Ok, Albert’s succinct and brilliant 5 words commentary is probably all you really need to read, but what the hell, if you prefer the long winded, convoluted, overly analyzed version, read on! (this shows exactly why I’m never dreamed of publishing anything my whole life, not even in my high school yearbook - and which Asian kid didn’t write for their yearbook? well atleast I played the violin)

In 2005, vertical search engines reached almost the epic hype proportion of B2B . Everywhere you turn, a vertical search engine was launched. . . one for video, another for blog, some for code snippets, others for medical information, others for houses. (I wont stump on their graves by linking to them).

Back then, I called bullshit on the whole thing for a slightly different reason than Tom Evlin . . . but both of us agree that the majority of them will fail. Which was highly controversial given that many heavy weights (Fred, Danny, and Jupiter) believed in its promise.

Well, the majority of vertical search engines followed the trajectory of the once mighty technorati blog search engine - vanquished by Google in one effortless scoop . . . killed by Google’s increasing indexing speed, ever expanding indexing capabilities (size & scope). . . and not the least of which, the quickly unbuzz worthy but hugely successful “OneBox.”

One of the main short comings of the Google machine was the speed in which it picks up new content . . . it used to be close to 2 weeks before any given page would be indexed. Today, for some content it could be in hours if not shorter. Google added new hardware and tied its indexing frequency algorithm to something like a pagerank. Many vertical search engines had hoped to win by focusing on categories where content relevancy is closely tied to timeliness . . . it turned out to be a dead end.

Other search engines tried to go “semantic” on Google by extracting meta data out of webpages and offering additional filtering and attributing functionalities. As it turned out, users only wanted to type once and click on the results. No one wanted to spend more than 2 minutes fiddling with drop downs and other filtering options.

Furthermore, despite, its public stance against the semantic web (perhaps simply a strategic posturing to stay ahead of competition), Google brilliantly used OneBox to extract information from webpages and presented in context of its more traditional search results. Video results is a great example. It used to be only only “oneboxed” with a few lines on the top of the search results and now its fully integrated into the SERP. (I wanted to throw in a Lord of a Ring reference here but decided against it)

Not all vertical search engines have failed though. Those that does not rely on web based data for its index has done pretty well (house hunting sites) - however they have turned into more of a traditional database + portal than a classic search engine. Others have relied on crawling the “deep web” where google bots do not/cannot visit to differentiate itself. One such category is travel search engines (where a lot of news came out last week). I’m, however, very very skeptical of the financial results of Kayak and SideStep - I have reasons to believe that a significant portion of their revenue have nothing to do with travel or search. (I’ll write about it later when I have time to do some screen caps).

So whats the final take away? Give the Google PM and the engineering team responsible for OneBox a huge raise and promotion. These guys fended off the biggest threat to Google’s paid search golden goose since Goto.com+Inktomi and didn’t even get enough respect to be poached by Benchmark to be “EIR’s”. (ok, maybe there hasn’t been many legitimate threats to Google so maybe its not that big of a deal . . . oh ya, and no, Facebook is not a threat to Google . . . yet )

Josh K. has an interesting post that contrasts the acquisition & retention model of social networks (and community sites) in general.

The winners have a “catch and keep” model where the site is “sticky” while the less succesful players have a “catch and release” model where repeat visits are low and value is garnered linearly.

Another way to put it . . . we should try to build a site with a set of functionalities which gives users incrementally more value on the second visit than the first visit . . . third visit more than the second vist . . . and so forth. In many ways, this is a practical intent of metcalfs law and perhaps much more actionable than simplying trying to build a large userbase and claiming to have reach critical mass and network effects. The goal for any website would be creating accretive value per incremental visit.

