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.

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* 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.

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.

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* 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.

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.
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* Sorry, bad chart, no time. Real ad spend per capita left axis, from Douglas Galbi based on Coen numbers, http://purplemotes.net/2008/09/14/us-advertising-expenditure-data. Real GDP per capita, right axis, from Louis D. Johnston and Samuel H. Williamson, "What Was the U.S. GDP Then?" MeasuringWorth, 2008. URL: http://www.measuringworth.org/usgdp/

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.
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* The institution, that is, not necessarily the people in it. I hear tell of individual professors trying to steer bright students into entrepreneurial endeavours.

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.

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* 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.

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.

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

Hitting the tropopause

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.

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* 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.