Silicon Valley startups saw high valuations in Q2. Will the good times last?

A new report shows startup valuations increasing at pre-2008 levels — but can these soaring numbers weather the recent market instability?

The most recent Silicon Valley Venture Capital Survey from tech-focused law firm Fenwick & West looked at 117 Silicon Valley-based technology and life sciences companies that took funding in the second quarter of 2011.

During this time period, the firm tracked “up rounds” (in which the company receiving funding takes the money at a higher valuation than it got during its last round) and “down rounds” (pretty much the opposite: taking money at a lower valuation). Fenwick & West found that 61 percent of funding deals were up rounds, compared to 25 percent down rounds and 14 percent at unchanged valuations.

Q2 2011 marks the eighth consecutive quarter that saw more up rounds than down rounds; in other words, for the past couple years and for many venture capitalists, confidence in startups’ revenue-generating potential has been creeping back toward pre-recession levels.

However, Q3 saw some rapid deterioration in global markets that raised red flags for many investors.

“A lot of people right now have a wait-and-see attitude,” said Barry Kramer, a partner at Fenwick & West, in an interview with VentureBeat.

“I think if you’re a late-stage VC looking to invest in a company you thought would IPO in the near future at a high valuation, you probably want to pause for a minute. Clearly there’s a lot of turbulence. If you’re an earlier stage investor, I don’t think it has an immediate effect on you. You’re investing for five or more years out, so what’s going on today is less relevant.”

Kramer continued to say that the market fluctuations “may have a depressing effect on valuations, which are more dependent on what the market is doing right now. But it’s still early. We’ve seen this volatility for the past month. It might stabilize, or it might change.”

Fenwick & West also measured the changes in share price from round to round for the same group of companies. The firm found that on average, share price increased 71 percent. This represents a 19 percentage point jump from last quarter’s results and is the highest increase since 2007.

The startups leading the pack in terms of valuation performance were mostly in the software, software as a service, Internet and digital media sectors.

In fact, deals for these kinds of startups (consumer-facing web apps and software companies) were a sweet spot for investment overall in the first half of 2011, according to a comprehensive funding report from Dow Jones.

Still, many Silicon Valley investors think the robust deal activity and higher valuations may be indicators of a bubble. Another report from the Silicon Valley Venture Capitalist Confidence Index showed a slump in investor confidence for Q2 2011. One polled VC even stated, “2011 will be remembered as the year that everyone went nuts and overpaid — $1B is the new $100M valuation. For most, this will end in tears.”

Fenwick & West partner Michael Patrick stated in a release that current market fluctuations may also have some negative effects on investments in the coming quarter. “Q3 has started out very turbulently with a falling NASDAQ, financial market volatility and IPOs being postponed. The effect of all this on the venture market bears watching and is a cause for concern.”

The IPO delays Patrick referred to include a record number of setbacks last week, when around 13 IPOs were put off due to unfavorable market activity. But, as Renaissance Capital’s Paul Bard said at the time, “Investors are looking for unique companies that are capable of growing through all kinds of market conditions and that have a product that is gaining significant traction… We don’t know how much froth has been taken out of the Internet market.”

“There’s certainly concern about [a bubble], but I think the first concern is about worldwide financial stability, which truly has nothing to with Silicon Valley,” Kramer responded. “There was the trouble in Congress, gold’s going through the roof… There’s certainly a concern about a valuation bubble in the internet space, but I’d bet the global market is giving us more pause right now.”

Kramer continued to say that tech, which keeps consumers entertained and can help companies and other organizations save money, is likely not in for a dotcom-style beating if global markets do take a dive.

“While no industry right now is in for a really great time, I don’t thing tech is going to be the first thing to get hit. Governments have to reduce their spending. Industries that are dependent on government spending are a problem — tax breaks for cleantech, NIH funding for life sciences, military contracts for defense companies, those are areas that will have a problem.

“Corporate America is going to cut back on spending, too, and that means advertising. The startups that are focused on consumer-facing and making their money off ads are going to have a problem.”

However, Kramer ended our chat with an interesting and applicable observation on Internet companies that charge users little and give them a lot of value in return — think Hulu Plus, Netflix or Zynga. “In recessions,” Kramer said, “the sale of margarine goes up. It’s cheaper than butter, and butter sales go down. So some of these companies are like margarine. They’re cheap, they provide entertainment. The beauty of business is there are some companies that can ride it out better than others.”