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Lucrative Alternatives to Online Advertising


Web startups such as Gaia and SmugMug—and big guns like Facebook—are turning to sales of virtual goods and subscriptions

As chief executive of Gaia Online, an Internet hangout for some 6 million teens, Craig Sherman should be worried about how the worsening economy could slam Web advertising. Nope, not a bit. Unlike so many Web startups that until recently saw ads as an easy ticket to riches, Gaia gets most of its more than $1 million in monthly revenues from sales—in this case, virtual items: clothes, jewelry, and other accessories to dress up one's avatar, or online character. They run from a few pennies to $10 or so apiece. Gaia's gross profit margins on sales of virtual goods, which are up tenfold from two years ago, top 95%. After all, they're just endlessly reproducible bits and bytes.

Gaia is just one of dozens of Web companies increasingly mining revenue sources beyond ads. Virtual goods are now a more than $1 billion business worldwide. And subscriptions to sites, once thought to be a losing proposition on the wide-open Web, have become at least a $2 billion business, with millions of people willing to pay monthly or annual fees to companies such as United Online's Classmates.com and family research service Ancestry.com. Other companies are selling job listings, lists of prospective customers, and more.

IMPENDING AD SLOWDOWN

The time is ripe. Online advertising is hitting its first rough patch in more than five years, creating troubles for many of the startups that count on ads for their revenues. In anticipation of reduced online ad spending, video sharing service Seesmic, adult-content startup Zivity, ad network AdBrite, which connects Web sites with advertisers, and others have started laying off staff. The coming ad slowdown is spurring new interest in once-spurned Web business models. "A lot of startups are scrambling to look beyond advertising," says Reid Hoffman, chairman of the business networking site LinkedIn and an early investor in more than 50 Web companies, including Facebook and Digg. "In the pitches I see, people are saying, 'Oh, we have a new plan that's not advertising.' "

None of these revenue models is entirely new. But Google's runaway success with modest text ads alongside search results made any strategy but advertising passé for much of the latest Web startup generation. And even beyond the effects of the economy, startups have learned the hard way that free sites, which must use ads to pay the bills, don't always work well. Three years ago, for instance, the photo site SmugMug tried offering free photo-sharing accounts as a hook to get more subscribers, who pay $39.95 to $149.95 a year to store, share, and sell photos. But even before SmugMug started considering whether to run ads, it found the free accounts attracted porn, driving away other users, says CEO Don MacAskill. Now, with 200,000 subscribers, sales have doubled each year for the past two years, to more than $10 million last year.

While consumers often balk at paying subscription fees for online content, corporations are far more willing to subscribe for a service they value. Salesforce.com, for one, is expected to gross $1 billion for the year ending in January by selling online customer tracking and management services, starting at $9 a month per user. The company's success has helped launch an industry of so-called software-as-a-service outfits that provide online software for payroll, collaboration, and many other functions.

The most surprising model for reaching masses of consumers, though, is virtual goods. They've been most common in online worlds such as Second Life, where people create avatars to play and collaborate in a game-like setting, and in hard-core online games including World of Warcraft, where people acquire tools, trinkets, or magical potions. For years virtual goods have been the key business model on popular sites in Asia. Two-thirds of the $523 million in sales by China's Tencent social sites comes from virtual goods such as pets; only 13% is from advertising.

DIGITAL MANOLO BLAHNIKS

Now virtual goods may turn out to be a crucial money maker for burgeoning casual gaming sites and social networks in the U.S., too. Consider Facebook: It's one of the fastest-growing sites on the Web, but it has struggled to make money from advertising. That's because ads are more distracting than alluring on sites where people are there to interact with one another rather than surf for information or products. By contrast, virtual goods are essentially social artifacts that people use to gain status among online peers. That makes them a better fit than traditional advertising on socially oriented sites. Facebook sells virtual gifts such as roses and beers for $1 apiece, and they're now a multimillion-dollar business.

Brand marketers are taking notice and starting to use virtual goods as a substitute for traditional ads. New Line Cinema promoted its Sex and the City movie in May with free virtual shoes. Within 24 hours, Facebook members gave more than 500,000 digital Manolo Blahniks to each other, accounting for more than 220 million viewings on Facebook the first day. Many people keep them on their profiles, proving ongoing brand affiliation with the movie. "Some of our best experiences come from our virtual gifts," Facebook COO Sheryl Sandberg said recently.

Promising as they may be, these alternative revenue streams won't be strong enough by themselves to save a lot of existing companies. Even startups may find it tough to change business models quickly. And the $26 billion online ad market almost certainly will dwarf the other revenue sources for years. But as recession-slammed advertisers cut budgets in coming months, the alternatives may be the last best hope for many Web startups.

Hof is BusinessWeek's Silicon Valley bureau chief.

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