Watching the latest inflationary hype-value cycle taking place in the Valley, I find myself feeling that we’ve all gone nuts… again. The folks at Path saying no to a $100m buy-out from Google might be the high water event… Time will tell whether or not they’ve pulled a Digg/Thelma & Louise.

In my repeated private conversations with professional investors, reporters, big company execs, and entrepreneurs, everyone acknowledges that things are out of whack. Amongst the warning signs are the following:

1. Valuations for early stage companies are way too high for too little value
2. Acquiring companies are throwing out rational valuation models in favor of highly suspect ‘strategic’ models
3. Investors of all stripes are over-competing for deals with less and less diligence
4. “Me-too” ventures are seeking funding in record numbers
5. Founders/Investors are making historically anomalous decisions regarding valuations and passing on 10x exit opportunities.
6. Rationales as to why “it’s different this time” start to circulate. This time: “social/mobile/local (or whatever) is a utility for the new web”.

The Next Two Years Summarized

Here’s what I predict starts to happen in the next 12-24 months when the inevitable exogenous economic variables cause a direct or indirect correction in Silicon Valley valuations. It doesn’t even matter what that economic factor is, but the result will be the same. Fear will cause a retreat from this untethered bullishness, like it always does. The results:

• A large chunk of recently funded startups are not going to get more professional financing. They never should have received money in the first place, so this is good news. The companies fold. The good employees find new jobs or the companies get “acqui-hired” by larger companies. Founders got some great experience and the smart ones will modulate for their next ventures.
• A smaller group of good companies who show market traction will merit subsequent financing, but will have to endure flat rounds.This will be considered a big success just to stay flat… just like it was last time around in the early 2000s. Of course, when liquidation preferences on top of the out-sized dilution are taken into consideration, those rounds won’t really be all that “flat” from a founder/employee perspective.
• A larger group of survivable but not thriving companies will face the difficult situation of taking a down-round in order to continue. Based on how this plays out historically, even when you take that down-round, the founding team and culture of the company will never be the same, and most of these companies statistically fail, anyway. It’s just not pretty.
• Bright spot: The robust angel investing infrastructure of the Valley could play an interesting role this time around in a correcting environment, providing entrepreneurs with a “snap-back” capability that has not historically existed. They are best suited to adapt quickly to new funding signals and team up with founders to give them “cockroach funding” to either keep a good company alive or bootstrap new ideas at sane terms/valuations again.

How can you avoid this pain? The easiest way, which is not available to most folks, is to not take outside funding. But, if you are taking funding, do yourself a favor and don’t overshoot your valuations. Trading up on a never-never paper valuation is worthless in the long run. It just is. Seems hard to believe sometimes, but it’s true. Find sane, adult investors who actually give a shit about you and your long-term non-bubble success(this presupposes that you and your team truly care about long-term success, obviously.) Most importantly, don’t get too greedy… if a big company offers you a lot of money for your young company, really examine that offer in a historical context, NOT your current bubble context. It is always your call, and there’s always more than money at stake, but think hard about this in a grander scheme of things. The good times never last. Fact of life.

A lot of younger entrepreneurs have not seen this “movie” the first time around. Those of us who have owe those who have not the benefit of our prior learning. I’m not convinced this has happened, and that’s a real shame. In that respect, things seem to have changed around here…

[Editor’s Note: Brad O’Neil is the CEO of TechValidate Software, a enterprise marketing content automation company that he  co-founded. This was cross-posted on his personal blog. –mrh]