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Margin Surplus – Or Why the US Ain’t Broke

In an article in the WSJ also available free on his blog, Andy Kessler – a very smart guy – offers an explanation of why the stock market keeps going up in the face of so many relentless negatives:

“Oil is over $70 a barrel, Iran's got nukes, and soon they'll price gas per ounce. The Fed has jacked short rates up 15 times… The yield curve is as flat as a subsidized Iowa corn field. There's $1 trillion of teaser rate Adjustable Rate Mortgages about to burst all over Southern California and 'burbs everywhere. Gold is over $600, commodities are roaring, the dollar is dropping again, there are trade deficits as far as the eye can see and GM is on life support. Drunken sailors in D.C. are running a sea of red ink…” says Andy.

Then he points out that Dow is near an all-time high, the NASDAQ has doubled in three years, and the S&P 500 is over 1300.  “The stock market knows something and is predicting some future the rest of us can only guess at,” he claims.

Andy says that what the stock market may know is that the US is in a transition from and industrial commodity to a design economy!

Andy’s getting back to the theme of “margin surplus” which he explains very well in his book Running Money.  There he used it to explain why the US currency and economy haven’t collapsed under the weight of huge trade deficits and foreign-funded government debt.  Now, of course, many people would say that the stock market is irrationally exuberant and that the collapse of the American economy is an accident about to happen; but I think Andy’s on to something.

To paraphrase him: think of a PC.  We all know that most of the components don’t come from here even if the nameplate says Dell.  The screen may come from Korea; the diskdrive from China; etc. etc.  Two critical components do come from the US, however: Windows (not to mention Office and other software that may be loaded on to the machine) and the design of the Intel chip.  Together, these may only constitute 10-20% of the total cost of the machine.  So, when we buy a machine, no question that it looks bad on the balance of payments – lots of money flows out of the US.

But what about margin?  The margin on the physical components, the screen, the keyboard, the diskdrive, even the RAM is paper thin.  The gross margin on Windows, on the other hand, is near 100% - Microsoft has no incremental cost of manufacture when a pre-installed version of Windows ships (maybe a back up CD-ROM or two).  And Intel’s margin on the chips, while not as high overall, is near 100% on the intellectual property part even though the chip itself may be manufactured off shore.

It may that half the total MARGIN on a PC shows up as profit in US companies even though a much smaller share of the component cost ends up here.  This makes these US companies good investments so the dollars that flowed out of the country to buy the low margin components come back to buy stock in US companies, to buy a share of that profit stream.  This makes the US as a whole a good investment so foreigners are also willing to hold our bonds.

When you think about it that way, all the places that make the cheap components are doing us a favor because the low price of the foreign-manufactured PC makes it a mass market product and enables huge sales and huge profits for Intel and Microsoft (and AMD).  Hmm…

The dollars which come back to buy shares in Intel and Microsoft (and AMD) don’t show up in the trade balance numbers.  But they are real.  And, according to Andy, they not only keep the US economy afloat but make it attractive.  We have a trade DEFICIT but we have a margin SURPLUS.  It’s the stock market which evens things out.

In yesterday’s article Andy explains how the design economy, which creates the margin surplus, works:

“You invent something here (chip, movie, iPod, medicine, financial instrument), email the design overseas for manufacture in $1-an-hour factories (OK, not financial stuff), and then ship it back for consumption. Sure, this runs up trade deficits, and our precious dollars leave the country, but that’s only half the story. Those dollars come back and invest in the U.S.”

Although Andy doesn’t point it out here, globalization is key to our success as a design economy.  If we didn’t have access to low-priced labor and overseas manufacturers working on paper-thin margins, we wouldn’t get the return from our high-priced designs because the resulting products would be too expensive to have a world-wide mass market.

Andy thinks the stock market is also sensing a future shrinking in the rate at which we create new government debt from a combination of increased fiscal discipline and the positive economic effects of lower marginal tax rates.  Less debt means less long bonds for foreigners to buy.  So, if they want to invest in the US, the stock market could get a greater share of the inflow.

Before you further hock the house, though, Andy does point out that the time to invest in this market may not be now: “The time to load up was three years ago. The stock market is notoriously schizophrenic. Remember, it thought you could sell pet food over the Internet. But it’s more often right than wrong, especially when proving pessimists wrong and optimists delusional.”

The Next Huge Thing – What It Looks Like

Metrofi

If you were in one of the California cities of Santa Clara, Cupertino, or Sunnyvale using the free WiFi offered by MetroFi to read Fractals of Change, this is what your browser window (Internet Explorer version) would look like.  Notice that above the banner for Fractals of Change, there is a full screen horizontal bar with an ad in it and a chance to perform a search.  The ad rotates whether you are refreshing the banner or not.  I’ve seen both Google and Yahoo show up as the search engine.

The price of this sponsored service is the space on your screen that you give to MetroFi in which to display ads. You get one meg access for it (as good or better than most DSL) so not a bad deal.

 

In theory (and perhaps in practice), your location could also be pinpointed within a couple of blocks.  MetroFi offers advertisers the opportunity to target by “city, region, or zip code” which makes me think that the ads you see almost certainly depend on where you are.  That could be done by supplying different feeds to different antennae and doesn’t necessarily mean that your location is being tracked explicitly.  The search does not appear to be customized to a location.

BTW, cell phones can be tracked to the tower they are using even if they don’t explicitly have GPS capability as many do.

You are required to give an email address for “security reasons” when you sign up for the free service.  I’m not quite sure what that means or who is being secured against whom.

MetroFi says they will also have an ad-free service at $19.95/month.  This ad-free service was part of their winning bid to unwire Portland, Oregon. So you know exactly what that 728x90 pixel area on your screen is worth.

Note to Fellow Nerds

I was not in any of the cities served by MetroFi when I captured this screen shot.  There’s a hint at how I found if you look at the text that popped up as I moused over the back button in my browser.

Figure it out yet?

OK.   Here’s the answer.  I use a service called Site Meter to see how many people are reading my blog.  In most cases, it can give me the referring URL that led people to my site.  I noticed this strange URL: http://www.ifreespot.com/sites/cup-mf/index.shtml?url=http://blog.tomevslin.com/2006/03/free_business_i.html so I clicked on it (note: clicking on strange URLs can be dangerous to your computer’s health). When I clicked on it, I linked to the page server of the free service even though my access is not through MetroFi. 

