After several years of cautious surveillance, VCs are once again pouring money into Web startups. One of their favorite categories: advertising-supported content sites, which were about as popular as spent plutonium in the aftermath of the dot-com crash.
So far in 2006, venture capitalists have placed roughly half a billion dollars in Web content companies that depend almost entirely on ads for their revenue. Video-sharing sites, social networking sites, gaming sites and other Web 2.0 startups are attracting the most attention.
Which raises the obvious question: Is there enough money flowing into website advertising to support the hoard of venture-backed Web 2.0 companies? The answer, say VCs and industry pundits, is that there isn’t enough ad revenue to keep every single Web startup afloat, but there is plenty to create some large, sustainable companies.
“The Internet is not a high school experiment anymore,” says Raj Kapoor, a managing director at Mayfield Fund. “We’ve crossed the bridge with advertisers and there is now tremendous opportunity.”
Television viewership is way down among young people. Time online is way up. “Teens are now spending a third of their time online,” notes Raj Kapoor. “Yet ad dollars online are still just a fraction of offline spending.”
Follow the money
Research firm eMarketer projects that while traditional media spending—TV, radio, billboards, newspapers—will grow just 4% this year, online ad spending will grow by 25 percent. That’s a very encouraging stat, but it needs to be placed in context. Namely, online advertising has a long way to go before it’s on par with other mediums. Web ads made up just 4.6% of the total advertising market in 2004, and they will still fall below 10% of the total in five years (accounting for 8.6% in 2011), according to JupiterKagan, an Internet research firm.
But that’s still a lot of money. A lot. JupiterKagan says online display advertising—which includes video, rich media, static images and text ads—will grow from $5 billion this year to $9.3 billion in 2011.
The valuable [Web 2.0] businesses that emerge will be even bigger than people believe now and, naturally, the garbage that’s being funded will be worthless.”
Kevin Efrusy, General Partner, Accel Partners
Emily Riley, lead advertising analyst for the firm, notes that traditional brand advertisers like consumer packages goods and automotive are starting to shift dollars online as an alternative to TV and print. Moreover, they are willing to pay for more expensive rich media and video advertising. She believes video advertising will experience its greatest growth between 2009 and 2011 once video becomes a core feature of mainstream websites.
Ford Motors, for instance, cut its magazine ad budget in 2005 but increased spending on the Internet, according to AdAge magazine. Companies like Ford, General Motors and Absolut, which typically spend hundreds of millions annually on advertising, all plan to spend 20% of their ad dollars online in 2006, according to a report by investment banking firm Piper Jaffray.
“Brand advertisers are realizing the younger demographics they covet just aren’t using traditional media the way they did,” says Kevin Efrusy, a general partner at Accel Partners.
The opportunity to make money advertising to teens spurred Mayfield to invest $7 million in Tagged earlier this year, beating out a dozen other VC firms. The startup currently reaches about 3 million teens. “Tagged has the ability to appeal to a broad set of teens and then appeal to brand advertisers,” notes Kapoor.
Brand advertising is the holy grail of any ad-revenue-based Web company. But to capture them a site must demonstrate a very large audience. That’s why most VCs are not looking to invest in niche sites that use aggregators like Google AdSense to generate revenue. Those sorts of businesses—like blog Gawker.com—aren’t likely to generate VC-style returns.
Brand advertising is where the money is. A CPM (or cost per thousand impressions) from a brand advertiser pays many times more than a pay-per-performance ad.
Today, brand advertisers pay an average CPM cost of about $3 to $5, according to industry watchers. However, analysts believe that as more brand advertisers enter the fold, competition will increase for premium ad placements on the leading sites, causing overall CPM rates to rise. Indeed, the demand for Internet ads will likely result in “high single to low double digit,” price increases, according to Piper Jaffray.
Riley of JupiterKagan notes that when the Web 1.0 bubble burst in 2000, advertisers either left the medium all together or demanded a cost-per-action model in which an advertiser pays only for the ad when an action has occurred, such as a form being filled or a product purchased. But with the return of more brand advertisers to the Web, the balance of power has returned to the website owners themselves, who overwhelmingly favor the CPM model.
A lot of businesses created to facilitate consumer-contributed programming simply hope people will show up and hang out.”
Mark Terbeek, Partner, MK Capital
Tagged, for instance, runs ads from pay-per-performance aggregators as well as from brand advertisers, but “our goal is to get to the point where we have 100% brand advertisers,” says Tagged CEO Greg Tseng. “That’s how you create a billion-dollar business.”
