How humans' ability to conceptualize and capitalize on gains from trade leads to economic and societal progress:
Working from the in-laws basement this week and took a little retreat time to watch a few TED.com videos. If you want to get blown away by things like dialing cell phone by touching your fingers or seeing if you flight is on time by looking at your boarding pass, this is for you. (And I am really not doing this justice...) It's interesting that Mistry talks about bring the computing world into the objects world. His concept, to me at least, is bridging the gap between reality and the virtual world.
On the business side of life, there's been an active discussion this weekend about a new initiative led by the National Association of Realtors called the REALTORS® Property Resource (RPR) which is designed to provide a national property data exchange for agents to provide to clients. Yes, snooze-fest if you're not in the real estate industry. Our CEO does an excellent job describing the RPR project and its affect on the real estate industry.
On a personal level, the current industry discussion reminded me of a recent TED presentation by Tim Berners-Lee on Linked Data. As described on the TED website:
20 years ago, Tim Berners Lee invented the World Wide Web. For his next project, he's building a web for open, linked data that could do for numbers what the Web did for words, pictures, video: unlock our data and reframe the way we use it together.
Just a quick plug for our work at Altos Research. Mike Simonsen, our CEO, was interviewed on FOXBusiness News this week with a focus on potential bright spots in the US Housing market. Always cool to see our little shop get some national exposure. Here's a link to the video interview. (There's a short commercial as with all videos - just a quick 15 seconds then to the good stuff....)
With the launch of Google’s new browser – Chrome – I can’t help but consider one of the basic laws of market economics:
Monopolies are good.
Back in 1997, strategy+business published an interview with Paul Romer, a Stanford economist that has been a leader in the development of new growth theory. In the article, Romer discusses how the possibility of monopoly gives incentive to the private sector to innovate new products, so that they may corner the market for a period of time and generate increasing returns on investment.
About that time (in 1997), Microsoft was considered the dominant software company and expected to run the computer world for generations to come. Since then, it's endured tremendous pressure from its destruction of Netscape and ongoing anti-trust battles across the world. I refer to Microsoft, because in the last decade we’ve seen Google emerge as the new leader of the information age. In leveraging their search engine technology and other innovations, they’ve launched Google Docs and Google Spreadsheets to compete with Microsoft Office. Their search has reorganized the way the companies build websites and deliver content. With the release of Chrome, Google is hitting Microsoft head-on in the web browser arena where Microsoft had the assumptive monopoly less than ten years ago.
From October 2007 through August 2008, the Windows operating system has gone from 92.5% to 90.6% market share, with Mac and Linux slowly creeping up. This 2% doesn't seem like alot, but ask Microsoft if they're worried. (Internet Explorer has lost 6% market share during this same period.)
Recently, Firefox nabbed 17% of the browser market and Safari grabbed another 6% according to Market Share. With Chrome now reported to have 1% of the market in just 24 hours, it seems that the monopoly is less than so nowadays.
Going back 20 years to the mid-1980s, Microsoft was the young, nimble company targeted the entrenched monopoly of the terminal computer. Seeing a pattern here?
No company, especially in the IT industry, is safe from competition. This is what drives Silicon Valley and the world to build the better mousetrap. Ten years from now, you'll be reading about how Google’s dominance is fading because of some other new emerging leader. Ten years is just a single business cycle in economic terms. While monopolies appears to exist, they don't last very long. That's why companies strive to acheive them, protect them, and maximize on them, because they know that they are fleeting.
Capitalism works if you let it breathe.
Over the last couple of weeks, I've been intending to comment on the recent report released by VCExperts released in June regarding trends in venture funding in Q1, 2008. The graph below illustrates some of the key data from the report. The labels of A, B, etc. refer to the Series Round of Financing.
Given the overall volatility of the stock market, perhaps potential suitors are sitting on the sidelines and taking an inward focus to developing operational strength and cash flow rather than seek growth through acquisition. Stock market volatility also appears to affect the number of IPOs filings, with only 13 IPOs filed in Q2, 2008 compared with 56 filed in Q2, 2007 (sourced from the Hoovers IPO Scorecard). Renaissance Capital's IPO Index is showing a -5.2% return over the past 1-year period, with year-to-date returns at -17.8%. It's just not a great time for IPO exits if you're a VC-funded company. (Of course, the DJIA is at about -10% YTD and the NASDAQ is about even so far YTD...)
