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Betaworks might be the most influential early-stage investment firm no one's ever heard of. If it's take on Web 2.0 is right, that's sure to change. Tech Confidential takes an in-depth look at the innovative New York firm and the business model co-founders John Borthwick (pictured) and Andrew Weissman are experimenting with.

After Internet stocks crashed in 2000, certain words synonymous with that era of irrational exuberance became taboo. One was "dot-com"; another "incubator." Eight years later, while the former has still not regained its currency, the latter is staging something of a comeback. Yet, as in that earlier era, Internet incubators, or "accelerators," mirror the startups they nurture and, more broadly, the Web itself, which is altering technology financing as it changes the technology.

Epitomizing that approach is a low-profile, seed-stage investment firm called Betaworks. Obscure even among Web insiders, the New York firm is experimenting in how to build companies that, like Facebook Inc., MySpace.com and YouTube LLC, exploit the Internet's power to connect people online.

Betaworks functions neither purely as a venture capital firm nor as an incubator. Instead of raising money from limited partners, as VCs do, the firm is structured as an operating company that shareholders own. And Betaworks is itself a tech developer, building "light" Web applications that might benefit its portfolio companies and catalyze further innovation. In short, it's a hybrid whose organizational structure effectively encodes the dynamic shaping the Internet today.

Betaworks co-founder and CEO John Borthwick (pictured) views the Web's changing ecology in biological terms. "We're seeing the organisms spread across the petri dish and add value to one another," he says. "As investors, we're starting to see the incremental value to us, but the proof will be in the pudding."

Since September, Betaworks has quietly invested in 15 of the most notable startups specializing in social networking and other so-called Web 2.0 technologies, often alongside prominent VC firms. Despite the buzz around these startups, which include Covestor LLC, Iminlikewithyou and Tumblr Inc., Betaworks' founders have deliberately stayed out of the spotlight as they tinker with its business model.

One reason for Betaworks' long incubation may be that the approach is notoriously hard to get right. Incubators have a mixed record. " 'Incubator' is a loaded word reminiscent of the previous bubble," says SoftTechVC's Jeff Clavier, an early-stage Internet investor in Silicon Valley who co-invested with Betaworks in Songkick.com Inc., a startup that lets users track concerts. For Clavier, the term connotes "requiring a lot of money and doing a lot of stupid things."

The first business incubator started as a real estate play. When agricultural equipment maker Massey Ferguson of Duluth, Ga., closed its Batavia, N.Y., plant in 1956, it left behind unemployed workers and an 850,000-square-foot complex of multistory buildings, according to the National Business Incubation Association. The Mancuso family, which owned businesses in the area, bought the site and asked family member Joseph Mancuso to find a way to use it profitably. Unable to find a single tenant, Mancuso divided the building into individual spaces. His genius was to provide not only space to businesses, but also advice, office services and help raising capital. Within five years, the Batavia Industrial Center was full. Mancuso, 88, died in April.

Taking up the concept, Xerox Corp. in 1970 opened Palo Alto Research Center, or PARC, which brought together researchers in information sciences and physical sciences to create "the architecture of information." While PARC has focused on developing technologies rather than startups, it claims credit for helping create more than 30 tech companies and famously spawned innovations such as laser printing, distributed computing, Ethernet and the now-ubiquitous graphical user interface.

Incubators sprouted in the U.S. in the 1980s and spread to the U.K. and Europe. Today the NBIA estimates there are roughly 5,000 incubators worldwide. During the last decade, however, the model fell into disfavor -- at least publicly -- as formerly high-flying Internet companies backed by dot-com incubators such as CMGI Inc. of Andover, Mass., and Idealab Inc. of Pasadena, Calif., crashed to earth.

"An incubator is a very, very hard thing to make work," says Bill Gross, who founded Idealab in 1996 and who has since expanded his investment focus beyond the Internet into clean technology and other sectors. "A lot of our companies did not succeed, but we learned from ones that did."

Despite the challenges, a new generation of incubators has emerged to focus on seed-stage Web startups. Many have a fairly set method of operating. For instance, Y Combinator of Mountain View, Calif., and Cambridge, Mass., expects founders to move to its offices for three months, during which the entrepreneurs get assistance with everything from naming the company to filling out incorporation papers. The firm hosts weekly dinners with entrepreneurs, VCs, lawyers, bankers and executives from large tech companies. Ten weeks in, Y Combinator hosts a day when startups make presentations to potential investors.

Betaworks' style is looser. Mentoring is informal, with the most structured element a monthly brown-bag lunch with no agenda. Thoughts are exchanged, products dissected and reassembled.

This improvisation reflects Borthwick's own style. In conversation he can come off as deceptively light, even whimsical, which obscures the depth of his observations about the Internet and how it's changing business.