Another interesting interpretation of Josh’s post is that social networks that are augmenting/turbo charging offline & parallelsocial interactions seems to have higher value and relevancy to the user than ones which tries to be completely virtual. If a site has relevancy to the daily (and thus offline) lifes of its user (campus life for facebook users, professional & personal networking for meetup users etc) it will remain more sticky than a site which is simply trying to act as a bridge or replacement for physical interactions. (Yes, I believe the future lies in “singularity”)

Lastly, to the snarky title of this post. It wasnt long ago (12 month?) that the web is buzzing about “attention aggregators” which mostly became just “catch and release” websites. It is very possible to create a “edge” based site which has the “catch and keep” value proposition (google for one) . . . but in truth, the functionality and features required to provide accretive value per incremental visit can rarely be achieved by an aggregator unless aggregation can provide such a value (which only occurs very very rarely . .. such as in google’s case). In most cases, aggregation is not enough and product/feature based value can only be built and captured through a “walled garden” like website which nurtures and builds value within a tighly controlled environment. A potentially winning model (I have to think more about this) is a hybird site like digg which combines edge aggregation with wall-garden like product and features . . .

I was partaking in the “two screen” experience yesterday - surfing and watching TV at the same time (30% of young adults between 16-28 does this regularly according to a presentation I attended by AOL/TIME Warner VP of Market Research). On my TV was E! True Hollywood Story (”THS”) on the making of Mean Girls (you know, Lindsay Lohan & Rachel McAdams!). On my laptop I was reading Jeremy Liew’s Game Mechanics which led me to spend the rest of the show googling Amy Jo Kim. It was about 15 minutes into this experience that I realized that what Amy Jo Kim was talking about is not so different than re-creating high school (or the first year of MBA) online (ie Mean Girls). I had called it Vanity Marketing about a year ago. She merely called it “social design” or “game mechanics” for online communities.

Here is a good summary of what Amy teaches. The women has been at it since 1996! . . . a whole 10 years before all this became so hot . . . a pure genius.

Thinking back ten years ago. . . software product design was all about value proposition, ROI, defining pain points, identifying catalysts for change, finding stakeholders, and many many more boring adult stuff. . . all really coming back to money. As such when websites (esp web apps) were sprouting up every where in 1998, product managers/designers/entrepreneurs simply followed the paradigm borrowed from the software development world where interactions where focused between an application and its user (rather than user to user). Ease of use, “information architecture,” features, funtionality, workflow, integration . .. etc etc . . .

eBay changed all that. (I’m not kidding, Amy Jo Kim really believe eBay is one of the best designed communities out there . . and obviously the first to ever scale). Today, the emotional aspect of product strategy is not something that can be ignored any longer. Drawing a parallel, behavioral finance has fundamentally changed the way economists and wall-street view the markets for financial instruments . . so will this discipline.

Building products catering to the psychology of user is a completely orthogonal discipline than what is traditionally considered product management. Today, its just as important . . . especially in this web 2.0 world. (eck I said it again)

Instead of regurgitating her research (which you should read yourself) this is my take.

Online, we are all 16 year old teenage girls. Put your self in the shoes of your users. This is your first day of high school. You are new, you dont know any one. How do you know who are the cool kids and who are the crowd to stay away from? (feedback or rating system, leveling) How do you become popular? (participation, collecting, flaunting - good ole online materialism) . How do you fit in while standing out? (completing a set, virtual scarcity, customization) . How do you achieve your status and let everyone know about it (leader board, stars, feedbacks again). How do you curry the favor of the in-crowd? (exchanges, gifting). How do you find a sense belonging? (groups, social networks) How do you fight back? (foums, comments). How do you know what to wear (customization, widgets). What activities and clubs to joing? (games, puzzles, treasure hunts, . . . and MMOG!)

How do you become the Queen Bee? The one all the girls want to be and all the guys want to be with? . . . give your user a way to become the Queen Bee and flaunt it!

Exploiting Leveraging insecurity and vanity of the user is key to building a vibrant and succesful online community. The line between e-commerce and community has already been blurred. The line between web app and community will go next. Pretty soon community and MMOG will blur itself too . . . and websites will become one big goo of cat-fighting teenage girls

It is well known that the advertising industry has a high Beta compared to the general economy. In short, the industry does very well during good times and very bad during bad times. There are several reasons to this, when the economy does well 1) companies forgo ROI for marketshare 2) companies believes advertising is a capital expenditure to build brand equity 3) keeping up with the jones, as advertising effectiveness is extremely sensitive to competitive spend. It is not to say these reasons are not rational, they are somewhat. But that the industry tends to go in boom and bust cycles because of them.