In December 2007, a National Venture Capital Association (NVCA) press release reflected some bullish sentiments by venture capitalists, with "59 percent of the venture capitalists are predicting further IPO market recovery." I found this optimism particularly interesting given the counterview outlook illustrated by the USF Venture Capital Confidence Index. The most recent update released on July 9, indicates that VC confidence has fallen to an all-time low since establishing the index in 2004. Wish these VCs could make up their mind....
One factor in this trending may be the ongoing movement of venture capital. Data from PWCMoneyTree provides sufficient evidence that venture capital is falling into later stage investments over the long run, as discussed in an article back in March.
I'm guessing the truth is somewhere in between...
I spent the day today at the Hotel Kabuki in San Francisco, serving as a coach to aspiring young entrepreneurs and companies in developing their "elevator pitch" and venture capital presentations during the University of San Francisco International Business Plan Competition.
Although the competition is a compilation of student-led groups that have been vetted at previous competitions, I wasn't quite sure what to expect.
As one of the coaches, I worked with Judith McGarry of Keen Consulting and A.C. Ross of Indigo Partners (and a few other colleagues) to listen to five student group presentations and then provided advice on how to tighten things up. Judith consults with firms seeking venture funding, and clearly understands Silicon Valley and what it takes to get funding. Her breadth of knowledge in numerous industries is striking. A.C. is a Silicon Valley veteran with vast experience on the strategy consulting side of the equation.
We watched presentations about software for the nanotechnology industry, online men's shopping, product development for emerging economies, online media, and HDTV. After spending the day, my observation is that some people are just more prepared that others.
The creme always rises to the top. The most interesting and compelling of the day - the presentation that turned into an collaboration session - was Project Einstein out of MIT. Couple of guys that are launching a men's clothing online shopping site with a strong Web 2.0 flavor to it. I think they have a chance! The presenters, Bob Meese and Will O'Brien, were very well-prepared and have clearly thought through the concept realistically. Their concept hit home as I remembered my painstaking afternoon in Macy's a couple of weeks ago trying to find the right casual shirt and sportcoat for my Spring wardrobe... Nice job guys, and good luck!
To check out this company, and all of the others in the competition, the semi-final and finals are open to the public. Check out the schedule and stop by - worth the price of admission for sure!
Over the last couple of years, Yahoo! has been on a perpetual shopping spree in recent years – acquiring social media and social networking companies to boost its status in the Web 2.0 world.
18 months ago, a Business Week article by Catherine Holahan – “Yahoo’s Strategy: Growth By Acquisition” – supported Yahoo’s strategy, promoting the relatively low cost of these acquisitions. In 2006 for example, Yahoo! acquired Del.icio.us for about $20 million. Smaller acquisitions of maturing start-ups put Yahoo! in the position of a late-stage venture capitalist – pick a portfolio of seemingly good bets and expect that a couple of them will pop. Not a bad idea if you're flush with cash and need some new products.
That was then, this is now. More recent acquisitions are well above venture capital money - Blue Lithium for $300 mln, Zimbra for $350 mln, Maven Networks for $150 mln, and Right Media for $680 mln. As I wrote in a previous article, it seems that Yahoo! gave up cash for a goodwill asset on the balance sheet. More importantly, Yahoo! appears to have become a quilt of media companies, Web 2.0 technologies, and social networking tools that hardly generate revenue.
Back in January on TheDeal.com, David Shabelman suggested that Yahoo! consider more acquisitions - possibly of Monster.com, Expedia, and Shutterfly (among others). At some point, Yahoo! seems almost addicted to acquisitions as if the next one will be their saving grace or missing piece to the puzzle.
Shabelman also suggested that Yahoo! might combine Right Media and BlueLithium and spin out the combined company as an IPO. To break even on the acquisition costs of these two companies, the IPO proceeds would have to exceed $1 billion. To provide some perspective, Vision China’s (VSIN) IPO hit the market at about $544 mln in late 2007 and Digital Domain (DTWO) is scheduled to hit the market at $72-84 mln. This isn’t exactly a thriving IPO market for technology companies.
Corporate finance maneuvers of acquisitions, spin-offs, and juggling won't save the future of Yahoo! I have more thoughts on this, especially when compared to Google’s ability to grow its business more organically through innovation and development. Stay tuned for more….
