July/August 2008

Part I: The Business of Social Networks

Can social-networking sites make money?

By Bryant Urstadt

Leah Culver, a cofounder of Pownce Credit: Stan Musilek

Multimedia Timeline of key events in the rise of social-networking sites.

KickApps is an 80-person social-networking startup with its head office in a loftlike space just off Fifth Avenue in New York. In less than two years it has created the underlying structure for more than 20,000 social-networking sites--"mini-Facebooks" with an aggregate of 300 million page views per month. You've probably never heard of it.

KickApps gets a fraction of the press coverage of a giant like Facebook, but its growth has been sufficiently impressive that venture firms like Spark Capital and Prism VentureWorks have backed it with $18 million in startup financing, hoping for the payoff of a monster IPO. Its software allows companies to quickly roll out social networks with many of the features of Facebook or MySpace. Its clients--which include local radio stations and newspapers, national networks like NPR and ABC, and brands like AutoByTel, Harley-Davidson, and Kraft--want to offer fans a place to gather and share their love of a team, a product, or anything else.

KickApps' CEO is Alex Blum, formerly of JumpTV, an online television service specializing in sports. "We have 35 programmers working in this office," says Blum, leading a reporter through a sea of desks and flat-screen monitors, "and we only have two marketing people. We don't really have to sell our product."

Like most of the social-networking sites enjoying huge growth, KickApps is giving its product away, expecting that the communities built around it will generate ad revenues. It's a model that stirs memories of the first Internet bubble: build the user base and hope the money comes--from an IPO, a buyout, or ads. At this point, KickApps does not reveal revenue figures, or even what kind of a cut it is taking from the ads. That, too, brings back memories: staying mum about revenue was always a sign that there wasn't much to talk about.

Many Users, Few Dollars
Social networking is the fastest-growing activity on Web 2.0--the shorthand term for the new user-centered Internet, where everyone publicly modifies everyone else's work, whether it's an encyclopedia entry or a photo album. The growth of social networking is astonishing, and it has spread to sites of all sizes, which are increasingly intertwined as platforms open (see "Who Owns Your Friends?"). Even small players are soaring.

Ning, for example, is similar to KickApps but caters to individuals. Founded in 2004 by Netscape's Marc Andreessen and former Goldman Sachs analyst Gina Bianchini, it has been backed with $104 million in venture capital by a variety of firms, including Legg Mason. "We've got 267,787 sites," boasted Bianchini in May. "And we're adding 1,500 to 2,000 a day." ComScore, a firm that measures Internet usage, reports that the Ning domain, on which all the sites reside, sees three million unique visitors a month.

Meanwhile, Bebo, a social-networking site more popular abroad than in the United States, sees more than 22 million visitors a month. (AOL bought it for $850 million in March.) Club Penguin, a network for kids, sees five million. LinkedIn, a ­business-­networking site, gets nearly five million unique visits.

But that's just the smaller players. Facebook, according to ComScore's latest research, saw 33.9 million unique U.S. visitors in January 2008, nearly double the number from the previous January (but down by about 2 percent from December 2007). MySpace doubled Facebook's numbers again, with nearly 72 million unique visitors in the same month.

Nevertheless, the sites seem largely incapable of generating revenues commensurate with their popularity.

Last year, Microsoft bought a 1.6 percent stake in Facebook for $240 million, giving the company a dubious valuation of $15 billion. But Facebook is likely to lose $150 million this year, according to a January conference call heard by Kara Swisher of All Things Digital, a Wall Street Journal-affiliated site devoted to "news, analysis, and opinion about the digital revolution." That's based on projected earnings--before interest, taxes, depreciation, and amortization--of $50 million and an expected $200 million in capital expenses, including new servers.

Revenues for MySpace parent Fox Interactive Media fell $100 million short of predictions this year, apparently leading to the dismissal of the chief revenue officer. And Google met with disappointment after paying $900 million in 2006 to get a piece of MySpace's traffic, buying the right to deliver ads for three years against keywords entered on the networking site. "I don't think we have the killer best way to advertise and monetize social networks yet," said Google cofounder Sergey Brin in a call with investors after Google announced its fourth-quarter 2007 results.

Ning does not release numbers about ad sales. All Bianchini will say is, "The number of networks we have is our leading indicator." If Ning's experience is anything like MySpace's and Facebook's, its leading indicator just indicates a lot of users.