Google’s is in this very cyclical industry . . . so much so that the offline equivalent of ad brokers (agencies) are mostly private shops or loose but public cooperatives/roll ups to even out the cyclicality. Furthermore, Google has one large issue. . . that like the Real Estate bubble in Hong Kong in the mid 90’s, much of the spending on Adwords has been done by speculators trying to arbitrage traffic/eyeballs rather than companies productively selling a service or product.

For the past months, I’ve been tracking (unscientifically) the percent of adword advertisers with the main business model of advertising. In short, instead of selling shoes or providing a service (like translation or loan brokerage), these sites are simply trying to pay for eyeball on Google and hoping to make more than they spend on getting that visit (or visitor if the site is sticky enough). Even worse, some of these companies are venture funded so they are simply looking at whether the cost of that visit will get them an equivalent increase in VALUATION. They dont mind losing money, as long as they can flip the company to someone else in the short term.

In decemenber I tracked about 200 queries and found that about 20% of adword advertisers are arbitragers. Early this week, that # has gone up to about 35%. Again this is about unscientific as it gets and I hope some research analyst will start tracking this metric sytematically.

But I think the point is made that increasingly the revenue growth google is able to capture are significantly more risky than before. Google’s revenue beta is becoming higher and Wall Street has yet to take that into consideration. Remember back in the dot com days, all the venture money raised was poured into buying Sun hardware. when the bubble collapsed, so did Sun. Today, because the lower cost of infrastructure, this money has been poured into advertising and marketing instead (specifically into Google with a disproportionate share). If (when?) the battle for traffic is over and the casualties emerge, a significant portion of Google’s advertiers (and corresponding revenue) will also go the way of a server spending on Solaris machines . . .

But like a game of chicken, advertising spend usually drop off the cliff rather than decelerate, so there will be little to no warning when it does happen.

Ran across a timely academic research on the first internet boom/bust - aka the “dot com” era. Goldfarb, Kirsch, and Miller has published a huge amount of material on the era. Furthermore, they are widely considered the leading business historian on the time between 1998-2004 (really between Netscape IPO and the rise of web 2.0). In fact, they are major contributors and curators to the Business Plan Archive. The 50 page report is titled Was There Too Little Entry During the Dot Com Era?.

Seems like deja vu lately with a very public discourse on the simultaneous rise of web 2.0. bubble and bust (so which is it?) between Arrington and Fred Wilson. With commentary from NYT and Zoli.

Perhaps its because the paper is 50 pages of equations, regression, and bayesian analysis; no one picked up on its publication. But I do find that it provides a eye openning analysis of the era and how we have learned (perhaps not individually but as an institution) and applied it to web 2.0.

Before I jump in, I’ll have to say that I’m biased. I had a Flatiron partner as my board member during the dot-com era. And I myself was roasted by the Fucked Company mob (sometime deservingly but other times not). I dont feel so bad now, as the Pud’s company, Adbrite, is now run by a CEO who was also tarred and feather by Pud’s creation I believe studying failure is important, but even more importantly, it needs to be constructive (like Goldfarb, Kirsch, and Miller). The Techcrunch Deadpool serves an important purpose but it has the potential to degenerate into useless personal attacks and rumor mongering. Either way, Arrington is like a hedge fund manager, he likes volatility and profits from it . . . the Deadpool is his hedge or even an instrument to profit from the web 2.0 cycle. (dont get me wrong, there is nothing wrong with it, I would be doing the same if I’m a jounalist . . . no he is not a blogger, not anymore)

The paper tries to prove a few points

1. “Get Big Fast” was the predominate strategy for venture startups and it created a cascading effect commonly called house of cards or greater fools theory in which assumptions build on top of other assumptions driving irrational behavior.

2. Ironically, the GBF strategy created a huge concentration of investments in a few large companies - belief that first mover + funding amount is a barrier to entry which prevented more startup in any space from getting funded or even started.

3. As a result, eventhough the AMOUNT of venture investment might have been irrational, the number of startups was actually lower than ideal.

A few surprising numbers crunched by Goldfarb, etal support this

Exit rates of dot com firms are comparable with or perhaps lower than exit rates of entrants in other industries in their formative years. Five year survival rates of Dot Com firms approach 50%.

