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In praise of dual-class stock structures for public companies

A dual-class stock structure means that a company has two different classes of common stock. Each class of stock has the same economic ownership of the company, yet different voting rights.

In a typical scenario, Class A shares have a single vote per share, whereas Class B shares have 10 votes per share, for any shareholder vote.

Using this mechanism, for example, the Class B shareholders might only own 20% of the company in economic terms but have a clear majority voting position relative to the Class A shareholders.

In short, Class A shareholders have shares labeled with the earlier letter in the alphabet, but Class B shareholders control the company -- in stark contrast to the more normal single-class stock structure which is more classically democratic: "one share, one vote". Since Class B shareholders will typically be some set of founding management or founding investors in the company, in practice the presence of a dual-class stock structure means that the founders control the company and can overrule all other shareholders on a wide range of issues, including if and when to sell the company.

Both public and private companies can have dual-class stock structures, but the controversy around dual-class stock structures is usually confined to public companies, due to the presence of public shareholders. And so I will focus purely on public companies.

I used to be an absolutist against dual-class stock structures -- I used to believe that dual-class stock structures were obviously a bad idea, that the democratic single-class approach of "one share, one vote" was more fair to public investors and more likely to lead to a healthy company in the long run, since total founder control of a public company can allow the founders to overrule normal market forces and the interests of their public shareholders.

And in fact, practically all investor advocates and shareholder activists agree with that stance -- dual-class stock structures are at the top of the list of techniques that entrenched managers can use to foil the normal market discipline of a public stock, and to frustrate outside public shareholders who can easily become disenfranchised even when they have majority ownership of a company... with a long-run outcome similar to the kind of insularity and inbreeding you find in royal families. These days, the New York Times Company has of course become the poster child for entrenched bad management operating against the interests of their public shareholders due to its dual-class stock structure -- how could anyone possibly be in favor of that?

And on the face of it, a dual-class stock structure simply seems unfair -- how can someone own part of something but have a tenth of the rights of someone else who owns the same amount?

After 15 years in the technology industry, though, I have done a complete 180-degree turn on the topic -- with some caveats.

I come not to bury dual-class stock structures, but to praise them.

I now believe that dual-class stock structures are a great idea for a technology company that is in the process of going public, under the following conditions:

• The key leaders of the company -- typically the founders -- who will own the controlling Class B shares, are also major economic shareholders in the company. They own a significant portion of the company and are therefore highly incented to maximize the value of the company over time.
• The key leaders of the company who own the controlling Class B shares have a long-term goal of building a major franchise, and the commitment required to execute against that goal.
• The controlling Class B shareholders have a commitment to treat Class A shareholders fairly and equally in all respects other than voting power.
• All public shareholders understand what they are getting into up front -- no bait and switch.

The key to the whole thing is shared goals -- particularly the shared goal of long-term value creation, particularly the creation of a long-term franchise, the kind of franchise that can require 10 years or longer to build.

With such goals, I now believe the interests of public shareholders will often be better served by ceding voting control to the founders and key leaders of the company.

This is a provocative statement, so let me back it up.

In practice, the world at large, the markets in which companies operate, and Wall Street in particular, throw up all kinds of short- and medium-term noise in the face of every public company, all the time.

And in fact, my sense is that the level of such noise is steadily increasing for about a dozen different reasons, including but not limited to the proliferation of hedge funds, buyout funds, arbitrage funds, corporate raiders, shareholder activists, shareholder representation firms like ISS, sell-side analysts, cable television financial news, financial web sites, Internet message boards, online stock trading, increased consumer interest in stocks and markets, and visibly shortening investor time horizons across the entire landscape.

When you are running a public company, here are some of the things that get routinely thrown at you that have practically nothing to do with building a long-term franchise:

• Stock market booms and busts -- the stock market is bipolar; it doesn't matter what finance academics say about efficient markets, everyone knows greed and fear whipsaw the market around all the time.
• Economic booms and busts -- e.g. this ridiculous credit crisis and real estate fiasco. Modern economies are apparently characterized by one self-inflicted crisis after another. And even when you're not directly affected by a particular crisis, if you're running a public company, you're probably going to be indirectly affected, often for no good reason aside from the universe's desire to inflict collateral damage.
• Hedge funds aggressively short-term buying and shorting stocks for the quick pop, and often spreading malicious and untrue rumors along the way. I'm no Patrick Byrne, but every CEO of a public company regularly contends with just silly rumors all the time that are obviously being spread by someone talking their book, or rather lying their book -- and SEC oversight of such market manipulation is almost completely absent.
• Leveraged buyout funds that make apparently attractive buyout offers financed with massive amounts of debt, and then strip-mine the company for fees and dividends before sending it back out into the public markets weaker than before. These guys are wonderfully skilled at paying themselves; on average, their franchise-building skills are questionable at best.
• Corporate raiders of various stripes. I'll certainly grant that corporate raiders as a category have probably been good for capitalism as compared to the clubby Fortune 500 status quo of the 1970's, but when a raider gets his hooks into your public company, he's only in it for the quick pop, and he'll agitate to get it acquired as fast as possible.
• Hostile takeovers -- which may provide a quick payoff to current investors but which definitively bring to an end any opportunity to build a long-term franchise.
• The intense quarterly earnings guessing game that you end up playing even if you don't want to -- even if you refuse to issue guidance, and perhaps especially if you refuse to issue guidance, in which case Wall Street just goes ahead and sets expectations for you without consulting you. The vertiginous stock drop that follows "missing your numbers" can actually damage your company -- you wouldn't believe how many customers check Yahoo Finance before each sales call.
• Financial journalists -- who can be outstanding writers with journalism degrees from the best schools, and in many cases know almost nothing about the companies they are covering or the products those companies make, which does not keep them from writing all kinds of nonsense. High-quality business journalism is distinctly the exception, not the rule; every CEO knows it, and the noise from inaccurate bad press can again actually damage your company.
• And then, finally, pure good old fashioned company-specific fluctuations -- sometimes things are going well, sometimes they're going poorly. If you're building a franchise, that's OK, and even to be expected; you just need to power through the rough patch. However, if you're subject to short-term market demands, a rough patch can kill your dreams amazingly quickly.

All of these things can meaningfully interfere with long-term value creation, particularly if you are trying to build a long-term franchise.

The huge advantage of a dual-class stock structure is that it lets the company's core management simply ignore most of this stuff and stay focused on the long-term goal.

What's the ideal situation for a public shareholder with a long-term time horizon? To invest in a company whose leaders are highly motivated to build long-term value -- to grow the value of the company 10x or 100x or 1,000x -- not flip it to the first interested acquirer for a quick pop, or even the fifth, or the tenth. And therefore to invest in a company whose leaders have the ability to pursue building for the long term, versus getting constantly compromised by short-term market noise.

At this point, if you listen closely, you can hear the howls of outrage. They are saying, how can shareholders expect to countenance being effectively powerless?

And of course the answer is alignment of goals.

Investors that have short-term goals, or even medium-term goals, shouldn't invest in public companies with dual-class stock structures. Remember, I'm presuming no bait and switch. You are always free to not invest in any company for any reason, including this reason.

But, if you're an investor with a long-term time horizon, you will, I believe, be best served investing in companies with a similar long-term time horizon.

The best part of taking this position is that I get to roll out the big gun: Warren Buffett similarly advocates dual-class stock structures for precisely this reason, and puts his money where his mouth is -- he famously has been a long-term investor in the Washington Post Company, for example, which has a dual-class stock structure that gives the Graham family total control, and which has been a stellar long-term investment for Berkshire Hathaway.

Now, dual-class stock structures have been customary in the media industry for a long time, but are relatively new to the technology industry. The most prominent example of a public technology company with a dual-class stock structure is of course Google, whose structure puts total voting control of the company in the hands of Larry Page, Sergey Brin, and Eric Schmidt. Corresponding to that, Larry, Sergey, and Eric have made a 20-year commitment to Google, and are clearly pursuing the goal of building a long-term franchise.

As far as I can tell, shareholders haven't exactly been scared off from investing in Google as a result.

If anything -- and I haven't done a statistical analysis of this, but just look at the charts and the stock prices of this decade -- Google may actually be getting a premium in the market due to its dual-class share structure, as investors are able to make a clean bet on long-term value creation, and they know that the core team can just put their heads down and power through any short-term nonsense.

I think Google has changed the rules on this topic -- I think many technology companies, certainly the ones with high potential, that go public over the next decade will have dual-class stock structures, due in part to the Google precedent.

On to some practical questions:

Don't companies with dual-class stock structures risk limiting their access to capital if they are only attracting long-term investors?

Perhaps, but again, Google is a clear counterexample. You can hardly say it's been starved for capital.

More generally, I would say that this question reflects the fact that companies with dual-class stock structures are still subject to market discipline. If the market overall doesn't like the dual-stock structure, it can refuse to provide capital to those companies, and instead provide that capital to companies with shorter-term objectives and more outside shareholder control. But I don't predict that will happen, and I would be willing to bet my own company on that.

Viewed systemically, dual-class stock structures are an alternative governance model that can compete in the open market for capital with other governance models. Capital will flow appropriately. All is good.

How would you apply this to the drama unfolding around Microsoft and Yahoo?

Well, clearly, if Jerry Yang and David Filo had dual-class-powered voting control of Yahoo, the whole situation there would be playing out very differently.

Microsoft would have been forced to negotiate a purely friendly deal from the very start, and at a price that would have caught Jerry and David's attention from the start. Hostile threats would have been meaningless. Had a deal gone down, it would have been on Jerry and David's terms, and the premium might have been even higher than a normal process would generate, since Jerry and David would have had the perfect walkaway option: we're not selling, and there is no appeal -- pay up or shut up. And the company could have been entirely focused on current operations the whole time -- no distraction.

But what about the outside shareholders? Several of Yahoo's largest outside shareholders -- including one who owns 16% of the company, four times the amount Jerry himself owns -- are in the national press tonight saying, we are furious Yahoo didn't sell for $34/share when Microsoft was already offering $33/share.

The obvious answer: in the alternate scenario with a dual-stock structure and founder control, those outside shareholders would not have invested in Yahoo in the first place, unless they believed Yahoo had a valid plan for long-term value creation and building a franchise.

If, in that alternate scenario, investors didn't believe Yahoo had a valid plan for long-term value creation, then that's another matter. There would be no excuse for that. But that would be a very different problem that would apply regardless of stock structure.

In point of fact, many of Yahoo's largest shareholders today are also, or have been in the past, major Google shareholders. Clearly Google's dual-class structure didn't scare them or their peers off at any point I could see -- instead, Google shareholders seem delighted to be aligned with a core team that has the control to execute a long-term plan.

And here's the kicker: it's not like outside shareholders in Yahoo, even though they own over 70% economic and voting control in the company, can just make the company do whatever they want -- as you can see from all their frustration in the press tonight. Sure, the outside shareholders as a group will ultimately get whatever they want, up to and including a sale to Microsoft, but they may have to put up a significant fight to do so, and that fight may require a significant amount of time and effort, with significant opportunity cost. And along the way, the process has been and will be characterized by confusion, ambiguity, and uncertainty. The whole thing is clearly a massive distraction to any form of long-term value creation to the point where even Microsoft believes Yahoo is risking damaging its long-term prospects by reacting to Microsoft's hostile public bid. So it's hard for me to see how a single-class share structure is nirvana for anyone in a situation like this.