Supporters of America’s H1B visa system argue that firms such as Microsoft and Google (both opposed to the existing system) should simply send these jobs overseas by expanding their current operations in places like China and India. The problem with this argument is that it does not follow economic logic.
There are several economic factors that influence the ongoing development of technology-based industries in the United States. These factors further support the position that the H1B Visa system should be significantly restructured (or abandoned altogether).
1. Agglomeration Economics – As firms in related industries (“clusters”) work in relative proximity to each other, several positive effects are felt:
--> The overall cost of production is reduced because of the increased competition of suppliers and the greater number of firms consuming production inputs. This includes such items as laboratory equipment, software, hardware and other necessary production inputs to developing new technologies .
--> There is an increase in the number of innovations through implicitly shared knowledge.
--> Positive externalities develop - that is - the number of “knowledge spillovers” occur.
These economies of scale and externalities cannot be artificially manufactured by establishing a research park in a foreign country. Economic clusters are complicated organisms that have evolved over time. The organic systems resulted from years in response to market dynamics and locational factors.
2. Labor is not the only factor of economic production. Capital – meaning machinery and related technical equipment - is also a major factor. (Together, Capital and Labor compose the basis of the Cobb-Douglas Production Function upon which economists such as Robert Solow, Greg Mankiw, and Paul Romer have based parts of their research.)
Collect a labor pool of scientists with PhDs from the best universities in world and put them together in Siberia with no research and testing equipment. Their output of new innovations will fall to negligible levels. This basic fact creates another significant advantage to economies such as the United States, and more specifically places like Silicon Valley, that have an inherent base of both private, public, and education sector research and development facilities.
3. Enforceable property rights legislation and intellectual property protection in the United States support research and development better than other developing nations. Countries such as China have a well-documented global reputation for poor enforcement of patent and copyright laws. The ability to develop a new technology and maintain a monopoly on their innovation and idea provides the necessary for profit-maximizing firms to operate. Economies that do not protect a firm’s ability to maximize its profit are not adequate environments for technology firms to effectively operate.
4. And finally, the proximity to a market where the developing firm will be likely to sell whatever technologies it develops plays a role. Technological innovations are likely to be adopted and integrated into the world’s most developed economies first, then eventually trickle down to lesser developed economies. Because firms seek to minimize costs and maximize profits, it makes good business sense to develop technologies in countries where these technologies will be purchased and utilized.
The United States’ comparative advantage in technology industries requires that it be supported the best and brightest global minds regardless of the individual’s country of origin. Without such support, our economy runs the risk of unintentionally developing other “technology clusters” manned by scientists and researchers in other countries. The end result could be the loss of our comparative advantage and our leadership position as the world’s innovator.
The single best solution to maintain our technological leadership is to leverage the privilege of living and working in the United States to attract foreign workers. This labor competition will also pressure the domestic workforce to increase its knowledge and capabilities, resulting in a more effective, innovative labor force.
It’s interesting when talking to start-up CEOs and entrepreneurs how often they are enamored with landing venture capital, as if receiving the funding itself is their main business objective. Venture capital is the beginning of any start-up's journey- a vehicle to speed product development, expand market reach, and grow the firm more rapidly than what would be possible through self-funding from revenues. Venture capital is never the destination.
Just remember the VC's rough equation:
10 investments = 7 failures + 2 breakevens + 1 successful exit
You're one of ten - there's a better chance that you're one of the future failures in this model than the successful exit.
Just as bankers provide small business loans to firms that meet their expected rate of return hurdles, venture capitalists invest in start-ups that offer the opportunity for them to meet their own capital growth goals. This is not philanthropy. One rarely hears an entrepreneur express delight for their pending small business loan from their banker, yet closing a round of venture capital is met with valedictory celebration.
In many ways, it would seem logical that the bank loan should be the capital event to spark celebration at a small business, since the bank only wishes to be compensated with interest payments, instead of preferred shares. Of course, most start-ups don't fit the lending criteria of most banks - this is illustration is meant to offer some perspective.
Certainly venture funding is vitally important to fill the investment gap between angel investors, private equity, and traditional lenders. The start-up entreneur should just remember that there are two sides to any transaction. If a VC is willing to invest $5, $10, $15+ million in your biotech, software, or patented technology, that money will come at a cost. Be sure to weigh the cost/benefit of the transaction before considering venture capital funding to be the end game.
