Money from Friends: Finding the Right Revenue Model for Social Media

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Mark Zuckerberg’s honeymoon with Wall Street did not last long. Since Facebook’s initial public offering in mid-May, shares have fallen by 58% to $40.8 billion. Last week, its stock dipped below $20 a share with the expiration of a lockout barring the company’s initial investors from selling their holdings. Mobile games developer Zynga also has fallen off a cliff since its IPO; the company’s market cap has plunged by 81% from its peak as flaws in its business model emerged. Groupon, whose shares have struggled amid questions about its viability, fell even further — down 85% to $3.1 billion. CEO Andrew Mason might be kicking himself for turning down Google’s $6 billion buyout offer.

Investors, it would seem, are giving a collective thumbs’ down to social networks. Yet investors across the board also tend to move in tandem, often throwing away the proverbial baby with the bath water. For example, a single piece of bad news about a company can tank shares of competitors in the same industry — a malady that has afflicted social networks as well. While investors might lump Facebook, Zynga, Groupon and their ilk together, these companies are not replicas of each other. All offer an element of social networking, but only Facebook is a pure social network and, with its nearly one billion users, is a unique entity unto itself. As such, experts suggest caution when making generalizations regarding the plight of social networks based on Facebook alone.

What is a social network? At its most basic, it is a group of individuals wishing to connect to each other digitally in order to socialize. Facebook users want to know what their friends, relatives and acquaintances are doing. The company’s main purpose, as Zuckerberg himself has often noted, is to “make the world more open and connected.” Zynga is a developer of games that use social networks to connect players. Its main purpose is gaming, not socializing, although that can occur through games. Groupon uses the power of the collective to get bargains. But the purpose of joining Groupon is to purchase products and services, not to socialize. Twitter is more similar to Facebook, although its follower approach makes it a quasi-social network. LinkedIn members use the platform to socialize and network professionally.

Investors might be punishing most of these companies too harshly for not getting their financial ducks in a row as they test different ways to monetize their businesses. Wall Street does hate uncertainty, experts point out. But the decline could be merely a short-term effect, given that the concept of social networks is fairly new, and business models are still being fleshed out. “It’s clear Facebook and other social networks haven’t figured it out yet,” says Wharton management professor Ethan Mollick. “Things are stacked against them in the short term.”

The Facebook Model

Typically, the early focus of social networks is to build up a base of users quickly by offering their services for free. But once these networks gain traction, costs to serve the users escalate. The companies then face the dilemma of figuring out how to make money from their many followers without alienating them with too many ads or suddenly charging for basic services. It can be a tricky balancing act. “It’s a double-edged sword for these social networks,” notes Wharton management professor David Hsu. “Once consumers are used to a revenue model, it’s very difficult to change it.”

Social networks, Hsu says, should have a monetization path in mind at the beginning for a smoother transition. “It’s important to think through how to make money from the start,” he adds, pointing to the digital revenue models of The New York Times and The Wall Street Journal as examples of how tough it is to switch business strategies once readers are used to a certain model. The Times faced a consumer outcry when it decided to charge for online content that used to be free, he says. The Journal, however, has never faced such a backlashbecause readers have always had to pay to access its content on the web.

Facebook is attempting to modify its business model as well. Currently, nearly all its revenue comes from advertising. Can it stay that way? “It can work, but it is always a good idea to supplement that with subscriptions,” says Wharton marketing professor Pinar Yildirim. Whether or not the social network will implement some sort of paid subscription plan, it certainly has been busy diversifying its sources of revenue. In 2009, around 98% of total revenue came from ads. But the proportion fell to 95% in 2010 and got whittled even more in 2011, to 85%. Last year, users buying digital or virtual goods on Facebook, along with fees from other services, generated the remaining 15% of revenue, according to Facebook’s registration statement filed with the Securities and Exchange Commission.

Social Media on the Stock Market

Results have been mixed for social media companies that have gone public.

        
— LinkedIn: May 19, 2011

LinkedIn was the first social media company to debut on the stock market. The IPO was priced at $45. The share price closed at $94 that day and now trades around $104 a share.

— Groupon: Nov. 4, 2011

Groupon opens by selling 35 million shares at $20, raising $700 million and bringing its market cap to $13 billion, the largest IPO since Google in 2004. The price is now around $5, 71% below the IPO.

— Zynga: Dec. 16, 2011

Zynga opens with an IPO of $10 for 100 million shares, raising $1 billion and breaking Groupon’s record. Shares are now around $3, also a 70% drop.

— Yelp: March 2, 2012

Yelp opens at $15 a share.On the first day of trading, shares ended up 64% from their opening price. The stock now trades around $22.