So what about the New York Times Company?

Well, it is true that the New York Times Company and similar failing newspaper companies -- most of them, except for the Washington Post Company with its superior diversification -- with dual-class stock structures are not exactly good investments today, since their entrenched management teams can fight off shareholder activists and hostile takeovers indefinitely while riding their declining franchises straight into the ground.

But on the other hand, it's not like you couldn't have seen it coming. Every investor in any declining dual-stock media company today knew they were buying into that stock structure and did it with their eyes open. And any investor still holding stock in such a company has been aware of the Internet for 15 years and has been able to track the performance of the company's management team in dealing with the Internet over that entire time. Certainly it's possible to be delusional about your investment and think that recovery is right around the corner, but you can't blame the stock structure for that delusion.

And remember, the New York Times Company had its dual-class stock structure for decades, and for much of that time, ordinary investors would have done very well to own its shares. It just so happens that the wrenching technology shift that is causing so much trouble coincided with a generation of managers who are unprepared to deal with it. That's life.

So I think the fate of the dual-stock media companies has a lot more to do with the "media company" part of it and a lot less to do with the "dual-stock" part of it. The only investors mad about the dual-stock part -- well, the non-delusional ones -- are the ones who want the short-term stock pop from a sale to Rupert Murdoch. And those are not the investors you want if you are trying to build a franchise.

What's your recommendation to technology companies that are going public?

Strongly consider implementing a dual-class stock structure, but only under the following conditions:

• The founders are committed to run the company for the long term and want to build a real franchise.
• The founders are also major economic owners of the company.
• The founders have an absolute commitment to treat all other shareholders fairly, and to consider themselves entirely in the same boat economically.
• All public shareholders starting with the IPO know exactly what they are getting into -- no bait and switch.

Under these conditions, a dual-class stock structure is not only an outstanding idea -- I think, for our industry, it may be the future.

Examining Microsoft's and Yahoo's unspoken concerns

In this post, I discuss what I believe are some unspoken concerns that weigh on the decisions both Microsoft and Yahoo are making during this very exciting takeover battle.

Quick status update, largely derived from the excellent Wall Street Journal and its role as official public go-between:

• Various forms of backchannel communication and price negotiation have been happening between the Microsoft and Yahoo teams this week -- including via the press.
• Microsoft and Yahoo still disagree on price -- Microsoft is at about $33/share and Yahoo is holding out for about $36/share, maybe more -- and probably other issues, some of which I discuss in this post.
• Microsoft is threatening to launch its first truly hostile volley tomorrow unless the Yahoo board agrees to whatever deal is on the table now.
• Yahoo is still working hard to convince its institutional investors -- who control the company's ultimate destiny -- that it can thrive standalone. Most notably, Yahoo is apparently close to an ad pact with Google that could significantly boost Yahoo's independent revenue and margins.

Now, reading a lot of the press coverage, you would think that the current standoff is all about Yahoo's desire to stay independent, plus price. I think that misses the unspoken and quite complex issues that are likely bedeviling the boards of both companies as they wargame the various scenarios that could play out from here.

First, I think there is a very big and very real nonobvious concern that is a major roadblock to Yahoo accepting a Microsoft offer at almost any price:

A deal could be negotiated and announced and then fail to close.

The consequences of this scenario to Yahoo would be devastating, and it very well might happen.

Big mergers and acquisitions, particularly among public companies, particularly among public companies that have large shares of their respective markets, can take a year or more between the day the deal is signed and announced, to the day the deal is actually executed and closed.

During that year plus, all kinds of things can happen that could cause the deal to fall apart.

Microsoft and Yahoo will have to get approval from various US regulatory agencies, including some combination of the Federal Trade Commission and the Department of Justice. This approval process will likely be rigorous, due to both companies' large market shares and because of Microsoft's historical antitrust issues. The US government could disallow the merger entirely, like when Microsoft tried to buy Intuit in the 1990's, or impose conditions on the merger that would render it infeasible, and the deal could collapse.

Microsoft and Yahoo will also, as global companies, presumably need to get approval in other jurisdictions -- certainly the European Union. The EU is currently harsher on these issues, and on Microsoft in particular, than the US government. If the EU refuses to approve the merger, or imposes various adverse conditions on it, the deal could collapse.

Microsoft shareholders could revolt. Opinions among the Microsoft employee ranks, executive team, and shareholder base vary wildly on the pros and cons of this takeover. Microsoft stock has been flat for years. A shareholder revolt could cause all kinds of changes at Microsoft, and the deal could collapse.

The broader economy could cave in and we could enter a serious recession. Some people think that's fairly likely. If that happens, it could significantly change all kinds of assumptions that are built into the business rationale for this takeover, and the deal could collapse.

Microsoft could simply get cold feet for its own reasons. Perhaps during the closing process it discovers new information about Yahoo and decides the deal is a really bad idea. A conspiracy theorist might even say that Microsoft could choose to walk away at the last minute in order to permanently and deliberately cripple Yahoo -- and such a conspiracy theorist could point to a few almost-mergers in Microsoft's history that could justify such a fear. I am not saying that I am such a conspiracy theorist, but in all seriousness I bet there are at least a couple of them on Yahoo's board right now. In such scenarios, the deal could collapse.

Typically, an acquisition target tries to wrap the merger agreement as tightly as possible to prevent any scenario where the deal collapses. For example, one can specify a large breakup fee, which the acquiror would have to pay to the target. In a merger like this, the breakup fee could be in the billions of dollars. And of course litigation is reasonably likely in the wake of a deal collapse, especially if one side believes the other side has explicitly violated a binding contract.

However, none of those protections actually protect Yahoo all that well in the event that the deal collapses because it is disallowed by a government. And further, none of those protections actually do that much to protect Yahoo all that well even if the deal collapses for other reasons. Here's why:

The minute a merger agreement is signed, an enormous amount of focus, time, and effort at the target company is redirected towards the implications of the merger. Legally both companies are supposed to continue to operate as fully independent companies with independent strategies until the merger closes, but in practice, a lot of people in the target company are going to be highly preoccupied -- whether with formal roles in integration planning, or just due to the general distraction and anxiety that would be prompted in the halls at Yahoo at the prospect of actually being merged into Microsoft. It is extraordinarily difficult for a management team at such a time to keep an employee base focused on the standalone business -- in fact, I think it's basically impossible.

So imagine what happens if the deal is signed, a significant percentage of Yahoo's internal bandwidth over the next 12 months refocuses onto the implications of the merger, and the deal collapses. Yahoo would be simultaneously behind in many of the key initiatives it would have normally pursued to be competitive as a standalone company, and highly disorganized, fragmented, and demoralized for the Microsoft-less road ahead.

Suppose the deal collapse triggers a big breakup fee -- suppose $3 billion in breakup fee cash drops into Yahoo's lap. So what? A traumatized corporate victim of merger interruptus is going to have far larger problems than cash, even a large amount of cash, can fix. Same with a lawsuit.

There are other things that Microsoft could do to offset these concerns.

The most obvious thing Microsoft could do is execute a commercial agreement with Yahoo simultaneous with a merger agreement. The commercial agreement would require Microsoft to shut down its own Internet efforts and instead use Yahoo's -- completely independent of the merger. Microsoft Search would shut down and Microsoft would point all of its users at Yahoo Search, and so on for all of the various overlapping product lines. Yahoo would of course share revenue with Microsoft in return.

This would almost completely protect Yahoo from all of the collapsed deal scenarios. Even if the deal collapses, Yahoo still has an enormously valuable commercial contract to be Microsoft's de facto Internet arm -- in essence, that contract is Yahoo's compensation for taking on the risk of the merger going through.

You can also see why Microsoft wouldn't want to agree to this.

Other than that, the Yahoo board may be simply trying to get Microsoft to pay a higher price than even Yahoo thinks their company is worth, in order to offset this risk. There obviously would be a price that would be so good that the merger close risk would be worth taking. I'm not sure what that price is, I'm not sure whether Yahoo's institutional shareholders are willing to hold out for it, and I'm not sure whether Microsoft will be willing to pay it.

But we're probably going to find out.

There is another, related, enormous issue in Microsoft's mind.

That is the issue of timing of the regulatory approval process.

If the entire merger could be approved and closed before the new US president takes office in January 2009, that would be wonderful for Microsoft.

I think that's one of the reasons why Microsoft made their offer when they did -- in January 2008, a full year before the US presidential handover.

I also think that's one of the reasons Microsoft is so frustrated with Yahoo's apparent sluggishness -- dragging this into May at the very earliest for a negotiated deal.

I also think that's one of the reasons why Yahoo has been so apparently sluggish -- Yahoo is probably thinking that the longer this gets dragged out, the less likely the deal could be approved before the US presidential handover, and therefore the less likely Microsoft is going to consider it a clean deal, and the less likely Microsoft is going to want to go through with it.

Because just like Yahoo is worried about the consequences if the deal falls through -- so is Microsoft, one would imagine, for many of the same reasons. Merger interruptus bites both ways.

What's the big deal with the US presidential handover? The Bush administration is known to be quite friendly to large companies, large mergers, and Microsoft. Any Democratic administration would probably be notably more hostile to this kind of merger than the current regime. And even a McCain administration might have different views from the current government -- who knows? That very uncertainty is the issue.

The most likely outcome of the arrival of a new US administration is that a merger like this certainly won't become more likely to be approved, and will possibly, or probably, become less likely to succeed.

There are a few other implications one can draw from this.

One is that Microsoft probably would have been willing to pay more for a friendly deal early in this process, when there was more time to get the deal closed before January 2009.

Yahoo may have operated against its own best interest in getting the optimum friendly price by delaying so long.

On the other hand, Yahoo may be pushing the timing out so far that Microsoft will become increasingly disincented to proceed.

Or, perhaps this is why Microsoft hasn't yet gone fully hostile -- they don't want to risk prolonging the approval process, and a hostile takeover will certainly take longer than a friendly one.

And, correspondingly, if Microsoft does go hostile, it will be a very real expression of Microsoft's need to do this deal despite considerable risk that a new US administration, particularly a Democratic one, would not permit it to proceed.

More to come!

If Microsoft goes fully hostile on Yahoo

[Revision 1.1; see change log at the end of the post.]

We have seen extensive press coverage of Microsoft's pursuit of Yahoo over the last few months, including notably excellent coverage from Silicon Alley Insider and the Wall Street Journal. However, I have not seen a detailed analysis of how a full hostile takeover might play out -- the kind of analysis that you would be receiving if you were a Microsoft or Yahoo board member.

So I asked a pair of expert corporate attorneys -- Michael Sullivan and Ed Deibert at Howard Rice Nemerovski Canady Falk and Rabkin in San Francisco -- to work up such an analysis. What follows is their take blended with my commentary. (Any factual errors have been caused by my edits to their work. This is complex stuff -- if you are a corporate attorney or investment banker and notice any errors, please email me: pmarcablog (at) gmail (dot) com.)

