Are Second Life “Businesses” Worth Anything? Willing to Prove It?

[Comments Closed]

After writing a highly controversial analysis of the Second Life economy, asserting that it resembles a ponzi pyramid scheme in structure, I received any number of testimonials from apparently profitable Second Life business operators.

This started me thinking. Perhaps media hype aside, these virtual ventures really do have quantifiable value, a claim which can be tested. Second Life ventures should be measurable by widely accepted, standard methods, if they are indeed legitimate. This is a critical issue. The media is trumpeting the virtues of Second Life, with the passive and sometimes more active support of the game’s maker, Linden Research (Privately held, “Linden Labs”, “LL”). A brief sampling of news links from the official Second Life website operated by LL in support of Second Life include:

• Second Life: It's not a game Fortune's David Kirkpatrick reports on why IBM's Sam Palmisano and other tech leaders think Second Life could be a gold mine.
• I got my job through Second Life Looking for work? Your best bet may be an interview in virtual reality. Fortune's Katie Benner explores the cutting edge of corporate recruitment.
• Starting a Second Life Business Find out what entrepreneurial opportunities the virtual world of Second Life has to offer.

Self declared virtual world economics expert Edward Castronova stated that “the SL economy is so obviously not a mere scheme that it's hardly worth opposing the notion”. Far be it from me to challenge the logical validity of Mr. Castronova’s argument, but no instance of testable quantitative proof has been provided allowing for an analysis which would serve to disprove my original, falsifiable claims.

In fact, comments from my first article revealed that there is wide disagreement even among the Second Life faithful between how many and to what degree there are actually profit winners within the game’s virtual economy. One long time resident insists that Linden’s official economic statistics support his/her (remember, nearly all Second Life business proprietors are anonymous) claim that over 1,000 business operators are realizing over $1,000USD per month; that’s more than $1,000,000USD being earned just by the small guys. However, another Second Life operator who apparently sits much nearer the top of the economic ladder contests this claim. Instead, using Linden’s same statistics as support, claims more like 6 to 18 large operators are making less than half a million USD per month, with very little trickling down to the vast majority of second life “entrepreneurs”.

The Challenge

Castronova defends Second Life by comparing it to a small village he quaintly calls “Mayberry”, and thus is incapable of carrying the type of commerce I was attempting to aid my clients in perpetrating upon its tender economy. “Mayberry” is very legitimate and not at all a scheme, scam, or pyramid, he asserts.

I take this challenge and would like to attempt to prove it in specific, testable terms which may be easily criticized and debated. Even “Mayberry’s” businesses are measurable, in widely agreed upon financial terms, as going economic concerns. One should be able to value that virtual wedding planner in the game of Second Life in the same manner as they value a real world flower shop in “Mayberry”.

All the hype over the distinctly differential advantages of doing business in a virtual world aside, both business types produce cash flows which can be subjected to discount rates, measured as a factor of risk, and extrapolated by growth rates. If these Second Life ventures are really valuable businesses, one should be able to demonstrate that conclusively. After all, I have to do that all the time in the real world as I distinguish a hobby-project from a venture worthy of investment, acquisition or debt lending.

And, if as the headlines say, people are quitting their boring real-world business provided jobs to instead work for exciting virtual businesses, it is a matter of some concern that we establish that these even are businesses of any tangible value.

Structured Offer

I offer to prepare a business valuation of one typical Second Life business. Specifically, I solicit anyone operating what they believe to be a legitimate business, one of going concern (that is, you intend to run this business for at least 12 months), to provide me with the same data I would use to create a valuation for a real-world business. I will select the most typical respondent, someone running one of the thousands of smaller businesses, and create a standard financial business valuation.

Further, I’ll give you this analysis, free of charge, and allow you to do what you will with it. Use it to sell your business, take out loans, or get acquired in the real or virtual worlds. Or use it to put on a dart board or web site to mock and ridicule. The only right I reserve is to use this analysis, stripped of anything which would directly identify you or your business, to demonstrate the notional real world value of a typical Second Life business venture. Normally, this type of analysis would cost a private venture $300 per hour or more of real-world money to have created.