This tells us that someone got to Fractals of Change through the free service and, if you’re a nerd, also tells you a lot about how they manage to get the ad into the browser window.  Actually pretty straightforward; capable of being misused but not indicative of misuse.

I think sponsored WiFi covering all cities in the US within the next three or four years is going to be the foundation for the next huge opportunity.  Posted on that here.

Posted on the potential problem of muniopolies here.

Interview on MarketWatch

Frank Barnako of MarketWatch interviewed me on the occasion of the hardcover edition of hackoff.com shipping.  The interview is more wide-ranging than just the book, though.  It covers some of my early history and also whether we are now in Bubble 2.0.

Audio of the interview is available here and an article drawn from the interview is here.  the interview will also play on CBS radio stations but the time varies by station so I don't know when.

Interestingly, Frank said he wanted to do the interview on Skype "in order to get good quality."  It wasn't long ago that the rap on VoIP was poor quality.  Now it's the PSTN (legacy phone system) that's not good enough.  The audio quality's not perfect, though.  I was wearing my second best mike for reasons not worth going into.  Too many "uhs" as well but tough to blame that on the equipment.  Just haven't done a live interview in a while.

What Should Google Do About Its Stock Price?

Nothing!  Nada.  Ignore it.

[full disclosure: Neither Sergey Brin nor Larry Page have asked me for advice.  Haven’t even had a call from CEO Eric Schmidt who I know for his days at Sun and Novell.  But I have lived through a bubble as a CEO so I’ll give them all some advice anyway.]

It’s hard to face the fact that your stock is over-valued.  Google was over-valued at its peak of $475.11; it’s over-valued at yesterday’s close of $364.80.  It was probably over-valued at its 52 week low of $172.57.

At yesterday’s close, Google has a P/E ratio of 73.  It is even selling for 14 times sales!  Small companies get multiples like this or even better because they can grow sales at a very high compounded rate and can grow profitability at an even higher rate as growth makes it easier and easier to cover their fixed expenses.  This growth – if it happens – means they will grow into their stock price.  The market sets prices, almost anyone will tell you, on future expectations – not the past.

Huge companies can’t grow at as high a compounded rate because the universe isn’t big enough to accommodate them.  Google’s CFO George Reyes has been criticized for pointing out this mathematical fact.  Bullshit! He’s right; he’s telling the truth.  Nice of him to worry about investors too dumb to know this.

Moreover, there are diseconomies of scale.  You can’t scale a mouse to the size of an elephant; its legs would break because they’d be too thin to support its bulk.  Likewise, as a company grows past small, productivity per employee starts to go down.  You can’t find enough brilliant solo achievers; worse, you can’t get the best from many brilliant achievers within a large organization because they can’t get noticed without squandering some of that brilliance on internal politics.  You need proportionally more managers, accountants, lawyers and HR people in a large company – more overhead.

For all of 2005, Google had revenue of $1,411,163 and profits of $336,872 per employee.  But, by the fourth quarter, with both more employers and a lower profit margin, both numbers were down: $1,355,187 and $262,838 respectively.  New people are contributing less in profitability each than old people – significantly.

So Google isn’t going to grow quickly into an outsized valuation.

Obviously over-valued stocks can go up. If you’re a speculator, you might want to buy Google on a dip and sell when it recovers.  This is not investment advice; it’s management advice.

You can’t optimize for two things at once; it’s another of those inconvenient mathematical facts.  That means that if you spend executive time on stock price you don’t spend that time on creating a better company.  By staying private until they were very profitable, the Google founders gave themselves time to build an excellent company and excellent technology which now defines and dominates the search market.

As a public company, they can’t afford to get distracted from company building by worrying about the stock price – particularly when the stock is over-valued!

As a public company, they’ve been criticized for not giving “guidance” on expected revenues and profits.  Now that they have “disappointed” the Street, they’re probably glad they didn’t give guidance which might have been lawsuit fodder.  When I was a public company CEO, I did give guidance.  It was a mistake.  Generating the guidance numbers took too much management time.  Worse, the specter of missing the guidance we’d given motivated us to focus on quarterly results when we should have been spending all that time on building a better company for the long term.

Google got this one right.  I hope they stick to it.

Financial analysts are suggesting that Google announce some “strategic acquisitions” or “exciting new lines of business” in order to reignite the market for its stock.  It’s very hard not to listen these suggestions while your stock is sinking as inexorably as it once rose.  But Google doesn’t owe “investors” who bought over-priced stock in hope that’s it would become even more over-priced a short-term bounce so they can execute a quick exit or have a better looking portfolio at quarter end. 

Google owes it to its stockholders not to consider cosmetics at all in making acquisitions; it’s tough enough to choose the right acquisition candidates and to execute acquisitions well even when you focus on all the right things.  Google should only make announcements when it is strategically or tactically important to do so – to get new customers or to attract new partners, for example.  Making announcements with one eye on the stock ticker almost assures you’ll get the timing wrong.

Great companies are great in good times and bad.  A declining stock price isn’t even very “bad” compared to declining earnings or running out of cash – neither of which problems Google is anywhere near.  Declining stock price does mean it’s harder to use options to recruit employees and tends to raise salary costs.  A declining stock price is not as good a currency for acquisitions as an appreciating stock.

But, when a stock is too high, it will eventually come down.  The market will likely over-react on the downswing just as it did on the upswing.  As long as the company continues to execute and doesn’t get distracted by the anguished cries for relief from the Street, the decline sets the stage for future advances.

Last week 26.1% of visits to this blog came through Google US.  By comparison, 2.5% came from MSN search and 1.9% from Yahoo.  Google Canada accounted for 1.6% and Google UK 1.4%.  Google’s challenge is to continue to innovate around this extraordinary position.  These are the numbers Google executives need to remain fixated on along with employee productivity, ad rates, and all the things which really define their business.

