MARK ZUCKERBERG: founder and chief executive officer of Facebook Inc. BLOOMBERG

Bloomberg

SAN FRANCISCO—A murmur of recognition ripples through the standing-room-only crowd at San Francisco’s Commonwealth Club of California as Mark Zuckerberg steps on stage.

He looks like your average college kid, in his green Urban Outfitters T-shirt, jeans and Adidas flip-flops. Yet Zuckerberg, 22, is royalty to the Webheads who have assembled on this cool November evening to hear him speak on “Defining the Self in a Virtual World.”

Zuckerberg is founder and chief executive officer of Facebook Inc., a three-year-old social networking web site that’s exploded into an online hub for more than 17 million young people.

Last fall, Yahoo! Inc. offered to buy Facebook for $1 billion—conjuring up a specter that last haunted Silicon Valley during the late 1990s: a technology bubble. Zuckerberg turned the offer down. He’s also received e-mailed marriage proposals on his own Facebook page. He’s turned them down, too.

Zuckerberg and scores of Web-savvy entrepreneurs who’ve grown up chatting, dating and shopping online are defining new rules for the Internet startup economy seven years after the dot-com bust.

This generation is building hundreds of so-called Web 2.0 companies on a shoestring by tapping users to contribute videos, photographs and personal details and share them with ever-widening audiences.

Zuckerberg, who was writing software code in sixth grade, says he created Facebook to give his friends at Harvard University an easy way to communicate. “I threw it together in about a week,” he says, cracking a nervous smile. He ran the site on about $85 a month before dropping out of Harvard after his sophomore year in 2004 and moving to Palo Alto, California. 

Mass-market phenomenon

CREATING online communities that thrive on home-grown content has long been the dream of Internet impresarios. Dale Dougherty and Tim O’Reilly, publishers at O’Reilly Media Inc. in Sebastopol, California, coined the term Web 2.0 to describe these postbubble ventures.

Facebook, along with video-sharing behemoth YouTube Inc. and social networking site MySpace Inc., has turned that goal into a mass-market phenomenon. Smaller sites such as CriticalSole, where sneaker lovers post photos of Air Jordans and compare notes on custom footwear, are piling on.

“Web 2.0 is what everyone was looking for in 1999,” says Ronald Conway, who’s funded so many Internet startups, including Google Inc., he’s known as the “Godfather of Silicon Valley.” “The technology has finally gotten us there.”

MySpace, with 60.9 million visitors a month, is the sixth-most-popular web site in the US, according to Reston, Virginia-based ComScore Networks Inc., which tracks Web traffic. YouTube experienced a more than 18-fold surge in US contributors and viewers to 29.6 million in December 2006 from the previous December. 

A new bubble?

IN November, Google paid $1.65 billion in stock for YouTube even though it wasn’t clear how much demand there would be for ads shown next to users’ home-grown videos.

Venture capitalists are so eager to unearth the next YouTube that they plowed more than $455 million into 79 Internet companies in the first nine months of 2006, more than double the same period in 2005, according to research firm Dow Jones VentureOne Corp.

VCs are banking on Web 2.0 to recover from a half-decade drought. Venture firms notched a collective minus 1-percent return in the five years ended on September 30, according to the National Venture Capital Association (NVCA), an Arlington, Virginia-based trade group. 

‘Damn frothy time’

SOME investors worry that the influx of capital is fomenting a new bubble. “It’s a damn frothy time,” says Peter Rip, a general partner at Crosslink Capital, a San Francisco-based investment firm. “The YouTube deal was a clarion call. Everyone’s salivating for easy money again, and people are suspending disbelief.”

For all of the Web 2.0 hoopla, this boom looks a lot different from the mania of the 1990s. For starters, there’s no hot market for initial public offerings (IPOs) to inflate companies’ valuations or, for that matter, provide individual investors with a way to cash in.

“The gold ring was always the IPO, and that’s not the case anymore,” NVCA president Mark Heesen says.

