Wednesday, December 15, 2010

OpenRTB and Architectural Innovation

I sent out a good number of emails on Sunday asking for opinions on OpenRTB.  People were mainly dismissive, partly because of the secretive way in which it was concocted, partly because some think Google is better accomodated than challenged, but mainly because the current goals of the spec are slight.  After reading the spec, I was a bit underwhelmed myself.  But I've changed my mind.

In a post in April, I talked about architectural considerations in ecosystem design, taking the engineering concept of End-to-End as an analogy.   In that post I was pushing for architectural change because innovation is highly dependent on a layered and modular architecture*.  Architecture is important.

But architectural change is also interesting in determining winners and losers, and that was my deeper motivation.  From a (technically astute) businessperson's point of view, the article to read is Rebecca Henderson and Kim Clark's Architectural Innovation: the Reconfiguration of Existing Product Technologies and the Failure of Established Firms.  They point out that "architectural" change favors innovators over incumbents.

In laying out their thesis, the authors talk about the failures of incumbent firms in adapting to relatively minor market changes, despite their deep expertise in the core components of the new products being built**.  They also make the distinction between incremental change, radical change and architectural change to draw attention to the fact that seemingly minor changes in the architecture of a system are actually more likely to cause incumbent dislocation than radical changes in the underlying technology.  This is an extremely important point.

The essence of architectural innovation is the reconfiguration of an established system to link together existing components in a new way... Architectural innovation is often triggered by a change in a component... that creates new interactions and new linkages with other components in the established product...
Established firms often have a surprising degree of difficulty in adapting to architectural innovation. Incremental innovation tends to reinforce the competitive positions of established firms, since it builds on their core competencies... In contrast, radical innovation creates unmistakable challenges for established firms, since it destroys the usefulness of their existing capabilities...
Architectural innovation presents established firms with a more subtle challenge... established organizations require significant time (and resources) to identify a particular innovation as architectural, since architectural innovations can often initially be accomodated within old frameworks.  Radical innovation tends to be obviously radical--the need for new modes of learning and new skills becomes quickly apparent... the introduction of new linkages is much harder to spot.  Since the core concepts of the design remain untouched, the organization may mistakenly believe that it understands the new technology***.
Dismissing OpenRTB as not being really anything very interesting at all is missing the point.  OpenRTB is not radical change, it barely qualifies as incremental change.  But it is architectural change.  It is the reconfiguration of existing linkages, or the beginning of it

Architectural change is subtle.  It is ignorable, for the time being.  But it may--may--be enough to change the existing architecture, the architecture that is more and more contained within Google.  Those that realize this and adapt to it will prosper.  Those that dismiss it--either because it is too subtle or because they are a large incumbent and ignore those who profess to compete with them--might find themselves Xeroxed.

There's a subtle belief in our VC-backed community that technological innovation is the sine qua non, the ne plus ultra.  Build a better mousetrap and the world will beat a path to your door.  Unfortunately, we're wrong.  Build a better technology and the incumbent will copy your innovation: they will notice a better technology pretty quickly.  What we need to do is change the competitive dynamic by shaping the architecture of the ecosystem.  This is something we can do without the permission of the Incumbent, and something the Incumbent will have a hard time responding to.

OpenRTB is just as start.  But the more new linkages we can create in the ecosystem, the better chance we have to compete based on merit.

* An overview of this argument and its consequences was brought to my attention by Brad Burnham somewhat after I wrote about it: Internet Architecture and Innovation.  I want to say that this book is really excellent, because it looks like it, but I haven't had the time to do anything but flip through it yet.
** I am not in love with their chosen examples.  In both cases the lower-cost/lower-functionality disruptive (as in Innovator's Dilemma disruptive) element is also present, so as natural experiments they leave something to be desired.  Christensen, in fact, draws heavily from Henderson's work in his book--IMHO, more heavily than he seems to admit.  His description of this paper, in Dilemma, mentions their thesis primarily as a study in organizational structure.  Christensen then talks about "value networks" instead of architecture--and Dilemma is an essential read--but I think Henderson and Kim's work is more directly to the point here.
*** Read the article, really.  The case studies alone are worth it (and might give some comfort to those of us who despair at the ever-incipient chaos in our little sub-industry by highlighting that this is not something we managed to invent ourselves but is, in fact, normal.)

Wednesday, December 8, 2010

Old Style vs. New Style VC

Wrote a comment over on David Lerner's blog on his "Are Super-Angels Extinct" post. He said

What I am saying is that some of these superangel funds may structurally resemble traditional VC funds, but they are something altogether different- and more akin to an angel group.
My comment was that structure matters.  If you set up the Red Cross just like a bank, with the same incentives, they would have caused the Panic of 2007.

Maybe it's just two different world-views.  I've thought about this and written about it for a long time.  My take is that if you want to create a better venture capital system, you need to change the system, not just the people.  Calling yourself a super-angel and saying you are different does not change the investing world.  Changing the processes and structures of the investing world will change the investing world.  There are firms (and super-angels) doing this.

In the spirit of changing the game, some "old-style" and "new-style" comparisons:

Old-Style New Style
Money managers Company builders
Organized like a law firm Organized like a start-up
Generalists 'T-shaped'
Managing $1bn Managing $25mm
Living on management fees Living on expected future carry
Scaling by hiring more partners Scaling by being more efficient
"Loose lips sink ships" "You should read my blog"
Going to NVCA meetings Going to the R Meetup
Joining Angel Investor groups Writing $25k checks
Starting an owned seed fund/ incubator/ hackathon Supporting a grass roots effort
Sports jackets Kicks
Networkers Community builders
Lawyers Series Seed
Participating preferred Straight preferred
51% 15%
LPs measure success by: IRR LPs measure success by: IRR

Saturday, December 4, 2010

Coinvestor Graph Code

I've had a bunch of people asking for the data behind the coinvestor network map and a few asking for the code.  It's actually pretty easy to generate the basic graph from the Crunchbase API.  The hard part was cleaning the Crunchbase data, augmenting it with some other data sources and then making sense of the resulting graph.

But even so, the skeleton code is below. It will get you started. Then take a look at the raw output of Crunchbase's API. Play a bit with NetworkX and note that you can tag any node or any edge with whatever data you want. Then go create your own! If you find anything interesting, let me know.

# Crunchbase to NetworkX network builder
# Builds a network from the Crunchbase database and outputs it in graphml format.
# Required modules:
#    simplejson (
#    networkx (

import urllib2, simplejson as json, networkx as nx

def getCBinfo(namespace, permalink):
    api_url = "" % (namespace, permalink)
    return json.loads(urllib2.urlopen(api_url).read())

def add_clique(G,investors):
    # Take a set of investors and add them to the graph, along with edges
    # between them all. Where an edge already exists, increment its weight.
    l_inv = len(investors)
    if l_inv > 1:
        # add nodes
        for inv, typ in investors:
            G.add_node(inv, inv_type = typ)
        # add edges
        for i in range(0,l_inv-1):
            for j in range(i+1,l_inv):
                if G.edge[investors[i][0]].has_key(investors[j][0]):
                    G.edge[investors[i][0]][investors[j][0]]['weight'] += 1
    return G

# Main.
# Get the list of companies Crunchbase has data on
company_names = json.loads(urllib2.urlopen("").read())

# initialize Graph
G = nx.Graph()

# Iterate through companies, getting CB data on each
for company in company_names:
        co_info = getCBinfo('company', company['permalink'])

    # For each company make a set of all investors
    investors = set()
    if co_info.has_key('funding_rounds') and co_info['funding_rounds']:
        for iround in co_info['funding_rounds']:           
            for investment in iround['investments']:
                for i_type in ['financial_org','person','company']:
                    if investment[i_type]:

    # Add investors and edges between them to the graph
    G = add_clique(G,list(investors))

# Write the network to a graphml file /projects/cb_graph.graphml
# NetworkX supports many other formats as well, check the docs.

