Social climbers

Salil Deshpande should be suffering from Facebook overload.

Three weeks after launching a funding program for applications that run on the popular social networking site, Deshpande and Bay Partners Associate Angela Strange have slogged through hundreds of submissions. Some are from experienced entrepreneurs. Other applicants aren’t so seasoned, such as one team of teenage developers whose parents contacted the firm.

“It’s fun,” Deshpande insists, regarding the review process, which revolves largely around determining if a Facebook app can make money. Bay has yet to invest in anyone through the “AppFactory” program, but Deshpande says the firm is on the verge of funding a few, adding that “the constraint is not capital but the time and effort required to find these and to nurture them along.”

While Bay Partners is unique in its focus on Facebook-related startups, venture firms across Silicon Valley have been flocking to the fast-growing social networking space with the kind of fervor usually reserved for bored teenagers.

This year alone, venture capitalists have poured about $250 million into more than 30 companies that operate social networking websites or offer services centered on the sites (see table). Sequoia Capital has been the year’s most active investor, with five investments. It backed 51.com (a Chinese social networking site), Eons (a network for the over-50 set), Loopt (which lets people locate friends with their cell phones), Minglebox (an Indian network), and Sugar Publishing (whose offerings include a social network for women).

Several other VCs have done at least two deals in the space this year, including Intel Capital, New Enterprise Associates, Redpoint Ventures, Shasta Ventures and Steamboat Ventures.

As usual, funded startups are vastly outnumbered by the unfunded. VCs who invested in the first round of social networking ventures in 2003 report that their inboxes are filling up again with business plans for next-generation applications.

A few months ago, when you talked to VCs, a lot of them would say: ‘It’s bubble time. Valuations are too high.’What we’re seeing now is a new wave.”

Drew Clark, Director of Corporate Strategy, IBM Venture Capital Group

But that may be changing. Facebook’s May decision to open its application programming interface (API) to the public has already spurred a wave of new widget making. To capitalize on the application creation fervor, Bay Partners launched its AppFactory program in July, with plans to make investments of $25,000 to $250,000 in as many as a few dozen applications.

This isn’t so much a social networking play as a platform play, insists Deshpande, a general partner at Bay. “Any time a platform has been successful, lots of money has been made through successful applications on top of the platform,” he says. “So the question is: Is Facebook going to be a platform? We think they’ve got a chance. They are forcing other social networking sites to rethink their strategies because right now the other social networking sites are walled gardens.”

That will change, however, if more popular sites open up their APIs, a move Deshpande believes is likely now that Facebook has done so.

For now, few widgets seem like obvious candidates for venture funding. The most popular Facebook apps—which include a tool for writing graffiti on pages and a template for adding friends’ pictures to one’s profile—don’t have a clear-cut moneymaking strategy. Moreover, the open API hasn’t been around long enough to allow for development of systems to generate ad revenue from apps.

Six degrees of profitability

It isn’t clear if social networking will be the money-minting enterprise so many VCs are counting on. Among established social networking companies, only a handful have disclosed profits or provided profitable exits for venture backers.

Classmates Media, which operates the Classmates.com networking site, posted revenue of $139 million in 2006, up from $85 million in 2005, according to its IPO prospectus. It is still in the red, however, posting a loss of $2.1 million in 2006, compared to $8.2 million in 2005. The Woodland Hills, Calif. company filed to go public in August, and is looking to raise $125 million.

Ten years from now it’ll be pretty much an automatic assumption that anyone on the Internet will be using social networking.”

Dustin Moskovitz, Co-founder, Facebook

Estimating the public market value of a social networking company is difficult, given that there are few comparables, says Ali Mogharabi, an analyst at B. Riley who follows Classmates’ parent company, United Online. To set his estimated $800 million market value for Classmates, Mogharabi says he factored in valuations from companies as diverse as media site News.com and online dating service Spark Networks.

Among private companies, 4-year-old LinkedIn appears to be on track to deliver returns. Executives at the networking site for professionals say their company reached profitability in March of 2006. (Although it did raise an additional $12.8 million expansion round from Bessemer Venture Partners earlier this year.) LinkedIn’s chief revenue generator is a job posting service in which employers pay to participate.

MySpace is also in the black, albeit by a slim margin. For its fiscal year ending June 30, News Corp. reported that its interactive unit, which mostly consists of MySpace, turned a profit of $10 million on revenue of $550 million, largely generated by advertising.