(There's some solid reading and perspective on venture capital and angel investing at The Smart Startup).
I get the social part of it. I just found a friend of mine from high school, spent 10 minutes with my wife perusing pictures to put on my profile, and even reviewed 20 results for “Sambucci” including two in London, one in Glasgow, and one in Ecuador. I don’t get the 100x revenues to determine its $15 billion valuation.
Facebook’s foray into tracking member purchases went awry. Advertising dollars reach their ceiling quickly unless you’re Google.
The Facebook marketplace is less than overwhelming. There are 2598 items for sale in Silicon Valley, CA at the time of this posting. When I click “For Sale", the first page results include a 5"x5" cheese cake for $50, Oracle SQL/DBA Training for $360, and a 2007 Hybrid Ford Escape 4WD for $26,000.
Huh?
A marketplace is a place of aggregation where economic activity transpires. On the Internet, eBay is the typical example - an established marketplace with buyers and sellers. Defining the market more loosely, the same occurs when someone uses Google or another search engine to find a product that they eventually purchase. Members join Facebook for social networking, not to directly engage in economic activity.
With no indications that Facebook’s revenues are rising exponentially, it’s likely that direct revenues Facebook will generate for itself will remain relatively low compared to the true online marketplaces like eBay (~ $7 bln in 2007) and Google (~$15+ bln in 2007).
If this is indeed true, they why use Facebook’s revenues as the metric for valuing the company (currently at 100x revenues according to Microsoft’s recent investment)? Maybe there’s a more accurate way…
Let’s assume that because I’m a Facebook member, I meet up with a long lost high school friend in New York City and have dinner. It’s fair to assume that this happens frequently with many Facebook members – connecting with friends either directly or in part because of Facebook – which results in economic activity of some sort taking place (a $100 dinner in this case).
By taking this approach, we can then begin to connect a certain amount of economic activity attributable to Facebook. Some members are “power” users and others are more cursory like me. But overall, there is likely some average amount of economic activity per member that can be measured. Economists use “mulipliers” to calculate these “down line effects” of some event or activity. (In fact, the consumption multiplier is the rationale for the recent tax cuts approved by Congress and President Bush.)
If we can quantify these economic activities per Facebook member, then why not use a “Facebook Multiplier” to determine the firm’s value? This multiplier is not related to the revenues of Facebook. Instead, the newly-created revenues of other market participants as a result of Facebook existing become the determining factor to establish Facebook’s economic value to the market. Using the multiplier establishes a true intrinsic value for the firm, not an arbitrary market value as was done with Microsoft’s investment in Facebook.
This proposed multiplier may indeed show that Facebook’s firm value is indeed 100x revenues, but not because we use Facebook’s revenues as a basis for arriving at the valuation. Instead, Facebook is valued based on its contribution of total economic activity. This multiplier can be justified going forward because of the lock-in effect of Facebook, and possibly the growth of the multiplier as Facebook members utilize Facebook more frequently.
This creates a clear divide between Facebook’s economic value (its contribution to the economy as a whole) and its shareholder value (market value). To the displeasure to future Facebook shareholders, the multiplier approach values Facebook on the total revenues that it creates in the general economic, not revenues that it collects as a participant in the market.
The result? Facebook’s economic value is different than its market value. In fact, its economic value is greater than its market value. We assume that shareholders value a firm based on future earnings due to them as a part owner of the company. Shareholders that purchase shares of Facebook based on the market valuation of $15 billion established by Microsoft will be sorely disappointed if the firm’s personal revenue growth of Facebook remains at its current level.
In the end, I’m not contesting that Facebook is worth $15 billion. It could be even more than that. I just disagree that Facebook’s market value is $15 billion. The firm may hold an economic value of $15 billion with the resulting multiplier effect, with the market value falling far short of this number.
(Also consider that perhaps Microsoft established a $15 billion market valuation for Facebook to artificially inflate the market price to other would-be suitors…)
Caveat emptor.
[Author's note: A new article on this blog regarding Google employee retention is also available.)
A recent Wall Street Journal article - "Start-Ups Make Inroads
With Google's Work Force" has many people in the technology and business community clamoring with regard to Google’s innovation and employee retention challenges.
