Network World — It may seem like the worst of times for tech companies trying to secure investments from venture capital firms, but the darkest days may be yet to come, says longtime venture capitalist Michael Fitzgerald.

When asked if the VC industry has hit bottom yet, Fitzgerald replies, “I would say no.”

10 Biggest Network Venture Capital Deals From Q2

The venture industry is going to “shrink dramatically” over the next three to five years, contends Fitzgerald, founder and managing general partner of Commonwealth Capital Ventures in Massachusetts. “There’s going to be a lot less capital out there,” he says.

Through the first two quarters of this year, U.S. venture capitalists have invested $6.9 billion, bringing the industry down to levels seen in 1996 and 1997, according to the MoneyTree Report from PricewaterhouseCoopers LLP (PwC) and the National Venture Capital Association (NVCA). MoneyTree Report authors predicted a “gradual increase in investment” through the rest of the year, so Fitzgerald's view isn’t shared by all venture capitalists.

But VCs are hesitant to invest in new companies as returns have decreased significantly in the past decade, Fitzgerald says. Single-digit returns on investment are common these days, whereas before the dot-com crash venture firms routinely racked up double-digit profits and a few funds produced triple-digit returns, he says.

The dot-com crash and current recession have done their share in slashing available venture funds, but Fitzgerald, who has more than 20 years experience investing in early stage companies, argues that there is still too much venture cash available. Shrinking the pool of available funds will ensure that only the most worthy companies receive funding, and prevent niche markets from being flooded with too many vendors, he said.

“Generally speaking there's way too much money in the business,” Fitzgerald says. “It's always healthier when it's a much smaller business.”

Going forward, startups will have to be lean and mean, and “may need to start the company on seed capital or no capital,” he says.

Venture cash invested in Internet companies recently took a nosedive, but Fitzgerald remains confident in the software-as-a-service business model and says that market will drive many new investments. SaaS, the sale of Web-based business applications, offers clear cost benefits compared to business models that require sale of large, expensive software or hardware packages, he says.

“The enterprise software model is under a lot of pressure,” Fitzgerald says. “If you’re selling a big-ticket item, the only way to get that to market is with a direct sales force, and that sales force is hugely expensive to build and maintain.”

While venture capitalists may invest big in software-as-a-service companies, they won’t necessarily swoon over cloud infrastructure ventures, the kind that need massive data centers to deliver raw computing, storage and network services over the Internet, he says.

“The VC community doesn’t have the capacity to take on a capital equipment project that's as expensive as these cloud computing facilities are eventually going to look like,” Fitzgerald says. “You’re going to see those things put together by very large companies, like IBM, Google, Oracle, Amazon and Microsoft.”

Follow Jon Brodkin on Twitter: www.twitter.com/jbrodkin.