Thursday, December 2, 2010

Co-evolution and other housekeeping

A couple of weeks ago I wrote something for AdExchanger's 'Predictions for 2011' series. It needed to be brief, and I wanted to talk about what entrepreneurs will be beta testing two years from now.  I made a couple of observations that are pretty obviously true and then ventured this prediction:

Towards the end of [2011], the smartest entrepreneurs will start thinking about how to reinvent the core platforms to better support the needs of the best emerging applications. A dynamic similar to the software/hardware co-evolution of the '70s and '80s will begin, creating similar strategic opportunities.
I actually think this is a pretty tame thought, but once John published it people starting asking me what I meant and how it's actionable.


I should talk about what I'm thinking generally, though.  I've been pretty quiet since the Summer and where I used to be tightly focused on the data-driven web-based display-ad exchange ecosystem, I'm now a bit broader*.

1. In web-based display I've continued my 2010 push on the publisher side of things.  In addition to my investment in MetaMarkets--who are doing some pretty astounding things--and advising PubGears, I've got another pub side investment that should be announced anon.  I'm still looking for others doing something unique here, but to some extent I feel like these three companies are building 80% of what's undone in getting publishers back their negotiating leverage in a data-driven world.

2. The only other pieces of the web-based ROI feedback loop that I articulated in February that remain unaddressed are the piece at the marketers and the piece at the individuals.  I am still actively looking for companies in the former.  I've met a couple of really exciting ones and am working with them to get to launch-readiness, but want to meet more; this is a big area.  I'm trying to figure out what, if anything, could work at the latter.  I would have invested in Hunch, had I the opportunity back then, but I think there are other ways to address the consumer side of the people-product matching problem.

3.  Social may be one.  The social loop will share superficial characteristics with the display loop, but it's really completely different.  A softer, more subjective approach is needed. IMHO, the area with the most near-term leverage will be tools that help communicators understand the impact of how they are communicating and then help them make better decisions.  I've made an investment here that will probably also be announced anon.  I'm treading carefully in other areas of social because I've seen a lot of ideas imported from the display ad world rise and plateau: social is different and harder to scale.

4. Mobile.  In addition to my long-ago investment in Pinch Media (now Flurry) I've made an investment in a geo-data startup.  This one has not announced publicly, but it's a big idea.  Other than that, again I'm treading carefully.  Steve Jobs' reaction to Flurry earlier this year is an example of why: no matter where you invest in mobile, you're at the mercy of some pretty ruthless gatekeepers.  That said, it's exciting to think about how much value startups could add through the mobile platform.

5. Data is a big problem.  And, to be clear, it's been a big problem for a long time so it has some big and expensive solutions sold by big and slow corporations.  But the companies that are bringing data-munging solutions into the reach of smaller companies operating without teams of specialists are pretty interesting.  I've been trying to get a feel for the process, on a small scale, as my last couple of posts show.  But I've got a lot to learn before I even begin to feel competent.  (If you have something to teach me, I'll buy lunch.)  I want to find companies that can democratize data science.

6. Respect for the individual.  I think about this a lot.  I don't talk about it a lot.  It's a difficult area and using a rational thought process on something that's pre-rational in our makeup is tough.  I haven't been able to organize my thoughts, so I have no idea how I support the value-creation process.  But it's always there in the back of my mind.  I am open to suggestions.

So that's what I've been doing and thinking.  Points 2 through 5 will probably continue to be my focus through most of 2011.


In terms of the AdExchanger bit, here's what I was getting at.

At IBM in 1988, in meetings to discuss moving an instruction's execution from the microcode engine to the hard-coded execution engine, I realized that our design team was at the tail-end of a long chain of product-market fit interactions. Because of the way end-users were using applications, applications had changed which parts of the operating system were critical paths, and the operating system designers had come back to us hardware folk asking that certain instructions be optimized for performance.

This was part of a long-standing and ongoing co-evolution between the hardware and the software.  Innovations on the hardware side changed what software was viable.  Innovations on the software side changed what was needed of the hardware.  Read Melinda Varian's intensely interesting VM and the VM Community, where she talks about the development of IBM's time sharing operating system, and think about it as a co-evolutionary process.  IBM in 1964 opened an office in Cambridge as a liaison to the MIT software engineers developing the first time-sharing operating systems.  Because of its proximity to the users, this office was instrumental in pushing IBM to change its mindset from building machines optimized for batch processing to building machines optimized for time-sharing.

During the next few years, both sides--the operating system writers and the hardware designers--pushed the other side to optimize around what they thought was needed or what they could deliver.  The software engineers pushed for address relocation capability and other features needed for time-sharing. The hardware engineers spec-ed a new processor to meet those requirements.  The hardware engineers floated the idea of virtual machines.  The software engineers built an operating system to take advantage of them**. 

Calling this co-evolutionary may be oversimplifying.  In fact, each layer of the stack co-evolved with the adjacent layers.  Sometimes the tension between different layers evolving differently led to entirely new organisms forking off, like Multics (which then evolved into Unix and its descendants.)  This process can happen in any multi-layer ecosystem that has different actors in different layers.

The data-driven display ecosystem is like that.  The tensions between co-evolving layers is evident (AppNexus/Google anyone?)  And forks are emerging.  I expect that within three years there will be a major fork away from the owned exchanges into a crossing platform that can better support the demands of the adjacent layers: the data exchanges, analytics, the DSPs and the SSPs.  Right now none of these are especially happy with what the exchanges are offering.  Not to say that they're unhappy, but they each have a laundry list of things they would improve or change.  The best of them are creating ways to avoid the exchanges, but only because there is no good alternative.  A platform would still be most efficient.

The exchanges, on the other hand, seem to be pretty content with the way things are.  Or, at least, they feel that they should be controlling the pace and direction of the evolution.  This opens the way for entrepreneurs to build something disruptive.  If you're an entrepreneur with the chops to build something here, you should start thinking about it soon.  2012 will be too late.

* No Thanksgiving jokes, please.
** One great anecdote talks about how the early CP/CMS OS could only keep one virtual machine in memory at a time.  So when a user logged on, the OS would reserve space on the paging drum for the copy of their virtual machine while somebody else's was running.  When the paging drum was full, space would be reserved on disk.  Since the paging drum was so much faster than disk, people started showing up to work earlier and earlier so they could get a slot on the drum.  Finally the OS designers made the page slot allocation mechanisms dynamic.  They just weren't morning people.

Wednesday, December 1, 2010

More VC Coinvestment Visualizations

I've always believed that unless you try your hand at something, you can't really appreciate the people who do it well.  That was my motivation in creating the VC Coinvestment Network Map I posted two weeks ago.  And believe me, after munging that together I did appreciate the complexity of the process and the expertise of the people who can do it well.

As a side-benefit, I got to meet and talk to several people in the data visualization/network analysis community.  Drew Conway over at Zero Intelligence Agents was the first, and he put up a visualization of the data that teased out some of the structure that I couldn't find.

Now Linkfluence has put up a visualization that does something different.  It doesn't find the 'bones' of the data, as Drew did, but it allows you to find nodes and interact with them.  Below is a screen shot of my node and its neighbors (i.e. the companies and people I have coinvested with, per Crunchbase and AngelList data as of two or three weeks ago*.)  The screenshot doesn't show my cursor hovering over KP, but that's why their name shows up.  Also, we added links back to the Crunchbase database from each node (some of the people don't have CB entries, but that's a small minority of the nodes.)

