On social network transience and profitability

Consider this piece of logic from Derek Powazek:

The flow, as I see it, works like this.

  1. We want to be a social network. The more people in it, the more “value” it has, so we need everyone to join. Because we want everyone to join, we cannot put up a pay barrier, so we have to make money another way. Let’s say advertising. (Note: Most never make it this far.)
  2. Our advertisers want as much data about, and contact with, our users as possible. We want to only allow limited engagement. Either advertiser interest wanes (Flickr), or we coast on our investment (Twitter, Tumblr), or we give in and let the advertisers run the show (pretty much everyone else).
  3. Members become angry at us because we’re selling them out. The exodus begins. There’s always somewhere else to go (see Friendster, MySpace). Go back to step 1.

See it? The bigger you go, the harder the road.

And a similar idea put differently by Maciej:

Were you a big Gowalla fan? Did you like Dodgeball? Did you think Trunk.ly (gasp!) was better than Pinboard? Did you make a lot of contributions to Nextstop? Do you miss Aardvark andEtherPad? Did "I Want Sandy" change your life?

These projects are all very different, but the dynamic is the same. Someone builds a cool, free product, it gets popular, and that popularity attracts a buyer. The new owner shuts the product down and the founders issue a glowing press release about how excited they are about synergies going forward. They are never heard from again.

Whether or not this is done in good faith, in practice this kind of ‘exit event’ is a pump-and-dump scheme. The very popularity that attracts a buyer also makes the project financially unsustainable.

I think there is something in this. Facebook and LinkedIn are highly profitable free social networks, but I can’t think of any others. I can however think of many that are very popular, but not making money – Twitter, Tumblr, and Pinterest spring to mind. Four or five years ago the list of free social networks that were popular but not making money was equally long, but totally different. Back then I might have listed Bebo, Myspace, and Friendster. Of these three, two sold out for what seemed like big headline prices at the time before going into terminal decline and the third (Friendster) slowly faded into insignificance. The most common explanation for this is that they were fads, but maybe the tension between user experience and profitability had more to do with it.

From Flickr to Instagram, over the last ten years building large but unprofitable social networks and selling them to large corporates has been a lucrative business for entrepreneurs and their VCs, but it hasn’t usually worked out well for the acquirers, or more accurately their shareholders. This imbalance won’t continue forever. I think the two ingredients for change are acquirers getting smarter about assessing whether their target has the magic to be one of the very few that monetises like Facebook or LinkedIn, and reduced valuations on the public markets for acquirers (high dollar value acquisitions look cheap to CEOs of companies with highly valued stock). The first of these ingredients isn’t far away, and may even be in place already. The second is harder to predict.

The implications of this analysis, which I’m not yet wholly sold on, is that the odds of winning the ‘get big really fast’ lottery are in decline. This is a bit counter-intuitive given recent successes at Instagram and Pinterest, but it is important to remember the large numbers of Pinterest wannabees and avoid being deceived by selective reporting and success bias.

Bonus extra: When he’s not writing about social networks Derek Powazek edits a quarterly book of true stories and original art called Fray. It’s rather good.

  • http://www.gamesbrief.com Nicholas Lovell

     I think there is a different explanation, well articulated by Tim Wu in his excellent book The Master Switch, known as the Khronos Effect.
    Khronos was a Titan who believed that one day one of his children would usurp him. To prevent this from happening, he ate his children as soon as they were born, until somehow Zeus escaped and, indeed, usurped him.
    The Khronos Effect explains the dreadful track record of acquisitions of AOl and Yahoo and others. It doesn’t have to happen on purpose. Sometimes the organisation kills it by mistake (by forcing a strong existing community to jump through corporate AOL or Yahoo hoops, for example).
    But it keeps happening. I suspect the Instagram acquisition by Facebook was a Khronos acquisition: Facebook knows that mobile poses an existential threat, and will buy things that threaten it.
    The Khronos strategy fails when entrepreneurs refuse to sell. As Zuckerberg did. As Pincus did.
    And so the Titans will fall.

    That’s one theory, anyway 🙂

  • http://www.theequitykicker.com brisbourne

    Bad management post acquisition is definitely part of the story, but social sites that don’t get acquired fail too – e.g. Friendster and Digg.

  • http://twitter.com/FredLardieg Fred Lardieg

    Nic, you are raising interesting points. 

    If the social networks that are profitable are the independent ones (e.g. Facebook and LinkedIn) and the ones that got acquired never made money (e.g. MySpace, Flickr, Bebo, etc.), I think you have to question the role of the corporate acquirers.

    These large social networks take a long time to reach profitability because 1. growing the user base takes time and 2. getting the balance right between user experience and profitability takes a lot of tweaking, u-turns (e.g. Facebook Beacon) and patience. Large corporations don’t do tweaking. They usually don’t have the patience to allow their recently-acquired start-up to find the right revenue model.

  • http://www.theequitykicker.com brisbourne

    Hi Fred – staying independent is no panacea, but maybe it is a necessary condition. If the rumoured acquisition of Facebook by Yahoo a few years back had gone through I doubt whether they would have had the stomach to invest as much in the platform as DST and all the other guys did.

  • http://www.charleshudson.net chudson

    Theere is a nuance which I don’t think is captured here. There are some networks that need scale in order for the business model to work and there are those where there simply isn’t a business model at all. Take LinkedIn for example. You describe it as a “free” social network, which it is for the majority of its users. But there is a non-trivial transactional and advertising business that generates hundreds of millions of dollars in revenue per year because LinkedIn is the de facto place to look for professional information. That business model wouldn’t work nearly as well without scale. You need the critical mass of audience to make the thing work.

