I was finally catching up on old magazines and came across a September issue of Business 2.0 and an interesting article “The Facebook Economy.”   We hear so much about web 2.0 social communities, so how does an angel investor determine the hype from the substance?  Do they watch this trend flame out or do they jump on the wave?  The danger of the hype of the web 2.0 companies is that we can get caught up in the same groundswell of exciting yet non-commercial concepts as we saw happen in 1998 with the flood of dot-com investment opportunities.  It is important to understand that “web 2.0″ isn’t a new technology platform or a new World Wide Web, rather it references the changes in how software developers and end users use the web.  It is kind of like the difference in 2-D and 3-D video.   It is still video but in changing the way it is used, you create a whole new experience.  Visit http://en.wikipedia.org/wiki/Web_2.0 to get more insight into the start and evolution web 2.0.

The west coast angel investors seem to “get” the web 2.0 social community concept and invest seed and early stage capital.  The shock of the market value on such early market makers such as Myspace and YouTube got the attention of angel investors seeking the excitement of jumping in and being at the forefront of another trend.    The east coast private equity investors and venture capitalists seem to be much more hesitant for two very valid reasons: 

1.  It is hard to identify the shining golden apple from a whole bushel of apples…..   so many of them are popping up all over how does one know which one is the one that will make it when you don’t want to be the one that bet on Pets.com (the one with the sock puppet) , a pure Internet play, rather than the investment in a hybrid that made it like PetSmart.  

2.  Similarly to the dot.com bubble, the revenue models for the “social community” companies is often ill defined.   Therefore, individual investors have a difficult time understanding how the company will scale and produce an expected return on investment.   Wise early stage investors are wary of an exit strategy that is solely based on attracting enough users (eyeballs) to the become an attractive acquisition candidate, but lacks a strategy to create positive cash-flow.  Fundamentals of business should still apply regardless of whether or not a company is part of a hot trend or not.

 So here are 4 revenues streams that a web 2.0 “social community company” ought to address….either because it is included in their revenue stream or because it is not, and therefore why it is nota valid revenue stream for them….what is now being called the “facebook economy”:

  1. Sell Ads:  obvious and the most documented source of revenue for web 2.0 communities.   The problem is that it depends on the volume it drives.   The very nature of web 2.0 social communities is that they have a viral appeal that causes one friend to tell another friend and so on and so on.  That is very “trend” centric and anyone who has paid attention to trends know that the come and go and the Internet speeds up that process of fire to flame out significantly.    The whole world of pay per click and screen real estate selling is changing more rapidly than one can even forecast therefore it is an extremely unreliable source of revenue for a start up/ early stage company to build a whole company on.
    Take away:   if  a web 2.0′s company’s primary source of revenue is advertising they are a turtle with their head in their shell.
  2. Attract Sponsors:   This is a viable alternative to advertising in that the “sponsor” is advertising but to a very targeted group and often it is related to a symbiotic product or event.  It is similar to product placement in a movie or show.   When you see the stars of your favorite show drinking Budweiser instead of some unknown foreign beer or no name, you connect with that image. 
    Take away:   If a company has some focus group that it has been successful in targeting, sponsoring because a valid alternative to advertising….it is like the “infomercial” for an online alternative.  It takes longer to develop the validation of a sticky community, but can be much more effective because the community doesn’t realize they are being “sold to”.
  3. Sell services:  This is  as a result of the large onslaught of ancillary applications (widgets and plug-ins) that avid users of social communities use to enrich their experience.   Usually there is a “free” version to get started with and then a for fee version for an enhanced functionality.   
    Take away:  This is a very viable business model because a compelling application or service will gain a loyal user community.  Awareness often comes from others seeing the functionality or the use of that app/service and with built in click appeal, that company has a new user.   As an investor, you need to make sure the management team really understands the viral marketing strategy and knows what their target market will bear.   You don’t reach users and paying customers with a Google adwords campaign for this type of business model.
  4. Sell Products:    Typically, this is affiliate products being sold for pennies on the dollar.   The idea is “now that I have eyeballs at my site, let’s sell them something”.   It gets very compelling when the products are actually originated and centric to the community.   The products become popular in the same viral way the web community gets known and embraced.
    Take Away:  This is much more like an old school business model that has a new twist because the “store” and the target market is all virtual and none of the old rules and methods apply.   But given a management team with insight and knowledge on how this can be done, in part because they are part of the “facebook” economy as users, this can be very solid.

The article only listed the 4 revenue sources, and I’d like to add a 5th: Subscriptions.   We are seeing a trend where users are willing to pay a monthly subscription to get better or more services.   They can participate a long as they want for free for basic service or usability, but at some point their hunger for more will drive them to upgrade.   This revenue model has the greatest scalability and brings together both worlds:   Cash-flow and the hype of a large user community.   The other revenue streams (advertising, products etc) can add onto the foundation of subscription revenues.

Bottom line:  An early stage investment opportunity needs to have a plan to reach cash flow positive in the foreseeable future.   It doesn’t take a lot of money to launch a web 2.0 community and to make it known if the company knows how viral marketing in social communities works.   Often, the company will grow organic and have minimum friends and family seed investors involved and only seek significant capital when they are ready for the real push into the market and their platform needs to be enhanced to make it more robust to handle volume and incorporate new features.   This is a good time to get involved for an angel investor because the valuation is still low, but the basic market appeal and business model has been proven.

I welcome any insights you may have as investor who has invested in web 2.0 communities, the decision process you went through, or other insights you have gained regarding investing in this sector.

UPDATE  to POST 2/14/09.  

Statistics posted at www.techcrunch.com shows that the term web 2.0 is dropping off dramatically in search engines and in the way that companies describe their online business.   I commented that we have seen the same thing when companies submit their business plans to angels for investment.   I think web 2.0 isn’t going away or dying, it just isn’t novel anymore.  Companies aren’t using it to describe their companies because it as assumed they are integrating that functionality in any web design.  Like not calling your company a dot.com company by year 2000. 

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