July 2023 - The Myth of Capitalism by Jonathan Tepper with Denise Hearn

We learn about the fun history of many monopolies and anti-trust! While I can’t recommend this book because its long and poorly written, it does reasonably critique aspects of antitrust and monopoly formation. Its repetitive and so aggressively one-sided that it loses credibility. The fact that the author used to advise and now runs a hedge fund that owns monopoly businesses tells you all you need to know.

Tech Themes

1. Consumer Welfare. Tepper’s fundamental argument is that since the 1980s, driven by Regan’s deregulation push, the government has allowed corporate mergers and abuses of market power, leading to more market concentration, higher prices, greater inequality, worse worker conditions, and stymied innovation. Influenced by the Chicago School’s free market ideas and Robert Bork’s popular 1978 book Antitrust Paradox, the standard for antitrust enforcement morphed from breaking up market-abusing companies to “consumer welfare.” With this shift, antitrust enforcement became: “Does this harm the consumer?” A lot of things do not harm consumers. Broadcast Music, Inc. v. CBS, Inc. (1979) is widely regarded as one of the first antitrust cases that shifted the Rule of reason towards consumer welfare. CBS had sued Broadcast Music, alleging that blanket licenses constituted price fixing. Broadcast Music represented copyright holders and would grant licenses to media companies to use artist’s music on air. These deals were negotiated on behalf of many artists, and did not allow CBS to negotiate for selected works. The court sided with BMI because the blanket license process was simpler, lowered transaction costs by reducing the number of negotiations, and allowed broadcasters greater access to works. They even admitted that the blanket license may be a form of price setting, but concluded that it didn’t necessarily harm consumers and was more efficient, so they allowed it. The consumer welfare ideology has recently come under fire around the big tech companies - Apple, Microsoft, Google, Meta, and Amazon. Lina Khan, Commissioner of the Federal Trade Commission (FTC) wrote a powerful and aptly titled article, Amazon’s Antitrust Paradox, highlighting why in her view consumer welfare was not a strong enough stance on antitrust. “This Note argues that the current framework in antitrust—specifically its pegging competition to “consumer welfare,” defined as short-term price effects—is unequipped to capture the architecture of market power in the modern economy.” The note argues that Amazon’s willingness to offer unsustainably low prices and their role as a marketplace platform and a seller on that marketplace allow it crush competition. Google is currently being sued by the Department of Justice over illegal monopolization of adtech and its dominance in the search engine market. The government is attempting to shift antitrust back to a more aggressive approach regarding monopolistic behavior. From a consumer welfare perspective, there is no doubt that all of these companies have created situations that benefit consumers (“free” services, low prices) and hurt competition. The question is: “Is it illegal?”

2. The ACTs - Sherman and Clayton. The Sherman Antitrust Act, passed in 1890, was the first major federal law aimed at curbing monopolies and promoting competition. The late 19th century, often referred to as the Gilded Age, saw the rise of powerful industrialists like J.P. Morgan, John D. Rockefeller, and Cornelius Vanderbilt, whose massive corporations threatened to dominate key sectors of the economy. Public outcry over the potential for these monopolies to stifle competition and exploit consumers led to the passage of the Sherman Act. Senator John Sherman, intended the law to protect the public from the negative consequences of concentrated economic power. The Sherman Act broadly prohibited anticompetitive agreements and monopolization, empowering the government to break up monopolies and prevent practices that restrained trade. However, the Sherman Act's broad language left it open to interpretation, and its early enforcement was inconsistent. President Theodore Roosevelt, a proponent of trust-busting, used the Sherman Act to challenge powerful monopolies, such as the Northern Securities Company, a railroad conglomerate controlled by J.P. Morgan. The Supreme Court's decision in the Standard Oil case in 1911 further shaped the interpretation of the Sherman Act, establishing the "rule of reason" as the standard for evaluating antitrust violations. This meant that not all restraints of trade were illegal, only those that were deemed "unreasonable" in their impact on competition. The Clayton Antitrust Act, passed in 1914, was designed to strengthen and clarify the Sherman Act. It specifically targeted practices not explicitly covered by the Sherman Act, such as mergers and acquisitions that could lessen competition, price discrimination, and interlocking directorates. The Clayton Act also sought to protect labor unions, which had been subject to antitrust prosecution under the Sherman Act. The passage of these acts led to a wave of significant antitrust cases. Prominent examples include: United States v. American Tobacco Co. (1911): This case resulted in the breakup of the American Tobacco Company, a dominant force in the tobacco industry, demonstrating the government's commitment to using antitrust laws to dismantle powerful monopolies. United States v. Paramount Pictures, Inc. (1948): This case challenged the vertical integration of the film industry, where major studios controlled production, distribution, and exhibition. The court's decision led to significant changes in the industry's structure. United States v. AT&T Co. (1982): This landmark case resulted in the breakup of AT&T, a telecommunications giant, into smaller, regional companies. This case marked a major victory for antitrust enforcement and had a lasting impact on the telecommunications industry.

3. Microsoft. The Microsoft antitrust case, initiated in October 1998, saw the U.S. government accusing Microsoft of abusing its monopoly power in the personal computer operating systems market. The government, represented by David Boies (yes, Theranos David Boies), argued that Microsoft, led by Bill Gates, had engaged in anti-competitive practices to stifle competition, particularly in the web browser market. Gates was famously deposed and shockingly (not really) came away from the deposition looking like an asshole. The government alleged that Microsoft violated the Sherman Act by: Bundling its Internet Explorer (IE) web browser with its Windows operating system, thereby hindering competing browsers like Netscape Navigator, manipulating application programming interfaces to favor IE, and enforcing restrictive licensing agreements with original equipment manufacturers, compelling them to include IE with Windows. Judge Thomas Jackson presided over the case at the United States District Court for the District of Columbia. In 1999, he ruled in favor of the government, finding that Microsoft held a monopoly and had acted to maintain it. He ordered Microsoft to be split into two units, one for operating systems and the other for software components. Microsoft appealed the decision. The Appeals Court overturned the breakup order, partly due to Judge Jackson's inappropriate discussions with the media. While upholding the finding of Microsoft's monopolistic practices, the court deemed traditional antitrust analysis unsuitable for software issues. The case was remanded to Judge Colleen Kollar-Kotelly, and ultimately, a settlement was reached in 2001. The settlement mandated Microsoft to share its application programming interfaces with third-party companies and grant a panel access to its systems for compliance monitoring. However, it did not require Microsoft to change its code or bar future software bundling with Windows. This led to criticism that the settlement was inadequate in curbing Microsoft's anti-competitive behavior. History doesn’t repeat itself, but it does rhyme and Microsoft is doing the exact same bundling strategy again with its Teams app.