It's pretty cool to play with.  Take a look.

* The caveats and filtering I did to the data noted in my previous post still apply.

Wednesday, November 17, 2010

Venture Coinvestment Map

It was a grand plan. I was going to learn all sorts of new things: Pentaho, R, Processing. All sorts of new things. In the end, I got caught up in getting something done and learned none of those things. Again.

Using trusty old Python with the beautiful NetworkX module and the shockingly fast--if a bit rough around the edges--graph visualization tool Gephi, I pulled Crunchbase data to create a social network map of how venture investors coinvest. You can skip straight on down if you want, playing with it is more fun than reading about it (and more fun than learning Pentaho, it turns out.)

I can't believe Crunchbase didn't rate limit me* but most of the data is from their excellent database. I augmented it with info individuals have made available on AngelList. I didn't include any non-public info, even though I know of several excellent angels who didn't make the map because they've kept their activities under the radar.

I then had way too many nodes to make any visualization make any sense. So I did two things: any person mentioned as an investor who was also a venture firm employee was folded into the firm. I also made some fixes I knew of (merging my friend Roger Ehrenberg's IA Capital into IA Ventures, for instance.) I know some venture partners invest as angels outside their firms, but since this is a map of social connections, I think the step not only makes sense, but weights individuals more accurately. (Roger Ehrenberg, for instance, would not get the weight his activities deserve if his investing activity was split among three entities.)

Then, again to make it manageable, I took out any investors with fewer than five investments. Ran it through Fruchterman-Reingold. Colored venture firms red, people green and others (corporates, incubators) blue. Made node size proportional to number of investments.

The result is below, in Some things that stand out:

- The network is incredibly connected. If you go into the "core", where the Sand Hill Road firms are, there are so many edges, they are indistinguishable. Generally, in this visualization, the drawn edges are more or less decorative, because there are too many to have them make sense.

- Because of the dense interconnectivity, there are not many noticeable subnetworks, from 50,000 feet. Here's a map key, such as it is, showing some areas that are distinguishable. The separation between biotech and the core is no more noticeable, to my eye, than that between web 2.0 and the core. I do find that the further I get from my own node, the less I know about the investors.

Map key:

I should note the usual caveats.  Crunchbase data is not a complete record of investment activity, in fact it tends to be severely self-selecting.  I assume both non-US and non-Internet-tech are underrepresented.  I know non-VC investment is underrepresented.  Also, my few fixes are not all-encompassing.  This was a project I had time for because of a couple of long train rides.  I do have the raw dataset (both gephi, graphml and pickled networkx graphs) for the entire network.  If you want them, let me know.

Drag and zoom.  Find your friends.

* Or maybe because I was hitting their API while on the Acela, they figured it couldn't possibly be programmatic. In any case, to my fellow train passengers, I apologize for hogging the bandwidth.

Thursday, September 30, 2010


I think Chris Dixon is one of the smartest investors around.  I co-invested in him when he was an angel and I've co-invested with his early stage fund, Founder's Collective.  But while I generally agree with his recent post on venture investing segmentation, I need to call bull on this:

What we are witnessing now is a the VC industry segmenting as it matures. Mentorship and angel funding are performed more effectively by specialized firms.
It's kind of surprising to me that someone who did such an excellent job as an angel would imply that he really wasn't the best investor for those companies in the first place but, hey, he's entitled to his opinion.  But saying you'd be a better angel if you were a firm is like saying that you'd be a better amateur athlete if you went pro*.  You can't be an angel if you have a fund.  And though this sounds like a semantic argument, it make a real-world difference to entrepreneurs.

What bothers me is the lumping of angel motivation and technique in with the "Super-Angel"/micro-VC motivations and techniques.  The otherwise excellent David Lerner makes this mistake when he says he intends to explicate the angel investing world and then lists, as half his angels, people with funds.  This is a fundamental analytical mistake: taking the average of a bimodal distribution tells you nothing very interesting at all.

There are reasons why angels existed in the first place.  While the lower cost of getting a startup from A to B has changed the dynamics of early stage rounds, it hasn't changed most of the fundamental advantages of having individuals investing their own money: a personal--rather than institutional--connection to entrepreneurs, the ability to make quick decisions, the ability to make decisions that may not seem fiduciarily responsible but are for the greater good, primary expertise in an industry and in company building rather than in money-management, etc.  Most importantly--despite what the Supreme Court may think--firms are not people and they don't, in the long run, act like people.  Angels do.

* While this is the reasoning behind the modern Olympics and many college football programs, it flies in the face of the actual meaning of "amateur" and destroys what makes amateur athletics so appealing. 

Friday, September 24, 2010

It's not about the founders, it's not about the money. It's about what you're building.

I spent my Summer thinking about how I could continue to be useful as an angel investor.  Then this Angelgate thing happened and I can't seem to write the post I meant to write about it.  So I'm writing this instead, hoping to get some thoughts out of my head and move on.  I don't think I'm saying anything new here and this is just a distraction from real work, and I've allocated time as such, so forgive the disjointed style.

1. "Judean People's Front?  We're the People's Front of Judea.  Judean People's front, caw...  The only people we hate more than the Romans are the fucking Judean People's Front."  Every successful revolution is the same, cold comfort though it is, the most vehement feelings are directed towards people working towards the same goals in different ways*.   We're all on the same side and we all want the same thing: more and better startups.

2. Venture investment today is far preferable to every other system of financing innovation we've ever had.  It's not perfect, or even great, but it's far better than what was.  The financing of innovation has improved, in fits and starts, for the last five hundred years.  Think about how the early explorers were funded, think about how the Wright brothers were funded, think about how the second industrial revolution was funded.  For goodness sakes, think about how internet startups were funded fifteen years ago.  The new VC model is better.  The new angel model is better.  Should we make it better still?  Of course.  Should we talk about just chucking it all?  No.

3. It's better for entrepreneurs, but that's not the driving force here.  The entrepreneurs and investors are both bit players in a bigger show.  I tend to disagree with Jon that founders come first, although the why of my disagreement may seem a bit like theological hair-splitting.  Founders don't come first, the idea does.  If a founder thought it was all about them rather than what they were building, I wouldn't invest.  That said, no one works on building something as hard or as smart as the person whose idea it was.  I back ideas, but I believe in founders.  I believe in them because they believe in their idea.  But this semantic distinction leads to a fundamental difference: I'm not doing this to make founders rich, I'm doing it to see good ideas turn into great companies.  When this happens, the founders tend to make a lot of money, but that's a second order effect.

4. Likewise, investors make money.  But startup investors aren't in it for the money: the return on investment is also a second-order effect.  That said, investors need to make money; if they don't, they don't get to invest anymore.  That's true when you invest other people's money, but it's also true for angels.  I have a significant chunk of my money invested or earmarked for startups.  If I lose it, I won't be able to invest anymore.  If I make money, I get to reinvest it.  Not a week goes by when I don't wish I could invest in more companies or invest more in a company that no one else believes in yet.  But not a day goes by when I don't think about the gambler's ruin.

5. Seed-stage VCs are not in it for the money, not in itself.  Angels even less so.  No one on the Forbes 400 list made it there by dint of venture investing.  No one.  [Edit, 9/25/10: Should have checked first... John Doerr and Michael Moritz are both on the list, both by dint of their investment in Google.]  Venture investors aren't robber barons, they don't make the cut.  Think about the economics of a First Round Capital... a fund structured that way won't make the partners much more than minimum wage unless it's one of the top-performing funds in the world.  Any world-class investor would have made a multiple of what they made if they had been a world-class entrepreneur.  VCs have a lower beta, it's in the nature of what we do, but we're all on the same risk-reward curve.  The startup world is a choose your own beta kind of world.  Don't get pissed off when someone chooses a different one.

