Figure 1 - Web 2.0 Meme Map by Tim O'Reilly[1]

1. Introduction

The World Wide Web started as a loose collection of links to documents for various universities and research centers.  Today, the Web is a highly interactive medium for consuming content and conducting business.  A fundamental evolution of the Web that has made this possible has been termed "Web 2.0."  The technologies behind Web 2.0 provide a richer user experience and make use of information in unique ways.  However, Web 2.0 is more than just technology, as it encompasses social interactions and a variety of business models.  It is among the first concepts to combine technical, social, and business theories.  We find this mix to be intriguing, and will focus much of our paper on these aspects of Web 2.0.

The table below provides illustrations of some Web 1.0 or first-generation web technologies in a given sphere and their Web 2.0 equivalents.

Figure 1 From O’Reilly[2] with left column added by authors.

The term “Web 2.0” was coined by Dale Dougherty of O’Reilly Media and Craig Cline of MediaLive while brainstorming ideas for a conference.  They wanted a term that would recognize a renaissance for the Internet to highlight the idea that the Web had not “crashed” but had evolved into a new frontier.  This term would represent the architecture of participation and distributed independent developers.

Wikipedia cites three definitions for Web 2.0:

• A transition of websites from isolated information silos to sources of content and functionality.
• A social phenomenon referring to an approach to creating and distributing Web content itself, characterized by open communication, decentralization of authority, freedom to share and re-use, and ‘the market as conversation.’
• A shift in economic value of the web, potentially equaling that of the dot com boom of the late 1990’s.

The definitions for this term are split between those which identify social issues and those which represent economic ideas.  Web 2.0 is a complex mix of business concepts, technologies, and social phenomena.  Different factions will seek to apply or exploit this mix to gain benefit from the more interconnected world presented by the social aspects or from the economic benefit derived from an ever-expanding market and audience.  In order for communities to be furthered or businesses to be started, the entirety of Web 2.0, including all social and business concepts, must be thoroughly understood.

This paper will seek to define, clarify, and illustrate the definition of Web 2.0 on three levels.  First, we will look at several of the key technologies used in Web 2.0 applications.  Next we will examine the different business models that are currently or will be employed by those using the technology.  We will then look at several case studies in some depth.  We will close by offering some conclusions and by looking at the future of Web 2.0.

Figure 2 - SmugMaps.com, a site that allows users to annotate maps with personal information 

It would be a mistake to think of Web 2.0 as one technology or one business model.  It is better to think of Web 2.0 as a loose term indicating a new generation of web sites, applications, and services.  A Web 2.0 offering would likely combine several of the technologies and business drivers we discuss in the rest of this paper.

2. Technology

This section of the paper explains the key technical concepts related to Web 2.0.  As discussed in the introduction, Web 2.0 is as much about business models and social interactions as it is about technology.  In fact, some critics claim that one of the key differences between “Web 1.0” and the current web is the reduced significance of technology: many of the standards (XML[3], SOAP[4], and others) and infrastructure elements (such as Linux[5] or Apache[6]) used in Web 2.0 applications have been taken for granted as de-facto, established market standards for years.  These applications and specifications are not the focus of our paper.

Instead, we focus on what we believe are some technical aspects that appear to be a central part of many Web 2.0 sites, applications, and discussions.  In this section, we explain the ideas and principles behind each technology, and attempt to provide at least one brief example of a site or application that relies upon the technology as a central tenet of its business model.  These are not the only technologies relevant to Web 2.0, nor is any one site likely to rely on just one of these technologies: rather, this is a set of important technical concepts that we have observed as common to numerous Web 2.0 service offerings.

2.1 Perpetual Beta

The idea behind perpetual beta software is to release the software to the public early—sometimes only as a crude working prototype—in order to solicit feedback from early users and critics, gauge the level of excitement about the idea, and establish a footprint in a rapidly growing market; or at least establish a footprint in a market that the company founders think might be growing rapidly.  This idea is similar to Raymond’s[7] “Release Early, Release Often” credo, in which he argues for rapid iterative software development with a focus on listening to customer feedback after each iteration.

In traditional software engineering literature, beta testing refers to testing done by customers of the software once it has passed all the internal tests in the development organization and is almost ready for final release.  In the Web 2.0 world, beta testing is almost the only type of testing done, and some organizations claim it is never finished.  This is where the “perpetual” part of the term perpetual beta comes from.  This practice has made some critics unhappy[8] but nonetheless is gaining traction.

For an example of perpetual beta software, consider GMail, Google’s electronic mail service.[9] GMail has been available since early 2004 and now counts several million users.  It has gone through at least a dozen releases, each fixing bugs and adding new features.  These releases are largely transparent to users, who at most see a notice at the bottom of their screen informing them of the new features.  However, the capital “BETA” text part of the GMail logo on every screen serves as a constant reminder of and caveat to Gmail’s status.

