Adware anxiety gives Claria cold feet

There's profit in software that spawns pop-ups, but a postponed IPO shows it's a risky business, too.

The decision by adware leader Claria to postpone its initial public offering comes as the fast-growing business of advertising-supported software is increasingly coming under pressure.

For years, millions of people have acquired adware as the price of using free applications such as file-trading software from the likes of Kazaa. The adware, designed to track Web-surfing behavior and deliver targeted ads such as pop-ups, has become profitable enough to draw investors' interest.

News.context

What's new:
Adware specialist Claria--once known more notoriously as Gator--puts the brakes on its stock market debut.

Bottom line:
The decision to hold off on an IPO reflects apprehension among investors about adware as an engine of business. Despite strides to legitimize the software, it maintains an air of the taboo.

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But adware remains a risky investment because of legal battles between Web publishers and advertisers, focusing on the right to control a consumer's desktop experience. Pending federal legislation also aims to outlaw adware's more nefarious cousin, spyware, and could exert more pressure on applications that collect data on Web-surfing habits for advertising purposes.

Technology solutions to rid PCs of such software are also growing popular, threatening the wide distribution that is required to make adware companies profitable.

"There continues to be controversy about how these companies are able to target people--questions remain about the implicit agreement the consumer has made in putting that adware on their machine," said Rich Lefurgy, a partner at Walden VC, a venture capital firm.

In the latest sign of industry turmoil, Claria, formerly known as Gator, postponed its IPO late Wednesday. The Redwood City, Calif.-based company, which filed to go public April 8 , reported profits of about $35.6 million last year on revenue of about $90 million. The company also has 425 advertisers, including Cendant and Orbitz.

Claria spokesman Scott Eagle confirmed the delay. "A number of opportunities have arisen since we filed our S-1, and as a result we are delaying our IPO," Eagle said. Bankers handling the prospective sale include Deutsche Bank Securities and Piper Jaffray.

The holdup could reflect a softening market for Internet stocks: This week alone, MatchNet, PlanetOut and Nanosys postponed their IPOs. But the delay also comes as the adware business is having growing pains, according to many investors. Despite great strides to legitimize the industry, with mainstream advertisers and investors showing support, adware has maintained an air of the taboo.

"There's been a lot of question in the venture world--should a company like (Claria) be public? When your main distribution partner is Kazaa, how do you feel about that?" said Sharon Wienbar, director at BA Venture Partners, the venture arm for Bank of America. Wienbar and her partners have looked closely at investing in the adware business in recent months.

Spiffing up their image
Adware has notoriously frustrated consumers, and its distributors have long been criticized for failing to disclose terms, installing applications onto consumers' PCs without permission, and attempting to control features and change browser settings. In some sense, the early practices of adware makers made a bed that many in the business don't want to lie in now.

As a result, the biggest players have worked hard to clean up their image and separate themselves from the reputation of

"Desktop software that connects to the Net is a powerful tool--it uses a lot less bandwidth. We as an industry can't afford to not make it a reality because of a few bad people."
-- Andy Jedynak, senior vice president, Weatherbug
spyware--which is surveillance software that can be used to log keystrokes of users, steal credit card numbers or manipulate a PC to send spam. Many others have distanced themselves from the term "adware" altogether, opting for the phrase "ad-supported software." But as in the e-mail business, there is a wide swath of companies operating in between spyware and ad-supported software, ranging from spammers to legitimate e-mail marketers.

Still, the industry as a whole gets a bad name.

"Desktop software that connects to the Net is a powerful tool--it uses a lot less bandwidth. We as an industry can't afford to not make it a reality because of a few bad people," said Andy Jedynak, a senior vice president at Weatherbug, which distributes real-time weather information in an application bundled with a search toolbar from Ask Jeeves' MyWay.

"Right now for desktop applications, people are still wondering, what does this do?" Jedynak said. "The Internet application industry is still defining itself."

He compared the ad-supported software business to the early days of the Web and the uproar over cookies, programs used by Web sites to keep tabs on visitors and remember user names and passwords.

Investors are drawn to the financials in the business. Earlier this year, adware maker 180 Solutions raised nearly $40 million from Spectrum Equity Ventures. WhenU.com, one of Claria's closest rivals, has also been exploring financial options , having hired an investment bank in recent months to secure financing or strategic partnerships.

Weatherbug also recently secured $23 million in financing from Sequoia Capital, which is a backer of Google, and others. Illustrating the sensitivity around the word "adware," company investors and executives insist that Weatherbug isn't a purveyor of advertising software. Rather, they say it's an information provider supported by multiple sources of revenue. Still, many investors consider this company to be in the adware market.

