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Why Social Games have become a $1 Billion market? Selling to the Impatient!

So the social games market has been exploding in growth.  Companies like Zynga, Playfish and Playdom are virtually minting money as they distribute their games via Facebook and other social networking sites.  It is funny as I speak to people about this business, they say to me “I don’t get it”.  And to be honest, that is the beauty of the model.  With about only 8% of users actually paying and really 2% driving 80% of the revenues, it is only a small amount of people that really “get it”.  If you actually dig in and understand why people pay for some of these games, it gets really interesting.  First of all, the motivations of why people play social games are:

1. Challenge of the game.  It is a game and people enjoy the challenge of winning or doing better.

2. Escapism.  I was speaking with a friend of mine of why she plays Farmville and she said she plays it because she like to take a quick break from other thing in her life. Games have often been a  a form of “escapism” and it is true for Social Games

3. Competing and Collaborating among friends.  These games are both competitive in which you want to do better than your friends.  However, a lot people especially women love to collaborate with their friends in order to get better at the game together.

So all of this is interesting but what actually makes people pay?

Well one reason why people pay is because of their impatience. The most successful games in generating revenues from microtransactions are about selling you virtual goods in order for you to achieve higher levels without having to wait.  This is actually a big difference from games designed for hard core gamers like those that play MMOGs like World of Warcraft.  Those games sell virtual goods in order to save you time.  Most of these gamers spend countless hours “grinding” it out in order to achieve higher levels.  However, social games have been designed to be used primarily by people that may go in it every day and spend a short amount of time (like 10 minutes) when they visit.  This is why it has become much more for the masses as it actually doesn’t consume that much of your day.  However, to progress in the game you have to wait.  Take Farmville for an example.  I asked a friend if she thought about actually spending money to buy “coins” and she said she almost did.  Here is what she said

“I was real close to buying coins.  I basically spent all the currency I earned to expand my farm.  I accidentally let some my raspberries wilt and had to wait 4 days for my next harvest.  I thought about buying at that point.  I didn’t and it took me almost two weeks to earn enough currency to afford to harvest a full crop.”

So for a lot of these games, people are ultimately paying because of their impatience.  A lot of these games are not about grinding it out but more about waiting it out.  The game sets you up to have aspirations to progress at higher levels and gives you a chance to get their more quickly by buying virtual goods to get you there.  Still sound weird to you?  Well, we have been accustomed to buying things because of our impatience like express delivery when you shop online.  And that is what driving the growth in the virtual goods market – building games that sell to our needs whether it be impatience, power or fame.

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VC Math

So I just read an ebook titled “Early Exits” by Basil Peters. The book argues that VCs are spurring on companies to go for the “home runs” when it may not be in best interest of the entrepreneurs or angel investors . The book argues that companies should be wary of taking VC money as their business models are reliant to go for huge return exits versus going for “singles” or “doubles”. These singles and doubles can offer very rewarding returns for their shareholders payed out much earlier and with greater probability.

To illustrate the point about the VC business model, he writes the following:

“An Outline of the VC Math

Peter Rip of Leapfrog Ventures describes the math behind VC funds in a fascinating post titled ‘Traditional Venture Capital Sure Seems Broken—It’s About Time.’ This is a high level summary of
how the math works for a VC fund.

In a typical VC portfolio, all the returns are from 20% of the investments. These are the two out of ten investments that are winners. A minimum respectable return for a VC fund is a 20% compound return. For a ten-year VC fund, the fund needs to pay investors 6x their investment to generate a 20% compound return. So those two winners each have to make a 30x return on average to provide investors with the 20% compound return—and that’s just to generate a minimum respectable return.

This math is simplified but it’s more than accurate enough to illustrate this important point. If you are not familiar with the math behind an investment portfolio, I hope you will spend a few minutes with a spreadsheet so you feel comfortable with these numbers.

Even more interesting is that a traditional venture fund is usually a limited partnership. This means that the fund managers only get to invest the money once. So if they make an investment and exit for a 3-4x return, they give the principal and gains back to their institutional investors. They don’t get a chance to invest it again. From the VC partner’s perspective, this effectively guarantees they have failed.”