First, a wrapup of events to date:

Recall that Microsoft has offered to acquire Yahoo for 50% cash and 50% Microsoft stock. Given Microsoft's current trading price of $29.83 -- which is a little lower than when this all started -- the current offer value works out to $29.68 per Yahoo share. (You can track this day by day via Silicon Alley Insider's excellent bid calculator.)

Yahoo stock closed on Friday at $26.80 per share. The difference between that and the Microsoft offer price is $2.88, or about a 9.7% discount to the offer. That discount reflects the stock market's collective estimate of the odds of the deal not happening -- or, alternately, of Microsoft's stock falling further if the deal proceeds, or, alternately, of Microsoft lowering its offer.

At the time of the original offer -- January 31 -- Yahoo stock was trading at $19.18 per share. Microsoft's offer at that time represented a 62% premium. Since then, both the S&P 500 and NASDAQ indices are roughly flat, so it's reasonable to assume that if Microsoft pulls its offer now, Yahoo's stock will revert to approximately $19.18 per share -- perhaps a little higher if shareholders are more encouraged by Yahoo's standalone prospects now versus before, and perhaps a little lower if shareholders are less encouraged.

Three weeks ago, Microsoft set a deadline of last Saturday for the Yahoo board to accept its offer. Yahoo's board did not agree to the deal. In Microsoft's words: "If we have not concluded an agreement within the next three weeks, we will be compelled to take our case directly to your shareholders, including the initiation of a proxy contest to elect an alternative slate of directors for the Yahoo! board." Microsoft has also threatened to lower the offer price, but on the other hand Microsoft has also said in recent days that it might walk away from the deal. Microsoft also insists it will not raise its bid.

External factors are more or less the same as they were when the bid was originally made. There have been no alternate bids for Yahoo from any other companies in any form. Microsoft has signalled weakness in their own Internet business and lowered their 2008 Internet revenue estimates; this may reflect an oncoming recession, may be specific to Microsoft, or may represent a form of posturing in the negotiation.

The possible scenarios from here, in roughly decreasing order of probability, include:

• Hostile Takeover: Microsoft moves forward with a full-fledged hostile takeover -- trying to replace Yahoo's board and/or taking its offer directly to Yahoo's shareholders.
• Higher Offer: Microsoft raises its offer or otherwise modifies its offer terms to make them more attractive -- for example, Microsoft could shift to an all-cash offer -- in an attempt to make the deal happen without going fully hostile.
• Walk Away: Microsoft drops its offer and walks away; Yahoo's stock drops to its pre-offer level of $19.18, give or take. Lots of moves and countermoves could follow: Microsoft could come back later with a lower or higher offer; Yahoo could cut a Google advertising deal to boost its revenue and margins and make itself harder to buy; Microsoft could take its $44 billion and go buy virtually every new Internet company of any consequence founded in the last 10 years; etc.
• Yahoo Caves: Yahoo's board caves and accepts the current Microsoft offer.
• White Knight: Another bidder enters and offers Yahoo a higher price.

Let's assume the Hostile Takeover scenario, which seems to me to be the most likely given Microsoft's strategy and explicit public statements. What happens then?

There are two primary hostile takeover tactics:

• A tender offer, which we can equivalently call an exchange offer since the offer includes Microsoft stock that would be exchanged for Yahoo stock. This would be an offer by Microsoft to acquire Yahoo shares from existing Yahoo shareholders directly. Note that this hasn't happened yet; Microsoft's offer up until now has been made to Yahoo the company -- in a tender offer, the offer would be made directly to Yahoo's shareholders.
• A proxy fight by Microsoft to take control of Yahoo's board of directors -- to put in place a new Yahoo board that would accept Microsoft's current offer.

These two tactics could be used alone or in tandem.

In the case of a tender offer: if shareholders owning more than 50% of Yahoo's shares agree to the offer, Microsoft gains control of Yahoo directly.

(Actually, Microsoft probably wouldn't need to own a full 50% of Yahoo's shares -- it could own, say, 40% and then have effective control, because only one-sixth of Yahoo's remaining shareholders would have to vote with Microsoft on any issue in order for Microsoft to exercise control.)

Yahoo's best defense against a tender offer is its poison pill. The poison pill works like this: if Microsoft acquires more than 15% of Yahoo without Yahoo board approval, the poison pill kicks in and issues a flood of new Yahoo stock into the market in such a way that Yahoo becomes much more difficult and expensive to buy. Poison pills have been used as defensive mechanisms by public companies against hostile takeovers for years, and the dilution they cause is so huge that no poison pill of this type has ever been triggered.

Rather than trigger the poison pill, Microsoft would most likely condition its tender offer on Yahoo's board cancelling its poison pill. If the Yahoo board refused to cancel the poison pill, Microsoft could sue in a Delaware court to force a cancellation of the pill. (Any and all litigation to force Yahoo to come to terms will be in Delaware, since that is where Yahoo is incorporated.)

Delaware courts give some deference to target boards in resisting hostile takeovers, especially in the early stages of a takeover fight, but in many cases the courts have been unwilling to allow targets to "just say no" in the face of a well-financed offer at a significant premium -- which is the situation Yahoo is facing. It's impossible to predict what a court will do, but Delaware courts are more likely to force a poison pill to be cancelled when a target board has had plenty of time to drum up alternatives to the hostile offer, and where the hostile offer is well-financed and represents a significant premium to the company. This gets even more likely if the bidder has raised its price during the process, which hasn't happened here -- yet.

In the case of a proxy fight, which Microsoft has overtly threatened: Microsoft would nominate an alternate slate of directors for election to the Yahoo board in place of the current directors. If Yahoo shareholders favor the Microsoft bid, they can vote for Microsoft's alternate directors, who -- if elected to Yahoo's board -- would approve the Microsoft bid.

A proxy fight may have special appeal for Microsoft for a couple of reasons.

First, it could work in one fell swoop.

Many public companies have a "staggered" board, where some directors are up for election or reelection each year, but the entire board is never up for reelection in a single year.

Yahoo, however, has its entire board standing for reelection each year.

In retrospect, this was not a good idea -- whoever set this up at Yahoo made a serious mistake. In a proxy fight with a staggered board, target management can lose a proxy fight and still control two-thirds of the board. In Yahoo's case, if Microsoft wins one proxy fight, it takes out the entire Yahoo board.

It would be practically impossible for Yahoo to change to a staggered board now -- in fact, trying to do so would immediately give Microsoft its opportunity to nominate its slate of directors.

Second, Yahoo can't block a proxy fight via a poison pill or any other mechanism. They can delay it -- a bit -- but they cannot block it.

Microsoft gets control of Yahoo if it puts up a slate of directors for election and they win at Yahoo's 2008 annual meeting. All that is needed for Microsoft's slate to win is to get more votes at the meeting than Yahoo's incumbent directors. Since not all Yahoo shareholders will bother to vote, Microsoft doesn't need a majority of all shares to win -- it just needs more votes.

As it turns out, Microsoft has leaked to the press the fact that it has already assembled a slate of directors who have agreed to run against Yahoo's board in the event Microsoft moves forward with a proxy fight. The Microsoft slate includes several former CEO's, COO's, and CFO's -- individuals certainly qualified to sit on a corporate board.

If Microsoft wins the proxy fight, then its acquisition of Yahoo is probably a foregone conclusion. Microsoft's slate of directors would be expected to vote to cancel the Yahoo poison pill, allowing Microsoft to make its tender offer for Yahoo's shares. However, the new Microsoft-installed board would still have to exercise its fiduciary duties and carefully assess whether the Microsoft offer is in the best interests of Yahoo shareholders -- if the new board acted rashly to rubber-stamp the Microsoft takeover, it could theoretically be sued by pro-Yahoo shareholders, although that lawsuit would be an uphill battle. Further, Yahoo's poison pill would throw some procedural hurdles Microsoft's way: the pill says that for a 180-day period following a successful hostile proxy fight, the new board can only cancel the pill if it follows certain procedures, including getting an independent financial advisor to opine that cancelling the pill is in the shareholder's best interests. All this would do is slow down Microsoft's takeover -- it would still happen.

The shareholder vote on the Microsoft board slate would happen at Yahoo's 2008 annual shareholder meeting.

Yahoo has bought time by amending its bylaws to delay the deadline for making board nominations for this year's board election, and could buy additional time by delaying the date of its 2008 annual shareholder meeting.

Previously, Yahoo board nominations had to be made by March 14. While searching for an alternate bidder, Yahoo did not want to face a proxy fight starting in March, so it amended its bylaws to require board nominations to be made within a 10 day window after Yahoo announces the date for its 2008 annual shareholder meeting.

Yahoo has not yet announced the date for its 2008 annual meeting. However, under Delaware law, Yahoo has to have its annual meeting by July 12 -- the 13-month anniversary of its last annual meeting -- or Microsoft can sue to force a prompt annual meeting. Microsoft would almost certainly win that lawsuit, and the court would probably force a meeting within 60 to 90 days. So Yahoo can at least delay its annual meeting and therefore the board election process until July, and perhaps as late as October if it is willing to force Microsoft to sue to schedule a meeting.

So this may yet come to remind you of the Democratic presidential primary season -- it may last a while.

Other interesting questions:

How is Yahoo's board legally required to think about the Microsoft offer?

Delaware law requires a board to act in the best interests of the company's shareholders. Yahoo's board is not required to take Microsoft's offer, but a fully-financed offer at a 62% premium -- as this offer is -- puts a tremendous amount of pressure on Yahoo's board to take the offer, even if Microsoft doesn't increase the price. I.e. the Yahoo board is not refusing the current offer lightly.

If the Yahoo board continues to refuse Microsoft's offer without a better offer in hand, it could be dealing with shareholder lawsuits for years to come. These would be lawsuits where lawyers who specialize in such claims accuse the board of breaching its fiduciary duties and costing shareholders money as a result. Odds are Yahoo's directors would not be personally at risk, since Yahoo has various indemnity and insurance arrangements in place that protect directors from personal liability. But still, those lawsuits would be no fun.

What happens if another acquiror -- say News Corp. -- enters the bidding with a higher price?

Suppose another bidder, like News Corp., enters the fray and offers $32/share, versus the current $29.68 Microsoft bid. Yahoo's board would of course be free to take the higher bid from News Corp.

On the other hand, suppose Microsoft then raises its bid to $33/share, and then News Corp. holds its bid at $32/share. Could Yahoo's board still take News Corp.'s bid in preference to Microsoft's? In a word: no. When a board is presented with multiple offers, it can either take the highest objective offer or it can turn down all the offers. It cannot take an offer lower than the highest objective offer.

There is a caveat to this: a target board is allowed some leeway in interpreting an offer that consists of the bidder's stock, in whole or in part. So judging objective value can get complicated.

But the upshot is, even if Yahoo gins up another bidder, it still cannot accept an alternate bid if Microsoft's offering price is objectively the highest of the available offers.

Who are the Yahoo shareholders and how are they thinking about this?

Yahoo's shareholder ownership profile is the key to the ultimate outcome of all of this. If a majority of the shareholders want Yahoo to stay independent, it very well might be able to -- or, if not, not.

Insiders, including cofounders Jerry Yang and David Filo, own just over 10% of Yahoo's stock -- not enough to block Microsoft.

