Online privacy: what’s at stake

It is widely believed that a flourishing democracy requires an independent, diverse, and financially solvent press.  With print newspapers set to disappear in the next few years, the future of quality journalism is highly uncertain. This year, the online version of the New York Times will generate about $200M in revenue, a number that will need to approximately triple to support the current Times newsroom.

Most people who understand Internet economics believe that the best hope for online journalism is online advertising. Luckily, online advertising has significant room for improvement. Most of the revenue of the Times’ online business is generated through display ads. The main metric used to price display ads is derived from the rate at which users click on the ads, a rate which today is dismally low.  Thus the Times could continue to support its current newsroom staff if display ads became even moderately effective.

Lots of smart people are working on improving the efficacy of display advertising. Large companies like Google and Microsoft are investing billions in the problem. As usual, though, the best ideas are coming from startups. Companies like Blue Kai and Magnetic are bringing search intent (particularly purchasing intent – the core of Google’s profits) to display ads.  Companies like Media6Degrees are using social relations to target ads based on the principle that “birds of a feather flock together” (Facebook will likely start doing this soon as well).  Solve Media turns the hassle of registration into an engaging marketing event.  Convertro is working on properly attributing online purchases “up the funnel” from sites that harvest intent (search, coupon sites) to sites that generate intent (media, commerce guides). All told, there are a few hundred well-funded ad tech startups developing clever methods to improve display advertising.

Many of these targeting technologies rely on gathering information about users, something that inevitably raises concerns about privacy. Until recently, online privacy depended mostly on anonymity. There is a big difference between advertisers knowing, say, users’ sexual preferences and knowing users’ sexual preferences plus personally identifiable information like their names.  Like most people, I don’t mind if it’s easy to find my real name along with my job history, but I do mind if it’s easy to discover other personal details about me. When I’m not anonymous (e.g. on Facebook) I want to control what is disclosed – to have some privacy – but when I’m anonymous I’m far less concerned about information gathered for marketing purposes.

Before the rise of social networks, online ad targeting services (mostly) tracked people anonymously, through cookies that weren’t linked to personally identifiable information.  Social networks have provided the means to de-anonymize information that was previously anonymous. Apparently, the wall has been breached between 1) my real identity plus my self-moderated public information, and 2) my anonymous, non-self-moderated private information.

The good news is that the things users want to keep secret are almost always the least important things to online advertisers. It turns out that knowing people are trying to buy new washing machines or plane tickets to Hawaii is vastly more monetizeable than their names, who they were dating, or the dumb things they did in college. Thus, there are probably a set of policies that allow ad targeting to succeed while also letting users control what is associated with their real identities.  Hopefully, we can have an informed and nuanced debate about what these policies might be. The stakes are high.

Note:  As with almost everything I write on this blog, I have a ton of conflicts of interest.  Among them: I’m an investor, directly or indirectly, in a bunch of technology startups.  Some of these – including some companies mentioned above – are trying to create new advertising technologies. I am currently the CEO & Cofounder of Hunch, which among other things is trying to personalize the internet through an explicit user opt-in mechanism.

While Google fights on the edges, Amazon is attacking their core

Google is fighting battles on almost every front:  social networking, mobile operating systems, web browsers, office apps, and so on.  Much of this makes sense, inasmuch as it is strategic for them to dominate or commoditize each layer that stands between human beings and online ads.  But while they are doing this, they are leaving their core business vulnerable, particularly to Amazon.

When legendary VC John Doerr quit Amazon’s board a few months ago, savvy industry observers like TechCrunch speculated that Google might begin directly competing with Amazon:

[Google] competes with Amazon in a number of areas, particularly web services and big data. And down the road, Google may compete directly in other ways as well. Froogle was a flop, but don’t think Google doesn’t want a bigger chunk of ecommerce revenue from people who begin their product searches on their search engine.*

In fact, Google and Amazon’s are already direct competitors in their core businesses. Like Amazon, Google makes the vast majority of its revenue from users who are looking to make an online purchase. Other query types – searches related to news, blog posts, funny videos, etc. – are mostly a loss leaders for Google.

The key risk for Google is that they are heavily dependent on online purchasing being a two-stage process:  the user does a search on Google, and then clicks on an ad to buy something on another site. As long as the e-commerce world is sufficiently fragmented, users will prefer an intermediary like Google to help them find the right product or merchant. But as Amazon increasingly dominates the e-commerce market, this fragmentation could go away along with users’ need for an intermediary.**

Moreover, Google’s algorithmic results for product searches are generally poor. (Try using Google to decide what dishwasher to buy). These poor results might actually lead to short term revenue increases since the sponsored links are superior to the unsponsored ones.  But long term if Google continues producing poor product search results and Amazon continues consolidating the e-commerce market, Google’s core business is at serious risk.

* Froogle (and Google Products) have been unsuccessful most likely because Google has had no incentive to make them better: they make plenty of money on these queries already on a CPC basis, and would likely make less if they moved to a CPA model.

** Most Amazon Prime customers probably already do skip Google and go directly to Amazon.  I know I do.

Facebook is about to try to dominate display ads the way Google dominates text ads

It is customary to divide online advertising into two categories: direct response and brand advertising. I prefer instead to divide it according to the mindset of users: whether or not they are actively looking to purchase something (i.e. they have purchasing intent).*

When users are actively looking to purchase something, they typically go to search engines or e-commerce sites. Through advertising or direct sales, these sites harvest intent. Google and Amazon are the biggest financial beneficiaries of intent harvesting.

