Thursday, January 12, 2006

Notes From Silicon Valley

I recently went on a three day trip to Silicon Valley with a group of Columbia Business School students. There were about 25 students in total - first years, second years, and an assortment of executive MBAs. Over three days, we visited the following companies: Google, Yahoo, Ebay, Apple, HP, Intel, SAP and LinkedIn, in addition to attending a panel of VC's and a morning meeting with a few former Cisco execs who are now running a startup chipmaker. The trip visits generally comprised a brief intro to job/internship possibilities by an HR person, then about an hour of talks by various executives at the company, often Columbia alumni.

Below is my take on the trip. There is quite a bit of editorial commentary. Take it with a grain of salt. Also, I don't believe that I am betraying any statements that were made on an implied off-the-record basis, and if I do, I apologize.

Geography & Background

What is perhaps most fascinating about Silicon Valley is how pedestrian the location is. Geographically, Silicon Valley is basically the collection of towns along Highway 101, which runs from San Jose northwest to San Francisco. Palo Alto (home of Stanford) is roughly in the middle.

Highway 101 has about as much going on as the highway connecting Seattle and Tacoma - i.e., not a whole lot. It basically looks like any other highway connecting a series of office parks; only those office parks happen to be home to some of the most interesting companies in the world, whose collective market probably runs upwards of a trillion dollars. It speaks well of the dynamism of Silicon Valley, in particular, and the United States economy, in general, that Ebay, Yahoo, and Google didn't exist 11 years ago and now they are global giants worth hundreds of billions of dollars.

A terrific journalistic history is Silicon Boys and Their Valley of Dreams by Robert Kaplan. Although it was written in 1999 and does not cover recent events, it's a great read.

General Impressions
The companies seemed exactly like one would expect based on accounts from the general press, and each very much seemed to reflect the personality of its CEO/Founders. I was a bit surprised at the extent to which this was true. If a sparrow falls at Apple, Steve Jobs knows it. And not just from an operational standpoint, either. A minor example: after we met folks at Apple, we went to the Apple Store on the campus for ten minutes of shopping. It was around lunchtime, so someone arranged for a cart of sandwiches to be brought in. The head recruiting guy, who had been around Apple for awhile, saw this and asked for them to be moved outside and said, quote, "If Steve sees this food in here, I will be out of a job." I had the feeling that he was not really joking.

Silicon Valley as Racket
Silicon Valley is a money machine and in some ways resembles a gigantic racket. I say that mostly in admiration.

An example (and while I might have some of the details slightly wrong, the basic story holds):
We heard the two founders of a chipmaking company speak on a panel. Each of them had worked at Cisco for a number of years, one guy as the head of a department there. While they were at Cisco, they identified a technology that the company needed but was not going to develop itself. They left to form a startup, with backing from Cisco. They developed the technology, and eventually sold the company back to Cisco for a heapload of money (the acquisition was lead by the guy's former boss). Around and around we go; these guys were on their third company. A classmate on the trip had worked at Cisco for a number of years and told me this kind of thing happens all the time.

That makes sense to me from a rational business perspective, but the possibilities for subtle (or not-so-subtle) corruption seem large. For instance, what if the Cisco guy was on the board of the startup, and perhaps had a large slug of options in the company? While I am sure that Cisco and other companies have policies/rules against this, it all seems very cozy.

Google
One of the great business juggernauts of all-time, the place is obviously full of legions of formidably smart people. Their stated modus operandi is "to throw a lot of stuff against the wall and see what sticks", and their culture is perfectly set up for this kind of "let a thousand flowers bloom" mentality. That being said, the very rapidity of its rise is going to cause some problems over the next few years.

Will Google collapse under its own weight?
It will be interesting to watch at Google is the ability of the organization to absorb its massive and rapid employee growth. The number of employees at year-end has done the following over the past five years: 284 to 682 to 1,628 to 3,021 to roughly 6,000 in 2005. That is a massive influx of people - how many companies have ever grown that quickly? The specifics of its business aside, this presents an immense organizational problem.

