Nov 22, 2008

Business - Facebook's Land grab in face of a downturn (G.Read)

Spencer E. Ante

As gloom descends on Silicon Valley, most startups and giants are growing cautious and cutting back. But not Facebook. The social-networking Web site sees a bleak economy as all the more reason to press ahead with aggressive plans for growth. "This is not the time for tech companies to be cutting back; this is the time to be hitting the accelerator," says Peter Thiel, a Facebook board member and investor.

Facebook executives think they can use the economic downturn to gain ground on the competition. So they're going to great lengths to keep user growth on track in these rough times. The company is gearing up for more acquisitions, hiring rapidly, and rolling out new advertising programs. Rather than trim the site's development costs, Facebook has engineers cooking up versions in languages such as Xhosa, Tagalog, and French Canadian to go after niche audiences around the world. "We're in this game not just for five or 10 years," says Sheryl Sandberg, Facebook's chief operating officer. "We're in it for 20 to 30 years."

To fuel growth, the company asked the Securities & Exchange Commission earlier this year for an unusual exemption. Typically, private companies that exceed 500 shareholders must start disclosing their financial results publicly. (This is the law that helped push Google to go public in 2004.) Facebook is approaching that threshold, so the company asked the SEC for a waiver that will allow it to keep hiring and handing out restricted stock without public disclosure. The SEC granted the request on Oct. 14. That will help the company reach 800 employees by the end of the year, up from 400 at the close of 2007.

The company is even reducing its revenue goals to pull in more users. In January, founder and CEO Mark Zuckerberg said Facebook was shooting for revenues of $300 million to $350 million this year. But this spring, Zuckerberg and his board lowered the revenue target to $250 million to $300 million, say sources familiar with company finances. Thiel says engineers were shifted away from ad programs to concentrate on fresh features, languages, and other projects that will boost user growth. Even as the economy has weakened in recent months, Facebook has decided to stick with its spend-now, profit-later approach. "We still think it's a land grab where we have to try to get to scale first," says Thiel.

It's a gutsy strategy, increasingly rare in Silicon Valley. Last month, prominent venture firm Sequoia Capital gave a presentation to its startups titled "R.I.P. Good Times," which argued that companies must cut costs fast to survive. One Power Point slide included a skull-and-crossbones and the words "death spiral" to show the likely fate of startups that fail to come to grips with the new reality. The Sequoia view has become accepted wisdom among Valley venture capitalists, leading to layoffs at scores of companies.

Facebook isn't yet profitable. But Thiel says the company can afford to be aggressive. It has raised about $500 million and is "slightly cash-flow negative," Thiel says. At its current burn rate, he says, the company has enough cash for three or four years. "If we stopped growing, we could make money, but it makes no sense for us to stop growing," he says.

Facebook's strategy stands in contrast to that of rival MySpace (NWS). Part of Rupert Murdoch's publicly traded News Corp. (NWS), MySpace has dialed back on growth to focus on profits. Over the past year the site has expanded modestly, to 118 million users, while Facebook has more than doubled in size, to 161 million users, according to research firm comScore (SCOR).

MySpace argues that the horse race isn't that important. Travis Katz, head of international operations, says about 85% of the world's online ad spending is concentrated in five markets—the U.S., Britain, Japan, Germany, and France—and in those markets, MySpace is 30% larger than any competitor. That's one reason MySpace, though smaller in number of users, will generate an estimated $606 million in revenues this year, according to Goldman Sachs, (GS) more than twice Facebook's revenues. "We're not worried about rolling out in every single country," says Katz.

Facebook may not reach every country, but top executives like Zuckerberg give the impression they would like to. A social-networking site that can connect people with friends in Saudi Arabia or the Philippines or Tonga, they say, is simply more valuable than one that can't. Chief Financial Officer Gideon Yu says he is actively looking for deals to expand the company's reach. Top options could include sites in Brazil, Germany, India, or Japan, where Facebook does not have a strong presence. "If there's a way for us to acquire a geography or a demographic, it may be prudent to go off and buy it," says Yu.