Despite all the money invested in social networking sites, no VC has had a Google-like exit from such an investment. The biggest deal to date was News Corp.’s purchase of MySpace owner Intermix Media for $580 million in 2005. MySpace’s biggest venture backers, VantagePoint Venture Partners and Redpoint, got in at valuations around $50 million and $150 million.

The most notable deals, including Yahoo’s acquisition of photo-sharing site Flickr and bookmark-sharing tool Del.icio.us, happened nearly two years ago. Prices haven’t been disclosed for many of this year’s acquisitions, such as Cisco’s purchase of Utah Street Networks (owner of the Tribe.net networking site) and Hearst Corp.’s planned acquisition of Kaboodle, an online social shopping community. The “deal” that got the Internet in a lather, Microsoft’s rumored $6 billion acquisition of Facebook, has yet to materialize.

Meanwhile, many of the first social networking companies to generate buzz haven’t generated enduring traction. Spoke Software, which runs the Spoke.com networking site for businesspeople, drew $26 million in venture capital investments, with most raised in 2003. It recently ranked 15,568 on Alexa’s list of top global sites. Ryze, another business-oriented networking site launched by a Napster investor, ranked 8,096.

Still, optimism abounds among entrepreneurs. In a panel discussion this summer at AlwaysOn, a conference for entrepreneurs, speakers predicted that social networking would eventually become as ubiquitous as e-mail or search.

Any time a platform has been successful, lots of money has been made through successful applications on top of the platform. So the question is: Is Facebook going to be a platform? We think they’ve got a chance.”

Salil Deshpande, Partner, Bay Partners

“Ten years from now it’ll be pretty much an automatic assumption that anyone on the Internet will be using social networking,” Facebook Co-founder Dustin Moskovitz told audience members in the crowded auditorium at Stanford University. Karl Jacob, CEO of social networking site Wallop, went a step further, forecasting that “social networking is going to be woven into pretty much every product and thing we touch.”

Like Moskovitz, most VCs focused on the space take a long-term view. “I remain extremely bullish on social networks and their ability to increase the vibrancy of online applications,” says Hornik of August Capital. “Social networks gain value exponentially with scale, and since it takes time to get to scale, it will take time for social networks to reach terminal velocity.”

SIDEBAR: IPO hopeful Classmates in red

Despite all the excitement around social networking, there is scant public information to prove that the businesses can make money. Classmates Media’s recent IPO filing offers a rare peak at how the networking sites turn traffic into dollars.

Classmates Media, which includes both Classmates.com and online loyalty marketing business MyPoints, makes its money through subscriptions and advertising. The company, which is owned by free dial-up Internet provider United Online, posted revenue of $139 million and a loss of $2.1 million last year.

Subscriptions are the largest source of revenue. As of the end of June, 2.7 million of Classmates.com’s more than 50 million registered accounts were premium pay subscriptions, which cost $2.50 to $5 a month. Six months earlier, Classmates.com had just 2.2 million paying subscribers.

The spin-out is well-timed because social networking sites appear to be at a peak in terms of value, says Ali Mogharabi, an analyst at B. Riley, who factored in valuations of News Corp.’s acquisition of MySpace and of private companies such as Facebook and LinkedIn. The timing also makes sense for United Online, which built its core business around ad-supported dial-up Internet, which is rapidly being supplanted by broadband.

“The value of the social networking side of United Online’s business was hidden,” Mogharabi says. “They wanted to make sure that since this side of the business is doing well, it doesn’t have to be discounted because the other side is in a declining space.”

Valuation of Classmates Media was not provided in the filings, but Mogharabi estimates it will be approximately $600 million, based on the assumption that United Online will own approximately 80% of shares after the offering. Classmates is seeking to raise $125 million in its IPO.

Venture capital firms aren’t listed as beneficial owners of Classmates Media, but they have funded components of its business and that of its parent company. Classmates.com raised about $13 million between 1999 and 2000 from Arch Venture Partners, BEV Capital and Madrona Venture Group before United Online purchased it for $100 million in 2004. MyPoints raised about $26 million from more than a half-dozen venture investors in the late 1990s, before going public. And NetZero, which became United Online, raised about $50 million in venture capital from investors including Draper Fisher Jurvetson, Accel Partners, Foundation Capital and Clearstone Venture Partners. —J.G.