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Why Facebook Wants To Sell You Out

The connection between your privacy on Facebook and how Facebook needs to make some cheddar

Image: facebook_eye

It's all about the money

Seems like every day someone shares a link on Facebook about how their privacy settings have changed again , or how the Facebook privacy policy has changed , or a link to an article about how Facebook is sharing more of your personal information against your will .

Nobody is thrilled about this erosion of privacy. At the same time, though, people come to Facebook not only because all their friends are already on it, but because it's free. When rumours were floating around that Facebook might start charging, Facebook groups with names like "If Facebook starts charging, I'm out of here" started popping up.

A friend of mine posted a comment on Facebook wondering, essentially, if the same people who say they don't want to pay for Facebook and the ones bitching about privacy concerns are the same people. Do they understand the connection between privacy and payment that Facebook is trying to manage?

I think most people don't, though not because they are too stupid to make the connection. I think they just have the wrong assumptions.

I talk about internet stuff all the time, 'cause I'm basically a geek, so topics like Facebook come up a lot for me. Most of my non-geek friends are surprised when I tell them Facebook is hurting for cash. How could it be, they wonder, if it has 500 million users ? Surely you couldn't have even got to that point if you weren't doing it right.

It seems a lot of investors kind of agree with you if that's your thinking. That's essentially why Russia's Digital Sky Technologies paid 200 million US dollars to invest in Facebook last year . They think, like Microsoft and other investors, that surely if you can get 500 million users, there has got to be a way to make money with this Facebook thing. Digital Sky Technologies thinks that Facebook is worth about 10 billion dollars.

Ten billion dollars? Surely if the company is worth that much, they have at least some of that money kicking around. Surely they don't need me to suddenly start paying 15 dollars a month to use Facebook? Aren't they already making money?

It didn't say in the article where I got the information, but I know, and so does anyone else familiar with investing, that Digital Sky Technologies must have bought about 2 percent ownership in Facebook. Because 2% of ten billion dollars is 200 million dollars.

To see how Facebook could be broke and worth 10 billion dollars, you need to know a little about how companies get evaluated by investors.

Let's say I form a company right now. I'm sure I'm going to be the next Microsoft, and so you'd be lucky to even have a tiny share in it. Tell you what, give me one dollar, and I'll give you one share of my company. How much ownership does a share represent? As the company owner, I can essentially make up how much I want to divide my company up to share with people. I expect that everyone is going to want a piece of my awesome company, so I need a lot of shares to go around. I'll need at least a million shares, so I decide that, for now, one share is one one-millionth of my company.

Now some other guy comes along and he is thinking of buying out the whole company. He doesn't know you or me, but he wants to know how much he should pay for it. What's the company worth? There's only one thing we know for sure about the company, which is that the last person to buy a share paid one dollar for it. So if this new guy wants to buy all the shares, he will have to buy out all the shares at one dollar a piece.

So my company is "worth" one million dollars. Only on paper, though. All I had in my pocket is the one dollar you gave me, but I've already spent it on one third of a Starbucks coffee, so that's gone.

Of course, real life investors like Digital Sky Technologies do a lot more research on a company than seeing what the last share price was. They don't just take it on faith that the last guy wasn't a complete idiot. They do "due diligence", where they crawl around every nook and cranny of a company to see what it's "really" worth. In the end they come up with an offer, which then creates a new value for the company. In this case, the 10 billion number they came up with is based on a lot of speculation and theory about how Facebook might make a profit in the future, if everything goes right.

In terms of the actual cash Facebook has, though, at the time Digital Sky Technologies gave Facebook 200 million dollars, that might have been the only 200 million Facebook had. They may even have been in debt. Just like that dollar you gave me for my company, that money is probably gone by now.

Gone where? Here's another mistaken assumption that people have about web sites, which is that it's all just bits and bytes of invisible data that is essentially free to send around the internet. Any goof can pick up "HTML For Dummies" and make a web site for next to nothing, and most web sites sit around getting just about no visitors, so they are close to being free to run.

If a web site actually gets some traffic, though, things are different. You know how if you run ten programs at once on your computer it slows down? The same thing is true on the computers called "servers" where web pages are stored. The more people who access a web page, the more the computer servers will slow down to deliver web pages to those people. Nobody wants to wait for a web page, so if you're a web business, you need to get more servers to handle the load. These days, if your web site is seen by a few thousand users, your 5 dollar a month web hosting service can easily handle it. But hundreds of thousands of users will have your web hosting service calling you telling you that you need to pay more to handle the load. Millions of users means setting aside computers dedicated just to your web site. Hundreds of millions of users means whole data centres worth of computers, housed in buildings built especially for them.