— Facebook: May 18, 2012

Facebook opens at $38 a share. Stock is now down 60%, trading around $20 a share. Facebook’s stock plunged to a new low Aug. 16, the first day early backers could sell.

Source: ValueWalk

Still, since advertising remains the main revenue driver for Facebook, the company is working to rev up its ad engine even more. For example, it is testing the Facebook Ad Exchange, which lets marketers bid in real time for their ad to appear on a web page while an Internet user is visiting it. Based on third-party data about the user, certain marketers may spot a target customer and decide to bid more aggressively for their ad to appear. Facebook also recently started rolling out “Sponsored Stories,” where ads contain comments of users who like certain products or services. However, the company is being sued for allegedly violating a California statute that bans the use of a person’s name or photo in a paid ad without consent.

In addition, Facebook is working to make ads more relevant, with a measurable return on investment. It has partnered with Nielsen to demonstrate that people remember its ads better. “Facebook ads drive 98% better ad recalls and 31% higher brand awareness than non-Facebook online ad campaigns,” said COO Sheryl Sandberg during a recent earnings conference call with analysts, citing studies of more than 500 ad campaigns. “That is not surprising since people are more likely to remember a message that comes from a friend.” In addition, she noted that Facebook is making progress on measuring how its ads lead to actual sales. An independent analysis of 60 campaigns showed that 70% delivered a return on ad spending of three times or better than other ads while about half of these campaigns returned five times or better, Sandberg said. For example, Electronic Arts spent $2.75 million promoting the game “Battlefield 3″ on Facebook and attributed $12.1 million of sales to these ads. That translates to a 4.4 times return on their ad expenditures, she added.

Advertisers remain cautious. General Motors famously yanked its advertising from Facebook earlier this year, saying its ads there did not boost car sales. The Wall Street Journal noted that GM spent a comparatively miniscule $10 million on Facebook out of a total $1.8 billion ad budget in 2011. (GM reportedly later began talking with Facebook about resuming the ads.) It did not help that around the same time, U.K. digital marketing agency Greenlight released a survey showing that 44% of respondents never click on a Facebook ad or sponsored listing, and 31% rarely do so. “Today, nearly every one of the Global Ad Age 100 advertisers spends with us every quarter,” Sandberg stated during the earnings call. “But to date, most only allocate a small slice of their budget to Facebook even though their customers spend large amounts of time using our service.”

That is not to say that ad revenue models rarely work out. They can be the main revenue source for a business, depending on the user’s purpose in visiting the website or mobile app. Google thrives on ad revenue because when people search for information, products or services, they are open to purchases. Therefore, it is a logical place for ads. With pure social networks, people visit the sites to talk to other people. They are not there to make purchases, although it could happen. “Consumers who go to Facebook aren’t there to buy anything,” Yildirim notes. That is one reason why Facebook has a tougher time convincing advertisers to spend money on its platform. In contrast, Google and even Yahoo, with all its troubles, remain must-buys for online ads.

Facebook sees the problem and is attempting to invent a revenue model for social networks that has never been seen before. “We’re a completely new kind of marketing. We’re not TV; we’re not search; we are a third medium,” Sandberg said. “And that presents a challenge because the messages that talk at consumers on other platforms need to really be adapted and changed to be more inclusive. The right ad on TV or on search is the wrong ad for Facebook. Facebook marketers need to learn how to make their ads really a two-way dialogue with consumers.”

Zuckerberg thinks social ads are the future. “The best type of advertising is a message from a friend. Facebook wants to offer advertisers the best tools to create ads that are social. We believe that the more our advertising includes interesting content from people you care about, the more marketers will be able to create advertising that adds value to people’s experience on Facebook,” he noted during the same conference call. For example, Zuckerberg said, if he likes a restaurant and he shares it on Facebook, “that’s likely a more convincing ad than anything the restaurant would produce on its own. That’s an example of aligning social activity and ads.” This may be true, but the quality of the tips can be degraded if they come from folks you barely know, Yildirim points out. Many people accept Facebook friend requests from acquaintances, or even someone they have never met.

Facebook may be taking the lead in creating a new ad revenue model for social networks, but that does not mean its efforts can be copied successfully. At least for now, there is no other social network like it on earth. Indeed, where other social networks may fail, Facebook could succeed due to its sheer size, says Mollick. “They have so much data available on customers [that] there should be a way to make it work.”

Scale is critical to Facebook because the company depends mainly on advertising. But businesses where socialization is secondary to its main purpose often have a greater variety of revenue models beyond just advertising and subscriptions. Because Groupon’s main business is to sell discounted deals, its problems are different from Facebook’s. Groupon’s business model is under fire because it can be copied easily. Moreover, it attracts shoppers who flit from place to place for discounts but rarely become regular customers. “It is highly unlikely that they will become loyal consumers, or come back for repeat purchases,” Yildirim says. Zynga is a different story. Its challenge is to continue to be creative with games and reduce dependency on Facebook, she adds.

