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SocialMedia, a San Francisco company trying to find compelling ways to advertise on social networks, is offering advertisers a new product: Something called “FriendRank.”

The company scans data about your activities on Facebook and other social networks, infers who your best friends are, and ranks them. Then the company exploits that ranking to serve you relevant ads.

It does so with something it calls “social banners,” which insert references to your best friends within advertisements.

The idea is that showing you ads that reference your friends will attract your attention and thus make the ads perform better.

I sat down with SocialMedia cofounder Seth Goldstein last week, who told me that the response rate to standard display advertising on social networks is abysmal. People click on ads about 0.02 percent of the time, he said, because people have started ignoring ads.

Thus the deperate need to interject your friends — to knock you out of your efficient browsing routine.

CNET uses the following example of a movie advertisement to explain how it works. Instead of simply showing you the movie ad, this product invites you to interact with the movie by inviting you to contact your friend about it.

[The] social banner would ask which of your close Facebook friends, among a short list, you’d like to invite to see the movie. Or a social banner might inform you that a friend Jim just ranked Iron Man with three stars, and it might ask to “click here to buy tickets at Fandango.”

See image below, which shows the example of an ad, with friends on the top right.

The word FriendRank is a play on Google’s PageRank, which became the breakthrough technology in the late 1990s to rank Web pages in results when you searched for things on Google.

The word FriendRank is not new. Notably, former Yahoo employee Jeremey Zawodny was talking about “FriendRank” more than four years ago; it’s also notable that Zawodny has gone to Craigslist, an advertising company well-known for its dismissal of Web 2.0 hype. Will Zawodny help Craigslist cook up something in the social advertising arena? Don’t know. But Zawodny, back four years ago, used FriendRank to focuse on the concept of “influence,” as opposed to simply who your “closest” friend is. It’s clear that sometimes you can be influenced by friends who aren’t that close but who you perceive as being more hip or important.

SocialMedia’s execs say FriendRank will look for positive reinforcement. If you tend to click often on an ad featuring a particular friend, that friend’s ranking rises within SocialMedia’s algorithm. Also, someone you don’t interact with at all won’t be part of your FriendRank. While your parents may be influential in your life, if they don’t interact with you much on Facebook, they won’t count for very much in SocialMedia’s algorithm.

SocialMedia finds out information about your friendships by watching who you play games with on Facebook or MySpace, or who you otherwise communicate with using other applications on those networks. SocialMedia is in a good position to get this data because it serves ads on hundreds of applications, which in turn can access certain profile data of the people viewing the pages.

The company said it has filed a patent on the algorithm it uses to aggregate interactions on social networks to determine what friends to display in its ads.

I’m unaware of any competing products. Facebook has used its own news feed to display advertising to users and is said to be working internally on using your friendship network to serve ads, but it hasn’t offered any feature with an explicit friend ranking like this. Myspace, in turn, offers what it calls hypertargeted ads, but it doesn’t go as far as tracking your friendships. Lookery, another ad company on social networks, says it targets demographics but also hasn’t articulated anything about friendship relationships.

Goldstein said the company now gets exposure to 20 million users a month via its placement on applications.

He also provided first signs about how the company is doing financially. He said his company had awarded $8 million to applications developers on Facebook and OpenSocial in the year through May 2008. SocialMedia is quiet on the exact percentage of the revenue it keeps from advertisers before passing it on to developers, but generally ad networks keep at least 20 percent, and sometimes they can keep as much as 50 percent. That gives SocialMedia at least more than a million in revenue a year, so it’s turning into a real business.

The company, which has taken $4 million in financing from CRV and angels such as Marc Andreessen and Jeff Clavier, is now profitable, with 25 employees in two offices, Goldstein said.

Goldstein said advertisers are still largely in an experimental mode placing ads on social networks but predicted advertising would increase strongly next year.

SocialMedia was earlier called Appsaholic, when it became the first advertising platform on Facebook. It allowed developers to promote their applications by letting them place ads on other applications (essentially a way to purchase traffic from other applications). While SocialMedia still lets publishers buy ads promoting “installs” across its network of application clients, the company has expanded into other forms of advertising. They include video, banner ads, branded sponsorships, and virtual currency.

He said the company is emphasizing brand advertising, not direct-response performance based ads.

In testing, the product showed users are two to three times as likely to click on the ads, Goldestein said.

Nick Gonzales, former writer at Techcrunch, is now working at SocialMedia, evangelizing the company’s products at the company’s blog. He said the company is taking security and privacy seriously.

The company provides consumers with a notice and a choice to opt out of sharing their information within the social network. From a privacy page, it also lets users opt out of the ad itself by clicking on a “what’s this” text.