Sue Decker | Vox

Circling Square

2019-03-06T05:45:22-05:00

Square’s recent $2.9 billion IPO is either a huge win for its investors or a sign of very bad days to come, depending on whether you believe the “high-five” tweets from prominent venture capitalists (VCs) or the slew of hand-wringing articles — from sources like NPR, The Verge and the Wall Street Journal — essentially saying it marks the end of free-flowing startup capital.

The wildly contradictory responses to Square’s Nov. 19 debut on the New York Stock Exchange, when the payments-processing company’s stock was priced below its previous funding round in the private markets, has left a lot of people in the startup community (and beyond) wondering what’s going on.

The new rules of the hunt for “unicorns” are creating a small class of “haves” and a much larger class of “have-nots.”

My take is that the IPO is further evidence that the new rules of the hunt for “unicorns” — startups valued at more than one billion dollars — are creating a small class of “haves” and a much larger class of “have-nots.” The lucky ones are the earliest-stage investors that find tomorrow’s unicorns. The less lucky are often the late-stage investors — generally the providers of the bulk of the capital — and the talent that signs on as these companies grow to fighting strength and scale. I think this is likely to cause a rebalancing of late-stage valuations and an increase in transparency in private markets.

The basic facts are these two data-points: The company, which started with zero value six years ago, ended up worth $4.2 billion at the close of the market on the day of its IPO. Thus the high-fives. Yet at the moment of its public market debut, its lower-than-planned share price put the company’s value at just $2.9 billion, significantly lower than its $6 billion valuation at the time of its Series E funding round a little over a year earlier, implying the dreaded “down-round.”

And yet, the real substance to this story — in terms of how if affects the future — may have more to do with the many markers in between those selected pricing bookends. In other words, behind the magnitude of the value created by Square from inception (which is significant and real), how is it distributed and allocated across the various stakeholders, VCs and employees? What does that suggest going forward?

The old adage of “the early bird gets the worm” is apropos here — both for employees and investors — but very little of the capital or employees were there for the best spoils, which may have implications for the future.

Let’s use Square as Exhibit A for this allocation-of-value story, which is really just beginning. For those wanting a spoiler alert, the old adage of “the early bird gets the worm” is apropos here — both for employees and investors — but very little of the capital or employees were there for the best spoils, which may have implications for the future.

Some quick math from the various public filings suggest that the investors did well — and pretty much as they were supposed to — with later rounds taking less risk and generating lower returns. These rounds of equity invested are labeled “A” through “E,” with each letter designating a subsequent discrete investment, generally by different investor groups. Each investor group that follows an earlier one is taking less risk because the company is further along in its development and, as such, is presumably expecting lower returns. But just “how low?” is the question.

Note that sometimes a round will have two closes with modestly different terms. While the B and C rounds each had two tranches of closing dates for Square, I collapsed them in the tables that follow, because their valuation levels and return profiles are very similar to each other. But the E round is very different, so that it is shown in the tables that follow by tranche.

Interestingly, the valuation in each round in Square’s case was essentially one multiple lower than the previous one: The B round was 5x the A round, C was 4xB, D was 3xC, and E was 2xD. While simple to remember and probably not fully a coincidence, it might not be the best approach for the C/D/E rounds in the future ☺.

Translating the original investment of each round into compound annual growth rates, and taking into account time invested, shows the following:

The A and the B rounds generated compound growth rates over a five- to six-year period of 72 percent to 95 percent. Considering that only about 25 percent of startups make it to a C round, this return seems about right; if 75 percent of investments go to zero for these early-stage investors, then the other 25 percent need to generate close to 100 percent in annual returns to deliver a weighted average overall return to their limited partners of about 25 percent to 30 percent.

If you think about it, in a different era the C, D and E rounds of Square might have been conducted in public markets, in which price discovery is based on inputs from a much broader investment base, and in which the terms of the deal are transparent to all current and future investors.

By the time of the C round, almost two and a half years after founding in February 2009, the company achieved its unicorn status, valuing it at $1 billion. It had expected revenue in the calendar 2011 year of $40 million (per an article in the New York Times). Although the C round may not have generated quite the returns hoped for at the time of investment, the Series C value looks to be roughly in the right valuation ballpark. At an 18 percent Compound Annual Growth Rate, this round came in when the risk was substantially less than the previous rounds; and an 18 percent CAGR is nothing to sneeze at, compounding for four years.

Where things get really interesting is the D and the E rounds. Here, one might argue that proper private value discovery is much more challenging in closed private rounds than it would be in the public markets.

The D round is sitting at a 3 percent CAGR now, for its three years of capital invested, clearly well below the expectations at the time the investment was made. And it is even worse for the E-2 round, which is down 96 percent.

Surprisingly, the investors of the first tranche of the Series E round were guaranteed a 20 percent return at the time of an IPO, through the issuance of extra shares if the IPO price were to be lower than the agreed upon share price. Consequently, because of the number of extra shares the Series E-1 investors received as a result of the $9-per-share IPO price, their cost basis per share was effectively cut in half, dropping from the original $15.46 per share to $7.50 per share.

This means that the Series E-1 investors with the ratchet clause had a higher CAGR than the Series C and D investors, even though those investors put money in two or three years earlier and assumed more risk. The Series E CAGR is somewhat close to the Series B-2 CAGR, and that round was completed almost four years earlier.

Granted, these Series E-1 returns have accumulated for only one year, versus four years for the earlier rounds. Nevertheless, this “ratchet,” acting almost like an embedded put option tied to a discount to the IPO price, will result in a highly nonuniform return experience for the late-stage investors.

In a public market situation, this would not occur; regulations in place make sure all investors see the same information, and the terms of any public offering are transparent and harmonized across investors.