Getting it free
Another way to build revenue is by a keeping down your cost of production. While traditional media companies spend most of their money paying people to create content, many Web media businesses often get it for free. Social-networking sites like Tagged, Facebook and MySpace and video-sharing sites like YouTube and MetaCafe rely on users to generate their content. That means ad dollars are largely pure profit.
Of course, user-generated content presents challenges. “Some brands don’t want to be on a site where users can speak up and trash their brand,” says Tseng of Tagged. Earlier this year, for instance, Chevrolet ran online ads that allowed consumers to mix and match images and text to create personalized commercials for its Chevy Tahoe sport utility vehicle. As one might expect, some users took it as an opportunity to slam the vehicle for its poor gas mileage and contributing to global warming. To Chevrolet’s credit, it did not pull those ads.
Brand advertisers also “are nervous about the changing nature of content on user-generated websites and their lack of control,” Riley says. “They don’t want to appear next to some mildly pornographic material on MySpace or YouTube.”
As a result, brand advertisers are more likely to stick with established sites like Yahoo and ESPN.com, where they can be sure of the environment in which their ads appear. Some advertisers have a list of 20 or so “acceptable” Web properties they’ll work with.
VCs and entrepreneurs believe it’s only a matter of time before brand advertisers embrace user-generated content sites, if for no other reason than that’s where their consumers are.
Hitting the target
Consumer fickleness is amplified on the Internet and that does worry us somewhat as investors.”
Jim Feuille, General Partner, Crosslink Capital
Advertisers that don’t want to deal with websites where content is not controlled can trade sheer numbers for the vertical communities offered by Web businesses with a more targeted approach. For example, sports site NBX.com offers advertisers the highly sought after 18-to-34-year-old-male demographic. “These are people who have a lot of income, many of whom are heads of households,” says Mark Terbeek, a partner at MK Capital, which led a $3.3 million series A round in NBX. “They’re watching less TV, they’re reading fewer newspapers and they’re spending more time on the Internet.”
Advertisers like NBX because they know what they’re getting—not a mass of teens but a fervent group of sports fans. As a result, NBX can charge more per impression than undirected Web-based social networks. NBX attracts ads for shoes, beer, pizza and the like. When Sony Pictures released Benchwarmers, it carpeted NBX.com with ads.
“You’re seeing a lot more deep vertical plays now—sites where you’ve got a more consistent audience,” Terbeek says. If a site can deliver a consistent and passionate user base, it has a much better chance of proving ROI to advertisers, he adds.
Another ad-revenue-based Web business that has aggregated the 18-to-34-year-old male demographic is online-gaming site WildTangent. “You can build real scale working in this niche demographic,” says Steve Baloff, a general partner at Advanced Technology Ventures, which led a $16.5 million expansion round in WildTangent. “It’s a big enough market to focus on, whereas maybe female scuba divers would be harder to build a case for.”
Gaming sites also present built-in opportunities to serve ads. WildTangent users watch ads while games load. “It takes time to load up a game, so an ad placement from a company like Chrysler can be very relevant,” Baloff says. “We even built a game for Chrysler. Coke has placed ads in our games because they want to reach this important demographic. Our CPMs are north of $10, which is extraordinary.”
Another company offering built-in opportunities for brand advertisers is Tagged. It has created icons on its site, which teens can use to describe themselves. These “tags” say things like “hottie” or “skater chick” and can be placed on user pages or exchanged like friendship bracelets. For a fee, advertisers create tags based on their own brands. “Teens are very brand conscious,” explains Tseng. “The kids will actually pick out these brands and put them on their pages, like, ‘I’m a Gucci girl who loves her iPod but also plays Xbox.’”
Do ad-based websites run the risk of driving users away with too many ads that are too intrusive? There is such a thing as overkill. But VCs aren’t losing sleep over the prospect just yet. They say the online audience is different now—fewer nerdy iconoclasts, more red meat, run-of-the-mill consumers who understand that they have to put up with some ads if they want free content.
“In video in particular, we’ve been taught to accommodate a certain amount of advertising,” says Accel’s Efrusy, who led a $15 million investment in video-sharing site Metacafe in July. “Putting a 10-second ad in front of a two-minute clip isn’t all that disruptive.”
We’re not talking about a proprietary technology here. There is luck involved and it is a hit-driven business.”
Raj Kapoor, Managing Director, Mayfield Fund
That said, Efrusy believes sites have to be careful to use advertising in a way that doesn’t distract from the core experience. If you do, consumers will quickly develop a taste for someone else’s website. This is especially true of Web consumers, who tend to be young, well networked and ever ready to try something new.
“Consumer fickleness is amplified on the Internet and that does worry us somewhat as investors,” says Jim Feuille, a general partner with Crosslink Capital, which is an investor in ad-supported music site Pandora.