Survival is unrelated to the receipt or the amount of private equity financing. VC-
financed and other privately financed firms were neither more nor less likely to survive. There is no evidence that return on private equity investment was positive or that, conditional on survival, internet traffic ratings was higher for private equity-backed firms.

In more detail,

Annual exit rates for autos during 19001909 averaged 15%, 21% during the 19101911 shakeout and 18% during the period from 19101919. The annual exit rate from the tire industry during 19051920 averaged 10%; it was 30% during the shakeout in 1921 and 19% during the period from 19221931. The exit rate from the television (production) industry was 15% during the period 19501952. Finally, the exit rate from the penicillin industry was 5.6% during the period 19431954 and 6.1% during the period 19551978. These numbers suggest that the exit rate for Dot Com rms is in line with other emerging industries.

In sum, the survival analysis shows that in our data private equity investment is not related to firm survival and this result is robust across many specications. Moreover, we also found unremarkable IRR and no relationship between web traffic rankings and the receipt of VC funding. We interpret these results as consistent with the hypothesis that pursuing a GBF strategy was, on average, a poor strategy for most internet businesses during the late 1990s.

Well, you know where I’m going with this . . . we are smarter than we thought! Look at the current web 2.0 modus operandi . . .

- small investment is not neccesarily bad (as large funding round does not equate success)
- VCs are not the pre-dominant source of equity capital
- GBF is not the preferred strategy
- double or triple the # of competitors in any space compared to dot-com
- re-cycling or old 1.0 ideas (cause ideas failed for reasons other than the concept itself)

In short, failures are the REQUIRED by product of needed experimentation to exploit an opportunity as big and important as the Internet. Bubble or not, deadpool or not - the opportunity justifies irrationality as the rational thing to do.

To be clear, we do not posit that there was insucient investment in internet ventures. Rather in the absence of a belief cascade, more entrants might have received smaller amounts of funding. To envision how these events might have unfolded, consider the case of Webvan, a $1 billion internet grocery venture that entered many major cities in 1999. Webvan turned out to be a spectacular failure. Absent beliefs about the necessity of GBF, we might have observed many smaller-scale startups all experimenting with different models perhaps in different cities delivering grocery products to the consumer. Instead, we observed a single very large bet on one particular delivery model. In general, mistaken belief in GBF concentrated too many resources in too few ventures. In this sense, we argue, there was too little entry.

Yesterday, Amazon launched endless.com (coverage at techcrunch and techbeat). Obstensibly its an obvious response to the $1B that Zappos.com is taking in a year (close to 35% of the total shoe market) . But even more strategically, its an increasing sign that the first generation internet giants has reached some sort maturity and limits to scale that traditional marketing techniques like brand extensions (ie, Coke -> Diet Coke) are beginning to become popular if not standard strategic growth options.

Furthermore, as much as the web 2.0 crowd (we? me?) would like to believe, mashups are not invented by the internet generation. Using internal assets and re-aligning them to create new products our services was invented when Henry Ford (finally) launched Model A.. And continutes today, the Chrysler Crossfire uses the same chasis as the Mercedes SLK, another example. (What is interesting is that mashups has moved form assembling internal assets to mixing external and internal assets through loose couplings and arms length relationships). For endless and ebayexpress, the main assets that are being leveraged are the inventory (both share a subset of inventory from the mother site).

I blogged about this a few month back and it appears to me that Amazon is hitting the same scalability issues.

For giants like eBay, Yahoo, Google, and even Facebook and Myspace (today). . . the MARKETING FACT OF LIFE - SEGMENTATION has slowly reduced the value of network effects. By definition, network effects is a mass market play. It is in opposition to the concept of niche marketing, niche product, for niche segments - ie the better you can target your product or service to a particular niche the more likely he or her will chose your product over a competing generic solution. These giants cant no longer band-aide new site wide features and functionalities hoping to attract new segments to their website as USAGE TIME, SCREEN REAL-ESTATE, USABILITY limits the feature creep. This admission that network effects is no longer the dominant driver of their business - that segmentation is - is widely seen but rarely discussed . .

It further amazes me how the mentalities of a startup can blind someone from making the right business decisions (better, faster, cheaper /= better for the customer). For some reason, the “why’s” of endless and ebayexpress were not obvious to the pundits of the tech world. . . but for someone that works at Gap, P&G, or a HomeDepot it must seem very obvious.