Another critical angle here is that it is in these late stages of capital raising that the bulk of the employees join. To wit, hiring talent is a primary use of the capital, funding salaries of the employees that will drive the scaling of the business, after product/market fit is found.

At the time of the A and B rounds, in which investors (and early founding employees) were well-rewarded for their risk, the company only had about 10 employees. By October 2012, around the time of the D round, the employee base had grown to 300. In the most recent three years, it has expanded to about 1,200. Most of those employees joined with the dream that they would share in the value creation.

The three most fascinating insights to how the invested capital is allocated in Square (and likely many other successful unicorns) are:

The tricky price discovery and generally lower returns for these late-stage private rounds is applicable to the bulk of the capital that was invested. In this case, the D and E rounds together represent a total of $402 million dollars of the $550 million raised, or 73 percent.
The return profiles of the D, E-1 and E-2 rounds are dramatically different, even though they were successive to one another. Incredibly, the E-1 round has a CAGR approaching the B-round profile. As the light shines on these variations, it will beg questions.
Nearly 80 percent of the employees joined the company and were awarded equity grants at prices near or above the IPO value. And there are no ratchets or liquidation preferences that will adjust downward the exercise prices on those equity grants.

Late-stage private capital is here to stay, but it is like a partying teenager now, and it will need to mature to an adult, with more curfews and controls.

So where do we go from here? And what is the trickle-down effect to earlier rounds of capital if the late stages are coming to a table with not enough food in returns? Is this the end of the late-stage private investing?

I don’t think so, but here is a stab at my take on likely changes ahead:

First, late-stage private capital is here to stay, but it is like a partying teenager now, and it will need to mature to an adult, with more curfews and controls.

I think it is a positive development to have more capital options for private companies than the public market. (Incredibly, Yahoo went public only two years after it was founded, with $1 million of trailing sales.) And the structural factors at work creating this class of capital — hedge funds and mutual funds wanting to get in before the IPO — are not going away.

But for this late-stage private capital to stay viable, the allocation of value today is too large now in favor of the earliest rounds. A recent article in The Economist talks about how late-stage values are already coming down, dropping an estimated 25 percent in the past six to eight months, according to Fred Giuffrida of Horsley Bridge.

This value adjustment will come both as demand slows — many funds are shifting their investment priorities closer to the seed and A rounds — and also with more muted step-ups in value from prior rounds. This may lower returns somewhat in A rounds and/or produce very high values in certain cases (a.k.a. Vessel) as the market goes through this adjustment.

Second, I think it will also force more discipline on burn rates of startups, as they come to realize that huge premiums for later-stage capital may not be there. Perhaps that means we will also end up with fewer steps in the process, as entrepreneurs realize they may need to stretch their capital for more time in between rounds, and it may lead to a more uniform understanding of what the startup has to achieve from A to B and B to C.

Third, the ratchets and liquidation preferences that act as embedded put options in various late-stage rounds today are likely to become more transparent and uniform across rounds of capital. It is wacky that the return profiles here across D, E-1 and E-2 are so vastly different, and late-stage investors will increasingly require pass-throughs of future favorable terms to apply to their own rounds as the public market disclosure process turns a light on in this dark room.

How Square performs in the next few years will determine a lot in terms of how the bulk of the employees and the last-stage capital invested (including those that just invested in the IPO) fares.

Obviously, for the specific case of Square, what matters most from here is the rest of the story; how Square performs in the next few years will determine a lot in terms of how the bulk of the employees and the last-stage capital invested (including those that just invested in the IPO) fares.

But I think there are some lessons learned here, that we will be taught a few more times again for those unicorns that are successful enough to access public markets. And in those lessons, we will see some changes to values across stages, more transparency in terms and a move to reduce burn rates for those lucky enough to receive the capital.

Sue Decker, former president of Yahoo, serves on the boards of directors of Berkshire Hathaway, Intel and Costco Wholesale. Reach her at her blog, DeckPosts.net or @suedecker.

This article originally appeared on Recode.net.

A Fish Is the Last to Discover Water: Impressions From the Ellen Pao Trial

2019-03-06T05:20:17-05:00

On Tuesday, my fiancé and I took our daughters out of school, canceled my meetings for the day, and, for the first time, walked into the San Francisco Superior Court. Our mission: To hear the closing arguments of the Ellen Pao discrimination suit against Kleiner Perkins Caufield & Byers.

Truth be told, I have been obsessed with this case. Most days for the last month I have Googled news stories to catch up with what has been happening, and I have been actively following Re/code’s great coverage by Liz Gannes and Nellie Bowles. I was spoiled by their liveblogging on the days of high intrigue, and deeply disappointed when I had to wait until the end of the day to read the digest on what happened, rather than the blow-by-blow coverage of each moment.

The case somehow found its way to the fore at our family dinner-table conversations on several occasions. So when I announced on Monday evening that I was going to the courthouse to watch it live on Tuesday, our daughters were quite articulate about why this was an educational experience worth their missing school. With great thanks to the administration of their schools, we all trekked to 400 McAllister Street in San Francisco to hear the final chapter of oration.

What is it about this particular case that gripped me?

At the heart of it, is that I think it takes a lot of guts to do what Ellen is doing, and I think she is hitting on a very valid and important issue. And in so doing, I think we may look back at this as a watershed moment — regardless of how the very attentive jury comes out on their verdict. Let me also add that I don’t know Pao or her partners at KP well enough (other than Mary Meeker, for whom I have great respect) to come into this particular situation with biases on either side.

I find it easy to emotionally “compartmentalize,” to put things in the background that are bothering me, in order to focus on the task at hand. This “skill” is something that many have said has helped me to succeed. And yet there is something about this case that struck a deep chord in me, and that made me want to slow down time and to experience every one of its moments. To process it in real time.

The title of this essay is a proverb that I first heard in college from my favorite economics professor, Derek Jennings. It means that it is hard to see a new paradigm when people are immersed in the one they know. If something is as natural as breathing, it is just the way things are, and the existing culture can make people oblivious to how it might or should be different.

