Venture capital shrivels 40 percent — It really is the end of the tech boom

There’s no mistaking it. The richest era of internet boom, the early part of what has been called the “greatest creation of legal wealth in the history of mankind,” has played itself out.

Today’s data, which shows that investment into U.S. venture capital firms dropped 40 percent in the first quarter, compared to a year ago, is just the latest sign.

Silicon Valley, and its great technology prowess, is now settling into a era of continued innovation, albeit with financial rewards much more modest than most of us have come to expect. At least, unless some unforeseen amazing technology trend emerges that we can’t possibly imagine right now.

The valley’s decline is only news to those who were still holding out hope — the large number of valley folks still desperately dreaming of hitting the Internet jackpot. After the big Internet bubble burst in 2000, Google emerged from the ashes, and in 2004 unleashed one of the biggest most successful IPOs in history. With hundreds of new millionaires freshly minted, these believers thought Silicon Valley was off to the races again. The hope held out through late last year — in part because Web 2.0 was a giant head-fake. YouTube entranced us with a $1.6 billion exit, and Facebook continued the seduction with a purported $15 billion valuation from Microsoft. But the financial performances of these and other Web 2.0 companies have vastly undershot initial expectations. The revival is just not coming.

Let’s look closely at the evidence. The number public companies here in Silicon Valley — ground zero for the U.S. technology juggernaut — has dropped significantly over the last decade. In fact, it has fallen for eight straight years, and stands at 261. That’s below the 315 the valley had in 1994, when the local newspaper, the San Jose Mercury News, itself a tiny semblance of its former heft, started keeping track. The overall public valuation of these companies is also atrophying. If you look at the top 150 companies in Silicon Valley, their value has dropped 32 percent for the year ending March 31, the Mercury News also reported over the weekend. And few companies have emerged to go public to change this: Only 90 IPOs happened in the valley between 2001 and 2008, compared to 331 between 1990 and 1998.

Venture capital firms are shutting up shop too (see our very long list of walking dead VC firms, just recently published), now that investors realize the goldrush era of technology prospecting is over. The latest evidence was in this morning’s data from the National Venture Capital Association and Thomson Reuters: Investors placed $4.3 billion into just 40 venture capital funds in the first quarter, down from $7.1 billion in 71 funds in the same quarter a year ago. It’s the fewest number of funds backed since 2003. (Though the year-over-year drop is smaller than the one seen during the last three months of 2008.)

True, the financial meltdown has played a role in the decline in funding and local company fortunes. But if you step back, you’ll see there really is no massive, fundamental value creation going any more like there was in computer and Internet revolutions of the 1980s and 1990s. When the valley’s best known venture capitalist John Doerr (pictured here) proclaimed during the late 1990s that the Internet was creating the greatest legal wealth in history, it was true. His firm, Kleiner Perkins, was behind scores of investments into companies that built out the Internet backbone as we know it. From server company Sun, to networking companies Siara and Cerent, to router companies like Juniper Networks, and then search giant Google — each of these companies produced billions in wealth. Kleiner made billions of dollars in profit from them. Other firms like Sequoia made billions from similar investments, such as Cisco, the big router company and in early computer companies like Apple. Entrepreneurs and employees everywhere benefited too. Everyone was winning. That’s no longer the case.

As the Internet build-out has diffused through the rest of the economy, the massive amounts of money is no longer there to be made, and we’re seeing a different kind of valley emerge. The technologist fervor here in the valley remains as strong as ever. We see entrepreneur’s starting new companies all the time, but they’re just not creating as much value as quickly as they once did. The bonanza days are over, and it’s back to eking out an honest living, smaller, cheaper bets with more modest results. We’re seeing consolidation too: Database software giant Oracle years ago saw it growth slowing significantly, but it has achieved revenue through consolidation. We’re witnessing the same in other sectors, and we’re probably see the same in digital media over the course of this year (more on that in another post). Meantime, the innovations that do happen are creating more efficiencies, sometimes sucking out value from elsewhere. The hit from 2007 was VMWare, when it led a wave of “virtualization” technology, making servers more efficient in corporate data center. That means incumbent servers are too costly, and companies like Sun are struggling. And over 2008 and this year, the innovation is on the mobile phone and in the emergence of cheaper, smaller computing devices known as netbooks.

But in both cases, the new players (Apple with the iPhone and the string of Asian netbook manufacturers) are upending existing players by driving costs down (Dell and HP, for example, which depend on existing computer sales). While Apple creates wealth for itself, which is good, the other winners are the hundreds of developers building applications for it. But their riches are distributed globally, and in much smaller amounts.

And now the number VC firms are shriveling. We’re returning to a bootstrapped model, and to hope that something dynamic will take the place of that good old Internet boom. The VC industry believes the next new thing is clean technology. That may be the case. There’s a trillion dollar energy market that is ripe for disruption. You’re seeing government policies helping encourage investment in alternative energy. Solar companies, new electric car companies, and wind and other efficiency-related companies are proliferating. But for now, the sort of localized massive wealth creation we saw in the 1990s just isn’t coming back, and we’ll just have to get over it.