Bo Peabody wrote a thought-provoking article for Business Insider called “Facebook And Twitter Will Always Be Crappy Businesses“.  I had to respond to a few things:

• It is still too early to tell what brand managers are going to do, particularly on Facebook.  You’re talking about a group of businesses (brands and agencies) with highly engrained habits and beliefs after decades of one-way, mass communication with customers. Social media and online advertising is simply new. Media buyers still don’t know how to get their arms around it, or how to efficiently buy it. But mental shifts are happening.
• Proctor & Gamble seems to be making quite an investment in Facebook.  Yes, they have a large experimental budget (they’ve been my customers with that budget), but this doesn’t sound like experimenting anymore.
• I’m a big believer in virtual goods when tied to the right experience design.  While I’ve attended events where Facebook execs dismiss virtual goods as niche compared to advertising, you know that they have studied the large Chinese web companies which make the bulk of their money from virtual goods of different sorts.  Contrary to Bo Peabody’s statement that “[a]ny monetization efforts are going to drive some users away and that will in turn erode value for the users that remain” — one of the benefits of virtual goods is that each user can determine their own level of investment.

But more than anything, I had to raise my eyebrows when Bo Peabody wrote, “Through my experience building Tripod and Everyday Health I’ve concluded that individuals get on the Web for one of two reasons: to find people or to find information.”

Come on Bo, you can’t define the world through your own lense! The dominant activity on Facebook is playing games, and YouTube and Hulu ain’t no slouches either.  Yes, I’m talking about entertainment.   Furthermore, there is this wee little trend going on. I’ll just put it out there for consideration.  It’s only hundreds of billions of dollars, and it’s called ecommerce.

Virtual goods have been used extensively in Asia for years, but are now coming into their own as a business model in the U.S.  With that growth comes media attention — including articles like today’s piece in the New York Times, “Virtual Goods Start Bringing Real Paydays“.  The entire thing isn’t awful, but I have to take the journalists to task for a few pieces of idiocy:

1. The lead sentence: “Silicon Valley may have discovered the perfect business: charging real money for products that do not exist.“

Excuse me, Claire Miller and Brad Stone, but what exactly do you think all software is?  Or any business based on intellectual property rather than physical manufacturing?  I know that sensationalism brings readers (witness the phenomenon of Glenn Beck), but really now…

Of course, while I might protest, I also know this is how the media works: fan up hype on a new tech, and then wait to tear it down.

2. “Analysts estimate that virtual goods could bring in a billion dollars in the United States and around $5 billion worldwide this year — all for things that, aside from perhaps a few hours of work by an artist and a programmer, cost nothing to produce.“

Wow, once again in one sentence they manage to insult every non-manufacturing-based profession.  Replace that with: “The legal services market is estimated at $250 billion worldwide – all for things that, aside for a few hours of work by a lawyer or paralegal, cost nothing to produce.”  Okay, maybe that’s a bad example since people love to resent lawyers!  Insert entertainment and media, advertising, banking, and huge swathes of technology, tourism, healthcare, hospitality, etc etc

Never mind that you not only need to pay those “artists and programmers”, but you have to design, create, market and support a game or online community that has millions of users and effective virtual good compulsion loops.  I’m not saying that the margins cannot be very good for the winners, but that in itself is not unique (cough: Google, Microsoft, etc).

3. “For outsiders, the selling of virtual goods — items with no actual value in the real world — might seem the very definition of a swindle.“

OK, this one I don’t blame the journalists for because it is true; there are people that simply have a hard time understanding what it means to pay for something intangible because they’ve never really examined what it means to pay for things like software, movies, music or anything experiential. Maybe if they received a cardboard box in the mail every time they bought a virtual good, these people would feel better. Then they can be idiots AND bad for the environment.

The journalists do have a good quote on exactly that from a Pet Society player who says, ““It’s an experience, like going to the movies.”  They do also quote Moshe Koyfman over at Spark, saying “It’s not about the good itself, it’s about the underlying human emotion or desire.”

But I’ll blog my dissatisfaction anyway.

<3% Conversion

For those actually in the social games space, the data point to note is the stat from Zynga that less than 3% of users buy virtual currency/goods. That is lower than many virtual worlds and MMOs, but not surprising given the scale and nature of social games (which should also have lower infrastructure and support costs than virtual worlds/MMOs).        (here’s some information on historical ARPU levels)

eMarketer has an article today highlighting the importance of non-advertising revenue streams for social media sites.  The above chart was from a Feb 2009 survey of “social media leaders”.  (note: they don’t share more detail about sample size or definition of “social media leader”)

Virtual goods have finally been legitimized as a revenue model, rather than a niche (even weird) activity ignored in favor of advertising. Now the concept is spreading beyond its game / virtual world roots, and we’re seeing large numbers of companies trying to figure out a “virtual goods” strategy.

