Corporate Profile Investment Strategy In The News Events

The New Internet Gamble By Carolina Braunschweig, Senior Editor Venture Capital Journal December 1, 2003

Meet John. He's a 52-year-old St. Louis native who makes his home in Silicon Valley. He bikes, snaps photos and loves genomics, Internet services and women. John still mourns the passing of Jerry Garcia. Bob is a friend of John. On Saturday nights, this 47- year-old Bay Area bachelor stays up to watch "Six Feet Under" on HBO. Originally from Flint, Mich., he also enjoys live music, basketball, fly fishing and classic rock. John and Bob are not just friends. They are two of 3.4 million Friendsters and the most high-profile venture capitalists to gamble on a new generation of online social networks like Friendster. John (Doerr) is a general partner with Kleiner Perkins Caufield & Byers, and Bob (Kagle) is his counterpart at Benchmark Capital. In the last week of October, the duo led a $13 million Series A round in Friendster, giving the startup a $40 million pre-money valuation and sparking a feeding frenzy in the space. Since Pope John gave his blessing, VCs have rushed to fund two other social networking companies: LinkedIn pulled in $4.7 million from Sequoia Capital, and Spoke Software closed on $11.7 million from DCM - Doll Capital Management, Partech International, Sierra Ventures and U.S. Venture Partners. Meanwhile, Friendster competitor Tickle Networks bulked up with an acquisition, online party organizer Evite added Friendster-style features to its site, and all of the Internet's brand names - Google and Monster included - have started planning their own social networks. "The feature set and product set of sites like Friendster is not hype - it's a reality," says Andrew Anker, a partner with August Capital in Menlo Park, Calif., and an investor in Tickle. "Hype is the $53 million [post-money] valuation on a company with no revenue. The classic venture bubble has now hit social networking. The pure play social networking companies are increasingly struggling to build a revenue model." At least 50 million people participate in online social networks to connect with friends and meet people for social activities and business. Through Friendster, for example, a user can ask a friend to make an introduction to another friend. Friendster is the middleman between users, making the links between people transparent. So far venture capitalist have poured $100 million into the space. At least a dozen names fall into the category (see chart, page 30), but the list is growing as the hype builds. "We're very cautious, but enthusiastic and passionate about personal networks," says Joseph Tzeng, a partner with Crystal Ventures, a Silicon Valley investment firm that made a killing off of content plays like CNet.com and About.com. "But they need to find a way to substantiate themselves rather than relying on [investors] to support them." One scenario has online social networks evolving into online dating services or e-commerce sites like eBay and Craigslist, which link buyers directly to sellers. Another possibility is that social networks could become next-generation content providers, an encyclopedic collection of personal profiles and Weblogs. Or, the companies could become enterprise software makers, adding versions of their applications to corporate Intranets as a way of linking people and inducing them to collaborate, something that Spoke Software now does. The underlying belief is that if you can aggregate millions of users you'd be hard pressed to not figure out a way to make money from them. A safe bet? Hardly. Deja Vu All Over Again? "There is a lot of me-too activity, and a lot of these sites will have trouble," warns Adrian Scott, founder and CEO of San Francisco-based Ryze, a pioneer in the space. "There is something big here, but it will take effort, strategy and patience. I think there will be some mistakes made in a big way." The buzz over online social networks is like the noise that drove the rise and fall of the first-generation of consumer Internet companies, circa 1999. The public markets may be partially responsible for venture capitalists' interest. The stock prices of Amazon.com, eBay and Yahoo are up over last year and holding steady, and Wall Street has been receptive to new Net issues, like iPayment, Netflix, RedEnvelope and PayPal (later acquired by eBay). The buzz promises to get even louder with Google's highly anticipated IPO next year. At least two social networking companies (Tickle and Ryze) have been able to turn a profit. But it is by no means clear that any of these ventures can mature into large, profitable Internet companies. It's entirely possible that entrenched players could buy them and add community features to their own Web sites or simply copy their functionality. The only thing giving a company like Friendster an edge over the competition is its brand, and even that is ephemeral. The biggest question that dogs the online social networking sector is why people even need a Web service to broker and mediate their relationships. There is value in making the ties that bind both visible and accessible, as many of the social networking sites claim to do. They're also fun to use. Still, a message sent through a social networking site is no more likely to result in a business lunch than an email or a phone call. And even fun has its limits. In order to be more than flavor-of-the-month Internet sites, online social networks must prove they can add value to relationships and make money without alienating their user base. On that note, we took a close look at three of the better-known social networks to find out what makes them tick, how they plan to make money and what they're up against. Can We Be Friendsters? When David Hornik, a general partner at August Capital, logged onto Friendster (friendster.com) in December 2002, he was user number 1,889. Four months later, 3.4 million people were Friendsters and the site was the 81st most popular site on the Web, ranking higher than NFL.com Orbitz.com and even soft porn site Voyeurweb.com, according to Alexa, which monitors Web traffic. Kleiner Perkins' Vinod Khosla and Benchmark's Bill Gurley are Friendsters. So are associates and GPs at Battery Ventures, New Enterprise Associates, Lux Capital, Mobius Venture Capital and Summit Partners. The VCs who log onto Friendster are just curious bystanders. For the most part, users are young, urban and hip. They log onto the site, post a photo and a