We’ve got a lot more to say about this before we’re done. And we’re hoping that Facebook and MySpace make the right decisions for users and begin to enforce their own rules on subscription and other scams. Even if it means a huge drop in advertising revenue from the apps that rely on scams to make money.

But in this post we’re going to let two other people make their points. In a comment to the post yesterday HotOrNot founder James Hong talks about how his company tried, and quickly removed, scammy offers from their site. He says “In a nutshell, the offers that monetize the best are the ones that scam/trick users.”

And PlentyOfFish founder Markus Frind talks about being pitched by companies like Offerpal and SuperRewards. He also follows up with a post on his own blog.

James Hong:

We ran offers like this back in 2005 for a very short period of time at HOTorNOT, that is until we realized what was going on. In a nutshell, the offers that monetize the best are the ones that scam/trick users. Sure we had netflix ads show up, and clearly those do convert to some degree, but i’m pretty sure most of the money ended up getting our users hooked into auto-recurring SMS subscriptions for horoscopes and stuff. When I hear people defending their directory of deals by saying Netflix is in there, i am reminded of how hotel pay-per-view has non-pornographic movies. Sure it gives them good cover, but we all know where the money is made.

In the end, we decided to turn the offers off. Quite frankly, the offers made us feel dirty, and pretty much on the same level as spammers. For us, the money just wasn’t worth it. On top of that, we relied on our goodwill with users and focused on growing by having a product and company that our users liked. Our sense was that using scammy offers would make good money in the short run, but would destroy our userbase in the end. Perhaps apps on facebook don’t feel this pressure because facebook is so huge, and there are always new people to burn.

I’d like to point out that there are some game companies out there who are holding out on using offers to monetize their users. Personally, that makes me 10 times more likely to pull my credit card out for them.

PS. I don’t think the concept of letting people fulfill offers to get credits is structurally a bad one. I for one would like to see the offer networks work together to create some set of public agreement on what types of practices are banned from their network, and perhaps they can evan have some sort of certification logo. These practices will only stop when companies are not competitively crippled by NOT doing them. In effect, we need a nuclear non-proliferation treaty among the offer networks.

Markus Frind:

I’m surprised it took this many years to be reported by the “media”. These kind of scams have been going on for years and I get several emails a month from these vendors promising to make me millions of dollars a month. I’ve no doubt I could make millions a month off these scams, but they are scams and will eventually bring government regulations. Michael mentions tattoo media look up tatto media sued on google and you will see all the government agencies sueing them.

Michael, is just barely scratching the surface, these scams are extremely far reaching and deep. Some of these scams are charging users over $1 million dollars a day, and many of these middle men/networks are nothing more than smoke screens.

There are a number of comments from anonymous posters saying that there’s no fire here behind the smoke. The thing is, they’re lying.

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The buyers are investors connected with Avid Life Media, and paid somewhere around $20 million for the site. Hong and and Young have been taking money out of the very profitable business all along the way – which we reported was another $20 million or in May 2007. HotOrNot never raised outside funding.

The investors are creating a new company, called HotOrNot Media (new site coming soon), and they may be acquiring more properties as well.

I spoke with Hong a few moments ago, who confirmed the acquisition, which closed on Friday, but not the price. He says he and Jim will not be affiliated with the business on a day to day basis going forward. “We’ve been working on HotOrNot for seven years now,” said Hong, adding “It’s time to break up with this girlfriend.”

HotOrNot makes money from advertising, virtual flowers and a premium fee when users want to connect. They experimented briefly with a free model, but abandoned it last September in the face of overwhelming spam. Their annual revenue is estimated to be around $5 million, with $2 million in profit. According to Comscore, the site has around 5 million monthly unique visitors and 200 million page views.

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If ever there was a Website designed as a social application, it is HotorNot. It’s the original voting app, applied to ranking people’s looks. HotorNot took off because it’s simple, voyeuristic, somewhat addictive, and a great time-waster. And for a meaningful percentage of users, it can actually lead to a date (although that feature, which people pay for on HotorNot.com, is not as fully developed yet on Facebook). So with this in mind, I recently asked Hong why it needs to remain a destination site at all. His response:

I have really stopped thinking of HotoNot as a destination site and worry about how many people are using our service no matter where they are. The concept of a destination is so 1999. I think you are going to see a big shift. People will go where they will go. The world is evolving. Sites like HotorNot are starting to see themselves as services and less as destinations.

