The Truth About The Bizarre Theory That Facebook Is Poised For Disaster, Just Like Yahoo In 1999

Justin Sullivan/GettyFacebook CEO Mark Zuckerberg, presenting his app monetization plan in San Francisco earlier this year.

Recently, some people have started to worry that Facebook's revenues may have an entrenched weakness that CEO Mark Zuckerberg is not telling investors about: The number of advertisers on Facebook who are venture-backed tech startups that will go bust as soon as the supply of venture capital that backs them starts to shrink, as it did in the dot-com bust of 2000.

In this theory, Facebook is a bit like Yahoo in 1999: Poised for a revenue collapse because it is overly reliant on ad revenue from non-functional tech companies.

We recently spoke to Julien Codorniou, Facebook's platform director for Europe, the Middle East, and Africa, and he told us that the idea Facebook's revenues would be "damaged" by a VC implosion is fanciful. It is based on a misunderstanding of the way that tech startups buy ads on Facebook.

In essence, these ads are funded by the revenue they generate, so startups that make money buying them keep buying them, and those that do not quickly self-select out of the system. The notion that a huge number of startups are burning cash on Facebook ads that do not generate revenue is likely wrong, Codorniou says, and he does not know of any Facebook client that spends that way.

"I cannot think of a European mobile company burning cash on mobile app ads in a non-profitable way. I cannot think of one right now," he told us.

The idea that VC money will shrink is plausible. As Business Insider has noted previously, there is a boom in tech because interest rates are incredibly low, not because tech companies are doing especially amazing things right now. Interest rates will eventually go up again - these things move in cycles - and when that happens VC money will dry up because higher interest rates make it more expensive to invest in risky new businesses.

Thus, the tech boom will eventually go into a downward cycle.

But Facebook's mobile app install ads - the ads at the center of this controversy - have the potential to insulate Facebook, rather than expose it, to such a crisis.

Here is how they work. You want people to download your app, so you buy ads on Facebook that contain a link that makes it easy to download an app onto a phone directly. Maybe those people pay 99p (or 99 cents in the US) to get the app, or maybe you sell ad space on the app to other advertisers, or maybe users can buy things from you via the app. Whatever your model, you obviously want the revenue from the app to be more than the cost of advertising it on Facebook.

Let's say that for every $10 you spend on mobile app install ads, you make $15 in revenues. Immediately, you're likely to invest another $10 or more on Facebook ads, in the hopes of making another $15 in return. And so it goes. (On the other hand, if your $10 investment only netted you $7 in sales, you would stop what you were doing immediately.)

Bluewater Productions"We're a very large player in direct response advertising space."

This is basically old fashioned "direct response" (DR) advertising, in which the ad budget is a direct function of the sales made. DR budgets either go on forever - like those spent by Priceline on Google - or they stop as soon as they've started, and barely register. Facebook COO Sheryl Sandberg has actually tried to communicate this to investors, although it is not at all clear whether investors actually understood her. Wall Street analysts repeatedly underestimate Facebook's revenues in part because they do not fully account for recurring and additional ad business triggered by direct response ad buys. In 2013 Sandberg said:

We're a very large player in direct response advertising space. Businesses are using Facebook to promote things to people, and those people are going to their sites and walking in their store doors and buying things. We're seeing significant increased spend among e-commerce companies.

Twitter's ad revenues are generated the same way (and that is another company that has repeatedly surprised Wall Street by the size of its sales.)

Moreover, Facebook's biggest advertisers tend not to be small tech startups backed by VC funding. They tend to be massive consumer brand names: Procter & Gamble, Samsung, Amazon, Walmart, and Target. And these brands all have their own apps that they would love you to download. Target has a particularly elaborate one called Cartwheel; and if you have ever downloaded Amazon's app you will know how easy it is to "accidentally" spend a bunch of money on it buying books and music.

Now let's be clear: Facebook's revenue can and probably will decline if a recession hits. Facebook is an ad-selling media company like any other, and when the economy hits a downturn, companies tend to retract their ad budgets as they try to save money. That is the reason Facebook will suffer. It will not be because its $8 billion in annual revenue is dependent on the goodwill of venture capitalists like Andreessen Horowitz et al.

If it were the case that some tech companies were burning money fruitlessly on Facebook, then Facebook would see that in terms of client "churn", or the number of companies that try advertising and then stop either because they run our of money or the ads don't work.

Codorniou told us that he just does not see any mobile app advertisers burning money like that. (A second source at Facebook confirmed to Business Insider that the company does not see significant revenue from VC backed tech startups which are not making back the money they spend.)

Here is our conversation with Codorniou:

Do you have a percentage of dysfunctional mobile gaming companies who are simply burning money and not gaining users?

That's the magic recipe. As long as you can make more money from your users than spent from acquiring these users, you're making a profitable investment. Companies who don't respect that might be in trouble one day.

What percentage of platform users buy mobile app install ads and are not there next year?

I don't think it's a big number because most of the guys we work with are profitable. It's an amazing business and they would not spend any money if it wasn't a profitable investment. If Facebook cannot provide them with a profitable investment, then they will go to somebody else. As you said, it's direct performance.

If there was a percentage of your partners who were not profitable, you would see churn in your partner base.

I'd have to look at the numbers, but all of the companies mentioned today [Rovio, King, Supercell, Spotify, Wooga, Playdom, Minecraft] are making money, growing and making profitable marketing investments in general. I cannot think of a European mobile company burning cash on mobile app ads in a non-profitable way. I cannot think of one right now.