The Blogobubble

The Blogosphere is a bubble!  Well, you should have known.  It’s round; it doubles every five and a half months (according to Dave Sifry at Technorati); it makes people crazy with greed and has even made some money for some people.  It has caused irrational exuberance.  Good thing Alan Greenspan isn’t at the Fed any more or he’d probably administer a stern slap on the wrist.

But bubbles are a good thing.  It was a bubble that raised the capital and enthusiasm (not in that order) which launched the popular Internet and the WorldWideWeb.  Despite the collapse of that bubble, the Internet and the WorldWideWeb are still around.  The blogobubble hasn’t been accompanied by a stock market mania; the participating companies are mainly still private unless they’ve been acquired by public companies; so the bursting of this bubble will cause less pain than the last one.

But is the blogobubble bursting?  The question has caused a burst of blogging and some anticipatory lick smacking in the beleaguered traditional media.

If you chewed bubblegum (I know you don’t) and if you blew a bubble that kept doubling, you would know that you would soon have bubblegum on your nose and perhaps even in your eyebrows.  If we define “collapse” as an end to the current growth rate, then collapse must be nearly upon us if not already here.  We’ll have to discover universes full of literate extraterrestrial beings and get them online and set up with TypePad accounts immediately if the growth rate in blogs or bloggers is going to continue.

According to a recent Gallup poll quoted in a WSJ article by Jason Fry, growth in US blog READERS is “somewhere between nil and negative.”  It’s always been somewhat questionable whether there are as many blog readers as blog writers.  48.4% of respondents to a poll of readers of my blog also blog themselves.

Fry also cites the poll in saying: “just 9% of Internet users read blogs frequently, 11% do so occasionally, 13% rarely bother, and 66% never do.”  But, Fry, who blogs himself, points out correctly that many people read blogs without knowing that’s what they’re doing.

26.5% of the people who visited this blog site last week came through Google US. This is by far the largest source of new readers.  Most of them weren’t looking for a blog; they were looking for information or opinion on something or other and the magical Google algorithm suggested they look here.  Can’t tell but I bet most of them don’t know or care that the web site the search engine led them to is actually a blog.

If the number of blogs is still doubling every five and half months and US readership is constant, it would seem that blogging may no longer be the easiest route to fame and fortune, at least in the US.  But, also according to Technorati, less than half of new blogs get any new posts after three months and only 10% are updated more than weekly.  Maybe it’s discouraging not to have any readers.  It is work – although enjoyable work – to keep to a regular posting schedule.

OK.  Here’s what I think is happening: the bubble phase of blog growth is ending.  The rational growth phase – jumpstarted by the inflation of the blogobubble – is now beginning from a significant base of both bloggers and readers and has a wealth of technology to build on.

Blog writing for broad consumption will decline.  The shakeout is beginning.  People do tire of the discipline – especially if it doesn’t result in instant fame or wealth.  People do have to go back to their day jobs.  Something else will come along that’s trendy to try.  This pending decline in the absolute number of “broad consumption” blogs is a good thing.  The survivors get more readers.  Readers will still have a huge but perhaps not as daunting a choice of blogs to read.

Blog writing for narrow consumption has just begun.  A blog is a great refrigerator door for a dispersed family or group of friends and all kinds of organizations.  These narrowcast blogs don’t care whether they can get enough links from a-band bloggers for a high Technorati ranking; they may not even make themselves broadly accessible.  They are a way to implement one-to-a-few communication with some feedback for existing groups.  They are a way to form and maintain interest groups regardless of physical location.

Blog technology will be rapidly adopted by existing and new websites.  There are two main things which distinguish blog technology: ease of authoring and, most important, the automatic prominence of new information.  By contrast, older web technology usually requires at least semi-technical skills for initial setup and even update and DOESN’T make it easy for visitors to see what’s new since their last visit.  Because blogs make new information prominent, most marketing websites will have a blog component.

Blog technology and technology developed to support blogging will increasingly be used to support subscription service.  RSS (Real Simple Syndication) is still a mystery to most people although 69.5% of those who responded to my survey do say they use it (you’re a techie bunch).  But even the traditional media know that they already lose significant market share if they don’t make RSS feeds of their content available.  We’ve found that RSS-based email subscription offered by FeedBlitz is an effective way to shield readers of the hackoff.com serialization from having to know anything about RSS.  RSS-based subscription capability is being built into new browsers.  FeedBurner does a particularly good job of making RSS technology more capable to the benefit of both writers and readers.  Money will continue to be made by providing blog technology, usually in the form of low cost services.

Blogging is the current manifestation of Internet disintermediation, the flattening of almost everything.  There are no visible intermediaries between a blogger and her readers.  Anyone with a computer and an Internet connection can write a blog; anyone with a computer and an Internet connection can read any publicly accessible blog.  Readers discovering writers, however, do require intermediaries. Typically these are friends, already-read blogs, or, very important and pretty democratic, search engines.  This direct access diminishes the power of traditional information and entertainment gatekeepers like newspaper editors, traditional book publishers, book reviewers, record labels etc. etc.  Being able to buy ink (or airwaves) by the barrel no longer creates a near impregnable platform.

I don’t think blogging will destroy traditional media; it’ll both make it better and more accountable and more accessible.  But, those information and entertainment companies which don’t adapt to the Internet in general and blog technology and openness in particular, will perish.

The collapse of the blogobubble is like the falling away of a first stage booster rocket. It is just the beginning of wider use of blog technology and greater blog influence.

Disrupting the Venture Capital Industry

All venture capitalists (VCs)  SAY that they like to invest in disruptive technology; some VCs (the best ones) actually do invest in disruptive technologies.  So it is certainly a fair and relevant question to ask whether new technology or other changes will disrupt the venture capital industry. And, fair and relevant or not, the discussion has broken out all over the blogosphere.

[Note: This post and the ones I quote below are only about venture capital as applied to Internet and software technology; other industries have very different capital needs.]

Vastly oversimplified To oversimplify what he is saying, VC Rick Segal blogs that a VC used to provide both a Rolodex full of contacts which the entrepreneur himself or herself doesn’t have but badly needs and the boatload of cash required to execute on an idea.  Now, Rick says, the blogosphere is the Rolodex through which customers, supporters, and investors can be mobilized and new technology including free and software and services for almost any purpose as well as very cheap hardware often reduce the money required to what an entrepreneur can float on her or his credit card. 

