Embracing Chaos

Although most corporate mergers fail (often due to mis-aligned incentives on the part of the deal-makers) there is a solid economic foundation for the proposed Microsoft + Yahoo! merger.  Most of their assets will work no better combined than separate.  But the merged Microhoo ad network would be significantly more valuable than the sum of two ad networks alone. 

Why bigger is better for online advertisers

The reason lies in network effects of the online search + advertising industry.  Imagine you’re an ad buyer which is to say you have a service you want consumers to find online.  Unless you’re a huge company, you have limited energy to expend buying your ads.  So rather than buying and managing separate ads from each Microsoft, Google and Yahoo, you’re likely to just deal with a single ad publisher.  The sensible ad buyer will choose the ad publisher which gives them the most value for limited effort. 

Right now the clear choice for an online advertiser is Google.  Because they have the most search traffic, they are best able to reach customers.  Combined with their adsense network, Google clearly has the largest inventory for an ad buy making them the natural choice for anybody not willing to spend a lot of energy managing their online advertising.  This logic underlies the recent acquisitions of Doubleclick, AvenueA/Razorfish/whomever, and now Yahoo!  Network effects in advertising mean that the largest network will be the most sucessful.  So the mergers will continue as far as the anti-trust regulators allow them to until a handful of bitter enemies remain.

This much might be obvious to some of my readers.  But I felt like sharing this analysis since I’ve read nothing in the common press that explains the basic economic motivation of this deal.

Wrinkles, twists

An irony of the network effect comes from the auction nature of keyword buys.  Advertisers bid for the right to get their message in front of customers.  When more advertisers are competing for the targeted eyeballs of consumers, the prices for advertising go up.  This means that prices will tend to be higher on the larger ad networks.  So bargain seekers can get more advertising for their dollar by seeking out smaller networks.  This appears to contradict the logic that bigger is better for ad networks.  But many advertisers are limited not so much by budget but by the ability to reach highly qualified customers.  If you are selling poodle tattooing services in the pacific northwest, odds are you will not hit max out your advertising budget on any of the ad networks simply because not that many people are searching for your services.

I could probably fill pages with speculation about the culture clash between Microsoft and Yahoo and other reasons why it will or won’t work.  But if you’re interested in that stuff, I’m sure you’ll have no problem finding it in the backwaters of the blogosphere.  I can’t help but drop a couple relevant ideas though.  First, from what I hear, the executive management at Microsoft is so dysfunctional right now, Yahoo will provide fertile new ground for their turf wars.  If the top bosses are adept, they will use the many iterations of re-orgs to sluff off ineffective execs to projects where their overall damage can be minimized.  Second, I think I hope Microsoft has evolved enough humility to understand that they’re better off simply shutting down Yahoo’s services than forcing everything to port over to NT servers.  Right, guys?

Disclaimer

I feel compelled to point out that the opinions expressed here are mine and mine alone.  In no way does this article reflect any official position of my employer.  This is my personal analysis of the economics behind the industry I work in.

After months of rumors about companies trying to buy Facebook, yesterday a deal was announced.  In a sense the deal is quite small because Facebook sold just a 1.6% equity stake to Microsoft.  But by paying $240 million, the deal values Facebook at about $15 billion!  What’s going on here?  This surely can’t be based on rational economics, can it?  Let’s analyze how these deals should be valued and take a few steps back through recent internet acquisition history for context. In trying to keep this post focused, I wrote a separate article about why mergers and acquisitions rarely work.

Economically, companies should be valued at the present value of their free cash flows.  That is to say, project forward all the possible ways the company might behave, and take a probability-weighted average (expectation value) of the total dividends the company would pay in each of these scenarios.  Discount these cash flows by an appropriate discount rate and you’ll get a fair market value for the company.  This is called fundamental analysis.

Now anybody who’s tried their hand at such financial calculations will know there’s a lot of judgement calls involved.  Small differences in numbers like discount rate or growth rates have huge effects on the results, and these numbers are hard to judge.  So it’s definitely possible to come up with a believable (by some) model of future cash flows that will value any currently successful company at whatever huge valuation you want.  But that doesn’t make it correct.  Is Facebook worth $300 per user?  It’s not possible for me to click on a $10 CPM ad every day for 100 years, but maybe they can add more users to grow into that?  Maybe?  It sure seems high.  I think there’s something else going on.

For context, think back to March of 2005 when Yahoo bought Flickr.  IMHO that made Google feel bad because Picassa wasn’t doing so well.  I think they saw this as a big missed opportunity to help organize the world’s photos.  I think this was big on their minds when they paid too much for YouTube.  And Google is still very far from monetizing this investment.  But they now control the dominant way that videos are communicated on the net.  This has to help them feel good about getting closer to their corporate mission of organizing the world’s information.  Since it’s not clear right now how they’re going to achieve that goal for photos.

Now consider Facebook.  Left and right, Facebook’s internal applications are surpassing total usage of th best dedicated net applications.  Their invitation app gets many times more usage than evite, and I believe their photos app is actually well beyond flickr in terms of usage too.  I don’t know where they stand for videos right now.  But it’s clear that they are a force to be reckoned with.  As I’ve written before, their application platform is potentially game-changing because it’s very attractive for information service developers and democratizes the process of product development in a novel and powerful way. 

