Investors beware: is the new dotcom bubble going to burst?

As ever, Warren Buffett puts it best. "If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy," he says. And in bubble 2.0, just like the first dotcom boom and bust more than a decade ago, the world's most famous investor is staying on the sidelines rather then risk being made the patsy.

Not that investors in LinkedIn, the social networking site for professionals, are in any mood to listen to such warnings. After seeing its share price more than double on its US stock market debut on Thursday, its founder, Reid Hoffman, might have expected to see his $2.4bn (£1.47bn) stake take a reality check yesterday, and by the closing bell the shares had fallen slightly by 1.2 per cent.

For those old enough to remember the heady years of the late nineties – when many of today's young technology entrepreneurs were still in short trousers – the stock market's new-found fascination with social networking and all-things internet prompts a weary sense of déjà vu. In Britain, dotcom mania peaked, remarkably neatly, on the final day of the last century, after a boom that saw technology stocks more than double in 1999 alone. The US Nasdaq index struggled on until March 2000, having registered similarly impressive returns. Their fall was equally dramatic, with technology stocks having given up all their gains – and more – within two years, prompting a wider stock market crash.

The stories that stick in the mind from that period include the likes of Boo.com, which went bust within 18 months of raising £100m from investors. But for each of the launches that crashed and burned, there were many more dotcoms whose investors simply over-estimated the potential to make money. And it is these examples that investors forget when they point out that today's red-hot technology companies do have some sales.

"During bubbles, investors stop valuing companies based on fundamentals and instead invest based on the expectation that prices will continue to rise and 'greater fools' will buy from them at a higher price – this process is unsustainable which is why bubbles eventually pop," says technology blogger Chris Dixon. "But when the economic fundamentals are strong, the last buyer can always hold on to the asset and collect a return through the asset's cash flows."

This is true, of course, but it may be a long time before that cash repays the original investment. To give you an idea of what these companies might really be worth, LinkedIn's value at the end of its first day of trading was roughly equal to the value of Sainsbury's. The British supermarket chain had sales of almost £23bn last year. LinkedIn managed just over £150m.

Zynga, the gaming company now attracting similar valuations, is more credible, with sales of $850m last year. But experts are not convinced. "I am sorry but when Zynga is worth $10bn something is a bit strange," says Alexandre de Rochefort of the video games maker Gameloft. "If this is not a bubble, I don't know what is."

In a bubble, curious phenomena develop – like the "acq-hire", a Silicon Valley trend that has seen firms such as Facebook buy a string of internet start-ups at heady valuations just to acquire the skills of those behind them. The start-ups themselves are then closed or left to stagnate: when everyone wants to be the next Mark Zuckerberg, Zuckerberg himself knows he has to buy the best people out.

"This time will be different" is the thought with which investors almost always console themselves. In the first dotcom bubble, the thesis was that the broadband revolution would constitute a "new paradigm", producing growth rates previously unimaginable. This time around, the social networking phenomenon is the justification.

The problem is that while new technology can create fantastic opportunities, they are finite. "If every penny of advertising in the world came to Silicon Valley", says technology blogger Rick Webb, "out of these thousands of new start-ups, there would only be nine Googles."

There will be some winners in the latest technology boom, but picking them is going to be harder than people think. And there will be many more losers. Who knows when the bubble will pop? LinkedIn's trajectory may yet be eclipsed by those that follow it, Facebook in particular. Or this might be a high water mark: Renren, the Chinese social networking site that floated this month on even more outrageous valuations than we have seen in the West, is already 20 per cent down.

"When I look at where we are right now, it reminds me so much of 1999 and frankly it scares me," says one venture capital investor active in the technology sector. "But we are not pulling back." Why not? Well, one reason is that no one wants to miss out while the bubble inflates. Another is that in this internet bubble, so far at least, the patsies are only just arriving – few companies have yet offered their shares to the investing public. Where they have done, though, there is some evidence that the smart money is getting out: Goldman Sachs sold its entire LinkedIn holding this week.

This flotation has fired the gun on the race to cash in before it's too late. "There is a lot in the pipeline," says Ryan Jacob, manager of the Jacob Internet Fund. "We expect to see a continuation of this for the next six to 12 months before the grand finale of Facebook going public."

Fine. But remember the fable of the Emperor's New Clothes, or Britain's South Sea Bubble of 1720, in which one entrepreneur famously raised a fortune for "a company for carrying out an undertaking of great advantage, but nobody to know what it is". New paradigms come and go, but some things never change.

How it affects London's 'silicon scene'

*Silicon Valley is the place where investors are most likely to invest big money in high-risk internet start-ups, but Britain is by no means immune to this new wave of optimism, and more importantly, money.

"The first question you get is, 'How are you doing in the States?'," said Bruce Akhurst, commercial director at Audioboo – a small British company that allows users to upload audio files to the web.

The $11bn valuation of LinkedIn "gives everyone grounds for optimism," he added.

"I think it will be one of the biggest growth industries of the next few years," said Joshua March, the CEO and co-founder of Conversocial. "Seeing a multi-billion dollar business like Facebook certainly helps as well," he said, adding that many companies like his own will be announcing some large investment soon.

While the internet start-up scene in the UK is relatively niche in comparison to the US, large-scale investment in British companies is already underway, according to Ian Maude, an analyst at Enders. "There are lots of early stage investments going in right now. There are more investors around and lots of competition," he said. "The question is, when will the money dry up, and what will happen as a result?"

Richard Hall

The new internet stars

LinkedIn (floated)

Founder Reid Hoffman, the serial investor.

What is it? The site that takes the 'social' out of social networking – a place for professionals and businesses to interact. LinkedIn is the first pure social networking site to go public, hence the astronomical price-tag.

Value: $11bn

Turnover in 2010: $243m

Groupon

Founder Andrew Mason – bargain hunter with an interest in politics.

What is it? The source of money-off vouchers for every product and service you care to think of. It has grown quickly and already has a big international presence. IPO announcement is thought to be imminent.

Projected value: $15bn. Turned down $6bn bid from Google this year

Turnover in 2010: $760m

Zynga

Founder Mark Pincus the entrepreneur who turned us all into farmers.

What is it? The producer of games such as Farmville for social networking sites including Facebook. A float could be announced as soon as November.

Projected value: $10bn

Turnover in 2010: $850m (estimated)

Facebook

Founder Mark Zuckerberg – the college dropout who wants us to share.

What is it? Not the original social networking site or necessarily even the best, but Facebook has ruthlessly bulldozed its way to world domination. When Goldman Sachs sought investors for a $500m fund raising for the company earlier this year, it was inundated. During that exercise, Facebook said it would float next year.

Projected value: $50bn

Turnover in 2010: $2bn (estimated)

Twitter

Founder Jack Dorsey– the software architect and innovator.

What is it? A chance to share your thoughts with the world in 140 characters or less – as 200 million users already do. A fund-raising last year valued Twitter at $3.7bn, but since then both Google and Facebook have been linked with a bid for the company, sending its value soaring. If no offer materialises, an IPO is likely next year.

Projected value: up to $10bn.

Turnover in 2010: $45m (estimated)

Yelp

Founder Jeremy Stoppelman, Russel Simmons – software engineers and friends turned business partners.

What is it? A social networking site that allows users to search for and review local businesses and services. Yelp's co-founder Jeremy Stoppelman announced in late April that the company would go public, but did not say when. Google and Yahoo are both said to have made offers of around $500m.

Projected value: $500m

Turnover in 2010: $50m (estimated)