Technical Details

• I will prepare an analysis for exactly one (1) respondent. These types of analyses can be quite time consuming. They are something a business is normally charged a healthy consulting fee to create. Therefore, I can’t agree to do a bunch of them.
• I will create a discounted cash flow (DCF) analysis, which is a broadly accepted method of      valuing going concern businesses.
• I will utilize an entity approach in this analysis, applying a weighted average cost of capital (WACC) formula.
• Since a target WACC should be easily arrived at for a typical Second Life business, this method should provide a result roughly as accurate as a Total Cash Flow Approach. The DCF WACC analysis is a very common textbook method of valuation, and therefore more readily criticized in explicit terms than alternative methods.
• I will provide your analysis in Microsoft Excel format, and email it to the address you provide me.
• I will allow you reasonable time to correct any errors in the input values.
• I will work with you to ensure that a “sterilized version”, which I intend to publicize through my blog site, does not implicate you or your venture.

Requirements

• Your business venture must be contained within the Second Life virtual economy. I am not offering to provide a valuation of your real-world consulting, design, marketing, public relations or other business which, while providing services related to Second Life, bills and settles payments in real currencies.
• Your business must realize Linden dollar (“L$”, “SLL”) cash flows as US dollars (“USD”) via one of the publicly available exchange mechanisms including LL’s LindeX exchange. I will not cover translation from $USD to a third currency.
• Your business must be subject to US taxes as best understood at the time of the analysis. I cannot agree to provide analysis under any other taxation regime.
• You must read and write English well enough to respond to questions I may need to ask via email.
• You must be willing to provide either reasonably complete standard balance sheets and profit and loss statements, or the equivalent data necessary to create them. I will create simplified financial statements as a function of preparing this analysis.

FAQ

• Why are you doing this? It was my original contention that little real value is being created or realized within the Second Life economy outside of the flow of money from new entrants and existing players to large operators and the owners of the currency exchanges. In response I was assured by any number of Second Life players that they indeed operated profitable going concerns. In many cases they claimed their businesses supported multiple employees, provided better than real-world salaries, and were growing at an amazing rate. These are testable claims, which I can aid in confirming or disproving, thus helping to bring conclusion to the controversy.
• Why would I want to cooperate? If you operate a Second Life venture, and believe it is a going concern business, then it is in your interest to learn what type of value it really holds to external interests. That is the definition of value in a financial context. I will make no qualitative value judgments about your venture. I will simply endeavor to determine the notional financial value of your venture.
• Who cares what my Second Life business’ value is anyway? The media has bandied about all kinds of incredible claims about the values being created and reaped from the Second Life virtual economy. The business and financial press should be very concerned about whether they have overstated (or understated) the actual facts. If you intend to ever monetize or liquidate your Second Life business, then you should know what its true value is.
• How can this benefit Second Life and make people like you go away? Whether this analysis proves Second Life businesses are indeed valuable, or perhaps not so valuable, the associated media hype should dissipate. In the first case, the skeptics and critics will have a point of quantifiable evidence to overcome in their complaints about Second Life. In the latter case the Second Life media hype bubble will deflate, and only those with more reasonable expectations will be attracted to the virtual world.
• But you’ll just cook the numbers to make Second Life look bad. My analysis will be a standard, textbook DCF WACC analysis. There will be no shortage of people capable of taking issue with my techniques, formulae, or results if I deviate from honest expectations. By working with a real Second Life company, and keeping their identity secret, they have the capability to reveal themselves anytime they wish. This thereby deters me from taking their input data and modifying it to suit any preconceived notions about the conclusions. In other words, if I lie about the input data, I’ll probably get busted. If I create a bogus analysis, it will be blatantly obvious to anyone with intermediate financial knowledge.
• What good are DCF, WACC, or whatever other acronym you can think of? These types of analyses are often sufficient for smaller private companies to secure debt financing, secure equity investors, attract buyers in an acquisition, or more accurately plan for future growth. They don’t only apply to huge public companies, but also to mom & pop operations in little “Mayberry”.
• Will you retract your claims about Second Life resembling a “ponzi” or “pyramid” scheme if the results prove typical Second Life businesses are valuable? I [will] consider the results in the context of my original statements. If it is apparent that my analogies were wrongheaded, then I’ll gladly retract and/or revise them.
• How do I contact you if I’m interested? Simply send me an email at [email protected], briefly describe your business, give me an idea how much you think it might be worth in $USD, and include anything else you think I should know about it. I’ll reply if I have any questions. I’ll reply to everyone who submits a request, letting you know if you were selected. Further, if those not-selected wish, I will also list them by whatever identity they want to be referred, when I publish my results of the venture I do analyze. This should serve to deter me from blatant selection bias, or at least allow critics to take issue with my choice in a reasonably open and fair manner.

Clarifications

Some coverage my original article received contained errors; mostly of a minor nature.