Business Themes

1. Monopoly Markets. Tepper lays out all of the markets that he believes are monopoly, duopoly, or oligopoly markets. Cable/high speed internet (Comcast, Verizon, AT&T, Charter (Spectrum)) - pretty much the same, Computer Operating Systems (Microsoft) - pretty much the same but iOS and Linux are probably bigger, Social Networks (Facebook with 75% share). Since then Tiktok, Twitter, Pinterest, and Snap have all put a small dent in Facebook’s share. Search (Google), Milk (Dean Foods), Railroads (BNSF, NSC, CSX, Union Pacific, Kansas City Southern), Seeds (Bayer/Monsanto, Syngenta/ChemChina, Dow/DuPont), Microprocessors (Intel 80%, AMD 20%), Funeral Homes (Service Corporation International) all join the monopoly club. The duopoly club consists of Payment Systems (Visa, Mastercard), Beer (AB Inbev, Heineken), Phone Operating Systems (iOS, Android), Online Advertising (Google, Facebook), Kidney Dialysis (DaVita), and Glasses (Luxottica). The oligopoly club is Credit Reporting Bureaus (Transunion, Experian, FICO), Tax Preparation (H&R Block, Intuit), Airlines (American, Delta, United, Southwest, Alaska), Phone Companies (Verizon, Sprint, T-Mobile, AT&T), Banks (JP Morgan Chase, Bank of America, Citigroup, Wells Fargo), Health Insurance (UnitedHealthcare, Centene, Humana, Aetna), Medical Care (HCA, Encompass, Ascension, Universal Health), Group Purchasing Organizations (Vizient, Premier, HealthTrust, Intaler), Pharmacy Benefit Managers (Express Scripts, CVS Caremark, Optum/UnitedHealthcare), Drug Wholesalers (Cencora, McKesson, Cardinal Health), Agriculture (ADM, Bunge, Cargill, Louis Dreyfus), Media (Walt Disney, Time Warner, CBS, Viacom, NBC Universal, News Corp), Title Insurance (Fidelity National, First American, Stewart, and Old Republic). Since the book was published in 2018, there has been even more consolidation - Canadian Pacific bought Kansas City Southern for $31B, Essilor merged with Luxottica in 2018 in a $49B deal, Sprint merged with T-Mobile in a $26B deal, and CBS and Viacom merged in a $30B deal. Tepper’s anger towards lackadaisical enforcement of antitrust is palpable. He encourages greater antitrust speed and transparency, the unwinding of now clear market consolidating mergers, and the breakup of local monopolies.

2. Conglomeration and De-Conglomeration. Market Concentration. The conglomerate boom, primarily occurring in the 1960s, saw a surge in the formation of large corporations encompassing diverse, often unrelated businesses. This era was fueled by low interest rates and a fluctuating stock market, creating favorable conditions for leveraged buyouts. A key driver of this trend was the Celler-Kefauver Act of 1950, which, by prohibiting companies from acquiring their competitors or suppliers, pushed them towards diversification through acquiring businesses in unrelated fields. The prevailing motive was to achieve rapid growth, even if it meant prioritizing revenue growth over profit growth. Conglomerates were seen as a means to mitigate risk through diversification and achieve operational economies of scale. Many conglomerates formed that operated across completely different industries: Gulf and Western (Paramount Pictures, Simon & Schuster, Sega, Madison Square Garden), ITT (Telephone companies, Avis, Wonder Bread, Hartford Insurance, and Sheraton), and Henry Singleton’s Teledyne. However, the conglomerate era ultimately waned. The government took a more proactive approach to acquisitions in the late 1960s, curbing the aggressive approaches. The FTC sued Proctor & Gamble over its potential acquisition of Clorox and merger guidelines were revised in 1968, setting out more rules against market share and concentration. Rising interest rates in the 1970s strained these sprawling enterprises, forcing them to divest many of their acquisitions. The belief in the inherent efficiency of conglomerates was challenged as businesses increasingly favored specialization over sprawling, unwieldy structures. The concept of synergy, once touted as a key advantage of conglomerates, came under scrutiny. Ultimately, the conglomerate era was marked by performance dilution, value erosion, and the realization that strong performance in one business did not guarantee success in unrelated sectors.

3. Industry Concentration. A central pillar to Tepper’s argument that the capitalism game isn’t being played fairly or appropriately, is that rising industry concentration is worrisome and indicative of a broken market system. He uses the Herfindahl-Hirschman Index (HHI) to discuss levels of industry concentration. According to the Antitrust Division at the DOJ: “The HHI is calculated by squaring the market share of each firm competing in the market and then summing the resulting numbers. For example, for a market consisting of four firms with shares of 30, 30, 20, and 20 percent, the HHI is 2,600 (302 + 302 + 202 + 202 = 2,600). The agencies generally consider markets in which the HHI is between 1,000 and 1,800 points to be moderately concentrated, and consider markets in which the HHI is in excess of 1,800 points to be highly concentrated.” The HHI index is relatively straightforward to calculate. It can be a quick test to see if a potential merger creates a more significantly concentrated market. However, it still falls prey to some issues. For example, market definitions are extremely important in antitrust cases and a poorly or narrowly defined market can cause the HHI to look overly concentrated. In the ongoing Kroger-Albertson’s Merger case, the FTC is proposing a somewhat narrow definition of supermarkets, which excludes large supermarket players like Walmart, Costco, Aldi, and Whole Foods. If Whole Foods isn’t a super market, I’m not sure what is. And sure, maybe they narrowly define the market because Kroger and Albertsons serve a particular niche where substitutes are not easily available. Whole Foods may be more expensive, Aldi may have limited assortment, and Costco portion sizes may be too big. However, if you have a market that has Kroger, Walmart, Costco, Aldi, and Whole Foods serving a reasonable size population, I can almost guarantee the prices are likely to remain competitive. In some cases, high industry concentration does not mean monopolistic behavior. However, it can lead to monopolistic or monopsonistic behavior including: higher prices, lower worker’s wages, lower growth, and greater inequality.

   Dig Deeper

• Microsoft Volume II: The Complete History and Strategy of the Ballmer Years

• Lecture Antitrust 1 Rise of Standard Oil | Walter Isaacson

• Anti-Monopoly Timeline

• How Xerox Lost Half its Market Share

• (Anti)Trust Issues: Harvard Law Bulletin

May 2023 - Constellation Software Letters by Mark Leonard

We cover Canada’s biggest and quietest software company and their brilliant leader Mark Leonard.

