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‘Social network’ websites are the next big thing on the internet and the venture capitalists are piling in. Paul Durman explains the attraction.

A 58-year-old former cleaning lady and factory worker known only as Liisa must rank as one of the world’s most surprising technology entrepreneurs.Publicity-shy Liisa, thought to live near Turku in southern Finland, spent her working life in a series of low-paid jobs after her father blocked her plans to go to art school. But when she retired, she turned her attention to her love of fashion, and bought her first computer to start making simple drawings. As she progressed to more sophisticated software, she realised what she was creating bore a strong resemblance to the paper dolls that she had made as a child — little figures that could be dressed with innumerable brightly coloured dresses, blouses, hats and shoes.

In the digital version, the clothes could be picked up from the rail with the click of a mouse. Liisa decided to put some of her drawings on the internet at Geocities, and young girls started to stumble across them and play with them. Before long, Liisa was being bombarded with requests for more models and designs. Simply by word of mouth, her Paper Doll Heaven website took off. Despite her unusual background — “in theory, it was a clear case of ‘don’t ever touch’,” said one investor — Liisa has been able to secure funding from some of the smartest technology investors in the business.

Earlier this year, Index Ventures, which scored a huge success from backing internettelephony sensation Skype, invested in the renamed Stardoll. The investment round was topped up to $4m (£2.1m) by angel investors, including Klaus Hommels, another early Skype investor. Two weeks ago Stardoll received another $6m, mostly from Sequoia Capital, the Californian venture-capital firm that had big hits with Yahoo and Google. Danny Rimer, general partner at Index, said Liisa “had no idea that she had created a phenomenon. There’s no space (on the internet) for girls to hang out and talk about music and fashion. Stardoll is a community for girls who want to play with dolls. It is the largest aggregation of girls aged 7-18. They’re coming three times a week, and they’re spending an hour a visit. That’s pretty unbelievable.

That’s the reason we invested.” To older eyes, there is much about Stardoll that is unbelievable. Its range of more than 300 digital dolls even includes Camilla Parker Bowles, as well as more obvious models such as Madonna, Angelina Jolie and Keira Knightley. New additions include Teri Hatcher, Billie Piper and Ronaldinho. Since its relaunch in April, Stardoll has attracted 1m new members. Mattias Miksche, chief executive, said: “We are growing so incredibly fast by word of mouth and viral marketing. Nobody had done anything online for girls between 10 and 17. We have an enormous opportunity to capture a large global audience. I think the sky’s the limit, to be honest.”

STARDOLL is only one example of the dozens of “social networking” firms sweeping across the internet. Led by MySpace, Facebook (in America) and Bebo (in the UK and Ireland), their astonishing rate of growth both fascinates and terrifies “old media” companies. Along with Google, they form the vanguard of the second wave of dotcom firms dubbed Web 2.0 — businesses delivering services over the internet and predominantly funded by advertising. Tens of millions of teenagers and students are spending hours creating their profile, or web page, on networking sites — listing their favourite bands, movies and heart-throbs, their hopes and ambitions. They can link to their friends’ pages, add music and video, share photographs, write a blog and send e-mails. Fostered by the broadband revolution, this is creating new ways of communicating and interacting that many young people clearly find compelling. It also bites big chunks out of the time they have to watch television or read newspapers.

MySpace is only three years old this month, and yet it already has more than 90m users, generating billions of page impressions every month. That represents a huge audience for online advertising. In May, according to Nielsen/Net Ratings, MySpace was the world’s fourth most-visited website, overtaking MSN and closing fast on Google, Ebay and Yahoo.

Michael Birch, the British founder of rival Bebo, predicts MySpace will become the most popular destination on the internet within a year. Some critics scoffed when News Corporation, the parent company of The Sunday Times, paid $580m for MySpace last year. “I thought it was the deal of the century,” said Birch. “Now people are clearly seeing what’s happening. (Some people have suggested that) MySpace is probably worth $6 billion.”

In Britain, the potential power of MySpace was quickly recognised by the music industry. The site is routinely given a lot of the credit for the success last year of the Arctic Monkeys — although the story has been rubbished by the band as well as by others in the know. Regardless, a profile on MySpace has become de rigueur for any up-and-coming artist. Lily Allen, whose song Smile was the highest entry in the single charts last week, is the latest to be given a leg-up by MySpace.

