Starts-ups may be lovelier the second time around

When Jay Adelson was asked to speak at an internet conference in the Netherlands in July, he had a problem since he was still in San Francisco. But for the conference organisers this was no difficulty. They put Adelson, the chief executive of digg, a news-ranking site, on an “ichat” videoconferencing service and interviewed him in front of 200 people in Amsterdam while he sat in his office.

Although the audience could see him, he couldn’t see them. But that didn’t matter. Many used their mobile phones to photograph Adelson, 35, and uploaded the pictures to Flickr, the new online public photo-sharing site. “You could see every line on my face,” Adelson says.

Digg is one of the most successful of the new wave of start-up companies whose activities and services have given the internet a fresh lease of life after the crash of 2000. But how do investors get involved with what has been called Web 2.0? Unlike the internet entrepreneurs of the 1990s who rushed for stock market listings and guzzled investors’ cash, the nature of the business the new companies are in – digg’s news sharing rather than Amazon’s expensive e-commerce – means they may not be looking for outside millions in such a hurry. In spite of the immense buzz and excitement surrounding companies such as Flickr, digg, MySpace and Bebo, the opportunities for ordinary investors to take part may be limited.

The principle behind Web 2.0 is that millions of internet users come together in cyberspace to be part of online communities. This is driven by the ubiquity of the internet – a billion people are now online and many have access to relatively cheap high-speed internet.

There has also been a generational shift. Young people have grown up with the web and are willing to socialise and share personal information online. Some of the first new online communities were sites for people seeking to meet other people, such as MySpace or Facebook. But the latest tend to involve people socialising while they are doing something else. Flickr users share some of their most intimate photographs. On del.icio.us, they swap internet bookmarks. YouTube users post home video clips for a potential audience of several million. On digg, people post their favourite news stories and the site’s community votes on them.

About 4,000-5,000 articles are posted on digg daily. The 450,000 registered users who have created online profiles can vote for – or “digg” – a story they like. They can also press a button to “bury” one they don’t.

The most popular stories rise to the site’s front page. At first, digg focused on technology but it has recently opened to all news. “Digg uses the collective wisdom of the crowd to filter news,” says Adelson. “You are giving choice. Instead of giving someone a limited view, you are allowing them to choose what the media should say. We expected a few hundred people. Now there are 450,000 registered users. They get most of their news from digg.”

Sites such as digg, Flickr and YouTube are free. Digg’s business plan is to make money from advertising. The reliance on advertising is helped by what some of these entrepreneurs see as a new generation of advertisers. Services such as Google’s Adsense have given people who would not have advertised on the web before a means to do so.

“It went from being traditional online ad agencies and media buyers to a broad base of advertisers, everyone from cat breeders in Minnesota,” says the chief executive of one of the new businesses who prefers not to be named. “It is not just traditional advertisers but it is also all of the people who never thought of advertising. Now they can do that by going to Google Adsense and putting in their credit card.”

While the companies are benefiting from what they see as a revolution in advertiser behaviour, they are also supported by the fact that the costs of the new companies are lower than they were in the first internet boom. Compared with a decade ago, the cost of computing power has fallen dramatically. “To start a business 10 years ago, something that is so dependent on telecommunications would have certainly been an expensive proposition,” says Adelson. “One in 100 ideas could get funded. Today it costs almost nothing.”

With Ning, a site that allows users to mix and match tools and build their application, the costs fall to zero since Ning hosts the site for nothing. It has about 17,500 applications running on it.

In addition, the companies do not need the big workforces of the previous wave that were once hired by the likes of Amazon. They are not setting up complicated online retailing operations. Typically the users do most of the work. On digg, for example, it is the users who post stories, sort them, and create the home page for others to see.

All this means the new companies’ thirst for outside capital has been modest. In October when digg looked for funding, it turned to a small group of high-profile angel investors, including Reid Hoffman, the founder of LinkedIn, a business networking site, and Marc Andreessen, Netscape co-founder, and two venture capital firms, Greylock Partners and the Omidyar Network, led by one of the founders of Ebay. Digg raised a fairly small $2.8m.

Adelson says: “People were like, ‘Why don’t you raise $12m? You could, you know.” But I have got 17 people at digg. That is all it takes, I feel. If you are an information peddler, what are the economics of information and what is the cost of doing it when your workforce is the primary user?”

Not only are they not turning on the taps of venture capital, the new companies are avoiding the stock market. Many of the entrepreneurs in the latest boom were around during Nasdaq’s collapse after 2000 when investor confidence in the technological sea change – which appeared to be coming from Silicon Valley and which had built up spectacularly in the late 1990s – suddenly evaporated.

This has made them wary of initial public offerings. Adelson was the founder of Equinix, a data centre provider, which listed on Nasdaq. He says getting a listing distracts young companies from innovation and growth. “Nobody wants to do an IPO any more,” he says.

David Sze, general partner at Greylock, says: “The financing environment for these companies is overheated now relative to these realities,” He concedes there will be “a large number of failures”.

But he believes there are differences compared with the first internet bubble. He says companies need much less capital and fewer people, so less capital will be wasted in the failures. Also, he says, the models for generating revenue are more defined and successful, there are far more users with higher-bandwidth connections spending much more time online and there are big public companies looking at strategically partnering and acquiring the new breed of Web 2.0 companies.

Thus when companies have sought more funding or an exit strategy, they have preferred a corporate sale. Among those sold, Flickr and del.icio.us were bought by Yahoo. MySpace went to Rupert Murdoch’s News Corporation last year for $580m.

The diminished thirst for funding and the avoidance of the stock market may limit the opportunity for smaller investors to take part directly in Web 2.0. For the time being, the best way for investors to become involved is as angel investors – if they can – or to buy into venture capital funds that are specialising in this field.

All this may change as the new companies expand and their ambitions grow. Memories of the Nasdaq crash could dim. The corporate exit route may become more difficult as most of the likely purchasers such as Yahoo have already made big acquisitions.

Of course, investors may not want to get involved. Since the threshold cost of starting new companies is lower, bad ideas may get through more easily. Some of the new companies such as Bebo and digg say they are profitable but many of the new generation are yet to break even.

Even for those companies that are profitable, it is possible that the millions that have flooded to their sites will be fickle and move on to the next fad. And, even if online social networking is here to stay, it is not clear whether users will remain loyal to any one particular site.

Friendster, for example, was once the leading social networking site but dramatically lost ground to MySpace. And even if they stay loyal, will all those users actually buy anything? If not, the advertising revenue will dry up.

At present, business optimism about the new sites is predicated on a sharp rise in online advertising spending. But that expectation may be wrong. Some investors may be wary that Web 2.0 could follow the previous internet cycle and become Bust 2.0.

Digg will be trying to prove them wrong. For his part, Adelson is clear that, just as the new companies are different from last time round, investors have to take a different approach too. “You have to be willing to make much longer-term investments,” he says. “It is not a one-year return on investment. It is a five-year return on investment.”