When Microsoft (MSFT) bought a small stake in the wildly popular social network, the price paid implied an overall value of $15 billion. The rumored prices at which Facebook insiders are trying to unload some shares carry an implied overall value of as low as $3.75 billion to $5 billion.

It is clear that Facebook currently cannot be worth $15 billion. The Facebook Apps platform that attracted so much attention from independent software developers has lost a lot of momentum. Independent developers who invested a lot of time, money, and energy into creating Facebook Apps have found it increasingly difficult to attract a significant audience. While finding users has been tough, monetizing their creation has proven to be a Herculean task. Special venture funds created to fund Facebook apps have not been able to deploy much of their capital as most Facebook apps are ill-conceived or frivolous with no clear business model. I would return that money to limited partners rather than hope a genius comes along to battle for market share owned by early movers like Slide and RockYou!

Advertising, the main business model of free social networking platforms, continues to disappoint, with click-through rates and conversion rates declining alarmingly. While international growth remains strong, domestic growth is decelerating noticeably. This could be spun as a positive, but I don’t think the youth of other countries have spending power approaching anywhere near that of American youth.

Will this mark the end of the current cycle of funding exuberance on the part of venture capital firms for all things Web 2.0 or social? The pace of venture funding in this sector of the Internet really picked up when Myspace sold for close to $600 million to News Corporation (NWS-A). Since then, millions have been poured into all flavors of social networks and social networking apps. It reminded me of the fin de siècle bubble that burst so painfully for all involved. Below is an essay I wrote for an investment letter published in June 2007 distributed high net worth clients.

Irrational Exuberance 2.0

We are not calling a bust of the current bull market. As much as we admire Barron’s editor Alan Abelson’s wit and literary style, we are cognizant of the ravages that might befall our track record if we were permanent bears. Still, we can’t help but imitate his dour tone of the 1990s when he repeatedly called too early for the bursting of the dot com bubble. Mr. Abelson eventually got it right when we entered the new century and collectively blinked at the stratospheric levels we had taken the market to. Then as now, venture capital funding of cockamamie business ideas served as a reliable indicator of an impending rinsing out of “frothiness.”

As we once again witness new highs in the stock market, it may be wise to examine the shenanigans our friends in the venture capital world are participating in. Are they helping to start companies “built to last” or are they throwing money at silly business ideas “built to be sold?” After a quick survey of recent startup financings, we think a strong sense of déjà vu might visit us.

While yesteryear’s absurd venture deals were justified as the obsolescing of brick and mortar business models by an online nirvana fueled by UPS (UPS) and FedEx (FDX) trucks, today’s venture activity centers around “social networking” and the wisdom and power of crowds, also known as Web 2.0 in geeky circles.

Take NaturallyCurly.com for example. It proclaims itself as the social network for people with curly hair. Purportedly, individuals with curly locks need an online support network for all their hair maintenance difficulties. Don’t forget the most important feature of any social networking community, the ability to make friends with similar interests. We delight at the prospect of spending all our time discussing hair. A technology industry veteran who sold his company to Compaq invested $600,000 into this dandy of a site.

A little less silly but nonetheless vacuous is a website called Flixster. This is the social network for all things cinematic. Users rate movies, join fan clubs celebrating famous thespians, read up on news regarding upcoming films, and make friends.

Websites that allow people to rate movies and chat about their favorite scenes already exist. They just don’t allow people to make friends. This ability to make online friends convinced Lightspeed Ventures, a very reputable venture capital firm, to invest around $2 million into Flixster.

If the dollar amounts involved look nothing like the wasted mega-millions of the late 1990s, we present Geni.com, a website for constructing family trees. The premise revolves around getting relatives to help by emailing them a digital “widget” with which they could plug themselves in the appropriate branch of the family tree. It is the wisdom of crowds, albeit a familial one here, that makes this a very compelling idea indeed. Unfortunately, it occurred to us that great great great grandpa Bob of many years before cannot respond by email from Heaven. That did not prevent Charles River Ventures from injecting $10 million for 10% of the company, effectively valuing the then seven week old company without any revenues at $100 million. We believe the large valuation might have something to do with being able to turn relatives into online friends.

The Big Bang that gave rise to all this Web 2.0 insanity occurred when Rupert Murdoch’s News Corporation bought the top dog of all social networks, Myspace, for $580 million. Users of Myspace could create their own web pages and browse around the online community to make friends. Google (GOOG) soon followed by buying YouTube for $1.6 billion. YouTube users upload their homemade videos for the whole world to watch. One of the key principles of Web 2.0 is getting the community to contribute user-created content. Did we mention that YouTube users could also make friends with fellow wannabe Spielbergs?

Almost overnight, lemming-like venture capitalists funded dozens of Myspace clones with typically cute techie names like Tagworld, Bebo (TWX), Facebook, Facebox, Multiply, and Gather. Of course, all of these allow users to make friends.