Institutional shareholders -- large professional money managers -- own about 72.4% of Yahoo's stock. These institutions, broadly speaking, fall into two categories: normal investors, and arbitrageurs.

Normal investors may want to back Yahoo management, but yet may still be forced to vote in favor of the Microsoft deal since they may be unwilling or unable to stomach the likely fall in Yahoo's stock price if the deal doesn't happen.

Arbitrageurs, on the other hand, are only in the stock to make money on the spread between Yahoo's current stock price and the ultimate offering price of a consummated deal. These are the people who bought Yahoo stock on the day Microsoft's offer was announced, when Yahoo's stock jumped nearly $10 in a single trading session. They will always support a transaction, by definition -- the last thing they want is to be long-term holders of anyone's stock.

It's not clear what percentage of Yahoo's institutional ownership consists of arbitrageurs vs normal investors.

Finally, individual shareholders own the remaining approximately 17% of Yahoo's shares. What they do is always anybody's guess.

In practice, there is a group of about seven or eight large institutional shareholders who will ultimately decide Yahoo's fate.

Would a dual-class share structure have been a good idea for Yahoo?

Yes.

A dual-class share structure is when a company's founding managers or investors own a different kind of stock that gives them voting control of the company even when they don't own a majority of the total shares.

Dual-class share structures have been common for decades in the media industry -- they are the reason the New York Times is still controlled by the Sulzberger family, even as the value of its business plummets towards zero. But they have not been common in the technology industry, where they have been viewed as hostile to normal investors.

However, I think Google has changed all that -- Google has a dual-class share structure that gives Larry Page, Sergey Brin, and Eric Schmidt de facto total control over the company, and investors certainly haven't avoided Google's stock as a result.

Yahoo does not have a dual-class share structure, and it's too late to put one into place now.

If Yahoo did have a dual-class share structure, Yahoo's cofounders would have been much better situated to block Microsoft from attempting a takeover.

You can bet that this is being noticed by the founders of every technology company that might go public from here on out.

What are we learning about hostile takeovers in the technology industry?

We are learning that hostile takeovers have arrived in our industry. This is the second major hostile takeover so far -- the other was Oracle's takeover of Peoplesoft -- but there will be more.

This is significant because historically hostile takeovers practically never happened in technology. Potential hostile acquirors assumed that hostile takeovers wouldn't work because the target company's employees would bail and the target company's business would collapse.

It turns out that as technology companies become larger and more mature, acquirors are becoming increasingly convinced that neither of these assumptions hold. Perhaps employees of large tech companies aren't that bonded to current management, and perhaps many of them would actually prefer to work for a larger, more dominant combined company. And maybe as a consequence, the target's business would do just fine in the wake of a hostile takeover -- in fact, maybe it would do better, due to advantages of combined size and scale.

My bet is that hostile takeovers, particularly of larger and more mature companies, are going to become increasingly common in our industry.

The excitement may be just beginning.

[Change log:

Version 1.1: Cleaned up description of Microsoft's offer terms; tweaked interpretation of Yahoo stock's trading discount; removed paragraph on Yahoo's new employee retention agreement since not particularly relevant to how the hostile takeover might happen. Thanks to commenters!]

Left unchecked, this could become problematic

The newspaper industry has experienced the worst drop in advertising revenue in more than 50 years.

According to new data released by the Newspaper Association of America, total print advertising revenue in 2007 plunged 9.4% to $42 billion compared to 2006 -- the most severe percent decline since the association started measuring advertising expenditures in 1950.

The drop-off points to an economic slowdown on top of the secular challenges faced by the industry. The second worst decline in advertising revenue occurred in 2001 when it fell 9.0%.

Total advertising revenue in 2007 -- including online revenue -- decreased 7.9% to $45.3 billion compared to the prior year.

There are signs that online revenue is beginning to slow as well. Internet ad revenue in 2007 grew 18.8% to $3.2 billion compared to 2006. In 2006, online ad revenue had soared 31.4% to $2.6 billion. In 2005, it jumped 31.4% to $2 billion...

The NAA reported that online revenue now represents [a completely inadequate] 7.5% of total newspaper ad revenue in 2007 compared to 5.7% in 2006.

That growth could not stave off the losses in the print however. National print advertising revenue dropped 6.7% to $7 billion last year. Retail slipped 5% to $21 billion. Classified plunged 16.5% to $14.1 billion.

[Source: Editor and Publisher.]

Congratulations, you're paying Jimmy Cayne's marijuana bills!

Failed former Bear Stearns absentee CEO Jimmy Cayne is in the news today:

James "Jimmy" Cayne, chairman [and, until January, CEO] of Bear Stearns, sold his shares in the crippled securities firm for $61.3 million...

Cayne sold 5.66 million shares at $10.84 apiece on March 25 [two days ago], according to a regulatory filing today.

The value of his stake plummeted from almost $1 billion last year, when the shares peaked at $171.50 before the collapse of the subprime mortgage market toppled two of the firm's hedge funds and prompted a contraction in credit markets worldwide [and the effective bankruptcy of Bear Stearns, rescued from real bankruptcy at the last possible moment only by a $30 billion loan from the US taxpayer via the Federal Reserve].

[Source: Bloomberg.]

Allow me to translate from the Wall Street:

The US taxpayer is loaning Bear Stearns and JP Morgan Chase, Bear Stearns' acquirer, $29 billion -- just revised from $30 billion, simultaneous with JP Morgan Chase raising its acquisition price for Bear Stearns to $10/share from $2.

Without that $29 billion of taxpayer money, Jimmy Cayne's stock would be worth $0/share, and if you multiply that by 5.66 million shares, the total would be $0.

The $29 billion taxpayer loan is almost certain to lose money as it is being used to backstop stinky assets on the Bear Stearns balance sheet -- the same assets whose plummeting fall in value catalyzed Bear Stearns' effective bankruptcy.

It is virtually certain that taxpayers are going to take some loss on that $29 billion loan.

When we do, we will have the immense satisfaction of knowing that the first $61.3 million of those losses represent a direct cash transfer from US taxpayers to Jimmy Cayne.

I wonder if there's any more color out there on this...

In the past weeks, together with his wife... who is a student of Jewish religious traditions, Mr. Cayne has spent considerable time searching for comparable events in religious history to see what lessons can be learned from the collapse of his firm, said a person who has spoken to him recently.

Oh yes, that episode where the money changers in the temple leveraged their business up 40-to-1 and then went bankrupt, but got bailed out by a loan from the Roman citizenry of 29 billion pieces of silver, comes immediately to mind.

[Source: New York Times.]

A thought:

A friend of mine who is a significant expert on US securities law told me something interesting a couple years ago, after Sarbanes-Oxley passed.

He said, you know, Marc, the laws on public company governance and controls -- particularly the responsibilities of the CEO -- are now so intense and so tight that I bet if you had subpoena power for any public company in the country, you could prove some form of criminal violation by the CEO.

No matter how honest and upright the individual -- the laws are so strict and there are so many details that have to be correct, almost any CEO could be found guilty of and sent to jail for something.

I suggest Jimmy Cayne as an excellent test case.

The Psychology of Entrepreneurial Misjudgment, part 1: Biases 1-6

Charlie Munger is an 80-something billionaire who cofounded top-tier law firm Munger, Tolles & Olson and is Warren Buffett's long-time partner and Vice-Chairman at Berkshire Hathaway, one of the most successful companies of all time.

Some people, including me, consider Mr. Munger to be an even more interesting thinker and writer than Mr. Buffett, and recently a group of Mr. Munger's friends assembled a compilation book of his most interesting thoughts and speeches called Poor Charlie's Almanack, inspired by Ben Franklin's Poor Richard's Almanack. (The Munger book is only available on Amazon in used form, although you can apparently buy a new copy here.)

Mr. Munger's magnum opus speech, included in the book, is The Psychology of Human Misjudgment -- an exposition of 25 key forms of human behavior that lead to misjudgment and error, derived from Mr. Munger's 60 years of business experience. Think of it as a practitioner's summary of human psychology and behavioral economics as observed in the real world.

In this series of blog posts, I will walk through all 25 of the biases Mr. Munger identifies, and then adapt them for the modern entrepreneur. In each case I will start with relevant excerpts of Mr. Munger's speech, and then after that add my own thoughts.

One: Reward and Punishment Superresponse Tendency

I place this tendency first in my discussion because almost everyone thinks he fully recognizes how important incentives and disincentives are in changing cognition and behavior. But this is not often so. For instance, I think I've been in the top five percent of my age cohort almost all my adult life in understanding the power of incentives, and yet I've always underestimated that power. Never a year passes but I get some surprise that pushes a little further my appreciation of incentive superpower.

...We [should] heed the general lesson implicit in the injunction of Ben Franklin in Poor Richard's Almanack: "If you would persuade, appeal to interest and not to reason." This maxim is a wise guide to a great and simple precaution in life: Never, ever, think about something else when you should be thinking about the power of incentives...

One of the most important consequences of incentive superpower is what I call "incentive caused bias." A man has an acculturated nature making him a pretty decent fellow, and yet, driven both consciously and subconsciously by incentives, he drifts into immoral behavior in order to get what he wants, a result he facilitates by rationalizing his bad behavior [like a salesman who harms her customers by selling them the wrong product because she gets paid more for selling it, versus the right product -- see, e.g., the mutual fund industry].

...Another generalized consequence of incentive caused bias is that man tends to "game" all human systems, often displaying great ingenuity in wrongly serving himself at the expense of others. Antigaming features, therefore, constitute a huge and necessary part of almost all system design.

...Military and naval organizations have very often been extreme in using punishment [the inverse of reward] to change behavior, probably because they needed to cause extreme behavior. Around the time of Caesar, there was a European tribe that, when the assembly horn blew, always killed the last warrior to reach his assigned place, and no one enjoyed fighting this tribe.

Human response to incentives is indeed a huge behavioral motivator, and I think Mr. Munger is right that once you think you realize how big it is, you need to assume it's even bigger.

This is why stock options work so well in startups -- and the fewer people in a startup, the better stock options work, since when there are only a few people in a company, it's usually crystal clear to each person how her work will impact the value of the company.

There is a wrong-headed and dangerous theory afoot that restricted stock (grants of fully in-the-money shares of stock) is a more appropriate motivator of employees of tech companies than stock options:

Mr. Gates wanted Mr. Buffett's input on whether to drop options in favor of restricted stock at Microsoft. [Gates] recalls asking: "How will employees respond to getting a lottery ticket that gives them a definite amount instead of one that could amount to nothing or a ridiculous sum?"

Mr. Buffett's reply, according to Mr. Gates, was: "My wife would rather have a ticket for one fur coat, than a ticket that gave her two or nothing."

Overt sexism aside, from an incentive standpoint the result of shifting from stock options to restricted stock should be obvious: current employees will be incented to preserve value instead of creating value. And new hires will by definition be people who are conservative and change-averse, as the people who want to swing for the fences and get rewarded for creating something new will go somewhere else, where they will receive stock options -- in typically greater volume than anyone will ever grant restricted stock -- and have greater upside.

And sure enough, in the wake of shifting towards restricted stock and away from stock options, Microsoft's stock has been flat as a pancake. The incentive works.

