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For the fourth in our series of VC interviews, we spoke with Richard de Silva at Highland Capital Partners. Richard specializes in digital media; for example, he is on the Board of Digg. So, he seemed like the right person to ask about the theories floating around the blogosphere that we are in an advertising bubble and that online advertising is doomed.

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Here is the executive summary of his view: we are still in the early days of a big shift to online advertising, so the secular trend is good. But online advertising is now big enough to be affected by the economy, and we all know that is lousy. So, don’t mix up cyclical and secular trends. But he also pointed out that the last recession accelerated the shift from CPM to CPC, and Richard believes that this one will accelerate the shift from CPC to CPA (cost-per-action, aka cost-per-sale).

What’s Happening in VC Land?

Before getting Richard’s insights into online advertising, we asked two questions that we have been asking all investors about the health of early-stage investing and the changing models in the VC industry.

Question: How is early-stage financing doing during this downturn compared to the last one in 2001/2002?

Summary: The last time we “fell off a cliff,” investors stopped investing and entrepreneurs pulled back, but it is “different this time.” Like others, Richard pointed out that the last earthquake was in the Valley; this one was in New York. This time, the veterans, both investors and entrepreneurs, are “sticking with it.”

Question: How is the VC model changing, if at all, and how does the global financial crisis impact this change?

Summary: There are “too many VCs chasing too few (good) deals.” Richard forecasts a shakeout, with weaker VCs closing shop as they did in the late 1990s, when too many got in the game. Shakeouts in the VC industry take longer than most because it takes a while for the results to come in.

What’s Happening in Online Advertising?

To hear this part of the interview, skip to around 5:30 of the MP3.

Some recent blog chatter says that online advertising is doomed. The best reasoned case for this is made by Doc Searls (of ClueTrain Manifesto fame), who is touting his radical Vendor Relationship Management (VRM) as an alternative. Searls is an academic (Harvard Berkman Center). Another academic, Eric Clemons, Professor of Operations and Information Management at the Wharton School of the University of Pennsylvania, kicked up a storm with his guest post on TechCrunch titled “Why Advertising Is Failing on the Internet.”

Academics are often right, if you don’t mind waiting an eon or two for their pronouncements to be realized. In business, you need a more pragmatic view. Richard’s view is not earth-shattering or original but seems like a sound basis for building a business:

1. “Advertising has been and always will be the primary way for media to make money.” I agree. To debate this, one has to come up with a viable alternative, first, to pay for content and, second, to connect sellers and buyers. Listening to all of the alternatives reminds one of Winston Churchill’s conclusion about democracy (a lousy system, but better than the alternatives).
2. We are still in the early days of the transition of dollars to online advertising; it’s around 10% today, much less than the time spent online. This is one of those big waves of change you cannot bet against.
3. But online advertising is now big enough to be affected by the economy, and so we will see declines in some sectors over the economic cycle. I agree. It is very easy to mistake a cyclical and secular trend when you are in the middle of one.
4. Cyclical downturns amplify secular trends — in this case, the trend towards performance advertising. In the last recession, Google made CPC popular, increasing the shift from CPM to CPC. In this recession, we will likely see the next wave, the shift from CPC to CPA. (In simple terms, the advertiser takes the click through the funnel and turns it into revenue.)

This is mostly accepted wisdom, which may mean that most people, including Richard, are wrong. In this case, I side with accepted wisdom.

If you want to peer through a murky glass at an emerging and tough problem, this is where it gets interesting.

What Big Unsolved Online Ad Problem Needs Solving?

The trend from CPM to CPC to CPA does not mean that CPM and brand advertising will go away. Online video is re-invigorating brand advertising. Publishers prefer CPM to CPC and CPA. If you have ever tried selling an unknown brand using AdWords or any direct marketing method, you know how critical building a brand is.

The missing piece is connecting the dots between brand advertising and purchases. This is not easy to do without putting an implant in humans. How can you possibly know that the ad I saw for Atomic skis on a sports blog made me buy that pair of skis two weeks later when I saw it on sale? A lot of smart data and analytics are required to get even a partial answer. If you have a good solution to this problem, Richard may want to hear from you.

Talking Up His Book

Here are three companies in Highland Capital’s portfolio that Richard thinks would be interesting for ReadWriteWeb readers:

• Digg. Yep, we know Digg! Richard has a good line about how the value of a Web 2.0 company grows “when you can remove the number of adjectives used to describe it.” A year ago, Digg was described as “the #1 social media news site.” In December, Richard claims, Digg’s audience surpassed CNN.com’s. So now Digg is simply “the #1 online news site.”
• Metacafe. A video-sharing site. Marshall Kirkpatrick covered some news on Metacafe here previously. I was not familiar with it, and when I hear “video-sharing site” I think YouTube, of course. Marshall’s take on Metacafe — that it has a “much lower idiot-to-civil commenter ratio than YouTube” — makes sense as a differentiator.
• Affine Systems. This is a recent early-stage investment that you may not have heard about. We hope to cover it soon; it sounds fascinating. It does real image search in video… not searching tags: searching the actual images. That is easy to want but really hard to do. This is technology that has come out of defense. The story is that the economics of searching video images directly may now be becoming viable.

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