Figure 3 - The GMail Logo

There are some underlying assumptions regarding the perpetual beta approach.  One is that because customers are typically not paying for Web 2.0 applications, at least not initially or for the early versions, they do not mind getting imperfect software.[10]  This is in stark contrast to most business organizations that demand technical support and related services should something go wrong.  Instead, Web 2.0 companies typically provide an electronic mail address to which users can send complaints, bug reports, and feature requests.  No guarantees are made that an issue will be fixed, much less when it will be fixed.  Users thereby use the system on the faith that these issues will be addressed.

Another assumption is that of reduced legal liability: by always claiming the software is imperfect, the provider helps reduce the probability and extent of any legal action should the software malfunction.  While this argument may be effective from a legal perspective, it can also lead to a type of pyrrhic victory, in which users stay away from the software because it malfunctions often.  In that case, the software will fail regardless of the absence of any possible legal action.

Perpetual beta is therefore a process, rather than a specific technology.  The process itself is not new; Microsoft and other firms have employed beta testing strategies with external customers for decades.  The only new aspect to the process in Web 2.0 is the scale of the process (i.e. how many users are included in beta testing) and the duration of the process (i.e. how long it takes).  We believe perpetual beta is a good means of soliciting user feedback, but the term contains negative connotations for experienced software developers, managers, and users alike, and so should be used with caution if the relevant organization wants to cross the chasm and attract mainstream customers rather than only early adopters.

2.2 User Network Effects

Another key technical aspect of Web 2.0 applications is that they rely on a massive number of users in order to deliver value.  This is sometimes referenced as a reliance on network effects[11] or network externalities. Traditional applications need user volume to drive profitability, but the value of the application to any one individual is the same regardless of how many users of the application there are.  For example, Microsoft Word is as useful to an individual author whether it is used by one other person or a billion other people; sharing can always be done using a lowest-common-denominator format such as plain text. 

This is sometimes called Metcalfe’s Law: the value of a system is proportional to the square of the number of users participating in the system.  Web 2.0 companies tend to rely on this Law quite heavily, although its universality remains questionable.

Figure 4 - Network Effects: Metcalfe's Law Suggests Value as the Square of Users.  From http://exonous.typepad.com/nkda/

However, with Web 2.0 applications, there is typically very little value if only one or a few users are actively employing the application.  For example, Wikipedia,[12] which is discussed as a case study later in the paper, would not be very useful or valuable if it only had a few authors.  Its value comes from having many thousands of contributors, each with some personal information or point of view, and some with editing skills.  It is their combined effort that delivers increasing value over time.

Figure 5 - The Wikipedia Logo

This need for many users is a barrier to entry for Web 2.0 applications.  To date, they have relied on “buzz” and word-of-mouth marketing techniques, primarily via popular blogs and technical news sites such as SlashDot[13] to attract users.  This is hard to scale in a cost-effective manner, and hard to maintain once the application’s novelty has worn off.  However, these strategies also serve as early measures of the promise and appeal of the company’s concept; if users do not respond to these blogs or news sites and do not use the application, the cost to the organization is small.  They can simply scrap the idea without having used significant resources on marketing and sales.  Of course, perhaps marketing and sales would have created a means of bringing additional revenue—enough to sustain and grow the organization—but it appears that many of these Web 2.0 companies are content with the low-cost, low-risk approach.  Once a service achieves a critical user mass, however, that user base becomes a barrier to entry for competitors, and so the first-mover advantage is a significant strategic asset for Web 2.0 companies.

Technically, there are scaling challenges in supporting many users.  Indeed, many Web 2.0 applications are only possible due to the decreasing costs of bandwidth, storage, and database processing.  For example, some plans currently offered include the domain name, Linux servers, several gigabytes of database capacity, and unlimited bandwidth usage for less than ten dollars per month.[14]  This plays into the low-cost, low-risk approach: when the infrastructure is so cheap, experimentation is more easily conducted and financed without the need for large venture capital infusion.

However, this inexpensive infrastructure does not reduce the need for good software engineering.  The founders of Web 2.0 companies must possess these skills or recruit the proper technical staff to help them.  In this regard, the staffing and recruiting challenges are the same as those faced by traditional software development organizations.  The one distinguishing factor at the time of this writing is the “cool factor” around Web 2.0 technologies; this is a hot field and many engineers would like to get involved.  Accordingly, Web 2.0 companies may be able to recruit more easily or offer lower salaries in exchange for equity or other rewards if the company later becomes profitable.

Currently, the most prevalent manifestation of this need for and effect of user network scaling is “tagging,” a term describing the technology that allows users of a given application to tag its contents with their own interpretation.[15]  On Flickr, a digital photo sharing web site discussed later in this paper, users can add tags to describe other people’s pictures.  On del.icio.us, users add tags to describe bookmarks.  In both cases, other users can search for specific tags.  For example, a user can search for photos tagged “Caribbean” to find photos from that region of the world.  Users can see many users' photos from that area, and then view each user’s collection of relevant photos.  Furthermore, users can subscribe to a news (RSS[16]) feed that will electronically notify them each time a new photo with a specific tag is posted.  Similarly, a business intelligence analyst with company X can subscribe to a del.icio.us feed to be notified every time someone bookmarks a link to his company’s web site, or perhaps a competitor’s web site.  Neither of these tools would be of much value if Flickr and del.icio.us did not have millions of users.