This is probably a bit exaggerated. In speaking with some other friends that are either VCs or been VCs there are plenty of situations where they would be very content to take a 3 or 4x return. This is especially true if they are a later stage venture capital firm where that type of return would be considered a home run. However, for early stage VCs, I do believe that their model definitely has them put on rose colored glasses if they see that their portfolio company may be able to achieve that home run. This is because the personal risk/reward scenarios for the stakeholders involved.

Think about it this way, for a basic “single” or “double” exit, you can see entrepreneurs making single digit millions of dollars and angels would make anywhere between 3 to 5x from their original investment. Each of them would probably be pretty happy with that. As for the VCs personally (not the funds investor but them personally), it is a very different story. Let’s say they put $3 million in and could exit with a 3x exit. That would mean that they had a $6 million gain ($9 million for original investment of $3 million). The VC would take 20% of the carry being about $1.2 million ($6 million x 20%). Split that among 5 general partners and that is less than $250k each. After tax, that is really not much at all for them personally. So if they have a chance to go for a home run which they could make millions or tens of million of dollars individually and all they had to risk is something like $125k after tax. I think they are more inclined to “go for it”. This is the danger of taking VC money. The shareholders may not be aligned given the very different economic incentives. So bottomline, if you do take VC money, be ready to realign your personal incentives to more closely match theirs or set your terms so they don’t get to completely control your destiny.

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Why Facebook won’t end up like Friendster

This topic comes up constantly. Facebook has crossed the 300 million active member mark which is staggering but there is still some skepticism that they will flame out like Friendster or MySpace. However, what people don’t realize is how Facebook has differentiated themselves as a social networking site. Facebook has done an incredible job on focusing on real life relationships. Unlike other social networking sites, Facebook adheres to people sharing their real identity and connecting with others only if they are actually friends in real life. This positioning is quite different from sites like MySpace or even sites like the ones we created at Community Connect such as BlackPlanet.com. These sites became dominated by people meeting new people. How do I know this? Easy, look at most of the friends’ lists on these sites. Most people have friends of the opposite sex (for heterosexual members of course) and that is because men don’t go online to make new friends with other dudes. That’s not cool. The problem is that it it opens itself to lower competitive barriers and some might argue to a naturally “trendy” lifecycle. If the core experience is meeting new people, the site is more susceptible to lose to the “cooler” place because switching costs are low and past connections don’t have that much value. Think of it this way, sites like MySpace are like night clubs in that they get popular but eventually lose their buzz as other sites come in and offer a new experience for people to meet new people. The switching costs are not high and therefore allow competitors to gain share quickly. Facebook on the other hand has a major advantage. By focusing on existing relationships and the social graph, they now established real switching costs. Going to a new site and having to re-establish all of those relationships is real work. On sites where my “friends” are more superficial and transient, the switching costs are really low. Someone asked me why BlackPlanet.com didn’t completely flame out and that answer is simple – No one opened up another good black online night club.

Mark Zuckerberg was brilliant to take Facebook and make it more niche than sites like MySpace. Think about it, he wanted to make Facebook bigger than MySpace and the key to that goal was to have Facebook narrow down the focus of what MySpace was doing. MySpace wanted you to do both – meet new people and connect with real life friends. He realized that to truly serve those that wanted to connect with real friends that he had to position his site to ignore those that want to meet new people. He realize that by focusing on that segment, he could actually become bigger than MySpace. It’s an example of how making a product more niche and focused actually make the market larger. Facebook is a much better position by focused on the social graph and I predict will be around for a long time.

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What I would have done differently?

It has been a while since I posted to this blog.  I have spent the last 3 months out in Asia.  I did a little work but it was definitely mostly pleasure.  Great to get away from things and have time to think, reflect and clear the mind.  So I have been back in New York for about 2 weeks and recently had lunch with a friend who is a CEO of a publicly traded Internet company.  He asked me during that lunch that now having sold and no longer being a part of Community Connect if I had reflected on what I would have done differently.  It is a funny question because I have thought about it but mostly by recounting specific incidences or situations and not pulling it all together to give an overall assessment.  I ended giving an answer but I think it was a lot of rambling and if I could take a mulligan, this is what I would ultimately say would be the 1 biggest thing I would have changed:

I was Too Deep in the Weeds and not Strategic Enough.