Bureaucracies aren't bureaucracies because they are full of bureaucratic people - bureaucracy is an emergent function of large organizations. This was readily apparent to me when we visited Intel and Hewlett Packard later in the trip. I am sure that both of those companies had cultures similar to Google when they started, but coordinating the actions of over 100,000 people (or even 10,000 people) is inherently a cumbersome process, especially without a mature infrastructure.

Google, as an organization, appears not to have come to grips with the fact that this is even an issue. One of the senior project managers who presented boasted of how Sergey and Larry had personally approved each of the 3,000 or so employees who were hired in the past year. When I went up to her afterwards to ask her about the possible bottlenecks in a Sergey & Larry, Inc, model, she replied, literally, "Well, they will work longer hours." She then went on about how Google was a "learning organization" that was able to rapidly grow and respond to problems. My impression is that the place is almost entirely run by Larry and Sergey - every single project is run across them.

This is not an inherently bad thing - just that Google is still very much in a honeymoon phase and is going to have some serious growing pains in the next few years. It is like the brilliant kid who graduates from Cal Tech at age 15. While the kid will do very well, at some point his lack experience and maturity is going to bite him in the ass, hard.

What are the issues caused by the stock going so high, so fast?
Another interesting thing to watch will be the secondary effects of the rocketship stock price growth. Google's market cap has gone so high so fast, and this will have an effect on recruiting hotshot engineers who want to get rich.

To illustrate:
Microsoft went public in 1986 with a market cap of roughly $700m. The stock price compounded fairly steadily (at roughly 60%/year) for the next 15 years, to a high of around $500b in 2000. (It is now at roughly $290b). That steady rise was a very good thing for its employees and for the general stability of its workforce, as those who joined at any point between 1980 and 1995 and stayed did very, very well. And because the stock continued to rise at a steady pace, there weren't enormous gaps between people who joined in, say, 1988 and 1992.

Google, on the other hand, went public at a $24b market cap and now is roughly at $130b. While this is very good for the early investors and employees, it's a very bad thing for recruiting current employees who want to get seriously rich. Google's market cap is not going to go up 20x from here. Most of the Google centi-millionaires have already been minted. While the company has a ton of money with which to compensate its employees and is currently the hot place to be for seriously talented software engineers (the lifeblood of the company), these types of people have others options whose financial lures will become greater over time. Of course, Google will acquire many of those startups, but it will face competition in doing so.

People tend to forget that Google is an advertising company
While it sometimes seems to get lost in the hullabaloo over the stock price, Google makes 99% of its money from advertising, (the business model was originally to license its search engine to other sites, something which it still does, although the money pales in comparison to the advertising revenue. It stumbled upon its current model out of desperation, as it was running out of money in 2001.) In looking at the new products, the fundamental question to ask is, "How will this help Google make more money from advertising?". Robert Cringeley, a seasoned and very tech-savvy Silicon Valley reporter, has written quite a bit about this and I highly recommend his weekly column. A neat feature and good grounding exercise for investors is that he has archives going back to 1997. Remember Prodigy? (Bonus points if you knew that it was originally a joint venture between IBM and Sears.)

Betting against Google would be insane
On the advertising sales side, Google has recently "verticalized" into twelve different areas and is hiring lots of ad salespeople to get out there and beat the bushes for business. One of the biggest barriers to Google's growth (and internet advertising in general) is not the technology, but convincing marketing people at various companies that they should switch their ad spend from television to the internet. This is inherently a slow process, as there is a great deal of inertia in the advertising industry, and the tens of thousands of people who work at ad agencies and ad production houses have, let's say, a vested interest in sticking around. This is very good news for Google, as it means there is plenty of room to still grow - internet advertising still accounts for only 5% of all advertising spend, roughly equal to Yellow Pages spending in 2005.

For all of the talk above about how Google is going to hit some speedbumps, it is sitting fat in the middle of a $220 billion marketplace that is massively inefficient and just starting to shift online, and it has built a better mousetrap. A much better mousetrap. Betting against this company would be insane.