Bebo is more closely associated with schools and colleges than with music, but its growth has been similarly astonishing. Only a year old, Bebo already has 25m registered users, and is generating 3.1 billion page views a month — half as many as MySpace when it was acquired, Birch noted. Bebo has become the most popular networking site in Ireland and New Zealand, and claims to be running neck and neck with MySpace in the UK. In America, traffic is doubling month on month, though still a long way behind MySpace. Birch, who moved to California four years ago, is a veteran of other dotcom start-ups, including Ringo.com, an early networking site that he sold when its growth threatened to overwhelm his ability to fund it.

Lessons learnt, Birch, 35, and Xochi, his wife and co-founder, have ensured that Bebo will not face a similar cash crunch, by achieving early profitability. But, in addition, Bebo recently took $15m of investment from Benchmark Capital, the firm that made its name and fortune from investing in Ebay. The deal is thought to have valued Bebo at about $100m. Benchmark had previously backed Friendster, an early networking success in America that lost its way and was overtaken by MySpace and Facebook.

FRIENDSTER’s stumble, and the speed with which Bebo has emerged seemingly from nowhere, suggests there are few sure-fire bets in this area. If it takes only a year for Bebo to catch MySpace, at least in the UK, what’s to stop some new sensation displacing them both? There are certainly plenty of pretenders — too many, surely, for them all to succeed. It takes too much effort to establish a detailed profile on multiple sites — one advantage enjoyed by the established players. There’s Faceparty, a personal ads and dating site. There’s Xuqa.com, a college-focused site that seems to specialise in pictures of drunken and snogging students (girls kissing girls seem particularly popular).

Then there are the more specialist offerings. Last.fm, a London-based outfit that recently received funding from Index, has attracted 2m music fans who — thanks to a clever piece of software — are telling the firm what they are listening to. That enables Last.fm to recommend other music they might like, and introduce them to others with similar tastes. It also provides a showcase for new music. The 22-person firm has signed up 10,000 record companies, and has assembled a database of 45m songs from around the world — far in excess of the number on Apple’s iTunes.

Another approach is location-based websites. Plazes, Platial, 43places, Wayfaring and Flagr all look to be seeking to harness the power of their communities to give better information about places you might visit. For example, if you want the name of a good Chinese restaurant in San Francisco, you could look to one of these sites for a personal recommendation. In addition, the internet old-guard, in the form of Yahoo and Microsoft’s MSN, are working hard to add networking functionality to their portals. Ian Lobley, a senior partner at 3i, said: “There’s a huge amount of money going into this area. While we believe in social networks as an important social trend, we’re trying to be cautious about following the investment herd.” Lobley observed that many, if not all, the business models are unproven and in a state of flux. Although advertising revenues are growing rapidly, the numbers are so far modest — certainly compared with some of the valuations that are being touted. For example, MySpace is thought to be on course to produce revenues this year of $200m — a relatively modest sum for a market leader.

Again, Flickr, the photo-sharing site, was a Web 2.0 sensation but it sold out to Yahoo for only about $30m. Lobley said: “If they’ve only had one round of investment, then (venture capitalists) can make money from that. But it’s not a Skype, it’s not a CSR.” CSR, or Cambridge Silicon Radio, is the bluetooth wireless technology specialist that was a spectacular success for 3i. Skype was bought by Ebay for an initial $2.6 billion. Lobley said: “MySpace was a breakthrough deal, but there have not been that many businesses that have broken through to high-valuation expectations.” Rimer at Index said networking is not enough. “Friendster has been an education. If you own a demographic, that’s powerful. It’s not good enough just to provide a hangout. You’ve got to make it contextually interesting.” That’s one reason for his enthusiasm for Last.fm — “the largest community of music lovers in the world”.

Hommels, who used to work for Bertelsmann, the German media giant, has just joined the London office of Benchmark. He thinks old-media firms are facing a daunting challenge. “The industry of social networks is amazing,” he said. “It’s very difficult for traditional media to offer something comparable. “Very practically, my kids have a certain amount of time that they are allowed to spend on media — it used to be the television. Now they sacrifice television time to swap it for computer time.” Spend a little time on the networking sites, and it is easy to conclude that something profound is going on. The ease with which the under-25s are adapting to their new lives online is striking evidence of a digital-generation gap. In Silicon Valley and elsewhere in technology circles, there is the whiff of euphoria once more.

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