I'm not defending anyone and I'm not downplaying what happened (whatever did happen... I wasn't there.)  But if one of the guys in that restaurant likes you enough to gives you a valuation, I guarantee you that you can find a less well-known investor who will give you a higher one.  There is no collusion that could affect your outcome.  I doubt there is anyone who believes otherwise.  So I think the anger about this is really a pent up anger about the startup finance system altogether.  I've been an entrepreneur, I've raised money for a startup, and I realize how bad that process sucks, how random and uninformed it all feels.  We have to keep working at and looking for ways to improve it.  But let's not forget that we are all on the same side and we all want the same thing: for startups to have a better chance at success.

* Of course, in this case there's been no anti-bolshevik league-like purges, no ice picks in the back of the head, no duels at dawn in Weehawken.  Well, not yet anyway.

Monday, August 9, 2010

Online Ad Tech Curriculum: Links

[I am going to make additions/changes to the list by editing the post itself.  I think that's better than cluttering everyones' feed.]

A VC friend asked what he should read to better understand the online advertising market.  At the time I thought I could offer some decent advice.  But as I started to think about it I realized that the stuff you need to know to know how this stuff works is scattered all over the place.  Simple things--like a flowchart of how an ad is delivered to someone visiting a site, complete with multiple ad servers, redirects, etc.--I can't find.

So I figured I'd start making a list.  It's nowhere near complete.  In fact, it's sort of off-the-cuff.  I could use some help improving it.  If you were going to point someone to a few resources that would improve their knowledge of the fundamentals--not the news, not the opinion--of the online ad business, what would they be?

In no particular order.

Books and articles:
Randall Rothenberg, Where the Suckers Moon: The Life and Death of an Advertising Campaign (link to Amazon)
The book to read on the messy details of how an ad campaign gets made with all the wacky interplay between agency and client.

Mark Tungate, Adland: A Global History of Advertising (link to Amazon)
The other day someone tried to tell me just how little I knew about the history of the agency world.  Upon pressing him, I learned he got all his info from watching Mad Men.  I told him to read this book.

Dean Donaldson, Online Advertising History (PDF)
A good--if woefully incomplete--history of online advertising.  And the only one I could find out there.  Part of Donaldson's master's degree program.

Kyle Bagwell, The Economic Analysis of Advertising (PDF)
What does advertising do and what is its societal purpose?  Bagwell provides a nice survey of the various academic work over the years.  In the end you might be underwhelmed by how little we know, but there it is.

Demetrios Vakratsas; Tim Ambler, How Advertising Works: What Do We Really Know? (JSTOR link, unfree*.)
If Bagwell is top-down, this is bottom-up.  Various cognitive models of advertising.

Gerard Tellis, Advertising's Role in Capitalist Markets (PDF)
I think it's important to note that advertising is a necessary part of our economic system.  If it were not, it would not be much use thinking about it.

Core Online Ad Enabling Technologies:
Cookies are one of the core technologies used in web advertising., Cookies (PDF)
Flash Cookies Explained (HTML)

Ad Servers:
Understanding ad serving is one of the trickiest parts of understanding the online ad infrastructure. 
Eric Picard, Ad Serving 101, Revised (HTML)
Pointed to this by Ian Thomas, below, but his link is broken.

Why do Publishers and Marketers have Separate Ad Servers? (HTML)
There's more to it than this, but it's a start.

Ad Tags:
Operative's Blog on Ad Tags (HTML)
How to Read Doubleclick Ad Tags and Ad Tag Variables (HTML)

Promotional material:
OpenX White Papers
Pubmatic White Papers
In general I find industry whitepapers to be self-serving.  Doesn't mean you can't learn something from them, though.  These two companies have some informative stuff.

Terry Kawaja/GCA Savvian, Display Advertising Technology Landscape (PDF)
DeSilva+Phillips Online Ad Networks: Monetizing the Long Tail (PDF)
DeSilva+Phillips Ad Exchanges, RTB, and the Future of Online Advertising (PDF)
Investment Bank whitepapers.  When these reports are good, they're invaluable in their industry coverage.

Government Scrutiny:

FTC, Self-Regulatory Principles for Online Behavioral Advertising (PDF)
The Office of Fair Trading Online Targeting of Advertising and Prices (PDFs)
Some of the most informative publicly available industry coverage is in the reports prepared for government agencies looking at whether and how to regulate.

Bloggers are flaky and difficult people who write about whatever they please whenever they please.  Um, present company excepted.  So, instead of plugging blogs, some posts I think are worth reading.  All of these are from bloggers in my feed.  They're not all the bloggers in my feed, of course, but posts specific to this discussion.

Jay Weintraub, Risk, Arbitrage, and The Root of (Much) Evil
Ian Thomas, Online Advertising 101 series
Mike Nolet, RTB Part I (and parts Ia, Ib, II, III)
Jonathan Mendez, The True Media Value Delta
Brent Halliburton, The Chaos of Second Price Auctions
Greg Hills, Shouldn't It be Cheaper if I Buy More?
Darren Herman, Advertising to Audiences

* If you head to your library, and they have access to JSTOR, you can get it for free.

Friday, August 6, 2010

The future of free media

Monday's Wall Street Journal article on cookie tracking was a bit underwhelming. So although (a) we've been having the same conversation over and over again since 1996 without getting anywhere*, (b) the article was a bit misleading and maddeningly vague, and (c) industry rumor has it that the church/state divide at the Journal does not quite live up to the J-school ideal, I am siding with Jeff Jarvis in believing that News Corp is not well enough organized to stage a conspiracy: the article was just poorly done.

These arguments are nominally about privacy. And providing privacy is a worthy but complicated** goal. But given the general level of philosophical confusion about privacy, I believe much of the commentary (and the comments to the commentary) is motivated by a hostility to advertising in general.

If you hate advertising, you hate advertising. Arguing that not paying for music means a diminished supply of quality music does not sway the downloader. Not paying for media--in whatever sense of pay--means a diminished supply of quality media. This argument does not sway the hater of advertising, but I'm not trying to convince them. Advertising provides something important: free (as in beer) media. This may not mean much to Rupert Murdoch--who can afford to pay cash for his media--but it means something to society. And it should mean something to those of us who are trying to find a way to make quality ad-supported online media a viable proposition.

Paying cash for media is regressive. High cover prices exclude those with less disposable income. (This strategy is used purposefully by mixed-model high-end media outlets to produce a demographic appealling to better-paying advertisers.) Advertising democratizes media***. And media allows a democracy.

Online media is suffering. Susan Athey and Joshua Gans say "the adoption of targeting... leads to higher impression prices, higher profits, and higher social welfare." Online media is in dire need of profits, much less higher profits. The alternative to targeting is the pay-wall. The FTC, in thinking about targeting, needs to seriously weigh the regressive impact of limiting advertising against the opinion of news outlets like the Wall Street Journal, who have consciously set out to exclude those who don't have a spare $363 per year to spend on something they can get elsewhere for the nuisance cost of seeing a few ads.

* i.e., The Financial Times, February 12, 1996, "This Bug in Your PC is a Smart Cookie"; and San Jose Mercury News, February 13, 1996, "Web 'Cookies' May be Spying on You."
** If you can quickly and simply articulate what privacy is and why it is important, I will quickly and simply point you to a counter-example. Privacy is not a single thing, it seems more like a bundle of things, so it defies easy analysis.
*** A fact evidenced by laws compelling certain content to be aired "free." This content, naturally, is usually sporting events, but that's a rant of a different color. Hansen & Kyhl "Pay-per-view broadcasting of outstanding events: consequences of a ban" talks about the EU directive of 1989.

