Facebook's Advertising Problem

Facebook's History: From Dorm To IPO Darling

It may never be clear how much General Motors' public disparagement of Facebook advertising helped cool investor enthusiasm for the social network.

But even if Facebook's IPO woes owe more to problems with stock trading software and skepticism among financial industry insiders than to GM's claim that Facebook advertising doesn't work, the automaker's dissatisfaction with Facebook ads bears further consideration.

Facebook is clearly worth a lot of money. Perhaps not the $100 billion argued with the opening share price of $38, but its present $70 billion market capitalization is not a trivial valuation.

At the same time, other tech companies that straddled advertising and content have flown high and fallen. AOL had a valuation of $222 billion in December 1999. Today, it's worth about $2.6 billion. Yahoo, the darling of the 1990s, is still trying to recapture its glory days after years of uninspired management.

[ Learn more about Facebook's stock offering snafus. Read Facebook's Tech-Snarled IPO: What We Know. ]

Facebook is arguably special because it knows so much about its users and because it has so many of them--845 million monthly active users, according to the company. But other once-popular websites like MySpace and Friendster have risen and fallen. There's no reason to assume that Facebook will be forever.

As Facebook itself says in its prospectus, "A number of other social networking companies that achieved early popularity have since seen their active user bases or levels of engagement decline, in some cases precipitously. There is no guarantee that we will not experience a similar erosion of our active user base or engagement levels."

Facebook's plan to generate revenue from its users depends on increasing the amount of time people spend on the site to increase their exposure to advertising. The problem is that people seem to react to advertising the way bacteria react to antibiotics: Those who don't succumb build up immunity.

The first banner ad ran in 1994 at HotWired.com. It had a click-through rate (CTR) of 78%, and the CTR has declined significantly since then. Banner ads had a 3% CTR in the mid-1990s and that dropped to 0.28% in 2003, according to a 2010 study, "Internet Advertising Formats and Effectiveness."

Author and advertising entrepreneur John Battelle recently expressed hope that the ad industry could come up with something to replace the increasingly anemic display ad. "Boxes and rectangles on the side or top of a website simply do not deliver against brand advertising goals," he wrote on his blog. "Like it or not, boxes and rectangles have, for the most part, become the province of direct response advertising, or brand advertising that pays, on average, as if it's driven by direct response metrics. And unless you're running a high-traffic site about asbestos lawsuits, that just doesn't pay the bills for content sites."

Why is display advertising in decline? A rise in ad blocking may have something to do with it. In 2009, Wladimir Palant, creator of popular ad blocking extension Adblock Plus, indicated that 5% of Firefox users had installed ad blocking software.

Earlier this month, ClarityRay, a startup based in Israel, claimed that overall rate of blocked ad impressions is 9.26% in the United States and Europe and predicted that ad blocking will double over the next 20 months.

It's worth noting that ClarityRay is not a disinterested party in this issue--it offers software-as-a-service to publishers to enable them to offer paid subscriptions to those who'd otherwise block ads.

Whether Facebook is seeing more of its ad impressions being blocked remains unclear. The company didn't respond to a request to discuss ad blocking. But even if it's somehow immune to this apparent increase in ad blocking, Facebook is still likely to be forced to come up with new ways to reach users with advertising messages as current Facebook ad formats become less and less effective over time.

All this might be nothing more than the ongoing need for marketers to find fresh ways to reach people were it not for the social nature of Facebook.

There's only so far you can push marketing before people turn to technology for defense or abandon the platform entirely. And that distance is much smaller where friends are involved. Social advertising has limits that other advertising does not.

Facebook is going to have a hard time turning social interactions into billable advertising opportunities.

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