What Causes Internet Companies To Fail?
Do you want to own a company that analysts value in the millions, with a product used by people all over the globe, which becomes a cultural phenomenon overnight? Start a social media site. The past decade has seen a new class of dotcoms that offer people a new way to connect to each other and spread information, and coupled with the massive proliferation of mobile technology, these startups have become a ubiquitous presence in the daily lives of people worldwide.

While the omnipresence of social media may give the uninformed the impression that they are massive "cash cows," the fact is that many of these companies fail to maintain a sustainable following after a few years. Why do some of these social media sites, which once monopolized the social media landscape and attracted the eyes of many hungry investors, crash and burn? Here are a couple examples of sites that are significantly less popular today than they were five years ago, along with some reasons as to why these sites lost momentum.

SEE: 4 Companies Behind The Social Media Curtain

Digg.com
For starters, many dotcoms (which include social media sites and app developers) fail to develop loyal customers. Despite the Internet being a forum for innovation, users can be surprisingly sensitive, and often hostile, to change. For example, some news came out in July concerning Betawork's $500,000 acquisition of digg.com. For the uninitiated, Digg is a community in which web content is shared and recommended through a system of voting, with the highest-rated content rising to the front page and thus receiving the most traffic. At its peak, Digg netted visits ranging somewhere in the ballpark of 236 million hits a year. When Digg was at the peak of its popularity, Google was in talks of acquiring the site for approximately $200 million in 2008, making its then-CEO Kevin Rose an instant celebrity.

Cut to four years later and Digg's traffic is significantly lower, with average visits now at a mere fraction of what they once were. What happened? Critics have argued that Digg lost a significant chunk of its activity due to issues regarding the overall user experience. The biggest issue concerns the fourth redesign to the site, which suffered from numerous bugs and glitches - culminating in a migration of visitors to Reddit.com.

MySpace
Perhaps the most notable example of a dotcom losing popularity by ruining its user experience is MySpace. This website was the darling of the Internet before Facebook and Google took the spotlight. In 2006, MySpace attracted more users in the United States than Google. In 2005, News Corp. purchased MySpace for $580 million, which given its share of the market at the time, was seen as a smart buy for News Corp. In 2011, News Corp. sold MySpace for just $35 million. Again, what happened?

Users stopped visiting. Some of the reasons behind the exodus from MySpace include issues with security and most notably the abhorrent visual pollution that arose when MySpace allowed users more flexibility to individualize their pages. While granting users the freedom to customize designs can be an attractive way to market a product (see: Converse Shoes), in the case of MySpace, increased customization resulted in pages becoming virtually inaccessible, many often crashing upon visitation due to the poor use of code that users were able to embed when tailoring their pages.

Will We Ever See a Blue-Chip Web 2.0 Company?
While this frequently touted web 2.0 period has transformed global culture into one that embraces constant connectivity, the financial longevity of the companies born in the past few years still remain to be seen. Investors who endured the turbulence of the late 90s dotcom bubble are undoubtedly the first (and perhaps the most vocal) critics of this new wave of companies with bold ambitions but thin financials - and justifiably so.


Early dotcom companies operated on venture capital while offering their products for free in hopes of later profiting from brand recognition. Now, many companies have adapted business models wholly dependent on ad revenue (such as Facebook), with some companies offering additional content access - or simply the removal of ads - for a small premium, while offering services to consumers free of charge.

The primary purpose of a business is to provide a good or service in exchange for money, and many web 2.0 companies fail to fulfill half of that equation. The Nasdaq 100, an index comprised of 100 of the largest companies on the exchange, is full of tech companies, many of which operate under this simple financial formula. Even companies such as Blizzard Activision and EA Games, which debatably provide no economic benefit to their consumers, provide a tangible good. Though they may not grace the ranks of the DJIA anytime soon, questions regarding their ability to generate revenue are far from the mouths of critics.

Unlike video game companies, where the product is video games (obviously), the product for social media sites is you. Without charging members use of services, social media companies depend on targeted ads located in the margins of pages to earn profits. Thus, without your information and eyes on the page, the company loses money. If the site fails to maintain a strong user experience, or becomes unfashionable to use (such as Digg and MySpace), the decline in traffic equates proportionally to the decline in ad revenue. A company with revenue streams that sensitive to trends is unlikely to last.

SEE: Is Social Media Slowing Down?

The Bottom Line
A business philosophy of providing free service is obviously a red flag for traditional investors when analyzing future earnings. Despite the popularity and ubiquity of social media in today's culture, in the grand scheme of the markets, nebulous services like allowing users to drench their phone photos in sepia or broadcast the contents of their breakfast in less than 140 characters, are likely passing fads. Without a long-term commitment to keeping users coming back to use your services, as well as a sustainable model where revenues aren't entirely dependent on whether something is trendy, investors should approach these companies with skepticism before sinking money into them.

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