Rick says his own daughters have business ideas which they don’t seem to need him to fund. He interprets this as a wakeup call.

Chronologically in between Rick’s two posts on this subject (here’s the earlier one), Dave Winer who invented or participated in the inventing of many Web 2.0 technologies including RSS, podcasts, and OPML (and who blogged long before blogs were invented), weighed in with a post proposing the disintermediation of VCs and the formation of a public corporation whose initial funding, at least, would come from users which would both provide funding for startups and plow back some of its profits into “pure technology research and development.” It’s the users who create value for startups anyway, Dave argues.  Although he is angry at VCs and accuses them accurately enough of funding too many “me-too” startups in the last bubble as well as ignoring basic research, Dave does suggest that Rick Segal be the CEO of this publicly-traded funding vehicle.

Segal reciprocates the (well-deserved) mutual respect: “My working theory is that a ‘Capital firm’ with Esther Dyson, Mark Evans, Shel Israel, Doc Searls, Robert Scoble, Dave Winer, or some combination, might have value that, along side my money, could bring ideas into the mainstream in a much different fashion with great returns for all.”

Although (full-disclosure) I have been and am an investor in several venture capital funds, I can only comment from experience as an entrepreneur . As an entrepreneur (even more disclosure),  I’ve been dissed by, funded by, frustrated by, helped by, well-advised by, and poorly advised by  VCs – sometimes all at the same time.  From an entrepreneur’s point of view, it doesn’t matter if the VC industry even exists or not (investors feel differently as do VCs); what matters to entrepreneurs is that we get funded.  We accept advice from those who fund us as a necessary evil that comes with the money even though, after the fact, some of it turns out to be pretty good.

Since it is never a good idea to sell more of your company than you have to earlier than you have to, it is a good idea for inventors to take advantage of all the free and cheap stuff that Rick talks about in order to build a prototype or even to begin service without having to raise money first.  The fact that many a business can really be launched without either acquiring a rich uncle or quitting your day job really is a disruptive change.

This disruption affects both the entrepreneur and the VC.  Some entrepreneurs now can get by with no venture capital; others will be able to sell less of their company than would otherwise be necessary because they have demonstrated BEFORE raising money that their idea “works” and maybe even that it attracts users.  VCs, on the other hand, can take less risk by eliminating “untested” ideas and wannabe entrepreneurs who don’t believe enough in their own ideas to build the first beta on their own.

“Show me the PowerPoint” has become “show me the service.”  “Tell me who your potential users are” has become “tell me who your early adopters are.” Companies who are at this milestone are not only ready for funding; they are also potential acquisition candidates. So VCs have to compete from the getgo with offers to simply acquire the company.

But, if one company can get to early adopter status on just sweat equity, so can one hundred others.  Scaling is always harder than we entrepreneurs think it’ll be (and more expensive).  The first employees, benefits, and legal stuff cost a lot more than you think they will – and, even worse, take a lot of your time. Mary will tell you that I have always underestimated the marketing dollars needed to get a good idea – even a very good idea – into the marketplace.  Sure, the Web has enabled many more creative ways to market, but it’s done that for your competitors as well.  This is an arms race.  Arms still cost money.

So, my entrepreneur friends, you are still likely to need VCs - not always, but a lot of the time.  So what’s changed?  Has the VC industry been disrupted?  Is what either Dave or Rick is suggesting the shape of the VC industry to come?

Short answers:

Two big changes are the lower cost of getting started (means less need for VCs early and more for them to look at later) and VCs blogging (a good thing if you’re an entrepreneur).

The VC industry has been disrupted by compression of the time between when a company first needs money and the time it is an acquisition candidate,  Even if an initial round is needed, a second may not be.  Harder, then, for VCs to put money to work.  Moreover, it is likely that the initial round needed will be small, so an extensive and expensive round of contract writing and due diligence simply isn’t justified.  The best VCs are learning how to efficiently put up smaller sums.

Although I would love to have Dave as an advisor (and have benefited from his advice in the distant past) and Rick sounds like a very good VC and both of them have correctly diagnosed industry problems,  I don’t agree with either prescription.  I’m afraid being funded by a public shell would lead to private startups having many of the reporting problems and transparancy issues of public companies without the (dubious) benefits of being public. Publicly traded holding companies for startups have been notable failures in the past.  And a board of advisors – even the brilliant ones that Rick suggests – is still a committee.  Entrepreneurs come to VCs for money.  Committee time is wasted time at best and a dangerous distraction at worst.

Coming attractions:  Putting Small Amounts of Money to Work and How to Read Your VC’s Blog.

The World Economic Forum at Davos Continued

There’s an interesting blog by NY Times and International Herald Tribune reporters at Davos this year.  A few of the highlights:

 

  • There are very few Chinese leaders at the WEF even though they were invited and the remarkable economic growth of their country and India are themes of the conference and the topic of many of them seminars.
  • Management of the WEF apologized when they found that a magazine they distribute to attendees contains an article equating Zionism with racism and calling for a boycott of Israel.  Executive Director and Founder Klaus Schwab attributed the appearance of the article to an "unacceptable failure in the editorial process, specifically an insufficiently short period for review of content - for which there is no excuse."  The WEF does have a history of being very even-handed in the Middle east.
  • Bill Clinton is going to make a surprise, unscheduled appearance.  He is popular there (as you’ll see below) and I think he misses playing a role on the world stage.

 

Yasser Arafat was a frequent attendee as well. He won’t be making a repeat appearance, of course, although the electoral triumph of Hamas is the final great failure of his leadership and of Fatah.

 

On a lighter note, Saturday is party night and no one does that better than the WEF.  Below is an extract from my book hackoff.com: an historic murder mystery set in the Internet bubble and rubble. The fictional characters are hackoff.com CEO Larry Lazard, his wife Louise, and their new Israeli friends the Roslovs. The parties are loosely drawn from what I can remember of the visits Mary and I made to Davos at the height of the Bubble in 1999 and 2000.