Every brand has its limits, even Amazon and ebay. Ofcourse, Amazon decided to completely remove itself from the endless brand while ebay tried an extension to target new segments of users.

One size fits all is only true for baseball caps (and even that is questionable). Beyond the brand, the flexibility to create custom search/discovery experience within a category can create a significantly better conversion rate AS WELL AS re-enforce the brand itself. In the physical world, the Apple Stores and its shopping experience are a clear extention of the Apple brand.

“Enhancements” are not always better. Ajax might be cool, you might love all the drag and drop functionality of the latest website profiled on TechCrunch. But you and I are a sample size of one. For incumbent companies, by definition through the size of its userbase, late adoptors are the largest segment. In the end, the feature needs to be rigorously tested with a large enough sample size to really know if “enhancements” are good for the bottom line. . . not just kinda cool.

Who knew Knowledge@Wharton would have good articles these days? When it first started, it was kinda of a self-promotional spam-letter. But these days, its actually somethign I scan everytime it arrives in my inbox.

Michael Porter Asks, and Answers: Why Do Good Managers Set Bad Strategies?

Porter stressed that managers get into trouble when they attempt to compete head-on with other companies. No one wins that kind of struggle, he said. Instead, managers need to develop a clear strategy around their company’s unique place in the market.

Bad strategy often stems from the way managers think about competition, he noted. Many companies set out to be the best in their industry, and then the best in every aspect of business, from marketing to supply chain to product development. The problem with that way of thinking is there is no best company in any industry. “What is the best car?” he asked. “It depends on who is using it. It depends on what it’s being used for. It depends on the budget.”

In the Internet world, eitherthe “Pie” is still growing so fast that competitors often dont really compete directly OR the “Pie” is so small no amount of optimizing can help any company win. (How many times have you seen a “space” completely disappear along with every company in it. . . gorilla game with bunch of monkeys. . .) As a result it seems like being the BEST is the ONLY strategy that all these web startups can pursing. (as seen in the continuous feature-one-ups-manship).

It is possible that because the industry changes so fast that the competitive landscape is continually defined and consumer taste always shifting; and as a result, competition never reaches the point of saturation for segmentation to really matter. (atleast not until the company is worth a few billion dollars and public)

He went on to describe key principles of strategic positioning, including a unique value proposition, a tailored value chain, clear tradeoffs in choosing what not to do, and strategic continuation, or ongoing improvement. The underpinnings of strategy are “activities that fit together and reinvigorate each other.

In the end, it seems like the hard part is betting on the right horse (aka segment) which drives your strategic choices and align your operations. However, if the company picks a slower growing segment than its competitor . . . all is lost . . . perhaps than the hardest part of “strategy” as defined by Porter is “who you want to serve” . . .

Metcalfe’s Law (as it is common interpreted) is miss-leading. Even Bob Metcalfe himself recently re-iterated that the law can only be applied “locally” rather than “globally”. IE, the network effect is subject to a limited portion of the X-axis and not the entire curve. To put it in layman’s term, network effects derived from Metcalfe’s law do not last forever . . . in fact. . . it only applies only when the network is achieving scale. In his words:

As I wrote a decade ago, Metcalfe’s Law is a vision thing. It is applicable mostly to smaller networks approaching “critical mass.” And it is undone numerically by the difficulty in quantifying concepts like “connected” and “value.”

Not sure how I missed this post (Metcalfe’s Law Recurses Down the Long Tail of Social Networking) by Bob Metcalfe himself. But this is huge . . . even Bob admits that an entire generations of companies during the first bubble has crafted its strategy based on the vision of the world as V = N^2 rather than what he really meant -> V = A*N^2.

So, if V=A*N^2, it could be that A (for “affinity,” value per connection) is also a function of N and heads down after some network size, overwhelming N^2. Somebody should look at that and take another crack at my poor old law.

Of course the cost (C*N) of getting connected in a social network has been going down thanks to the proliferation of the Internet and its decreasing price. The value (A*N^2) of particular social networks has been growing with broadband and mobile Internet access. Emerging software tools expedite the viral growth and ease of communication among network members, also boosting the value of underlying connectivity.

