Place Your Bet on Ad-Driven Social Networking Sites, Or Not

The Bang

Online social networking giants such as Facebook and MySpace have become part of a cultural phenomenon. Increasingly, these sites are turning into the de facto way for people to keep in touch with friends, family, and even strangers. A report published by Datamonitor estimates revenues in social networking sites will reach US$2.4 billion by 2012.

As social media grabs an increasingly larger share of online time, Joe Chen, chairman and CEO of Beijing-based Oak Pacific Interactive, envisions that individuals will use social networking sites as their one-stop destination to handle personal tasks. For example, users will leverage their online social network as a personal portal to send messages, look for a new job, manage personal calendars, check out potential dates, and/or play social games with other online users.

According to Asian Venture Capital Journal (AVCJ), industry experts predict that online social networks will prosper during the current depressed economic cycle as people look for less costly ways to amuse themselves. In China, for instance, teenagers can play online games in Internet cafes all day for only RMB 10, or about US$1.50.

But does this flurry of activity translate into a good investment opportunity for you?

The Dang

Before you go rushing off in search of the next social network to invest in, stop for a minute. Note that Datamonitor’s prediction was made between the end of 2007 and early 2008, which hadn’t yet seen the full impact of current economic recession and the negative effect it’d have on experimental ad formats, such as the ones on online social networks. In fact, ad revenue forecasts continue to drop below the optimistic expectations. Since most of the social networking sites depend on ad revenues to survive, this downward slide is taking a tough toll on this once-tempting opportunity.

In addition, it isn’t easy to place a measurable value on ad-driven social networking sites. As Wharton accounting professor Robert W. Holthausen states, “You have little data on what kind of revenues they can generate and what their cost structure is.” The dearth of information means there’s no reliable data to plug into traditional valuation models.

Without the measuring stick, valuation becomes an abstract assessment. As VC Experts reports, the level of funding isn’t always based on the actual membership numbers at the time of investment, but on how much other similar sites have received in funding. Such seat-of-the-pants evaluation is prone to inflated expectations and decrease returns.

The Game

With the current hype and excitement surrounding the concept of online social networks, niche social networking sites targeted at specialized demographic and interest groups are popping up by the minute. But is more better? And will the highly targeted niches suffer from their narrowed focus?

As the volume of social networking sites swells, the number of people available to spread within those social networks shrinks. Datamonitor predicts the explosive membership growth in social networks will reach its peak in 2009, and plateau worldwide by 2012. Leaders like Facebook, which saw a 153% rise in membership from 2007 to 2008, will withstand the onslaught, while lesser known communities will feel the pinch of being too clique-ish.

Given the ad-driven nature of the bulk of the social networking sites, the sluggish membership growth and diluted membership base will eventually render the online communities unattractive to advertisers. If economic recession persists — and it’s expected to get worse before it gets better — advertisers will be less willing to invest their shrinking marketing budgets on experiential ad formats. This fading infatuation will mean that even niche network owners will no longer be able to command premium advertising fees, which translates into decreased return on investment on your angel dollar.

A caveat here: This is not to say that ad-driven social networks aren’t worth your investment. Assuming overall predictions are on the right track, angels who wish to invest have about a three- to four-year window of reaping a worthwhile ROI since growth isn’t expected to level off until 2012. From that pinnacle point, it’s predicted that revenues will be much less and those who wish to invest may have already “missed the boat,” so to speak — or, more likely, will experience that sinking feeling in Titanic proportions.

Business Models

Though big names like Facebook and MySpace [note 1] have continued to expand and rethink their non-advertising revenues, they still rely on ad offerings as their primary source of income. This model, however, is unstable and difficult to forecast. Investors may want to look instead into the new Asian social networking model, which offers not only friendship and business connections but also electronic commerce, mobile commerce, search, and gaming — areas that are more advanced in Asia than in the west.

Benjamin Joffe, CEO of mobile and Internet consultancy Plus8Star in Beijing, noted that instant messaging service QQ, which has successfully gone public, tops China’s charts with 500 million online users and $523 million in revenues for 2007. Other Asian sites are also generating rapid revenue growth and demonstrating high profitability.

By contrast, Facebook only generated $150 million in total revenues in 2007, which is confirmed by CEO Mark Zuckerberg in a January 2008 conference call with employees, according to eMarketer.

Joffe explains, “One key reason for the difference in earnings is that Asian sites rely on a broader range of revenue sources than do their western counterparts. For instance, Facebook depends primarily on ads, brand pages and digital goods to bring in dollars.

“But many Asian sites tap supplemental business from fees by users. The fees go toward purchases of music and games online — even while individuals use the sites to socialize or search for jobs within the network. This more comprehensive strategy helps such sites as Korea’s Cyworld generate 80% of its dollars from users, compared to almost no user-generated fees for Facebook.”

Note

1. MySpace is already feeling the pinch, with only a 3% gain last year. Without significant changes in its perception as a for-teens-only community, this site is likely to be hard hit.

Take Away

Unless ad-driven social networks in the West can rise to the levels of their Asian counterparts or adopt the Asian social networking model, they may have a hard time generating steady revenues in the years to come. Investors may be better off investing in technology providers [note 2] that support the infrastructure needed to run social networks, such as handling network scalability and availability issues. Keep in mind, though, the foreseeable slowdown in membership growth and be sure to ask potential investees whether they have any solid backup plans and strategies to sustain their ventures when the membership growth of those sites that their company supports turns sluggish.

Questions

To those of you who are currently invested in ad-driven social networks, no matter how big or how small the online community, what shifts and returns are you seeing? How do you determine the value of a user? For those whose investments are raking in profits, what has worked best for you?

Note

2. It doesn’t include companies that help end users and enterprises launch social networks. This market is incredibly crowded. TechCrunch found at least 34 companies in this field.

References

Social Network Revenues Down: Here’s Why

Social Networks: Millions of Users, Not So Many Marketers

Asian Venture Capital Journal: Investors click onto Asian social networking sites

Valuation of Social Networking: Private Equity and Venture Capital

Datamonitor: The Future of Social Networks

Dot-Com Bubble, Part II? Why It’s So Hard to Value Social Networking Sites