Checking job postings is a good method of competitive intelligence.
On a related note, one executive on the trip mentioned that a good way to do competitive intelligence and figure out what a company is up to is to look at the job postings on a company's website. Simple, yet very effective.

Minor architectural comment
Google and Yahoo both have "zany" campuses - with outdoor volleyball and primary colors galore. They look more like Romper Rooms on steroids than corporate headquarters. From an architectural standpoint, I don't think these are going to age well. Ebay's HQ in San Jose, on the other hand, is a bit more understated and should stand the test of time. But maybe that's just my snooty East Coast bias talking.

Yahoo
The company seems like, well, a burgeoning, media conglomerate of the future, with its eye firmly focused on grabbing more and more user time and fees and advertising dollars. Good job, Terry Semel!

I like where Yahoo is going with the heavy incorporation of social networks/tagging (Flickr, Delicious...Youtube?). I think this will prove to be a very smart direction to head.

Ebay
Ebay feels like a fairly mature place. Meg Whitman worked at Proctor & Gamble and as a strategic consultant prior to joining Ebay, and she has clearly hired people in that image. That is not meant as a knock. Ebay clearly understands network effects very well. For anyone wondering what the company is up to (like why they paid $2.6b for Skype), they put out a Powerpoint presentation after the Skype acquisition that pretty clearly explains their strategy.

It is intesting how dominant Skype is across the world - it is the VOIP leader in almost every country, and the United States is actually the market where it is least dominant, by a large margin. They go through it in the presentation, and personal anecdotal evidence from talking with international students at school confirms it.

Skype cellphone?
Thought: Say it's 2007 and WiMax is broadly deployed (roaming broadband internet access), or some equivalent. What is to stop Ebay from making a Skype-friendly cellphone? All else being equal, I would rather not pay Verizon $600 a year. Are there major technical hurdles that I am missing?


There was an engineer at the Ebay talk, a guy who used to work at Microsoft, who spoke to a few interesting topics.

Why hasn't Ebay entered Classifieds more aggressively?
I asked him why Ebay hadn't attacked the classified advertising space in the US more aggressively. After all, this space is right in Ebay's sweet spot, it has already made significant related acquisitions in Europe, and the U.S. landscape is still very fragmented. He said that the Craigslist acquisition had a lot to do with their holding back.

He indicated that Ebay had hoped it would be able to pull Craigslist into it fold, and had been frustrated that it had so strongly resisted this. And, given the relationship, Ebay had been somewhat wary of immediately launching a direct competitor, although this resistance was fading. This was surprising to me.

To review the history:
Ebay picked up a minority stake in Craigslist in mid 2004 (25% for $10m), purchasing it from an early employee who Craig had given stock to way back when it was still a garage project.

I have read a number of articles about Craig Newmark and I met him once, briefly, at a panel discussion. He strikes me as the absolute last person in the world who would ever sell out or change his ways for a financial carrot. If Craig wanted to be a billionaire, he could be one tomorrow, with or without Ebay. That Ebay would think it would be able to commercialize Craigslist in any way, without owning a controlling stake, strikes me as naive. And to the extent this move delayed their entrance into the marketplace by a few years (enough to give Google Base an opening), it was an absolutely terrible decision.

"Don't Be Evil", my ass
When I was talking with this engineer afterwards, the topic of net-neutrality came up, and he had an interesting theory. "Net-neutrality" is the idea that content carried over the internet pipes of service providers (the cable companies and telcos of the world) is all treated the same, i.e. Comcast cannot favor its own content over Ebay's. With the recent rise of video downloading and other pipe-intensive, the service providers are howling. The following is from a Business Week Nov. 7 interview of Ed Whitacre, CEO of ATT (formerly SBC):

BW: How concerned are you about Internet upstarts like Google (GOOG ), MSN, Vonage, and others?