• I am not a Financial Analyst, although I do financial analysis. I claim the title of Venture Analyst which is materially different. I am not a Certified Financial Analyst (CFA).
• I am not an Economist, although I do economics analysis often while analyzing new ventures or housing bubbles.
• I might be referred to as “Bubble Economy Expert”, as one publication did, although I am not comfortable claiming the term “Expert”. I do have expertise in analyzing bubble economics, which I have utilized quite extensively in articles I have authored about “The Housing Bubble”.
• I am not a legal expert, a regulatory expert, and certainly not a lawyer.
• I am not a journalist. I do not get paid to write blog articles. I didn’t even figure out how to get my blog ads working until a couple days ago, well after the bulk of traffic had hit. At last check, I’ve earned $1.88(USD), hardly profitable when considering the extra bandwidth costs.
• I have no relationship to Linden Research, any Second Life business venture, anyone currently trading in L$ currency, or any of the investors currently funding Linden Research. I have no      equivalent relationships with competitors to Linden Research or Second Life.

 

Comments

[Mark Wallace]

Randolph -
Could you show us a similar analysis of a Mayberry-sized business in the real world for comparison? Is this the kind of analysis that's useful to those businesses?

[randolfe_]

Mark

I regularly do DCF analyses for companies with very small cash flows and modest gross revenues -- often under a couple hundred thousand per year. In fact, many statups have negative cash flows and sometimes close to zero gross revenues.

A Mayberry sized company would actually imply a much larger cash flow, assuming they have employees. A lumber yard, flower shop, or book store would most likely have a yearly gross revenue of half a million to a couple of million per year.

Most likely, I'll take my template model and eliminate over half of the irrelevant metrics and computations. For example, I don't expect a lot of complicated debt structure; probably zero debt I'd suspect.

DCF are very relevant for "Mayberry" companies, as they are for Second Life companies. I'm sure, however, that someone will come along and insist that for whatever reason DCF's don't work in the virtual economy.

-- Ironically, I grew up in a town roughly the size of Mayberry; a little Midwestern town where many of my relatives still live. I recently helped one secure debt to expand their business by, you guessed it, preparing a DCF financial analysis for them. Their gross revenues were about $200K per year, well within the claims of many a Second Life venture.

I'll post an example spreadsheet of a tiny company a bit later. I have to scrub one of identifying information. The screen shot is from a real one.

[Cyde Weys]

Hey Randolph, I don't think you're using trackbacks correctly. You tried linking one of my blog posts as a trackback, but since you didn't actually include a link to it in your post, it got moderated as spam by my blog and hidden.

[Cyde Weys]

Ohh and by the way, this is an awesome offer you're making. I can't wait to see someone take it up and see the detailed analysis. It'll be fascinating.

[randolfe_]

Thanks Cyde. I'll try again. Typepad is kind of qwirky at pinging trackbacks.

[Birdman]

Randolfe,

I believe that no one will agree to your offer for the following three reasons:

1) Less than half of one percent (being generous here) actually makes any notable amount of money from the game. These people will not be willing to offer their information as an example to yours or anyone’s studies unless sanctioned by Linden Lab itself. Why? Well why would anyone risk being discovered or outed? This would certainly bring unwanted attention to them by Linden Lab or, at the very least, by the “clickish” SL online community. Which means you could only present them as a non-reliable source and/or someone that would remain anonymous. Either way your findings would be in doubt and therefore could be disputed.

2) The whole thing is a scam. No one is really making any sizable amount of real money from SL except Linden Lab itself, a few “insiders”, and the lucky few people who were the first ones in on the casino and sex clubs (and therefore hold a monopoly). None of these people would have any interest in speaking with you as they would gain nothing from it.

3) The last reason would be to implicate oneself. If on the off-chance some people are actually making decent or large sums of money from SL, what are the odds these individuals are correctly claiming it as income to governmental sources (like the IRS). Would you be willing to go to jail to protect your sources if the IRS demanded you turn over all information on the person you report on? I know this is a far flung idea and may never come to fruition but its still remains in the realm of possibility.

Personally, I think you have a great idea. But you may need to approach it from a better or safer angel. Unfortunately I don’t know what that would be.

Birdman

[randolfe_]

Birdman,

I take your points to heart. You may be right in your contentions about the truth of the Second Life economy. Clearly, my suspicions are similar.

If no one takes up the offer then this should be a giant red flag to the fawning press and adoring academics that they've been had. Even if there are real profit winners in the game, but they are all tax cheats scared of being found out, well...then there's still something amiss in Mayberry.

As to the safety of anyone who takes me up on my offer, all they need to do is protect their real identity from me. After all, Second Life is all about anonymous "Chip Midnights". No one but Linden Labs knows who most of these people even are.