Figure 6 - The del.icio.us

From a technical perspective, the infrastructure required for tagging is not particularly new or complex.  Tags are typically implemented as separate tables in a relational database according to tag category.  For example, a del.icio.us record for a bookmark exists in one table, and that record has a unique identification.  Another table contains all the tags applied to the bookmark by various users, using the bookmark ID as the foreign key, and the ID of the user who applied the bookmark as another foreign key.  Metadata such as tags are rarely manipulated in any meaningful way.  More typically, plain text tags are entered by users, recorded in a relational database, and displayed on the web site.

Recently, venture capitalists have begun to understand the idea of “tagging” and to sponsor companies such as del.icio.us based on this business model.[17]  However, we still believe that the fundamental challenge of attracting enough users to make these network effects provide value is substantial.  It will be a sufficiently high barrier to entry for companies using this business model that most will fail unless they resort to more traditional marketing and sales techniques, or focus on strategic alliances and partnerships with other organizations that will steer users toward them.

2.3 Users as Developers

Another underlying trend in Web 2.0 applications is the exposure of public application programming interfaces (APIs).  While traditional organizations frequently expose APIs to partners and allies so that the latter may better design complementary products, Web 2.0 organizations expose their APIs to the general public.  Moreover, Web 2.0 organizations rely on the general public to derive usage scenarios for the API that may be outside the realm of the original application, outside the use-cases for the original application, and possibly not provide commercial benefit to the original Web 2.0 organization which published the APIs.

There are two goals for API exposure.  The first is to attract developers, who are considered a special type of user, and hope that these developers not only start using the product, but they start advertising it on their blogs and via word of mouth.  The purpose here is to attract more users of all types, and to help bring about the beneficial network effects as discussed above.  The second goal for exposing an API to the public is to stimulate creation of additional applications using the data and API provided by the organization.  If any of these applications are successful, the APIs and by default the underlying technology will be more successful as a direct result.

One example of public API exposure is the Google Maps API.[18]  Google designed its Maps service to be available via a simple and easy-to-use API, and published the API to the public.  Anyone can download the relevant documentation including code samples, and anyone can use the API to develop a web site or application.  Google makes no warranty as to the suitability of the code or its continued availability.  However, because it serves as a powerful driver of user innovation and as a point of technical pride, the likelihood of Google removing the service is remote.  The service has been widely used by many users, and sometimes a successful application of it has led to the developer being hired by Google as a full-time employee.

Figure 7 - Google Maps Logo (Note "BETA" as in perpetual beta)

From a technical perspective, exposing an API presents nothing new or novel; as mentioned above, companies have done it for decades.  The documentation is frequently generated automatically from code-inspection tools, and the API is made available for download as a small, binary package.  The company that provides the API typically implements a web service to accept requests, parse them, and service them as needed.  The web service most likely uses SOAP (Simple Object Access Protocol) messages in XML format, although other formats, such as Javascript (used by Google Maps) are available as well.  In fact, some analysts exchange “web services” for “public APIs” as a key technical feature of Web 2.0.

2.4 Rich User Experience

A richer user experience (when compared to first generation or Web 1.0 sites) is a central part of Web 2.0 approaches.  “Richer” in this context has two distinct meanings.  The first is a better-designed, more intuitive, and more user-friendly graphical user interface.  The other is a cleaner interface, one that is not excessively crowded with options and links.

Many critics claim that Web 1.0 was a step backwards in user interfaces: we went from the well-developed rich clients like the Apple desktop and the Microsoft Windows equivalent to HTML pages that were close to plain text.  In applications that demand data entry, multiple workflow steps, or rich data visualization, Web 1.0 is a cumbersome and ineffective option because its user interface is too simple.

A number of the technologies in Web 2.0 aim to make the user interface more like that of a rich client.  One is called AJAX, for Asynchronous Javascript And XML.  It is a technology that allows dynamic replacement and updating of parts of a web page without requiring a full page refresh from the server.   It leads to the appearance of a live page that is continuously updated without the inherent latency that is typical of most Web 1.0 applications.  An interesting AJAX Web 2.0 example is WickIT, a Belgian wiki provider: visit its site at www.wikit.be for a live example of how the AJAX interface appears smoother, richer, and faster than traditional or Web 1.0 pages.