I, and most women I know, have been a party to at least some sexist or discriminatory behavior in the workplace. Many of the examples raised in this trial are behaviors I have personally witnessed along the way. At the same time, the men who may be promulgating it are often very unaware of the slights, and did not intend the outcome. And for the women, it happens in incremental steps that often seem so small in isolation that any individual act seems silly to complain about. So we move on. But in aggregate, and with the perspective of hindsight, they are real.

Although many have questioned this aspect of the case, and the defense hammered at it, I am personally not surprised that Pao did not raise many of her current claims along the way as they happened. She purportedly didn’t ask for HR policies or outwardly complain or report to others the various alleged discriminatory actions as they first arose. To some, this is seen as changing her story for the legal case.

But I can imagine that as the little injustices built up, she compartmentalized and moved on. That’s the easier path. It might not have occurred to her in real time that there should be a policy in place, for example. I know many women in high-powered positions who have not reported incidents or didn’t want to rock the boat. It can be the benefit of reflection on the totality of the situation that provides clarity.

There is no doubt that this case is complicated, and that the defense has raised some good points. That is part of what makes it so intriguing. At the same time, hearing a Kleiner partner call Pao Ellen “entitled” reminded me about other status-quo reactions in history, when a group in minority asks for a level playing field. For the African-American community, they were labeled “uppity” by American culture for asking for such rights. Asking for things that are not the status quo can be perceived as presumptuous.

Some women I have spoken to about this case have the view that “boys will be boys”. One said — about the alleged conversation on the now-legendary plane ride — that Pao should “grow a pair,” since many of us have witnessed that same kind of locker-room discussion during travel with colleagues. It is important to note that several people denied that this conversation occurred. Even if it didn’t happen the way Pao claimed, I’ll admit that had I heard such a conversation, I probably would have ignored that sort of thing, rolled with the punches, and moved on. I have in the past, for sure.

I think it takes someone with a little bit of crazy to actually stand up and take a stand on these issues. It may be that Pao found it harder to not feel slighted by the various examples that many other successful women would have ignored along the way. Perhaps she was raised differently.

But thank goodness there are people willing to stand up for civil rights at times when others are afraid to do so. The numbers have long shown there is a problem for women reaching senior positions in the venture capital industry. No one argues with that.

Whether Ellen Pao was the best plaintiff example of gender discrimination in the workplace, and whether Kleiner Perkins was the most egregious defendant choice, I do not know. There may be better examples on both sides. But it is this case that shined the light on a very important issue, and there is no one I have spoken with who doesn’t think at least a part of Pao’s claims are true.

Regardless of how the verdict comes out, I think it will have the impact of a wake-up call for all of us fish. For a moment over the last month, we jumped out of our water and thought very critically about the environment within which we swim. More and more women and men are starting to “lean in” and take responsibility for changing the waters.

And for my daughters, I think it was well worth the day of hooky to see this process in action. They saw that the waters are changing, and that sometimes it takes a moment of disruption for people to see with more clarity.

Sue Decker, former president of Yahoo, serves on the boards of directors of Berkshire Hathaway, Intel and Costco Wholesale. Reach her at her blog, DeckPosts.net or @suedecker.

This article originally appeared on Recode.net.

Digital Content and the Social Flywheel

2019-03-06T05:18:37-05:00

I have always loved the publishing business. It started in my teenage years in Denver, getting up at 4 am, snow or shine, to deliver newspapers to 250 doorsteps. Once the job was complete, the cycle started anew. The next-day edition was already in process; content being created, edited, packaged, printed, stacked and dropped on my driveway for me to distribute every 24 hours. Amazing.

My passion developed further during my twenties and thirties, when I worked on Wall Street as an equity research analyst, covering the public companies in the publishing industry. I was fascinated to learn about the families and media titans that had come to control the business, and came to more deeply understand the economic juggernaut of limited competition in each market.

These two defining characteristics — a 24-hour manufacturing business and geographic market owners — have given way to the tidal wave of digital in the last 15 years. Amidst the offline ashes from these wrenching changes, the phoenix that is rising is a merging of social signals with online news.

What is so fascinating to me is that what is often chalked up to yesterday’s industry, may actually have its greatest growth in the years ahead as people increasingly take on a curation role, and social networks and content discovery are becoming more inexorably intertwined.

Atomized content

Marc Andreesen’s blog post from last summer is a great starting place for this discussion. In it he notes, “Market size equals destiny. The big opportunity for the news industry in the next five to 10 years is to increase its market size 100x AND drop prices 10X. Become larger and much more important in the process.”

I think he’s right. On the demand side, people inherently care about what is going on in their communities, and want to make sense of their world. This is basic to the human condition. Abraham Maslow called them “cognitive needs.” This demand is growing more global and 24/7 as communication and mapping technology make the world a smaller place, and as digitization and search technology can surface information instantly.

Supply factors matter, too. The amount of news being produced and the velocity with which it is being distributed is skyrocketing. Distribution has become open, and the barriers to write and publish are disappearing. And smartphones (computers in every pocket) have massively increased accessibility.

The economic barrier in the old-world publishing model of bundling content to command higher pricing is the dam being washing away in this digital deluge. In its place is an atomized content world — just as albums have given way to a la carte song purchases and television content can be bought by the episode on Amazon rather than in a pricy cable package, so, too, are articles available disintermediated from the publisher.

Also contributing to the breaking of the bundle is the fact that the primary remote control to access digital content was through a Google search. Those very loyal to a certain publisher might go to their URL directly, but a quick query in a search box instantly delivers good results, decoupled from the rest of the publisher’s content.