For all these reasons, I think Facebook has the potential to dislodge Google as king of the hill.  No, Facebook isn’t going to become the dominant search engine, or even the dominant deliverer of internet advertising.  But I think Facebook could become the dominant way the humans communicate with each other using computers.  This could be the leverage they need to claim the crown of innovative thought leader on the internet.  If I were running Google, I’d be concerned about this possibility.  If I were running Microsoft, I’d be excited to get a piece of this.  Any piece.  Because even a tiny piece (like <2%) means that Google can’t take control of Facebook.  And yesterday, Microsoft got their foot in that door.  So, the game is on.  It’s gonna be fun.

I see a trend of how we’re approaching Tim O’Reilly’s Web 2.0 ideal in a way that he didn’t really identify.  But I think the trend is important, and growing, although still in its infancy.  The trend is towards richer web APIs
that enable people to build value on top of existing websites.  I’ll
give some history on how we got here, and talk about the current
trend-leaders that I see: Facebook and Google Maps.  I’ll also explain why I think Microsoft is in the best position to build the required enabling technology.

Original Web 1.0

Universal access to massive volumes of data.  Being able to search
through masses of data and find what you want.  Connecting people to
huge databases really well.  Key examples:

• Online telephone books
• Web search
• Huge e-commerce sites

But in all of these applications, the data set is static.  User activity will not change the data for anybody else.

Web 2.0.1: Democratizing use of the data

The users of these data make the data better.  They can collectively
organize the data.  (i.e. tags)  They can help filter good data from
junk.  (i.e. voting)  Or they can help you find the data that are most
interesting to you.  (i.e. collaborative filtering).  In other words,
you can interact with the data.

Any "Web 2.0 company" worth their salt has an API that federates out their raw data.  This enables other sites to use the data in new and novel ways.  But the primary problem with this paradigm is that anything built using these API’s is done from the ground up.  Using the gmail POP interface, it’s possible to build a better UI for gmail.  But to do so you need to first build an entire AJAX mail client — no small feat.  Better would be the ability to add features into the gmail UI itself.  But this is really the standard in web 2.0 API’s today.

Web 2.0.2: Democratizing the feature set

The next big trend will be enabling users to make more compelling ways to interact with
the data.  Users can change not just the data, but how other users see
and use the data.  Sometimes this means API’s with UI hooks.  Or other ways to enable new functionality into an existing site.  This kind of platform enables Independent Software Vendors to improve upon the UI’s that the original sites created.

Facebook is doing this by allowing ISV’s to add new communications features to their site.  Google Maps is doing this through maplets that allow developers to create new ways to interact with mapping data from within the fabulous Maps UI.  Right now these are the only two examples of web 2.0.2 platforms that I’m aware of.

Building this kind of API is very challenging.  There are several very different ways to go about doing it.  Here are a couple of ideas:

• Provide a server-server API that includes content generated from the ISV’s servers into the main experience.  Facebook style.
• Allow developers to author XML files that define new algorithms that are interpreted on the primary host’s servers.  Yahoo pipes is a service in this style, but they’re not doing anything to enhance an existing service so it doesn’t really meet my 2.0.2 criteria.
• Allow developers to author javascript plugins to run on the client machine.  Greasemonkey is essentially doing this.  This strategy has the best shot for a lot of applications in the long term, IMHO.  But it comes with some serious problems right now.

Doing this correctly would allow ISV’s to add new features to Gmail.  Think about it — if I wanted to change the way gmail messages were displayed, or how addressing happened, or whatever it was, this kind of platform could provide hooks for making gmail better in a way that a POP interface never would.  And even though a POP-style interface theoretically could do this, there would never be momentum because having a high-level base to build upon means that there are network effects from the extensions.  (Rails achieves a similar advantage over other web frameworks — just having a standard, any standard, means people will build upon that standard rather than argue over which library to use and extend none of them.)

3rd-party javascript

The big problem with this approach is security.  There is none.  You need to completely trust the ISV before you should allow their code to run in the context of your site.  The kind of editorial review required to do this today would completely kill the democratic goal of such a platform.

The world needs a security sandbox to run third-party javascript code inside.  This way primary site hosts could allow ISV’s to run their code on client machines safely.  Here are a few examples of places this kind of tool could be used.

ISV’s could…

• Add UI features to Gmail
• Create alternate ways to share and discuss images on Flickr
• Define new mathematical formulas to run client-side on a web spreadsheet
• Create new playlist selection / shuffling algorithms for Rhapsody

… and much more.  Even better, individual users (not developers) could pick which UI extensions they wanted to use.  Any site which provides such an API has democratized the feature development process in a very important way.  Not only does it provide a distributed mechanism to figure out which features are best, but it allows users to self-segment as to which features work for them.  Without such a mechanism the entire service must have the same features for everybody, which means product designers must play a political game where they’ll never make everybody happy.  Right now I think really only Facebook has solved this problem.

Building a security sandbox is an area that Microsoft could probably do best and fastest.  They are good at code API’s and layered security models,a nd they have a perfect place to do it with Silverlight and the CLR.  They’re trying to position Silverlight as a faster way to run DHTML, which is something else the world desperately needs right now.  But I just can’t imagine them doing anything this innovative or generally valuable.  Doesn’t sell more Office.  Doesn’t sell more Windows.  They don’t even really have many services that could use third party extensions, and they’ve lost touch with the ISV’s who might build such extensions too.  Google Gears could conceivably add such an extension.  There’s precedent there considering the javascript threading extensions they provide.

This will be a difficult problem to solve, I have no doubt.  But I hope somebody with the resources to leverage a solution takes it on, because I think it would really make the world a better place.