When the user is not actively looking to buy something, the goal of an online ad is to generate intent. The intent generation market is still fairly fragmented and will grow rapidly over the next few years as brand advertising increasingly moves online. P&G – which alone spends almost $4B/year on brand advertising – needs to convince the next generation of consumers that Crest is better than Colgate. This is why Google paid such a premium for Doubleclick, Yahoo for Right Media, and Microsoft for aQuantive (MS’s biggest acquisition ever).

In 2003, Google introduced AdSense, a program to syndicate their intent harvesting text ads beyond Google’s main property  The playbook they followed was: use their popular website to build a critical mass of advertisers; then use that critical mass to run an off-property network that offers the highest payouts to publishers. AdSense became so dominant that competitors like Yahoo quit the syndicated ad business altogether. Today, Google has such a powerful position that they don’t disclose percentage revenue splits to publishers and extract the vast majority of the profits.

It is widely believed that Facebook will soon follow the AdSense playbook by introducing an off-property ad network. They’ll try to use their strong base of advertisers to dominate intent generating ads the way AdSense dominated intent harvesting ads.

But to win the intent generation ad battle, data is as important as a critical mass of advertisers. For intent harvesting, users simply type what they are looking for into a search box. For intent generating ads, you need to use data to make inferences about what might influence the user.

This is what the introduction of the Facebook Like button is all about.  Intent generating ads – which mostly means displays ads – have notoriously low click through rates (well below 1%). Attempts to improve these numbers through demographics have basically failed. Many startups are having success using social data to target ads today. But the holy grail for targeting intent generating ads is taste data – which basically means what the user likes. Knowing, for example, that a user liked Avatar is an incredibly useful datapoint for targeting an Avatar 2 ad.

Publishers who adopt Facebook’s Like feature may get more traffic and perhaps a better user experience as a result.  But they should hope the intent generation ad market doesn’t end up like the intent harvesting ad market – with one dominant player commanding the lion’s share of the profits.

* Most text ads are about intent harvesting and most display ads are about intent generation, but they are not coreferential distinctions. For example, with techniques like “search retargeting” (you do a Google search for washing machines and the later on another site see a display ad for washing machines), sometimes intent harvesting is delivered through display ads.

Facebook, Zynga, and buyer-supplier hold up

The brewing fight between Facebook and Zynga is what is known in economic strategy circles as “buyer-supplier hold up.” The classic framework for analyzing a firm’s strategic position is Michael Porter’s Five Forces. In Porter’s framework, Zynga’s strategic weakness is extreme supplier concentration – they get almost all their traffic from Facebook.

It is in Facebook’s economic interest to extract most of Zynga’s profits, leaving them just enough to keep investing in games and advertising. Last year’s reduced notification change seemed like one move in this direction as it forced game makers to buy more ads instead of getting traffic organically. This probably hurt Zynga’s profitability but also helped them fend off less well-capitalized rivals. Facebook could also hold up Zynga by entering the games business itself, but this seemed unlikely since thus far Facebook has kept its features limited to things that are “utility like.”

The way Facebook now seems to be holding up Zynga – requiring Zynga to use their payments system –  is particularly clever.  First, payments are still very much a “utility like” feature, and arguably one that benefits the platform, so it doesn’t come across as flagrant hold up. It is also clever because – assuming Facebook has insight into Zynga’s profitability – Facebook can charge whatever percentage gets them an optimal share of Zynga’s profits.

The risk for Zynga is obvious — if they don’t diversify their traffic sources very soon, they are left with a choice between losing profits and losing their entire business.  But there is a risk for Facebook as well. If buyers of traffic (e.g. app makers) fear future hold up, they are less likely to make investments in the platform. The biggest mistake platforms make isn’t charging fees (Facebook) or competing with complements (Twitter), it’s being inconsistent.  Apple also charges 30% fees but they’ve been mostly consistent about it. App makers feel comfortable investing in the Apple platform and even having most of their business depend on them in a way they don’t on Facebook or Twitter.

Stickiness is bad for business

It is common to hear entrepreneurs and investors talk about the high level of engagement (what we used to call “stickiness”) of their website.  They quite rightly believe that it’s better to have a more engaging user experience, as that generally means happy users. Unfortunately, the dominant advertising model on the web – Cost per Click (CPC) – rewards un-sticky websites.  As Randall Lucas said in response to one of my earlier posts:

The paradox, it seems is this: in a pay-per-click driven world, site visitors who want to stay on your site — due to it having the once-much-lauded quality of “stickiness” — are worth much less than those who want to flee your site because it’s clearly not valuable, and hence will click through to somewhere else.

Facebook recently became the most visited site on the web. Yet their revenues are rumored to around $1B – about 1/30 of what Google’s revenues will be this year. Google has the perfect revenue-generating combination:  people come to the site often, leave quickly, and often have purchasing intent. Facebook has tons of visitors but they generally come to socialize, not to buy things, and they rarely click on ads that take them to other sites. Facebook is like a Starbucks where everyone hangs out for hours but almost never buys anything.

The revenue gap between sites like Facebook and Google should narrow over time.  Cost-per-click search ads are extremely good at harvesting intent, but bad at generating intent.  The vast majority of money spent on intent-generating advertising — brand advertising — still happens offline. Eventually this money will have to go where people spend time, which is increasingly online, at sites like Facebook. Somehow Coke, Tide, Nike, Budweiser etc. will have to convince the next generation to buy their mostly commodity products. Expect the online Starbucks of the future to have a lot more – and more effective – ads.