Woe to Web 2.0 Start-Ups: Too Few Ads to Go Around

Entrepreneurs Discover Digital Spending Isn't an Infinite Quantity

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NEW YORK (AdAge.com) -- Start-ups of the second web boom -- so-called Web 2.0 companies -- have revolutionized the way we communicate (Twitter), consume media (YouTube) and relate to one another (Facebook). But most have one thing in common: They are built on the notion that if they can build scale, a near-bottomless well of advertising awaits, allowing them to offer tools, software, bandwidth and media to consumers for free.

In the past five years, trends have justified that optimism and helped fuel massive venture-capital investments in online start-ups that will, theoretically, one day be advertising-supported. But what if the advertising isn't there, or if the shift doesn't happen as fast as once thought?

That's the new reality filtering down to start-ups: If advertising was your panacea, better think of something else and quick.

"My concern is the really great concepts that are features, not companies," said Ross Levinsohn, former CEO of Fox Interactive and partner in Velocity Interactive Partners. "There isn't enough advertising to support all those features, and in compression times, advertisers tend to flock to safe names and sites that have real traction."

One could excuse the latest crop of start-ups for their undue optimism; almost all were conceived, funded and began operating in boom times. Online advertising rebounded from three years of negative growth in 2003 and has grown at more than 20% a year (actually, more than 30% in 2004, 2005 and 2006) in the five years since.

But onetime hyper-growth is coming to an end. If trends hold, online advertising will grow in the low double digits or high single digits this year, driven largely by search. While declining growth seems unlikely, the venture-capital community is preparing its portfolio companies for coming years of lesser incremental growth.

Modest growth
"The last three years have been boom times. My guess is there will be a 5% to 6% increase next year in an overall flat advertising market," said Warren Lee, partner at Canaan Partners, whose portfolio companies include Tremor Media, Associated Content and Motionbox.

Raising money for an ad-supported web business is going to be tough for anyone who can't demonstrate a clear, relatively quick path to profitability, and advertisers are about to get a lot more conservative than they've been for the past three years. Marketers likely won't decrease their online spending, but they'll be under pressure to justify it and show results, which means a flight to search and proven sites and less experimentation with social media and new platforms such as Meebo, Twitter, FriendFeed, Drop.io and even YouTube.

"When you have a contraction like this, people stay with the best brands," said Andy Chapman, a digital media buyer at WPP unit Mindshare Interaction.

Less experimentation means less playing in social media, which won't spell trouble just for MySpace and Facebook, but for the burgeoning economy of ad-supported applications that live within those networks peddled by well-funded start-ups such as Slide, which raised $50 million, and RockYou, which raised $52.5 million. Those companies have raised plenty of cash to weather the downturn, but some of the other app makers may not make it.

Start-up veteran Hank Williams, who writes frequently on the topic of free vs. fee, doesn't believe any productivity or communications tools are compatible with advertising because they don't get a meaningful slice of user attention.

"The vast majority of stuff is not going to be ad-supported; they can't be," he said. "There is going to be a revolution in that people are going to have to start paying for really useful productivity tools."

Consolidation
Few believe the market will support all of the 400-odd ad networks that have launched in the past five years. Consolidation seems inevitable as those with no unique technology or selling proposition are swallowed by those with either scale or expertise in a particular niche.

That process has already begun, as Microsoft, AOL, Google and WPP Group have snapped up the largest ad networks and targeting firms over the past few years and will accelerate as prices come down.

Publishers may not be immune to a big cull after growing up in what Spark Capital principal Dennis Miller calls a "fantasy marketplace." "You will probably see a healthy movement to two or three in each category that are delivering visitors and time spent on the site," he said.

In video, there is plenty of pent-up advertiser demand for professional product from the TV networks, and new inventory will be snapped up as soon as it's created. That's good news for ABC.com and News Corp. and NBC Universal joint venture Hulu, but not so for the myriad sites peddling user-generated video, considered experimental by advertisers even in the best of times. Sites such as Daily Motion, Metacafe and Megavideo could be looking at tough times ahead.

Selling services
It's telling that YouTube's latest revenue gambit, a buy button for content partners, has nothing to do with advertising. Like all online social networks, LinkedIn has big plans for advertising, but the network is not counting on it and has a subscription model and job listings to fall back on.

Less than a year ago, the idea of charging people fees for stuff on the web, and for media in particular, seemed quaint enough that analysts clamored for Rupert Murdoch to pull down the pay wall on WSJ.com after his acquisition of Dow Jones.

It's been a while since anyone has made that argument convincingly. So does this mean consumers are going to be asked to start paying for things? Probably not. "For certain businesses subscriptions work, but for most, they don't," Mr. Levinsohn said.
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