In fact, A is not even a constant but another equation which has dependent variables N as well. There are HUGE HUGE (can I be more pedantic?) implications. Network effects did not kill the Techonology Diffusion Cycle (aka the S - Curve), in truth, it only describes locally the ramp up portion of the curve. In the end, the S-curve will win out and adoption will slow - with or without network effects. . .

Bob has essentially made 2 admissions

- the ramp is steeper than ever, that at the initial adoption phase, due to large decrease in cost of network connections in the last 5 years, network effects is as strong as there ever was

-However, as a network scales, opposing forces will come into play which cancels or reduces its increasing returns properties and flatten out adoption

What does this mean? Web 1.0 (and some web 2.0) giants are fucked as they finish climbing up the S curve and as network effects dissipates. Web 2.0 startups faces a much easier path to critical mass than ever before, thus it can mount a credible challenge against the incumbents.

1. For new start-ups the decreasing cost to scale has created cheap and fast ways of gainning large amount of users and achieving critical mass. Look at how fast youTube grew in the last 18 month. Simply unbelievable. Even Google took 2-3 years before achieving traction. It wasnt just 24 month ago that Myspace was just a speck. . .

2. For giants like eBay, Yahoo, Google, and even Facebook and Myspace (today). . . the MARKETING FACT OF LIFE - SEGMENTATION has slowly reduced the value of network effects. By definition, network effects is a mass market play. It is in opposition to the concept of niche marketing, niche product, for niche segments - ie the better you can target your product or service to a particular niche the more likely he or her will chose your product over a competing generic solution. These giants cant no longer band-aide new site wide features and functionalities hoping to attract new segments to their website as USAGE TIME, SCREEN REAL-ESTATE, USABILITY limits the feature creep. This admission that network effects is no longer the dominant driver of their business - that segmentation is - is widely seen but rarely discussed . . .

- Facebook opening up to non-college students

Still fighting a good fight, refusing to give up on network effects eventhough the number are telling them that the growth is lowing. They might just stab themselves in the foot by refusing to segment their social networks.

- Myspace demo over 35

The value of each connection within network is decreasing for new users & existing users as demographics become more diverse.

- eBay launching eBay Express

Recognizing that there is a segment of cusotmer (new! now!) that will never “take” to the traditional ebay.com and that segment wants an entirely new shopping experience that having a new & BIN filter simply does not allow

- Google buying youTube

Trying to conitnue to depending on its userbase from google.com to build critical mass in its newly launched properties no longer works. It bought youtube to create another destination to funnel traffic to its set of services . . . it needs more than one network effects to drive it future growth . . .

The net effect is, ofcourse, that the world is getting flatter. That the ebb and flow of startups & incumbents will continue, competition will increase . . . and that nothing grows forever . . . (perhaps not such a new concept after all)

I was going to title this post Marketplace 2.0 (you know like software 2.0, enterprise 2.0) but I realized I dont want to create another empty bandwagon Anyways, last week, oDesk raised a good chunk of cash from an investor that knows more than anyone about building marketplace businesses - Benchmark. Which reminded me of one of the most important things I learned in the 2000 B2B craze.

As much as most people think that the value created by market places are from counter party discovery (aka search), capturing that value rest solely on providing transactional settlement services.

eBay.com is the exception rather than the rule. For consumer goods, the search cost of finding a business is high and the switching cost low. Thus EVERYTIME you want to buy a laptop, you will try to find someone to give you the lowest price. Thus eBay was able to build a gigantic business focusing solely on “discovery” as its main business. However, in the long run, when Google has taken over the world’s entire need for search, I would venture to guess that in 5 years, Paypal will generate over 2x the revenue of eBay’s Marketplace business. Note that Paypal is an example of a settlement service (financial one).

During the B2B days, eBay’s success on its business model let many to believe that if one created a marketplace and help business x find business y (or person x and person y) one can charge 10% for helping to broker that transaction. Oh boy, were we (I) wrong.