Tech Themes

1. Critics and Critiques. For a long time, Constellation heard the same critiques: Roll-ups never work, the businesses you are buying are old, the markets you are buying in are small, the delivery method of license/maintenance is phasing out. All of these are valid concerns. Constellation is a roll-up of many software businesses. Roll-ups, aka acquiring several businesses as the primary method of growth, do have tendency to blow up. The most frequent version for a blowup is leverage. Companies finance acquisitions with debt and eventually they make a couple of poor acquisition decisions and the debt load is too big, and they go bankrupt. A recent example of this is Thrashio, an Amazon third party sellers roll-up. RetailTouchPoints lays out the simple strategy: “Back in 2021, firms like Thrasio were able to buy these Amazon-based businesses for around 4X to 6X EBITDA and then turn that into a 15X to 25X valuation on the combined business.” However, demand for many of these products waned in the post-pandemic era, and Thrasio had too much debt to handle with the lower amount of sales. Bankruptcy isn’t all bad - several companies have emerged from bankruptcy with restructured debt, in a better position than before. To avoid the issue of leverage, Constellation has never taken on meaningful (> 1-2x EBITDA) leverage. This may change in the coming years, but for now it remains accurate. Concerns around market size and delivery method (SaaS vs. License/Maintenance) are also valid. Constellation has software businesses in very niche markets, like boating maintenance software that are inherently limited in size. They will never have a $1B revenue boat maintenance software business, the market just isn’t that big. However, the lack of enthusiasm over a small niche market tends to offer better business characteristics - fewer competitors, more likely adoption of de-facto technology, highly specialized software that is core to a business. Constellation’s insight to combine thousands of these niche markets was brilliant. Lastly, delivery methods have changed. Most customers now prefer to buy cloud software, where they can access technology through a browser on any device and benefit from continuous upgrades. Furthermore, SaaS businesses are subscriptions compared to license maintenance businesses where you pay a signficant sum for the license up-front and then a correspondingly smaller sum for maintenance. SaaS subscriptions tend to cost more over the long-term and have less volatile revenue spikes, but can be less profitable because of the need to continuously improve products and provide the service 24/7. Interestingly, Constellation continued to avoid SaaS even after it was the dominant method of buying software. From the 2014 letter: “The SaaS’y businesses also have higher organic growth rates in recurring revenues than do our traditional businesses. Unfortunately, our SaaS’y businesses have higher average attrition, lower profitability and require a far higher percentage of new name client acquisition per annum to maintain their revenues. We continue to buy and invest in SaaS businesses and products. We'll either learn to run them better, or they will prove to be less financially attractive than our traditional businesses - I expect the former, but suspect that the latter will also prove to be true.” While 2014 was certainly earlier in the cloud transformation, its not surprising that an organization built around the financial characteristics of license maintenance software struggled to make this transition. They are finally embarking on this journey, led their by their customers, and its causing license revenue to decline. License revenue has declined each of the last six quarters. The critiques are valid but Constellations assiduousness allowed them to side-step and even benefit from these critics as they scaled.

2. Initiatives, Investing for Organic Growth, and Measurement. Although Leonard believes that organic growth is an important measure of success of a software company, he lays out in the Q1’07 letter the challenges of Constellation’s internal organic growth projects, dubbed Initiatives. “In 2003, we instituted a program to forecast and track many of the larger Initiatives that were embedded in our Core businesses (we define Initiatives as significant Research & Development and Sales and Marketing projects). Our Operating Groups responded by increasing the amount of investment that they categorized as Initiatives (e.g. a 3 fold increase in 2005, and almost another 50% increase during 2006). Initially, the associated Organic Revenue growth was strong. Several of the Initiatives became very successful. Others languished, and many of the worst Initiatives were terminated before they consumed significant amounts of capital.” The last sentence is the hardest one to stomach. Terminating initiatives before they had consumed lots of capital, is the smart thing to do. It is the rational thing to do. However, I believe this is at the heart of why Constellation has struggled with organic growth over time. Now I’ll be the first to admit that Constellation’s strategy has been incredible, and my criticism is in no way taking that away from them. Frankly, they won’t care what I say. But, as a very astute colleague pointed out to me, this position of measuring all internal R&D and S&M initiatives, is almost self-fulfilling. At the time Leonard wasn’t concerned with the potential for lack of internal investment and organic growth. He even remarked as so: “I’m not yet worried about our declining investment in Initiatives because I believe that it will be self-correcting. As we make fewer investments in new Initiatives, I’m confident that our remaining Initiatives will be the pick of the litter, and that they are likely to generate better returns. That will, in turn, encourage the Operating Groups to increase their investment in Initiatives. This cycle will take a while to play out, so I do not expect to see increased new Initiative investment for several quarters or even years.” By 2013, he had changed his tune: “Organic growth is, to my mind, the toughest management challenge in a software company, but potentially the most rewarding. The feedback cycle is very long, so experience and wisdom accrete at painfully slow rates. We tracked their progress every quarter, and pretty much every quarter the forecast IRR's eroded. Even the best Initiatives took more time and more investment than anticipated. As the data came in, two things happened at the business unit level: we started doing a better job of managing Initiatives, and our RDSM spending decreased. Some of the adaptations made were obvious: we worked hard to keep the early burn-rate of Initiatives down until we had a proof of concept and market acceptance, sometimes even getting clients to pay for the early development; we triaged Initiatives earlier if our key assumptions proved wrong; and we created dedicated Initiative Champion positions so an Initiative was less likely to drag on with a low but perpetual burn rate under a part-time leader who didn’t feel ultimately responsible. But the most surprising adaptation, was that the number of new Initiatives plummeted. By the time we stopped centrally collecting Initiative IRR data in Q4 2010, our RDSM spending as a percent of Net Revenue had hit an all-time low.” So how could the most calculating, strategic software company of maybe all time struggle to produce attractive organic growth prospects? I’d argue two things - 1) Incentives and 2) Rationality. First, on incentives, the Operating Group managers are compensated on ROIC and net revenue growth. If you are a BU manager and could invest in your business vs. buy another company that has declining organic growth but is priced appropriately (i.e. cheaply) requiring minimal capital outlay, you achieve both objectives by buying lower organic growers or even decliners. It is almost similar to buying ads to fill a hole in churned revenue. As long as you keep pressing the advertising button, you will keep gathering customers. But when you stop, it will be painful and growth will stall out. If I’m a BU manager buying meh software companies that achieve good ROIC and I’m growing revenues because of my acquisitions, it just means I need to keep finding more acquisitions to achieve my growth hurdles. Over time this is a challenge, but it may be multiple years before I have a bad acquisition growth year. Clearly, the incentives are not aligned for organic growth. Connected to the first point, the “buy growth for low cash outlays” strategy is perfectly rational based on the incentives. The key to its rationality is the known vs. the unknown. In buying a small, niche VMS business - way more is known about the range of outcomes. If you compare this to an organic growth initiative, it is clear why again, you choose the acquisition path. Organic growth investments are like venture capital. If sizeable, they can have an outsized impact on business potential. However, the returns are unknown. Simple probability illustrates that a 90% chance of a 20% ROIC and a 10% chance of a 10% ROIC, yields a 19% ROIC. I’d argue however, that with organic initiatives, particularly large, complex organic initiatives, there is an almost un-estimable return. If we use Amazon Web Services as perhaps the greatest organic growth initiative ever produced we can see why. Here is a reasonably capital-intensive business outside the core of Amazon’s online retailing applications. Sure, you can claim that they were already using AWS internally to run their operations, so the lift was not as strong. But it is still far afield from bookselling. AWS as an investment could never happen inside of Constellation (besides it being horizontal software). What manager is going to tank their ROIC via a capital-intensive initiative for several years to realize an astronomical gain down the line? What manager is going to send back to Constellation HQ, that they found a business that has the potential for $85B in revenue and $20B in operating profit 15 years out? You may say, “Vertical markets are small, they can’t produce large outcomes.” Constellation started after Veeva, a $30B public company, and Appfolio, a $7.5B company. The crux of the problem is that it is impossible to measure via a spreadsheet, the unknown and unknowable expected returns of the best organic growth initiatives. As Zeckhauser has discussed, the probabilities and associated gains/losses tend to be severely mispriced in these unknown and unknowable situations. Clayton Christensen identified this exact problem through his work on disruptive innovation. He urged companies to focus on ideas, failure, and learning, noting that strategic and financial planning must be discovery-based rather than execution based. Maybe there were great initiatives within Constellation that never got launched because incentives and rationality stopped them in their tracks. It’s not that you should burn the boats and put all your money into the hot new thing, it’s that product creation and organic growth are inherently risky ventures, and a certain amount of expected loss can be necessary to find the real money-makers.

