Venture Capital 2010: Hot (and cold) sectors to watch

(Editor’s note: Steve Fredrick and Don Rainey are general partners at Grotech Ventures. They submitted this story to VentureBeat.)

As we mentioned in a recent column, 2009 wasn’t as bad as advertised for the venture capital industry. The first half of the year was rocky; however, growth stormed back in the latter half of 2009. The 2010 IPO and M&A markets are shaping up to be the strongest in years and early- and mid-stage venture capital firms with cash have good reason to be optimistic.

Normal consolidation occurred in our industry this year. A number of prominent firms went quiet or declined to raise new funds. As the capital markets thaw a bit more in the coming months, we expect the strongest of these firms to reemerge, though probably in scaled-down fashions. Others will manage their current investments to fruition and new funds and models will be born.

2010 should be the ultimate buyers’ market for investors with cash to spend because entrepreneurs who tightened their belts last year cannot do so indefinitely. In early 2010, many will begin looking for funding to grow and continue operations. We expect these companies to come out lean, mean and with ramping revenue.

The improving exit markets will increase confidence and appetite for risk, which is a necessary ingredient for startup prosperity. Also, the recession has encouraged a substantial amount of innovation from otherwise unemployed entrepreneurs. VCs with good reputations and cash on hand will have plenty of prime cuts to choose from in 2010.

The best time to buy is when confidence in the economy is growing, but prices are still low. The trick is hitting that timing on the nose. The few big names will continue recent acquisition sprees, but we also expect mid-sized companies to look to M&A as a strong option for growth in 2010. The pace of private-to-private mergers amongst venture-backed companies will also increase.

A leading indicator of activity in the venture-backed ecosystem is job creation. There are more than 10,000 job openings at venture-backed companies listed on StartUpHire.com (disclosure: Steve is an advisor to StartUpHire). So, while companies have tightened their belts, they continue to hire at a meaningful level and nothing shouts confidence in the future like rapid team building.

In terms of hot 2010 sectors, we expect social media to move from promising to prime time. This category, especially sites like Twitter, Facebook and LinkedIn, has already gained a strong foothold in the global consciousness. But despite this progress, there are still many questions about how to monetize the conversational and real-time nature of social media.

We expect social media to move towards profitability in 2010. One of the biggest measures of success will be enabling people and companies to work more collaboratively and more efficiently.

We also expect to see more money flow to the cloud in 2010. Cloud computing (and other operations) provides startups with an operational trifecta: cost savings, infrastructure savings and productivity enhancement. To date, many companies have been reluctant to move into this space because of security concerns, but these fears are rapidly easing as security offerings mature to address this risk.

One formerly hot area that we expect to fizzle in 2010 is the prosumer technology space. Users expect mobile devices to be great at specific tasks, rather than serving every need in a marginal fashion.

The quintessential example is the iPhone. While it achieved phenomenal market acceptance in 2009, professional use is stymied by a lack of reliable nationwide coverage and the challenge of email integration at many enterprises. Competitors are taking note and the re-separation of consumer and professional devices is coming. This will have a trickle-down effect on the plethora of startup companies developing for the iPhone and competitive platforms.

The freemium model is also worth watching. While it works in some sectors, overall, the gap between free and paying customers is widening. This is happening because buyers can be very fickle. As their attention spans shorten, their brand loyalty diminishes as well.

In the mobile space, for instance, a game or app that’s hot today can easily be forgotten tomorrow. Users have little or no incentive to upgrade, so they just move on to the next trendy, free offering. Providers must innovate at an incredibly rapid pace in order to keep pace with market demand. But they can’t be careless – offerings must be thoroughly tested before they go public, since most people won’t give something a second chance if they’re unhappy the first time. And these providers must have a clear and compelling upgrade path to entice a larger percentage of paying customers.

While 2009 was a bumpy ride, we are eagerly anticipating the opportunities that await in 2010. We expect to see many significant deals early in the New Year across many different sectors, and we are heartened by the brave souls who are moving towards IPOs.

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Tags: 2010 lookahead, Venture Capital