Build-it-and-They-Will-Fret, Twitter shows the way out.

On Wednesday Twitter announced something seemingly minor. They made a deal with Microsoft. They also stated that a few more deals are on the way with Google and others. In case you missed it, here is one announcement. Here is another. Here is another.

A reasonable reaction could be “Ho Hum. Good for Twitter. They finally figured out how to make a little money.” Ah, but there is more to this one than meets the eye. They are showing the way out of a trap.

I bet most of the smart VCs recognized what Twitter had done, and this morning started placing calls to the CEOs of their start-ups. That leads me to forecast that we will see more deals like Twitter’s in the future.

This will take a short explanation.

The start up guessing game

Think long term. Ever since the commercial web first appeared there have been start-ups trying to make money from exploiting the functionality enabled by the technology. All things considered, we have seen some impressive commercial hits so far — Ebay, Google, Yahoo!, Amazon, and so on.

Of course, as with all movements involving high tech entrepreneurship, there has been failure too. While the sock puppets of Pets.com, and the empty warehouses of Web Van get most of the publicity, the majority of commercial failure is more subtle. Good people with good ideas get very close to something but never get the brass ring. Indeed, most insiders know this: “close but no cigar” characterizes most of the start ups in the commercial web. It can be maddening.

More to the point, most VCs know this too, especially for the so-called Web2.0 entrants — Facebook, MySpace, Delicious, Shutterfly, Glam, Wikia, and so on. Many commercial ideas do get a bit of traction, enough to provide some hope, but have not made a whole lot of revenue.

So… for many entrepreneurs a victory remains elusive. This is so common I will give it a label, “Build it and they will fret” (or BIATWF for short). Like Kevin Costner in Field of Dreams, they build something with the expectation that somebody will come. Unlike Costner, however, a full team does not show up to play. Here is the common pattern behind BIATWF:

1. A web site with a new idea goes live with a free service.

2. It is not an instant hit, but it appeals to some users, and, slowly the site builds up a loyal following.

3. The site does not cost too much to operate, and the burn-rate is not too high, so the VC lets this go on for a while.

4. The site tries to find a way to monetize all the traffic. A popular approach recently involved selling ads.

5. After a bit of experimenting with revenue-generating activity management reaches the conclusion that the site generates modest revenue at best.

So what is the problem with BIATWF? Think of it this way: Modest revenue is the worse of all possible outcomes. On the one hand, it is not a complete failure, so there is no strong reason to close the site. The web site is popular with a niche set of users, and there is the potential for it to grow into something bigger, just not tomorrow. On the other hand, modest revenue gives the VC no good exit option. An IPO will not generate much value, nor will selling to another firm for a merger. In short, the founders of the firm also become pessimistic about any large payout in the short term.

That is where Twitter’s recent deal comes in. They may have figured out a way to avoid this trap.

Twitters’ solution to BIATWF

As the students in my class know, this fall I used Twitter as an example of a firm in the midst of a difficult choice. It is unclear whether they should go-it-alone as a stand-alone service, building on top of what they have already achieved, or whether they should sell out to someone else, who might value what they could do with the user base Twitter has developed.

That choice looks particularly interesting in Twitter’s case for two reasons. First, they have a large user base, though no obvious source of revenue from advertising. Second, they set their service up in such a clever way to protect their processes. All the traffic goes across Twitter’s servers, and that information remains proprietary.

If they go it alone, then they have to figure out how to build new services for their existing user base. If they sell out to someone else, then they have to find another firm who has a way to make money from access to that proprietary information which Twitter collects.

As this recent deal suggests, I was wrong. Indeed, I am happy to admit that I set my students up for a false dichotomy. There is a third choice. Twitter could license access to their traffic information on an on-going basis. The deal with Microsoft’s Bing search service does just that. The rumors about a deal with Google’s service would do the same. Surely there are others who would like to make such a deal as well.

The search engines want this for a variety of reasons. Those in the business of tracking on-line moods and cultures want this for a variety of reasons too.

Therein lies the general lesson. Any service with a sufficiently valuable walled-garden could do the same.

The keys are: (1) The site must be big enough for others to care about what happens on it; (2) The site must generate enough new information that others want to know; (3) The site must put up a barrier between itself and others, so it can sell access to its proprietary information.

Facebook and MySpace are the next obvious sites to make similar deals. And that is my forecast. Other sites will mildly restructure themselves if they can put themselves in a position to make such deals…

Is this the end to BIATWF? Perhaps it is. More to the point, changing the revenue structure for many start-ups could make a big difference to what we observe in this area of the commercial web. There is more to watch here. I wonder how this will develop.