CircleID

There has been an ongoing debate on domain name blogs about the relationship between investment and speculation, but there has been no attempt to clarify and reconcile different views. In this essay, I shed some light on the relationship and analyze the implied value creation of transactions in the secondary markets.

Both investment and speculation involve price risk, but speculation. Domain names are speculative investments because their price risk cannot be hedged (yet), and investors have not attempted to diversify the risk through a portfolio approach. Moreover, the marketplaces' relatively thin transaction volume, a factor exacerbated by issues with the usefulness of current appraisals, creates barriers to quick elimination or change in risk position through selling domain names.

"Speculation" is not an evil word. For example, speculation in the futures market — trading commodity futures contracts, such as for oil and gold — can be value adding, in that it sets prices for the underlying asset (oil, gold, etc.) and makes related markets more price efficient. However, excessive speculation is bad, as it tends to increase price volatility and create bubbles. Speculation can also take place in the primary market, such as by investments in some of the new ICANN-proposed top-level domains (TLDs), or in the secondary market (where exchange of existing domain names takes place). Nevertheless, some types of speculative assets create no value and are indeed useless. A recent paper by Shleifer and Vishny suggests that a number of the financial assets recently concocted by investment banks are certainly innovative but not at all value creating.

Domain name investments can create, destroy, or transfer value. The acquiring party, in addition to operating risk, faces three types of investment risk: overpaying, price, and use. Overpaying is a common problem with standard auctions (technically called "the winner's curse") and in choosing an inferior selling venue (auction or negotiate). However, poorly designed auctions can have the opposite result, namely underpricing (as in the auction for Toys.com). The price risk, which as noted above, cannot be hedged and is rarely diversified away. Thus, I focus on use risk in three types of transactions.

1. Sale to a non-end user who will have the domain name

• Parked. Changing parking service providers to increase revenue does not necessarily result in value creation. The buyer can see higher revenue, but the acquisition will be value destroying if the presale domain name had useful information for visitors. Nevertheless, a domain name may be better suited for leasing than parking (based on its brand-to-traffic ratio). Under such a scenario, parking would be value destroying.
• Developed. Development creates value when it results in a higher expected risk to return than the site used to enjoy. For that to happen, the new design must be user-friendly and the site must provide useful information for visitors. Development that doesn't accomplish both goals will be value destroying. Incorporating user-generated content (UGC) does not necessarily result in value creation, as demonstrated by Coke and the Bud.TV experiment.
• Kept inactive. Buying an inactive domain name and keeping it inactive does not create value, only transfers value from buyer to seller.

2. Corporate acquisitions can be value destroying when

• Cyber- and typo-squatting domains are not analyzed within a cooperative trademark regime.
• A typo or a brand-related domain name doesn't forward the user to a relevant corporate page Motorolla.com provides an example of what not to do, though Motorola has since taken the issue more seriously and has implemented forwarding. (Who knows? Maybe some nudging from this quarter played a part.)
• Generic domain names are misbranded.

3. Catching expired domain names can destroy or create value, depending on the use of the domain name.

Thus, buying and selling domain names are speculative investments that can create, destroy, or transfer value.

By Alex Tajirian, CEO at DomainMart

Related topics: Domain Names