3. Larger deals. Leonard stopped writing annual letters, but broke the streak in 2021, when he penned a short note, outlining that the company would be pursuing more larger deals at lower IRRs and looking to develop a new circle of competence outside of VMS. I believe his words were chosen carefully to reflect Warren Buffett’s discussion of Circle of Competence and Thomas Watson Sr.’s (founder of IBM) quote: “I’m no genius. I’m smart in spots - but I stay around those spots.” While I appreciate the idea behind it, I’m less inclined to stay within my circle of competence. I’m young, curious, and foolish, and I think it would be a waste to pigeon-hole myself so early. After all, Warren had to learn about insurance, banking, beverages, etc and he didn’t let his not-knowing preclude him from studying. In justifying larger deals, Leonard cited Constellation’s scale and ability to invest more effectively than current shareholders. He also laid out the company’s edge: “Most of our competitors maximise financial leverage and flip their acquisitions within 3-7 years. CSI appreciates the nuances of the VMS sector. We allow tremendous autonomy to our business unit managers. We are permanent and supportive stakeholders in the businesses that we control, even if their ultimate objective is to eventually be a publicly listed company. CSI’s unique philosophy will not appeal to all sellers and management teams, but we hope it will resonate with some.” Since then Constellation has acquired Allscript’s hospital unit business in March 2022 for $700m in cash, completed a spin-merger of Lumine Group into larger company, WideOrbit, to create a publicly traded telecom advertising software provider, and is rumored to be looking at purchasing a subsidiary of Black Knight, which may have to be divested for its own transaction with ICE. These larger deals no doubt come with more complexity, but one large benefit is they sit within larger operating groups, and are shielded during what may be difficult transition periods for the businesses. It allows the businesses to operate more long-term and focus on providing value to end customers. As for deals outside of VMS, Mark Leonard commented on it during the 2022 earnings call: “I took a hard look at a thermal oil situation. I was looking at close to $1B investment, and it was tax advantaged. So it was a clever structure. It was a time when the sector could not get financing. And unfortunately, the oil prices ran away on me. So I was trying to be opportunistic in a sector that was incredibly beat up. So that is an example….So what are the characteristics there? Complexity. Where its a troubled situation with — circumstances and there’s a lot of complexity. I think we can compete better than the average investor, particularly when people are willing to take capital forever.” The remark on complexity reminded me of Baupost, the firm founded by legendary investor Seth Klarman, who famously bought claims on Lehman Brothers Europe following the 2008 bankruptcy. When you have hyper rational individuals, complexity is their friend.

Business Themes

1. Decentralized Operating Groups. Its safe to say that Mark Leonard is a BIG believer in decentralized operating groups. Constellation believes in pushing as much decision making authority as possible to the leaders of the various business units. The company operates six operating groups: Volaris, Harris, Topicus (now public), Jonas, Perseus, and Vela. Leonard mentioned the organizational structure in the context of organic growth: “When most of our current Operating Group Managers ran single BU’s, they had strong organic growth businesses. As those managers gave up their original BU management position to oversee a larger Group of BU’s (i.e. became Portfolio Managers), the organic growth of their original BU’s decreased and the profitability of those BU’s increased.” As an example of this dynamic, we can look at Vencora, a Fintech subsidiary of Volaris. Vencora is managed by a portfolio manager, itself a collection of Business Units (BUs) with their own leadership. The Operating Group leaders and Portfolio Managers are incentivized based on growth and ROIC. Furthermore, Constellation mandates that at least 25% (for some executives its 75%) of incentive compensation must be used to purchase shares in the company, on the open market. These shares cannot be sold for three years. This incentive system accomplishes three goals: It keeps broad alignment toward the success of Constellation as a whole, it avoids stock dilution, and it creates a system where employees continuously own more and more of the business. Acquisitions above $20M in revenue must be approved by the head office, who is constantly receiving cash from different subsidiaries and allocating to the highest value opportunities. At varying times, the company has instituted “Keep your capital” initiatives, particularly for the Volaris and Vela operating groups. As Leonard points out in the 2015 letter: “One of the nice side effects of the “keep your capital” restriction, is that while it usually drives down ROIC, it generates higher growth, which is the other factor in the bonus formula. Acquisitions also tend to create an attractive increase in base salaries as the team ends up managing more people, capital, BUs, etc. Currently, a couple of our Operating Groups are generating very high returns without deploying much capital and we are getting to the point that we’ll ask them to keep their capital if they don’t close acceptable acquisitions or pursue acceptable Initiatives shortly.” Because bonuses are paid on ROIC, if an operating group manager sends back a ton of cash to corporate and doesn’t do a lot of new acquisitions, then its ROIC is very high and bonuses will be high. However, because Volaris and Vela are so large, it does not benefit the Head Office to continuously receive these large dividend payments and then pay high bonuses. Head Office will have a mountain of cash with out a lot of easy opportunities to deploy it. Thus the Keep your Capital initiative tamps down bonuses (by tamping down ROIC) and forces the leaders of these businesses to search out productive ways to deploy capital. As a result, more internal growth initiatives are likely to be funded, when acquisitions remain scarce, thereby increasing organic growth. It also pushes BUs and Portfolio Managers to seek out acquisitions to use up some of the capital. Overall, the organizational structure gives extreme authority to individuals and operates with large and strong incentives toward M&A and ROIC.