So, if I get put under oath and asked to turn over evidence, you bet I will in a heartbeat. I'm not a reporter, and I don't have sources to protect. *BUT*, if all I have is a carefully managed email address pointing to "Chip Midnight", then it certainly can't be anything I could have which might implicate them.

And on a more personal, unsolicited advice note: Anyone hiding behind anonymity in Second Life, perhaps cheating on their taxes or earning illegally sourced income, you're already deep in it. My advice is shut down shop, uninstall the game, give away what's left of your "virtual money", and hope you're a small fish. Do you really think Linden will protect your identity when the IRS or Justice comes knocking? Somehow I don't see Benchmark going for that.

[Petey]

The response (or lack thereof) to this opportunity could be as informational as the results of any such analysis.

Thanks for posting this randolfe.

[randolfe_]

To those who keep emailing me accusing me of trying to hype for ad revenues, here you go.

What a jackpot!

I sure hope this isn't how Second Life businesses measure their economic success.

[Prokofy Neva]

I'd have to go look at the page again, but the 1000 people making $1000 may not count their tier.

Tier takes out a huge chunk of your income.

I'd be happy to have someone analyze my business like this but I think it would be a long, tiresome, time-consuming task. I wouldn't at all insist on being anonymous. In fact, I'm one of the few people that openly reports on these businesss and what they really entail and what they are worth.

When I was first interviewed by Fortune, I prepared two sample monthly budgets. I showed a cautious return budget that involved an auction purchase, development, and rentals, and a more high-risk budget that involved inworld liquidation purchases, resale, development, rentals.

The issue I see with the reality of the virtuality is the volatility of it due to the constant change in the features set. Constant upheavals, patches, changes , costs, etc. make it impossible to plan.

The transactions are hellishly hard to keep records of -- they come in daily excel sheets that you have to remember to individualyl download into separate excel files with new names, or they wipe after 30 days. You do this for awhile and then you give up -- zillions of little $150 and $20 microtransactions fill up scads of pages and it's just pointless.

Another thing you can try to do is look at these monthly balance sheets on the avatar or the group tools -- but these are very primitive too.

Most people, like me, cobble together an amalgam of activities that involve:

o content sales
o casinos
o rentals
o sales of land
o donations to cover tier on things like parks
o events admissions
o PayPal transactions
o tips

It's not really strictly a business as a kind of profit, non-profit, immigrant bank, credit union sort of place.

I'm just indicating this to give you an idea of the rocky road there is to trying to cover and analyze and document transactions.

The Lindens business info is for the birds, too, as they remove land sales from the business calculations. That shows their ideological bias. Why? They say it's because it's an "investment". That's just their wishful thinking. Land purchases are not investments always; they are often profit-making ventures. End-users hang on to land as a capital investment but even they go out and flip land on extra tier as one of the many things you have to do to make ends meet in SL.

And how many people turn tricks, sell some porn, have a sugar daddy, etc. that they don't exactly want to tell you about?

I don't think I could submit an application for this exercise because I would have to declare all of SL business basically run at a break-even or loss basis *because our time is not billable in RL hours*. I could set up a schematic where I pay myself less than mimimum wage, but I earn more than that at my RL jobs, so it's not a fair test.

Not being an analyst, I don't understand some of the terminology and concepts you are talking about in terms of weighting and such. These aren't huge corporations; these are mom 'n pop stores, with a line of clothing or shoes, or a line of rentals. Income comes in, it goes out in the form of tier payments and infrastructure expenditures like having to pay a builder or a security guard or a door script maker. It's all pretty basic stuff. Subjecting such a simple economic field to this sort of more sophisticated analysis may skew it terribly, I can't tell.

[randolfe_]

Prokofy,

Those are fair questions and considerable hurdles. I suspect there would indeed be a significant amount of work involved in creating a consolidated valuation of your business holdings. If it's any consolation, it often isn't much easier for real life upstarts either.

The DCF WACC valuation process can be quite complex when applied to large, public corporations with multiple types of debt and equity. But, the way it works, the most complicated terms can be reduced and eliminated for a simple mom & pop operation, yielding an analysis that really isn't overly complex.

The main complexity is the effect of taxes, and how they come into play with debt. But again, if there's no debt, as I suspected with Second Life businesses, even taxes are simplified to a simple multiplication.

I have applied DCF WACC to small town businesses including a lumberyard, a small family winery, and a comic book store in a tiny farm town in Southwest Ohio that wanted to take a loan to build an adjoining coffee shop.

