The calls for tough government regulation designed to protect the privacy of internet users are getting stronger in the United States. But could there be unintended fallout if regulations are implemented?

Jeremy Liew, a managing partner at VC firm Lightspeed Venture Partners, thinks so. In his opinion, the impact of the level of regulation that is being demanded “would be enormous for companies relying on online advertising“.

In a blog post, he suggests that restrictions on behavioral targeting will make it harder for ad networks and online publishers to monetize.

Now I’m no fan of overzealous government regulation. In general, I think such regulation ends up hurting businesses and consumers. When it comes to online privacy, however, it’s not hard to understand why proponents of regulation find support: companies are amassing large amounts of valuable data about individuals online, most of the time without their express knowledge.

It’s safe to say that the average internet user does not know what data is being collected by whom, how it’s being used and what he or she can do to opt-out. Most internet users don’t read privacy policies, many privacy policies are vague and most don’t even name the third party entities that may be collecting data. Given all this, it’s hard to make the case that the average consumer has the ability to easily protect his or her privacy online.

If there’s a regulation smackdown on internet advertising, you can be sure it will be based in large part on this fact. But Liew is correct in noting that this will have an impact on the internet economy. Ad networks, online publishers and various other online startups will find it harder to monetize with advertising.

Inevitably, it will be the smaller players that get hit the hardest. When it comes to online publishers, for instance, large properties with endemic advertisers will be hurt far less than smaller properties that can only move their inventory through ad networks that rely on behavioral targeting, retargeting, etc.

It does occur to me, however, that many components of this discussion are red herrings. First, it’s not exactly proven that many of the targeting technologies that are in use today really deliver much. I for one am largely skeptical of many of the claims made about behavioral targeting; a reasonable conclusion is that it works some of the time. Second, as we’ve seen over the past decade, advertising as a business model isn’t exactly a guarantee of success. Plenty of ad-supported internet businesses have gone under and the renewed focus on paid content in many markets is a testament to the fact that advertising isn’t the panacea of business models that it can appear to be when times are good.

In reality, there’s probably little that can be done to stop the regulation train. Smart startups should hope for the best and plan for the worst. That means working to build direct relationships with advertisers. And it also means looking carefully at whether advertising is an ideal business model.

Photo credit: dierken via Flickr.