The same could be said for practically any destination site. The concept of drawing traffic to a central Web destination is blowing up for all but the largest sites. A site today needs to be able to live everywhere on the Web (and not just on Facebook).

But Facebook remains a special case since it is becoming an uber-destination for many different services on the Web. That is why Hong compares Facebook to a mall. If everyone is going to the Facebook mall, then Hong is better off sticking HotorNot in the mall than trying to get people to come to his standalone site. Even if Facebook starts charging rent, Hong is fine with that as long as the rent is reasonable (like any mall landlord, Facebook should know that its stores have to make money too). The same goes for MySpace, which Hong is eager to develop a HotorNot app for once MySpace opens up its platform.

The mall analogy breaks down a bit, though, because the social network landlord could one day create its own HotorNot app and promote that to its members—which would be like a mall owner opening his own clothing store to compete with the Gap, greeting people at the door with flyers as they enter the mall, and charging his store below-market rent. But that’s a risk any Facebook (and, soon, MySpace) developer has to take. Then, of course, there’s the fact that malls tend to lose their foot traffic as soon as a newer one opens up down the road.

Still, why not just ditch the destination site altogether if HotorNot is more powerful as a social-networking application? (On Facebook, for instance, it’s easier to vote on how attractive all your friends are and their friends, rather than be presented with total strangers). It is not hard to imagine one day soon when more people will access HotorNot through Facebook, MySpace, and other social networks than through the site itself. HotorNot should just become a widget company or sell itself to Slide, right? After all, Slide (which Hong happens to be an investor in) is in a better position to serve ads across widgets and Facebook apps since it owns a network of the most popular ones.

It all sounds good, except for a few things. First, HotorNot makes its money from subscriptions, not ads. When Hong tried to make his dating service ad-supported, the spam level became unacceptable. Second, it not yet clear what kind of landlords Facebook or MySpace will become (see above). Third, the question remains whether or not a social-networking app is more useful inside the context of that social network, or if there is power in bridging together different people from different sites. A single app spread across many sites could benefit from greater network effects than many apps that are each stuck in a separate social-networking silo. Right now, the HotorNot Facebook app is built on a separate system than the main site because that was the fastest way to get the app up and running. But that won’t always be the case. Once you cycle through everyone in your social circle, then what?

These are issues that any startup developing a Facebook app must grapple with. In the end, the most successful social-networking apps will find clever ways to both bring in data from similar apps living elsewhere, while at the same time still hooking into the various social networks so that they seem like they were customized just for you and your friends.

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What is it? Product Evangelist Keith Crowell says its a way for users to decorate their profile pages in much the same way as teenagers decorate their rooms – with posters, music, etc. Users take (or create) images, videos, style sheets or just about anything else and then add it to their profile. Each content item also includes descriptive data and tags. When someone creates something (say an image showing a band or artist name), any other user can add it to their profile as well. All of the “stuff” created in the Piczo Zone will then spread virally as the more popular items gets added by more and more users.

Users like this stuff – they can see what the popular kids (however defined) put on their profiles and then add the same things to their own. For now users can’t add stuff that they see directly from their friends’ profiles, but software engineer Devon Boyle says they’ll add that functionality shortly.

Users Love This Stuff. But So Do Advertisers

But there’s another reason this is important: user profiling for advertising. As users add artists/bands, popular movies and well known brands (nike, whatever) to their profiles they build an extremely detailed demographic and psychographic profile of themselves that can be used for far more targeted advertising. As an example, a music label could focus advertising around a new album release to users who’s added certain similar bands and artists to their profile. It’s highly likely that the advertising will be aimed at people who are likely to buy, and ad rates increase dramatically.