Tuesday, July 6, 2010

Startup R&D has replaced corporate R&D

I have a problem with Yves Smith's and Rob Parenteau's op-ed in the Times:

Over the past decade and a half, corporations have been saving more and investing less in their own businesses... Since 2002, American corporations on average ran a net financial surplus of 1.7 percent of the gross domestic product—a drastic change from the previous 40 years, when they had maintained an average deficit of 1.2 percent of G.D.P. ... To show short-term profits, they avoid investing in future growth...
Smith and Parenteau evidently believe that since 1995 corporations have spent less on R&D, stifling innovation.   But, on the face of it, there has been plenty of innovation since 1995.  What gives?

Steven Kaplan and Josh Lerner say in their recent It Ain't Broke: The Past, Present and Future of Venture Capital:
Beginning in the early 1990s... American corporations began fundamentally rethinking [internal R&D facilities]... relying much more heavily on what has been termed "open innovation," i.e., alliances and acquisitions of smaller firms... venture-backed firms are approximately three times as efficient in generating innovations as corporate research.
Corporations are spending less on internal R&D.  But this is because internal R&D is far less efficient than buying venture-backed companies.  Smith and Parenteau forget that Savings = Investments.  When a corporation saves money, it invests it somewhere else.  Sometimes in something innovative.

Smith and Parenteau recommend
[Creating] incentives for corporations to reinvest their profits in business operations... impose an aggressive tax on retained earnings that are not reinvested within two years...  At the same time, the federal government must continue to encourage investment in the economy—ideally by creating incentives for investments in national priorities, like new energy technologies. 
This is exactly wrong.  Corporations should save money or distribute it to their shareholders to save.  That money should be turned into investment in innovative new firms that the corporations can later acquire.  And as to the government steering investments: if corporate-backed R&D is three times worse than venture-backed R&D, I can't even imagine how bad government-directed R&D is.

More investment does decrease consumption in the short-term*, and this is a problem during a downturn.  But because investment increases income growth, it increases the opportunity to consume longer-term.  It might well be that this is the wrong moment in time to encourage savings over consumption, but to create a policy that would discourage more productive investment for years to come makes absolutely no sense.

* GDP = private consumption + gross investment + government spending + (exports − imports)

Thursday, June 24, 2010

The last days of the ad exchange

Darren Herman wants a conflict-free ad exchange. So do I. We assume there could be one because we look at the much bigger and more efficient financial markets and see they are run on exchanges. But, in reality, the financial world has moved on from exchanges, and so will the ad world.

An article of faith: markets inevitably evolve from inefficient middlemen/arbitrageurs to efficient, transparent and fair crossing platforms. From Bazaar to Exchange. And then they live happily ever after.

But wait, consider this: of the buy and sell orders UBS handles in NASDAQ-listed stocks, it sends less than 5% to an exchange. The rest it internalizes (the infamous "dark pool"). That is, UBS matches buyers and sellers of stocks amongst their own brokerage customers.

Brokerages avoid exchanges. Instead, these days they tend to either be market-makers, internalizing as much of their trading as possible, or sell their order flow to third-party market makers, like Knight Trading*.

Internalization allows brokerage firms to minimize exchange fees, keep the bid-ask spread for themselves, and avoid giving information to competitors. Internalization does not provide transparency and fairness, like an exchange does, and that is part of its draw for the market-makers. Putting your orders into the exchange, where everyone can see them, is like a poker game where everyone else can see your cards. Exchanges level the playing field, and if you're smarter than average, you dislike level playing fields**.

Exchanges were the best way to minimize transaction costs when communication was cheap but computing power was expensive. That time is past.


All the major ad exchanges are now owned by some of the biggest online media companies. AdX: Google. RMX: Yahoo! AdECN: Microsoft. They are no longer open markets, they are internal markets. As Yahoo! turns off Invite Media and everyone else contemplates the same, the media companies start to look like silos. Google's acquisition of Invite is the final clue. Invite is their e-Trade, the customer UI that allows easy access to their inventory. Whatever audience you're buying, Google can find it in their content network. So can Yahoo!, to an extent, and Microsoft and AOL and FAN and Akamai. If they don't happen to have an audience in house, they will buy order flow by subsidizing publishers to come into their content networks. Each of these companies can internalize all orders that come to them. They will not interoperate*** and they do not need to interoperate.

By internalizing, these media companies get to keep the transaction costs and keep their market activity quiet. They also get benefits that the brokerage houses aren't allowed--because the brokerage houses are regulated--like pushing their own inventory even if there is a better deal for their customer somewhere else.

How this will play out: the major media companies will each buy or build DSP-like capabilities to allow data-driven access to their inventory. They will build out their network of publishers so they can fulfill any audience request internally (internally here meaning either their own inventory or that of their enfiefed publishers.) At that point media buyers will be faced with an array of relatively undifferentiated media companies to buy from, each offering to best place the media buyer's ads in its own audience.

Sound familiar? This was exactly the situation of the media buyers four years ago, vis a vis the ad networks. We have taken our two steps forward and are now taking one back, to a closed world where media sellers protect their margins by obfuscating what they are selling. Not with the complete opacity of the ad networks, but through the inability of buyers to learn because they are kept apart from the data and segmentation that guides their buy.

Media buyers need to figure out how they can hold their own against the big media company market makers. They need to build, buy or closely partner with a DSP, one that is direct connected to all the large media companies and pub brokers, and lets the media buyers have their own proprietary data, algorithms and results.

Tomorrow's online ad buying world will look a lot like yesterday's, only with more technology.


Prediction without predictions is just prattle, so here are some:
  1. There are not enough DSPs to go around. I count maybe ten indies that have technology up and running. A few more in the works that I know of. There are at least twice as many companies that will need to build or buy one. I don't expect more than two or three of the current indies to still be independent in 18 months.
  2. Yahoo! will realize it needs to buy order flow. It will bring in some premium ad networks to provide audience balance in RMX by buying or partnering.
  3. Direct connection between DSPs and pub brokers/publishers will proliferate, producing much fail among the technologically naive.
  4. Third-party ad exchanges will stop calling themselves that and start calling themselves what they are, pub brokers.

We've had a lot of innovation in the last five years. It's starting to worry the entrenched players. Their reaction is to move us from innovation to integration. There is some good in this: allowing audience buying, dynamic optimization and RTB at the major media companies is a big step forward. But there is a lot of bad also. There is still a lot of innovation that needs to happen, especially on the optimization side. And the publishers that aren't big enough to be market-makers themselves are going to be even worse off than they are now.

An independent ad exchange--really a private crossing network with a clearinghouse function--needs to exist. It will allow innovation to continue outside of the spotlight. But it needs to rise up organically from the industry, because there's no money to be made, no exit. The New York Stock Exchange was formed as a cooperative by a group of brokers who needed interconnection and interoperability. They didn't support it because they thought the entity itself would be valuable, they did it to make their own businesses more valuable. What we need now is our very own Buttonwood Agreement with the same aims and similar methods.

* A brief survey of the market microstructure issues around internalization is here. But read it for its discussion of transparency.
** The leading proponents of the recission of NYSE Rule 390 in 2000 were the big brokerage houses. Cynical voices said this was because they were also the largest investors in the ECNs. But it seems obvious from a remove that the investments in the ECNs arose from the same cause as the desire to get rid of 390: the desire to trade in private.
*** This is where the financial services analogy starts to fall apart. The big market-makers interoperate not just through the exchanges but through ECNs and private crossing networks. The reality of financial markets makes this necessary. There is not, at this stage, and won't be for some time, the same need for interoperability between, say, Google and Yahoo!