To say the very least, I was a very hands on CEO.  I know this was a flaw of mine.  I often deep dived into certain business operations and initiatives.  For a company of about 100 people, I think it is inevitable that you do that once in a while to make sure that the “factory” is running efficiently but I was in it too much.  Trends and dynamics in this industry change so quickly and you need to be on top of it.  I should have been better aware of our competitors, technology trends, VC dynamics, potential suitor situations and shifts in the consumer market.  I didn’t have my head in the sand but I didn’t spend nearly enough time understanding how the dynamics that affect our business was changing.  Someone once told me that “Timing is Everything” and I realize that it’s not about being lucky.  Instead it is about grasping market dynamics  and being able to “time” the best way to react to those changes especially when they hit that watershed moment.  For Community Connect,  I saw the wave of Social Networking 2.0 sites (Friendster, MySpace, Facebook) but didn’t fully grasp how much of a tsunami it was going to be.  The change that happened in the industry was incredible from consumer behavior, advertising demand, traditional media needs and venture capital funding.  Our path is that we should have either made a bigger move earlier or we should have been bought when we were in more of a leadership position.  We took too much of a middle of the road path and that was not the way to react to such a huge shift.  Some people say to me “how can anyone have anticipated that type of transformation?”.  I should have been able to anticipate it.  We were leaders in the market with the most experience in building a successful online community business.  I should have completely predicted how quickly social media was going to take off.  Timing is everything.   These monumental shifts happen.  You just need to be prepared to take advantage of it.  I won’t make that same mistake…..trust me.  🙂

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Entrepreneurs – Shrink the Market!

Fred Wilson recently posted on his blog his presentation about Disruptive business models that he gave to Google staffers.  The slide I like the most was the one he talks about Shrinking a Market.  He discusses how the Internet continues to get more and more capital efficient.  The costs for things like software, hardware, bandwidth and storage are 1/10th what they were 10 years ago.  I think that this is an underestimation.  Bandwidth for example, used to cost $1200 per Mbps.   Now you can easily get a rate of less than $30 per Mbps.  Anyway, things are a lot cheaper.  Well, combine this capital efficiency and target a market where you can win not only by providing a more effective service but also by undercutting the price and you may become the market leader by shrinking the market.  Fred Wilson quotes another VC who uses this thesis as part of his investment criteria who said “If you have a business that will shrink an existing market, allowing you take $5 of revenue from a competitor for every $1 you earn, let’s talk!”

The example that Fred Wilson discusses is Craigslist and the classifieds business.  The classifieds business was a multibillion business for newspapers and Craigslist completely dismantled that business with a basic online classifieds system that is almost all free.  They charge a minimum amount for certain categories such as job postings that if you talk to any HR person, they will tell you is the most efficient buy in terms of a cost per applicant.  Craigslist is the dominant player in classifieds and has shrunk the market to probably no more than $100 million.  However, by completely owning the market Craig Newmark is basically running a monopoly because no one can touch him in both price and scale.

Shrinking the market isn’t limited to a Web service business that targets a market dominated by an offline business.   It happens in markets dominated by online businesses as well.  An example of this is what PlentyofFish.com is doing.  I was always puzzled on how much money online personal sites could charge and how it really is a capital efficient business if you didn’t have to pay a lot in marketing costs.  Well, Markus Frind figured that out and applied some basic rules including:

1. Pick a Market where competitors charge money and do it for free!

2. Keep your cost low.  Really Low.

He is disrupting a billion dollar online personals market by attempting to shrink the market.  And he is making some incredible traction. Look how he is quickly catching up with market leader Match with just a small fraction of the resources and advertising budget.

So what does this mean for Internet Entrepreneurs?  Well, in a recession economy, running a capital efficient business in not only a necessity but actually can be the main advantage.  Target markets in which you can shrink the market and be the disruptor.