While I believe very strongly in virtual goods as an effective business model, I also think the number of folks trying to get a piece of the market will outstrip the total share of wallet possible. We shall see attempts at virtual goods revenue streams put into place without a clear understanding of the compulsion loops and triggers that drive spend.

I’ve been meaning to write a longer post about vgood compulsion loops for a while now, but time has been limited so I’m just going to start with a few bullet points. If you are thinking about a virtual goods business model, it is worth cross-examining your design against these concepts.

And what do I mean by “virtual good”? Within the context of games and virtual worlds, it is most commonly thought of as a discrete digital item upon which a user/player can exert some level of control, even if temporary. Examples include simple 2D pictures (ex: current Facebook gifts), 2D or 3D avatar or interior design accessories (ex: clothing, animations, furniture), and game pieces (ex: swords, armor, food). They can be functional or purely visual. For the purposes of simplicity, I am also going to treat digital currency and “activity points” as virtual goods.

The Right Environment
Virtual goods businesses don’t work well for hit-and-run or extremely lightweight experiences. They thrive with a game or service with one or more of the following:

• Repeat visitors (high re-playability)
• A sense of community
• A reasonable level of social or gameplay complexity

Purchase Motivations

• Competition: you want to beat others, you are tired of others beating you, or you have strong self-competition and a desire to be the best, thus you purchase virtual items if it clearly helps you achieve that goal
• Impatience: this manifests in two separate ways — the first is a clever use of “activity points” that forces people to pay more to keep on playing (i.e. feed the addiction – this is an example where customer irritation tied with desire leads to opening the wallet); the second is a desire to accelerate progress to “elite” status (tied to competitive motivations).
• Self-expression: often related to aesthetic rather than functional virtual goods (but not exclusively), this ties into the human desire to show off a sense of style / identity / personality, show off an affiliation with a group, or demonstrate a loyalty to a celebrity of some kind
• Gifting: gifting is a strong motivator if you have a definite community (or lots of small sub-communities) — where humans seeks to foster relationships.  As everyone knows, not all gifts are equal, so in a world of free/commodity items, motivated gifters will seek out a more valuable form of expression, either through money or through time (spent earning or creating the gift)
• Entertainment: this seems to appeal more to the female demographic, but shopping (especially if there is a social feedback loop) and/or collecting (especially if there is an overlay of social cooperation or competition) can be strong forms of entertainment

There are two approaches to building a virtual goods business: you can slap them on top of your experience and hope people buy, or you can design the requisite compulsion / motivation drivers into the core fabric of your experience.  The latter strategy ensures a much greater chance of success.

David Pakman has an excellent post up called “Confusing Traction with Value“, pointing to the “distressed exit of iLike” and then pointing out a few Web 2.0 aberrations in valuation.  For those of you who experienced Web 1.0’s up and down, this is a bit “been there, done that”.

Web 1.0 was about startups far outstripping the available audience.

Web 2.0 was about startups finding audience, but far outstripping the available monetization sources (i.e. advertising, subscribers and virtual goods).

Advertising will continue to grow and mature online, but I remain fan of freemium and virtual goods as business models.  Of course, to have the latter, you have to have a product that fits and design in the right kinds of compulsion loops — virtual goods are not something you can just slap on top and expect to make money (although no doubt in the wake of the advertising drought, a new wave of business plans are doing exactly that).

Speaking of virtual goods, congrats to Mitch and Andrew over at Live Gamer on the acquisition of Two Fish — I’ve been expecting consolidation in that space and I think Live Gamer is creating a force to be reckoned with.

A few months ago, I listened to a panel organized by Battery Ventures called “Monetizing Social Media”.  Perhaps not surprisingly for a New York-based event, the panel spent 99% of the time talking about advertising.  Still, I was surprised to see both the Facebook and MySpace representatives brush off microtransaction business models as niche and not worth discussing.

The total advertising market is certainly much bigger than virtual goods, so I can understand why they keep trying to capture ad spend dollars, but when you look at companies like Tencent and watch the rapid growth of micro-transaction based apps, the dependence on advertising starts to feel a bit like wearing blinders.  However, notwithstanding the panelists statements, both MySpace and Facebook seem to be working on virtual currency strategies, and they are smart to diversify since ad dollars still aren’t racing their way.

eMarketer now forecasts that advertising in online social networks is going to fall 3% in 2009, although they do think it will recover in 2010 and grow 10% above the 2008 levels.

After pouring so much effort into advertising, will they understand enough about virtual goods to capitalize on the new model? That remains to be seen. Facebook’s neglect of its gift system has not been a good sign, but perhaps times are a-changing.

The point is not that micro-transactions are the new savior to socnets.  Advertising will be an important revenue source.  However, as the music industry is learning, diversification of revenue streams is the name of the game.