 

 

On Saturday afternoon, Bill Clinton speaks. Tickets to the Great Hall are almost impossible to get, but there are a sufficient number of listening rooms furnished with headsets which translate to many languages and wide screen television views of the podium. Larry and Louise are in one of these.

There is a delay. Apparently the American Secret Service has become alarmed and want everybody out of the hall so that they can go through and look for bombs. They have both dogs and electronic noses ready. But they can’t empty the room because of the crush of people trying to come in. There is a dissatisfied mutter about the arrogance of the Americans who are not satisfied with security arrangements, which were, after all, good enough for everyone else.

The Secret Service compromises on just clearing the first five rows since these will be closest to the President. This is doable but means that the VIPs who have these rows will have to be shuffled out, so more offense is taken. To make matters worse, once the Secret Service and its hounds have finished, the relative plebeians flock into the seats meant for the patricians. It takes most of the staff and tact of the WEF to sort this out.

Finally, it’s time for Herr Klaus to introduce the President. “You graduated from Yale University. You were a Rhoades Scholar who studied in London,” he says to the President. “You were Attorney General and then Governor of the State of Arkansas. In 1992 you were elected to be President of the United States of America; and, in 1996, you were re-elected. You have pursued a strong domestic agenda and you are well-known and well-liked in the capitals of the world. You have been a strong voice for negotiated settlements to the world’s problems.

“President William Jefferson Clinton, it gives me great pleasure to introduce you here at World Economic Forum 2000 in Davos, Switzerland. The delegates look forward to your remarks.”

Clinton beams. He likes the audience and the audience likes him. He jokes about the security and he is forgiven for it. He speaks nonspecifically but sincerely about a “shared vision”. The audience shares this nonspecific vision.  When this likeable man speaks, it does seem that differences will disappear, that prosperity will overcome despair, that the darkest, coldest corners of the world will be lit and warm — that, indeed, the spirit of Davos, the vision of Davos, the inclusiveness and well-meaningness of Davos, can and will become the spirit of a happier world.

“He was good,” says Louise afterwards.

“He didn’t say a fucking thing,” says Larry.

“He doesn’t have to,” says Louise.

Saturday night is the big night at Davos; on this night a tux or equivalent national dress is suggested. The main hall at the Congress Center has been transformed into a huge nightclub with small tables in front of a large stage.  Counters of food line the edges of the room with ample small bars between them. Larry and Louise have come early and take a table near the stage.

Simon Peres, his wife, and another couple take the table in front of them.  Peres nods to Larry and Louise but it is not clear whether he recognizes Larry from the meeting or is just friendly. [nb. See previous post for how Larry met Simon Peres.]

There is much table-hopping. The Peres table is visited first by the new King of Jordan and his wife. The women are on cheek-kissing terms. The men shake hands warmly. The Jordanian royalty chats with the Israelis for ten minutes or so before moving on. Various delegates in national garbs stop by to pay their respects to the Pereses; a good percentage of them are in Arab robes.  Peace seems possible at Davos.

The premier act of the night’s entertainment is a group of 200 gypsies playing violins. They fill the huge hall with rich sounds alternating between joy and sorrow. The country-less violinists are a hit with the delegates, all of whom have countries of their own at the moment.

After the nightclub dinner and show, there are national parties to discover throughout the Congress Center. Sometime during the entertainment, Larry’s new friend Chaim Roslov has joined them at their table with his wife Devorah. Larry and Louise and Chaim and Devorah go first to Mauritius for a party. It is in and around a huge pool, perhaps used as a swimming pool at other times, in a building which connects through a huge walkable (and warm) hose to the Congress Center. The awesome Mauritian band is on a platform in the middle of the pool as isolated as Mauritius itself is in the middle of the Indian Ocean. It’s not clear how they got there or how they’ll get back. They can’t and don’t take breaks.

At one end of the pool is food, which is presumably Mauritian. There are large variety of vegetarian dishes ranging from mild to extremely spicy; these are the contributions of the island nations’ mainly Hindu population. There are also a variety of the spicy pork and goat dishes favored by the minority Creole population. Most confections have a coconut base.

At the other end of the pool is a dais where some Mauritians give speeches. They are very glad to have the delegates visit their party and hope that they soon will visit Mauritius. They will find it is a country that realizes its future is within and not isolated from the world economy. To that end, the Prime Minister has begun a program of legal reform to create the required transparency and to assure that contracts are respected. Protectionism is as dead in Mauritius as the dodo which once thrived there.

It would be helpful if the developed world would remove punitive tariffs on the agricultural and manufactured products of Mauritius and would stop unfair subsidies to domestic sugar growers. That is, the world should notice, all that Mauritius is asking in addition to some reasonable forbearance of debt contracted by previous profligate regimes. Mauritius is not asking for foreign aid. The new loans it seeks are economically sound and can be amply repaid.  Even the old loans can be repaid if only those unfortunate and unproductive tariff barriers were just to be removed.

The Mauritians are good hosts who speak briefly and smile often. The band plays very danceable Reggae, and the delegates and their spouses dance standard American dances on platforms erected on the sides of the pool. Magdala, the Lazard’s appointed guide to the WEF, is there with her “significant other”, a tall thin Swiss of about thirty with a German accent. He is a consultant and dances well. Chaim and Larry each dance a couple of times with Magdala and each other’s wives while Magdala’s significant other makes sure no trailing spouse is left a wall flower. Chaim has a brief conversation with Magdala and the significant other in German.

Next to the food tables there is a bar. A very potent punch, which may or may not be indigenous to Mauritius, is served there, as well as a standard selection of bar wines, beers, and hard liquors. It is not clear what the scion of an Argentinean steel company was drinking before he fell off the dance floor and into the pool. No matter; he is quickly and efficiently hauled out by a combination of wait staff and quickly-appearing security forces. The dancers stop to cheer as he is helped wetly away. The puddles behind him are immediately mopped.

Chaim exchanges a few words of Hindi with some of the hosts.

The US party features blues from Chicago sung by a very sexy black woman who is an expatriate Chicagoan, but usually to be heard in Europe and sometimes Japan. The room is dark, partly illuminated in ultraviolet, and with creative neon outlines of jazz instruments on the walls.  Either there is no speaker at the US party or the Lazards and their new friends the Roslovs arrived too late to hear them. These blues are not meant to be danced to, although some people try.