In 2006, 58 venture-backed offerings raised $5.3 billion—half of the $11 billion raised via 93 offerings in 2004, according to the NVCA. Both sums are trifles compared with the previous decade’s Internet lovefest on Wall Street.

From the IPO of Web browser pioneer Netscape Communications Corp. in August 1995 through December 2000, more than 920 venture-backed offerings raised $315 billion, according to the association. 

Cheaper than ever

“THIS isn’t tied to the public capital markets,” says Jonathan Feiber, a general partner at Mohr Davidow Ventures, a Menlo Park, California-based firm.

Thanks to the distribution of free software code as part of the open source movement, it’s cheaper than ever to create new companies. Three partners formed instant messaging startup Meebo Inc. in 2005 with $6,000 charged on their credit cards.

“Open source has been absolutely critical in driving innovation,” says Roel of Botha, general partner at Sequoia Capital in Menlo Park, who backed YouTube and is now supporting Meebo.

Botha, 33, parlayed an $11.5-million investment in YouTube into a $504- million windfall for Sequoia after the Google deal, according to a February 7 filing with the US Securities and Exchange Commission. 

One Disappointment

YET even Botha says he’s anxious about converting Web 2.0 investments into juicy returns. He says a company today needs at least $100 million in revenue and a $500-million valuation to do an IPO.

“Even if you create a business that’s worth more than $200 million, it’s hard to take it public,” says Botha, former chief financial officer of PayPal Inc., the online payment processor that eBay Inc. acquired in 2002. “That’s one of the disappointments that may loom in Web 2.0.”

Without IPOs, many would-be Web moguls are looking to Google, Yahoo and media companies such as Rupert Murdoch’s News Corp. as potential acquirers. News Corp. paid $580 million for MySpace parent Intermix Media Inc. in 2005.

“Some people are happy to create something that’s valuable, and they do it very quickly,” says Toby Coppel, senior vice president for corporate development at Yahoo, who fields a hundred pitches a month. “They may fit very well into the road map of a company like Yahoo. So we’ll snap them right up.”

That happened with MyBlogLog, which lets blog readers message each other and set up online communities based on what they read.

Coppel tracked down CEO Scott Rafer in the lobby of the Palace Hotel in San Francisco at a Web 2.0 conference in November and hammered out an acquisition. The companies didn’t disclose the terms of the purchase, which was completed in January. 

Dot-com bust

ANOTHER letdown may come from an area where Web 2.0 looks suspiciously similar to Web 1.0: soaring valuations for companies with little to show in revenue or profit.

In December and January, five private Web 2.0 startups, including Meebo, raised enough venture money to value each at an average of $80 million. Between them, the quintet has about $5 million in revenue, Rip says. “There’s going to be a lot of wreckage,” he says.

That has a familiar ring. In the 1990s, startups flush with bull market riches and no profits added .com to their names and burned through millions of dollars before failing. Software maker Interwoven Inc., which survived the dot-com bust, gave away free use of BMW Z3 roadsters to the first 20 engineers it hired in the spring of 2000.

In the space of nine months that year, money-losing online retailer Pets.com Inc. went public, spent more than $1 million on a Super Bowl commercial featuring its sock puppet mascot and filed for bankruptcy. 

More sober

THE Nasdaq Composite Index crested at 5048.62 on March 10, 2000, before plummeting 78 percent to 1114.11 on October 9, 2002, wiping out more than $4 trillion in market value. On February 22, the Nasdaq closed at 2524.94, still 50 percent off that all-time high.

“During the bubble, people were assigned success based on their ability to spend money,” Feiber says.

So far, the advent of Web 2.0 has been more sober than dot-com mania—when anybody with an Internet-related pitch had a shot at VC money, says Benjamin Wayne, founder and CEO of Fliqz Inc., an Emeryville, California-based firm that runs a site where consumers can store digital video files.