2. Selling Constellation. We all know about the epic “what would have happened” deals. A few that come to mind, Oracle buying TikTok US, Microsoft buying Yahoo for $55B, Yahoo acquiring Facebook, Facebook acquiring Snapchat, AT&T acquiring T-Mobile for $39B, JetBlue/Spirt, Ryanair/Aer Lingus. There are tons. Would you believe that Constellation was up for sale at one point? On April 4th 2011, the Constellation board announced that it was considering alternatives for the company. The company was $630m of revenue and $116m of Adj. EBITDA, growing revenue 44% year over year. Today, Constellation is $8.4B of revenue, with $1.16B of FCFA2S, growing revenue at 27% year over year. At the time, Leonard lamented: “I’m proud of the company that our employees and shareholders have built, and will be more than a little sad if it is sold.” To me, this is a critically important non-event to investigate. It goes to show that any company can prematurely cap its compounding. Today, Constellation is perhaps the most revered software company with the most beloved, mysterious genius leader. Imagine if Constellation had been bought by Oracle or another large software company? Where would Mark Leonard be today? Would we have the behemoth that exists today? After the process was concluded with no sale, Leonard discussed the importance of managing one’s own stock price. “I used to maintain that if we concentrated on fundamentals, then our stock price would take care of itself. The events of the last year have forced me to re-think that contention. I'm coming around to the belief that if our stock price strays too far (either high or low) from intrinsic value, then the business may suffer: Too low, and we may end up with the barbarians at the gate; too high, and we may lose previously loyal shareholders and shareholder-employees to more attractive opportunities.” Many technology CEOs could learn from Leonard, preserving an optimistic tone when the company is struggling or the market is punishing the company, and a pessimistic tone when the company is massively over-achieving, like COVID.

3. Metrics. Leonard loves thinking about and building custom metrics. As he stated in the Q4’2007 letter, “Our favorite single metric for measuring our corporate performance is the sum of ROIC and Organic Net Revenue Growth (“ROIC+OGr”).” However, he is constantly tinkering and thinking about the best and most interesting measures. He generally focuses on three types of metrics: growth, profitability, and returns. For growth, his preferred measure is organic growth. He also believes net maintenance growth is correlated with the value of the business. “We believe that Net Maintenance Revenue is one of the best indicators of the intrinsic value of a software company and that the operating profitability of a low growth software business should correlate tightly to Net Maintenance Revenues.” I believe this correlation is driven by maintenance revenue’s high profitability and association with high EBITA levels (Operating income + amortization from intangibles). For profitability metrics, Leonard for a long time preferred Adj. Net Income (ANI) or EBITA. “ One of the areas where generally accepted accounting principles (“GAAP”) do a poor job of reflecting economic reality, is with goodwill and intangibles accounting. As managers we are at least partly to blame in that we tend to ignore these “expenses”, focusing on EBITA or EBITDA or “Adjusted” Net Income (which excludes Amortisation). The implicit assumption when you ignore Amortisation, is that the economic life of the asset is perpetual. In many instances (for our business) that assumption is correct.” He floated the idea of using free cash flow per share, but it suffers from volatility depending on working capital payments and doesn’t adjust for minority interest payments. Adj. Net Income does both of these things but doesn’t capture the actual cash into the business. In Q3’2019, Leonard adopted a new metric called Free Cash Flow Available to Shareholders (FCFA2S): “We calculate FCFA2S by taking net cash flow from operating activities per IFRS, subtracting the amounts that we spend on fixed assets and on servicing the capital we have sourced from other stakeholders (e.g. debt providers, lease providers, minority shareholders), and then adding interest and dividends earned on investments. The remaining FCFA2S is the uncommitted cashflow available to CSI's shareholders if we made no further acquisitions, nor repaid our other capital-providing stakeholders.” FCFA2S achieves a few happy mediums: 1) Similar to ANI, it is net of the cost of servicing capital (interest, dividends, lease payments) 2) It captures changes in working capital, while ANI does not 3) It reflects cash taxes as opposed to current taxes deducted from pre-tax income (this gets at a much more confusing discussion on deferred tax assets and the difference between book taxes and cash taxes) 4) When comparing FCFA2S to CFO, it tends to be closer than comparing ANI to reported net income. For return metrics, Leonard prefers ROIC (ANI/Average Invested Capital). In the 2015 letter, he laid out the challenge of this metric. First, ROIC can be infinity if a company grows large while reducing its working capital (common in software), effectively lowering the purchase price to zero. Infinity ROIC is a problem because bonuses are paid on ROIC. He contrasts ROIC with IRR but notes its drawbacks, that IRR does not indicate the hold period nor size of the investments. As is said at investing firms, “You can’t eat IRR.” In the 2017 letter, he discussed Incremental return on incremental invested capital ((ANI1 - ANI0)/(IC1-ICo)), but noted its volatility and challenge with handling share issuances / repurchases. Share issuances would increase IC, without an increase in ANI. When discussing high performance conglomerates (HPCs), he discusses EBITA Return (EBITA/Average Total Capital). He notes that: “ROIC is the return on the shareholders’ investment and EBITA Return is the return on all capital. In the former, financial leverage plays a role. In the latter only the operating efficiency with which all net assets are used is reflected, irrespective of whether those assets are financed with debt or shareholders’ investment.” This is similar to P/E vs. EV/EBITDA multiples, where P/E multiples should be used to value market capitalization (i.e. Price) while EV/EBITDA should be used to value the entirety of the business as it relates to debt and equityholders. Mark Leonard is a man of metrics, we will keep watching to see what he comes up with next! In this spirit, I will try to offer a metric for fast-growing software companies, where ROIC is effectively meaningless because negative working capital dynamics in software produce negative invested capital. Furthermore, faster growing companies generally spend ahead of growth and lose money so ANI, FCF, EBITA are all lower than they should be. If you believe the value of these businesses is closely related to revenue, you could use S&M efficiency, or net new ARR / S&M spend. While a helpful measure, many companies don’t disclose ARR. Furthermore, this doesn’t incorporate perhaps the most expensive investing cost, developing products. It also does not incorporate gross margins, which can vary between 50-90% for software companies. One metric you could use is incremental gross margin / (incremental S&M, R&D costs). Here the challenge would be the years it takes to develop products and GTM distribution. To get around this, you could use a cumulative number for R&D/S&M costs. You could also use future gross margin dollars and offset them, similar to the magic number. So our metric is 3 year + incremental gross margin / cumulative S&M and R&D costs. Not a great metric but it can’t hurt to try!

   Dig Deeper

• Mark Leonard on the Harris Computer Group Podcast (2020)

• Constellation Software Inc. -Annual General Meeting 2023

• Mark Leonard: The Best Capital Allocator You’ve Never Heard Of

• The Moments That Made Mark Miller

• Topicus: Constellation Software 2.0

February 2022 - Cable Cowboy by Mark Robichaux

This month we jump into the history of the cable industry in the US with Cable Cowboy. The book follows cable’s main character for over 30 years, John Malone, the intense, deal-addicted CEO of Telecommunications International (TCI).

