VCs getting social

It’s been the year of Facebook, without question. A social networking site that was started by a guy from Harvard University in 2004 as a way of keeping in touch with fellow students, it’s taken over the world, going from 60th most visited website to 7th in the space of a year, with user numbers expected to top 60 million by the end of 2007. More incredibly perhaps is that Microsoft has valued the company at US$15bn. The computer giant took a measly 1.6% but paid US$240m. In the face of such stellar numbers, it looks like Web 2.0 has hit its high-mark.

Closer to home, Hamburg to be precise, a more modest sum has just been invested in a new European Web 2.0 start-up. Zweitgeist is a German company that was founded in June 2006. It produces a free download called weblin, which allows people to communicate online on any website using personalised avatars which appear at the bottom of your computer screen; imagine a cross between Second Life and MSN Messenger. The company has received backing from a number of unnamed angels and three VCs: German early stage specialist High-Tech Gründerfonds, Swiss firm Mountain Partners and T-Online Venture Fund, the investment arm of Deutsche Telekom.

Europe’s presence in the brave new world of Web 2.0 has lagged behind the US, but over the course of 2007, the situation has altered. One of the biggest VC success stories of the year was the purchase of social music site by US media behemoth CBS for £140m in May, the largest-ever UK Web 2.0 acquisition. was founded in 2003 by and took home its first institutional investment in May 2006 from Index Ventures, investing US$2m then and taking back US$50m on exit.

Index has been going social networking crazy. The Skype investors have in their portfolio a host of such companies, such as Netlog, a Belgian social networking site and the largest of its kind based outside the US, and, a Swedish-based online dress-up and makeover community for young girls.

There are two basic models to achieve profitability: user-payment and advertising. The former is generally not something associated with social networking but there are a few instances, such as certain aspects of Netlog and photo-sharing website Flickr. Advertising though is seen as the big one. Ben Holmes, principal at Index, says: “The challenge is to find a way where it is not intrusive, so I think there’s going to be a demand for interesting advertising solutions for social networking sites.” He cites the example of Stardoll, which has a number of mini-games which manage to incorporate advertising from the likes of DKNY into the gameplay.

There’s only one real dark cloud in the Web 2.0 sky, but unfortunately it’s big and it’s America-shaped. Dow Jones VentureOne and Ernst & Young published some intriguing stats back in September which showed that while globally Web 2.0 deals were up 14% in the opening half of the year, this was driven almost entirely by Europe and Israel.

This has raised some questions as to whether the market has levelled out and that Europe is jumping in just when things are turning sour. As a blogger on the Library House website puts it: “History suggests European investors may be in for a rough ride again.” Holmes disagrees: “There are a growing number of social networking companies that are located outside the US and the issue for the future is will it be the US model growing internationally or will it be people with other models, outside the US. We believe there are opportunities outside the US with a different approach which can be successful. Companies which sit outside the US really need to think about how they are going to internationalise, which is a pressure American companies don’t really have because of the size of the home market.”

One possible explanation for the slow-down of investment activity in the social networking space in the US could be that the market has reached saturation point. A lot of money has been invested over there over the past 12 to 18 months and it’s a fairly well-established location on the venture landscape. In Europe, it’s only really just started to open up, which is why the statistics from the US show a plateau, whilst in Europe and Israel they show an increase. Facebook has only really taken off in Europe this year. The biggest network on the site is the London one, with over 1.5 million names.

Is it a fad? Holmes says: “There are a lot of people who are users of social networking sites and for a lot of them it accounts for a big spend of their time. It’s approaching TV and other forms of media in terms of time dedicated to it. It deserves to be taken seriously.”