Ads, subscriptions, selling of consumer data to third parties, revenue from app developers and direct sales of goods are all sources of revenue for most social networks, Yildirim notes. Some networks like Wikipedia rely on donations. Moreover, revenue-sharing models exist where the consumer gets paid to create viral content, such as Metacafe. “Most networks are still experimenting to decide what revenue model works best for them,” she says. “There is no single one-fits-all model.”

Facebook at least is treading carefully and working creatively to figure out the right model for its business, Mollick states. “There’s a degree to which we should be happy that Facebook is taking its time to make this work right. The social networks — the way we see them now — are a relatively new thing in the world. They have value, but it’s not clear how we are going to extract it. That doesn’t mean there isn’t a way.”

How LinkedIn Did It

One major U.S. social network that has not suffered much in the stock market since its IPO is LinkedIn. Its market cap stands at around $12.4 billion, down slightly from the all-time peak of $13 billion. Founding member Lee Hower, now a venture capitalist, says the business model for the company arose organically. Since LinkedIn was aimed at job seekers, networkers and recruiters, it was logical to charge them to get access to expanded tools on its site, with the basic membership staying free. Businesses would pay to post jobs, access a suite of recruitment tools and search user profiles for potential job candidates. Employees would pay a subscription fee to get expanded job listings and contacts. In 2011, hiring services comprised half of LinkedIn’s revenue. Advertising, including display ads, took up 30% of revenue while the rest came from premium subscriptions, according to LinkedIn’s latest annual report filed with the SEC.

Hower, Reid Hoffman and other colleagues from PayPal started LinkedIn in 2002. Back then, Hower said, companies such as Monster.com dominated online job searches. But LinkedIn decided to add a social component to its jobs site — something Monster did not do — and that feature made the service indispensable to users, prompting them to visit more often. People created professional profiles and they linked to other people on the site for networking. “If you think of Monster or a job board, end-users only use it when they are thinking of looking for a job,” Hower points out. Not so with LinkedIn.

Making the site a social network was a risk. According to Hower, the founders believed that it would be a powerful tool, but as trailblazers, they had to invent a new business model that melded jobs services with social networking at a time when the idea was totally new. “There was no real notion of social networking. Facebook didn’t exist,” Hower notes. “We created a unique business model that was suited to a product that we built.”

As they innovated, they tinkered with LinkedIn’s features. They initially thought that adding photos to user profiles on the site would be a violation of privacy. “That’s something that’s changed over time,” Hower says. “As LinkedIn became more widespread and [better] known among white-collar professionals, people had a clear sense of the brand, and it was less of an issue.” Another change was to let the public access the profiles. Back then, “you could only search people you were connected to. Via the friend of a friend, you could view that person’s profile and contact them. There wasn’t a notion of a public profile.” Now, it is a common feature.

One thing that did not change was a decreased emphasis on advertising revenue, a strategy that fits well with LinkedIn’s business model. “Unlike Facebook, people on LinkedIn visit the social network to access the ads [i.e. job listings],” Yildirim says. “Both from the employers’ and employees’ [point of view], it makes sense to be on LinkedIn and pay to advertise jobs and get access to people.” But LinkedIn should ensure that it can handle more growth, she notes. “Similar to Facebook, if LinkedIn grows too large too fast, it may start to suffer from the clutter of people and jobs.” Mollick agrees: “LinkedIn has shown that it can monetize, but it could still run into the limits of exponential growth that Facebook is worried about.”

Hower says that at the time LinkedIn started, the online ad market was much smaller than it is today. Online advertising had gone through an upheaval — an upsurge in the late 1990s, followed by a decline in early 2000s during the dot-com crash. Given the ad environment and LinkedIn’s purpose in connecting professionals and recruiters, the founders decided on a business model that charges workers and companies for expanded access to the site’s career services. LinkedIn would act as a repository of professional profiles for use throughout an employee’s career within a dynamic social network. It was a revolutionary concept. Hower calls it “resume 2.0.”

They were not always sure their ideas would work. “With any tech start-up, you have both confidence in what you’re trying to do and also some uncertainty,” he says. “If we look back to our original business plan, a lot of what we hoped might happen has come to fruition.” While LinkedIn decided not to rely heavily on ad revenue, it does not mean the business model will be problematic for social networks in general. As long as a site can reach millions of users, ads will come in time. “Advertisers lag,” Hower notes, “but they do come.”

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