At the same time, Facebook needs to figure out a sustainable business model. All the focus on expansion means Zuckerberg and Sandberg will have to do so in the face of a nasty downturn. Companies typically cut ad spending during recessions, especially for newer forms of ads, such as those on social-networking Web sites. "The first things to go are experimental ads," says Debra Aho Williamson, an analyst at research firm eMarketer.

Facebook hopes to make money in three ways. Online advertising is far and away the most important, accounting for an estimated $200 million to $225 million in revenues this year. The company is also selling digital goods—electronic versions of guitars, flowers, and the like that Facebook friends give each other. Charging $1 apiece for these goods will generate $30 million to $40 million this year, estimates venture capitalist Jeremy Liew.

The third leg of Facebook's business may be the most controversial. The company is seriously considering a plan to take a cut of money from the software developers who create applications for the site. These startups make software people use on Facebook to discover new music, play games, or share slide shows. Vice-President Chamath Palihapitiya, disclosing the initiative for the first time, says the company may be able to help these startups generate more cash from advertising or e-commerce and then take a slice of that revenue. "Over the next few years, I bet we will create a very meaningful revenue model," he says. Developers already have a delicate relationship with Facebook, though, so any grab for a piece of their revenues could prove contentious.

Facebook is counting on Sandberg to make all this work. The former Google (GOOG) sales executive played a key role in turning the search giant into one of the most profitable companies in the world. Adam Freed, who used to work at Google for Sandberg, says she's both demanding and supportive. He recalls working on a presentation to set up a Google office in Dublin and having Sandberg tell him it wasn't good enough. After making suggestions, she ultimately took over Freed's computer keyboard to help him find the right words. "She was tough on me to allow me to grow," he says.

Facebook and Sandberg are working on ways to move beyond traditional online ads—the text and pictorial banners that show up on most Web sites. They believe that only by offering something truly different, as Google did, can Facebook stand out among the many sites on the Web. One example came in August when Facebook began rolling out what it calls "engagement ads." Whereas most online ads are like billboards trumpeting a slogan, engagement ads are more like digital bulletin boards, encouraging users to respond to the pitches by commenting, sharing virtual gifts, or becoming fans of the ads themselves. Some of the trial efforts have taken off. An engagement ad for Paramount Pictures' Tropic Thunder, including a trailer for the movie, generated 30,000 comments from Facebook users. "I laughed so hard I couldn't breathe," wrote one fan.

A service set to launch this winter, called Facebook Connect, will bring social-networking capabilities to CNN, CBS, and other Web sites and could make advertising more relevant to Web surfers. The service tracks what people search for on the Net and what kinds of sites they visit. If Facebook learns that you frequent food sites, for instance, it could serve up an ad for a subscription to Gourmet magazine. To support these efforts, Facebook is more than doubling its salesforce, to 130. The team will complement the 400 salespeople at Microsoft (MSFT) responsible for selling Facebook's traditional display ads.

The company is making progress in attracting deep-pocketed advertisers—one reason revenues will as much as double from last year's $150 million. Clients include Blockbuster, Mazda, and Ben & Jerry's. Katie O'Brien, digital marketing manager for the Vermont ice cream maker, says her ad campaign this spring went better than expected. When the company let Facebook users give each other virtual ice cream cones, it anticipated hitting 250,000 cones. Instead, it gave away twice that number of icons. "It created good brand awareness and buzz," she says.

Still, O'Brien says social networks have yet to become a core part of Ben & Jerry's marketing. The company spends most of its digital ad budget on search-engine marketing and its own Web site. Social-network ads don't have the same track record, she says, and are time-consuming to create. For Facebook to become more successful on Madison Avenue, O'Brien and other marketers say, the company needs to make it easier to develop, automate, and manage ad campaigns. "Social networking has been fun," she says. But it will "probably take another successful year" for it to become essential.

Such skepticism doesn't faze Sandberg. Facebook, she says, is in this for the long haul. That's why it's so determined to forge ahead, even as others succumb to the slowing economy. "We are in a new industry," she says. "We are figuring it out."

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