What’s in a name?

As VC eyes the huge profit potential of direct navigation sites, domain owners complain that their internet properties are being undervalued.

If you were interested in doing some internet research for your home garden, how would you go about doing it? Would you go to a search engine such as Google and do a search for “gardening,” or would you try your luck by typing gardening.com in your navigation bar?

A whole industry has formed around the bet that you’ll take the second option. But rather than finding a fully functional site at the above address, you’d find one page with advertising links. That page is hot property.

“To tell you the truth I’ve never understood the behavior,” says Ron Jackson, editor of the industry trade publication Domain Name Journal, “but a certain number of people type in words that describe what they’re looking for and just attach a dot-com at the end of it.”

A certain number of people type in words that describe what they’re looking for and just attach a dot-com at the end of it

Ron Jackson, editor, Domain Name Journal

Setting up these sites with common subject or company names used to be known as “cybersquating,” a tactic in which savvy internet buyers would snatch up domain names and sell them for a huge profit to developers who wanted to make them into actual sites. Now all of the most obvious domain names are taken, and their holders have developed a new strategy, making one main page with advertising links.

The potential for profit is huge. Once owners have acquired a domain name, they can partner with Google or Yahoo, who will set up a page with advertising links free of charge. Companies will then pay Google or yahoo to advertise on the direct navigation site. For instance, an employment agency might pay Google to advertise on the site PartTimeWork.com. Google would split the profit with the domain owner, generally 50/50, and a steady revenue stream is born.

According to the first investment analysis report on the direct navigation market conducted by the Susquehanna Financial Group last year, direct navigation could become a $1 billion search advertising market by 2007 and currently comprises six to nine percent of the US and UK search advertising markets. The report goes on to conclude that with some reports estimating 80 percent profit margins for this business, and no visible leader in the market, the potential for consolidation is huge.

Venture Capital firms have taken notice. Jackson says after publicly traded Marchex, bought a gigantic portfolio of direct navigation domain names in 2004 for $164 million, venture capitalists quickly started showing up at the industry’s trade shows and made offerings to owners of large domain portfolios. Last year Highland Capital bought MyDomain.com for a reported $80 million. Recently, Maveron, the Seattle venture capital firm founded by Starbucks chairman Howard Schultz, invested in Houston startup Internet REIT, which owns 400,000 domain names. Earlier this year a group of investors including Generation Partners sunk $120 million into Los Angeles-based Demand Media, whose lead investor is Richard Rosenblatt, former chairman of the social networking site MySpace.com.

However many argue that this form of navigation is used only by first-time internet users, and as more people become experienced in the medium, the use of direct navigation will fade out. John Hawkins, a managing partner with Generation Partners, says Demand Media plans to counter that risk by offering actual content on its sites, modeling them after sites like MySpace by adding user-generated content. He says this could change the negative perception so many people have of direct navigation sites being internet traps.

John Hawkins, Generation Partners

“There is a common negative perception that, essentially, people type something in and they arrive someplace and its just paid links,” he said. “But what we’re talking about is actually having useful content on the site.”

Maveron’s Internet REIT is pursuing a similar strategy, adding content and social networking features to some of its sites such as africanamericans.com, americanrevolution.com and mutualfunds.com.

However Ron Jackson says most venture capital firms may never get the chance to acquire the sites if they continue making offers that are too low.

“The problem’s definitely been that they aren’t offering enough money to invest in the portfolio owners,” he says. “They want to convince them that they should sell, that prices are as good as they’re going to get. Honestly, the people who own the portfolios just aren’t buying it.”

In fact, Jackson says that the focus of the next industry conference, which will take place in Hollywood, Florida in October, will focus exclusively on why portfolio owners should hold out for higher offerings rather than sell. He says that there are many interested buyers, but few takers are willing to sell for the 3x and 7x revenue that’s being offered.

“Some of them want to see 50 to 100 times, and the venture capital guy wants to pay five times,” he says. “It’s going to be interesting over the next year or two to see where they meet. There’s just a huge gulf there right now.”