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When a startup shows an estimated $150 million in revenue, isn't wildly profitable, and doesn't have a clear revenue model, no company in its right mind would give it a $15 billion valuation -- except, it seems, if we're talking about Facebook.
Could Facebook defy business norms? Could it really be worth enough to give its founder, 24-year-old Mark Zuckerberg, a fortune estimated at between $3 billion and $5 billion? It all depends on the company's success at building an advertising network, details of which the company is expected to announce on November 6.
With all the dreamy-eyed developers and enraptured tech evangelists filling Silicon Valley with their Facebook love, it's important to remember that the $15 billion figure is fairly abstract. Microsoft was willing to pay $240 million for a 1.6 percent slice of Facebook, but it's debatable whether subsequent investors will see things the same way. In this case, Microsoft had compelling reasons to yield to Facebook's terms.
For one thing, $240 million is chump change to Microsoft, which has $6.6 billion cash in the bank. Greg Sterling, both an independent consultant and a senior analyst for advisory service Local Mobile Search, frames it this way: Microsoft wanted to block Google from horning in on its advertising relationship with Facebook. It also couldn't afford to lose perceived momentum with its largest advertising partner.
While advertising is an important business to Microsoft -- CEO Steve Ballmer has publicly boasted that online advertising will be 25 percent of Microsoft's revenue within a few years -- it's currently a big disappointment, and is the only major division of Microsoft that's losing money. Microsoft's Online Services Business, which encompasses online advertising, Live Search, MSN Messenger and Hotmail, among other things, showed a net loss of $262 million in the company's most recent quarter. Its revenues, $671 million, represented just 5 percent of the company's quarterly total. The loss in such a hyped area of the business was a conspicuous blemish in an otherwise dazzling quarter.
"Microsoft was paying to maintain the relationship on terms that were very favorable to Facebook," says Sterling, "and Facebook was in a position to negotiate that sort of valuation, because it had competitive bidders."
So what will it take for Facebook to reach the point where a suitor might actually pay $15 billion for it? Facebook earned its valuation on the market's expectations, and expectations for its future are high. Sustained growth will be critical.
Facebook has 50 million users today, and many believe it can ramp up to between 200 and 300 million users globally in the near term. The fact that Facebook is doubling its user base every six months bodes well for the future, says startup advisor and investor Dave McClure, but whether it can turn those users into cold, hard cash is the burning question. "If they can figure that out, then there's probably an even richer valuation than $15 billion," he says.
Much is riding on Facebook's upcoming ad network. "The key thing is that Facebook has an audience," says Forrester analyst Charlene Li. "Wherever audiences go and people spend time, that becomes an advertising medium." Presumably Facebook will use its extensive user data to serve up advertising targeted on an individual level.
A big challenge for Facebook will be the fact that users of social networks tend to click on ads much less than, say, search-engine users do. But Li points out the big money is in ads which put a brand in front of impressionable consumers. The more data Facebook can give back to brand advertisers -- for example how certain demographics behave on the site -- the more valuable its platform could become.
At the SNAP Summit in San Francisco Friday, Altura Ventures CEO Lee Lorenzen suggested another intriguing possibility: a shopping mall application that would allow users to curate their own "shop," effectively bringing online commerce to Facebook. "It's not rocket science to put together a bunch of merchants in one shopping cart," says Lorenzen. "As soon as that happens and Facebook trains users to put their credit cards into their platform, commerce could take off for the site."
The whole endeavor is risky. Social networks are largely about entertainment, not utility. "Much of that activity is tied up in the notion of being at the hip, cool party," says Sterling. "If the party gets less happening, people will move on. There's a perishable quality to the audience." Sterling muses that Microsoft may want to embed its Live Search into Facebook, giving it more users and making Facebook more useful.
And Facebook's competitors have deep pockets. Facebook has the media buzz, but MySpace has more than double the number of users. According to a report by research firm eMarketer, Myspace currently has 58 percent of the ad market and Facebook just 14 percent. Google's ambitions to grow its own social network, Orkut, are much rumored. Google's track record, you might say, doesn't suck. It's shown an ability to monetize users, but it needs to attract them first.
Right now the weight on Mark Zuckerberg's shoulders is to keep the party going while offering a sustainable revenue model that goes beyond the current banner ads and $1 virtual gifts. He's the $3 billion man . . . at least until November 6.
This notebook is following articles about Facebook's potential to expand into Web Search. The first article also touches on the concept/meaning of Social Search. 
