The Network Effect

Whenever the economy slows, one of the very first industries to get squeezed is advertising.

The current downturn is no exception. CBS, which makes most of its money from traditional advertising, said its TV ad revenue declined 6% and its radio ad revenue was down 10% in the last quarter. And Internet companies that rely on online advertising, such as Yahoo, have seen profits drop and are adjusting their outlook to reflect uncertainty.

But surprisingly, the cratering economy hasn’t prevented VCs from pouring huge amounts of cash into online advertising networks, which connect name brand advertisers and ad agencies with websites that want to host their advertisements.

Investment in the sector has soared over the past year, with venture capitalists pouring about $220 million into 23 ad networks in the past year alone, according to Thomson Reuters (publisher of VCJ) and VCJ research. That’s a huge jump from the $68 million that VCs invested in 11 such companies in 2007. (See table and chart.)

The most active venture firms in the space are Draper Fisher Jurvetson and the Mayfield Fund, which each made three investments this year.

Narrow-Minded

How many markets do you know that will go from $25 billion to $50 billion in the next four years? Investing in and building a successful ad network is one of the very best ways to take advantage of this opportunity.”

Jason Green

The more focused the network, the better, it seems. Among the startups that have received backing this year are Travel Ad Network, which operates an ad network for the travel industry, Martini Media Network, which runs an ad network for equestrian sports and other leisure pursuits, and Yardbarker, which operates a network of sports blogs and recently launched an ad network to target sports fans.

Advertising networks are on the rise, say industry watchers, because the Web is fragmenting around smaller, vertically focused Web properties and communities. For instance, sports fans aren’t just attracted to generic sites like ESPN, but are increasingly visiting niche properties that provide a greater level of detail and commentary around their specific passion, whether it’s bass fishing or bowling.

These sites, however, are too small to attract brand name advertisers or hire salespeople on their own. And advertisers would rather not deal with thousands of individual websites. That’s where ad networks come in. They aggregate these niche sites into a cohesive network, acting as one-stop shop for advertisers while providing publishers a better opportunity to monetize their sites.

But can these ad networks make money in an economic downturn? VCs understand as well as anyone that the advertising market will be hit hard by a recession. But they insist that “traditional media” that will take all the lumps, while the online world, especially ad networks, will continue to get a larger piece of the overall ad pie. That’s because ad networks are seen as a more efficient and lower-cost alternative to traditional marketing campaigns.

“We are still in the infancy of traditional ad dollars moving from old media to new media,” says David Welsh, a partner at Adams Street Partners who invested in a $10 million second round this year for Sportgenic, a company that brings together sports publishers and advertisers. “The ad market could get smaller and the online portion would still get more robust.”

History lesson

We are still in the infancy of traditional ad dollars moving from old media to new media. The ad market could get smaller and the online portion would still get more robust.”

David Welsh

That’s exactly what happened in the mid-1980s when the U.S. economy went through a recession, Welsh says. “There was a contraction in advertising, but cable, which was just gaining traction, was still able to capture more dollars because it was a much better way for advertisers to channel their ad budget.”

Today, the total U.S. advertising market is about $150 billion, according to industry research firm TNS Media Intelligence Inc. Online advertising is still a fraction of that, but it’s growing at a much faster clip. According to research firm eMarketer, the U.S. Internet ad spend this year will be $25.9 billion, and that number is expected to skyrocket to $51 billion by 2012.

“People are getting more and more of their information and content online, but the ad dollars are still largely in the old world,” says Josh Stein, a manager director at Draper Fisher Jurvetson, which has invested in three ad networks this year: Yardbarker, Glam Media, an online lifestyle hub for women that also offers a single brand advertising platform, and Mpire Corp., which runs an ecommerce advertising network called WidgetBucks. “We think that is changing and will continue to change, both because the ad dollars will follow the eyeballs and because the online medium is inherently more measurable and therefore effective.”

This thought is echoed by Jason Green, a general partner at Emergence Capital Partners, who recently led a $13 million investment in Lotame, a startup that allows advertisers to better target consumers on second- and third-tier social networking sites. “How many markets do you know that will go from $25 billion to $50 billion in the next four years?” asks Green. “I’ll tell you one thing, there’s not a lot. Investing in and building a successful ad network is one of the very best ways to take advantage of this opportunity.”

But aren’t these guys just a little worried about the economy? After all, we heard this same kind of happy talk before…and then the bubble burst.

Optimism abounds

The ad dollars will follow the eyeballs, because the online medium is inherently more measurable and therefore effective.”

Josh Stein

“The [economy] does give me pause,” admits Ted Maidenberg, an associate at U.S. Venture Partners, which recently led a $9 million round in Media6Degrees, an ad network that allows advertisers to reach not just consumers on a particular network of sites, but their friends and friends of friends. He says that ad networks typically take about 18 to 24 months to ramp up before they see any serious revenue. But those are very costly months in terms of maintaining a sales force and building the right relationships with advertisers.

“Clearly, you need a team that can manage the burn and get the early wins to push the company to profitability,” Maidenberg explains. “Some ad networks won’t get to break even in that time frame and they’ll die. But the ones that are able to ride out the storm will emerge as much more valuable companies.”

The careening economy isn’t the only risk facing ad networks. With new ad networks popping up with greater frequency, overfunding and market saturation is also making life difficult. “The depressing part is that we are starting to see too many me-too companies,’ says Habib Kairouz, a managing partner at Rho Ventures, which led a $15 million round in Travel Ad Network, the largest vertical ad network in travel.

Typically, a vertical ad network will take about 40% of the ad revenue it generates for a publisher in its network. But if there are five or six ad networks targeting the same publishers, price wars and deep discounting could ensue, to the point where “networks start doing stupid things to increase their reach, like lowering and lowering their revenue cut until they’re actually losing money on the deal,” says Kairouz.

He argues that a network such as Travel Ad Network (TAN) will succeed not just by providing higher CPMs (cost per thousand impressions) to the travel sites in its network, but also by delivering more traffic than the sites could attract on their own. Kairouz adds that travel is an ideal vertical for an ad network because consumers typically go to dozens of different sites before booking a trip. By offering cross-pollination features that encourage users to visit multiple sites within the same network, a company like TAN believes it can deliver a larger audience to its publishers and dramatically increase their reach.

The ROI Argument

The depressing part is that we are starting to see too many me-too companies.”

Habib Kairouz

“The bottom line is that publishers can earn more money and attract more visitors without having to spend a penny extra in marketing,” says Kairouz. “That’s what makes membership in an ad network like ours indispensable.”

Other ad networks, such as Lotame, rely on superior technology to differentiate themselves. With Lotame, for instance, advertisers can target users of social media sites like never before. Take a Hollywood studio that was has a new action movie coming out. With Lotame, it can not only target white males between 18 and 30 years old, it can go a layer deeper and target its movie trailer at those men who have actively posted a movie review on a social networking site within the last 30 days.

“On a low-value ad network [such as Google AdSense], our publishers would probably earn 10-cent CPMs, but that same inventory can now be converted to $5 and $10 CPMs with Lotame,” claims Lotame investor Green.

Even with an economy heading south, most venture capitalists believe the potential benefits of investing in an ad network far outweigh the risks. Some have already made good money in the sector and are coming back for more by investing in their second or third ad network. USVP, for instance, sold Adify to Cox Enterprises for $300 million before returning to the sector with its investment in Media6Degrees.

“There is no shortage of potential acquirers in this market,” says Green, noting that the founders of Lotame sold their previous company, Advertising.com, to AOL for $435 million. “I’d be very disappointed if we didn’t beat that this time around,” he says.