Facebook is different from, say, Google. You may look at Google and think that since Google handles way more visitors and data than Facebook, and yet still makes a profit, surely Facebook could easily do the same. Not so. Google doesn't really hold that much data of their own. They just point to other people's data. Facebook, on the other hand, holds onto every photo and piece of text that you see on any one Facebook screen.

I just checked my Facebook home page and with all the media and Javascript on the page, it's a whopping 1 megabyte of data. A Google page, even with it's image suggestions and everything comes in at less than one fifth the size, 180 kilobytes. There are other differences, too. A Google user generally goes to a Google search page, and then leaves again to whatever page they are searching for. A Facebook user hangs around, downloading page after page, transferring that much more data.

Without getting into too many more details, my point is that not all web sites are equal. Google has the right balance of visitors, data, and income. Facebook doesn't.

To run a site, you need all the computers, you need internet connections, and you need to power it all . And you need back up systems. Oh, and customer support, human resources departments, office space rentals, advertising, security, insurance, legal fees for when somebody tries to make a site that will help people remove their Facebook accounts ... the costs go up and up. Up into the millions. Facebook isn't a public company, so we don't know exactly what they spend their money on, but some reports indicate that in 2008, Facebook spent around 300 million bucks on stuff .

So ignore all the numbers thrown around, like 500 million users, 10 billion dollars, and all those numbers that make it seem like Facebook should be doing awesome. The 200 million dollar investment from Digital Sky Technologies only covered two thirds of one year's costs. Although Facebook is making some money in various ways, it has, so far, needed investment to keep going.

Where is Facebook now?

Currently, as of about May 2010, Facebook claims it is is "cash flow positive" , which means that for at least a little while, it was making more money than it was spending. Um... isn't that the same as saying it's "profitable"? Nope. You can often tell when something ain't quite right when people use complicated and specific terms to describe what should be simple situations.

Quick break down of "cash flow positive". Let's say your friend is a musician struggling to make it. His band has a van that they use to store their instruments in to go to gigs. Seems like he's not making enough money, though, because he's always asking you to buy beers for him when you go out, on the promise that he's going to make it big one day and then all the hookers and blow are on him.

Then one day he pays for the beers, and you think he must be doing better. He's got money, so maybe his band is "profitable". Then you find out that in order to cut costs, he sold the van the band has in order to save on gas, insurance, parking, and all those costs of owning a van. Without those costs, he has more money in his pocket, but without the van, his band is worse off because it's now harder to get to future gigs. He is "cash flow positive" at the moment, but you would hesitate to call him "profitable". Take his beer money now, because those hookers and blow aren't on the horizon.

How does Facebook cut costs?

Just as one example, recently they put a lot of work into making some of the software they use to run their site 80% more efficient . A move like that might have helped them be "cash flow positive" by cutting costs. More efficient software means less server activity, which means reduced costs all around.

It's better than the musician selling the van, but you can see that there's only so much one can do to keep costs down in order to beat expenses. Eventually, you have to stop cutting the pie into thinner slices and get some more pie.

Okay, that was a lot of learning about how Facebook isn't exactly making tons of money right now.

What does this have to do with Privacy?

Facebook is sitting on top of something incredibly valuable. Crazy valuable. There are advertisers out there who jizz in their pants at the thought of owning what Facebook has.

Market research data. Information about you, and your friends, and everybody.

You might not realize it, but you and advertising companies agree on at least one thing. Neither of you want you to see advertising that is not relevant to you.

If you sell feminine hygiene products, and you place your ads on television at random times, fifty percent of the audience who sees your ad are not customers. It's a waste of half your advertising dollar to send the ad to them.

What you want to do is know what shows women prefer, and what times they watch shows, so you can try to increase the chances that only women will be seeing your ad. The way you figure that out is market research. Wouldn't it be great if you could use this whole internet thing to get millions of women voluntarily putting lists of their favourite shows online?

Of course, women aren't going to come to your feminine hygiene product's web site and tell you things like their favourite shows, for no reason whatsoever. Unless you ran a contest or something, and then you have the problem that people might just be saying anything, true or not, just to win the contest.

If only there were a web site where everyone was voluntarily uploading everything there is to know about them. Simply because it was fun, and they wanted people to know. Then they encouraged their friends to do so as well. People would put up all their likes, dislikes, such as their favourite TV shows. And everything else as well. All their demographics, like their age, race, and relationship status. All their recent activities. Everything.

