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I've just signed up to text-link-ads.com, which doesn't appear to use rel="nofollow" on the links. After reading a couple of sources it appears to be against their TOS to add nofollow to the links myself.

So my question is, what are the downsides of having this type of links? I know Google doesn't like those links, but do they penalize sites for using them?

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up vote 5 down vote accepted

Yes, there are penalties. It's best to probably avoid that ad network if you can help it as you would lose the ability to pass PR which includes your internal pages.

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Exactly. There is no good reason for an ad network to not use nofollow, unless they wanted to also double as a link farm. How many ads you can afford to buy on other sites should not determine your search engine ranking. So pagerank/trustrank are intended to measure only organically-generated links that indicate a page's popularity and value. That's why search engines want people to use nofollow for advertising. – Lèse majesté Oct 4 '10 at 22:54

From Google Webmaster Central - Paid Links

Buying or selling links that pass PageRank [ie. that don't include rel="nofollow"*] is in violation of Google's Webmaster Guidelines and can negatively impact a site's ranking in search results.

* Note that using rel="nofollow" isn't the only way to prevent PageRank from being passed, as mentioned further down that linked article.

See also Google Webmaster Central - About rel="nofollow"

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Google, as the most dominant search engine, has the power to kill most on-line businesses - and they have used this power before - so, when you think about doing something Google doesn't like you have to think about the risk on getting caught and see if you can tolerate that risk.

With an ad network the risk of getting caught is very high, there is standard code you have to add to your page to show the ads and it's trivial for Google to detect it.

So, it's just a matter of time until Google decides to penalize this network and when they do you will go down with the network - not a good deal in my opinion.

I myself would never do something Google doesn't like because I'll probably take a serious financial hit if Google penalizes my site.

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