Figure 8 - WickIT, a Belgian Wiki Provider

AJAX as a technology has a high technical barrier to entry because it requires programmers who are fairly skilled at XML, normal server-side application design, and Javascript programming at once.  Moreover, browser support for AJAX varies, there are no relevant international standards, and tooling support is currently poor but rapidly improving.  As the tools improve, we expect more programmers to become adept at AJAX usage, thereby increasing the popularity of this technology even further, to the point where most new sites will use some form of AJAX.

There are two additional technologies are similar to AJAX in impact, but different from a technical perspective.  They are competing against each other, and both are based on Macromedia’s Flash player, which is installed on more than 90% of desktop computers worldwide.  One is Flex, a proprietary server-side product with an accompanying design studio desktop product.  It allows artists and graphic designers to assemble web pages in the graphical studio environment, and the product translates the controls into animations that run in Flash.  Laszlo[19] is the other technology, which directly competes with Flex along the same design process from a technical perspective.

The key aspect in both technologies—especially when compared to AJAX–is the ability for non-programmers to design the user interface.  Of course, this has been a goal in the web application software design world for at least the past five years.  Various other products have been marginally successful in this regard, but if these products are successful, they will be a key factor in Web 2.0 from a technology perspective.

Figure 9 - Sherwin-Williams Logo

One example of a Flex-powered application is Sherwin-Williams’ Color Visualizer.[20]   The application uses drag and drop as well as employing a rich interface and looks like it was put together by graphic designers and marketers, rather than engineers.  This is frequently a tell-tale sign of Web 2.0 applications.

2.5 Granular Addressability of Content

One final technology we wanted to note is frequently referred to as “granular addressability of content,” which refers to users being able to access only those parts of the applications they want at the time they want it.  For an anti-example, consider again Microsoft Word.  The user has to open the full application to read even a small section of a document.  It would be nice if the user could instead open a lightweight client to view only the section of interest.  This is the kind of functionality many Web 2.0 applications provide.

One typical technique used to implement this granular approach is user-customized RSS (Really Simple Syndication) feeds.  For example, the Google News site not only provides pre-canned RSS feeds for categories such as sports or entertainment, but also allows the user to compose a search query using any key words, and then save the results of that query as an RSS feed whose new updates are delivered to the user’s mailbox as they become available.  This technology corresponds to the “publishing versus syndication” line in Table 1 above.

This type of approach presents both design and scaling challenges.  In the Google News case, for example, there are millions of users who can each create numerous RSS feeds.  A large database is needed to store the feed definition and significant CPU power to process the feed updates.  Again, this is helped by the reduced infrastructure costs associated with operating systems, bandwidth, and databases.

From a design perspective, there are architectural challenges to properly modularize the application according to different usage scenarios.  However, these challenges are not particular to Web 2.0 applications, as they have existed in similar form for decades now.  The technology is simply made available in an easy-to-use form to millions of people, sometimes in less-than-polished form.  It is not brand new technology or brand new software development processes, it is a combination of the two fueled by cheap infrastructure and a growing base of users who are willing to endure imperfect software and send feedback to its providers.

3. Business Drivers

This section of our paper discusses various business models and financial drivers behind existing and projects Web 2.0 companies.  This is a very new field; only a relative few companies have been formed and fewer yet have proven successful.  We are seeing the first wave of Web 2.0 approaches at the moment, and these models will undoubtedly be refined over time as more experience is gathered at the company and industry levels.

Figure 10 - Efficiency, Efficacy, Innovation: All Needed In Web 2.0.  From http://www.jtknet.com

3.1 Startup Capitalization

Joe Kraus, the founder of Excite writes on his blog, “Excite.com took $3,000,000 to get from idea to launch.  JotSpot took $100,000”.

In contrast to the original (Web 1.0) startups of the 1990s, the capitalization and funding of Web 2.0 startups is very different.  In the past decade, there have been a number of dramatic shifts in the factors that affect the cost of launching a web startup:

• Hardware: Prices for all hardware components continue to decline.  The efficiency of the second hand market has also increased thanks to auction sites like eBay and classifieds services like Craig’s List.

• Software:  Linux, Apache, MySQL, PHP (LAMP) and other free open source technologies have dramatically reduced the cost of deployment of highly scalable web-based applications.  An organization can focus and spend money only on differentiating features specific to the business.

• Infrastructure:  The dramatic increase in capacity of data centers, hosting facilities and bandwidth has reduced the operating costs of delivering web-based applications.  Many providers offer cheap hosting programs with backups and virtually unlimited bandwidth: these services previously cost a lot of money.

• Talent:  Access to a global pool of educated and experienced resources has decreased the cost of software architects, designers and developers.  As lower-cost providers in countries such as India have been gaining experience, it becomes easier to shift software development overseas.

• Marketing:  Web 2.0 companies now primarily rely on Internet-based marketing strategies (blogs, search engine marketing, etc.) to increase the awareness of their products.  Gone are the days of multi-million dollar Super Bowl commercials.  Web marketing can now be more targeted and organizations tend to pay less overall, as they only pay for actual user clicks and not just placement.

