Under an expanded partnership announced in Oct. 2007, Microsoft will invest US$240 million for a 1.6% stake in Facebook, a privately held company that operates a fast-growing social networking site. Microsoft will become the exclusive provider of advertising platform technology to Facebook and will begin to sell advertising on Facebook sites worldwide, extending a previous agreement that covered the United States only. The deal will increase Microsoft's online advertising revenue and blocks Google from entering into a similar partnership.

The Social Networking Craze

Facebook was founded in Feb. 2004 as a way for college students to post personal information and establish online connections with others from their schools. Although it was one of the first social-networking sites, Facebook was initially eclipsed by other sites, particularly MySpace. In Aug. 2006, MySpace had more than 100 million registered users, while Facebook had less than 8 million. MySpace was also first with revenue-generating business deals: its founders sold the company to News Corp. for US$580 million in mid-2005, then News Corp. sold the rights to place advertising on the site to Google for US$900 million in Aug. 2006.

But Facebook made important changes to the service, such as opening membership to all users (not just students, who tended to abandon the site after they graduated) and creating a set of APIs that allowed Web developers to post simple applications for users to discover and share. As a result of these changes, Facebook's user base grew rapidly, and now stands at nearly 50 million, with an average of 200,000 new users registering per day, according to the company.

Despite their fast user growth, neither Facebook nor MySpace has ever reported revenue or earnings, and most analysts suspect they're not yet profitable. Weeks before Microsoft's Oct. 2007 investment, Microsoft CEO Steve Ballmer suggested that social networking sites are "faddish" and discounted the site's technology, saying, "There can't be any more deep technology in Facebook than what dozens of people could write in a couple of years."

Why Microsoft Invested

In Aug. 2006, Microsoft and Facebook signed a one-year advertising syndication deal similar to the Google-MySpace deal. Microsoft agreed to provide the technology for serving banner advertisements to Facebook sites based in the United States and to split the revenue from these advertisements with the company. In early 2007, the companies extended this deal to 2011.

Microsoft's Oct. 2007 investment expands the advertising partnership further: Microsoft will begin to sell advertising on Facebook sites outside the United States and will become the exclusive provider of advertising platform technology to the company.

Microsoft Platforms and Services President Kevin Johnson suggested that the Facebook deal will provide business benefits beyond increased advertising revenue but offered no further details. One possibility: Facebook has the potential to collect a lot of information about its users, including contacts and interests. Microsoft could use this information to help advertisers target commercial messages more effectively on its own sites, increasing revenue per advertisement. It could also use this information to improve the Atlas platform, acquired with aQuantive, which Microsoft sells to advertisers and third-party publishers.

In addition, Facebook could become a customer for strategic Microsoft Web development technologies, such as Silverlight and the Windows Live developer platform, or it could promote these technologies to developers who want their applications to run on Facebook.

The deal had a defensive aspect as well, as it prevents Microsoft's main online competitor, Google, from cutting into Microsoft's exclusive advertising deal for the time being.

From Facebook's perspective, the investment gives the company an infusion of cash to fund operations and expansion, and a market valuation of US$15 billion, which could convince other investors to overlook the company's lack of demonstrated profitability so far.