“During 1.0, you had to get funded on ideas,” Wayne says. “In 2.0, you need to demonstrate traction.” 

Keeping VCs waiting

WAYNE started his firm with a $700,000 investment in 2005. He didn’t receive any venture funding until December and January, when he accepted undisclosed sums from Mohr Davidow and other firms.

Some entrepreneurs don’t mind keeping VCs waiting. Kevin Efrusy, a general partner at Palo Alto-based Accel Partners, says he spent three months trying to nail down a meeting with Zuckerberg after hearing about Facebook from Chi-hua Chien, a student at the nearby Stanford Graduate School of Business, who’s now an associate at Accel.

“They’d set a date and then blow it off,” Efrusy, 34, says.

Efrusy persisted and, on April 1, 2005, finally got his audience. By the end of that month, Accel—which in the 1990s funded UUNet Technologies Inc., one of the first companies to provide access to the then nascent Internet—had invested $13 million in Facebook.

One thing’s the same: The Web 2.0 companies that succeed will have to overcome challenges that have bedeviled Internet optimists since dot-com entered the lexicon. They must prove that even with minuscule startup costs and users who spend hours online each day, they can convert free web sites into sustainable, profitable enterprises that reward investors. 

The Next Google

“ONE of the things we learned from the bubble is that what’s most important is building a successful, profitable business,” says Nick Grouf, 38, co-founder of Spot Runner Inc., a Los Angeles company that’s using the Web to make cheap TV commercials for small companies.

Web companies say they’re adopting a number of strategies for turning their startups into the next Google or Yahoo.

LinkedIn Corp., a networking site for more than 9 million business professionals, plans to keep expanding and eventually take a bow on Wall Street with an IPO—a milestone for a Web 2.0 company. Facebook is pursuing a time-honored plan: serve up ads to its audience of college-educated users.

At Meebo, the mantra is traffic, traffic and more traffic. The company is betting that revenue and profits, which are now nonexistent, will follow, just the way they did at Google. 

Playground game

ON a balmy day in December, Meebo cofounders Sandy Jen, Seth Sternberg and Elaine Wherry take a break from their computers for a round of four square, a playground game similar to handball. Their office/loft in downtown Mountain View, in the heart of Silicon Valley, has 15-foot-high ceilings and Ikea-furnished desks clustered on the sides of the main floor.

There’s plenty of space for Meebo’s 12 employees to whack the ball around. Wherry, 28, a blond programmer wearing jeans and a long-sleeved T-shirt, grew up on a Missouri goat farm. Using fast serves that send the ball careening, she makes quick work of her colleagues.

The trio is all business when it comes to Meebo. Sternberg, 28, a native of West Hartford, Connecticut, with curly brown hair and a toothy smile, had a self-described “pathological” need to start an Internet company.

“I have a very deep desire to create something that’s useful for a ton of people,” Sternberg says. “And it’s so much fun.” 

First job

STERNBERG says he almost dropped out of Yale University to pursue that goal. Instead, he earned a bachelor of arts in political science and international studies in 2001, much to the relief of his father Robert, a former Yale psychology professor, and mother Betty, Connecticut’s former commissioner of education, who’s now superintendent of the Greenwich school system.

“They don’t completely understand it,” Sternberg says of his vocation. “But they said, ‘If this is what you really want to do and it will make you happy, then you should do it.’”

Jen, a Stanford University-trained computer science engineer with black bobbed hair, chafed at her first job at Xilinx Inc., a maker of programmable computer chips. “They put me in a cubicle, and I said, ‘This isn’t where I want to be,’” says Jen, 26, who grew up in Silver Spring, Maryland, a Washington suburb.

Wherry, who majored in symbolic systems, a program at Stanford that explores the “human-computer relationship,” logged four years at Synaptics Inc., a maker of touch-sensitive pads for computers. She hooked up with Sternberg, an old friend, and Jen, whom she knew from computer science classes. 