For most other businesses (non-consumer goods) counter party discovery is a commodity. It is also part of the transactional value chain that is hardest to capture. In most transactions, relationships matter much more (finding a plumber, contractor, house, supplier of PCB’s, or babysitter). The switching cost to of changing vendors/customer are very high. In that environment, once the introduction is made, the relationship between buyer/seller is taken “offline” - there is no longer a need for the marketplace going forward (for the completion of the initial transaction AS WELL AS the next transaction) . . . UNLESS you can add value through settlement services.

The marketplace (the discovery portion) is actually NOT the core competency of the marketplace business, it is just another way for the venture to hedge and reduce spending on Google. The marketplace acts as a FEEDER into the settlement services provided by the marketplace. As does Google. . .

Google has create the biggest “suckout” in the history of business by rendering metcalfe’s law irrelevant.

In such a world, oDesk has created the model for the next generation of online marketplace ventures. While others are still stuck in the 1.0 world competing with Google on search/discovery, oDesk has instead focused on how to lower friction and increase trust for the ENTIRE value chain. It has created a platform for relationship management that does not in anyway pigeon hole the value of the marketplace to fulfilling the initial need for finding a counter party. It has inserted itself between the buyer and seller permenantly. And that, is the brilliance of oDesk.

(Guest Column: Peter Daley, Digital Media Analyst, Rutberg & Co)

During the one month period from July 1 through July 31, 34 private digital media companies announced $403.1 million in venture capital financings. Investments were primarily in the Advertising Infrastructure, Applications, and Content Publishers sectors. There were also 24 M&A transactions announced during the period, including Motorola’s acquisition of Broadbus, AMD’s acquisition of ATI, and Planar System’s acquisition of Clarity Visual Systems.

In this newsletter, rather than our traditional review of the previous month’s news items, we discuss the venture capital, M&A, and IPO activity in digital media over the past two quarters and compare these findings to the activity of 2005.

Venture capital activity in digital media is, by all accounts, robust. During the first six months of 2006, private digital media companies raised $2.4 billion of venture capital through 278 financings. This activity nearly matches that of the full year 2005, in which $2.6 billion was raised through 313 financings. Notably, 245 venture capital firms announced two or more digital media investments during the eighteen month period between January, 2005, and June, 2006.

The robust activity indicated by the financing totals is consistent with our conversations with entrepreneurs and investors. On an anecdotal basis, for example, we note the formation by numerous venture firms of digital media-specific strategies, practices, and portfolios over the past two years. Although raising capital is never “easy,” we believe the current environment is healthy for private digital media companies.

The M&A market remained steady in 1H06 with 181 transactions announced during the period, as compared to 183 and 185 in 1H05 and 2H05, respectively. Further, the IPO market for digital media companies remains muted. During the first half of 2006, only 6 IPOs were filed and 6 were priced in the industry, as compared to 5 filed and 19 priced in 2005. We do not find visibility toward a substantial change in the dynamics of the IPO market in the near-term. As such, we believe M&A remains the far more likely exit scenario for private equity investors.

Overall, we note that venture capital activity has increased substantially over the previous 18 months, while M&A activity has remained steady over this same period. Several venture investors in our conversations have referred to this situation as a “bubble without an exit,” indicating a concern and frustration over the high investment levels but low exit numbers. As we discuss below, we believe that this situation may be, at least partly, due to the early stage of digital media as an industry, and that there are underlying, positive indicators for future M&A activity in the industry.

Venture capital activity in digital media is, by all accounts, robust. During the first six months of 2006, private digital media companies raised $2.4 billion of venture capital through 278 financings. This activity nearly matches that of the full year 2005, in which $2.6 billion was raised through 313 financings.

On a quarterly basis, total venture capital raised during 2Q06 was $1.3 billion, representing 127% growth from the total during 2Q05.

Heading into 3Q06, venture investors appear poised to continue their strong pace. The $403 million of venture capital raised in July 2006 is on par with the $398 million monthly average over the previous six months.

The robust activity indicated by the financing totals is consistent with our conversations with entrepreneurs and investors. On an anecdotal basis, for example, we note the formation by numerous venture firms of digital media-specific strategies, practices, and portfolios over the past two years. Additionally, we hear comments from several entrepreneurs on strong interest by venture firms and on relatively attractive transaction valuations. Although raising capital is never “easy,” we believe the current environment is healthy for private digital media companies.