profile in order to sift through the photos and profiles of people who know people they already know. They can send messages or ask for an introduction. Users often link to their universities or their hometowns, creating self-generated and unmoderated user groups. It's all free for now, but not for long. Friendster plans to make serious money through "value-added services," like taking a cut of a purchase that results from a recommendation made on its network. Although Friendster was conceived as a dating site, its users are there to play, often creating fake characters, or "Fakesters." There are more than 30 Jesus Christs on Friendster. He's a friend of Peter, Paul and Matthew. Britney Spears, George W. Bush, Osama bin Laden and Saddam Hussein are all there, too. VCJ did an informal survey of dozens of the site's users to see how and why they were using the site. On average, users surveyed had been registered for six months and said they occasionally sent messages to other users via Friendster. Most use the site to satisfy curiosities - to see who's connected to whom, to check what people say about each other, to trace long lost friends. One user says she checked her ex- boyfriend's profile daily to see how many friends he had added since she last checked, what another user called "junior-high level social silliness." They're not willing to pay to play. "Stalking becomes so much more problematic, conscience-wise, if I'm actually spending money to do it," says one user. "I don't actually use Friendster for anything except stalking - no dating, no reconnection with old friends. I don't need a dating service or a means to keep track of those I know other than the usual channels of rumor and hearsay." If Friendster is serious about the dating market, it faces stiff competition. Online dating services abound. Match.com, a San Francisco company, is the largest of them all. Live since 1995, the site had 9 million active users during the third quarter. Each pays a monthly subscription fee to scour online personal ads, send notes through the system and play matchmaker. The company reported revenue of $40.8 million during the first quarter, a 61% jump over the same period a year ago. Match.com also has the heft of Barry Diller's USA Interactive (Nasdaq: USAI) behind it. Unwilling to give up its share of the online matchmaking market to upstarts, Match.com is rumored to be developing its own Friendster-like features. "We see these sites as fun little experiments in social networking," says Trish McDermott, Match.com vice president for romance and a member of its founding team. "But to go from there to a monetized community dedicated to the core experience of being single and meeting someone is a great leap. Their business models are unproven at this point. People come to Match.com because they want to be in a qualified community of single people looking for relationships, not pretending to be celebrities or rock stars." Benchmark's Kagle says Friendster doesn't compete directly with Match.com because they serve different demographics. He adds that dating is just one of many services that Friendster can offer. "I don't necessarily think it's relegated long-term to the dating function. I think there are lots of other potential functions [that can be built around] this network of trusted and closely associated people." "If you could be one click away from buying something that a number of your friends are actively recommending to you in real time, that's a pretty high- value service to you," Kagle says. For example, Friendster could make money by renting space to a company like Amazon.com. The thought of Friendster capitalizing on its users' fun and games has some users "horrified," says Danah Boyd, a UC Berkeley researcher who studies online social networks. "As soon as Friendster starts charging, they're going to see a huge alienation, especially among the most established users. They've contributed to Friendster as a system. They've given them all their data, so now they're asking, Why should I pay? Haven't I given Friendster enough?'" Some users are so outraged that they've started posting messages on the site's bulletin boards, encouraging others to revolt and flee to MySpace.com, a Friendster look-alike. That site promises to keep its current services free. "Friendster is in for a big surprise when they start charging for services," warns Jeffrey Tinsley, chief executive of Los Angeles-based Reunion.com. Join the Tribe Tribe Networks (tribe.net) is a network of people who need things. They're not looking for friends or relationships. They're online because they want a job, an introduction, a time-share in Tahoe or a dog- walker, preferably in the trendier areas of San Francisco, where Tribe is based. As they do on Friendster, users post a photo and a profile and invite others to join. The difference is that when users register with Tribe, they link into "tribes" and create their own - alumni networks, hobby groups or people who share programming skills. That way, when users need something, they can tap into a tribe and ask for help. During Tribe's first week online in August, each Tribe user invited 1.1 new users to join. By the third week, each user was inviting 2.5 users to join the network. By week number four, Tribe users had set up 1,000 tribes. Six weeks after the site went live, it had 10,000 registered users. Slightly more than half of Tribe users are women. Their average age is 31 and they're mostly professional, with lots of techies and Burning Man types. Investors see dollar signs in Tribe's demographics. The startup has raised $7.1 million from Mayfield and strategic investors Knight Ridder Digital and The Washington Post Cos. Tribe plans to capitalize on its usefulness by charging a fee for commercial listings like job openings. It's a business modeled after the success of Craigslist (craigslist.org), a San Francisco-based swap shop that went live in 1995. Two million people visit Craigslist monthly for its mix of apartment listings, job postings, activity partners and forums to rant and rave. In September it counted 300 million page views. It is free to post anything on the site but a job listing, which costs $75 for a 30-day listing. While Craigslist does not disclose its financials, the company has said it is profitable. Like Friendster, Tribe faces stiff competition in the online career and personals space. "These sites seek to be the whole world for the consumer - a place to take care of your love life, your job