Tech Themes

1. Repurposed Infrastructure. Repurposed infrastructure is one of the incredible drivers of technological change covered in Carlota Perez’s Technology Revolutions and Financial Capital. When a new technology wave comes along, it builds on the backs of existing infrastructure to reach a massive scale. Railroads laid the foundation for oil transport pipelines. Later, telecommunications companies used the miles and miles of cleared railroad land to hang wires to provide phone service through the US. Cable systems were initially used to pull down broadcast signals and bring them to remote places. Over time, more and more content providers like CNN, TBS, BET started to produce shows with cable distribution in mind. Cable became a bigger and bigger presence, so when the internet began to gain steam in the early 1990s, Cable was ready to play a role. It just so happened that Cable was best positioned to provide internet service to individual homes because, unlike the phone companies’ copper wiring, Cable had made extensive use of coaxial fiber which provided much faster speeds. In 1997, after an extended period of underperformance for the Cable industry, Microsoft announced a $1B investment in Comcast. The size of the deal showed the importance of cable providers in the growth of the internet.

2. Pipes + Content. One of the major issues surrounding TCI as they faced anti-trust scrutiny was their ownership of multiple TV channels. Malone realized that the content companies could make significant profits, especially when content was shown across multiple cable systems. TCI enjoyed the same Scale Economies Power as Netflix. Once the cable channel produces content, any way to spread the content cost over more subscribers is a no-brainer. However, these content deals were worrisome given TCI’s massive cable presence (>8,000,000 subscribers). TCI would frequently demand that channels take an equity investment to access TCI’s cable system. “In exchange for getting on TCI systems, TCI drove a tough bargain. He demanded that cable networks either allow TCI to invest in them directly, or they had to give TCI discounts on price, since TCI bought in bulk. In return for most-favored-nation-status on price, TCI gave any programmer immediate access to nearly one-fifth of all US subscribers in a single stroke.” TCI would impose its dominant position - we can either carry your channel and make an investment, or you can miss out on 8 million subscribers. Channels would frequently choose the former. Malone tried to avoid anti-trust by creating Liberty Media. This spinoff featured all of TCI’s investments in cable providers, offering a pseudo-separation from the telecom giant (although John Malone would completely control liberty).

3. Early, Not Wrong. Several times in history, companies or people were early to an idea before it was feasible. Webvan formed the concept of an online grocery store that could deliver fresh groceries to your house. It raised $800M before flaming out in the public markets. Later, Instacart came along and is now worth over $30B. There are many examples: Napster/Spotify, MySpace/Facebook, Pets.com/Chewy, Go Corporation/iPad, and Loudcloud/AWS. The early idea in the telecom industry was the information superhighway. We’ve discussed this before, but the idea is that you would use your tv to access the outside world, including ordering Pizza, accessing bank info, video calling friends, watching shows, and on-demand movies. The first instantiation of this idea was the QUBE, an expensive set-top box that gave users a plethora of additional interactive services. The QUBE was the launch project of a joint venture between American Express and Warner Communications to launch a cable system in the late 1970s. The QUBE was introduced in 1982 but cost way too much money to produce. With steep losses and mounting debt, Warner Amex Cable “abandoned the QUBE because it was financially infeasible.” In 1992, Malone delivered a now-famous speech on the future of the television industry, predicting that TVs would offer 500 channels to subscribers, with movies, communications, and shopping. 10 years after the QUBE’s failure, Time Warner tried to fulfill Malone’s promise by launching the Full-Service Network (FSN) with the same idea - offering a ton of services to users through a specialized hardware + software approach. This box was still insanely expensive (>$1,000 per box) because the company had to develop all hardware and software. After significant losses, the project was closed. It wasn’t until recently that TV’s evolved to what so many people thought they might become during those exciting internet boom years of the late 1990s. In this example and several above, sometimes the idea is correct, but the medium or user experience is wrong. It turned out that people used a computer and the internet to access shop, order food, or chat with friends, not the TV. In 2015, Domino’s announced that you could now order Pizza from your TV.

Business Themes

1. Complicated Transactions. Perhaps the craziest deal in John Malone’s years of experience in complex deal-making was his spinoff of Liberty Media. Liberty represented the content arm of TCI and held positions in famous channels like CNN and BET. Malone was intrigued at structuring a deal that would evade taxes and give himself the most potential upside. To create this “artificial” upside, Malone engineered a rights offering, whereby existing TCI shareholders could purchase the right to swap 16 shares of TCI for 1 share of Liberty. Malone set the price to swap at a ridiculously high value of TCI shares - ~valuing Liberty at $300 per share. “It seemed like such a lopsided offer: 16 shares of TCI for just 1 share of Liberty? That valued Liberty at $3000 a share, for a total market value of more than $600M by Malone’s reckoning. How could that be, analysts asked, given that Liberty posed a loss on revenue fo a mere $52M for the pro-forma nine months? No one on Wall Street expected the stock to trade up to $300 anytime soon.” The complexity of the rights offering + spinoff made the transaction opaque enough that even seasoned investors were confused about how it all worked and declined to buy the rights. This deal meant Malone would have more control of the newly separate Liberty Media. At the same time, the stock spin had such low participation that shares were initially thinly traded. Once people realized the quality of the company’s assets, the stock price shot up, along with Malone’s net worth. Even crazier, Malone took a loan from the new Liberty Media to buy shares of the company, meaning he had just created a massive amount of value by putting up hardly any capital. For a man that loved complex deals, this deal is one of his most complex and most lucrative.

2. Deal Maker Extraordinaire / Levered Rollups. John Malone and TCI loved deals and hated taxes. When TCI was building out cable networks, they acquired a new cable system almost every two weeks. Malone popularized using EBITDA (earnings before interest, taxes, depreciation, and amortization) as a proxy for real cash flow relative to net income, which incorporates tax and interest payments. To Malone, debt could be used for acquisitions to limit paying taxes and build scale. Once banks got comfortable with EBITDA, Malone went on an acquisition tear. “From 1984 to 1987, Malone had spent nearly $3B for more than 150 cable companies, placing TCI wires into one out of nearly every five with cable in the country, a penetration that was twice that of its next largest rival.” Throughout his career, he rallied many different cable leaders to find a deal that worked for everyone. In 1986, when fellow industry titan Ted Turner ran into financial trouble, Malone reached out to Viacom leader Sumner Redstone, to avoid letting Time Inc (owner of HBO) buy Turner’s CNN. After a quick negotiation, 31 cable operators agreed to rescue Turner Broadcasting with a $550M investment, allowing Turner to maintain control and avoid a takeover. Later, Malone led an industry consortium that included TCI, Comcast, and Cox to create a high speed internet service called, At Home, in 1996. “At Home was responsible for designing the high-speed network and providing services such as e-mail, and a home page featuring news, entertainment, sports, and chat groups. Cable operators were required to upgrade their local systems to accommodate two-way transmission, as well as handle marketing, billing, and customer complaints, for which they would get 65% of the revenue.” At Home ended up buying early internet search company Excite in a famous $7.5B deal, that diluted cable owners and eventually led to bankruptcy for the combined companies. Malone’s instinct was always to try his best to work with a counterparty because he genuinely believed a deal between two competitors provided better outcomes to everyone.