Chaim and the singer speak Italian for a few minutes.

The Russian party is renowned for its vodka and caviar — especially the caviar. The Lazards and Roslovs first heard rumors of the Russian caviar while still in Mauritius. In Chicago, between blues numbers, they speak to people who have actually been there and seen and eaten the mountains of tiny eggs. But no one can describe exactly how to get to the Russian party. Undeterred, the Lazards and Roslovs set out to find the land of vodka and caviar.

In one of the many sublevels of the Congress Center, they follow music hopefully into a loud room. Wrong country: it’s France. But it would be rude to tear yourself out of the grip of the buxom French farm women with plunging décolletage who pull you into the room. The food here is mainly elaborately constructed pastry. Champagne bubbles from a replica of the fountains of Versailles. A chamber trio plays baroque music in a corner.

Now, unfortunately, there will be a short speech. It is in French, which Larry understands not at all, and Louise only a little. However, Chaim translates concurrently: France is very much in favor of economic globalization. After all, the French invented international trade. However, there is a danger in globalization. This danger is cultural. One country in particular has imposed its culture on much of the world to the detriment of other cultures everywhere.

“Yeah, we make everyone wear fucking jeans…” says Larry a little too loudly. He is hushed by Louise and some of the people around them.

The speech goes on to regret that the benefits of the Internet — an outgrowth, one might say, of minitel, which was invented, of course, in France — these benefits are denied to much of the world because so much of the Internet is in English. In fact, the Internet, which ought to be international is fast becoming a mechanism for dangerous cultural imperialism. It is to be hoped that the delegates gathered here in Davos can work together to stem these unhealthy excesses of globalization and restore balance to international culture and…

“Anyone know where the Russian party is?” asks Larry rather loudly and very rudely of his neighbors. They either don’t know, don’t speak English, or don’t care to answer.

Chaim engages one of the security guards in a conversation in an unidentified language. He swears he has obtained the true location of Russia. To get there one must go up one staircase and down another; one must also go east in one hallway and west in another. There are various detours north and south and a final half story descent into a hallway at the end of which is, sure enough, the fabled land of vodka and caviar.

The mountains of caviar have suffered the ravages of time and appetite. You can deduce their former scale by the diameter of the plates the crumbled hills and scraps still sit on. Cracker crumbs have been ground into the floor and pasted down by squashed eggs. There are no longer crackers on tables with caviar nor is there caviar on tables with crackers. Condiments, in general, are available only on tables with neither crackers nor caviar. The persistent can still find more or less clean plates, load them with crackers from here, add caviar from there and find condiments somewhere else. This is what Larry and Louise and Chaim and Devorah do.

Here, as in France, breasts push up from low-cut peasant blouses. The Volga boatwomen are better-endowed and certainly more friendly than their French counterparts. Ignoring the women and the caviar, but drinking vodka freely and usually neat, there are multi-national clusters of over-dressed men.

“What do you think they’re talking about? Basketball?” asks Larry looking at an almost seven-foot Cossack in a black suit talking to an over seven-foot Chinese in a yellow suit. “I don’t understand Russian.”

“Actually,” answers Chaim, “they are speaking Mandarin and they are discussing oil in large quantities which does not pay taxes.”

“Really?” asks Louise. “Are people allowed to do business at the World Economic Forum? I haven’t seen or heard anyone else doing that.”

“Russians make their own rules,” says Chaim. “They are new to Davos as capitalists and they are enjoying themselves. But they still can bang their shoes on the table if they want to. Over there, for example, there is a Chechen discussing ‘precious weapons’ with a Kuwaiti.”  He is looking at a very small man in electric blue talking to an equally small man in Arab robes.

“Shouldn’t we tell someone?” asks Louise. “I mean that can’t be good, especially if precious means what I think it means.”

“Actually, I believe that the Kuwaiti works either for the CIA or Mossad so he is on the way to finding this source.”

“How could you possibly know that?” asks Larry. “If the Chechen doesn’t know who he’s talking to, how would you know?”

“I have sources, my friend,” says Chaim. “Didn’t I find Russia for us?”

By 3:00 AM the countries are a blur. Most of the food is gone, although there is apparently no end to the liquor or the music. Larry and Louise head unsteadily down the hill to Sunset Reising. It is bitter cold and a wind is blowing seriously. A few lights on the mountain sides illuminate huge swirls of blowing snow across and around the avalanche fences.

The water cannon and its accompanying troops are gone. There is no sign of protestors. Globalization is apparently safe for the time being, at least in Davos.

(end of extract)

 

AlwaysOn was kind enough to run a different extract here.

 

The whole chapter set in Davos is available online here or as a downloadable PDF here.

 

Yahoo.licio.us

The blogosphere is abuzz with the story of Yahoo purchasing del.icio.us.  Everyone knows who Yahoo is.  For those who don’t know del.icio.us, it’s the category leader in tagging (sometimes called bookmarking).  Many more people use del.icio.us to tag web pages than any of its competitors.  It’s been just eight month since founder Joshua Shachter left his day job at a brokerage firm and received first round venture funding.  Del.icio.us is free to use and doesn’t carry advertising so, to date, the company doesn’t have visible revenues.

So does this mean Bubble 2.0 is truly upon us?  Hard to say without knowing the price, of course, but I think not.  The deal makes a lot of sense without bubble psychology.

“But,” critics say, “without revenues let alone a path to profitability, this is not a real company. It was built to flip.” Or: “This is a feature, not a company.”

Even if true, so what?  Building value for resale rather than current income is good business.  Consider real estate.  Somebody buys property; gets a lot of permits; arranges for subdivision; maybe build roads and a little infrastructure; and sells the lots to builders.  Not a penny of current revenue during the process; just a gain at the end. Builders buy the lots; they build spec houses; they don’t get any income until they eventually sell the houses to some one else.

Even if Joshua and company built del.icio.us only for resale, they created real value in aggregating users and creating a folksonomy – a user defined categorization and ranking of web content.  They did a brilliant job of solving the dilemma of all network-value businesses – how do you get to critical mass when there is NO network value for the first users? 