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The Social Networking Advertising Play……..Data!

Getting display advertising to perform on social networking sites has always been challenging. There are inherent hurdles of the media including:

1. User-to-User Communication Experience lends itself for users to zone out ads
The next time you see two people having a conversation, try passing them an advertising flyer. They are far from being in a mode that is receptive to marketing communications. Social networking traffic is made up of primarily this type of communication whether it is exchanging messages, reading your friends status or leaving comments for a friend.

2. Not Aggregated around a Purchase Intent
Sites like TheKnot.com or TripAdvisor.com aggregate users around a purchase intent. TheKnot.com‘s audience is in the process of putting together their wedding and are in the market for services like photographers, caterers and florists. And TripAdvisor aggregates travelers who are in the market for flights, hotel rooms and travel insurance. Well, the issue with most social networking sites is that they are not aggregating users around a purchase intent and are not on the site in purchase mode or even research mode. Therefore, social networking sites are not as effective in terms of bringing consumers to advertisers at the right time to effectively market to them.

So the fundamentals of advertising – reaching the right consumer at the right time and at the right place implies that social networking sites are inherently not ad friendly because they are delivering consumers to advertiser at the wrong time and place. However, what social networking sites may have that is unmatched by any other site is the information so marketers can identify the right consumers to target. Social networking sites collect more self identified data than any other type of sites. Think about the data that you provide…..age, gender, location, marital status, occupation, favorite books, music and movies. And then additional data that you provide as you spend time on the site. When you download the Texas Hold’Em app, they know you like poker, when you become a Fan of the Yankees page they know you are a Yankee fan. So with all this data, how do marketers leverage it?

Well, the best advertising play for display may be taking that data and applying it when a user is on another site. Therefore combining the ability to target the right customer at the right place and time. Sound like something that is far away….think again. Look at what is happening:

LinkedIn.com recently created audience extension targeting by using Collective Media’s Amp platform. LinkedIn allows advertisers to target based on LinkedIn profile information such as Online Marketing professionals on other sites within the Collective Media network which includes most of the Comscore 250 sites.

Facebook is currently working on an ad network play by using Facebook Connect.  Facebook Connect is already getting traction by allowing publishers to grow registrations by using Facebook Connect.  Now they are testing an ad network solution which they will be able to sell ads on Facebook Connect sites by leveraging their user data.

BlueKai has created a data exchange that allow partners to buy and own intent data across any media.  Social Networking sites may be the largest data provider on intent data in this type of exchange.

At the end of the day, data may end up really being the fuel that online display advertising needs to grow more explosively.  The dirty secret about display advertising is that is for the most part a very poorly optimized and inefficient advertising vehicle.  The promise of the online advertising was the ability to deliver the right message via a 1-to-1 basis.  However, the lack of the portability of data has been a major roadblock.  Looks like those days may be over.  Now the next roadblock may be the proper technology to really optimize campaigns using that data.  We will save that for another conversation…..

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The Start Up – Venture Capital Disconnect

Great blog posting on PEHub today.  Venture Capital Right Sizing.

The post discusses how Venture Capital Funding is down about 70% and that is because of the lack of exit prospects.  So here are my two cents at least on how it applies to Digital Media:

1. Venture Capital funds are way too big.  VCs are incentivized to raise larger funds based on the economics of their take.  A 2% management fee and 20% carry – the bigger the fund the more they make.  This caused way too much capital to be deployed to this asset class.

2. Entrepreneurs should be focused on running capital efficient businesses.  They should raise the right amount of money to properly utilize the capital.  The problem with VCs with too much cash is that they need to invest large chunks.  They can’t manage too many investments at one time.  So they want to cut big checks.  The entrepreneurs are then enticed to take in too much money and have layered on some kind of Convertible Preferred that is ahead of them.  Meaning, if they dont’ properly deploy that capital, and if they ever exit, they will have a layer of investors to get through before they are paid.