3. Tracking Stocks. Malone popularized the use of tracking stocks, which are publicly traded companies that mirror the operating performance of the underlying asset owned by a company. John Malone loved tracking stocks because they could be used to issue equity to finance operations and give investors access to specific divisions of a conglomerate while allowing the parent to maintain full control. While tracking stocks have been out of favor (except for Liberty Media, LOL), they were once highly regarded and even featured in the original planning of AT&T’s $48B purchase of TCI in 1998. AT&T financed its TCI acquisition with debt and new AT&T stock, diluting existing shareholders. AT&T CEO Michael Armstrong had initially agreed to use tracking stocks to separate TCI’s business from the declining but cash-flowing telephone business but changed his mind after AT&T’s stock rocketed following the TCI deal announcement. Malone was angry with Armstrong’s actions, and the book includes an explanation: “heres why you should mess with it, Mike: You’ve just issued more than 400 million new shares of AT&T to buy a business that produces no earnings. It will be a huge money-loser for years, given how much you’ll spend on broadband. That’s going to sharply dilute your earnings per share, and your old shareholders like earnings. That will hurt your stock price, and then you can’t use stock to make more acquisitions, then you’re stuck. If you create a tracking stock to the performance of cable, you separate out the losses we produce and show better earnings for your main shareholders; and you can use the tracker to buy more cable interests in tax-free deals.” Tracking stocks all but faded from existence following the internet bubble and early 2000s due to their difficulty of implementation and complexity, which can confuse shareholders and cause the businesses to trade at a large discount. This all begs the question, though - which companies could use tracking stock today? Imagine an AWS tracker, a Youtube tracker, an Instagram tracker, or an Xbox tracker - all of these could allow cloud companies to attract new shareholders, do more specific tax-free mergers, and raise additional capital specific to a business unit.

Dig Deeper

• John Malone’s Latest Interview with CNBC (Nov 2021)

• John Malone on LionTree’s Kindred Cast

• A History of AT&T

• Colorado Experience: The Cable Revolution

• An Overview on Spinoffs

December 2021 - Trillion Dollar Coach: The Leadership Playbook of Silicon Valley's Bill Campbell by Eric Schmidt, Jonathan Rosenberg, and Alan Eagle

This month we read a book about famous CEO and executive coach, Bill Campbell. Bill had an unusual background for a silicon valley legend: he was a losing college football coach at Columbia. Despite a late start to his technology career, Bill’s timeless leadership principles and focus on people are helpful for any leader at any size company.

Tech Themes

1. Product First. After a short time at Kodak, Bill realized the criticality of supporting product and engineering. As a football coach, he was not intimately familiar with the intricacies of photographic film. Still, Campbell understood that the engineers ultimately determined the company's fate. After a few months at Kodak, Bill did something that no one else ever thought of - he went into the engineering lab and started talking to the engineers. He told them that Fuji was hot on Kodak's heels and that the company should try to make a new type of film that might thwart some competitive pressure. The engineers were excited to hear feedback on their products and learn more about other aspects of the business. After a few months of gestation, the engineering team produced a new type of film: "This was not how things worked at Kodak. Marketing guys didn't go talk to engineers, especially the engineers in the research lab. But Bill didn't know that, or if he did, he didn't particularly care. So he went over to the building that housed the labs, introduced himself around, and challenged them to come up with something better than Fuji's latest. That challenge helped start the ball rolling on the film that eventually launched as Kodacolor 200, a major product for Kodak and a film that was empirically better than Fuji's. Score one for the marketing guy and his team!" Campbell understood that product was the heart of any technology company, and he sought to empower product leaders whenever he had a chance.

2. Silicon Valley Moments. Sometimes you look back at a person's career and wonder how they managed to be at the center of several critical points in tech history. Bill was a magnet to big moments. After six unsuccessful years as coach of Columbia's football team, Bill joined an ad agency and eventually made his way to the marketing department at Kodak. At the time, Kodak was a blockbuster success and lauded as one of the top companies in the world. However, the writing was on the wall, film was getting cheaper and cheaper, and digital was on the rise. After a few years, Bill was recruited to Apple by John Sculley. Bill joined in 1983 as VP of Marketing, just two years before Steve Jobs would famously leave the company. Bill was incessant that management try to keep Jobs. Steve would not forget his loyalty, and upon his return, Jobs named Campbell a director of Apple in 1997. Bill became CEO of Claris, an Apple software division that functioned as a separate company. In 1990, when Apple signaled it would not spin Claris off into a separate company, Bill left with the rest of management. After a stint at Intuit, Bill became a CEO coach to several Silicon Valley luminaries, including Eric Schmidt, Steve Jobs, Shellye Archambeau, Brad Smith, John Donahoe, Sheryl Sandberg, Jeff Bezos, and more. Bill helped recruit Sandberg and current CFO Ruth Porat to Google. Bill was a serial networker who stood at the center of silicon valley.

3. Failure and Success. Following his departure from Claris/Apple, Bill founded Go Corporation, one of the first mobile computers. The company raised a ton of venture capital for the time ($75m) before an eventual fire-sale to AT&T. The idea of a mobile computer was compelling, but the company faced stiff competition from Microsoft and Apple's Newton. Beyond competition, the original handheld devices lacked very basic features (easy internet, storage, network and email capabilities) that would be eventually be included in Apple's iPhone. Sales across the industry were a disappointment, and AT&T eventually shut down the acquired Go Corp. After the failure of Go. Corporation, Bill was unsure what to do. John Doerr, the famous leader of Kleiner Perkins, introduced Bill to Intuit founder Scott Cook. Cook was considering retirement and looking for a replacement. Bill met with Cook, but Cook remained unimpressed. It was only after a second meeting where Bill shared his philosophy on management and his focus on people that Cook considered Campbell for the job. Bill joined Intuit as CEO and went on to lead the company until 1998, after which he became Chairman of the board, a position he held until 2016. Within a year of Campbell joining, Microsoft agreed to purchase the company for $1.5b. However, the Justice Department raised flags about the acquisition, and Microsoft called off the deal in 1995. Campbell continued to lead the company to almost $600M of revenue. When he retired from the board in 2016, the company was worth $30B.

Business Themes

1. Your People Make You a Leader. Campbell believed that people were the most crucial ingredient in any successful business. Leadership, therefore, was of utmost importance to Bill. Campbell lived by a maxim passed by former colleague Donna Dubinsky: "If you're a great manager, your people will make you a leader. They acclaim that, not you." In an exchange with a struggling leader, Bill added to this wisdom: "You have demanded respect, rather than having it accrue to you. You need to project humility, a selflessness, that projects that you care about the company and about people." The humility Campbell speaks about is what John Collins called Level 5 leadership (covered in our April 2020 book, Good to Great). Research has shown that humble leaders can lead to higher performing teams, better flexibility, and better collaboration.