‘IM anywhere’

THE three founded Meebo in April 2005 after becoming frustrated that they couldn’t send instant messages (IMs) from any computer. “We wanted to IM anywhere,” says Sternberg, a pilot who unwinds by flying rented propeller planes around California.

They set out to create a web site that would allow IMers to access their buddy lists on a variety of messaging systems: AOL Instant Messenger, Google Talk, Microsoft Corp.’s Windows Live Messenger, Yahoo Messenger and Meebo’s own offering—all without the hassle of a software download.

The first challenge was building a program inside a Web browser such as Microsoft’s Internet Explorer so users could have Meebo running with a couple clicks of the mouse.

Working mainly out of Wherry’s Palo Alto apartment, Wherry and Jen tapped a free database management program called MySQL to store user account information.

Jen adopted another piece of free code that enabled browsers to “talk” to web sites. To create Meebo’s own site, Wherry used a code-writing technique called Ajax, which fuses different programming tools and enables sites to update instantaneously. 

Troubleshooting

MEEBO went live in September 2005. The founders spurred traffic by turning it on to old classmates, colleagues and bloggers. Within weeks, the servers couldn’t handle the heavy message load. Sternberg, who was attending Stanford’s business school, wound up troubleshooting from the classroom.

“We need 10 more servers now!” he thumbed on his Palm Treo to Meebo’s computer supplier one day that September. Sternberg decided he couldn’t pursue his MBA and run Meebo. Without faster servers, Meebo would no longer be “instant” and would die, he says.

“It’s very hard to drop out of school, but if your baby’s dying, you need to get that server,” he says.

To handle the message load, Jen and Wherry switched to faster software called LightTPD and wrote a program that let Meebo pack 500 users onto a server instead of 100. Watchdogging the servers to make sure Meebo didn’t slow down was an all-consuming job.

“Elaine and I run around in our sleep chasing off server demons,” Jen wrote in a blog in December 2005. “Elaine and I pop up a few times a night to check server loads.” 

$3.5-M funding

SEQUOIA Capital’s Botha heard about Meebo through the Valley grapevine. Wherry and Jen were dating senior executives at a company that Sequoia was backing, and they told one of Botha’s colleagues about Meebo. Botha met with the trio and says he was impressed by how they’d based Meebo on the Web rather than on software downloaded on home computers.

“IM has remained locked up in a desktop application and hasn’t been integrated into the fabric of the Web,” he says. “That’s what YouTube did with video, and Meebo has the same opportunity with IM.”

In December 2005, eight months after Meebo started on $6,000 in credit-card charges, Botha led a $3.5-million funding round. In January, San Francisco-based venture capital firm Draper Fisher Jurvetson led a $9-million second round.

Sternberg, in a Spartan conference room next to a warren of empty cubicles, declines to explain how Meebo is going to use ads to generate sales.  “We have some solid ideas on what one or two tests would look like,” he says before clamming up. 

Built on speed

PIYUSH Shah, a consultant and former director of consumer Internet strategy at Microsoft, is a big fan of Meebo. Yet, he says instant messaging is built on speed and doesn’t lend itself to advertising.

“You can have a tiny banner that no one pays attention to,” Shah says. “Bloggers won’t use it if it has advertising. IM has never had a good revenue model.”

Meebo also didn’t obtain explicit permission from AOL, Google, Microsoft and Yahoo to access their IM networks. Sternberg says he talks with the companies to ensure their approval, and so far, the giants have tolerated Meebo. That could change.

“Third parties that unlawfully leverage Yahoo Messenger’s software and network for their own benefit are not authorized by Yahoo,” spokesman Terrell Karlsten said in a written statement.

Sternberg says he’s confident that Meebo is on strong ground. The five million users who log in each month form a base on which the company can expand, he says.

SAN FRANCISCO—A murmur of recognition ripples through the standing-room-only crowd at San Francisco’s Commonwealth Club of California as Mark Zuckerberg steps on stage.