We are in the early stages of a major phase transition. Whatever you call it, something new is brewing, and that nasty R word has a lot do with it. It is not the semantic web. That is a part of it, a big piece of the new technology pie, but it feels too much like a solution looking for a problem.

Nobody knows what name will eventually resonate with people. Web 3.0 sounds too derivative of Web 2.0. By the time this new phase gets a name, people won’t want to be associated with the past.

Just as in Web 2.0 era we don’t want to be associated with the Dot Com era. Hype eventually debases what was once a great name. Until then, whatchamacallit will have to suffice.

Web 2.0 emerged after a technology crash, plus a mini consumer recession, and solved the big problem in the Dot Com era which was the cost of audience acquisition. Do you remember how nutty Dot Com was? We would raise gazillions of VC cash in order to advertise in traditional media at high rates in order to get people to our site, so that we could sell advertising at low rates. On top of that we paid people to produce content. How could we have been that dumb?

Web 2.0 solved that cost problem, by getting users to create content and then promote the service to other people. We called that user generated content and viral marketing, and felt a bit smug. We had totally and completely solved the cost of eyeball acquisition. We even called it social media, so that people did not think we were in the grubby business of making money.

So what is wrong with the Web 2.0 picture? When the dust settles, on what issue will we be saying “how could we have been that dumb?”

This could be a long and deep recession

The dust may take a long time to settle. This is not a technology crash, it is a consumer recession created by excess debt, but it is likely to be longer and deeper than the last recession. 9 million Americans have negative equity, mortgages costing more than the value of the home. Total debt in America is $53 trillion, “that’s $175,154 per man, woman and child, or $700,616 per family of 4, $33,781 more debt than last year”. This may take some time to work through the system and it is likely to impact people’s behavior for a some time after that. That is a lot of people who will be acting more cautiously, spending less.

This matters to us, because Web 2.0 bet on the consumer. Selling to enterprises was way out of favor. The investor view was that selling to enterprises was not scalable, suffered from long and uncertain sales cycles, customers had too much clout and it was full of big firms in a market that was consolidating. All of that was true. So we all bet big on the consumer.

This is not our bubble. Technology/media is not at the epicenter this time, but the shock-waves will impact us all and in fundamental ways. Consumer media depends on advertising and advertising gets cut in a recession. Advertising $$$ will rush to what really works, deserting the marginal propositions. This is likely to be really ugly for a lot of print media, but online advertising will not escape unharmed. From this recession will emerge new models and new winners, just like Google and search advertising emerged from the last one. There will also be a re-assessment of the business models that currently drive Web 2.0.

The phase transition trilogy

This 3 part post will try to identify the early shape of the emerging new era and what entrepreneurs can do to position to be winners when the cycle turns positive again.

Part 1, this post, answers the question, what is the fundamental problem with Web 2.0 that will have us saying in a few years “how could we have been so dumb?”

Part 2, tomorrow, describes opportunities around the Main Street Web, when all the Web 2.0 services have gone mainstream and are applied to the way millions of people make a living.

Part 3, the final post, describes “Dancing with Gorillas“, the opportunities for entrepreneurs in a world dominated by a few big companies such as Google, Microsoft, Yahoo, eBay and Amazon.

The Web 2.0 problem is not on the cost side, it is on the revenue side

It has become fashionable to say “build a great service and the revenue will follow” and to deride people who ask about monetization as hopelessly unable to “get it”. Well yes, if you can flip it to somebody else before the music stops, that is a smart model. A few people made tons of money doing that. But investors in the public companies that acquire these services do eventually ask questions such us “how much money does Google make from YouTube or Yahoo from Delicious?

Public market investors are asking questions. Subsidies from massive cash cows obscure the problems with new services for a while. Microsoft could fund many cash burners for a long time and so can Google. But companies with slightly weaker cash cows get hammered. Investors do ask Yahoo how they are monetizing their acquisitions and eBay came under the spotlight for not making enough money from Skype.

This is not about “free is bad”. Free to air, supported by advertising, has been the media business model since radio and TV. That is a valid business model decision on who pays. It is “free to everybody with no revenue model at all” that is a problem. Or free with a weak revenue model. These are end-of-cycle warning signs.

Twitter will be the interesting case study. They have phenomenal traction at probably minimal cost. They have top class VC, so no worries on that score, they can last as long as needed. They are almost certainly not even thinking about getting to cash flow positive as, at least publicly, they are not even thinking about revenue. So an exit is pretty likely and the acquiring company will be thinking about revenue - because their investors are thinking about revenue!

4 problems with get big first, monetize later

Twitter, YouTube, Delicious and other ” get big first, monetize later” services face four fundamental problems:

  1. The standard revenue models are hard to apply once a service has got a lot of traction. There is push-back from people who have grown used to the service without ads. Advertising that is not useful, that is simply an interruption, will alienate users. Yes, we have spoiled users with a “free and no ads” value proposition.
  2. Innovative services may need an innovative revenue model, so that the advertising is useful and is not viewed as simply an irritation. But innovating on both fronts is hard. The big budgets are allocated conservatively based on proven models, standard ratios and lots of competing sites to choose from. Cost Per Click and search was a “made in heaven” combination, since the advertising could actually be useful to searchers and advertisers were incentivized to make their ads useful. Since then what ad model innovation has moved beyond experimental to deliver $100m plus revenue lines? Online advertising is still fundamentally either CPM or CPC, with a bit of unfashionable but possibly highly effective Affiliate Marketing.
  3. Subscriptions are tougher to sell to consumers in a recession (even if we want to sell subscriptions even more in a recession). This is even harder when your competitors, who have drunk deep of the “don’t worry about monetization Kool Aid”, are giving the same thing away. Hard, but very rewarding for those that succeed. When the give-it-away crowd run out of money, the subscription business may return to favor. However to sell subscriptions you need one of two propositions. Either you can say “our monthly subscription saves you money” (e.g. Sales Force vs Siebel) but that is usually a business proposition, less often relevant for consumer services. Or you can make your service addictively fun in a market without a free alternative, which fits some game/entertainment models.
  4. The supply and demand problem. Yes we are spending more time online. So ad $$$ will flow from traditional media to online media. The gap between time spent online (20%) versus ad $$$ spent online (5%) is still “big enough to drive a truck through”. But the supply of content, created by users or programs at virtually no cost, is increasing way, way faster than online attention time. So the total ad $$$ is continuing to increase, but it is being spread a lot thinner. Particularly when you subtract Google’s revenue from the total.

The lack of new models is not for lack of trying. Many sound very exciting and some of them even sound plausible. But what is missing is the solid, proven revenue model with at least 4 quarters of great growth that enables a company to IPO to “won’t get fooled again” public market investors. Google had that solid revenue growth when they went public. Since then, what web venture has had an IPO in America? Sarbanes Oxley provide a great excuse, but excuse is all it is. Companies with real and growing revenues have had successful IPO exits, but these have not been Web 2.0 companies

When the dust settles, when the cycle turns again and we emerge from this recession (or downturn or crash or bubble burst or whatever else you want to call it) people will say Web 2.0 was a blast, we built some amazing services and lots of people made money from M&A but how could we have been so stupid as to miss:

  1. We bet everything on selling to consumers who were betting everything on treating their house like an ATM on the basis that property prices would rise forever. Oops.
  2. We never invented a model that effectively translated social media activity into revenue. Without that it was just an expensive playground. Double oops.

Image: aturkus

Part 2: The Emerging Main Street Web; Part 3: Dancing With Gorillas: The New Web Era