Philip Rosedale has long been obsessed with virtual environments. In 2003, he created Linden Lab, the company behind Second Life, an online virtual world that still attracts an estimated 800,000 active users. Now Rosedale is experimenting with a virtual company, a software start-up that has no formal office and is staffed by an ever-changing crew of freelancers from around the world who work as much or as little as they please.

It all started with Rosedale's interest in using technology to make organizational communication more efficient at Linden Lab. "As soon as you walked in the door, you saw how Philip was experimenting with a different management style, one that was disruptive and challenging," says Ginsu Yoon, a former executive at Linden Lab who now works at Google. "It was his belief that to build an innovative product, you needed an innovative management style."

One of those experiments was LoveMachine, a program that let Linden employees send one another Twitter-like messages to say thank you or acknowledge a job well done. The cool part, Rosedale says, was that the system was transparent. Each time a message was sent, everyone in the company would receive a copy of it, which boosted morale and gave employees a better sense of what everyone in the company was working on.

After Rosedale stepped down as CEO of Linden Lab in 2008, he started a company called LoveMachine to commercialize the program. The basic software is free to use—the company makes money when businesses use the program to pay bonuses based on how many kudos employees receive from their peers. Rosedale says he has several paying customers, including a charter school with about 60 users that pays LoveMachine 10 percent of the bonus pool.

Unlike Second Life, LoveMachine has no full-time software development team. Anyone interested in working at LoveMachine can simply go to the company's website, peruse a list of tasks that need doing—say, fixing a software bug or designing a new login page—and bid on the assignment. "We had a vision of how we could make the start-up experience more fun," says Rosedale. "The idea was that we would be able to find people willing to do tasks cheaper, faster, and even better than if we had simply hired a full-time developer to do them, and we've had unbelievable results."

Rosedale and LoveMachine's other co-founders, Ryan Downe and Fred Heiberger, post available assignments on the company's online bulletin board. After setting up a profile, a freelancer can bid on a task by entering a short description of how he would tackle the job and his asking fee, which is typically a few hundred dollars. Once the job is awarded, the contractor collaborates with the rest of the team virtually, through a custom-built chat room on the company's website as well as through e-mail and Skype. After the work is done, the person who posted the assignment marks it as completed, which triggers an automatic payment to be sent to the contractor via PayPal.

One of the first projects created this way was the chat tool Rosedale and the contractors use to communicate with one another. Normally, building such an application, which involved integrating components such as built-in text messaging and real-time information sharing, would have taken months of time and several thousand dollars to complete. Rosedale says it took just two weeks and about $5,000.

The process works so well that Rosedale has begun taking bids on tasks not related to software development, such as processing payroll, recruiting new contractors, and putting together a profit and loss statement for investors. "We've also done things like having someone find us a solar cell charger, so we could use our laptops outside," he says. Rosedale has even given some regular contributors their own budgets, with which they can pay other contractors and themselves.

Transparency is the key to working effectively as a virtual team, says Rosedale. For instance, LoveMachine's internal system generates a public chat thread any time a contractor submits a payment request. "This creates tremendous social pressure to do good work and charge an appropriate amount," says Rosedale. "If you are overcharging, we won't use you anymore. It's a remarkable price-setting method."

Plus, anyone can sign up, log in, and access every conversation, line of code, and bid ever accepted at the company. You can even see how much LoveMachine has paid to each of the contractors, including the founders. According to the data posted on the company website, Rosedale earned $27,234.59 last year, mostly for managing the coding work of others.

All told, Rosedale has paid about $300,000 to 100 contributors, from countries such as India, Russia, and Australia. "What's amazing about the system is that we tapped into a real diversity of skills from people all around the world that most typical start-ups can't afford," he says.

One of the regular contributors to LoveMachine is TJ de Luna, an American who lives in Belgium. De Luna met Rosedale in the early days of Second Life, when de Luna worked for a Silicon Valley venture capital firm. After reading about Rosedale's new company, de Luna decided to bid on some jobs. He has been contributing to LoveMachine since February 2010 and earned more than $30,000 last year. Rosedale has given de Luna a budget of $35,000 to hire other contractors to fix software bugs. "I didn't start with any expectations, but, as it has worked out, my work at LoveMachine is now my primary source of income, making it my focus as a sort of investment," de Luna says. "It is a scary proposition, because you really have to put your trust in the company that your contribution is valued and that you are not an expendable resource at the end of the day."

Rosedale acknowledges that there are risks to relying on a virtual work force. But he insists that he trusts the people he works with, even though he has never met or spoken to many of them. "There is no better way to build trust in someone you don't know than to have him or her do a small job for you," he says. "It's often better than any interview you can do."

Rosedale says working in this kind of a transparent environment is sort of a "trial by fire" that quickly weeds out the workers who struggle within it. At the same time, because everyone can see how much work everyone else is doing, workers aren't as reliant on their immediate managers to acknowledge their efforts. "We believe that the overall performance and job satisfaction of this kind of transparent system is high," says Rosedale. "So, even if it doesn't work for everyone, that's OK."

Rosedale admits that there are downsides to working in a virtual environment. Sometimes it is more productive and fun to sit next to someone, he says. Rosedale is in the process of opening a co-working space in San Francisco that would give nearby LoveMachine contributors and other mobile workers a physical space in which to mingle. Meanwhile, contractors like de Luna who live in more remote locations have found their own way to connect: They meet up every week in Second Life.