Google has long been a source of personal interest, stretching back to 2000 when I was first introduced to the website by a business school professor. What most intrigues me about Google is its culture of innovation and development. I organized a tour of Google for an executive MBA cohort from Kyiv-Mohila Business School in 2005 and obtained brief exposure to its corporate life.
In reading the WSJ article, I began to think about Google’s innovation strategy from an economic point of view, and found the following “Equilibrium Innovation” model in a textbook sitting on shelf (stick with it - it's not as complicated as it looks!):
Where:
CoI = Cost of Innovation
PVI = Present Value of Innovation
LR&D = Amount of Resources devoted to R&D
g = Innovations/year
B = Amount of resources needed to create an innovation
(Source: Van Den Berg, Hendrick. “Economic Growth and Development,” c. 2001, McGraw-Hill. Page 216.)
PVI is a function of the monopoly profit (π), discount rate (r), and LR&D/B.
CoI is a function of the price of resources (w) and the amount of resources needed to produce an innovation (B).
This graphical model shows that as more resources are dedicated to R&D, the “Cost of Innovation” increases and the Present Value of Innovation decreases. In economic terms, the CoI curve is the “marginal cost curve” and the PVI curve is the “marginal benefit curve.”
So how does this relate to Google and its innovation strategy?
An article printed in the July 10, 2006 edition of BusinessWeek , considers the success rate of Google’s innovations – citing that the success rate of new products at Google is below planned corporate levels.
According to their 2006 annual report, Google anticipates “that research and development expenses will increase in dollar amount and may increase as a percentage of revenues in 2007 . . . because we expect to hire more research and development personnel and build the infrastructure required to support the development of new, and improve existing, products and services.”
In order to maintain the innovation growth rates of previous years, say from 2002 – 2004, Google is looking at a HUGE expenditure if it considers this investment in R&D in a per employee basis. Employee counts at Google have risen tremendously in the past 3-4 years, from approximately 1500 employees in 2003, to 3000 in 2004, to 7000 in 2005, to 11,000 in 2006.
Going back to our model and considering the R&D and infrastructure costs on a per employee basis, this equates to a potentially substantial rise in the Cost of Innovation (CoI), especially as labor markets remain competitive during the current period of economic growth – leading to a higher price of resources (w) and the increasing amount of resources necessary to create an innovation (B). As CoI shifts upwards, the number of innovations will ultimately decrease.
Regarding PVI, increases in B will contribute to a lower PVI. Additionally, as innovation occurs more rapidly, the monopoly profit that Google will receive for their innovation will decrease because new innovations will overtake the usefulness of current innovations (Joseph Schumpeter and “creative destruction”). These factors will shift the PVI curve downward, further decreasing the number of innovations produced.
If we couple two factors:
1. The effects of shifts in CoI and PVI due to higher overall innovation costs; and
2. The appearance of Google’s “shotgun” approach to innovation
the net result is slower innovation and development within the company.
If Google has had a penchant for hiring those unique individuals that want to innovate, incubate, and develop new ideas but their internal structure inhibits employees from doing so, this may explain the reported move of employees to new companies and start-ups.
Launch Silicon Valley was held last week at the Microsoft Mountain View campus on June 4-5. I was pleasantly surprised by the turnout of both entrepreneurs and venture capital representatives.
Of the presentations that I attended, the Digital Media group was the most interesting to me. The presenting companies included - EyeJot, fix8, SnapJot, Yodio, and Catalog Data Solutions. The boom of applications becoming available for Web 2.0 and the influx of user-generated content was quite remarkable. Since working with Aplia four years ago, the model for USG has changed dramatically. This is obvious given the boom in personal network pages and You Tube, but it was compelling to see new companies continuing to emerge with alternate approaches to the market.
However, one aspect of the companies and presentations at Launch Silicon Valley noticeably absent was a clear explanation the sales and revenue models of their companies. Some companies appeared to integrate a mention of - "we are a SaaS model, charging a monthly subscription fee" - but few of them that announced this methodology provided a clear picture of how the revenue process would occur. In many cases, I found myself contemplating whether or not these companies had truly considered the revenue model aspect of their business, or were wed to a cool, new technology, excited about its creation and were operating over the assumption that "build it and they will come." It was an eerie flashback to 1999 in some cases. Of course, this outlook may be the product manager/business developer in me that is overlooking the fact that the presenting companies were almost exclusively operating on angel capital or bootstraps, but then again . . .