    The same is true of Facebook – if you want to have a value proposition about having social preference data about everyone, you need everyone on the network. Having deep information on a small chunk of the audience isn’t interesting – you need everyone. And we know that Facebook has a pretty good business as well.

    I struggle to think of a meaningful social network that achieved scale and was unable to monetize. The services you mentioned above (Aardvark, Dodgeball, etc) never achieved scale. So it’s not surprising that they were shut down or turned into the forefathers for other services. I think Twitter and Pinterest have audience and can both monetize well – just too early to tell at this point. 

    Oh, and about users abandoning services. Despite the amount of complaining that users have about Facebook, Linkedin, etc., defections are far less common than one would suggest. Yes people quit Friendster (the site couldn’t stay up) and MySpace (ugly UI, too many ads, and a good alternative in FB) but lots of other networks are able to continue monetizing without alienating users. 

  • http://www.theequitykicker.com brisbourne

    Hi Chris – scale is critical to the business model at LinkedIn and Facebook, but they are the only two social networks I can think of which have adopted the ‘build a huge audience and the business model will come’ strategy and ended up with a sustainable business. The insight here, if it is an insight, is that most sites end up selling out because they can’t find a business model, or ruining the user experience with too many ads.
    Facebook defections aren’t very common, but the same isn’t true of Bebo, Myspace, etc, and time will tell for Pinterest and Tumblr. Twitter is probably a different case – the question there is more will profits get large enough to justify the investment that has gone in.

  • http://www.charleshudson.net chudson

    If you’re arguing that you have to be large to have a good business as a social network, I generally agree.

    The examples you cited (Bebo, MySpace) did not achieve Facebook-like scale. Not saying they couldn’t but they didn’t. Most of these business have strong network effects and if the market tips in your favor it works great – if not, social networks are not great businesses. If those sites had achieved Facebook-like scale, the same business opportunity (namely selling advertising powered by social data) would have been just as available to them – it’s not (IMHO) a failure of the ability to find a business model but rather a failure to achieve the scale required to make that model work. In the absence of scale, lots of social networks start doing things that hurt user experience in the name of monetization and hasten their decline (Myspace) or look to sell (Bebo).
    To me, Tumblr is not a social network – it’s a social publishing platform. Limited network effects. Clearly going to be supported by display ads. I am much more bullish on Pinterest as they have the ability to mediate transactions. They are already a significant source of referral traffic for many sites and I struggle to see how someone who is a big traffic referrer ultimately doesn’t monetize that position. 

    Also, I can’t think of any social network that grew quickly by putting the business model first and rigorously enforcing it before they had traction and scale. Social networks need social signals and social data for most of their business models to work.

  • http://twitter.com/a_alshalabi Abdullah Alshalabi

    Very interesting post. I genrally agree with everything you mentioned in this post, however I want to raise a point about Pinterest. I think Pinterest have a much better chance to monetize its platform, more than any other social network we previously had. While most social networks are about people, Pinterest is about products!! Pinterest is in the middle of the e-commerce experience, it’s your personalized catalog and with the Rakuten investment, people will be able to buy with one click.

    I’ll also argue that Facebook didn’t nail a revenue model that validates its valuation yet. While its Ads are showing some encouraging figures in mobile, you can feel that Mark Zuckerberg is still not  comfortable with its revenue model that relies on display Ads. Chris Dixon also talked about this subject http://cdixon.org/2012/05/15/facebooks-business-model/. I believe that Zuckerburg is aware of the decline in display Ads and he is willing to further test other new ways to monetize FB, however its always risky to search for a revenue model when you are a public company!!

  • http://www.theequitykicker.com brisbourne

    Interesting debate.

    Facebook and LinkedIn both innovated cleverly to find their business models (newsfeed, app platform, Facebook Connect, tools for recruiters) and their investors were happy funding huge losses in the belief that their innovations would be successful. Twitter’s investors are now making the same bet. It increasingly looks like you need truly massive scale and very patient investors for that bet to be a good one, and very few startups have those two characteristics.
    Pinterest might do, but it might not. Their first attempt to monetise their referral traffic went down terribly with their users, and they are still some way off massive scale (although, to be clear, I would be happy to have invested in them).
    I agree Tumblr is different and I shouldn’t have lumped them together with social networks, although investors attribute much of their recent growth to people leaving Myspace.
    My argument overall is that free social networks need to be very large to be successful and that the chances of success pursuing that goal are receding. Small social networks can be viable businesses, but only if they charge directly.

  • http://www.theequitykicker.com brisbourne

    It is going to be interesting to see whether Pinterest ends up being a commerce site or a social network. So far I think it is more the latter. The primary use case is communication and sharing, not buying products.
    Re Facebook – they have a profitable business model so they will be fine. Their problem is in living up to the promises they made to Wall Street, which whilst important is a second order problem.

  • http://www.facebook.com/stephen.beath1 Stephen Beath

    I wonder how long it’ll be before Facebook and Yahoo team up – imagine a reasonably good search engine within Facebook and all of a sudden advertisers will get really interested because they can start serving up really relevant adverts rather than relying on demographics and interest subjects. It’s the reason why many get such a good Return on Google due to its relevance and conversion to sales.

  • http://www.theequitykicker.com brisbourne

    Has Yahoo got good search?

    Sent from my iPad

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