If that existed, and you had access to it, you could potentially target your advertising in the right places and times with laser like precision. The upside in increased sales and efficient marketing costs would be so huge as to make buying access to that kind of data worth the price at almost any cost.

Duh. Obviously I'm talking about Facebook.

From an advertisers point of view, it's a pile of data with orgasmic levels if market research potential. If you were an advertising firm with that kind of information, you could charge your clients insane amounts of money to give them the guarantee that your ads only go to people who are 90 percent likely to buy the product.

If Facebook could sell access to this data, they would be rolling in so much cash that they could be competing with Google for profit records.

Except everyone on Facebook has signed up with a privacy agreement that says precisely that their information will not be shared outside of Facebook.

Damn.

So here's the problem Facebook has. It is sitting on a gold mine that it would love to turn a profit on. It has the buyers salivating to get a piece of the action. But it can't simply cut deals and start selling data because it has an agreement with users to not do exactly that.

Why not simply rip the privacy statement out of the Facebook user agreement and tell people that the trade off to using Facebook is that advertisers will use the information they post to it?

I think Facebook is terrified, justifiably so, that such a move would spark a flight of users out of the system, effectively killing the goose laying the golden eggs. A huge percentage of users have made it clear in one way or another that if Facebook was perceived to be a marketing tool that they would abandon it. If 30 percent of your friends started using some other service instead of Facebook, that could be enough motivation for you to consider other options too.

On the internet, word travels fast, and alternatives are easily accessible. Every internet entrepreneur knows that the same tipping points that can make them an overnight success can make them an overnight dot-bomb.

Whatever ideals Facebook started out with of making a site that is socially connected but respectful of individual privacy, they are under pressure from the people who invested to do something to resolve this privacy versus profit problem.

There is no obvious solution. Facebook tried implementing advertising, but all indications are that for whatever reason, it's not making enough cheddar. Again, we don't know the exact numbers, but with maybe 300 million dollars flying out the door every year, you need a lot of aromatherapy and yoga ads to top that up again.

So what they have been doing is fudging that boundary between privacy and market research. They've redefined their privacy policy multiple times, and changed their privacy settings to try and see if they can get users to be more comfortable with sharing their information with corporations.

One result of that is a recent feature for providing automatic personalization on external web sites . They want to make it so that a web site can pay them for the privilege of access to Facebook's data about you. To make your data available, though, they had to change the privacy settings in your account configurations.

If Facebook is inching toward profitability, this is the front line where it is happening. Web services like Yelp, Pandora, and Docs.com paid to have some kind of access to Facebook's data. I don't know how much they paid, but it was enough to motivate Facebook to fudge the privacy boundaries yet again.

If you're on Facebook you probably first heard about this by having friends posting status updates with warnings to make sure you opted out of this new "feature".

So here is Facebook, selling a service to these other companies, and then as soon as they implement it, all the users start sharing information on how to defeat that service. Pandora, Yelp, and Docs.com might have ended up buying not much of anything. It puts Facebook in a tough position, trying to keep both groups happy.

If they can, then they might be able to start getting returns from the massive gold mine they have built. They're trying to create as much profit as they can from their valuable data without ignoring previous privacy agreements, but by bending it as much as possible.

However, they are at risk at any moment of pushing too far in either direction and falling apart. If they go one step too far in the direction of sharing private data, users might abandon them in droves, gutting Facebook of the very thing that makes it valuable. Or, they might remain too tight in protecting user privacy, in which case investment and business partnerships may give up and the company would bleed out for lack of resources. This risk is pretty much a permanent concern, even after the point of profitability, as the concerns of both users and business partners never remain static. No one knows what future service or feature on Facebook might make users suddenly not comfortable with sharing their data.

Nothing is certain except that Facebook can't stay the way it is. It will eventually have to find a profit model, it can't survive on investment forever. Right now the most likely result is that Facebook will become more open about your information with people who want to advertise to you, using personal data you didn't think they would look at when you uploaded those crazy pictures from that last awesome party.

Are you okay with that?

I don't think there's an easy answer because the devil will be in the details. A service like Facebook is useful, but it can't be entirely for free. You have to pay either directly or indirectly, so pick your poison.

The important thing is that to hedge your bets in the way that is most likely to keep you protected in the face of whatever changes come, you should follow the advice that applies to the whole internet, not just Facebook.

Never upload any information you wouldn't wear on a t-shirt.

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