When digital content is accessed in this way, however, it loses the curation that serves as a quality screen to the reader. People now have content at their fingertips, but they have to wade through long streams of search results, RSS Feeds, timelines and tweets to get informed about their world, which creates anxiety.

In its absence, social signals and commentary from people we know and trust are beginning to take its place to deal with content overload. In the simplest form, these take the form of “Likes” or retweets, but they can also include a line or two of editorial introduction from a friend, with a forwarded link to selected content.

As a result, we are seeing a significant trend toward content discovery in social networks. This article shows that close to 35 percent of all news is discovered via social networks. Pew Research shows similar trends, in addition to how social media is changing consumption habits.

Search is still an important way in which content is discovered, but especially in mobile, where search use is less intensive, social networks are becoming much more important sources of traffic referral.

There is a chicken-or-the-egg question here. Are people discovering news from their social networks because that’s where they are hanging out all day, or are they going to their social networks in part to see what their friends and followers are saying about news content? I think the answer is both, perhaps related to demographics.

I go to Paper much more frequently than I go to Facebook, specifically to see what content my friends are forwarding and commenting on, and I inevitably discover interesting content that I missed from my other channels. Others — including my kids — may just be sitting in their social streams for other reasons, and happen to see interesting content tidbits float by that piques their interest.

The competitive flywheel

Competitive reactions to these forces — an expanding market for content in which social signals are increasingly replacing or supplementing the role of the publisher — are striking. Social networks are getting into content, content companies are becoming more social networking savvy, and content aggregators are pulling in social streams and signals for curation.

For example, in addition to Facebook’s stand-alone Paper app, we see LinkedIn’s purchase of Pulse and the development of its influencer network and publishing platform to encourage original content generation. Twitter’s recent attempts to better curate its endless timeline fire hose (“while you were away” and “what’s trending in your network”) are other examples of a move toward curation.

Even Snapchat is getting into the game. Their approach is more as an aggregator of professional content — applying hip, pithy titles and presented in short video snippet formats — than via social signals. But its success will depend on its large and growing young social network for traffic.

Symbiotically, new and old content companies that understand best how to use social media channels to make sure we see their stories are emerging. Brands like the Huffington Post and BuzzFeed, which are less than 10 years old, now attract significantly more monthly online users (115 million and 75 million respectively) than the digital versions of the New York Times and the Wall Street Journal. Emerging brands like the Verge and Upworthy are also gaining steam, fully taking advantage of mobile platforms and the social traffic streams of Facebook and Twitter.

Content aggregators — like Flipboard, SmartNews and Reddit — which present content created by others, also understand the role of social cues. Some or all of their content draws from social streams and they rely on social signals to highlight and promote trending or popular content. These brands and many others have sprouted up like mushrooms after the rain, taking advantage of the merger between news and social media. There are at least two dozen products that have emerged in the last year in this aggregation category.

Not only is news being distributed by social commentary, but social commentary is becoming the news. In this video, Sheryl Sandberg and Megyn Kelly discuss how social networks change the network news game by requiring analysis and context. Similarly, CNBC just ran a segment on Kat Gonso’s letter to Netflix to release “House of Cards” early because it was buzzing all over social media.

What’s next?

Looking forward, I believe this ecosystem will continue to evolve and that social signals will become increasingly embedded into content consumption and discovery. Even though the market has evolved, many people still feel underinformed and overwhelmed by this atomization.

A few concluding observations as these dynamics unfold:

High-quality content: The market for high-quality content to be produced and shared will continue to grow; those who deeply understand and take advantage of social traffic flows and curation and marry that with quality news generation will be the largest. And users will highly demand trusted curators to feel more informed and less overwhelmed.
Social networks will increase their role further in directing traffic to content, significantly surpassing search on mobile form factors, and their algorithms to separate wheat from chaff will become more sophisticated.
M&A: The idea that others have suggested of Google buying Twitter makes some sense viewed through this lens. Search was/is the remote control of the Web world, and Twitter is increasingly playing this role on mobile devices.
In fact, I wouldn’t be surprised to see a social network acquire a major next-generation content company to more finely tune editorial content to its mass audiences (like Costco offering its own quality Kirkland brand on its shelves while also merchandising other brands).
Independent content aggregators and original creators: These will need to embed social features and high-quality curation much more deeply in order to attract users on a daily repeat basis, and to compete effectively with social networks for content discovery. Some may find success with game-like features that make usage more habitual. Others will likely be sold or shuttered if they don’t attract habitual use.
Next-generation content platforms: Some may emerge that take social engagement around interest areas further than they do today, creating new social graphs around common topic areas. There are ad hoc “social networks” of interested people in the invisible network map of how news stories are spread across Twitter that next-generation content companies may proactively highlight and utilize— — or develop on their own. And there are invisible social networks within news stories — connected people and affinities — that can be harnessed as a form of curation around key interest areas.

In time, I can imagine a world in which news will travel and be curated online across both defined social networks — as it does today — but also impromptu ones that form around a story, a news cycle or a common interest. These may change and reform from day to day and hour to hour.

For consumers, getting the right trusted curators removes friction from the experience of endless streams. Back to the future, this may represent the next step in what the Economist was talking about in terms of how news once traveled through coffeehouses and social groups before mass distribution.

Buckle your seat belts — this area promises to be dynamic and interesting in the years ahead.

Sue Decker, former president of Yahoo, serves on the boards of directors of Berkshire Hathaway, Intel and Costco Wholesale. Reach her at her website, DeckPosts.net or @suedecker.

This article originally appeared on Recode.net.

Imma Be a BABA Bull: Yahoo, the Morning After

2019-03-06T06:21:05-05:00

After publishing a recent post on the Harvard Business Review and Re/code about how the Alibaba deal came together, I have received many inquiries about what Yahoo is worth, and how it will trade “the morning after” the big shindig of the pricing of Alibaba’s IPO on Thursday evening. I am a Yahoo shareholder, having long held onto my shares since I left the company in 2009, awaiting the events of this week. So I have a vested interest in this question, as well.

