Good Technology Is Nice; A Good Idea Is Better

It has never been easier to start an Internet company. Create a Web site, begin a "viral" marketing campaign to grow word-of-mouth and acquire an audience, garner some ad revenues, generate venture capital funding and sell out to a Web giant such as Yahoo! or Google. Startup costs can be minimized by using standard technology and by outsourcing corporate functions, such as advertising sales. The business model, at least initially, is optional.

This blueprint is becoming increasingly common among so-called "Web 2.0" companies--Web-based communities that facilitate collaboration and sharing. Companies like Facebook, the fast-growing social networking site, and Twitter, a popular mobile messaging service, didn't introduce breakthrough technologies, but they have become phenomenal success stories nonetheless.

According to Wharton faculty and other experts, these companies have altered the traditional venture capital formula, which used to count technology differentiation as a key requirement for Web companies. In many cases, technology has become a commodity, and a big idea can go a long way, provided there's a rapidly growing audience.

Wharton management professor David Hsu says that in today's venture capital environment, ideas are valued more highly than innovative technology. "Is it the technology or the idea that matters? With the new round of companies founded in the last few years, both are viable. The barriers to entry have been lowered. I can grab technology off the shelf if I have a good idea."

"It is much cheaper to get a Web 2.0-based company off the ground and running," says Jeffrey Babin, a lecturer in engineering entrepreneurship at the University of Pennsylvania. "The entrepreneur doesn't need as much money, so he can do a lot more bootstrapping. He can build more value before even going to a VC."

New companies face risks in this kind of environment, however: If they are successful, firms may not be able to defend themselves against the myriad competitors that will inevitably spring up around them, Hsu notes.

For now, the VC funding keeps rolling in. PriceWaterhouseCoopers' Money Tree survey revealed that first-quarter venture funding was $7.1 billion, the highest level since the fourth quarter of 2001. Of that sum, Internet-specific companies garnered $1.3 billion, the highest level in five years.

While the initial public offering market has been difficult in recent years, buyouts are prevalent. In 2005, News Corp. (nyse: NWS - news - people ) bought social networking site MySpace for $580 million. Yahoo! (nasdaq: YHOO - news - people ) purchased del.icio.us and Flickr. Google (nasdaq: GOOG - news - people ) acquired YouTube for $1.65 billion in 2006. In May, CBS (nyse: CBS - news - people ) acquired Internet radio and social music platform Last.fm for $280 million. On August 2, Disney (nyse: DIS - news - people ) bought Club Penguin, a virtual world for children, for $350 million.

Those deals are just a few among a bevy of recent acquisitions. Meanwhile, Facebook could be worth anywhere from $4 billion to $10 billion depending on the Wall Street analyst crunching the numbers.

Wharton management professor Gary Dushnitsky says there is an excess of liquidity--not only from VCs, but hedge funds and private equity firms--looking for a home. "The financing market has changed a great deal," he says. "There used to be a few dozen venture capital players. Now there's pressure from hundreds of private equity firms encroaching on VCs. The VCs feel more pressure among stages of investment. This money has to be invested or returned."

But as VC firms look for new targets, several questions come into play: How should companies be evaluated when they rely on technology that is easily replicated? How much value does a big audience carry? What's the preferred exit strategy?

"Advances in information and communications technology have opened up innovation in processes, products and services. There is a vast array of opportunities. How many of these will stick remains to be seen," says Raffi Amit, a management professor at Wharton.

Looking for Viral Growth

Amit says an evaluation of any company's prospects starts with the track record of its founders and management team. For instance, Joost--which promises next-generation television service via the Web--has been able to attract funding because its founders, Janus Friis and Niklas Zennstrom, also co-founded Skype, which was sold to eBay (nasdaq: EBAY - news - people ) for $2.6 billion in 2005. Joost raised $45 million in venture capital in May.