More or Less? Monetization Based on Facebook’s Business Model

Startups usually succeed because of a single major product or business innovation. Google is unusual in that they succeeded because of two major innovations: their core search product, and their keyword advertising business model. Back in 2000, when Google was wildly popular but generating no revenue, the conventional wisdom was that their business model was uncertain. Then Overture invented keyword advertising and Google adopted the same model.

Startups usually succeed because of a single major product or business innovation. Google is unusual in that they succeeded because of two major innovations: their core search product, and their keyword advertising business model. Back in 2000, when Google was wildly popular but generating no revenue, the conventional wisdom was that their business model was uncertain. Then Overture invented keyword advertising and Google adopted the same model. This turned out to be both wildly profitable and also, remarkably, created a better experience for both advertisers and users.

Facebook relies on an old internet business model: display ads. Display ads generally hurt the user experience, and are also not very efficient at producing revenues. Facebook makes about 1/10th of Google’s revenues even though they have 2x the pageviews. Some estimates put Google’s search revenues per pageviews at 100-200x Facebook’s.

The good news for Facebook is there is a lot of room to target ads more effectively and put ads in more places. The bad news is that, if there is one consistent theme in both online and offline advertising, it’s that ads work dramatically better when consumers have purchasing intent. Google makes the vast majority of their revenues when people search for something to buy or hire. They don’t have to stoke demand – they simply harvest it. When people use Facebook, they are generally socializing with friends. You can put billboards all over a park, and maybe sometimes you’ll happen to convert people from non-purchasing to purchasing intents. But you end up with a cluttered park, and not very effective advertising.

The key question when trying to value Facebook’s stock is: can they find another business model that generates significantly more revenue per user without hurting the user experience? (And can they do that in an increasingly mobile world where display ads have been even less effective.) Perhaps that business model is sponsored feed entries, as Facebook seems to be hoping (along with Twitter and perhaps Tumblr). The jury is still out on that model. Personally, I have trouble seeing how insertions into the feeds aren’t just more prominent display ads. You still have to stoke demand and convert people from non-purchasing to purchasing intents. A more likely outcome is that Facebook uses their assets – a vast number of extremely engaged users, it’s social graph, Facebook Connect – to monetize through another business model. If they do that, the company is probably worth a lot more than the expected $100B IPO valuation. If they don’t, it’s probably worth a lot less.