John Zdanowski, 39, lives in two worlds. He spends up to 15 hours a week working “in-world” as the handsome avatar Zee Linden, who bears a striking resemblance to Brad Pitt. In the real world, he rungs the finances for one of Silicon Valley’s most innovative companies, Linden Lab, creator of the popular 3-D online world known as Second Life.

Not that Second Life is all fun and games. This virtual world has become a petri dish of loosely regulated markets and has begun to pose some profound questions about the meaning of assets, currencies, and intellectual property. A recent financial meltdown inside the Second Life economy had academics, analysts, and “First Life” regulators peeking in to see what happens when virtual crises turn real. From the comfort of his computer, Zdanowski watches it all unfold.

How do you describe Second Life to someone who has never heard of it?

It’s like a game where you’re interacting in a simulated environment with many other people. The difference between Second Life and conventional video games is that the objective isn’t to slay a dragon and the story line is not created by the maker. Most of the content in Second Life is created by our users, our “residents.” You can skydive, you can dance, you can give a presentation.

Describe the work environment at Linden Lab.

We believe in and operate with 100 percent transparency. We publish all of our financial data internally and we have a pretty decentralized approach to decision making. People choose what they work on and how they get it done. We make sure that all employees have lots of information about what’s going on inside the company so they can make good decisions. We have adopted a number of tools to help us with that, including wikis and blogs and a hosted project-management system called Jira. We also use NetSuite, a hosted accounting application.

What are some of your most innovative tools?

The best example is something called the Love Machine. People generally find that, in companies, feedback about performance is top down and negatively biased. The Love Machine is a way for any person to send love to any other person inside the company, with a few words about why. For example, I might send somebody love for taking on more responsibilities or for doing a really good job with a customer or for cleaning up something in the accounting system. Somebody might send me love for being a good mentor or for helping him or her think through a tough problem. We keep track of all that in the database, and it’s all transparent. It becomes an interesting set of data with which to evaluate performance. In fact, we tie it to compensation a little bit. At the end of a quarter, we’ll pay out about one percent of aggregate salary for every love you receive. That translates into about $3 per love. For each employee, it can be a few hundred dollars of thank you.

How quickly has the company grown?

The company started in 1999. When I got here in September 2006, we had about 80 people; we have about 200 now. We’ve grown from about $1 million a month in billings to nearly $6 million, in a cash-positive and profitable way. We have pretty complex revenue recognition; that’s why I use billings instead of revenue at this point.

What part of the business generates most of the revenue or billings?

Linden Lab operates the virtual world Second Life, which consists of roughly 4,000 or 5,000 servers that host the virtual world application. Server space in Second Life is called “land,” using a three-dimensional analogy for land. Each CPU can host, or simulate, 16 acres of land. We sell each region as an island for $1,675 as an upfront setup fee, and then we charge $195 a month for the monthly maintenance fee, which is a recurring charge. Residents buy that land, which they can parcel out and resell to people who want to own smaller portions of land. They can [also] develop it and use it either internally or to interact with their customers. Land sales and maintenance make up about 60 percent of our billings.

Most of the rest comes from operating the virtual economy. In Second Life, everyone can use the virtual currency, which we call Linden dollars. The local currency can be exchanged in Second Life at a rate of 270 Linden dollars for one U.S. dollar. We implemented the Linden dollar to facilitate a marketplace of digital goods. I’m working with experts on how to recognize the sale of Linden dollars. I don’t quote revenue, because it’s not entirely clear yet how to recognize the sale of Linden dollars.

So you have to manage the finances of both Linden Lab and the Second Life economy?

We’re breaking a lot of ground in terms of trying to manage an open virtual economy. For the most part, it sounds a lot more complex than it actually is. We basically manage the Linden-dollar economy by managing the Linden-dollar supply. We can reduce the Linden-dollar supply by accepting fees in Linden dollars. So if you upload an image, you have to pay Linden Lab 10 Linden dollars. If you form a group, you have to pay 100 Linden dollars. If you get married or divorced in Second Life, you have to pay a Linden-dollar fee. If you buy a classified ad, you pay a Linden-dollar fee over a period of time.

Do you expect Second Life to go public anytime soon?

I don’t think we’ll be going public anytime soon. But I do believe that this is a very interesting company that can, in the long run, be a stand-alone public company. I think being primarily angel-backed, with Mitch Kapor owning a large portion of the company and the founder owning a large portion of the company, we probably won’t rush to be a public company. Being a small public company, from my experience, is very difficult. At this point, we are self-funded and we generate the cash that we need to continue to grow. Unless there are large acquisitions that we want to do, we should be able to get financed pretty easily. We should be able to finance our own growth.

How much of the business actually takes place in Second Life?

We use Second Life as a communication tool. With our geographically diverse team, we regularly have meetings in-world. We find that in-world meetings are much more productive and effective than conference calls. In Second Life, you can see everybody who is on the call; you can instant-message any individual or chat with text to the whole group. It opens up many more channels for communication and information exchange. You can also collaborate on things in-world. Every month, I present our financials in-world, and I’ve projected our financial statements in-world for everyone to view. I think Second Life and other virtual worlds are going to have a pretty profound impact on the way companies interact with their shareholders.

What is your position on calls for more regulation within Second Life?

I think virtual worlds in general will have to evolve and develop in concert with regulators in states and countries. I think you’ve started to see that. As a U.S. company, we clearly had to come out very strongly against gambling specifically. We generally ban any activity that is illegal in your jurisdiction. But we specifically called out gambling, primarily because our credit-card processors were very concerned about us processing payments for gambling activities. I think there probably will be other challenging issues that come up. Some of the lawsuits that happen between residents are also going to set interesting precedents in terms of the DMCA, the Digital Millennium Copyright Act, and how people share and build on top of the creations of others, which happens frequently in Second Life. I think Linden Lab will seek to provide tools that help people protect their intellectual property and try to do that in an open way so that people can continue to develop on top of the technology that we’ve built. That is why we have open-sourced our client, and that’s why in the long run we’ll seek to open-source our server as well. If we can create an open platform that continues to grow, then we will have a very good shot at setting standards for all three-dimensional interactions on the Internet. I think that we will be a very interesting and valuable company if we’re able to do that.

What is the vision for Second Life?

It is to connect us all to an online world that advances the human condition. We believe that people can connect in a very interesting way in Second Life that is not really possible with the two-dimensional Internet. The primary reason for that is that on the regular Internet, there’s typically no presence information; for example, you might be browsing books on Amazon.com and there might be a number of other people that might be browsing those same books, but you wouldn’t know that. But on Second Life, you see the people around you who are interested in the same things that you are.

And I think how people will use virtual-world applications 10 or 15 years from now is very similar to how the Internet has evolved since Netscape first went public and people were just initially building very simple brochure Websites. Now we interact with the Web in a much richer way than we did initially, and I think Second Life will be very similar to that progression.