YouTube copycats receiving venture funding include Veotag, Kyte, Mogulus, VideoJug, YeboTV, and Brightcove. Although we haven’t used these sites personally, we’re quite sure you could make friends on all these websites. How many News Corporations and Googles remain to stuff the coffers of venture firms by buying their portfolio companies? It seems as if entrepreneurs and venture capitalists in this space are banking on many more buyouts to come.

It isn’t just the private venture capital world that has fallen to the seduction of easy profits. When flimsy businesses with short operational histories try to tap the capital markets by going public through an initial public offering and find a receptive market, we are treated to such delicious examples as GoFish (GOFHE.OB) , a video sharing website in the spirit of YouTube. Debuting last October on the over-the-counter “bulletin boards”, the fishy company achieved a peak market cap of $147 million. With only $45,580 in revenue and no profits to speak of, investors in GoFish are swimming in a foamy sea of hope and greed.

Our favorite new social network? Stockalicious, a website that allows users to keep track of their portfolios and compare their performances against the market and each other. We wonder if Alan Abelson might jump on the Web 2.0 bandwagon and become a member of this Internet community. We could sure use a friend or two.

Since my current work is in new media and social networking, I am keenly interested in the turbulence facing the newspaper industry. Clients, ranging from Fortune 2000 companies to small innovative startups, come to my team at SocialOptimize to gain an understanding of the new media landscape and to develop an actionable strategy for building a meaningful presence in social networks. They ask about their traditional marketing budgets and I tell them that we will see the disappearance of many old model newspaper, radio, and television companies as they struggle and fail to adapt to the reality of new media on the Web. Consumers are spending less time watching television, listening to radio, and reading newspapers. Instead, they are spending more and more time on the Internet for their news and entertainment needs. Very few traditional media companies will emerge stronger from this “dislocation” but the opportunity exists for several to transform themselves into new media leaders.

As an investor, I train my eyes on public companies that report the news who are also making headlines themselves. During periods of disruption, large sums of value get destroyed but great opportunities arise at the same time. Thus my ears perked up when I learned that Harbinger Capital, playing the role of activist investor, initiated a proxy fight by nominating four candidates for the New York Times (NYT) board of directors. The New York Times, being one of the leaders and most important assets in traditional media, has been causing great anxiety and nervousness in shareholders. Newspaper subscriptions and newspaper advertising revenue, the old metrics of success, are steadily declining and this has caused a panic in investors. I argue that newspaper subscriptions can no longer be relevant in the evaluation of this company. While advertising revenue of course remains the lifeblood of media companies, revenue from the printed page should diminish in priority. The company needs a dramatic rethinking of what it means to be relevant and influential and how to reconfigure its revenue base. Harbinger seems to be on the same page as it calls for “bold action” in the form of selling off business units and increasing investments in online efforts.

If Harbinger succeeds in placing its nominees on the board, I think it will have its greatest impact by helping the company allocate capital in a more logical manner. The company should start by deemphasizing or changing its editorial makeup. Americans perceive mainstream media outlets like the New York Times as “out of touch” and severely biased in favor of liberal policies and politicians. Whether this bias is true or not matters little, one can only respond to the marketplace with logic and logic dictates that the customer is always right. This presents an opportunity to drastically cut the expensive editorial staff and balance it with editors of more conservative leanings. In no way am I advocating for a government mandated Fairness Doctrine. I’m pushing for a market-mandated, self-regulated, fairness regime that satisfies what consumers and readers are asking for. This will go a long way in maintaining relevance and influence while generating substantial cost savings at the same time.

As for overhauling its revenue base, I think that the New York Times has taken good steps towards improving its online efforts. Only Rupert Murdoch’s News Corporation (NWS-A) has arguably done a better job at shifting revenue streams online. It doesn’t get a lot of press for its investments in the Internet, but some of the companies it has invested in are very compelling. As with all new businesses, patience is required for a few of these to work out and become substantive revenue generators. Many of these have ambiguous business models to begin with and it will take some time to adjust to the market and settle on a viable strategy. I expect some of these will not gain traction and will fail, but that is the perilous, creative, and destructive nature of our evolving online business environment. Here are some of the company’s more notable recent investments in a portfolio style overview:

Earlier this year, NYT co-invested with a few venture capital funds in San Francisco-based Automattic. Automattic’s primary product is the blogging platform known as WordPress. WordPress software can be downloaded for free and hosted on private servers. WordPress.com is a hosted blogging solution that many major media outlets are turning to as a cost-effective solution for serving blogs and other content. Large media companies such as CNN, Fortune, and Fox are paying for the company’s WordPress.com services to host their blog content. WordPress is one of the leading content serving platforms on the Internet and continues to grow in popularity. I think Automattic will carefully find other ways to monetize the technology including serving advertising.

