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FEBRUARY 25, 2011

Online Trackers Rake In Funding

By SCOTT THURM

Venture capitalists are plowing money into companies that help target online advertising, despite public concern about privacy and potential government restrictions.

In the past three months alone, online-tracking specialists Lotame Solutions Inc., Media6Degrees Inc., eXelate Media Ltd., [x + 1] Inc. and Turn Inc. each secured new investments from prominent venture-capital firms. In January, Millennial Media and Tapjoy Inc., which deliver ads to smartphones, each said it had raised more than $20 million.

"It's a huge market and it's growing," says Chris Fralic, a managing partner at First Round Capital, which ranks among the venture firms most heavily invested in tracking the movements of Internet users. "We saw a lot of things jelling around those spaces."

First Round, a six-year-old firm that primarily invests in young companies, has backed 33Across Inc., which analyzes users' social networks, and Demdex Inc., which boasts a "behavioral bank" of user profiles.

Since 2007, venture firms as a group have invested $4.7 billion in 356 online-ad firms, according to Dow Jones VentureSource, a research firm owned by News Corp., publisher of The Wall Street Journal. Last year, such investments increased 29% to more than $1.1 billion, though they remained below the record totals of earlier years. Since 2007, First Round alone has made 30 investments, according to VentureSource

The investment climate for online-ad firms is "frothy," says Terence Kawaja, an investment banker at Luma Partners LLC. His diagram of the industry, which crams 250-odd companies into 23 niches, has become a reference guide. A shakeout is inevitable, Mr. Kawaja says. "When the music stops, not everyone can have a seat."

Venture investors' enthusiasm comes amid privacy concerns and government moves to regulate Internet advertising. The Wall Street Journal's "What They Know" investigative report has revealed over the past year that the top 50 U.S. websites collectively installed thousands of "cookies" and other tracking technologies on people's computers--in part to build sophisticated dossiers on people's personal activities and to track them in real time.

In December, the Federal Trade Commission called for creation of a "do-not-track" system and the Obama administration backed an online "privacy bill of rights" focused on commercial data-gatherers.

Venture capitalists say they're undaunted. "It is not affecting our desire to be active investors" in online advertising, says Randall Glein, a managing director of the DFJ Growth Fund, part of the Draper Fisher Jurvetson network. DFJ funds have made 29 investments in ad-related start-ups in the past four years, second only to First Round, VentureSource says.

Investors say they're attracted by the $26 billion-a-year Internet advertising market, and its growth prospects. Americans now spend 28% of their media time online, but the Internet captures only 13% of ad spending, according to former Morgan Stanley analyst Mary Meeker, now a partner at venture firm Kleiner Perkins Caufield & Byers.

Another factor: Online-ad start-ups don't require a lot of money, Mr. Kawaja says. "You can put $5 million in and see if the thing works," he says. "If it's successful, [the company] can get more money."

Many of the start-ups attracting funding aim to connect website operators with advertisers who want to capitalize on the Web's ability to target individual users. Online-ad companies are competing to find better ways to identify Internet users most likely to respond to an ad.

"They're trying to find better slices of data on individuals," says Nick Sturiale, a general partner at Jafco Ventures, which has largely avoided the sector. "Advertisers want to buy individuals. They don't want to buy [Web] pages."

That's sparked an arms race among the start-ups for math specialists who can slice and dice data about users' online behavior to generate more revenue. Some have migrated to advertising from Wall Street.

Ari Buchalter, chief operating officer at digital-ad firm MediaMath Inc., holds a Ph.D. in astrophysics and once ran a hedge fund that based trades on mathematical formulas. The company's CEO, Joe Zawadzki, is a former investment banker. Media6Degrees, which also analyzes users' social connections, employs four Ph.D. holders. Its chief scientist is a renowned data analyst and machine-learning specialist.

At First Round, Mr. Fralic says the firm has been focused on companies that help advertisers decide where to place ads, verify who has seen an ad and target ads. Mr. Fralic says privacy concerns can influence his investments.

For example, he says First Round has declined investments in companies that marry online data with offline databases to develop richer portraits of Internet users.

He and other investors say they rarely get involved in day-to-day decisions about targeting techniques. "I don't remember any situation where we had any kind of serious debate or legal issue come up," says Mr. Glein of the DFJ Growth Fund. He says he's seen few signs of a consumer backlash. "What I look for are the consumers raising their hands" against a perceived invasion of privacy, he says.

Write to Scott Thurm at scott.thurm@wsj.com