As industry leaders meet this week at the third annual Web 2.0 Conference, the internet sector faces rotund challenges and exciting opportunities.

The event, considered the ultimate conclave of internet movers and shakers, will be held in San Francisco from Tuesday to Thursday at a critical time for the web. Depending on how internet executives and investors play their cards in the next 12 months, the internet economy will either continue its rehabilitation or end up punch drunk and enveloped in a bursting bubble.

Opportunities to extend the success of the past four years are plentiful, experts say. Popular Web 2.0 services like wikis, blogs, podcasting, social networking, content syndication, tagging, application mashups, video sharing and social bookmarking can be enhanced. They can also be adapted for mobile devices, the enterprise market and for international audiences. The key, in all cases, is for entrepreneurs to aim for products and services that don't mimic what already exists.

"The danger entrepreneurs have to worry about is that their companies need to be Web 2.0 and not Web 1.1," says Munjal Shah, co-founder and CEO of Riya, which was founded in 2004 and runs an image search engine. Riya, which will be at Web 2.0, has attracted much attention because its search engine is based on image processing and recognition, instead of on indexing of photos' text metadata.

A common mistake entrepreneurs are making is developing a set of cool features that don't add up to a sustainable service, says Eric Chin, a partner at early-stage venture capital firm Bay Partners. This is a recent phenomenon, enabled by the low costs of hardware, software and bandwidth required to launch an internet company, Chin says. This low-entry barrier is crowding the internet market, and creating potential problems.

"A lot of people are jumping into the internet space and investing in it aggressively, so you're seeing companies getting funded that maybe shouldn't be getting funded. This is creating a hyper and unhealthy environment," says Chin, who also will attend the show.

If a lot of investors start bidding for a small number of very hot startups that can't justify the amount being invested in them, chaos could ensue, warns an analyst. "The concern now is that with so much money being thrown around, we might be looking at another dot-com catastrophe in a year or so if the market becomes overheated," says Rob Enderle of Enderle Group. If that happens and investors again retreat from the internet sector, innovation will suffer, Enderle says.

For now, Bay Partners' Chin sees big opportunities in what he calls "individual self expression" websites like Linden Research's Second Life, whose users are willing to pay to create virtual identities. Chin also likes companies that are using the internet to aggregate providers of services, while lowering the services' cost to clients and increasing the margins for providers.

There is also good business in the less sexy side of Web 2.0, like infrastructure, says Michael Gordon, chief strategy officer and co-founder of Limelight Networks. His company, founded five years ago and profitable for the past three, offers a content delivery network for distributing video, music and games. With clients like Amazon, RealNetworks and Microsoft, Limelight is expected to increase its revenue 200 per cent this year over last year to over $60 million, Gordon says.

Another area that offers an opportunity to innovate and solve a pressing need is in the control of spam in blogs and social networks, says Toni Schneider, CEO of Automattic. Spam can overrun these sites and ruin them. "Just like spam threatened to make email useless, the biggest threat facing Web 2.0 is spam," says Schneider, whose company makes the Wordpress blogging software and the Akismet blog spam-filtering service.

Various areas of vertical search, as well as next-generation ad networks are ripe with opportunity, says Jeff Crowe, general partner at Norwest Venture Partners, a venture capital firm. Industry analyst Greg Sterling of Sterling Market Intelligence says mobile Web 2.0 services will rock the market. "Mobile is the next big thing that will be disruptive and unleash innovation," Sterling says. "It's the next big opportunity."

Ultimately, what will keep Web 2.0 on track and prevent it from derailing is a vigorous culture of innovation, which could suffer if big companies start buying startups without rhyme or reason and then, not knowing what to do with them, stifle their innovative spirit, experts say. Another danger to innovation could come from a glut of startups that confuse investors and users, so that companies with truly good ideas get lost in the shuffle.

Venture capitalists investing in internet companies say that in the past 18 to 24 months, they have seen a steady increase in the number of entrepreneurs knocking on their doors. "There's a real heavy flow of Web 2.0 companies out there looking to raise funds right now," says Crowe. The consensus from venture capitalists is that while it's good to have a larger pool to pick from, it's also more challenging to evaluate all the hopefuls.

As the CEOs of Google, AOL, IAC/InterActive, Amazon, The New York Times and Adobe, along with noted Wall Street analysts, participate in the Web 2.0 Conference, they must not forget that it was a group of truly ingenious entrepreneurs who, through sheer force of will and smarts, slowly lit up the long night that followed the internet crash and brought the Web 2.0 dawn that everyone now enjoys.