Thinning the herd
There is general agreement that too many advertising-based Web companies are getting funded and a shakeout will occur at some point. “There’s a ton of garbage being funded,” Efrusy says. “I’ve done two deals in the ad-based consumer Internet space in the past 12 months—Facebook and MetaCafe—but I’ve looked at 500, and I’d say half of those were funded by somebody.”
Bill Gurley, a general partner at Benchmark Capital, which has backed Metacafe and teen networking site Bebo, agrees that “more marginal deals are getting funded. You end up with five players in a market, which is not sustainable.”
So is there such a thing as bubble 2.0?
“Unquestionably,” Gurley says. “Every firm up and down Sand Hill Road is hiring consumer Internet guys. Ten times the number of venture capital firms are highly interested in consumer Internet deals compared to a few years ago. But the cool time to be doing this was then, not today.”
MK Capital’s Terbeek says most sites that depend on user-generated content will have a tough time in the years ahead. “A lot of businesses created to facilitate consumer-contributed programming simply hope people will show up and hang out,” he says. “A lot of those won’t work.”
[Brand advertisers] are nervous about the changing nature of content on user-generated websites and their lack of control.”
Emily Riley, Lead Advertising Analyst, JupiterKagan
Many ad-driven websites, like those where users can share videos, are just too easy to replicate. “We’re not talking about a proprietary technology here,” Kapoor, who co-founded online photo service Snapfish before joining Mayfield. “There are lots of people who can attempt to do this. There is luck involved and it is a hit-driven business. Sometimes I feel more like a studio head than a VC, but I enjoy that. I think it takes a different type of investor to succeed.”
Still, there are certain fundamentals that VCs look for when investing in a Web company with an ad-based revenue model. One, they want zero customer acquisition cost, which means a site that can grow virally and doesn’t have to spend money on marketing.
Two, they’re looking for sites that have demonstrated some traction. They’re not willing to throw money at every new idea that walks in the door.
These two factors alone distinguish Web 2.0 from the first version, when investors famously blew millions on Super Bowl ads to drive traffic.
A good Web 2.0 website “should lend itself to viral adoption, and it has to be really simple to use,” says Chip Hazard, general partner at IDG ventures and an investor in Jingle Networks, a directory-assistance business that operates ad-supported Free411.com and which recently raised $26 million in series B financing.
The website should also have the potential to draw revenue from sources other than advertising—what Hazard calls a “second act.” “The second acts aren’t quite there yet, and I’m still not sure what they’ll be,” he says. “Maybe it’s subscriptions.”
Another big challenge is finding great opportunities that are still great investments. “They are two different things,” says Mike Hirshland, a general partner at Polaris Venture Capital, which invested $10 million in Heavy.com, which produces its own video content.
The kids will actually pick out these brands and put them on their pages, like, ‘I’m a Gucci girl who loves her iPod but also plays Xbox.’”
Greg Tseng, CEO, Tagged
Heavy has more than 12 million monthly unique visitors, grew 400% in the last year and is making money. “They’ve proven the revenue model,” Hirshland says. “There’s a Heavy brand, a Heavy personality, a Heavy demographic. For a lot of advertisers that brand is something they value, whereas YouTube is undefined aggregation of lots of different stuff, and advertisers don’t really know what they are getting other than sheer mass.”
So what is both a good opportunity and a great investment? “To be crass but truthful, the first cutoff is reasonable valuation expectations,” says Hirshland. “My sense is that as the heat generated around broadband video intensifies, valuations are getting somewhat unrealistic. I do think there’s a bubble here.”
Listening to VCs talk about the ad-supported revenue model, Web 2.0 starts to sound a lot like Web 1.0. There are good companies and bad companies. Some will get lucky. Some will thrive. Some will die. And, of course, some VCs will make a lot of money.
VCs recognize that this is a high-casualty industry and that many sites won’t get grab consumers’ interest. “But if it does grab attention and retain it, it can be a very big thing that makes lots of money,” says Feuille of Crosslink. “The risks are big but the rewards can be huge.”
For his part, Efrusy of Accel believes VCs are still underestimating the value of the truly noteworthy properties. “The valuable businesses that emerge will be even bigger than people believe now and, naturally, the garbage that’s being funded will be worthless,” he says.
The methodology used to separate the trash from the gold is still much the same. Says Gurley: “You look for an experienced team, you look for a proven level of momentum generated virally, and you need one hell of an idea or one hell of an advantage to prevent entry by competitors.”
Has he seen anything like that lately?
He laughs. “I’m looking.”
Tom Stein is a Silicon Valley freelance writer who specializes in covering technology startups and venture capital. He may be reached at email@example.com.