Virtual goods, which exist as digital bits on computers and cellphones, have grown more popular in the past year as important accoutrements for increasingly Web-oriented lives.
Often available for a $1 or less, virtual goods range from video game accessories like extra weapons for shooting games, to electronic birthday cards and flowers for friends on Facebook or dating sites like Zoosk and flirtomatic.com.
Virtual goods have been popular for several years in other parts of the world, particularly Asia, but are only now starting to catch on in the United States.
For many Web start-ups, digital merchandise is an important source of revenue to replace scarce advertising dollars. And a series of big-ticket deals suggests that virtual goods are emerging as more than just a quirky fad.
In November, video game publisher Electronic Arts Inc paid $275 million for Playfish, which makes games for social networks such as Facebook, which sell virtual goods.
A month later, a group of investors poured $180 million into Zynga, another social networking game company. Virtual goods account for 90 percent of Zynga's revenue, which a person familiar with the company said has annualized revenue of $300 million.
The bigger companies are putting their weight behind this model, said ThinkEquity analyst Atul Bagga. He believes the U.S. market for virtual goods could double in 2010 from an estimated $1 billion in revenue in 2009.
The rush to offer virtual goods comes as advertising sales, the traditional underpinning of free websites, erodes. U.S. Internet ad revenue fell 5.3 percent to $10.9 billion in the first six months of 2009 compared to the same period a year earlier, according to the Internet Advertising Bureau.
For many Web entrepreneurs, virtual goods are a better fit than advertising.
People don't want to click on an ad while playing a game. They don't want to be thrown out of the application (to view the ad), said Netanel Jacobsson, a former Facebook executive who now advises the online social gaming firm Crowdstar.
Crowdstar recently abandoned in-game ads in favor of virtual goods, he said, resulting in a significant financial improvement, though he would not provide details.
Ninety percent of new online game start-ups sell virtual goods, estimates Jeremy Liew, managing director at Lightspeed Venture Partners.
If people were not employing that model, then I'd have a lot of questions as to why they didn't have that, said Liew, who has invested in several social gaming companies including Serious Business and Casual Collective.
For all the optimism about virtual goods, it remains to be seen if the business will take root outside the online games and social networks. Virtual goods are unlikely to replace advertising as the main money-maker at companies like Google Inc and Yahoo Inc, which generate billions of dollars every year from selling ads on the Web.
The industry also took a hit this year when technology blog TechCrunch reported questionable business practices by third-party firms offering virtual currency. Since then, sites like Zynga, News Corp's MySpace and others have eliminated such offers.
For social networks like Ning, which introduced virtual goods in October, digital wares will remain one of several revenue-generating businesses, including ads and premium services, said Chief Operations Officer Jason Rosenthal.
The boundaries between virtual goods and ads will blur as virtual goods evolve, he said. Ning, which hosts more than 1.8 million customized social networks, will introduce new types of virtual goods in 2010 that could double as promotional coupons, allowing the recipient of a virtual handbag, for example, to get a discount or a bonus item in the real world.
Ning also wants to integrate entertainment like music and video into its virtual goods market, he said.
It's nothing that we've announced, but you'll be hearing from us on that early in the new year, said Rosenthal.
(Reporting by Alexei Oreskovic. Additional reporting by David Lawsky. Editing by Robert MacMillan)