Tuesday, June 15, 2010

Fiddling while Rome burns

I read Curt Hecht's AdExchanger interview this morning with puzzlement and, eventually, horror. Vivaki is drawing the precisely wrong conclusions from their evaluation of the situation.

[re Invite Media] Google realizes it's for the DFA stack, away from media, and they appreciate that it works just like search bid management or serving ads. It's a good thing for the industry that they're taking the interoperable view... I assume they'll eventually put them on the Google Stack, but for the time being we just want to keep progress going the way that it has been... I think [re the Invite Media acquisition] it's great that what you're seeing is some consistency where Omnicom and InterPublic Group... they both have come out supportive and positive.
If I'm reading this right, Vivaki thinks that Google wants a position in display like they have in search. Also, that Invite is not about media (I infer that it must, therefore, be about data.) And that even though Google is talking interoperability now, they will eventually integrate Invite into the rest of Google (making interoperability problematic, to say the least.) Oh, and they seem to think this is all peachy, and say that everyone else in the industry thinks so too.

This is why we can't have nice things.

For the sake of argument I'll grant that the agencies and their holding companies might not have been able to anticipate Google's dominance of search ads in the '00s. But let me nip future arguments in the bud: Google is trying to lock up display like it did search. Now you know. You're going into this particular battle with 20/20 foresight. If you do something stupid here, you've got no one to blame but yourself.

Google is a publisher and ad network. They make almost all of their considerable profit from people buying their ad inventory or that of their content partners. When any other piece of the value chain starts to look vaguely powerful, they commoditize it by buying and subsidizing someone who provides that piece. Urchin, Feedburner, Android, Teracent and (not yet subsidized, but mark my words) Invite Media.

In the short-term Vivaki will have lower costs. In the long-term the complement that will be commoditized is Vivaki. I know talk of disintermediating the agencies is as old as the DARPAnet, and I am usually one of the scoffers*. But this time it's different, for one important reason: data.

Google says that they are going to keep Invite as a separate entity. This is bull, as even Vivaki admits. The 2010 strategy du jour is to say one thing then do the opposite, and Google is a master of it**. Invite Media will be integrated with Google, and when it happens, a self-reinforcing cycle starts.

Brian Lesser said last week "we believe in the importance of proprietary technology to ensure the integrity of our client’s data... Every buy that an agency sends through a DSP makes that DSP smarter." If Google gives Invite access to the effectiveness and cost data from AdSense and GCN, Invite will have more data than anyone else in the business, by a long shot. By having more data, they can become more effective targeters, which will give them more market share, which will give them more data. This feedback cycle of proprietary learning will make it impossible for anyone else to compete in the market for targeting services. And Vivaki and the rest of the industry*** will end up as non-strategic customer service reps for Google's media planning and buying solution.

In fact, treating Invite as if Google's promise to leave it stand-alone were true is a mistake for everyone in the industry. It's easy to see, despite Neil Mohan's sweet-talking, that every DSP has to assume that each of their orders on the Google ad exchange will get seen by Invite. It's difficult to invest in novel strategies when you know your competition will see them in real-time. Almost everyone else in the industry has similar problems, or just the awful problem of potentially dealing with a single supplier/customer.

But the conundrum the other exchanges have is the most interesting. Vivaki implies that Microsoft is psyched about the Invite acquisition. That's ridiculous. The integration of Hotmail inventory and AdECN into Invite is not a result of Microsoft wanting to work with Google. Integrations take time, so this one certainly started (and was probably complete) before Microsoft even knew about the Invite acquisition. Moreover, while Microsoft has proven itself to be a difficult political environment for ad companies to thrive in, the people there are not stupid, not by a long shot. And being excited about giving your nemesis access to your trade secrets would be very, very stupid. The same is true of Yahoo! and AOL.

Because when Invite is integrated into Google, it seems reasonable to assume that Google will:
  1. Start cherry-picking the other exchanges' best publishers; and
  2. Start front-running the other exchanges, keeping the demand for themselves****.
By giving Invite access to their marketplaces, Microsoft, Yahoo! and AOL give Google access to data about position and price of every ad that runs through them. They would be giving Google the very data it needs to outcompete them. If the other exchanges allow this, they won't for long. Because if they do, they won't be in business for long.

Darren Herman said to me "it's like we're paying Google to take our business." It would be one thing if companies lose to Google because Google just flat-out does things better: there's no crying in baseball. But the game's barely started. Keeping progress going the way it has been is the wrong strategy. Recognize the threat and respond.

* When entrepreneurs tell me "if the agencies don't adopt our technology the agencies will become irrelevant," I say "if the agencies don't adopt your technology, then you will become irrelevant." The agency owns their customer, the marketer, and they are good at and jealous of that ownership.
** Google's switch on mobile phones and Apple's bait-and-switch to app developers are two recent examples.
*** I was a little puzzled by Hecht taking everyone else's lip service on the Invite acquisition at face value. While everyone I know is still pondering what it means, no one is really fully on board. Of course they say they are, but when was the last time you heard a holding company executive (Martin Sorrell the exception proving the rule, as always) say anything revealing? For what agency execs really think, read Darren Herman's post on Dart and Atlas.
**** It's widely rumored in the industry that Google has a double standard in exchange pricing between people buying through Google's user interfaces and people buying through the exchange API. If Invite is an insider, it shouldn't surprise anyone if they get preferred access.

Wednesday, June 9, 2010

Google/Invite acquisition

I know plenty of people who know the facts, but none of them will talk*. So I'll just tell you the rumors.

Invite Media was acquired by Google last week. The initial guesses at the purchase price were in the $60 to $70 million range. Peter Kafka now says it was $81 million in cash. The rumors I heard were it was $60 million guaranteed and up to $40 in earnout. Kafka probably has better sources than I do.

Rumors as to revenue and earnings were all over the place. Guesses I heard ranged from $25 million in billings last year and a net revenue margin of 25%, to $50 million billings run-rate and a 10%-15% net revenue margin. The company, rumors say, had recently started to turn a profit.

So, I'm guessing the acquired revenue (real revenue, not billings) was in the $5 - $10 million range. If this is right, then the acquisition was done at a 10x-20x net revenue multiple. My best guess as to multiple is 17x run-rate net revenue**.

This price, though it may seem low to people in the tech community, is incredibly high for people in the ad agency business. For purposes of absurd comparison, during the height of the .com bubble, Razorfish never traded much above 25x revenue. And at that point the people in the ad business (and every other rational person) were selling shares, not buying. Even for rapidly growing online agencies (including SEMs), prices are rarely above 2x-5x net revenue.

The difference is that ad agencies are hard put to create explosive growth (hiring all those people takes time.) The multiple paid for Invite suggests that Google believes huge growth, and scalable growth, are going to happen in the next year or so. This is good for valuations, because the revenue multiple will fall over time, but the companies will grow faster: future valuations will be higher than Invite's.

In addition to being optimistic about the value of other companies, I'm also optimistic for two other reasons. First, I believe that Invite had not yet reached the point where what it had learned was enough to reliably predict how to buy media that would be more effective. When that happens, the game changes. And second, there are fewer quality companies out there than there are companies that need to own one.

There are some concerns with Google/Invite also, but I'll blog about those later in the week.

* Ironically, if I had a single piece of non-rumor information, I wouldn't write this post.
** I get there by backing into expense run-rate from number of employees and typical compensation--which is much lower than their NY competitors--and assuming they are just starting to make a profit.

Tuesday, June 1, 2010

Is it worth trying to 'improve' advertising?

I wrote something for AdExchanger today. John asked me whether media and data should be bundled. I said, at the end of a bit of a rant,

[We] need a bit more idealism. We need to be trying to make the world a better place. We need to move beyond our defensive posture of being a necessary evil to the actual fact of being an indispensable part of the modern economy. If what we're doing is less about convincing people to buy things and more about helping people navigate a complicated world, then innovation will emerge from all corners.