The content can also be used to predict new trends far before traditional methods. Users will create their own images for a popular local indie band, for example. As more and more users add the image, someone with access to aggregate data will be able to see what’s going to become mainstream well before it actually does. Since Piczo’s users, mostly teenagers, are the trendsetters, it’s a particularly powerful tool.

Piczo isn’t the first social network to experiment with something like this. In July we wrote about a similar product called HotLists released by HotOrNot. HotLists are made up only of images, but like Piczo users create them themselves and they spread virally as users add them from the profiles of people they view. Users immediately took to the idea, adding brands, movies, artists and other things that they identified with to build out their profile. And HotNorNot now has much deeper user information to aim advertisement at. Everyone wins.

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According to an email from Hot or Not’s founders, since moving to a free model the site had become inundated by spam:

You also warned us that this would probably lead to more spammers and fake profiles. You were right, this is exactly what happened. The spammers got aggressive to the point where they were screwing up the system, even causing the “someone wants to meet you” emails to not be sent for periods as long as 5 days.”

As before, Hot or Not will now have a free level of membership then a paid tier for sending messages to profiles.

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The site launched in the summer of 2006 and has grown rapidly, particularly since March 2007. Worldwide comscore stats show 1.3 million unique visitors in July, up from 480,000 in March. The company also had nearly 100 million page views in July and is seeing 20% monthly page view growth.

That growth was apparently enough to get the attention of at least one possible suitor, Viacom. A source tells us that the company was very close to selling to Viacom for $10 million earlier this year, but the deal fell through when Viacom realized that owning the site, which contains a lot of copyright infringing content, may have hurt their positioning in the billion dollar ongoing litigation with Google. Crunchyroll refused to comment on the deal.

All video is uploaded by users and has advertising around it. Premium users who “donate” $6 per month to the site get an ad free version and higher quality video. Rumor has it the company is making $75k/month or so in revenue.

Crunchyroll’s business model is unique in that users pay them to view high quality versions of the content, much of which is copyright infringing. That certainly weakens their reliance on the Digital Millennium Copyright safe harbor provision, which protects service providers from liability for content uploaded by users.

The safe harbor provision only applies if the service provider “does not receive a financial benefit directly attributable to the infringing activity.” It is arguable as to whether advertising around copyrighted content is a direct financial benefit, but it is even more difficult to suggest that a direct subscription fee, even if it is classified as a “donation” doesn’t trip the clause. Either way, Crunchyroll is certainly pushing the envelope as to acceptable behavior under the DMCA.

Stretching The Limits Is Often Lucrative

What’s interesting is that some of the worst offenders when it comes to copyright law have ended up doing very well.

ALLOfMP3 continues to stay in business despite being sued for $1.65 trillion by the RIAA. YouTube, the king of infringers, sold to Google for a cool $1.65 billion. Blogmusik managed to land licensing deals and remain in business. Imeem is growing like a weed despite a very chequered past. The list goes on.

Crunchyroll’s pursuit of premium donations is so audacious that it just might work for them. The company says they regularly comply with DMCA take down notices and other requests to have content removed. And they say that in general their relationship with the Anime and other content creators is very good. Some of those content creators have even approached the company and have suggested working together.

In the end, Crunchroll has over a million passionate anime users who come to the site daily to view content. The business model is secondary. Smart content owners will find a way to mine that user base and make more money.

Crunchyroll has not raised any capital to date, but is talking to venture capitalists now.

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For the last several months they’ve been testing a new service called Hotlists, which lets users add a little brand bling to their profile and build out their identity through association. Co-founder James Hong writes about the new product on his blog today. I interviewed Hong last week in anticipation of this post – hear the podcast over on TalkCrunch.

HotOrNot users have been able to add descriptive tags to their profiles for years (well before “tags” were made popular by sites like Technorati and Flickr). But Hong and co-founder Jim Young wanted to let people add a visual “tag” too, and even let social networks pop up around these tags.

So they added quietly added “Hotlists” earlier this year, letting users add a brands, people, things, whatever to their profile along with a visual cue. Already, a significant portion of HotOrNot’s users have added things to their HotList, even though the site has not promoted the feature at all. People just see it on other profiles, then add it to their own, too.