I went to look for valuations from the experts, and saw that most of the Wall Street analysts who usually publish on Yahoo have been silenced by their firm’s role in the BABA IPO. At the same time, there have been some really interesting articles and blog posts recently talking about whether YHOO’s path would be similar to the experience of so-called “proxy stocks,” such as GSV Capital (GSVC), which had large stakes in Facebook and Twitter before their IPOs, and traded down following those events. Another similar example provided by Michael Santoli is how 3Com traded in advance of and right after the Palm IPO.

While really interesting, those proxy analyses don’t focus on the fundamental value of the sum of the parts. So I decided to dust off my analyst hat and see what the market is saying about the values and possible levers for upside/downside. The table below is what I came up with; the column at the far right and the conclusions at the bottom are what I found most interesting.

But first, I made a few assumptions. I used a multiple of six on core-business EBITDA, because I don’t see much growth there, for reasons well documented by others. For those who disagree, each multiple point is worth about $1.50 per Yahoo share.

I assumed full tax rates on Yahoo Japan and Alibaba in the event the positions are sold, though many have written about possible tax arbitrage situations if Yahoo were purchased by Alibaba or SoftBank, or if tax rates in Hong Kong prevail. If you believe that, there is upside to these figures.

I applied a 20 percent liquidity discount to YHOO’s Yahoo Japan stake, and none to the Alibaba stake. My thinking was that BABA will be relatively straightforward for YHOO to sell after the deal, but Yahoo Japan will not. Yahoo will hold 16-17 percent of BABA post-IPO, and if it plans to liquidate that over time, it is unlikely to meaningfully move the stock, considering the liquidity for future dispositions with BABA’s pending NYSE listing.

For Yahoo Japan, however, SoftBank and Yahoo together own about 77 percent of the shares, and only the remaining 23 percent or so is publicly traded on the Tokyo Stock Exchange. It would not be an easy matter for Yahoo to unload its 36 percent stake into a public market in which such a small piece of the company trades, among other issues.

What I thought was particularly interesting was that the specific IPO pricing level is almost irrelevant to the value of Yahoo’s shares; for every $1 per share change in the IPO price, it only amounts to less than a dime of value to YHOO shares. So if the IPO is priced above the range at $70 per share, it only makes a $0.18 per share of difference to YHOO’s share value versus my assumptions.

On the other hand, the real story is how BABA trades after the IPO price, given YHOO’s continuing stake and the higher implied trading values, and the much broader range of possibilities than tinkering with the IPO price by a few dollars per share. For every $1 per BABA share, YHOO’s retained BABA value will represent $0.24 per YHOO share. This is after considering a full tax rate of 35 percent; the ratio is even higher if you believe there is a tax angle here. So if BABA trades up to $225 billion valuation ($96 per share), for example, it adds about $3.60 to YHOO versus the math in the table ($.24 times $15 per share, the difference between $81 and $106). The reverse, of course, is also true.

The other interesting observation to me was that Yahoo’s residual stake in BABA, after selling a portion in the IPO, appears to work out to about 47 percent of YHOO’s total value (where YHOO is trading today), while pro-forma cash (boosted from the sale of part of its BABA position in the IPO) and its stake in Yahoo Japan are worth about 33 percent, leaving the Yahoo core business value at roughly 20 percent.

Those pieces — Yahoo core, cash pro-forma the IPO, and Yahoo Japan — work out to a combined value of around $23 per share (see table). Therefore, a quick way to do the math of where YHOO should trade on Friday is to take BABA’s price x $.24 plus $23. For example, at $100 per BABA share, YHOO should trade around $47; if BABA settles at $70 per share, YHOO should trade around $40. If the YHOO turns out to be less than those values, then it may be cheaper to buy BABA through YHOO; if it is more, then the market may be assuming a better tax case than I am.

I am an unabashed BABA bull. For those who want to own BABA for the long term, the key question for investors on Friday will be whether they play BABA directly or use Yahoo as a vehicle for exposure. I lean toward the former, unless the market values YHOO’s ongoing stake in BABA at less than $.24 for each $1.00 of BABA value.

Sue Decker, former president of Yahoo, and a former entrepreneur in residence at Harvard Business School, is a member of the boards of directors of Berkshire Hathaway, Intel and Costco Wholesale. This article is also available at her website, Deckposts.net.

This article originally appeared on Recode.net.

When Yahoo Met Alibaba: The Third Time Was the Charm

2019-03-06T06:19:09-05:00

In May of 2005, Yahoo CEO Terry Semel, co-founder Jerry Yang, business development executive Toby Coppel and I went on what would turn out to be a fateful trip to China.

Fateful for Yahoo, for certain.

Less than a decade later, the ownership stake that resulted from that trip has been the saving grace for the company that had once dominated the early Internet. The value of the shares bought then, in fact, now make up a big chunk of the value of Yahoo today, and the windfall of cash from that purchase is what many hope will allow it to remake its uncertain future.

At the time, though, we were just in search of a new approach to building a sustainable business in that oftentimes difficult but critical market. Things hadn’t gone well up until that point. In fact, you could say (and many did) that our previous attempts had failed, in the sense of amassing a sustained and meaningful market position.

The roots of this success were built on learnings from our prior attempts in China and a resolve to take some new risks to make this one successful. In some ways, these powerful lessons ring with greater clarity nearly a decade on and might shorten a comparative pathway to success for other business leaders seeking growth in that dynamic market.

Build, buy, partner

The first Yahoo forays into China started with a build strategy, later moved to a buy strategy and ultimately settled on a partnership strategy. In each incarnation, we spent a lot of time thinking about what might leverage our existing product. In hindsight, this thinking turned out to be far less important than the lessons we learned about leadership, control and trust, which ultimately were reflected in how each of the businesses were created, capitalized and staffed.