Becoming an ad network may be inevitable for many of today's companies. But it means our segment of the industry gets absorbed into the rest of it and most of what we've invented disappears. I would never tell any of the companies I've invested in or work with to forgo viability for a principle, but I think we should all be urgently asking each other "how can we make this round of innovation a base on which to build further innovation?"

Okay, so yeah, maybe I hijacked the question to make a point. Here's the point:

Advertising and economic growth are correlated*. Yes, yes, correlation is not causation, and I'm not making a claim about causation, I think that would be silly. But, OTOH, absent some plausible explanation to the contrary, I assume that advertising is a crucial ingredient in making economic growth work. If this is true, then doing it well is more important than the small size of the industry would make it seem.
* Sorry, bad chart, no time. Real ad spend per capita left axis, from Douglas Galbi based on Coen numbers, Real GDP per capita, right axis, from Louis D. Johnston and Samuel H. Williamson, "What Was the U.S. GDP Then?" MeasuringWorth, 2008. URL:

Thursday, May 27, 2010

Why isn't Columbia part of the entrepreneurial community?

I was at a conference about a year ago and listened to the head of tech transfer of one of New York's major universities say "We're doing a great job. I don't think there's anything we could possibly be doing better." And he actually seemed to believe it.

I had a bit of culture shock. The last time I had heard that sort of complacency, it was when I worked at IBM in the late '80s (see how that turned out!) Since then I have worked at professional services companies and in start-ups. That sort of attitude at either would be quickly fatal.

Stowe Boyd notices that Columbia and NYU do not have the sort of relationship with the New York entrepreneurial environment that Stanford does with Silicon Valley or MIT does with Cambridge. I couldn't agree more.

Stanford (and Berkeley, I was reminded yesterday by an alum) has birthed companies all over Silicon Valley, from HP to Google. They are key drivers of the community there. And it's no accident that the global hub of biotech is in the few blocks surrounding MIT.

I have degrees from both Columbia and NYU, and have a soft spot for both. But when I approached Columbia back in 1998, backed by a seriously large corporation, hoping to create a funnel for potential entrepreneurs into Silicon Alley, I was stymied by disinterest. I probably could have made it work without the university's cooperation, but, really, I had better things to do with my time. I tried again in 2003/2004 with similar results. Maybe I was just talking to the wrong people. But, then, no one else seems to have made much progress either, at least as far as I can see.

Columbia* then and now, it seems, is more interested in the money coming from a patent than in providing an enhanced community for its alumni and a better economic environment for its host city. NYU is not nearly so bad, hiring people like Clay Shirky and backing places like NYCSeed. But even they are nowhere near as engaged with life outside the academy as Stanford or MIT. It's a frustrating thing, and I wish I knew what I could do about it.
* The institution, that is, not necessarily the people in it. I hear tell of individual professors trying to steer bright students into entrepreneurial endeavours.

Friday, May 21, 2010

Taxing carried interest is nothing but a political circus

I should start by saying that because of the idiosyncratic nature of my thirteen years of venture investing, I've never been paid a carry. And, since I'm now a country gentleman, cutting the brush and tending the horses over here in bucolic Hoboken, I probably never will be. So maybe I'm uniquely qualified to give an opinion on the carried interest taxation issue, being neither fish nor fowl.

That is to say, I don't have an interest in how this turns out. But I do happen to dislike the political circus, the populist sop that our leaders trot out to convince us they are actually solving problems when all they're really doing is nothing.

Fred Wilson says, "someone has to pay the taxes to keep our troops equipped, our borders secured, our schools modernized, and our children healthy. It might as well be me and my wife."* So why do I think taxing carried interest as earned income instead of capital gains does precisely nothing?

The tax code has a certain mathematical beauty that rebels against the alchemy of turning capital gains into labor income just by decreeing it. So, while we could tax Fred on his carry at ordinary income tax rates, this would not, unless a whole lot else was changed, increase the revenue of the US Government by much, if at all.

Why? Because if Fred's firm paid him a salary instead of a cut of the gains, he would pay ordinary income tax rates on it sure, but (since VC firms are pass-through entities) it would be deductible to the firm's owners, the LPs**. To understand this you have to know how an LLC (or any "pass-through" entity) works. The LLC, when it has income or losses, reports them to its owners and the owners report their share as income or loss on their own tax returns. The LLC pays no tax, its owners pay all the tax. Also, the LLC does not just send a net profit number to its owners as the taxable amount, it sends a report of each item--ordinary income, capital gains, interest, ordinary expenses, etc.--and the owners slot each item into the appropriate spot on their own tax return.

So if a VC fund had a $100 gain, it reports now an $80 cap gain to its owners and a $20 cap gain to the people running it. The total tax take is $100 times the capital gains rate. If carried interest were considered ordinary income (i.e. salary), the fund would now report $100 in capital gains to its owners, a $20 salary to the people running it and, note this!, a $20 ordinary loss to its owners. Total tax take would be to first approximation capital gains rate times $100 plus ordinary income tax rate times $20 minus ordinary income tax rate times $20. For you ad folk who haven't done algebra since 11th grade, that equals exactly the amount being taken by the government now.

Of course, in this example, Fred pays more, but his LPs, big financial institutions and wealthy individuals in many cases, pay less. The VCs pay more and the the Money pays less.

If this is a question of fairness, as Paul Kedrosky implies, then let's talk about fairness***. Here's a scenario:

I start a company. I own all of it, since I started it. I raise $20 million in participating preferred with a ten-year redemption right at a $5 million pre. I now own 20% of the converted equity in the company. I use the $20 million to invest in other startups. Voila, I am a venture fund.

Simply by starting a company I have the same economic and tax characteristics as a venture fund, without any mention of a carried interest. In this sense VC funds are like any other startup. This illustrates that the same fairness argument being applied to VCs applies to entrepreneurs. Founders and VCs don't invest capital in their ventures but they both pay capital gains. No capital at risk, no capital gains treatment? If that's "fair" for VCs then it must be for founders, right? Be careful what you wish for.

To be clear, neither founders nor VCs "deserve" capital gains treatment. Neither founder's equity returns nor carried interest is a gain on capital, both are gains from labor****. Our society has tolerated treating these as capital gains because we want to encourage the activities. Personally, I think we should encourage both entrepreneurship and venture investing. Especially if it's merely a question of deciding how the same amount of taxes paid should be distributed between the VCs spending their not-especially remunerative lives***** trying to help people start companies and the Money that they're investing for.

* As an aside, I think we could pay more for the two of these I support by cutting the two I don't. But that's neither here nor there in this argument.
** And noting that many LPs are tax-exempt does nothing for me. In this case, where talent and not money is the scarce resource, I believe the tax incidence will fall on the owners of the firm, not the people running it. This is probably the source of the juggle of who pays what in the first place.
*** Which is a fuzzy thing to talk about anyway. The only cogent philosophical arguments for levels of taxation I have ever heard are exemplified by Nozick and Marx. The one thought it should be zero and the other thought it should be one. I've never heard a moral argument for 15% or 35%. These are maximum efficiency arguments.
**** Why does capital get treated better than labor anyway? Not because, as Fred avers, it deserves it. Rather, it gets better treatment because it's more mobile. Higher rates here than in Bermuda? Money moves to Bermuda. Higher ordinary income rates here than in Russia? People don't move because of that (unless you're extremely wealthy.)
***** See point 6.

Monday, May 17, 2010

Information and Markets, Pork Chop Edition

In The Omnivore's Dilemma by Michael Pollan, a thought-provoking book, I came across this.