Lookery, an advertising network that buys ad space on Facebook in bulk, has been reselling that space at 13 cents per thousand times an ad is served, or in ad industry jargon, at a $0.13 cost per mille (CPM). Facebook sets a minimum CPM of $0.15 for its "social ads," which allow advertisers to target ads to Facebook users and groups according to characteristics like location and age. And over the last year, MySpace has lowered its banner-ad rate from a CPM of $3.25 to one of less than $2. By way of comparison, a banner on ­Mashable, a blog covering the world of social networking, has a CPM of $7 to $33, depending on its size. Websites with clearly defined audiences of executives and technologists who purchase corporate products and services, such as TechnologyReview.com, do best of all. Technology Review's site boasts a CPM of $70.

But even low rates haven't been enough to lure advertisers and media buyers to social networking. "A lot of advertisers are very hesitant to get into MySpace," says Anthony Acquisti, who oversees strategy for emerging media at OMD, an advertising agency in New York. "We've even flat-out told interested brands, 'You don't want to be there.'"

Why not? The problems with social-network advertising revolve around three main issues: attention, privacy, and content.

Attention Deficit
In the last week of April, around 400 people who spend their days trying to figure out how to make money in social networking gathered at the Skirball Cultural Center in Los Angeles. The conference went by the not very catchy name of EconSM, short for Economics of Social Media.

The point of the conference was clear enough. As Kara Swisher, one of the panel moderators, joked on her blog: "I'm in search of the elusive profit, which I don't think I'm going to find."

Almost every player in the game was represented: smaller companies that sent their CEOs, like Alex Blum; investment banks that wanted to take them public; and companies like Yahoo, AOL, and Fox Interactive Media, which were in the market for acquisitions. (Facebook sent no one.) "This is a huge conference," Blum said. "All the people we work with are here."

But they didn't seem very engaged. Audience members were jumpy, posting updates to the micro­blogging service Twitter, checking e-mail, reading blogs, dipping into the newspaper, and--occasionally--listening. Specific problems addressed in panel sessions quickly sorted themselves out into a general problem and a general response. People weren't paying attention to the ads (as, indeed, people at the conference weren't much paying attention to the panels). One panelist, Seth Goldstein, put it this way: "Right now, 'social' advertising is anything on a social-networking site that users are pretty good at ignoring."

Goldstein should know, since his company, Social Media, sells advertising linked to the applications developed for Facebook and MySpace--products like Scrabulous and Compare People, which are hugely popular among the sites' users. "The trouble," says Goldstein, "is we're putting ads up in front of users, where they can ignore them. We've got to get them between users."

Goldstein's comment had the air of a slightly worn sound bite, but it did acknowledge a problem that outside observers describe more bluntly. "It's a really bad place to advertise," Jason ­Calacanis, founder of Webblogs and Mahalo.com, says of social-­networking sites. As he wrote in an e-mail, members of social networks "are busy in conversations and don't want marketing messages."

Compare the situation of social networks with that of Google, which manages to make money putting ads in front of users.

With about 140 million unique visitors per month, Google earned $16 billion in 2007, largely from ads that people did pay attention to. (It may bear mentioning that Facebook recently hired Sheryl Sandberg away from Google, whose phenomenally successful ad program she had led.) Google's AdWords auction sells ads on a cost-per-click basis: advertisers pay not for a thousand viewings but for each individual click on a particular keyword. Advertisers choose how much to spend over any period of time, and they can influence the placement of their ads by paying more. Bids vary according to keyword, of course, but they were averaging around 70 cents per click in the first quarter of 2008.

Advertising on Google works because visitors come to Google looking for specific information. If a user who types "scooter" in the site's search field is hoping to buy a scooter, the keyword ads that appear at the right of the search results can be more useful than the results themselves. In social networks, on the other hand, users show up to find friends; ads are, at best, irrele­vant to that goal. The click-through rates on social-­networking sites bear this out. While around 2 percent of Google users actually click on a given ad (and the number is much higher when users are conducting searches for purchasing reasons), fewer than .04 percent of Facebook users do, according to a media buyer's report obtained last year by the Silicon Valley blog Valleywag.

Users in the Crosshairs
When social-media insiders are asked how advertising could capture users' attention, they always answer, "Targeting."

