Twitter: A fine 'pre-business' but un-monetizable and a deadly acquisition target

Dear Google, Yahoo and any other potential buyer of Twitter. Bernstein analyst Jeffrey Lindsay says it’s a bad idea. A really bad idea.

In a research note, Lindsay delivers an interesting history lesson of Internet “pre-businesses.” You know the ones: The companies with large user bases, a lot of attention and no scheme to make a profit. Twitter—the latest Facebook and Google killer—falls into that pre-business category. 

Lindsay writes:

Twitter is finally part of the zeitgeist. Several of the candidates in the U.S. presidential election used Twitter as part of their election campaigns.  President Obama certainly did, as did Hilary Clinton and John McCain.  Most recently  several members of both houses sent Tweets during the president’s congressional address sparking another round of calls for a major player – read: Google or possibly Yahoo! -to step in and buy the company.  We think that would be a really bad idea.

Don’t get us wrong – we like Twitter and we think the concept of sending short open standard messages reporting on your activities is actually much more fun and more valuable than it sounds.  The problem is that Twitter falls into the broad category of new internet businesses that are almost un-monetizable.  Whoever buys it will likely have to operate it at a loss in perpetuity, or until the next cool web 2.0 social networking concept comes along and Twitter tweets no more.  Sadly, this would not be the first time that a major internet company had made a bad deal.

And then there’s the history lesson:

• Netscape: Acquired by AOL for $4.2 billion (arguably $10.8 billion at the close);
• AOL: Acquired by Time Warner for $120 billion (you’d be lucky to sell AOL for $3 billion today).
• ICQ: Acquired by AOL for $407 million. 
• Skype: Acquired by eBay for $4.1 billion. Hefty $1.4 billion eBay writedown ensued. 
• MySpace: Acquired by News Corp. for $580 million. That worked out because of a $900 million search deal with Google that won’t be renewed. 
• YouTube: Acquired by Google for $1.65 billion. A $1 billion Viacom lawsuit ensued. 

That list can easily be expanded. Lindsay’s point: Buying pre-businesses generally doesn’t pay. Here’s a suggestion: If a company really wants to blow a few billion on a pre-business just give shareholders a one-time dividend.

Lindsay continues: 

So why do some internet business models make money while others do not? The test, we would argue, is relatively simple. The ones that do make money can be described without referring to “future monetization layers”, “deeply embedded value stacks”, “keeping it as a free tool” or “the 50% of users who would definitely pay $5 per month for this”. The ones that do make money all seem to involve either mailing stuff to people who have paid for it online or getting advertising deals from the likes of General Motors.

Strictly speaking, some social networking properties do make money - a lot of money - but these are the ones that have a deal with one of the other types of web properties – the ones that have revenues.  For example, MySpace is still doing very well from its $900 million in guaranteed revenues from Google. It might not do quite as well when that deal eventually expires.

The fundamental issue seems to be that people just don’t want to click on ads when they are engaging in social networking activities.  And even when they do it is very difficult to know what they might be interested in other than social networking, making it difficult to get an advertiser to pay top dollar for targeting.  It is no accident that the most common advertisements on social networking sites are for online dating.

Those are good points, but behavioral targeting could fix those problems. Or not. I agree that the monetization model for social networks is clearly tougher than conventional portals. Why? There are no nice neat buckets to create destinations with. To create those buckets of demographics you need some user data—usually the kind that freaks the community out. 

Another monetization problem is unique to Web 2.0. Businesses can acquire massive user bases and scale before they have any time to cook up a business model.

Lindsay writes: 

The fallacy of Web 2.0 services like Twitter is that they quickly become large and popular achieving great publicity from their high profile and celebrity users (e.g. Britney Spears, Shaquille O’Neal, etc.).  More users are attracted to the service while it is free and the viral marketing and network effects come into play.  The problems start, however, when the owners of the service want to make it pay.  The users are used to using the service for free – if they are charged subscription fees many will quickly migrate to the next free service.  So that leaves advertising – display or paid search.  But the users have become used to an uncluttered website, they resent the banner ads, or sponsored links and once they appear, the users start to complain or worse, start to defect. Any attempt to leverage the user data, or in Twitter’s specific case to serve unsolicited Tweets from advertisers is typically met with user hostility.  The situation is further exacerbated by the initial venture capitalists who by this time are keen to get a return on their initial investment.

Lindsay’s advice to the potential buyers of these Web 2.0 darlings is to hang back and let the founders figure out how to make money. Why? If a buyer swooped in to buy Twitter right now it would only acquire a monetization headache. In addition, the buyers have all the leverage. These companies can’t go public and the only exit is a buyout. Meanwhile, the cool clock is ticking. 

We think that Google and Yahoo! and any other potential buyer should stay well clear of Twitter (and Facebook for that matter) at the “large but un-monetized stage”.  We think they should leave it to the original founders develop a business model and if the business survives, consider acquiring it then.  Taking on un-monetized services has proven to be a very uneconomic proposition for the Internet players over the last decade.  We think that those players who have revenues today would do well to avoid them.