Whitacre: How do you think they're going to get to customers? Through a broadband pipe. Cable companies have them. We have them. Now what they would like to do is use my pipes free, but I ain't going to let them do that because we have spent this capital and we have to have a return on it. So there's going to have to be some mechanism for these people who use these pipes to pay for the portion they're using. Why should they be allowed to use my pipes?

The Internet can't be free in that sense, because we and the cable companies have made an investment and for a Google or Yahoo! (YHOO ) or Vonage or anybody to expect to use these pipes [for] free is nuts! "

Pretty incendiary stuff. So Whitacre realizes that selling a commodity is a loser's game, that consumers would scream over variable pricing, and he wants a piece of the juicy content provider margins.

The mainstream media has latched on to this as Internet companies vs. Pipe owners.

However, the engineer had a different take, one that other people are speculating about as well.

He thought that Google would strike a deal with Verizon agreeing to pay the toll, and that after Google did this, the other major content providers would follow in suit. The theory behind this is that it would create an oligopoly for the content providers and effectively box-out the small, innovative (and poor) companies that could threaten their dominance because they couldn't afford the fees. Shrewd. Funny that Google didn't mention Adam Smith in their S-1, "People of the same trade seldom meet together even for merriment and diversion, but the conversation ends in a conspiracy against the public or some contrivance to raise prices." Hey, if you're going to try to take over the world, don't pull punches. You have to admire Bill Gates for at least being a straight-shooter.

Threats to the internet conglomerates will likely come from below.
When you think about the future threats to the large internet companies, it is much more likely to come from below - three software engineers in an office park in Palo Alto - than it is to come from entrenched "Old Media" companies. As long as Yahoo and Google can co-opt these threats either by buying them for $25m each or by blocking out access to important markets, they should do just fine. On a related note, it seems that Google paying $25m a year to lock up the most talented section of the Stanford Computer Science program would be a relatively cheap and effective insurance policy.

VC Panel
At one point, we attended a panel discussion of six VC's from assorted Silicon Valley firms. They were obviously very bright and talented people. A few things struck me.

Welcome to Herdsville, Population - Venture Capitalists
I was surprised as to how much herd behavior there obviously is in this community - similar to New York hedge funds, in many ways.

I have a theory that, in any given crowd, about 95% of people like to think of themselves as "independent thinkers", while about 5% actually are. The real independent thinkers are the ones who come up with and bet on ideas that are generally considered to be crazy at the time. Easy to say, hard to do - hence the 5%. What I find interesting is that when you ask the crowd, at the time, what they think about the crazy idea, it is generally dismissed not because the crowd has carefully analyzed the idea and come to a different conclusion - rather, the idea is dismissed out of hand as absurd. For instance, ask a "value investor" about Bill Miller's investments in Chinese Internet portals and see what kind of response you get. Forget about what you think about the investment – note how they respond.

On the topic of herd behavior/contrarian investing - one of the VC's mentioned a fund - Lake Street Partners - who go to corporations who are bailing out of their corporate VC investments and buy up those investments for something like 10 cents on the dollar and absolutely clean up.

Being a VC at Kleiner Perkins is like being an Admissions Officer at Harvard, only you own the upside.
Another thing I learned was how much the entire VC world was driven by social connections and signaling effects. This is obvious, I suppose, to anyone who works in that world, but I hadn't realized the extent to which it is true. If you are an entrepreneur with a great young company, the major reason to get funding from Kleiner Perkins is because that will signal to the world that you are a blue-chip prospect and give you access to decision makers at big companies, greatly enhancing your future likelihood of success. It doesn't have a lot to do with the sage wisdom of the VC's. (One guy mentioned that Kleiner Perkins 10th fund was in the red until the Google IPO. Think about the implications of that for second and third tier VC's.) Being a VC at Kleiner Perkins or Sequoia seems like being an admissions officer at Harvard, only instead of getting paid $40k a year, you get an equity stake of your admitted students' future earnings. Not a bad deal.