Targeting is at the core of traditional advertising; apparel manufacturers advertise in Vogue, for example, to reach readers interested in fashion. In the case of social-networking sites, targeting means sifting through the data in your profile to get an idea of what you're interested in. Social networks know more about you, your preferences, and your behavior than most businesses, and profiles are generally considered, in the words of former Fox Interactive Media executive Ross Levinsohn, "digital gold." Mining that gold is the best way for a social-networking site to make money--but, given users' attitudes toward privacy, the trickiest.

Startups that help advertisers and marketers better target the users of social-networking sites are fashionable investments for venture capitalists in North America and Europe. Such startups hope to sell advertisers detailed information about individual social networkers. They include the brand-new 33Across (which we profile in our list of 10 notable startups, which begins on page 50) and the more established Finnish company Xtract, which counts Vodafone, T-Mobile, and Blyk among its customers and has begun selling its software to advertising agencies and online marketers and publishers.

For social-networking sites, targeting will necessarily entail getting "between" users, as Seth Goldstein put it. You come to a social network because you are interested in your friends; ergo, the thinking goes, in order to get your attention, advertisers need to let you know what your friends are buying or thinking about buying, or they must somehow get you to send each other ads. It's either a beautiful idea or a creepy one, depending on whether you're an ad executive or the user of a social network.

In November 2007, Facebook tried to get between its users with its Beacon program. Announcing the program in New York, Facebook founder Mark Zuckerberg declared, "The next hundred years will be different for advertising, and it starts today."

Beacon was an advertiser's dream--and, like many things that are good for advertisers, very annoying to ordinary folks. ­Working with commercial websites like Blockbuster and eBay, Beacon tracked Facebook users' purchases and displayed them to their friends.

The problem was that users were enrolled in the program automatically. If a user went to, say, the Blockbuster site and rented a movie, that information was automatically sent to everyone in her Facebook network. (That's what happened to ­Cathryn Elaine ­Harris of Dallas; she is suing Blockbuster for violating the Video Privacy Protection Act.) Online petitions and negative press ensued, and the program was clumsily scaled back. On the company blog, Zuckerberg wrote, "We've made a lot of mistakes building this feature, but we've made even more with how we've handled them. We simply did a bad job with this release, and I apologize for it."

Still, "Beacon is alive and well," says Chamath Palihapitiya, Facebook's vice president of product marketing. "What happened was unfortunate," he says. "We took a step back and tried to figure out how to improve it." Now it's an opt-in system, and users can choose what information to share--or whether to participate at all. About 30 companies are still with the service, he says.

Most of the industry members at EconSM liked Beacon, wished it had worked better, and felt it would work eventually; Goldstein called it a "sign of things to come." But maintaining the user's trust in how data is used is paramount, says Roger McNamee, a venture capitalist who made early bets on companies like Electronic Arts and Intuit. "Facebook is so much more personal than Google," says McNamee, who invested in Facebook and is a confidant of Zuckerberg. "It really matters to people how their information is used."

Not every attempt at targeting has aroused as much protest as Beacon. In 2007, MySpace launched its HyperTargeting system, which scans users' profiles for information about their interests and demographics. It sorts the profiles into 10 rough categories--such as sports and entertainment--that are subdivided into more than 1,000 narrower categories, such as baseball or a specific film. (E-mail and personal messages are currently not scanned at either Facebook or MySpace.) Says Adam Bain, president of the Fox Interactive Media Audience Network, "People are essentially hand-raising every single day on MySpace and other social-media sites. What we want to do is take that and put it into easy-to-buy segments."

Bain says MySpace did extensive research before the launch. "The users said, 'I understand I have to live with ads, and I don't mind them,'" he says. "The concept of relevance really resonated with users." The algorithm is constantly modified by a 150-person team; it is already on its 12th revision. Although the program has not yet led to riches, "it has led to an unprecedented amount of advertisers coming to MySpace," Bain says. "We're getting blue-chip brand names like Adidas, Schwab, and Electronic Arts, Frito-Lay, Kraft, General Mills, and McDonald's."

Are those advertisers as excited as Bain is? "We've bought a little bit," says Marc Ruxin, director of digital strategy and innovation at the advertising firm McCann. "It's been okay." Well, that's better than nothing. Still, it doesn't exactly settle the question of whether targeting, even if it avoids the worst of users' privacy concerns, will ever be able to punch through the attention barrier.

Bryant Urstadt has written for Rolling Stone and Harper's.

Part II will be featured online tomorrow, June 24.