The fact that the nutritional quality of a given food (and of that food's food) can vary not just in degree but in kind throws a big wrench into an industrial food chain, the very premise of which is that beef is beef and salmon salmon. It also throws a new light on the whole question of cost, for if quality matters so much more than quantity, then the price of a food may bear little relation to the value of the nutrients in it ... As long as one egg looks pretty much like another, all the chickens like chicken, and beef beef, the substitution of quantity for quality will go unnoticed by most consumers...
Sounds like Akerloff's information asymmetry to me.

I have in the past conflated this type of information asymmetry, where lack of knowledge of quality drives high-quality items out of the market, with Gresham's Law, where a government requirement to accept unequal things as equal (such as silver and gold coinage) drives the more valuable out of the market. My bad. In both cases the bad drives out the good, but for different reasons.

Pollan's book, in addition to the above Lemon problem, also cites what I think is an example of Gresham's Law: the USDA definition of the word "Organic" conflates many farming practices but none entirely, allowing the least-common-denominator to appropriate the word in the marketplace. Perhaps this sort of informational hollowing-out is inevitable in marketplaces because of information friction. But what happens when information friction comes way down?

It's interesting to think about the different possible trade-offs:
[M]any consumers don't aim for such purity — particularly if they know that the meat is being raised ethically and in an environmentally sound manner. Many hog farmers raising animals according to various “natural” standards have found that customers come back once they learn about the practices each farm employs, even if they are not certified organic.

The 12-year-old Niman Ranch uses a network of small farms certified by the Animal Welfare Institute. They may feed hogs nonorganic corn, but otherwise meet USDA organic standards, said Paul Willis, a founder and director of pork for Niman Ranch, and the extra expense isn't worth the “piece of paper” that would certify his farming practices.

He compared his Iowa farm — a 20-acre pasture on 900 acres and 2,000 hogs — to an industrial farm down the road that has 6,000 pigs inside a building of no more than a couple acres. He composts pig manure on his fields, unlike his neighbor, who pumps thousands of gallons of liquid waste underground, where it can leach into the Iowa River.

His customers know his standards, and buy even [though] he doesn't have the “organic” label. “I guess,” Willis said, “it comes right down to how much of a purist you want to be.”

Niman Farms has invested in a brand name to communicate its practices to its customers. But the cost of building a brand is more than the cost of being organic, so many farms decide to be certified Organic instead. This is the marketing tradeoff: build a brand or commoditize.

The alternative, letting the customers bear the expense of finding a product that matches their particular needs, is too high: the vast majority of customers in most markets have such a large overlap of requirements that search costs are more efficiently borne by the seller.

But online, the search cost is the expense of tweaking the buying algorithm. This argues that, unlike many traditional markets, online markets should supply more information that can be used to determine quality and less commoditization.

Other posts in this series:
Information and Markets, 1
Information and Markets, 2
Information and Markets, 3

Wednesday, May 5, 2010

Hitting the tropopause

A mature cumulonimbus reaches the tropopause and, unable to rise higher, spreads into the characteristic anvil.Some of us old-timers are feeling a bit uneasy. My friend Seth is having flashbacks and reliving Q1 2000. I long ago overcame my own PTSD, embracing my dot com bubble grief after being repeatedly compelled to recall the events in excruciating detail by various lawyers and accountants (ah, the joy of working for a big company.) But I have my own reasons for unease, perhaps no less from the gut than Seth's, but disguised as usual in analytical trappings.

Years ago I was having drinks with a Wall Street friend when the bar TV announced that the Fed had lowered interest rates. The talking heads excitedly averred that this was a good thing. My friend scoffed: "They don't lower rates to make things better, they lower them because they think things are going to get worse. What does the Fed know that this buffoon doesn't?"

Every action is a reaction, a compensation for something else. Google and Apple are acquiring companies left and right. The linked article attributes this to competition between them, but what does this mean? Why are they competing with each other in the first place? No one (aside from the free-thinking Henry Blodget) seems to be correctly attributing this.

When companies anticipate growth in their core business flattening, they start to move outside of their competencies. When there are huge opportunities, companies go deep, become expert at what they do, and need to partner with others to provide complete solutions to customers. When they start to see opportunity becoming limited, they go broad and try to lock up adjacent markets*.

The general path of a new industry is (1) a profusion of new companies, each commercializing some aspect of a quickly-growing technological domain, and then (2) the consolidation of these technologies under a few roofs. This consolidation is not necessarily acquisition; technologies do not always need to be acquired, sometimes they are just replicated. The signal aspect of this consolidation is not an acquisition binge, but a move from cooperation to closed.

Thus Google shows its insecurity. As does Apple. And Twitter and Facebook.

Blodget, linked above, explains how Google has started to exhaust its opportunity in search. It makes sense for them to move into other markets (display, mobile, social, office apps) to compensate. This is an easy case to make**.

Apple, though, is the darling of Wall Street. Everything they do has been gold. They conquered music and mobile in short order. Now they're trying to move into TV/print with the iPad and advertising with the iAd. There's a case to be made that, with the knowledge gained with iTunes and the associated music sales, TV/print is within Apple's ambit. But advertising is a stretch. Failure here is not only a possibility, but likely***. Apple doesn't know advertising****.

Why would Apple take this gamble? Because they are scrambling for avenues of growth. That they don't see future growth in their core businesses is what troubles me, contra Seth. And that they think there may be growth to be found in someone else's business is not really all that comforting. Google thought it could get growth from Wave or Buzz. You don't know anything important about businesses you're not in.

That this panicky scramble for growth should hit Google and Apple is natural, given their size and their domination of the the markets in their respective primary growth engines. But Twitter is doing the same thing. So, it seems, is Facebook. Their actions say that they think the time for growth through innovation is past, the time for controlling as much of their market's profitable opportunities has come.

So, this is my unease. Have we reached that point already in the growth cycle? I don't think we need to wait for this decade's AOL to buy this decade's Time/Warner to ask "what gives?", if you were around ten years ago, you're probably asking it already.

* Allyn Young, in his 1928 speech "Increasing Returns and Economic Progress", said

Much has been said about industrial integration as a concomitant or a natural result of an increasing industrial output... But the opposed process, industrial differentiation, has been and remains the type of change characteristically associated with the growth of production.
Or, as David Warsh interprets Young in his Knowledge and the Wealth of Nations:
Such integration seemed to be a function of maturity. A young and growing industry dis-integrates; that is, artisans leave established firms and go into business for themselves, supplying several competing firms with components. There are spin-offs, breakaways, start-ups.
I think this is right even though it is, qua Young, a bit of a non-sequitur*****.

** Although, IMHO, they are moving too quickly to limit their display platform, shutting out
before critical mass is reached companies that would cooperate to build it to critical mass.

*** Just as it was in music and mobile, of course. Hindsight being what it is, these things may now seem inevitable, but they certainly weren't. Just because something pays out doesn't mean it wasn't a gamble.

**** The New York Times quotes Steve Jobs as saying, re their complete lack of knowledge of the agency side of advertising: "TBWA [has] been instrumental in helping [us] navigate an unfamiliar business." To anyone in the ad business, this is an extremely suspect statement. The TBWA folk are some of the very best in the world at making ads, but they are not advertising business strategists. There are a lot of people who could give extremely good advice on entering the ad business, but the guys who live and breathe making the ads aren't on the list. It's a completely different conceptual level.

To be expected because, since Warsh doesn't write footnotes, we have reason to doubt his seriousness. Serious people write footnotes. Like this one.

Thursday, April 29, 2010

A picture worth significantly less than 1000 words

As an aside to yesterday's post, here's the mental model I am using for the industry this week.