Now, against that, it is true that stock options, particularly for public companies, have an often-destructive random component: they tend to increase in value in rising stock market environments and decrease in value (potentially to zero) in falling stock market environments, regardless of whether value is being created inside your particular company.

For that reason, in the long run it probably makes sense for some new approach to stock-based compensation to be developed that both preserves the motivation to create as opposed to preserve value, but factors out the environmental swings of rising and falling stock markets. Some form of indexing against market averages would probably do the trick. This has been tried from time to time, and I expect it to be tried more in the future, at least for public companies.

As a company grows, stock options and other forms of equity-based motivation become less and less useful as an incentive tool, since it becomes harder for many employees in a large company to see how their individual behavior would have any effect on the stock price of the overall corporation. So, more tactical incentives kick in, such as cash bonuses.

The design of tactical incentives -- e.g. bonuses -- is a whole topic in and of itself, and is critically important as your company grows. The most significant thing to keep in mind is that how the goals are designed really matters -- as Mr. Munger says, people tend to game any system you put in place, and then they tend to rationalize that gaming until they believe they really are doing the right thing.

I think it was Andy Grove who said that for every goal you put in front of someone, you should also put in place a counter-goal to restrict gaming of the first goal.

So, for example, if you are incenting your recruiters on the number of new employees recruited and hired, you need to also give them a counter-goal (and tie it to their compensation) that measures the quality of the new hires three months in. Otherwise the recruiters are guaranteed to give you what you don't want: a lot of mediocre new hires.

One of the great unwritten Silicon Valley skewed incentive stories was a major datacenter vendor in the late 90's that incented its salespeople based on bookings of long-term datacenter leases, without sufficient counter-goals tied to revenue collection or the customer's ability to pay. Sure enough, soon the company's reported bookings were heading straight up, revenue was flat, and cash headed straight down, resulting in a truly spectacular bankruptcy. The salespeople got paid, though, so they were happy.

More recently, skewed incentives in the mortgage industry -- mortage issuers getting paid based on quantity of mortgages issued, versus ability to pay -- caused many of the current catastrophic Wall Street financial meltdowns you get to read about every day.

Even engineers need counter-goals: incent engineers based purely on a ship date, and you'll get a shipping product with lots of bugs. Incent based on number of bugs fixed, and you'll never get any new features. And so on.

Especially in smaller companies, peer pressure can be a very effective form of incentive. This is greatly enabled and abetted by transparency. People hate to be embarrassed in front of their peer group, so if it's crystal clear who's performing well and who isn't, poor performers will be highly motivated to improve -- and if they're not, that's good to know, since obviously then you really need to fire them.

Finally, any entrepreneur should be highly attuned to incentives when hiring outside executives, especially a CEO. Hire a CEO and give her a large stock-option grant with four-year vesting, and you can guarantee she will sell the company in year four. Give her a stock-option grant with accelerated vesting on change of control and she will sell the company sooner than that. Founders can get tripped up on this because they naturally have an emotional incentive to see the company succeed that hired executives often do not share.

And of course, never get caught between a venture capitalist and her incentives.

Two: Liking/Loving Tendency

...[W]hat will a man naturally come to like and love, apart from his parent, spouse and child? Well, he will like and love being liked and loved... [M]an will generally strive, lifelong, for the affection and approval of many people not related to him.

One very practical consequence of Liking/Loving Tendency is that it acts as a conditioning device that makes the liker or lover tend (1) to ignore faults of, and comply with wishes of, the object of his affection, (2) to favor people, products, and actions merely associated with the object of his affection (as we shall see when we get to "Influence-from-Mere-Association Tendency"), and (3) to distort other facts to facilitate love.

The application of this principle to entrepreneurs is obvious: entrepreneurs want to be liked just like everyone else, and wanting to be liked can be a major impediment to entrepreneurial success due to at least two major reasons.

First, an entrepreneur, like any CEO, has to make tough decisions about what her company will do, and those decisions will often run counter to the preferences of her employees. You don't have to be involved in that many startups to find one where the entrepreneur knows she needs to make a tough decision -- such as change strategy, or cancel a flawed project -- but can't quite do it because employees won't like it. Of course this always backfires: employees also don't like leaders who don't make the tough decisions that have to be made.

Second, an entrepreneur, like any manager, has to fire people who aren't great or who aren't right for the tasks at hand. This naturally makes people not like you, particularly the people you fire. But again, not doing this backfires: nobody great wants to be in a company populated by mediocre or ill-fitting peers.

I think these pressures are intensified in a small company versus a larger company, because in a small company everyone tends to know everyone else and people naturally form strong personal relationships within the group -- so the desire to be liked is stronger, and the perceived risk from making decisions that people won't like is higher.

A specific form of this dynamic in a startup is when you have multiple founders, of whom one is the CEO. The founder who is the CEO inevitably discovers that it becomes very hard to stay close personal friends with the other founders. As they say, it's lonely at the top -- if you're doing your job right.

Finally, some entrepreneurs have emotional resistance to pursuing a strategy that does not meet with immediate approval from press, analysts, and other entrepreneurs. This is worth watching carefully -- if everyone agrees right up front that whatever you are doing makes total sense, it probably isn't a new and radical enough idea to justify a new company.

Three: Disliking/Hating Tendency

In a pattern obverse to Liking/Loving Tendency, the newly arrived human is also "born to dislike and hate" as triggered by normal and abnormal triggering forces in its life...

As a result, the long history of man contains almost continuous war...

Disliking/Hating Tendency also acts as a conditioning device that makes the disliker/hater tend to (1) ignore virtues in the object of dislike, (2) dislike people, products, and actions merely associated with the object of his dislike, and (3) distort other facts to facilitate hatred.

If this is a problem inside your company, then you have bigger issues than I can help you with.

However, I think this dynamic kicks in for a startup when thinking about competitors.

I see two destructive consequences of this bias in startups with competitors:

First, I believe startups often overfocus on their competitors. It's the easiest thing in the world to orient yourself in opposition to another company in the same market, and to plan your actions based on what will cause damage to the competitor or block the competitor from getting business.

In the startup world, that often leads to multiple competitors engaged in a shooting war in a market that's still too small for anyone to succeed.

I think it's much better for a startup to focus on creating and developing a large market, as opposed to fighting over a small market.

So when your startup's competitive juices get flowing -- especially for the first time -- and you find yourself fixated on a competitor, be sure to take a step back and say, is this really what we want to be focused on right now -- is the market we're both in really large enough to warrant this? If so, sure, go for it, guns blazing. But if not, stepping back and thinking about how to focus instead on creating a large market might be more valuable.

A variant on this dynamic is letting your competitor determine your strategy by watching what he does and then making countermoves. The issue here is that it's highly likely that neither one of you actually knows that much about what you are doing yet -- since you are in a new market, by definition -- and while you know you don't know that much about what you're doing yet, you only observe your competitors's deliberate actions as opposed to seeing their equivalent or greater level of internal confusion. So they seem like they know what they're doing, and so you fall into assuming they know more than you do, when they probably don't.

Second, when you are in a truly competitive situation, this bias can easily lead you to underestimate your competitor by, as Mr. Munger says, "ignoring virtues in the object of dislike".

His product sucks, his salespeople aren't as good, his venture capitalists are those morons who backed that large datacenter vendor that went bankrupt -- and so on.

Notably, this attitude can become cultural in your company very quickly. I think that if you're in a shooting war, even if you privately think your competitor is an amoral pinhead, that you establish a tone that says, we'll assume that he's highly competent and has many fine virtues, which we will respect and then systematically target with our own strengths and virtues until we have killed him.

Four: Doubt-Avoidance Tendency

The brain of man is programmed with a tendency to quickly remove doubt by reaching some decision.

It is easy to see how evolution would make animals, over the eons, drift toward such quick elimination of doubt. After all, the one thing that is surely counterproductive for a prey animal that is threatened by a predator is to take a long time in deciding what to do...

So pronounced is the tendency in man to quickly remove doubt by reaching some decision that behavior to counter the tendency is required from judges and jurors. Here, delay before decision making is forced. And one is required to so comport himself, prior to conclusion time, so that he is wearing a "mask" of objectivity. And the "mask" works to help real objectivity along, as we shall see when we next consider man's Inconsistency-Avoidance Tendency...

What triggers Doubt-Avoidance Tendency? Well, an unthreatened man, thinking of nothing in particular, is not being prompted to remove doubt through rushing to some decision. As we shall see later when we get to Social-Proof Tendency and Stress-Influence Tendency, what usually triggers Doubt-Avoidance Tendency is some combination of (1) puzzlement and (2) stress.

This is probably a good one for entrepreneurs. You'd better not have a lot of doubts about what you are doing because everyone else will, and if you do too, you'll probably give up.

Of course, an entrepreneur's doubt avoidance is only a plus right up to the point where it becomes pigheaded stubbornness that interferes with her ability to see reality, particularly when a strategy is not working.

In my view, entrepreneurial judgment is the ability to tell the difference between a situation that's not working but persistence and iteration will ultimately prove it out, versus a situation that's not working and additional effort is a destructive waste of time and radical change is necessary.

I don't believe there are any good rules for being able to tell the difference between the two. Which is one of the main reasons starting a company is so hard.

Five: Inconsistency-Avoidance Tendency

[People are] reluctant to change, which is a form of inconsistency avoidance. We see this in all human habits, constructive and destructive. Few people can list a lot of bad habits that they have eliminated, and some people cannot identify even one of these. Instead, practically every one has a great many bad habits he has long maintained despite their being known as bad. Given this situation, it is not too much in many cases to appraise early-formed habits as destiny. When Marley's miserable ghost says, "I wear the chains I forged in life," he is talking about chains of habit that were too light to be felt before they became too strong to be broken.

[T]ending to be maintained in place by the anti-change tendency of the brain are one's previous conclusions, human loyalties, reputational identity, commitments...

It is easy to see that a quickly reached conclusion, triggered by Doubt-Avoidance Tendency, when combined with a tendency to resist any change in that conclusion, will naturally cause a lot of errors in cognition for modern man. And so it observably works out. We all deal much with others whom we correctly diagnose as imprisoned in poor conclusions that are maintained by mental habits they formed early and will carry to their graves...

And so, people tend to accumulate large mental holdings of fixed conclusions and attitudes that are not often reexamined or changed, even though there is plenty of good evidence that they are wrong...

As Lord Keynes pointed out about his exalted intellectual group at one of the greatest universities in the world, it was not the intrinsic difficulty of new ideas that prevented their acceptance. Instead, the new ideas were not accepted because they were inconsistent with old ideas in place...

We have no less an authority for this than Max Planck, Nobel laureate, finder of "Planck's constant." Planck is famous not only for his science but also for saying that even in physics the radically new ideas are seldom really accepted by the old guard. Instead, said Planck, the progress is made by a new generation that comes along, less brain-blocked by its previous conclusions...

One corollary of Inconsistency-Avoidance Tendency is that a person making big sacrifices in the course of assuming a new identity will intensify his devotion to the new identity. After all, it would be quite inconsistent behavior to make a large sacrifice for something that was no good. And thus civilization has invented many tough and solemn initiation ceremonies, often public in nature, that intensify new commitments made.