Borthwick has had ample experience launching startups and working in business development acquiring them. He sold WP Studio, a Web site developer he formed during the Internet boom, in 1997 to Digital City Inc., a joint venture of America Online Inc. and Tribune Co. After a stint at AOL, he served as senior vice president of alliances and technology strategy at Time Warner Inc. He left the New York media giant and became CEO of photo-blogging site Fotolog Inc., in which he had invested; Fotolog was acquired last year by Hi-Media Group, a French Web publishing and services company, for $90 million. He also invested in blogware company Blogger, whose parent Google Inc. bought in 2003 for undisclosed terms.

Betaworks co-founder and managing director Andrew Weissman worked in business development at AOL while Borthwick was there. The two met in the mid-'80s at Wesleyan University and started Betaworks in 2006, taking more than a year to refine their investment thesis and strategy. What they came up with -- creating a platform for developing seed-stage businesses that marry social networking with content produced by Web users -- showed auspicious timing. By 2007, Web 2.0 companies such as Facebook and YouTube that combine social networking and user-generated content were full-fledged Internet phenomena, with valuations to match, and the shift toward online advertising was accelerating.

For his part, Borthwick rejects the label of incubator in characterizing Betaworks. "The whole incubator concept was about sharing services that are mostly peripheral," he says. "Your lawyer or your accountant should be gotten from the market. Any entrepreneur who exchanges a desk for equity is probably not a good entrepreneur to bet on."

Rather than sharing business services, the companies Betaworks invests in and the products it develops share common features. Its portfolio consists of three "buckets." The first contains companies that build communications platforms for distributing user-generated Web content. New York's Tumblr, for example, lets people publish short, mixed-media blogs.

The second consists of startups such as Outside.in that extract and add value to information in user-generated content, such as blogs. The New York company -- a provider of "hyperlocal" Web services that has raised $2.4 million from Union Square Ventures, Milestone Ventures Partners, Village Ventures and individual investors such as Esther Dyson -- structures blog content around zip codes, enabling users to, say, get bloggers' recommendations for a neighborhood coffee house.

The third bucket consists of social media companies, such as online ad firms focused on behavioral targeting. One of these, Lotame Solutions Inc. of Elkridge, Md., analyzes how Internet users interact with, among other things, online video sites, noting whether the person posts, comments on or simply watches videos, key data for advertisers. In February Lotame closed a $10 million Series A round, led by Battery Ventures, bringing total funding to $13 million.

"My belief is that companies who are in our network, both companies we've invested in and technologies we're building, have a common DNA set," Borthwick says. "By having a common entity at the center who can help define and continue to grow that base of DNA, they'll profit, and we'll profit, and everybody will grow a little bit faster, better and cheaper."

Betaworks helps introduce its founders to entrepreneurs and investors with a shared Internet vision. Not only can that mean access to institutional funding, but strategic counsel from those who have faced similar challenges. David Karp, the 21-year-old whiz kid who founded Tumblr, credits Borthwick with guiding him through the initial fundraising and providing critical advice about how to turn the microblogging service from a flashy Web service into a commercially viable company. 

"John has the most accurate perspective on product of any early-stage investor I've ever met," says Karp, whose company has raised $775,000 in seed money from Betaworks, Spark Capital of Boston, Union Square Ventures, and angel investors.

Karp is also benefiting from Betaworks' business model. These days, Tumblr occupies Karp's attention full-time, which means he hasn't been able to focus on Senduit, a Web utility that helps users share large files over the Internet that he developed before Tumblr. Rather than let Senduit languish, he's handing over development to Betaworks, while retaining partial ownership.

Another Betaworks investment is Someecards Inc., for which the firm led a $350,000 Series A funding in April. Launched about a year ago by two former creative directors for online ad agencies, Brook Lundy and Duncan Mitchell, the provider of irreverent e-cards has become an underground hit, drawing 1.5 million unique visitors to its Web site a month. The unconventional, often edgy startup has become especially popular with Facebook users, who send cards to fellow network members just as people use e-mail to stay in touch by trading jokes or news articles. "Their content is being used as a jumping-off point for conversations, with a lot of activity on Facebook," Weissman says. "The two-way communication form is more interesting to me than the content, and the traffic is insane."

Chris Sacca, the former Google wireless chief turned full-time investor, also invests in Someecards. "Watching folks interact with the site, it's clear that these cards are really a way of outsourcing communication when we want to be wittier than we naturally are or when a subject might otherwise be hard to address," he says.

Despite the promise, Betaworks has an uphill climb. Skeptics question its ability to flourish both as an early-stage investor and as a tech developer. Betaworks' practice of joining deeper-pocketed VCs, including Spark, SoftTechVC, Union Square and Y Combinator, in backing startups can produce lower early-round valuations, alienating entrepreneurs. It also can hurt its returns through dilution as larger investors pile in.