Remember Metcalfe’s Law that the value of a network scales with the square of the number of users.  This implies that big networks have huge value but also that small networks have almost no value at all,  Makes it hard to get started.

Del.icio.us had value for user #1 even if it wasn’t “network” value.  Tagging is a good way to remember all the web pages you may want to find again.  That use doesn’t depend on any one else doing any tagging.  So more and more people used del.icio.us to bookmark web pages for later retrieval.

Since the tags are public, anyone can use everyone else’s tags as a way to find information.  So, as soon as enough people tagged for their own selfish purpose, their tags became useful to other people looking for web content.  Moreover, there is information in how many people tagged a particular web site or blog.  Popularity means something although it’s not always clear what.  Soon del.icio.us had real network value and was off to the races.

Del.icio.us got to a critical mass of users before its competitors.  That’s crucial to a network business because this lead kicks off a virtuous circle. The network service with the most users has the most value to each new user.  Other things being anywhere near equal, the larger network therefore gets more than its share of new users and grows faster than its would-be competitors.  Aggregating users faster than anyone else is why Skype succeeded and it’s why del.icio.us succeeded as well.

Yahoo understands the value of tagging.  Its taggable photo service Flickr, also an acquisition, is a runaway category leader.  Yahoo probably could have acquired tagging technology somewhere else.  If they’d bought a smaller competitor of del.icio.us, they presumably would have paid less.

Yahoo already has so many users – probably including a large number of del.icio.us users – that I doubt whether Yahoo acquired del.icio.us just to get what is, from their lofty point of view, a few more users.  My guess is that Yahoo wants to start as the category leader in tagging and never look back and that the number of active taggers and tag users aggregated by del.icio.us – estimated at around 300,000 and growing rapidly - is what made them a valuable acquisition.

Anyway congratulations are due Joshua and friends Fred Wilson and Brad Burnham at Union Square Ventures on creating value for web users and of finding a good path for the del.icio.us folksonomy.  It’s delicious to see del.icio.us as the most used tag on the web the last few days.

Public Company – The Beauty Contest

So you and your Board have decided to take your company public.  The market window is open; you don’t want your competitors to beat you to the money; you’ve always wanted to run a public company.  Whatever.  You’ve made the decision.  Now it’s time to pick the bankers for your IPO.  That process is called “the beauty contest.”

Typically, there’s one lead bank and two or three co-brokers.  The name of the lead bank appears on the left side of the cover of the prospectus and the co-brokers appear on the right.  It is important to bankers to be “on the left” and most of your effort goes into selecting the lead.  The major banker firms may not be willing to be “on the right” for your small potatoes company; so, if you want Morgan Stanley or CIBC in your deal, it may be as lead or nowhere.

When the market is receptive to IPOs as it was in 1997 to 2000 period, bankers are eager to do them.  They are prestigious when successful.  They are very profitable for more reasons than just the commissions they generate.  If the time is right for going public and your company fits whatever is the current definition is of IPO-ready, you’ll probably have your choice.

If your company was VC-funded, your VCs can be very helpful during the beauty contest.  Not only may your VCs know which banks (or individual bankers) to avoid; but VCs are also gatekeepers for bankers.  If your VC firm has a good track record, then banks want more of their “product.”  The banks will deals with your VC firm on many IPOs. They’ll deal with you at best (or worse) just a few times in your career as an entrepreneur. During the process of the ITXC IPO, we sometimes asked Fred Wilson then of Flatiron Fund and now of Union Square Ventures or Bill Collatos then and now at Spectrum Equity to intercede with Lehman Brothers, our lead banker.  Usually Lehman listened to them.

The beauty contest is fun.  The bankers all come trooping in with their presentations.  In those days they all felt they had to wear suits on their first visit to the company so you could always put them somewhat ill at ease by dressing down.  Not sure if they still come to high tech firms in suits. They bring spiral bound presentations with their logo and your logo prominently co-featured on the cover and usually every inside page as well. There are always some pages that show the logos of all the companies they’ve taken public.  There are impressive graphs showing that the bank you are talking to is the leader in some category relevant to you even if they are not the world’s most successful underwriter.

Trouble is the presentation are pretty much all the same so how do you choose?

Not on price, it turns out.  Unless you’re Google, you don’t have enough bargaining power.  In my novel hackoff.com, CEO Larry Lazard asks VC and Board Member Franklin Adams: “So how do they compete?  I thought the bastards all charge the same commission.”

“They do,” says Franklin. “They’ve got that part figured out. What we REALLY care about is how well they're gonna sell the deal and cover the company afterwards. It's very important that their sell-side analyst — the analyst they're going to have cover us — really understands the company and its story and is well enough respected to sell it. He or she is gonna have a lot to do with the success of the IPO and then with the success of the stock in the aftermarket. We WANNA hear from the VP who’s gonna own the deal. We’ll check our sources for you, that’s part of VC value-add,…”

“We’ll find out if the VP’s got a big enough dick in the firm to make things happen. There are a lot of deals going on now and we have to do what we can to make sure OUR deal’s gonna get enough attention. We may hear from one of their senior sales guys, but that’s not too important because they all say the same thing — they’re sales guys.  They tell you they're closer to Fidelity and Semper [nb. A fictional firm] and Janus and all the big funds than anyone else and that they’ll get the best set of appointments.

“We may hear from the trading guy, too. They all run pretty good desks but it’s worth listening to those guys to see if you like ’em. The stock’s in their hands once trading opens. They also count the orders during the roadshow so they can give us a handle on what’s going on.”

You do want to get a major firm on the left; on the right, too, if you can.  The major firms command more attention at the funds and it’s the funds who buy or don’t buy the stock in your IPO (more on that in a future post).  After that it all comes down to people.  Individual bankers vary greatly within firms.  You need a banker you can get along with.  More important, you need a banker who understands your business and can explain what it is that makes you a great investment. You want a banker who has a track record of success WITH COMPANIES LIKE YOURS.  Success in another industry hardly counts at all.