The Internet is a medium that is conducive to the convergence of different types of media such as text, video, and audio. The clean divisions between newspapers, radio stations, and broadcast television that existed before the rise of the Web no longer apply. In early 2007, the New York Times joined with other media companies such as Time Warner (TWX), GE Global Media & Communications (GE), Hearst Interactive Media, and IAC/InterActiveCorp (IACI) to fund Brightcove, a developer of IP video technology. Brightcove technology hosts and serves content published by professional media businesses. Brightcove has emerged as one of the more successful alternatives to YouTube for consumers of video content.

Just earlier last month, NYT partnered with Sam Zell’s Tribune Company, Gannett (GCI), and Hearst to form a joint venture called quadrantONE. Yet another in a long line of advertising networks, quadrantONE will sell localized online advertisements, primarily display or banner ads. Given that this network will include many regional and national newspaper organizations, it stands a reasonable chance of achieving success. The challenge will be to educate smaller, more localized marketers about this differentiating factor. Many small marketers are still only aware of Google’s (GOOG) advertising platforms. The real opportunity here belongs to the regional and local metro papers. Consumers will return to demanding more quality localized news and content. If the local news agencies can meet that demand, they can create the inventory necessary to make a localized ad network like quadrantONE a viable competitor online.

NYT has also invested in Federated Media, an ad network for blogs. There will always be a place in this world for professionally produced news content. I certainly don’t want an amateur giving me the scoop on a tightly guarded political scandal. Most amateurs don’t write well enough to convey the juiciness of the drama. And if an amateur suddenly stumbles upon a juicy scoop and is capable of writing cogently about it, that person immediately becomes a professional. Such has happened in the world of blogging. The new world certainly has space for an army of amateurs sharing their opinions regarding everything under the sun. This distributed rather than centralized model of content creation opens up opportunities for a talented few to break into the ranks of influential professionals. The good ones generate a relatively large following. Federated Media helps this top tier of bloggers monetize their audience and content. A recent rumor has management at Federated Media rejecting a $100 million buyout offer.

The rise of Craigslist, partially owned by eBay (EBAY) has devastated the classifieds advertising market for newspapers. Job listings revenue, usually the most lucrative segment in classifieds advertising, has fallen way down. The migration of job listings off news pages to online job boards such as Monster (MNST) only worsens the situation. The New York Times hopes its investment in Indeed, a search engine for jobs, will help it recapture some of those lost revenues. Indeed promises to give job hunters access to millions of job listings aggregated from online job boards, corporate websites, and newspapers.

I did not know there was a New York Times Research & Development Group. I hope the boys at Harbinger don’t look at this little skunk works team as a waste of scarce capital. Innovation and breakthrough business models take time and freedom to develop. I already look upon corporate-directed incubators with skepticism but when the parent company accepts that it is in crises mode, there might just be a chance for the mad scientists and geeks to make an impact. Shifd is a new mobile Web application that allows users to share content between their desktop computers and mobile devices. Shifd, pardon the pun, is a paradigm-shifting idea. It makes possible a future in which we don’t have discreet devices separate from each other. All our information lives on the Web and is available to us from any device and custom-configured to our needs. Your cell phone and your desktop computer will have roughly the same utility and functional profile.

Daylife calls itself a “news site and distribution platform.” It is a different take on the aggregation of related news items and competes against the likes of Digg and Reddit. Instead of relying solely on a community of users to vote news stories up popularity rankings, the company appears to utilize its own search technology and algorithms to organize related news articles. Daylife also offers Web widgets that help other publishers expand their news content. The New York Times invested in this startup in late 2006. If I had to short one of these startups, Daylife would be the one. I love their user interface design; these guys are definitely in tune with the modern aesthetic. However, the competitive landscape for news aggregation is simply too crowded and the company does not offer anything so different and compelling to suggest that it can take users from Digg, Reddit, or even Google News.

WideOrbit provides software systems that automate and manage the sales, traffic, and billing of advertising. It sells its products to radio stations, television broadcasters, cable networks, and data centers. This sounds like a wonderful product as I am sure that relatively few people are putting their minds to solving the billing management needs of content publishers. Most entrepreneurs are focused on the deservedly hyped Web 2.0 space. This may not seem core to the business of the New York Times, but any model that puts the company in the middle of revenue flows will create value. Non-core businesses such as Federated Media and WideOrbit may create value for the company as they are sold off at rich multiples and for handsome returns. But in this uncertain time, who really understands what is core and what is non-core?

Again, Harbinger Capital is spot on with its call for a dramatic rethinking of the New York Times’ business model. Much capital can be allocated away from traditional business activities to online efforts that can significantly change the structure of the company. New profit centers will arise and the company’s recent investments in Web startups give it a good chance to navigate the future. What the New York Times needs right now is a stable of patient investors.

Update 3/17/08 – The New York Times came to a compromise with activist hedge funds Harbinger Capital and Firebrand Partners by expanding board seats by two outside directors. Scott Galloway of Firebrand and James Kohlberg of Kohlberg & Company are the two outside nominees slated to join the board of directors.