Why aren't more VC's targeting the advertising industry?
I was surprised that none of the VC's mentioned or were funding companies in the advertising space. Given the recent successes of Google and Yahoo and the structure of that industry, it would seem to be a good target for disruptive innovation. I asked one of the panelists about this after the talk and his response was, basically, "That's not really something that we understand very well." Fair enough.

LinkedIn
We talked to an exec at LinkedIn, the social networking site for professionals. The guy was very sharp, and spoke more about the Valley culture and being a startup investor in general than about LinkedIn.

Quick notes on the company:
LinkedIn has about 4.5 million users and is adding about 50k new users a week. What is so valuable about LinkedIn is that the membership is largely drawn from the "best and the brightest". He showed one slide that showed that something like 65% of Google employees were members, 50% of Microsoft employees, etc.

Adsense has changed the game for content startups
He mentioned how Google Adsense had changed the game for many startups. Back in 2000, a startup would launch and spend $10m on big ads on television and AOL to try and get traffic. More often than not, that strategy failed, as the company did not get traction and it rapidly ran out of money. Trying to hire an ad sales team was difficult and expensive and was usually foregone.

Most startups today (at least those based on content), throw up Adsense on their sites and have a daily income stream which greatly slows the burn rate. His analogy: "It's hard to lose a football game when you are allowed to extend the clock." Adsense is a perpetual extending of the clock, and allows the company to keep experimenting until it hopefully catches lightning in a bottle.

It's nice to have friends in Silicon Valley
The exec was one of the angel investors in Youtube.com, the recent hot tagging video download site. How did he come across the investment? He was at a cocktail party in May, he ran into a few guys he knew and asked them what they were up to. They mentioned their cool new website. He gave them a $50k check on the spot. They insisted on taking him to a computer in some guy's bedroom in the house and showing it to him before taking his check, which he did.

If you ever talk to someone who is considering going to get an MBA at Stanford, and they complain about the tuition, tell them that story.

It's always a good idea to buy Hockey Stick Growth at a Reasonable Price
Related to this, the guy spoke about the different phases that startups go through. A few engineers get together, write the software, and unleash the product to the world. More often that not, it doesn't catch on, but sometimes it does and the user growth curve goes hockey stick. He mentioned that Mike Moritz (Sequoia VC, of Google and Yahoo fame) invests in these companies sight unseen, as they are indicative of a product that is catching on, and most products fail because they never really filled an unmet customer need. That strikes me as a very smart thing to do.

Startups hit a decision point at roughly the $50m mark
At that point, the entrepreneurs can usually sell the company for $25m - $100m to one of the bigger players. Youtube.com is at that point currently. It's a good deal for the entrepreneurs, as they make a nice little bundle in a short period of time, and they can go try and do the same thing again. Build, flip, repeat.

Or, the company can try and ride it through to relative maturity and, eventually, an IPO. The companies that make this decision risk failure, as when they don't catch on, they lose the early luster and end up being worth less than what they were worth in the early "heady" phase.

Evite is an example of such a failure. At its peak, the company apparently was offered $400m, which it turned down. It eventually sold to IAC for an enterprise value of $10m. Friendster is another example. It is apparently on the block right now for something south of $20m. The exec mentioned that thefacebook.com recently received an offer for something in the $500m-$600m range, and he thought they were crazy for turning it down.

2 Comments:

Blogger Shai Dardashti said...

Buffett mentioned the case of National Insurance.

EPS of $29.02 and traded in a range of $27-28.

"This company was located a block and a half from where I was working at the time in Omaha. Again, I went to check it out and there was absolutely nothing wrong.”

Here's a link to the Moody's Manual sheet Buffett saw when looking at National American:

http://www.wam.umd.edu/~shai/Moodys/1951%20-%20National%20American%20Insurance.pdf

3:37 PM  
Blogger peterxyz said...

Ben,

maybe you could share your thoughts on OSTK the stock? The company's performance and valuation have been somewhat clouded by "discussions" around naked short selling etc and Patrick's reuslting crusade

1:21 AM  

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