The profile above shows Hong’s Hotlist, which includes brands like Sprint, Nike and Apple, as well as the band Snow Patrol and others. Users can add anything at all to their Hotlist – if it doesn’t exist there is a simple process for creating it, adding an image and descriptive keywords. All users who then add it to their profile are linked in the service, and there is a dedicated page for each item that shows all users who’ve added it and lets people leave comments.

The purpose of Hotlists, says Hong, are to bring people together who have similar interests, something the site has done a very good job at over the years (up to ten marriages per day occur between people who’ve met on the service). But it also happens to be a brilliant business strategy, too.

Hotlists tell HotOrNot exactly what brands, bands, movies, TV shows and other cultural trends their users like. HotOrNot will learn over time to spot new trends (the hot new bands, for example), as they begin to rise in popularity in the Hotlists. And they will be able to market stuff to their users with a previously unheard of degree of precision.

This is a rare example of a new feature that strongly appeals to users (the adoption rate speaks for itself), and is also great for business. The more things people add to their Hotlist, the more information HotOrNot has about them. And over time they’ll be able to make money, I suspect, from that information.

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A lot of this I wrote about last month after interviewing Hong, but there’s lot of additional information that people will find fascinating. The company never raised venture capital, and was throwing off a significiant amount of cash early on. As free dating competitors emerged, however, the popularity of the site declined. They responded by going free as well (killing a $500,000/month revenue stream), and traffic has doubled to around 20 million daily page views.

HotorNot is now looking more like a traditional startup – they’ve converted to a C corporation and are giving stock options to employees. That suggests a sale or venture financing might be coming up in the near future. Of course, the amount of fun that Hong and cofounder Jim Young are having.

My favorite stat about HotorNot: Up to ten marriages per day can be tracked to couples who originally met at the site.

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It wasn’t too long before the service was hosted at RackSpace and the users were flooding in to rate user-uploaded pictures of themselves on a scale of 1-10. In January 2001 they added a dead simple dating site. Instead of reading endless profiles and trying to find a connection, users just say yes or no to a given picture. If it’s a yes, the other person is shown your picture the next time they look through profiles. If they like you as well, a connection is made.

The Money Rolls In

Until last month, HotorNot was free until that last crucial stage when two people wanted to meet each other. At that point, one of the members (usually the man, Hong tells me) must have been a paid subscriber, which costs $6/month. Hong says their conversion rate was extremely high – 15% of active users eventually upgraded to premium accounts.

The premium revenue, plus advertising and fees for virtual flowers, soon topped $600,000 per month. Nearly all of that was profit for the two founders, who reportedly pocketed $20 million or so between them over the years. The company has never raised any outside funding.

Hong says they receive 2-3 emails per day telling them about marriages that resulted from an initial meeting on HotorNot.

In the last year though a few competitors have popped up (see yesnomayb, a copy of the business model) and a number of free dating sites also started to eat away at traffic. Traffic started to drift sideways, and the developers were getting bored at doing little more than site maintenance.

Going To A Free Model

That’s when Hong and Young decided to rip apart their business model and remove the requirement for members to have premium accounts to talk to each other. A month ago, the requirement was turned off, and about $500k/month in revenue disappeared overnight. The founders also turned the company into a proper “C” corporation and issued stock options for the first time to all employees.

(I can’t help thinking that if HotorNot took venture financing somewhere along the way, they would not have been able to get their board of directors to agree to this.)

Hong says this lit a fire under the company, which is now running on reserve cash of a few million dollars. So far things look good. Traffic jumped over 60% – 10 million people visited the site in the last month, up from 6 million the month before. Advertising and virtual gift revenue spiked, and the site is now break even even though they killed their largest revenue stream.

Hong and Young aren’t stopping there. They have plans to expand the site greatly and say they will launch new products in the coming weeks.

Whether this works in the long run is yet to be seen. But the company wanted to try something new, and the founders took enough money off the table to be comfortable for life. Entrepreneurs tend to have a screwed up way of measuring risk – the more the better – and these guys are no exception.

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