3. Exits are going to be harder to get and a lot smaller in size.  As the PEHub post states, the IPO market for venture deals looks pretty bleak for a while.  So now you have to focus on M&A.  And according to a lot of investment banking and corp dev people I know, the sweet spot is going to be under $50 million and maybe under $20 million in deal size.  Acquirors now have digital media operations and just want to add.  They are not looking for super large transformative plays.  Can those deals still happen – yes.  But those bets are definitely not going to happen as often.

So where does this lead us for the entrepreneurs.  Run it lean, efficiently use your capital and expect lower exit numbers.  However, if you properly manage your cap structure your exit will still be very worthwhile.

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Monetizing Social Networking Sites

I was invited to be a guest lecturer for NYU’s Masters in Publishing program. The topic I was asked to talk about is monetizing Social Networking Sites. Here is the quick summary:

1. SNS sites are inherently harder to monetize via advertising than other content sites.
2. SNS growth will be driven by Performance advertising and using the extensive profile information to target and optimize.
3. Virtual Good may be the next big monetization frontier for Social Networking Sites

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Insights from another Internet Entrepreneur

So, I recently had breakfast with a fellow Internet Entrepreneur. He sold his company about 3 years ago for over $400 million. I wanted to hear about his thought process in how he decided what he wanted to do next. It was a great conversation and I really enjoyed his insights. Some of his key decision points included the following:

1. Disruptive businesses are more successful than Improvement businesses
This criteria is based on the notion that truly disruptive businesses either create new markets or completely change the paradigm of that market. His belief is that disruptive businesses have a much stronger foothold and are significantly more successful for a longer period time than a continuous improvement business. This entrepreneur said to me “I am sure there is a better way to do Citysearch.com, but I don’t want to be in that business!”. The issue with improvement businesses is that they are in a constant leapfrogging game with their competitors and that you feel like you are a hamster running in the wheel.

2. Small Businesses are more work than Large Businesses
This entrepreneur and I had a mutual investor in Comcast. Julian Brodsky, who was the Vice Chairman, always had these great insights which you would expect from a man that worked with Ralph Roberts for over 40 years in establishing Comcast as the largest cable company in the U.S. Julian advised this entrepreneur to focus on a business that can scale because larger entities actually require less work to run than running small businesses. You don’t think that makes sense? The best way that Julian explains it is to ask yourself “Who works harder? Ralph Roberts or the Local Dry Cleaner?”. Mr. Roberts had an army of people supporting him and really doesn’t work as hard as the local dry cleaner whose business doesn’t scale to afford him that luxury.

3. We have a 10 Year Window as “Internet Bridge” entrepreneurs
Him and I both started our Internet businesses in 1996. We are in a generation where we grew up and are familiar with a non-Internet/Digital Media world and have been in the center of the transition to what it has become now. We have created businesses that have helped bridge this transition. However, there is a new generation that is coming into this business that has never really been exposed to the “old way” of doing things. And thus, their thinking is untainted and their ideas are going way beyond the “bridge”. They will be the ones that cause disruptions to our businesses. His belief is that we have a window of 10 years where we can still be successful and masters of our domain but after that we are in trouble.

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Slow growth of the Internet Display Market because of Social Media

In the JP Morgan Internet Report 2009, they cite that Internet display advertising will grow only 6% while search will grow at 11%. They attribute the slower growth in display to:

– Lower ad budgets given macroeconomic weakness and shift towards performance based advertising
– Continued pressure on non-premium inventory pricing as social networks and other non-traditional sites struggle to find a monetization model that works
– Difficult comps due to the 2008 Olympics and political campaigns
– Continued trouble finding an appropriate way to monetize video inventory without alienating users

The issue of social networking inventory is more complex then what is briefly defined in the report. Social media sites especially social networks have exploded in traffic over the last 5 years. That is no secret. With that being said, the display market has been flooded with billions of additional impressions per month from MySpace, Facebook and the countless social networking sites that emerged on the scene. My guess is that social media now accounts for at least half of the available ad impressions in display. Most of this inventory is sold through ad networks and yield single or teen cent eCPMs. The failure of growth of display is obviously not a supply issue. So why is demand not taking advantage of supply and capitalizing on the this incredibly opportunity of cheap available inventory. Here are some key reasons:

1. Social Media Companies are Not Properly Pricing Inventory
If you called MySpace and tried to buy display, they will quote your prices ranging from an eCPM of $2 to $5 depending on volume, targeting and the placement. However, you can go through other indirect channels (ad network, exchanges, etc.) and pay an eCPM of less than $.20. And what happens is that the high eCPM revenue probably only consumes no more than 20% of their ad inventory. The rest of that inventory gets unloaded through third parties at rock bottom prices. So why the discrepancy? Well, the mindset in these organizations is to price inventory competitively against other sites especially content sites and portals. And they are adamant about it because they feel that pricing their rate card too cheaply will create a negative perception of their site as an advertising platform. They also worried that once advertisers buy inventory at low prices that it will be difficult to get them to pay for high CPMs later.

I find that argument ridiculous and I regret at Community Connect that we didn’t price inventory more efficiently. Whether it is for branding or performance advertising campaigns, advertisers are measuring performance. If you have the available inventory, price that inventory cheaply in order to give advertisers the ROI for them to spend more. Advertisers are complaining about the efficacy of social networking advertising. Of course they are, content sites are naturally better performers on an impression to impression basis because of both the context and the time spent on the page. However, social networking sites have virtually no inventory constraints. So if they can’t beat them by the performance of the impression, beat them in price to get them the ROI that they need.

2. High Engagement is Bad for Advertising IF you Don’t Properly Frequency Cap
Social networking sites have an incredible amount of inventory because there are a core number of users that visit the site regularly and spending an immense amount of time during each visit. Showing that user the same ad too many times is the kiss of death. Most of the remnant ad inventory goes through ad networks which ask for frequency caps but only for their campaign. So let me give you and example:

Advertising.com offer $.40 CPMs and says frequency cap my campaign at 3 per day. Via that campaign they run an ad for Vonage and it is served with the frequency cap. The social networking site then runs ValueClick ads who offer $.35 CPMs with a frequency cap of 2 after they fill the order of Advertising.com (you fill Ad.com b/c of the higher CPM offered). ValueClick doesn’t know that Advertising.com already served the Vonage ad and then serves 2 impressions for the same Vonage campaign to that same user who got 3 impressions from Advertising.com. So imagine if you are the 40th ad network in line and that you are also serving the Vonage campaign. That user may have already gotten 100 impressions that day of Vonage! They are going to completely ignore that ad. Why does this happen – there is no common operating system for the publishers and ad network to know what campaigns are running. The social networking publishers just see a generic ad tag from the ad network and have no idea what ads they are going to run through there and the ad networks have no idea of what campaigns the other ad networks are running and what frequency campaigns. Does this sound efficient to you? This is a disaster that continues to happen in the industry.

3. Not Leveraging the Targeting Capabilities
Tell me of any type of site that collects more individual demographic and psychographic data than social networking sites. You can’t because the amount of data that is collected from users is unsurpassed. Everything from age, gender, location, school, occupation, religion, marital status, music interests, favorite books and movies, and on and on and on. What a treasure trove of data. Yet no one knows how to leverage it. The ideal advertising technology would be able to take a campaign and be able to determine what segments are performing better and weigh those impressions accordingly. It would be able to tell what attributes of that user actually correlate with performance (for example does gender or whether they do yoga effect performance) and then create segments on the fly to optimize against. Now imagine how you can then use this data across other sites to combine with context to further optimize a campaign. Can you imagine if you can run a pharmaceutical campaign on a health site with the additional targeting from the data that was acquired from a social networking site. If you can optimize based on context AND demographic AND psychographic then you would see much stronger ROI from display.

Internet display advertising is not exempt from the basic tenets of effective advertising:

“Delivering the right message to the right person at the right time” (while of course doing it at the right price). This was the promise of internet advertising. I can tell you right now for social media, it is not even close to living up to that promise. They figure this out, you are going to see real growth in social media advertising.

JP Morgan Nothing But Net Report 2009

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