This goes hand-in-hand with doubt-avoidance, and again is usually a plus for a startup, since it leads to greater commitment on the part of the entrepreneur and the team. (And yes, I am in favor of blood oaths for startups.)

Perhaps this bias is most relevant to how new markets develop. Sometimes you get lucky -- you bring a new product to market, and the target customers all go, great, we'll take it! However, often you get a level of resistance from the market that can be puzzling -- "can't they see that our new product would be better for them than what they have now?"

This in turn leads to the odd dynamic you often see where a startup will field a new product, nobody wants it, and the startup goes belly up. Then three or four or five years later, another startup launches with a very similar product, and this time the market says, hell yes!

I think this is something that every entrepreneur needs to watch very carefully. Sometimes it's simply a matter of timing -- and if people just aren't ready for a new idea, you usually can't make them ready, and you have to wait for them to change or for a new generation of customers to come along.

My favorite way around this problem is the one identified by Clayton Christensen in The Innovator's Dilemma: don't go after existing customers in a category and try to get them to buy something new; instead, go find the new customers who weren't able to afford or adopt the incarnation of the status quo.

For example, when the personal computer was invented, the desirable market was not the universe of people who were already buying computers -- a.k.a. mainframe and minicomputer buyers -- but rather the universe of the people who couldn't afford a mainframe or minicomputer and therefore had never had a computer before.

Similarly, the desirable market for Hotmail in the early days was not existing email aficionados who were already using sophisticated email desktop software, but rather the universe of people who were coming on the Internet for the first time who didn't even have email yet and for whom web-based email was by far the easiest way to start.

Conversely, one of the reasons that today's consumer Internet companies have the wind at our backs versus our peers 10 years ago is that a whole new generation of consumers has come of age in the last 10 years for whom the Internet is their primary medium -- time and demographics are on our side now. That makes life a lot easier, let me tell you. Meanwhile, the average age of television viewers continues drifting higher and higher...

Six: Curiosity Tendency

This is, frankly, an odd one for Mr. Munger to include, since it's primarily a plus, and he doesn't really identify a downside.

The only important thing I can think to add -- aside from the importance of hiring curious people -- is that lack of curiosity can be a huge danger to a startup in the following way: often, your initial strategy won't quite work, but you can learn as you go based on other things that happen in the market and eventually iterate into a strategy that does work. Obviously, insufficient curiosity can prevent you from seeing the new data and lead you to continue to pursue a losing strategy even when you wouldn't have to.

To be continued...

Disney's Bob Iger beams a message back to 2001

Makin' progress, makin' progress...

Proclaiming the web "just as important as TV" for kids, Disney CEO Robert Iger urged fellow executives on Wednesday to join the digital revolution--or hire people who can.

"Hire new people," Iger declared to nervous laughter during a morning keynote...

Iger also impelled media companies and marketers to shed their protectionist [hostile, enraged, psychotic, litigious, counterproductive, foaming-at-the-mouth] stances on new and emerging technologies. "Most classic brand managers look at technology with a deep-rooted aversion [fear, loathing, dismay, anger, denial, Future Shock]," Iger said.

"Technology is good," he said [shortly before he was hit by a mysterious lightning strike from above], explaining how it allows brands to distribute more broadly, and to be more relevant in the marketplace. "You have to keep the consumer in mind and use technology to do that."

Beyond corporate strategy, Iger took time on Wednesday to regale the audience of new- and old-media types with his personal adventures in online media.

He admitted to having a Facebook page, but only two friends in the hot social network.

"It's important for executives to experience all of this," Iger said...

Iger said his presence was more established within Club Penguin, the virtual world for kids that Disney acquired last August.

"I've got some pretty cool stuff in my igloo"--which, he said, boasts a flat-screen TV, a fireplace, and a basketball hoop. "I've never been to an igloo with a basketball hoop, which is pretty great."

Meanwhile, elsewhere in the space/time continuum, the 2015 Bob Iger is giving another speech: "The web is way more important than TV for kids."

[Source: Online Media Daily.]

ABC thinks you're an idiot

From well-regarded television industry journalist and future blogger Bill Carter:

Looking to strike a blow against the proliferation of digital video recorders, the ABC network, its affiliated broadcast stations, and Cox Communications’ cable systems are establishing an on-demand video service that would allow viewers to watch ABC shows like “Lost” and “Desperate Housewives” any time they choose.

The catch: It uses a new technology that disables the viewers’ ability to fast-forward through commercials...

Several executives involved in the project, which ABC plans to offer to other cable systems around the country, said the move was an overt attempt to staunch the use of DVRs like TiVo, which viewers often use to avoid commercials. That activity is increasingly seen as threat to broadcast television, which depends on ad revenue to pay for programs.

“This does counter the DVR,” said Anne Sweeney, the president of the Disney-ABC television group. “You don’t need TiVo if you have fast-forward-disabled video on demand..."

Ray Cole, president of Citadel Communications, which owns three local ABC stations, who is also the chairman of the board of affiliated ABC stations, was even more direct about the goal of the new service.

“As network and affiliates, we both have an interest in slowing down the explosive growth of DVRs,” Mr. Cole said. “This is about combating DVRs. As we developed this at every stage, there was an agreement that however we put this together, disabling the fast-forward function was key.”

A pictorial representation of ABC's view of you, the viewer:

Link: What an ABC executive visualizes when she thinks of you.

Irony is dead, last gasp of newspaper industry edition

February 2008:

Four large newspaper companies are joining forces to sell advertisements on the Internet, hoping that the combined heft of their Web sites will encourage large advertisers to spend more money.

Each of the four companies — the Tribune Company, the Gannett Company, the Hearst Corporation and The New York Times Company — is transferring a portion of its online ad space to quadrantONE, a new company that will be announced Friday.

The purpose of the joint venture, which will be based in Chicago and will hire 17 people [commitment!], is to let national advertisers place ads on local Web sites with a single phone call [phone call!].

The sites belong to papers like The Los Angeles Times (which is a Tribune property), The Des Moines Register (Gannett), The Houston Chronicle (Hearst) and The Boston Globe (The New York Times Company).

Some of the companies’ flagship sites, however, will not be included, because they are not considered local. These include the sites of USA Today, a Gannett paper, and of The New York Times and The International Herald Tribune, which are owned by the Times Company. [These are also known as the ones that actually have reasonable numbers of readers.]

Executives involved said the newspaper companies understand [by which they mean, "used to have a local monopoly but don't anymore"] the local market better than Google, Yahoo and Microsoft...

The companies were also all part of the New Century Network in the late 1990s...

Source: New York Times.

March 1998:

[W]hen New Century Network was kicked off last April by nine [newspaper] giants teaming up to conquer electronic competition, even the launch party bombed...

In a ballroom at the Newspaper Association of America convention in Chicago, a thousand bottles of champagne emblazoned with ''New Century Network: The Collective Intelligence of America's Newspapers'' awaited the hordes expected to come to toast the watershed new-media joint venture. When fewer than 100 people showed up, Chief Executive Lee de Boer made an abbreviated speech before retreating...

The reception was the first public humiliation for New Century Network, but only one in a series of blunders that culminated in the company's abrupt shutdown on Mar. 10. Created in 1995 to unite newspapers against Microsoft Corp. and other competitors girding to woo electronically advertisers and readers, New Century Network came to embody everything that could go wrong when old-line newspapers converge with new media...

Started with $1 million each from Knight-Ridder, Tribune, Times Mirror, Advance Publications, Cox Enterprises, Gannett, Hearst, Washington Post, and New York Times, New Century seemed an entrepreneurial dream. The Internet had just opened to the world, creating vast new competition for readers--and for the advertisers that pump $40 billion into newspapers. But it also gave newspapers a chance to capture national accounts that favored the one-stop-shopping convenience of TV and national magazines...

[T]he [newspaper] companies had wildly diverging philosophies about how newspapers should make the electronic leap and what role the new venture should play. ''You had private companies and public companies and companies that were risk-averse and those that were risk-tolerant,'' says Harry Chandler, head of new media for Los Angeles Times. ''You had big-city papers and small chains. We shared a need. But it was frustrating trying to come together.''

While the wired world moved at warp speed, New Century spent 18 months hiring a permanent ceo and two years creating an electronic doorway to 140 newspapers... ''This [Internet] thing is really racing,'' says Al Sikes, the former Federal Communications Commissioner who is president of Hearst New Media. ''Organizations of a number of co-equals can't turn on a dime.''...

The partners ultimately invested more than $25 million in the virtual venture... The board decided... to pull the plug, coming to a remarkably quick agreement--for the first and final time...

Source: Business Week.

Andy Kaufman lives!

It's not me, I swear...

Some big companies have had a surprise during their earnings conference calls this quarter...

At least seven times just the past three weeks, a mystery caller has cleverly insinuated himself into the normally well-manicured ritual of the quarterly calls...

"Congratulations on the solid numbers -- you always seem to come through in challenging times," he said to Leo Kiely, president and chief executive officer of Molson Coors Brewing Co., on Feb. 12, convincingly parroting the obsequious banter common to the calls. "Can you provide some more color as to what you are doing for your supply chain initiatives to reduce manufacturing costs per hectoliter, as you originally promised $150 million in synergy or savings to decrease working capital?"

...[M]any CEO's have had... trouble telling the difference. Most have gamely tried to answer the questions. Mr. Kiely and two other Molson executives stuck politely with the caller through three detailed follow-ups. Timothy Wolf, the company's global chief financial officer, closed by telling him, "We think we will have some more positive encouraging things to share with you next month in New York," according to a transcript of the call...

Executives at PepsiCo Inc., Dean Foods Co., Newell Rubbermaid Inc. and others have had similar experiences since around mid-January...

[A]nnoyed executives and analysts are wondering why someone would want to play a game with dry business calls that normally follow a tightly controlled formula -- unless the game is the whole point. They can't figure out how the caller is getting any benefit from so closely mimicking them. "If he was spoofing I would hope he'd be funnier," says Bill Schmitz, an analyst at Deutsche Bank Securities.

[Mr. Schmitz has perhaps not been listening to the usual questions on such calls all that carefully.]

"Our quarterly earnings calls are key opportunities to [sic] us to interact with the investment community and to explain our results," says a Newell Rubbermaid spokesman, David Doolittle. "Anyone who would come on the call and use some of that time unproductively is disruptive."

[Mr. Doolittle then threatened to spank the mystery caller with a Newell Rubbermaid spatula.]

Source: Wall Street Journal.

The Titanic reports on the iceberg

New York Times:

In just the last few weeks, The San Diego Union-Tribune eliminated more than 100 jobs, one-tenth of its work force. The Chicago Sun-Times began a major round of newsroom layoffs, then put itself up for sale, and publishers in Minneapolis and Philadelphia warned that tough economics could force cuts there.

Not long ago, news like that would have drawn much commentary and hand-wringing in the newspaper business, but in the last few months, reductions have become so routine that they barely make a ripple outside each paper’s hometown. Since mid-2007, major downsizing — often coupled with grim financial reports — has been imposed at The San Francisco Chronicle, The Seattle Times, The San Jose Mercury News, USA Today and many others.

The talk of newspapers’ demise is older than some of the reporters who write about it, but what is happening now is something new, something more serious than anyone has experienced in generations. Last year started badly and ended worse, with shrinking profits and tumbling stock prices, and 2008 is shaping up as more of the same, prompting louder talk about a dark turning point.