Figure 11 - The Dilbert Marketing Plan

As a result of the above factors, many Web 2.0 startups do not raise any institutional capital and instead rely on personal funds and friends and family to launch their companies. 

Given that venture capital is not necessary for these companies, there are a number of interesting attributes of these startups versus traditional venture-backed companies:

1. These startups are often founded by software developers who can do a majority of the development work themselves or with a partner.

2. Founders generally focus most of their energy on developing the solution instead of writing the business plan.

3. Founders often work on the new company in their spare time without leaving their day jobs.  This means, in theory, the product development can go on indefinitely.

3.2 Business Models

Many of the current breed of Web 2.0 startups deal with the same challenge as that of their predecessors in the 1990s:  lack of defined revenue opportunities.  Much like the Web 1.0 companies, a significant percentage of these startups have no discernible revenue model.  At a recent Web 2.0 networking event in Cambridge, Massachusetts three startups that presented their offerings and not a single one made any mention of how they were planning to generate revenue.  One of the audience members finally directly asked how the firm would generate revenue.  The response was terse and somewhat dismissive: “probably advertising or something like that.”  It was obvious that devising meaningful revenue opportunities was not high on the list of priorities for these firms.

Another challenge related to revenue generation for Web 2.0 startups is that they often derive their value from integrating existing data and services.  Examples include sites such as chicagocrime.org which combines data from the Chicago Police department with Google Maps.  Though many of these applications are very useful to users, it is unclear how revenue will be divided between the various players that participate in the total solution.  This may be why Google, Yahoo! and others that provide API access to their services put a constraint on the volume of queries that will be accepted from a single organization and further stipulate that the data cannot be used for commercial purposes.

Figure 12 - The Six Classic Components of a Business Model

3.3 Advertising Revenue

Many Web 2.0 startups state the possibility for advertising revenue as a way to monetize their product offerings.  Much of this renewed interest in advertising revenue can be attributed to relatively efficient advertising platforms offered by companies such as Google, Chitika, and Yahoo!.  Google is by far the most prominent provider in this category with its very popular AdSense program.  AdSense allows web site owners to display Google advertisements on one or more pages of their site.  Advertisers pay Google for any clicks that are generated by these advertisements.  Google in turn shares a percentage of this revenue with the website owner. 

Advertising as a revenue model has an immense appeal for many Web 2.0 startups.  It takes very little effort to create partnerships with Google and others to start displaying ads on websites.  The opportunity for advertising revenue also provides the startup with a strong rationalization for not having to charge money for their services.  The plan is to monetize the traffic on their websites through advertising. 

Though advertising is certainly a quick and convenient channel for revenue, there are a number of significant risks with businesses that rely on advertising as a primary vehicle for revenue:

• There are still a very limited number of “suppliers” that act as an intermediary between advertisers and site owners with Google currently having the largest presence.  Lack of meaningful competition puts power into the hands of these established players.
• Advertising revenue is primarily a function of web traffic, click through rates and eCPM (effective cost per 1,000 clicks).  Any of these can change relatively significantly in very short periods of time.  This often makes advertising revenue streams highly volatile and unpredictable.
• The online advertising industry is being besieged with abusers that may erode confidence in the model (and thereby drive-down pricing).  Examples include click-fraud whereby advertising links on sites are clicked by automated software agents thereby distorting revenue numbers. 

3.4 Subscription Revenue

Many Web 2.0 startups recognizing the limitations of advertising revenue elect to charge a recurring subscription fee for access to their web applications.  This approach has a number of distinct advantages:

• Revenues are more predictable than advertising revenues.
• Different tiers of pricing can be offered based on features/functionality.
• Opportunity exists for creating a customer database since all paying customers are known.

One of the challenges with charging subscription fees—and the reason why many Web 2.0 startups are reluctant to implement them—is that they dramatically reduce the pool of people that are willing to use the application.  Many users of web applications have an expectation of free services that are subsidized by advertising or other forms of revenue and are generally unwilling to pay a fee for such services.  This is particularly true for services for which there are existing alternatives, such as electronic mail, blogging, calendaring, and photo sharing.

3.5 Network Externalities and the Need for Dominance

Most Web 2.0 startups rely on creating a large, loyal community of users, as discussed briefly in Section 2.2 above.  This is intrinsic to the business model.  The premise is that the value of the product or service increases for all users as new users participate.  This is the classic network externality that makes companies like eBay multi-billion dollar enterprises.  However, this very need for large user-bases also presents a challenge.  If there are a number of competitors in any given category, which there usually are, all of them are struggling to capture the mindshare within the same pool of people.  Though this often results in great innovations, it can also result in non-optimal behavior such as attempting to capture users with something other than differentiated value. 