Size of Financings

In terms of financing size, the average size of digital media venture transactions has remained stable since 2005. During 1H06, the average financing size was $10.6 million, as compared to $9.1 million and $11.5 million during 1H05 and 2H05, respectively.

Interestingly, over this period, transactions have trended toward smaller (less than $5MM) and larger (greater than $20MM) financings. The percentage of mid-sized (between $5MM and $20MM) financings has commensurately decreased. We believe this change in distribution is driven by two factors: 1) increased venture capital for private companies in the Applications sector, which is at an early stage of development and which typically requires less total capital commitments per company than the broader digital media industry; and 2) the emergence of private companies with late stage revenue levels in several digital media sectors, such as Semiconductors, Content Service Providers & Retailers, and Advertising Infrastructure.

Most Active Sectors

The sectors with the largest total venture capital raised during 1H06 were Semiconductors, Content Service Providers & Retailers, and Advertising Infrastructure. Notable financings during the period were: $150 million by Amp’d Mobile, $49.2 million by Digi TV Plus, $48.5 million by MovieBeam, $48 million by AdKnowledge, and $46.6 million by Sling Media.

By number of financings, the Applications, Advertising Infrastructure, and Provisioning & Delivery Infrastructure sectors were the most active during 1H06. In particular, the Applications sector included 46 financings during 1H06, as compared to just 9 financings during 1H05. The significant rise in venture activity in Applications companies is driven, among other factors, by the investment theses in user-generated content and other personal media.

Overall, as per our comments in recent newsletters, we remain bullish on investment theses related to user-generated content, casual video games, and content delivery networks, among other areas.

Most Active Investors

The investors with the greatest number of digital media investments in 1H06 were Intel Capital, Sequoia Capital, Cisco Systems, and Draper Fisher Jurvetson. Notably, 245 venture capital firms announced two or more digital media investments during the eighteen month period between January, 2005, and June, 2006. In our view, this demonstrates the broad participation and interest in the industry by venture firms.

Number of M&A Transactions

The M&A market remained steady in 1H06 with 181 transactions announced during the period, as compared to 183 and 185 in 1H05 and 2H05, respectively. Notable recent transactions involving venture-funded private companies include Microsoft’s acquisition of Massive, VeriSign’s acquisition of m-Qube, and Viacom/MTV’s acquisition of Atom Entertainment.

The North America region saw the largest number of transactions during 1H06, with 94 M&A announcements. M&A activity in the Asia region, however, increased significantly, representing 19% of transactions in 1H06, as compared to 8% in 2005.

Most Active Sectors

The 1H06 M&A transactions were primarily in the Content Service Providers & Retailers, Advertising Infrastructure, and Content Creators sectors. The Retailing Infrastructure sector experienced the sharpest rise in M&A activity, with 14 transactions announced in 1H06, as compared to 4 in 1H05. Further, the steepest decline in M&A activity occurred in the Content Publishers sector, with 19 transactions announced in 1H06, as compared to 36 in 1H05.

The IPO market for digital media companies remains muted. During the first half of 2006, only 6 IPOs were filed and 6 were priced in the industry, as compared to 5 filed and 19 priced in 2005. In our conversations with private company board members and CEOs, we find several inhibitors for IPO activity, including the generally unreceptive public markets and Sarbanes-Oxley compliance costs and risks. We do not find visibility toward a substantial change in the dynamics of the IPO market in the near-term. As such, we believe M&A remains the far more likely exit scenario for private equity investors.

Overall, we note that venture capital activity has increased substantially over the previous 18 months, while M&A activity has remained steady over this same period. Several venture investors in our conversations have referred to this situation as a “bubble without an exit,” indicating a concern and frustration over the high investment levels but low exit numbers. In our view, this situation may be, at least partly, due to the early stage of digital media as an industry. Industry drivers of broadband penetration and alternative media business models are just now emerging as visible, mass market forces, and revenues from the associated services and technologies are only recently beginning to be explored, defined, or built. Further, we find that interest on behalf of potential acquirers exists, even if only on an exploratory basis. Although it is infeasible to predict timing or to provide certainty, we believe the underlying dynamics are positive indicators for future M&A activity in the industry.