There are clearly different niches in the business. First, companies including Claria, WhenU.com, DirectRevenue and 180 Solutions create the technology or downloadable software that monitors users and delivers targeted advertising. They normally rely on advertising networks that can include Overture Services to supply ads to their users. Finally, they tap third-party applications, which are typically free to users, to distribute their software. To date, file-sharing applications have been the most popular means of acquiring adware.

Yahoo provides an example of the cyclical nature, and the scope, of the adware business. The Web portal sells ads to Freeze, a distributor of free screensavers that bundles adware like that of Claria's. If consumers click and download the screensavers, they receive adware, too. Claria's software delivers search results pages in the form of pop-up windows with ads from Yahoo-owned Overture. But consumers may decide the ads are overkill and install Yahoo's toolbar with Anti-Spy adware removal software, which labels Claria as "adware" and helps remove it.

Yahoo's antispyware effort illustrates the difficulty in mixing church and state on the Web. Internet companies such as Yahoo and America Online, along with mainstream advertisers , want to profit from the targeting capabilities and effectiveness of adware, but they also want to appear as if they're promoting a positive consumer experience.

A Yahoo representative did not respond to requests for comment.

Following the money
Adware is an attractive business to investors because it gives marketers the opportunity to reach consumers while they're buying something online. For example, a flower retailer could use Claria to send a $5 coupon to a Web surfer just as they're researching bouquets at a rival's Web site. That opportunity has drawn countless advertisers to attest to its effectiveness.

Claria's economics back up that notion. The company's cash flow is roughly 30 percent of sales, and according to investors, that's the general economy for all adware companies. They might break even at $2 million in a quarter, and generate cash flow at about 25 percent and 30 percent of revenue.

Part of the reason the business is so attractive is that most of the distribution happens on the back of downloadable music applications such as Kazaa, which charges for that privilege, but not at market rates. An adware maker might pay 15 cents to 20 cents per download (per user) and make that money back on the user in a month from advertising. Following that, everything else is profit. But the churn rate, or the rate at which people uninstall adware, is an average of three months, so adware companies are continually pressed to find more distribution.

Paid search has also been a gold mine for adware companies. Because marketers pay fees every time a Web surfer clicks on their search-related ad listing, adware makers have exploited this economy by playing up search results and toolbars. For example, Claria performs an estimated 4 million search queries a day through its Search Scout application, processing roughly 100,000 clicks for Overture ads, which splits the fees. At an estimated 40 cents a click, Claria makes about $40,000 a day on search alone, according to investors.

Some venture capitalists say Claria's delay stems from its overreliance on revenue from advertising-partner Overture, which runs one of the largest pay-per-click search ad networks. Yahoo-owned Overture, which provides Claria with search-related advertisements, contributed as much as 31 percent, or $35.6 million, of the company's revenue in 2003, as opposed to only $3.5 million in the preceding year.

That revenue could come under pressure from Yahoo's Anti-Spy program, which helps consumers detect and remove Claria's applications, along with other adware programs. Yahoo and Claria have both said that their relationship is in good standing.

Adware companies will also be under increasing pressure with the release of Microsoft's Service Pack 2 for Windows XP, which will make it harder to download software and will eliminate backdoor installations through ActiveX controls. Distribution fees will arguably go up over time, too.

Another looming threat is legal. Claria faces numerous lawsuits and some state laws that allege its pop-up ads violate the trademarks and copyrights of third-party site publishers. For example, a European court earlier this year issued a preliminary injunction against Claria that prohibits the company's pop-up and pop-under ads from appearing over the Web site of German rental car Hertz Autovermietung without the agency's permission.

Claria has introduced industry best practices that it adheres to, including clearly disclosing pop-up and pop-under ads that originate from its network. The company also says it discloses the nature of its application up front, gains consent and lets people uninstall its programs.

Google even outlined industry rules of politeness , too, after releasing downloadable toolbar and desktop applications that let people search the Web. The two applications send data on Web-surfing habits to Google servers and may be supported by ads.

Yahoo, Microsoft and AOL are in the ad-supported market, too, offering consumers free instant-messaging applications and search-related toolbars that are supported through advertising.

"Investors love the financials, but they want to know, is this going to be legislated out of existence," said Gary Stein, an analyst at Jupiter Research. "The theory of adware has always been so good, because you're targeting people and it's good for advertisers, but the practice has always been a problem."

 

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