Yahoo’s first attempt to build a business in China began in 1999, a basic effort to extend the brand and products, except for the extraordinary complexity of doing even that in China. To begin with, coding was entirely different in the so-called “double-byte” countries, since Web traffic has to handle the more data-rich characters associated with Chinese characters as compared to Latin ones. Even so, from 1996 to 1998, Yahoo had already launched businesses in Japan, Korea and Taiwan. At that time, China was seen as just another step forward into a fast-growing market.

As such, Yahoo China was launched in 1999 as a translation of U.S. content into two Chinese languages, including directory access to 20,000 websites with a heavy portal orientation, including news, finance, weather, email and instant messaging. We had done it elsewhere, and it was working.

When Yahoo China was established that year, roughly five million people were accessing the Internet in China. That figure would prove to more than double in each of the coming years, until China became the single largest country of Internet users, surpassing the U.S. by the end of 2005 with roughly 200 million users across PCs and mobile phones.

But by 2002, just two years into our operation, it was clear that Yahoo was not getting the traction that other local Chinese Internet companies were seeing. Revenue was only a few million dollars and we were drawing only five million to 10 million users to the site each month.

In contrast, our local competition were collectively generating close to $100 million in revenue at the time, with much higher user bases. The ad market in China was only approaching $70 million by 2002, so many of these companies were already experimenting with new types of revenue and business models that were beyond our reach. As a result, they were drawing increasingly more of the now 40 million people who were accessing the Internet in China by this time.

Having seen great success with local Chinese entrepreneurs, we decided that the solution was to acquire a local company that had already gained traction in the market, one that could give us proven local management.

We had also made search a priority in our core business after buying Inktomi in 2002, and we wanted an acquisition that could help us extend there, as well.

In November of 2003, following careful consideration of multiple alternatives and six months of due diligence, we announced our agreement to purchase 3721. The company met all the requirements: It was clearly of the Chinese market; they had five years of growth experience and close to 200 employees; and, perhaps most of all, it was run by an aggressive Internet entrepreneur, Zhou Hongyi.

The core product at 3721 was a browser download that helped users in China go directly to destination websites, which was essentially an early form of a search. The company generated revenue from selling hundreds of thousands of Chinese-language keywords for Latin alphabet domain names targeting small- and medium-sized businesses. It had also begun to sell wireless offerings from SMS and ringtones, as mobile phones had already surpassed PC internet users in China by this time.

The idea was simple: Combine the best of both companies into one blended operation to create the new Yahoo China. The tagline of the press release said as much: “Cooperation Will Help Asia’s Small- and Medium-Sized Businesses Reach Increasing Number of Consumers and Build a Bridge to Global Markets.” The combined companies were projected to generate more than $25 million in revenue in 2004. We had 300 people — mostly local talent — and, together, we were reaching more than 50 million users each month.

Careful attention had gone into structuring the deal to moderate the risks of operating in China, while also empowering the local talent. As we closed the deal, China had become the No. 2 Internet market in the world measured by users, yet our penetration was still only five percent. We felt confident that with a stronger presence and a more local team, opportunities to expand would follow, as more and more people came online. We were optimistic about Yahoo’s future in China as the deal closed in January 2004.

By mid-2004, however, the operation was mired in internal conflict, largely due to friction over control issues and management style differences. Most of the Yahoo China people had been forced out or elected to leave, because of the new management style. And our finance, legal and HR functions were in a complete state of upheaval.

Hongyi reportedly felt that the original Yahoos were overpaid and lazy, whereas the Yahoo team felt Hongyi wasn’t focused on the Yahoo operations, and felt bullied. So, we spent much of 2004 clarifying and trying to implement internal processes. As the business was wholly owned and consolidated into our financial statements, we insisted that the local team had to follow Yahoo systems and governance requirements. Not surprisingly, this didn’t sit well with the local team.

Ultimately the earn-out, which was a feature in the structuring of the original deal, was used as leverage to incent Hongyi to gain compliance with these issues, while building organization for a smooth transition for his eventual departure in 2005. He later went on to found and lead Qihoo 360 Technology, a $12 billion company that now trades on Nasdaq, in which he didn’t face the same sort of control issues that were placed upon him in the Yahoo ownership structure.

Although Hongyi was able to outperform the financial plan, the gap between 3721’s market position and the local competition was rising. Yahoo was in a stronger market position than before acquiring 3721, but there were big gaps, and both Google and Baidu were gaining share. Other local portals also continued to extend their lead versus our product offerings.

During the first half of 2005, as Semel and our executive team studied the landscape carefully, we were looking at companies we might acquire or with whom we might strike a partnership. And so began that auspicious trip in May of 2005, in which Semel, Yang, Coppel and I set out to meet dozens of companies and government officials over the course of a whirlwind week.

Most of the companies we met with were publicly held, but Alibaba was still privately held. The company was owned by management, venture capitalists and SoftBank. We met with founder Jack Ma and his chief financial officer Joe Tsai, with whom we immediately felt a strong cultural alignment.

Alibaba was based in the south, and had about 2,400 employees. The previous year, it had generated more than $4 billion in gross merchandise sales through its platform, yielding about $50 million in revenue.

The company also had two startup business lines, Alipay, a new payment system designed to work like PayPal, and Taobao, a startup auctions site. Both were offered free to consumers and merchants.

We had seen the power in Yahoo Japan of a similar partnership, and we thought that maybe Alibaba could help us bolster our market position in the things we brought to the table. We also had the financial resources to help them weather the days of offering auctions for free, as it attempted to compete against eBay. This was important, given Alibaba’s ambition to launch new businesses and a privately held capitalization structure.

