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.

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

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.

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* 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!

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.