That being said, it is hard to know during the beauty contest exactly who your banker will be.  A VP comes in and leads the pitch.  He’s (or she’s) the senior person who’ll own your IPO and makes resource allocation decisions.  But she or he probably won’t have much to do with the actual preparation of your roadshow and won’t accompany you on most of the roadshow.  Very important that you find out which junior bankers will be doing the work and going with you.

In Bubble 1.0 many analysts were outright shills for the companies their firms took public.  The banks touted the success of their analysts as touts when competing for business.  Some banks and analysts got in trouble for that.  The SEC is stricter now on how analysts are compensated and the walls between the analysts who write “objective opinions” of your company and the bankers who earn commission dollars have been reinforced.

Nevertheless, you know that you are going to get analyst coverage from the firms that participate in your IPO and, at least until your company or your stock is successful, you won’t get much coverage from anyone else.  You also know that institutional investors, as much as they may distrust sell-side analysts, also don’t like to buy stock in companies that don’t have analyst coverage.

Let’s assume that the coverage will be objective (it’s too soon in Bubble 2.0 to know); you still have an interest in making sure it’s competent.  Analysts have to work much harder these days than they used to.  Regulation FD makes it clearly illegal for companies to give the analysts the same kind of  non-public guidance that used to form the basis of much so-called analysis; and so the analysts have a lot of work to do to figure out a new company in an new field.  You need analysts at your banks, particularly at your lead bank, who are willing to work hard and who UNDERSTAND YOUR SEGMENT AND YOUR BUSINESS MODEL.

Your analysts will be writing about your company quarter after quarter once you’re public.  They’ll be predicting your sales and earnings.  They’ll be adjusting their firms’ buy, hold, or sell recommendation on your company’s stock.  People will listen to them.  It’s really a good thing for investment in the US that analysts have to do their own work and now run a lot of risk if they’re just shills.  You can’t tell them what to say; but, if your analyst is lazy or incompetent, you can bet that won’t be good for your company.

The right choice of banks in the beauty contest comes down to the right choice of people.  Good luck.

This post and this one are about Reg FD and predicting earnings.

Bubble 2.0 – Why Not APIs?

Why wouldn’t a web service include an API (Application Program Interface)?  In my previous post I blogged about how a good API (a way for one program or service to request services from another) can lead to fame and fortune for the developers who are smart enough to include it.  Google Maps is just one example of how making functionality available through an API results in a wealth of third-party services built on the API-supporting service.  However, most software and many web services do not support APIs.  Why?

The most common reason a service may not have an API is purely practical:  APIs take time and work.  Code has to be written and tested in order to implement an API.  We’re all in a hurry to get a new service out.  Most new services are built on a shoestring.  An API may be a “nice to have” in the first release of a Web 2.0 (aka Bubble 2.0) service.  Developing it can wait for the next release.  And the next.  And the next.

An API is also a commitment.  If I publish an API for my gidget.tabulo.us service so that you can incorporate my dancing gidgets in your web site, you’ll be unhappy with me if I stop supporting the API or change it in some way in my next release so that your service suddenly breaks.  Nerd ethics says that, if you hack into my site and somehow figure out how to make my gidgets dance, it’s your problem if my next release breaks your hack and the music stops. But, if I publish an API, you are entitled to rely on that API continuing to work as I published it.  Third party developers don’t want to build their services on shifting APIs.  So, once I publish an API, I am committed to maintaining it in each future release of my service.  Good reason to think twice about the costs and benefits of an API.  In general, services which do publish APIs publish them a release or two after they have made the same functionality available directly to human users through a GUI (Graphic User Interface}.

The second most common reason for NOT publishing APIs is that the developer of the software or the service wants to reserve all future exploitation of the API-less program or service for himself or herself.  I think my dancing gidgets are so cool that I will be able use them to create a more friendly search engine than Google; so I don’t want Google to use my APIs to incorporate the gidgets in its service.  Or I have a huge investment in the database I built which contains the present location of every iguana on earth.  I’m happy to have people look at this database because they buy iguna-anna from the accompanying ads; but I don’t want other services to be able to use an API to incorporate my iguana data so that they can also attract iguana-specific advertising.

Microsoft has often been accused of having a set of secret Windows APIs that developers of Microsoft Office Applications can use to enhance their applications. The alleged motive for this alleged behavior is to reserve the benefits of these APIs for Microsoft exploitation.  However, Microsoft is also motivated to have third parties develop for Windows.  As far as I know from my time at Microsoft, hiding APIs was NOT company policy. The point is, though, that it is not always a good business decision to allow third parties to incorporate all of the functionality or data that you are providing.

The third major reason for not building APIs into a service is to protect it from misuse.  del.icio.us does not support APIs which would allow other services to tag web content without user involvement.  Why?  Simple: if such an API existed, it would be seized by the spam community to automatically and massively tag websites that want to call attention to themselves.  For the same reason digg wants to be available only to humans, not to robots.  No API for digging.

APIs can be dangerous.  The rich sets of APIs available for Microsoft Outlook made it possible for viruses to raid address books and send infections disguised as email from a known human.  Microsoft now requires human interaction before a program is allowed access to the address book through its API.

When no API is available, developers who want to drive the function of one service from another – for good or bad reason – will often try to do so through the human user interface.  There is a joke that goes “on the Internet no one knows you’re a dog.”  Well, on the Internet, no one knows you’re a computer, either. I can write a program which looks to another program as if it were a human.  It appears to click a mouse and type in variables.  It appears to “read” what comes back.  But it is really another program and its function may well be malicious: it may be misappropriating your iguana data, stealing your gidget functionality, or spamming your folksonomy with phony tags for Viagra websites.

Of course, defenses have been built – antiAPIs if you will.  Sign up for a digg account and you have to prove that you’re a human by picking wobbly letters out of irregular backgrounds – something humans can so far do better than machines.  Many services require that each user have an email account and respond to a message sent to that account as part of the signup process. Unhuman behavior like thousands of requests a minute is often rejected.

Despite the costs and the dangers, my prediction is that the most successful Web 2.0 services will support rich APIs.  Most services only meet a slice of user need. Most users won’t even know about most services.  APIs allow services to be knit together into valuable aggregates.  It is the best of these aggregates that will get the user attention they need in order for their linked together services to prosper individually.

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