We thought there might be a window of opportunity to build a leadership position in search and commerce in China, to complement our portal offerings with the right strategic partners. We returned in late May to Sunnyvale, and began an intense two-month period of negotiation and crafting of what became the joint venture with Alibaba.

Yang had struck up a good relationship with Ma, which greatly facilitated the negotiations. On the finance and deal side, we also felt a strong kinship with Tsai. A complicated deal to structure, we eventually came to agreement in which Yahoo would own 40 percent, SoftBank held 30 percent, and existing management kept 30 percent. In addition, Ma and the Alibaba leadership team would retain management control.

The deal was valued at just over $4 billion, with Yahoo putting in $1 billion in cash and our Yahoo China assets, which were then valued at $700 million. It was an attractive offer and step-up in value, considering what we had contributed to 3721 and its $120 million purchase price two years earlier.

While Yahoo China was tracking toward about $40 million in revenue in 2005, Alibaba’s consumer business alone was poised to do more than double that for the year, so it was valued at close to double our operation. In addition — and at the time, this seemed like a big leap of faith — more than half the value of the venture, more than $2 billion, was attributed to Taobao and Alipay. Both were losing money, having told the market they would be free of service for the next few years.

Still, we announced the deal by early August, less than three months after the trip that gave birth to the venture.

Key lessons learned

Looking back now, it is clear that there were three primary factors that ultimately led to the Alibaba deal being set up for value creation in the Chinese market.

The goal of “failing fast,” and learning from those mistakes to pivot and change the approach, has almost become a maxim in Silicon Valley. We learned that a willingness and inclination to stay at it and keep trying new approaches was critical to our ultimate success.

I serve on two boards with noted investor Charlie Munger — Costco and Berkshire Hathaway. Munger is a legendary business leader with an abundance of wisdom. He says repeatedly to us that he has constantly seen people rise in life who are not the smartest. But he noted that “they are learning machines,” adding that “they go to bed every night a little wiser than they were when they got up.”

A second critical principle that contributed to our success in China was the realization that we had to be willing to loosen the reins of control.

The most “controlled” approach was our initial “build” strategy, in which existing Yahoo controlled the product and the team and generally centralized the compliance functions, such as finance and legal. To do that, we relied on talent hired by Yahoo employees and recruited managerial talent from within Yahoo. This facilitated communication to headquarters and know-how on the ground, and felt like a comfortable way to access a new market, considering the great distances, both geographically and culturally.

This approach, however, turned out to be problematic. The local hires in China felt that our Sunnyvale leaders did not understand the market. They viewed the “multinational” leaders we empowered to operate in China as outsiders. This fostered tension from the get-go, and nurtured a lack of trust. Lead times on approvals back to headquarters in Sunnyvale for locally generated ideas were too long, and we weren’t able to move fast enough in a fast-growing market to be competitive with local competition on the product side.

To remedy this, when we purchased 3721, we were willing to give up a lot of the product control to an aggressive and experienced Chinese leader, and allow much greater latitude for local decision-making. We thought this would speed up decision-making and product launches, tuned for the local market, a clear characteristic of all of the local competitors that were beating us.

We also empowered the 3721 management team to manage the combined operations, including the former Yahoo China operations. The functions of legal, finance and human resources were the only ones still reporting back to headquarters and outside the local business operations.

This “hybrid” approach seemed like a good way to thread the needle of local product control, while also recognizing the goals of building cultural alignment and establish compliance controls where we needed them. While 3721 was an evolution in giving up some control, it also wasn’t enough, and, in some ways, this hybrid approach was the most difficult. Too much time was spent internally on all the people issues that emerged from two different cultures and business practices. Worst of all, it slowed us down on the product side, as well.

And so, with Alibaba, we realized we needed to be willing to give up all operating control. Practically speaking, this meant forgoing our previous desire to own more than 50 percent of the local operations. It also meant that we would leave all employee issues with our partners, and to allow people with whom we had no history to have access to our code and to build on top of it.

While this was scary, at the same time we had a model that had worked spectacularly well in Japan, where Yahoo owned one-third of the company and licensed its brand and technology and local management called the shots. Sunnyvale’s role was a supporting one, with some governance rights through licensing agreements and board representation.

The third factor that was critical to our ultimate success in China was the match with the leadership team of Alibaba. To feel comfortable in giving up control, we had to find a management team with whom we could find some cultural alignment, and could work to build trust.

Although Ma didn’t have a U.S. education, he was an avid student of U.S. management and leadership practices, and was very expressive about this in our very first meetings. By contrast, we had seen, in meetings with many other management teams, the strong influence of Confucian principles respecting hierarchical, top-down leadership systems.

Ma expressed a desire to add top talent to help support him leading the company. We could see this willingness to share power and complement his strengths in Tsai, then the CFO, later COO, and now vice chairman of Alibaba. Tsai clearly understood U.S. business practices, and had strengths that complemented Jack’s strengths in strategy and setting the vision.

A 2010 Harvard Business School case by Professor Julie Wulf noted that Ma studied Jack Welch’s approach at General Electric and was inspired by decentralized decision-making. She noted Welch’s assertion that “Business unit presidents must have the freedom to do what is right for their business. I want business units to compete with each other … and focus on being the best in their businesses.” Ma wanted that same spirit for our business in China.

For us, having a leader in charge who had both the humility and confidence to hire, retain and grow talent felt like the change we needed. Thus, we were comfortable and ready to give him the keys of control on the Yahoo operations in China.

Beyond the Yahoo experience

Many other U.S. companies were either entering China or making plans to do so at around the same time that Yahoo was making its early moves. All entrants faced a similar set of circumstances and conditions, including unique business challenges and being subject to different laws and customs. Adding to this, the operation of social sites is more difficult for foreign companies, given that many local sites are not blocked to the same extent.

