• by Mark Walsh  @markfwal, February 2, 2010

Look out, Madison Avenue -- venture capital investors are happily underwriting your extinction. Ian Sigalow, a principal at Greycroft Partners, said "agency replacement software" is one of the key investment areas the firm is focused on this year.

"Companies have agencies for public relations, buying media and planning marketing campaigns," noted Sigalow, speaking at a venture capital panel on digital content at the OnMedia NYC conference Tuesday. "We're looking at companies that let them do these agency services in-house."

Greycroft invests in a range of companies in the digital media and advertising space including social media ad company Buddy Media, online survey service United Sample, social app analytics provider Sometrics, and content distribution service ImageSpan. Huffington Post is also among its portfolio companies.

Sigalow maintained that not only corporations, but smaller companies will increasingly take on traditional agency functions with "lighter weight tools" made by these startups and others. To the extent that agencies can acquire these companies, of course, they can try to stave off disintermediation while providing venture capital firms an exit strategy for their investments.

But VCs gathered on the panel expressed little optimism about the M&A market as a way for startups to cash in. After getting burned by acquisitions that ended in failure in recent years, big media companies especially are reluctant to spend on snapping up digital upstarts. "Anything over $100 million they're just not going to touch," said Warren Lee, a venture partner at Canaan Partners. "For startups, they can't assume they're going to get acquired in the next couple of years."

Last month, PricewaterhouseCoopers reported that overall venture capital investment in 2009 dropped to $17.7 billion, its lowest level in more than a decade. Funding of Internet-focused companies dropped nearly 40% -- to $2.9 billion in 629 deals from $4.8 billion in 902 deals in 2008.

The outlook for 2010 doesn't look much brighter. While other panelists weren't as specific as Sigalow about their investment focus, they collectively expressed interest in businesses that can take online user data and slice and dice it for marketers and publishers. "The big challenge is 'how do you take the massive fragmentation and massive data sets and all the ways people are interacting online and pull that together for advertisers?'" said Amish Jani, managing director at FirstMark Capital.

And Glam Media -- which Tuesday announced securing $50 million in a mezzanine financing led by Aeris Capital and prior investors, including Burda Digital Holding and Mizuno Capital -- has raised a total of $130 million to date by aggregating a network of more than 500 lifestyle sites and blogs to quickly become one of the Web's most trafficked properties.

Companies that can apply sophisticated targeting and tracking technology to social networks and other user-generated forums to help unlock ad spending stand to gain. "There is a huge amount of content but the understanding of how content performs and how users interact with it is still rudimentary," said Lee, whose firm has invested in Internet companies including Associated Content, AllBusiness, Match.com and Peer39.

Venrock's David Pakman said one model his firm isn't buying into is the build-it-and-they-will-come plan. "We're not investing in the humongo audience, no business model -- but don't worry, we'll figure it out," he said. Seems to be working pretty well for Facebook.