This phenomenon is already beginning to emerge as venture capitalists have started investing funds into Web 2.0 companies.  It is likely that since these companies do not require significant capital for product development, the funds will instead be used for generating traffic, drawing users, and otherwise attempting to win the zero sum game.  This already has many of the elements that were part of the Internet bubble of the 1990s.  When companies are evaluated using clicks, users or other proxies for actual financial performance, there is always the danger of distorted valuations and unsustainable growth strategies.

3.6 Addressing Long Tail Markets

A common theme among many Web 2.0 companies is that of the long tail market, which basically posits that much of the market consists of a highly diverse set of micro markets and that the aggregation of these micro-markets represents a major opportunity.  As a result, rather than focusing on “mega hits,” which individually may be significant and even multiple times the average, Web 2.0 companies focus on finding ways to include the million niche customers that are not being addressed.

Figure 13 - An Illustration of the Long Tail Concept, from http://www.jroller.com/page/croctech/20050406

Though the long tail market has been discussed in great length and examples like Amazon.com abound, it is still unclear how Web 2.0 companies intend to creatively address the long tail.  Attempting to provide capabilities that serve the unique needs of a highly fragmented user base can often be highly resource intensive and prohibitive for startups.  The most common approach today is harnessing user-generated content to address the long tail.  Basically, this strategy involves having users contribute their own content, which in theory, is relevant to the specific micro-markets of interest. 

3.7 Exit Strategies and Valuations

Since a large percentage of Web 2.0 startups do not have plans for building sustainable revenue and profits, it is not surprising that many of them also plan to be acquired by one of the established Internet players.  The idea here is to quickly build a web service, give it away for free, build a large body of active users and ultimately sell the result to a company like Google or Yahoo!.  The focus is on building the user base, not generating revenue or profits.  As such, the companies are likely never to become sustainable ventures.  This creates a “race-to-the-exit” mentality whereby the limited funds that are available are used to launch the product and create technology and market share that is compelling enough to be acquired.  Though this model has worked for a number of Web 2.0 companies such as Flickr, upcoming.org and most recently, del.icio.us, it seems unlikely that this will be a successful strategy for a large portion of the companies that will be pursuing it.  There are a limited number of companies that can act as potential acquirers, and the risk of the technology not capturing the attention of the mass market is very high.

Valuations for Web 2.0 startups are also difficult to ascertain objectively, and hence tend to vary dramatically.  Since there is no traditional benchmark data on which to base valuations such as revenues and earnings, each of these deals is generally done in isolation and is based on the needs of the acquirer and the motivations for the transaction.  It will take some time, probably at least a couple of years, before valuations of Web 2.0 companies begin to normalize.

Figure 14 - Traditional Valuation Process, from http://www.perceptionpartners.com

3.8 Web 2.0 vs. Bubble 2.0

A number of critics are comparing the Web 2.0 phenomenon with the Internet bubble of the 1990s.  Peter Rip, Managing Director of Leapfrog Ventures summarizes this phenomenon nicely.  He presents what he calls a “new Web 2.0 equation:”

Lots of talented developers wanting to start companies

+ Cheap sources of computing resources and availability of personal time

+ Relaxed financial criteria (minimal business model screening)

+ Shared knowledge of the big tech trends posing as technical innovation

+ Relative difficulty of knowing what everyone else is doing

= An abundance of startups pursuing the same general markets

The net result is that this large number of companies all competing with each other in the same category raises the bar for capital requirements, believing that those that can “outspend the competition” will break out.  This is causing VC investments in certain Web 2.0 categories already.  Lastly, there is the ultimate shakeout when it is finally discovered that only a small fraction of the companies—both funded and non-funded—will either reach sustainable status or be acquired along the way.

Figure 15 - A Bubble (Not Software-Specific)

3.9 Web 2.0 Business Challenges

There are a number of significant challenges confronting Web 2.0 startups, including:   

1. The definition of what Web 2.0 really is and means is still unclear to investors and customers.  Startups that label themselves as “Web 2.0” likely do themselves as much harm as good.

2. Revenue models and paths to profitability are unclear.  Too many Web 2.0 startups are focused on being acquired instead of generating earnings.

3. Many of the underlying technologies inherent in Web 2.0 companies like AJAX are immature are not yet widely standardized.  This will create compatibility issues and missed client expectations.

4. Given the low costs of development, there are inherently very low barriers to entry.  This attracts a significant number of new entrants.  Only a few of the companies amongst the dozens in any given category will survive.

4. Case Studies

In this section, we will analyze several prototypical Web 2.0 applications by examining their use of technology and discussing any viable business models they offer.  From this we will draw some conclusions in the next section about the potential opportunities for creating new businesses in the Web 2.0 space.

4.1 Wikipedia

Figure 16 - The Wikipedia Logo

Wikipedia was created several years before the phrase "Web 2.0" entered the lexicon, but it is often cited at the top of the list of Web 2.0 applications.  It started as a competitor to traditional encyclopedias.  The CEO, Jimmy Wales, hired a number of PhD editors to write articles and build a web-based encyclopedia from the ground up.  However, after the first year it was evident that the editors were not writing articles fast enough. They had an epiphany to open article submission and editing to the public. Now Wikipedia is approaching close to one million articles, more than all other encyclopedias combined.