life and your hobbies - all in one place," says Laura Behrens, a senior analyst with GartnerG2, in Cedar Rapids, Iowa. "But Match owns the personals market and Monster.com owns the career space, and there's really only room for one or two major brands in each space. It's no different in online marketing than it is in regular pedestrian goods." Tribe needs to combine the entertainment value of Friendster with the one-stop shopping experience of Craigslist. It's banking on the fact that Friendster really is that fun and that once it builds a critical mass, users will migrate to the site for shopping and entertainment. In a sense, Tribe is Craigster. Get Linked Tracking down potential sales leads, on its face, has more value than being able to find out how many Elvis fans are in your circle of friends. LinkedIn (linkedin.com) targets business users, giving them a way to connect with other business-people, but also giving them a filter so that they aren't spammed by people they don't want to hear from. A LinkedIn user invites associates into his personal network, and while that user can look at the personal networks of his own associates, he cannot make contact with anyone without an introduction. A user can pitch a business plan to someone in his network, hoping he'll pass it along to a friend who plays tennis with a certain venture capitalist. If everyone on the chain agrees it's a good idea, the plan might land in the hands of the potential investor. If not, it can be dropped at any point, and the sender will never know who dropped him. "There's a monumental difference between introducing yourself to a venture capitalist and being introduced," says August Capital's Hornik, who is a LinkedIn user but not an investor. "Being able to find me is important in terms of information, but from a business perspective, you're better off if you can find someone I know and trust. LinkedIn has the potential to help you discover that." Based in Mountain View, Calif., LinkedIn is the creation of Reid Hoffman, former executive vice president at PayPal Inc. and an angel investor in Friendster. The site is still in its beta phase, working through its kinks. All of its features are still free, but it plans to start charging for users to send messages along the network. At least one user in an online forum balked at the idea of paying for the service. "Our personal networks are as important as our reputations: They are linked. Why should I give that up to a Web service vs. controlling it myself via email and the phone?" the user asks. "To put it more bluntly, if it's an important business connection, why do it through a server owned by someone else?" asks another. Real Profits Those users would appear to be in the minority, because companies like Ryze and Reunion.com have been able to charge users and post a profit. Ryze, a business networking site the predates LinkedIn, launched in 2001 and has been profitable for about a year. "It's kind of funny how people keep asking, Where's the business model,'" says Ryze CEO Adrian Scott. "We're kind of proving it." Ryze makes money primarily from members who upgrade their free memberships to "gold" status for $9.95 per month. With the paid membership, users can do advanced searches, like look for people in the wireless industry who work in San Francisco and went to Harvard. They can also build their own business network around an industry, a geography or interest. Ryze also makes money from hosting business mixers around the globe. Scott wouldn't reveal the financials for his privately held company, but he notes that it has 60,000 registered users. Assuming every one of those users pays $10 a month, Ryze would pull in gross revenue of just over $7 million a year. Reunion.com has been profitable for the past two years by convincing less than 20% of its 40 million users to pay its $36 annual fee, CEO Tinsley says. Challenges Convincing users to pay can be especially hard for a startup when it's still working through the kinks in its technology. Since Friendster is in beta mode and isn't charging for its service, its users appear willing - for now - to put up with its slow network. Friendster is in fact using some of its venture money to re-architect its site and has hired a VP of engineering. But Kagle questions whether a technological edge will determine the winner in the social networking sector. For example, when eBay was a startup it was always at a technological disadvantage to more mature sites like Amazon and Yahoo, yet it continued to thrive. "And it wasn't because eBay had any IP they didn't have or a technology advantage. It was because eBay had critical mass and a community of users," Kagle says. It's possible that sites with better functionality could lure Friendster users away. Since Emode launched its Tickle social network in September, about 600,000 of its 40 million users have signed up for it. The Emode database holds 5 billion answers to questions like, "What kind of dog are you?" says CEO James Currier. The company claims to have the largest co- location facility in San Francisco. When it wanted to add a social networking component last year, all Emode had to do was create a new interface to its database. "Getting the engineering and privacy and scalability and control of the database structure and the attributes of the database right can take three to five years," Currier says. That's the kind of time frame that can make a venture capitalist lose patience, especially when a company still hasn't figured out how to make money. "Like all consumer Internet services, the business plan really needs to be tested," says Dave Tabors, a general partner with Battery Ventures and the firm's lead investor in Spring Street Networks, a New York company that provides the back-end technology for online personals. "We need to understand where the user growth will be, the revenue and the profit growth. Those factors need to play out over the next four or five years to gauge the potential for consistent growth." For the moment, sites like Friendster are an online phenomenon in search of a business plan. They need to build a sustainable, revenue-generating model that doesn't put them on a collision course with established and deep-pocketed Internet players. They also need to find a way to lure more users online and convince them to stay. Above all, they need to prove that they add value to personal relationships. Additional reporting by Lawrence Aragon.

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