds since 2008.

In terms of the recent growth of early-stage investing, last year funding rose 15% to $5.2 billion, while the number of deals leapt 25% to 1,147, according to the National Venture Capital Association.

Much of this deal making focuses on the tech sector, where early-stage investors hungry for a piece of the next Facebook, LinkedIn ( LNKD) or Twitter have created a gold rush-like scenario for social media-related firms. The problem: the funding mania sees some investors pouring money into start-ups with products that may not be ready for primetime.

"You're got a fair amount of companies who would normally test something at an angel stage who are now going to bigger rounds when they haven't necessarily proven their product," said Charlie O'Donnell, a principal at First Round Capital in New York, who has noticed the average seed round increase from $500,000 to $1 million as investors have become more aggressive.

"Sometimes a company that's received early stage funding hasn't cooked enough and it's kind of raw," said Paul Holland, a general partner at Foundation Capital in Menlo Park, Calif. "As a consequence you don't know what you have with the company until it has proven itself ... sometimes you're chasing smoke up a chimney."

As a result, some investors are finding their capital tied to concepts that differ greatly from what they initially bet their money on.

Take the recently-launched startup LocalResponse, a social advertising platform founded by entrepreneur Nihal Mehta that helps companies figure out how best to ping consumers with local ads and offers.

Mehta initially raised $4 million from several prominent venture firms in 2007 to found Buzzd, a mobile location-based city guide and social network. But as the sector became more crowded and other check-in companies like Foursquare, Loopt and Gowalla became more popular, Mehta decided to shift his company to focus on the business-to-business market instead.

According to Mehta, some of his investors -- those that had taken a stake in his company under the assumption they were investing in a consumer mobile-based product -- were not pleased.

"It was a struggle," he said. "They wanted the business that they invested in initially to succeed."

After months of negotiations with his investors, Mehta launched LocalResponse in April, where he works with former rivals like Foursquare -- providing them with data -- rather than competing with them head on.

"It used to be that market feedback would guide entrepreneurs away from the pursuit of bad opportunities toward something worth pursuing, but now the market doesn't push back as hard on mediocre ideas," said Jordan Cooper, a venture partner at Lerer Ventures in New York.

Another inevitable trend that comes with this type of frenzied market: Herd mentality. Investors become so enamored with owning a piece of a particular space that they're willing to forgo some of the strict due diligence required to determine if all the pieces of the startup puzzle -- an innovative idea, capable management, a solid customer base, growing revenues -- are in place.

"Venture investors may have missed out on the first investment, so they're trying to get into the second," Jeffrey Sohl, director of the Center for Venture Research at the University of New Hampshire recently told TheStreet. "They think everything could be the next Google ( GOOG)."

Take the daily coupon space, where Groupon and No 1. rival LivingSocial rule 90% of the market. With huge financial backers, a global presence and deep traction in local markets, it can be argued that both firms are poised to offer investors a nice return.

Prospects for many of the 322 other daily coupon sites -- the smaller, nichier sites riding Groupon's coattails that investors have poured $175 million total into -- could be more dim, say analysts.

There's also Color, a newcomer to the photo-sharing app space. Color faces a formidable wall of competition by already-entrenched upstarts like Instagram, Path and Picplz, all which boast thousands of users and downloads. Although it hasn't yet launched a solid product -- its initial version has a two-star rating in Apple's App Store and its Android version was pulled shortly after its debut -- Color has received the most funding in the sector, raising $41 million in March during its initial round.

Color also stands out an anomaly in a venture market where many start-ups can easily attract initial funding but struggle with raising capital in follow-up rounds.

"We call it a 'traffic jam' on Sand Hill Road because seeds have been given but later stage funding might not come for certain companies," said Sergio Monsalve, a principal at Norwest Venture Partners in Palo Alto, Calif. "Only great teams that have gotten traction will get the full funding to become operational."

The same goes with IPOs; it's unlikely that this surge in early-stage funding will negatively impact the quality of companies hitting the public markets, said Foundation Capital's Holland.

"If early stage investors 'overfund' the category, then the vast majority of those companies will be weeded out by the market before they can go public," he said.

And despite the potentially harmful effects of investor frenzy in the Internet space, most remain optimistic that this influx of capital has led to innovation that otherwise wouldn't have taken place.

"This is Florence in the 1450s," said Steve Blank, who teaches entrepreneurship at the University of California, Berkeley and Stanford University. "We're going through a renaissance and a revolution at the same time."

--Written by Olivia Oran in New York.

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