The one major complaint about Wikipedia has been related to quality.  The particular bias of some of the article authors has shown through.  For example, the entry for Bill Gates[21] had a negative tone and cited specific donations he made to various political campaigns.  His article has since been cleaned up, but this highlights the central issue with Wikipedia: it is very easy to create articles of varying quality, but it is also easy to improve them. 

4.1.1 Technology

As the name suggests, Wikipedia is built on top of a wiki.[22]  A wiki is a web application that allows the easy creation and modification of content directly through a browser using a simple markup language.  It is intended to promote group collaboration and thus participation, a key tenet of Web 2.0.  Wikipedia has "radical trust" for its users, which is both a blessing and a curse. Lastly, Wikipedia is the type of software that gets better as more people use it. Conceivably, if users find mistakes or problems with articles, they can easily correct them for the benefit of all.

4.1.2 Business

The Wikimedia Foundation[23] is the over-arching nonprofit foundation that owns Wikipedia.  The Wikipedia content is available for free under the GNU Free Documentation License.[24]  The Wikimedia Foundation also owns several other wiki sites including Wikitionary, Wikibooks, and Wikiquote.  The Foundation accepts donations to pay for bandwidth and data center operations.  Some have speculated that Wikipedia may use advertisements in the future to supplement donations, but this is unsubstantiated.

4.1.3 Synopsis

Wikipedia has become one of the most visited web sites on the Internet by providing a very valuable service to users. From a technology perspective, Wikipedia has many of the attributes defined by Web 2.0.  Despite the fact that Wikipedia is hosted by a nonprofit organization, a for-profit company could have likely done something very similar using advertisements to support the business and have been quite successful.

4.2 Google Maps

Figure 17 - The Google Maps Logo

The first application that "felt" different and helped differentiate Web 2.0 was Google Maps.  Google entered yet another crowded market (previously search and in this case web-based maps) and provided an innovative solution that redefined the market. Google Maps is an interactive map service that combines context-specific information such as local restaurants.

Like Wikipedia, Google Maps has become an emblem for a Web 2.0 application.  By integrating Google Maps into an existing application, a company can instantly gain a Web 2.0 appearance.

4.2.1 Technology

Google Maps has many of the attributes of Web 2.0.  The first, and perhaps most profound, was the use of AJAX that allowed for a much richer client experience. Another key aspect of Google Maps which increased its adoption was the support of an API.  Originally, users reversed-engineered the Google Maps implementation and created early Web 2.0 apps such as Housing Maps,[25] but Google quickly released a supported API that let developers easily plug maps functionality into their applications.

4.2.2 Business

Like all of their other applications, Google provides Google Maps and its API for free, which is another reason Google Maps has been adopted so quickly.  Unlike Wikipedia, Google is not a nonprofit; they make money through advertising.  People pay for prominent placement on Google Map searches, and many users of the API allow the previously described Google Ads on their pages.  Additionally, the “Powered by Google” logo is displayed on every map, which has helped increased Google’s brand recognition.

4.2.3 Synopsis

Google has set the standard for how to build Web 2.0 applications and make money from them.  Instead of creating products people pay for, they make use of many Web 2.0 features to create exciting products and subsidize them through advertising and increased brand recognition.

4.3 del.icio.us

Figure 18 - The del.icio.us Logo

del.icio.us is a social bookmarking site mentioned earlier that allows people to share their bookmarks, comment on them, and tag them.  Tags are used as universal categories, allowing for a type of search replacement; instead of searching with Google, search del.icio.us tags and follow bookmarks from trusted people. The site touts the convenience of accessing bookmarks from anywhere and not being tied to a particular browser or computer.

4.3.1 Technology

The primary Web 2.0 feature of del.icio.us is tagging.  Tags allow users to essentially vote on the topics they think are most applicable to a particular web page. This "folksonomy" has a few benefits over just plain searching because it harnesses the collective wisdom to categorize pages instead of just the content on the pages.

4.3.2 Business

The del.icio.us site is freely open and does not have any ads or paid account options.  The site’s creator, Josh Schachter, has received seed financing from several Internet notables including Amazon.com, Marc Andreessen, Esther Dyson, Seth Goldstein, Tim O’Reilly, and Bob Young.  Schachter and his investors have publicly acknowledged that they are not quite sure what the business model for the site will be.  The seed funding is being used to scale the site and improve usability.  Conceivably, they could use targeted advertising of one form for revenue and potentially paid accounts for additional services.

4.3.3 Synopsis

del.icio.us is another Web 2.0 application that is widely used, but is lacking a good business model.  Some people have speculated that del.icio.us may be attractive mainly to technical users.  The most popular del.icio.us tags are terms such as “programming,” “software,” “ajax,” and “linux.”  However, this did not stop Yahoo! from purchasing del-icio.us the week that we completed this paper.  This highlights the fact that in the Web 2.0 space, a company with a loyal following but little or no business model can still be attractive to the dominant players in the market.