“I’m an optimist, but it is very hard to be positive about what’s going on,” said Brian P. Tierney, publisher of The Philadelphia Inquirer and The Philadelphia Daily News. “The next few years are transitional, and I think some papers aren’t going to make it.”

Advertising, the source of more than 80 percent of newspaper revenue, traditionally rose and fell with the overall economy. But in the last 12 to 18 months, that link has been broken, and executives do not expect to be able to repair it completely anytime soon.

In 2007, combined print and online ad revenue fell about 7 percent. In the last six decades, only one other year — 2001, when there was a recession — had a steeper decline, according to the Newspaper Association of America. Adjusted for inflation, 2007 ad revenue was more than 20 percent below its peak in 2000.

Circulation revenue has declined steadily since 2003, and the number of copies sold has been slipping about 2 percent a year. Some of the largest papers — including The San Francisco Chronicle, The Boston Globe and The Los Angeles Times — have lost 30 to 40 percent of their circulation in just a few years.

The long-term shift of advertising to the Internet — especially classified ads for things like jobs, cars and houses — accelerated last year. The real estate downturn hit the newspaper business hard, especially in California and Florida, where real estate ads fell more than 20 percent at some newspapers...

Critics of the industry — including many executives within it [and the occasional blogger] — say that newspapers have done a poor job adapting to the Internet and working creatively and aggressively to sell ads.

Mr. Tierney agrees, “but you could change that and still be sliding,” he said. “When everyone’s taking on water, you can’t expect to stay dry — only less wet.”

That is in sharp contrast to his tone in 2006, when he led a group of investors who paid $515 million for the two Philadelphia papers. Back then, Mr. Tierney dismissed the industry’s gloomy talk, expressing confidence that it could win back paying readers and advertisers...

Falling stock prices made newspapers look like tempting targets to some buyers in 2006 and early 2007, but even then, the prices of the transactions that did take place were seen as inflated, and there was little interest from other potential bidders. McClatchy bought the Knight Ridder chain, and the News Corporation bought Dow Jones & Company, publisher of The Wall Street Journal. Many papers were sold in smaller deals, including the Philadelphia dailies, The San Jose Mercury News and The Star Tribune of Minneapolis.

Share prices have continued to fall since then, and analysts think they will go lower still. But since last spring, the supply of buyers seems to have dried up...

Silicon Valley after a Microsoft/Yahoo merger: a contrarian view

This post is not about the potential Microsoft/Yahoo merger.

Instead, let's just assume for the moment that Microsoft succeeds in its bid for Yahoo.

What would a Microsoft/Yahoo merger mean for startups in Silicon Valley?

Some smart people whom I respect a great deal believe that a Microsoft/Yahoo merger would be bad for Silicon Valley startups.

Says Bill Burnham, for example: "By swallowing up Yahoo, Microsoft will be removing one of the biggest and most active acquirors of start-ups in Silicon Valley... [making] M&A less competitive in general and [reducing] the # of potential exits... [which is] bad news for Internet [startups] and their VC backers anyway you look at it."

I respectfully disagree; I think that a Microsoft/Yahoo merger would have practically no impact on any high-quality Silicon Valley startup.

And here's why:

First, Yahoo has simply not been all that active in buying Silicon Valley Internet startups -- nor, for that matter, has Microsoft and Google -- contrary to popular perception.

Since Terry Semel's arrival as CEO, and continuing since his departure, Yahoo has become quite conservative when it comes to buying startups.

Yahoo only bought a relative handful of companies in 2007. The big ones were Right Media and Blue Lithium in the advertising space -- where Yahoo was highly motivated to make progress -- and Zimbra in the email space. The small number of other acquisitions (three in the US, I believe -- Mybloglog, Rivals, and Buzztracker) were tiny enough that Yahoo didn't even have to disclose the purchase prices.

Similarly, Microsoft bought surprisingly few companies in 2007. aQuantive was the big dog, and Microsoft was similarly motivated by a high degree of urgency to get on the advertising bus. Apart from that, you're looking at a very small number of very small deals, such as Screentronic and Jellyfish -- fine companies, I am sure, but tiny deals.

And even Google, which did more deals than Microsoft and Yahoo combined in 2007, only did a coule of sizeable ones -- Doubleclick (again that advertising thing), and Postini in email. And, Feedburner got a fine exit from Google given that it hadn't raised much equity funding. But most of the other companies Google bought largely to acquire engineers, and perhaps nascent products that hadn't yet shipped -- not doubles or triples or even necessarily singles from the perspective of venture-funded Valley startups.

Microsoft, Yahoo, and Google are only buying a relatively small number of smaller companies at all today -- so given that, taking Yahoo, or even Microsoft for that matter, out of the M&A races isn't going to reduce the number of deals going down each year by very much.

Second, the spectrum of companies that are doing Internet M&A is surprisingly broad, and, drawing from lists of deals from just 2005-2007, includes names like:

• Akamai
• Amazon
• American Greetings
• AOL
• CBS
• Cisco
• CNet
• Comcast
• Digital River
• Disney
• eBay
• Expedia
• HP
• IAC
• Jupiter Media
• Liberty Media
• Marchex
• MercadoLibre
• Monster
• Motricity
• NBC Universal
• New York Times
• News Corp
• Omniture
• Priceline
• Publicis
• Real
• Sabre
• Scripps
• Shutterfly
• Sony
• Valueclick
• Viacom
• WPP

So the base of buyers for Internet startups is considerably more diversified than you might think.

Third, consider what's likely to happen next.

Many of the traditional media companies -- in the US and overseas -- are looking at their core businesses today and seeing either rapid or imminent deterioration. This is certainly true for television, radio, music, newspapers, and magazines, and quite possibly also true for movies (given the decline in ticket sales and the recent apparent stalling out of the DVD market). And this is also true -- or will be true -- for a pretty broad range of various other businesses that are getting touched by the Internet.

For historical reasons -- skepticism about the potential of the Internet, combined with the false hope presented to many traditional businesses by the dot com crash of 2000-2002 -- many of these traditional companies are not yet appropriately positioned for an Internet-dominated future.

And now, if the Microsoft/Yahoo deal does go through, those same companies in many cases will be looking down a very scary double-barreled shotgun of an ascendant Google and an armored-up Microsoft, aimed right at their lunch, if you know what I mean.

I'm pretty confident guessing that the level of concern and even panic among many traditional companies -- particularly media companies -- is only going to escalate from here, as traditional non-Internet businesses in various sectors deteriorate and consumers continue moving en masse to the Internet.

And from there, it's not hard to guess that Internet M&A is likely to heat up considerably over the next several years, compared to the last several years, across a very interesting and surprisingly diverse cross-section of buyers.

Fourth, new buyers appear on a regular basis.

It wasn't that long ago that Google would not have gone on anyone's list as a significant buyer of other companies.

In the meantime, Facebook has emerged as a company with considerable financial firepower and is already starting to do M&A.

If past is prologue, several new buyers of one form or another will pop up over the next five years, and one or two of them will probably be on the "top buyers" list in 2010 or 2012 -- when you'd be selling a company you start today -- even though we probably haven't even heard their names yet.

Think also about the telecom companies, the mobile carriers, the Japanese consumer electronics companies, the Korean conglomerates, the mobile handset makers -- Nokia is ramping up their Internet M&A efforts right now, European media companies... not to mention the Chinese Internet companies. Any of these could emerge as meaningful buyers of Silicon Valley Internet companies of various forms in the years ahead.

After all, in a world where Cisco is buying social networking startups, anything is possible.

Fifth, building your startup with a goal of getting acquired is foolishness anyway, in my opinion. Smart people disagree with me on this, but I'll make my case in two points:

• Big companies don't want to buy startups that want to get bought. Instead, big companies buy startups that have built something of value that they decide is important to them.
• You can't possibly guess what things of value big companies are going to want to own in one or two or three years. The world is changing too fast -- witness the Microsoft hostile bid for Yahoo itself! -- and besides, big companies are Moby Dick and you can't understand the reasoning behind their decisions anyway.

Combine those two points with the fact that no big company buys that many startups each year anyway, and it's easy to see that the odds of you successfully anticipating something that a big company is going to want in the future and then actually selling your company to them -- as your strategy -- is a very risky proposition that is highly prone to failure.

And in fact, in my experience, most startups that start with the goal of getting bought, fail.

The formula for success in startups is the same today as it's always been, and it will be the same post-Microsoft/Yahoo:

Build something of value -- something that people want, and something that will be profitable at the appropriate point -- and the world is yours.

Successful companies -- companies that have built something of value -- have many options. They can stay private and throw off dividends. They can go public. They can get acquired by big companies who suddenly decide, hey, that looks really valuable, let's buy that. They can sell minority stakes to big investors or strategic partners at very high valuations. All options that are typically not open to the startup that started with the goal of getting bought and didn't build something of independent value.

Or, reduced to a phrase: the best way to get bought is to not be for sale.

Because of this, even if Microsoft, Yahoo, and Google stopped doing M&A completely, the strategy of any high-quality startup in the valley would not change one bit.

Sixth, I believe that a Microsoft/Yahoo merger would actually be a net positive for many high-quality Silicon Valley Internet startups, for a completely different reason.

Again, suppose the takeover bid succeeds. You're looking at probably a year of government approvals, followed by at least a year of integration.

You can't speed up the first part, because that's up to the government, and they don't react well when you scream "hurry up!" at them. And you don't want to speed up the second part, because integrating two companies of the scale and scope of Microsoft and Yahoo is an absolutely enormous undertaking and you want to make sure you do it right, or you're not going to get any of the benefits.

In practice, that will be two years in which both Microsoft and Yahoo will most likely be considerably less aggressive on rolling out new products and new initiatives -- because the key people at both companies will be consumed with the merger.

And, just think, if they are buying fewer companies as a consequence, that also means they're less likely to buy one of your competitors and come after you while you are building your thing of value.

I think this merger, if it happens, will help clear the field for a whole new generation of Silicon Valley Internet startups to create and scale the next set of killer consumer services that will go mainstream and be used by hundreds of millions of people worldwide.

Where does that leave us?

The Microsoft/Yahoo deal, if it happens, means very little for the entrepreneurial climate in Silicon Valley, or the opportunities available to you and your startup.

Your job is exactly the same as before: build something people want, scale it up, make sure it's defensible, and make sure you can make money with it.

Build a company you are proud of.

If you do those things, you'll do just fine; if you don't, neither Microsoft nor Yahoo nor any other big company were going to rescue you anyway.

Nobody ever said this was easy, but in a world moving this fast and this much in flux, it certainly is fun!

Inaugurating the New York Times Deathwatch

[With apologies in advance to Martin Nisenholtz, who I believe is genuinely fighting the good fight, and who will no doubt end up with a great job at some fine Internet company.]

The hiring of Bill Kristol was the last straw.

I can't take it anymore.

I hereby inaugurate my New York Times Deathwatch, which will continue until the last Sulzberger has left the building.