I guess I proposed this type of analysis because of the claims tossed around the past week, since I wrote my original article, many of which insisted upon gross receipts far in excess of that tiny comic book store, and net profits far in excess of the winery or lumber yard. Incredible claims, which I thought would be nice to test and prove.

If DCF isn't appropriate, and it may not be the best choice of methodology, there are plenty of alternatives which could better fit. For example, there are methods which rely upon the value at risk, measures of volatility, adjusted risk rates, value of real options, or investor and entrepreneur value perspectives.

I guess my frustration is with those like Mr. Castronova who just utter "posh" and dismiss it all, insisting that virtual world 'things' just simply can't be measured yet.

If I can figure out a reasonable value which is convincing to others for three guys in a garage with nothing but a brave idea and an old Dell server, then I can surely put a fair number to someone actually generating revenues and accruing income and expense data.

But your point from the last thread is well taken. It may simply be that a lot of people just don't want Second Life economic components to be measured.

[randolfe_]

Update

At present I have received 1 solid application, 3 tentative inquiries, and Prokofy's public comments about the notion and potential cooperate (above).

Prokofy's ventures are clearly not typical of average Second Life operations. Nonetheless, it could be very useful and informative to perform at least some higher-level summary analysis with Prokofy in addition to a typical company analysis.

Prokofy represents a fair case of the upper limit of economic private value creation with in the current SL economy. Interested academics and theorists might then be able to use this range of data to better determine the limits to private wealth generation within the current financial-economic structure.

At present, I intend to finalize the application stage of this exercise by Feb. 9.

[MrrX]

I thought I'd let you know how much I've enjoyed seeing this unfold - and seeing the matchless grace, poise, and determination you've shown to all critics, both pure trolls and those seeking better information.

I think what you're throwing out there - making quantifiable measurements of what's going on in virtual economies, well, more specifically Second Life - is something sorely lacking and at the same time fascinating and necessary. As an accountant I can easily see the need and use for such information.

Keep it up :)

[ivv]

Randolph,
A somewhat related question: what would be a good way to estimate the amount of USD in circulation in Second Life? If Linden Lab is essentially minting its own currency that it then exchanges for dollars, how much money can be made by investing these real dollars on a real-world market?

[randolfe]

Ivv,

Linden publishes "Economic Statistics" for the most recent month at http://secondlife.com/whatis/economy_stats.php. I think you need to be logged into a valid account to access. You can also get some interesting raw data files in Excel format with a little bit of history available. Some folks have questioned the completeness and/or accuracy of the data, and Linden disclaims accuracy:

While we hope to provide accurate and useful information, please note that we do not guarantee the accuracy of any information; and we expressly disclaim all warranties and limit liabilities as more fully described in the Terms of Service

My opinion is that the data is probably reasonably accurate, although a bit incomplete.

The last month I really looked in detail was 12/06.

Money Supply = USD @275 : 4,824K (1.3bn L$)

Dec. Net Money Created = 734K (15.2% of M)
Dec. Seigniorage = 417K (8.7% of M)
Dec. Monetary Infl = 317K (6.6% of M)

Note LL effectively operates a central bank with a zero-rate policy, and no reserve requirements (most banking functions are SL corporations holding large reserves). The money multiplier is also very close to 1.

This means that 15.2% of the total money supply must be accounted for by increased demand from either internal increased consumption or growth of new consumption (new users), or else exchange rates would have deteriorated.

It also implies that even top-of-the-ladder folks like Prokofy are being heavily "taxed" in their profits by Linden indirectly through their seigniorage and the derivative effect of depressing exchange rates. In other words, without Linden's activities on the L$ market, SL businesses would be realizing higher USD values on their L$->USD transactions.

The question is how much of this is justifiable as "volatility management"? It is here that opinions will differ, and I will write analyses that end up upsetting the Second Life faithful, who largely think that profit potential should be carefully managed.

Here's one question I raised which no one really has addressed: why should someone like Prokofy be forced to effectively lend large sums of money to Linden in the form of zero rate L$ reserves which cannot be (a) deposited for a return or (b) exchanged for USD at a free market rate? It's as if Linden wanted to create a national currency without a real central bank, and create quasi banking regime without a real reserve system, and instead they control the levers of the economy through seigniorage and taxes (sinks).

This will all end very badly unless, when demand abates, Linden makes good and buys back millions of dollars worth of Lindens on their exchange. Anyone wish to make a friendly wager on whether that will happen?

[randolfe]

Discussion Closed

Thank you everyone who participated in this debate.

This topic will no longer be discussed on this forum.