According to GreatFire — a Chinese Web traffic monitor — more than 2,600 websites are blocked by China’s censorship policies. This extends to any non-Chinese user-generated content sites, such as Facebook, Twitter and YouTube. Whether they are blocking because of a concern to control organized political resistance or to promote Chinese social sites, the impact is the same. Facebook does have a sales office in Hong Kong, and recently announced that it may be opening another in Beijing, but it is a long way from solving the big issues.

Within that context, most made the same mistakes that Yahoo did in those early attempts to build a presence in China. Many then left the market after those disappointments.

The most interesting attempts of a “buy” strategy was that of eBay and, in its earliest days, it looked like it might be very successful. EBay bought one-third of EachNet in 2002 for $30 million, which was the leading auction site, founded in 1999. In 2003, it paid $150 million for the remaining two-thirds, and subsequently funded another $100 million for operating expenses, in addition to funds expended in advertising with the major local Chinese portals, to drive its presence in auctions.

In 2003, EachNet had close to an 80 percent market share in the auction market, compared to Taobao’s share of less than seven percent. However, by the time we met with Ma in May 2005, eBay was already being locally outmatched. Ma told us he launched Taobao to defend Alibaba’s position in its core business-to-consumer business. He had seen eBay do the reverse in the U.S., and he felt the distinction between a small business and a consumer was small.

Since his main initial goal was to defend his consumer business, as opposed to build a profitable standalone auction site, Ma made a decision not to charge listing fees, whereas EachNet did. In addition, the site design and the marketing approach were distinctly oriented to the Chinese market. Taobao offered live chat features so users could make deals together and build trust. EBay feared this would allow users to avoid its listing fees and transact directly, so it didn’t offer this valued feature. Also, the eBay servers were located outside of China, making the service slow.

By 2005, Taobao had bested eBay for market share, and by the end of 2006, eBay pulled out of the market completely.

By contrast, Google’s strategy was primarily a “build” strategy, similar to Yahoo’s first foray. Google rolled out a Chinese-translated version of Google.com in 2000, running on servers from the U.S. The site was slow, and it was often censored or shut down, causing it to lose market share over time to Baidu.

In 2006, after much reported trepidation and debate, given the massive growth in the user base in China, Google attempted to rectify the situation by launching a local .cn version of its code, using servers located in China. This came with the known cost of more limited features than in the U.S. service and filtering results in order to meet local censorship requirements. It made some competitive headway, but even at its peak, it claimed about one-third of the market to Baidu’s two-thirds.

In 2009, Google changed its approach. It stopped self-censoring results and moved its business to Hong Kong in March of 2010. It had learned of a hacker attack aimed at surfacing information about human-rights activists. Google knew that China might ban access if it didn’t censor its results, and sure enough, the government did just that. This effectively ended Google’s attempt to compete in China. But how much of it was due to the political climate and how much to being outgunned operationally is unclear.

AOL’s approach was primarily through a variety of partnerships and investments in China, none of which appear to have borne fruit. In 2001, AOL entered China with a $100 million investment for a 49 percent stake of a joint venture with Legend (later Lenovo) to launch a Chinese-language portal. The venture was a flop within a few years. It also made a controlling investment in China Entertainment Television (CETV), which was sold in 2003.

Amazon.com purchased Chinese local Joyo for $75 million on August 19, 2004, but in its 10 years, it has not kept up with local competitors such as Taobao Mall and Jingdong Mall. The IT and logistics challenges in China are significant. It is still investing in China, but claims only about one percent of the e-commerce market in China. Amazon is still present, and it has launched a cloud service and an app store.

On the social side, sites like Facebook, Twitter — and, earlier, Myspace — have not made inroads, due to routine government blocking and censorship, and extremely strong local sites. Myspace was first in, attempting to avoid some of the early mistakes by using a local group of entrepreneurs to launch Myspace China. However, by the time they had figured out a plan, many local social and gaming sites were already very successful, including China’s dominant Tencent. By 2011, Myspace had all but left the market, with large downsides in staff, including its CEO.

Conclusion

Whether building, buying or partnering, all of the major U.S. Internet companies that did not succeed in China did not reenter with new or different strategies. Yahoo was not different from any of its peers with its early failed forays. The difference was that we kept going back, building on knowledge from the prior attempt, until the third time was the charm.

Nine years later, the venture has gone through a few many changes. For example, Alibaba was listed on the Hong Kong stock exchange in November of 2007, raising $1.5 billion, to become the world’s biggest Internet offering since Google’s initial public offering in 2004. The company subsequently went private in early 2012. There have also been changes in the framework agreement around the ownership of Alipay in both 2011 and 2012, as well as the buyback of almost half of the Yahoo stake, in May of 2012, for $7 billion.

Interestingly, these changes, as well as countless operational ones, would have been hampered by a layer of operating control from the U.S. parent. For example, Ma never really focused on the businesses of Yahoo China; in hindsight, his interest in the deal was largely to secure cash to help fund operating losses at Alipay and Taobao, and to leverage the Yahoo brand for the global business of Alibaba. But the core structure of the transaction empowered him to make the decisions to drive long-term value. Luckily, Yahoo felt it could live with this arrangement, but it would never have done on its own, and that probably would have created friction from time to time, had Yahoo corporate had a vote.

Today, the company is ranked beside Google, Facebook, Twitter and Tencent as among the titans of the Internet.

Currently, analysts estimate that the company will be valued at over $200 billion when it trades.

That works out to 40x the value of the deal we struck back in 2005. Had Yahoo held its entire stake, its share would be worth $68 billion, or $40 per Yahoo share, after tax today. Even still, the company will be reaping a huge return.

A version of this post originally appeared on HBR.org.

Sue Decker, former president of Yahoo and a former entrepreneur-in-residence at Harvard Business School, is a member of the boards of directors of Berkshire Hathaway, Intel and Costco Wholesale.

This article originally appeared on Recode.net.