Recent dispatches that are fit to print:

Leading the way [in terrible end-of-year news from the newspaper industry] was The New York Times Company, where total [quarterly] revenues fell 1.7% to $865.8 million, due mostly to a 4.1% drop in ad revenues... Advertising revenues at the news media group in particular fell 5.6%.

Source: Media Daily News.

Actually, that's being perhaps overly fair, since it takes into account an extra week last year. The straight year over year performance was:

[F]ourth-quarter revenue totaled $865.8 million, down 7.1% from $931.5 million a year earlier. The decline included a 9.1% drop in advertising revenue and a 4% fall in circulation revenue... [T]he company had an extra week in the final quarter of 2006, which boosted the year-earlier quarter's revenue by $50.8 million and its pretax income by $14.3 million.

Yes, we are dealing with a business where missing a single week means the difference between revenue falling 1.7% and 7.1%, and advertising revenue falling 4.1% and 9.1%. Go figure.

Source: Forbes.

Now, normally, beating up on someone like this isn't very much fun. But we are talking about a profession that specializes in passing judgment, often snide, on everyone else. And so, onward...

Turns out that December 2007 was particularly bad, and things may be getting even worse:

Separately, the [New York Times] reported that December ad revenue dropped 25.2%. Excluding an additional week in December 2006, ad revenue declined 12% for the month.

...[W]eakness across several national [advertising] categories including health care, books, technology products and transportation hampered results in the month. Classified ads, the traditional lifeblood of newspapers, saw steep declines in help-wanted, real estate and automotive sales. [Craig, you bad bad boy...]

"To date in January, the percentage decline in advertising revenue is trending similar to that of December..." said Janet Robinson, chief executive of New York Times...

As they say, sometimes it's darkest right before it goes pitch black.

Source: Marketwatch.

How are the company's other papers doing?

The [New York Times-owned] Boston Globe will soon announce cutbacks at the newspaper, including hundreds of layoffs, and an increase in the per copy price of the paper to 75 cents as of Feb. 1...

The Globe saw a nearly 7 percent decrease — from 386,417 to 360,695 — in its daily circulation between Sept. 2006 and Sept. 2007, according to numbers released in November by the Audit Bureau of Circulations. That report showed the paper’s Sunday circulation down about 6.5 percent...

When you have an obsolete, inconvenient physical product that nobody wants in an era of universal online access, the appropriate strategy is clearly to raise the price.

Source: Metro Boston, which amusingly itself is 49 percent owned by the Boston Globe, which is owned by the New York Times.

How about revenue at the Globe?

At the New England Media Group, which includes the Boston Globe, ad revenue fell nearly 16%. Circulation revenue fell 7%.

Source: Marketwatch.

How about the company's smaller newspapers?

The company's regional-media group, including papers in medium-sized markets such as Wilmington, N.C., and Santa Rosa, Calif., saw ad revenue decline almost 17%, while circulation fell 7.4%.

Source: Marketwatch.

Meanwhile, the Times faces its second assault from a major hedge fund in the last two years:

A hedge fund manager who acquired a stake in the New York Times Company and is pushing to gain seats on its board sent a letter to the company on Sunday in which he criticised directors as "ineffective" and called for it to shed more non-core assets.

Scott Galloway, founder of Firebrand Capital, who sent the letter, has joined with another hedge fund, Harbinger, to try to put forward their own nominees for the four independent seats on the media company's 13-member board at its meeting in April. The funds have amassed a combined 4.9 per cent stake in Times' shares.

Source: Financial Times.

An ineffective board? What could they be talking about?

Hmmmmm. That's not the direction you want to see those things go.

Well, given that the Internet is the central force dismantling the company's business, I'm sure that by now they've stocked their board with noted Internet experts. Let's see:

• Brenda C. Barnes -- CEO of Sara Lee; noted snack cake expert
• Raul E. Cesan -- former CEO of Schering-Plough; noted Levitra expert
• Daniel H. Cohen -- president of DeepSee LLC, "an oceanic exploration and submarine leasing company"; noted Jacques Cousteau expert
• Lynn G. Dolnick -- former head of exhibits for the National Zoologic Park in Washington DC; noted marsupial expert
• Michael Golden -- current publisher of the International Herald Tribune; former head of the company's Women's Publishing Division; noted sundress expert
• William E. Kennard -- former head of the FCC; noted "seven dirty words" expert
• James M. Kilts -- former CEO of Gillette; noted smooth, smooth shave expert; prior to that, unindicted coconspirator at Philip Morris; noted expert on your grandfather's hacking cough
• David E. Liddle -- here I have to take a pause as I actually know this one; based on what's happening at the company, it could be reasonably asked whether he's actually attending the board meetings.
• Ellen R. Marram -- former CEO of Nabisco; noted Oreo expert. Oh, wait, she actually ran an Internet company: "From 1999 until 2000, Ms. Marram was president and chief executive officer of efdex Inc. (the Electronic Food & Drink Exchange), an Internet-based commodities exchange for the food and beverage industry." Ooh. I wonder if that ended well.
• Thomas Middelhoff -- former CEO of Bertelsmann; noted expert on complicated family politics -- well, that's probably coming in handy...
• Janet L. Robinson -- current CEO of the New York Times Company; noted expert on horrific business implosions
• Doreen A. Toben -- CFO of Verizon; noted 30-year debenture expert
• And finally, Arthur O. Sulzberger, Jr. -- the Big Kahuna -- the Man -- the Guy In Charge -- the chairman and scion -- the dude with the cojones to actually defend Judy Miller. Not noted Internet expert.

So, if you want to issue bonds to pay for FCC-approved snack cake manufacturing in a submarine on display at a national park by a sundress-wearing cigarette-puffing Levitra-popping Judy Miller, you're pretty much set.

Go team!

Yeah, I'm paying attention... what?

Via Mediapost, new research from market research firm BIGresearch:

Regular activities engaged in by viewers during TV commercials:

• 41.2% channel-surf
• 33.5% talk with others in the room or by phone
• 30.2% mentally tune out [I've met them]
• 5.5% regularly fully attend to commercials [I haven't met them]

Rank ordering of activities engaged in by people while "using media", in order of declining popularity:

• Eating
• Doing housework
• Doing laundry
• Cooking
• Talking on phone

Top simultaneous media used when reading a newspaper are:

• TV
• Radio
• Internet

Top simultaneous media used when listening to radio are:

• "Engage in other activities"
• Internet
• Newspaper

It worked!

Jérôme Kerviel confessed that he gambled in the markets because he wanted to be a star...

Source: New York Times.

Does this guy look like he's telling the truth?

Really telling the truth?

Oh, Tiger...

[Link: Tiger Woods Buick commercial.]

Flashback to the start of the 2007-2008 TV season

When I wrote a recent post about the collapse in ratings for television soap operas this year -- pointing out that this collapse comes despite the fact that soap operas continue to air new episodes through the writers' strike, albeit episodes apparently written by scabs -- I received feedback to the effect of, "well, of course ratings collapsed, the writing got a lot worse."

So that compels me to go back to the very start of the prime time season in September-October 2007, when the TV networks put their very best feet forward...

Pulling from a piece of research from Lehman Brothers (not accessible online):

According to the initially reported Live Ratings provided by Nielsen Media Research, audience levels for the first week of the new season are on average roughly 10% lower Y/Y across all demographics.

In the most advertiser-coveted demographic [of] 18-49, the networks seeing the most significant declines are CBS and ABC each at -15% Y/Y, followed closely by FOX at -14% Y/Y, and NBC at -8% Y/Y. [Bear in mind that NBC was already in the basement, ratings-wise.]

CBS and ABC had the most difficult premiere week of any of the networks, as many of their franchise shows (including "CSI: Miami" on CBS and "Grey’s Anatomy" on ABC) experienced >20% slides.

So, not to repeat myself, but: TV ratings collapsed year over year; it wasn't the fault of the strike (which of course then caused additional viewers to flee); 2008 TV ad revenues will prove to be propped up by the election and the Olympics (as is usual for such years); and 2009 is going to be a deeply, deeply interesting year for the TV industry -- which this blog will follow most closely when it happens!

Great moments in journalism, Risk Magazine edition

Risk Magazine -- the finance industry magazine focused on risk management -- presented, this very month, its Equity Derivatives House of the Year award for 2008 to... ta daa... Societe Generale.

(The Societe Generale rogue trader did his $73 billion of dirty deeds with -- you guessed it -- equity derivatives.)

This is by far the best corporate award since Fortune Magazine gave Enron its Most Innovative Company in America award in February 2001 for the sixth consecutive year, right before Enron blew up and went bankrupt.

The best way yet to measure the implosion of the TV and radio industries!

Really, this is kind of genius...

WPP Group PLC [one of the really big advertising agencies] invested in a Silicon Valley start-up that arms consumers with cellphones that measure which television and radio ads they see and hear...

Integrated Media Measurement Inc. outfits survey participants with a device inside their cellphones. As long as the cellphones are on, any ads the people hear are recorded.

Getting accurate information about how many people are exposed to their ads is a top priority for marketers.

However, it is not yet clear how many of the following additional factors the new whizzy cellphone measurement devices will be able to track:

• Number of visits to the bathroom during commercial breaks while your cellphone is left on the living room couch -- pay-per-flush?
• Same for visits to the fridge -- pay-per-pie!
• Number of very very subtle and quiet clicks of your channel changer remote control
• Awakeness/alertness level of the viewer at any given time -- you guessed it, pay-per-snore
• Percentage of putative TV/radio viewing/listening attention instead actually focused on reading Digg on your laptop
• The frequency with which you can actually remember the brand of car or toothpaste or breakfast cereal being marketed by yet another bland, undifferentiated, generic TV or radio commercial -- pay-per-retain-anything-at-all
• The pounds-per-square-inch of pressure being exerted by your posterior when you're accidentally sitting on your cellphone while you watch TV
• Number of thousands of times you prop your cellphone up in front of your computer speakers and play the "Head-On! Apply directly to the forehead!" TV commercial on Youtube on an infinite repeating loop just to f--- with The Man, while you go out for a pizza
• Confusion level of your teenage son or daughter when confronted with the idea that you're supposed to listen to music interrupted by commercials -- or video interrupted by commercials, for that matter

Good luck measuring that ol' inherently unmeasurable media, dudes!

Wal-Mart nukes the magazine industry

The times, they are a-changing...

From the Silicon Alley Insider:

The world's biggest retailer is pulling [the New Yorker] and more than 1,000 other [magazines] off its shelves. Some of these are small fry mags you've never heard of, but there are some big mass market titles here as well - notably the big three business mags: Forbes, Fortune, BusinessWeek.

No official word from Wal-Mart about the reasoning behind the move, but we don't need one. Wal-Mart is ruthless about maximizing every inch of its floorspace, and it's clearly decided that it's only worth keeping a handful of magazine titles on its racks.

A delusional magazine industry type rationalizes to the NY Post's Keith Kelly that this could be good for the business, since it will reduce clutter and give the remaining magazines it sells more prominence. But make no mistake - this is a disaster for the magazine world, which depends on Wal-Mart for an estimated 20% of retail sales. [20%!!]

It is also a prelude to what's about to happen to the music business, as Wal-Mart and the other big box retailers start to hack away at the retail space they devote to music. And it may also happen to Hollywood, which depends on the [big box retailers] for DVD sales.