4.4 Flickr

Figure 19 -  The flickr Logo

Perhaps the best example of an application created by a startup that makes good use of Web 2.0 technology and has a viable business model is the photo sharing site Flickr. While there were many of photo-sharing sites on the web, most restricted access to photos.  Flickr took the opposite approach: they came up with as many ways as possible to allow people to access their photos. In addition, they made the site fun to use and made it seem more like "play." They also used innovative photo clustering and pooling algorithms to make it easy for users to find what they want and browse it easily.

4.4.1 Technology

Much like Google Maps, Flickr is the epitome of a Web 2.0 application.  A list of Web 2.0 features the site supports includes the following:

• Folksonomy: allowing people to tag pictures and letting others search for tags, so they find a variety of pictures from all sorts of people.
• Uses "popularity contest" features such as a "favorites" and "most interesting" to incentive users to post more content which enhanced the network effects.
• Uses customized RSS feeds as a way to hook people on Flickr content.
• Offers rich APIs for developers and bloggers to enhance site presence, visibility, awareness

4.4.2 Business

Flickr uses several methods to generate revenue:

• Targeted advertising (high margins, low returns)
• Subscription account ($24.95/yr) for users that provided unlimited storage and bandwidth (high margins, high returns)
• Photo printing (low margins, low return)

They were purchased by Yahoo for an estimated $25 million in 2005.

4.4.3 Synopsis

At its core, Flickr was not a business; it was an application with a business model wrapped around it.  This is characteristic of many Web 2.0 applications, but Flickr did it in such a way to make itself an attractive takeover candidate. Instead of being solely ad-supported, Flickr created other revenue streams.  It is not known exactly how profitable these streams are, but regardless they were in a much better position to have an attractive exit than sites such as del.icio.us.

5. Conclusions

There currently is a lot of hype and social interaction resulting from Web 2.0 technologies, but little money is currently being generated.  Business models remain troublesome to define and easy for companies to ignore.  The situation reminds us of the first internet bubble, and so it is not surprising that some analysts prefer to call this “Bubble 2.0” instead of “Web 2.0.”  However, we believe some technologies and companies have already emerged from this bubble to form viable businesses, and many others are trying.  There is a substantial amount of research and venture capital funding being poured into the technologies and companies discussed above, and that ensures that some of these will survive well into the future.

We believe the collection of technologies and business models known as Web 2.0 will gain in popularity, as it does not consist of radical, difficult-to-learn technologies.  Rather, it a set of simple tools combined together to make a social context in which to conduct technology business.  Several of the key technologies have been available in various forms for several years at least: indeed, there is very little process innovation here.  Rather, Web 2.0 presents a new combination of these technologies with the availability of cheap storage, ample bandwidth, and a growing willingness by publishers to rely on users for content and feedback.  Web 2.0 lives at a crossroads of business opportunity and social networking.  While at the present time it seems as though the emphasis is on the social aspects of this Internet Renaissance, correct application of the technologies of Web 2.0 can create a niche in which business may prosper, rather than simply communities.

Any business undertaking will have to be taken with great care, ass business models remain hard to define and barriers to entry are low, at least before a dominant player emerges.  Most of today’s relevant technologies are open (always in terms of interface, and frequently open-source as well) and free, leading to low initial costs.  We believe that to succeed, a company must differentiate itself and gain significant advantage by grabbing the user market share.  The first-mover advantage will be a significant determinant of success for a Web 2.0 company.

However, the negative aspect of the first-mover advantage is that companies that enter a specific market segment late will likely not succeed.  Without a strong differentiating factor in either technology or service, it will become increasingly difficult to capture enough users to sustain a Web 2.0 business.  There will only be a small number of successful pure Web 2.0 firms.  Web 2.0 firms may also find success by capitalizing on an existing market share and simply translate their technology to the Web 2.0 world by opening the programming interfaces and allowing open edits to their pages.

Overall, we caution the reader to separate wheat from chaff.  There is much hype around Web 2.0, and it is not all justified or even reasonable.  Much of the rhetoric reminds us of the late 1990s bubble, and we predict a large number of financially failing Web 2.0 companies in the coming years.  We may be at the height of the Web 2.0 bubble right now and over the next year, and after that Web 2.0 will cease to be a buzz phrase. The key technologies will be well-ingrained and taken for granted, as is already starting to happen with RSS and other syndication tools.

Even though it is difficult to define Web 2.0 at this stage of infancy, some are already looking to Web 3.0 in which the world will see a decentralization of services.  It will represent the next step in the social and business networking established by Web 2.0; users will move from posting content to a single website and instead have content (reviews, comments, discussions, email, etc.) that can be integrated across a variety of sites.

Figure 20 - The Future?

---