Meanwhile, developing cheap Web tools to plug into Facebook is one thing, but building a real business takes time, money and, of course, customers, no mean feat given the explosion of Web 2.0 companies. Among tools Betaworks is developing is a SwitchAbit, which lets users send digital content from one Web service to another, enabling them to, say, transmit online photos stored in Flickr to Twitter, a microblogging service. Also under development is fichey.com, which lets people flip through the Web like a magazine, and firef.ly, which allows users to chat with others visiting the same Web site.

"Data is moving and wants to move much more loosely across the Web than the vertical silos of Web sites have permitted," Borthwick says. "As data moves, it becomes more valuable because people add to it and algorithms add to it."

Another question: Does Betaworks have enough capital to survive the failure of some of its companies or even the collapse of what many see as a Web 2.0 bubble? Borthwick declines to say how much capital the firm has nor how much it's invested. But he's confident that Betaworks' capital base is scalable. "These people are not Sunday investors," he says, alluding to his shareholders. "They're professionals who understand what we're doing and the business we're trying to build here."

Betaworks' shareholders are some of the most astute, and well-heeled, Internet investors around, including Ron Conway, an early investor in Google and among the world's most prominent angel investors; Kenneth Lerer, co-founder of media blogging company HuffingtonPost.com Inc.; Tim Armstrong; Google's president of advertising; Scott Heiferman, co-founder of Fotolog and social network MeetUp Inc.; and former Yahoo! Inc. lead designer David Shen. Another shareholder is BV Capital, the San Francisco venture firm that backed Fotolog and social "bookmarking" startup Del.icio.us, which Yahoo! acquired in 2005 for $30 million.

Not all the ramifications of Betaworks' approach are understood yet, the founders admit, or its success assured. Meanwhile, Borthwick savors the experiment itself. "In six months' time, I think some of the pieces will be a little clearer. It's still early days." - Mary Kathleen Flynn

Mass Appeal
Betaworks invests in Internet startups specializing in user-generated content and in social media technologies
Company	What it is	Who it's for	How it pays
Carmun	Social network that helps students organize academic research, connect with peers and form study groups	College students	Advertising
Covestor LLC	Social network for public market investors to track and benchmark stock performance, exchange information with other members and earn financial rewards	Serious investors	Advertising
Dizzywood (Rocket Paper Scissor LLC)	Virtual world for children that offers games and visits to online environments	Kids	Subscriptions, item sales
Goodrec	Recommendation platform for restaurants, movies, bars, pubs, etc.	Twitter crowd	Local advertising
Ideeli Inc.	Members-only shopping network for women that offers discounts on designer fashions and luxury accessories	Trendy women	Advertising and paid memberships
Iminlikewithyou	Casual online gaming and social network that lets users create games and invite people to play	Young adults, casual gamers	Advertising, item sales
Lookery Inc.	Provides demographic marketing services to social networks	Social networking companies	Revenue-share
Lotame Solutions	Provider that helps publishers and advertisers devise ways to monetize social media and enhance advertising	Publishers, advertisers	Service fees
Outside.In	Social network that lets users compile, publish and access information about local communities and communicate with other members	Web users	Advertising, revenue share with publishing partners (eg: Washington Post)
Someecards	Online provider of caustic electronic greeting cards	Younger adults, urbanites	Advertising, e-commerce merchandise sales and content syndication
Songkick.com Inc.	Service that lets music fans automatically keep track of upcoming concerts and track a band's tours as tickets and other information appear online	Music fans	Advertising, ticket sales, and e-commerce
Summize Inc.	Site that aggregates user-generated reviews from around the Web on books, movies, electronics, music and other products	Web users	Advertising, licensing
SwitchAbit	A "switchboard" that lets you plug content from one service to another	Twitter, Flickr, etc., fans	Service fees and data analysis
Tumblr Inc.	Short-form blog that enables users to publish brief, mixed-media posts	Bloggers	Advertising, pro tools
Tsumobi Inc.	Makes programming tools that let software developers build mobile Internet applications	Software developers	Service fees
Source: Betaworks, portfolio companies, The Deal

For more on John Borthwick, see his blog
For more on Andrew Weissman, see his blog and his tumblelog 
For more on Idealab, see Apr. 22 post from Tech Confidential
For more on Covestor, see Apr. 7 post from Tech Confidential
For more on Tumblr, see Jan. 18 post from Tech Confidential and Nov., 2007, post from Tech Confidential
For more on Outside.in and other hyper local sites, see April 11 post from The Local Onliner,
Oct., 2007, post from VentureBeat, and Oct., 2007, post from Silicon Alley Insider
For more on Lotame Solutions, see Feb. 11 posts from Lotame CEO and founder Andrew Monfried, Tech Confidential and Silicon Alley Insider
For more on Someecards, see Apr. 10 post from Tech Confidential
For more on Chris Sacca, see Jan. 29 post from Tech Confidential

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