2. Teams Need Coaches. Campbell loved to build community. Every year he would plan a trip to the super bowl, where he would find a bar and set down roots. He'd get to know the employees, and after a few days, he was a regular at the bar. He understood how important it was to build teams and establish a community that engendered trust and psychological safety. Every team needs a good coach, and Campbell understood how to motivate individuals, give authentic feedback, and handle interpersonal conflicts. "Bill Campbell was a coach of teams. He built them, shaped them, put the right players in the right positions (and removed the wrong players from the wrong positions), cheered them on, and kicked them in their collective butt when they were underperforming. He knew, as he often said, that 'you can't get anything done without a team.'" After a former colleague left to set up a new private equity firm, Bill checked out the website and called him up to tell him it sucked. As part of this feedback style, Bill always prioritized feedback in the moment: "An important component of providing candid feedback is not to wait. 'A coach coaches in the moment,' Scott Cook says. 'It's more real and more authentic, but so many leaders shy away from that.' Many managers wait until performance reviews to provide feedback, which is often too little, too late."

3. Get the Little Things Right. Campbell understood that every interaction was a chance to connect, help, and coach. As a result, he thought deeply about maximizing the value out of every meeting: "Bill took great care in preparing for one-on-one meetings. Remember, he believed the most important thing a manager does is to help people be more effective and to grow and develop, and the 1:1 is the best opportunity to accomplish that." Meetings with Campbell frequently started with family and life discussions and would move back and forth between business and the meaning of life - deep sessions that made people think, reconsider what they were doing and come back energized for more. He also was not shy about addressing issues and problems: "There was one situation we had a few years ago where two different product leaders were arguing about which team should manage a particular group of products. For a while, this was treated as a technical discussion, where data and logic would eventually determine which way to go. But that didn't happen, the problem festered, and tensions rose. Who was in control? This is when Bill got involved. There had to be a difficult meeting where one exec would win and the other would lose. Bill made the meeting happen; he spotted a fundamental tension that was not getting resolved and forced the issue. He didn't have a clear opinion on how to resolve the matter, on which team the product belonged, he simply knew we had to decide one way or another, now. It was one of the most heated meetings we've had, but it had to happen." Bill extended this practice to email where he perfected concise and effective team communication. On top of 1:1's, meetings, and emails, Campbell stayed on top of messages: ""Later, when he was coach to people all over the valley, he spent evenings returning the calls of people who had left messages throughout the day. When you left Bill a voice mail, you always got a call back." Bill was a master of communication and a coach to everyone he met.

Dig Deeper

• Intuit founder Scott Cook on Bill Campbell

• A Conversation between Brad Smith (Intuit CEO) and Bill Campbell

• A Bill Campbell Reading List

• Silicon Valley mourns its ‘coach,’ former Intuit CEO Bill Campbell

• CHM Live | Trillion Dollar Coach: The Leadership Playbook of Silicon Valley’s Bill Campbell

February 2021 - Rise of the Data Cloud by Frank Slootman and Steve Hamm

This month we read a new book by the CEO of Snowflake and author of our November 2020 book, Tape Sucks. The book covers Snowflake’s founding, products, strategy, industry specific solutions and partnerships. Although the content is somewhat interesting, it reads more like a marketing book than an actually useful guide to cloud data warehousing. Nonetheless, its a solid quick read on the state of the data infrastructure ecosystem.

Tech Themes

1. The Data Warehouse. A data warehouse is a type of database that is optimized for analytics. These optimizations mainly revolve around complex query performance, the ability to handle multiple data types, the ability to integrate data from different applications, and the ability to run fast queries across large data sets. In contrast to a normal database (like Postgres), a data warehouse is purpose-built for efficient retrieval of large data sets and not high performance read/write transactions like a typical relational database. The industry began in the late 1970s and early 80’s, driven by work done by the “Father of Data Warehousing” Bill Inmon and early competitor Ralph Kimball, who was a former Xerox PARC designer. In 1986, Kimball launched Redbrick Systems and Inmon launched Prism Solutions in 1991, with its leading product the Prism Warehouse Manager. Prism went public in 1995 and was acquired by Ardent Software in 1998 for $42M while Red Brick was acquired by Informix for ~$35M in 1998. In the background, a company called Teradata, which was formed in the late 1970s by researchers at Cal and employees from Citibank, was going through their own journey to the data warehouse. Teradata would IPO in 1987, get acquired by NCR in 1991; NCR itself would get acquired by AT&T in 1991; NCR would then spin out of AT&T in 1997, and Teradata would spin out of NCR through IPO in 2007. What a whirlwind of corporate acquisitions! Around that time, other new data warehouses were popping up on the scene including Netezza (launched in 1999) and Vertica (2005). Netezza, Vertica, and Teradata were great solutions but they were physical hardware that ran a highly efficient data warehouse on-premise. The issue was, as data began to grow on the hardware, it became really difficult to add more hardware boxes and to know how to manage queries optimally across the disparate hardware. Snowflake wanted to leverage the unlimited storage and computing power of the cloud to allow for infinitely scalable data warehouses. This was an absolute game-changer as early customer Accordant Media described, “In the first five minutes, I was sold. Cloud-based. Storage separate from compute. Virtual warehouses that can go up and down. I said, ‘That’s what we want!’”

2. Storage + Compute. Snowflake was launched in 2012 by Benoit Dageville (Oracle), Thierry Cruanes (Oracle) and Marcin Żukowski (Vectorwise). Mike Speiser and Sutter Hill Ventures provided the initial capital to fund the formation of the company. After numerous whiteboarding sessions, the technical founders decided to try something crazy, separating data storage from compute (processing power). This allowed Snowflake’s product to scale the storage (i.e. add more boxes) and put tons of computing power behind very complex queries. What may have been limited by Vertica hardware, was now possible with Snowflake. At this point, the cloud had only been around for about 5 years and unlike today, there were only a few services offered by the main providers. The team took a huge risk to 1) bet on the long-term success of the public cloud providers and 2) try something that had never successfully been accomplished before. When they got it to work, it felt like magic. “One of the early customers was using a $20 million system to do behavioral analysis of online advertising results. Typically, one big analytics job would take about thirty days to complete. When they tried the same job on an early version of Snowflake;’s data warehouse, it took just six minutes. After Mike learned about this, he said to himself: ‘Holy shit, we need to hire a lot of sales people. This product will sell itself.’” This idea was so crazy that not even Amazon (where Snowflake runs) thought of unbundling storage and compute when they built their cloud-native data warehouse, Redshift, in 2013. Funny enough, Amazon also sought to attract people away from Oracle, hence the name Red-Shift. It would take Amazon almost seven years to re-design their data warehouse to separate storage and compute in Redshift RA3 which launched in 2019. On top of these functional benefits, there is a massive gap in the cost of storage and the cost of compute and separating the two made Snowflake a significantly more cost-competitive solution than traditional hardware systems.

3. The Battle for Data Pipelines. A typical data pipeline (shown below) consists of pulling data from many sources, perform ETL/ELT (extract, load, transform and vice versa), centralizing it in a data warehouse or data lake, and connecting that data to visualization tools like Tableau or Looker. All parts of this data stack are facing intense competition. On the ETL/ELT side, you have companies like Fivetran and Matillion and on the data warehouse/data lake side you have Snowflake and Databricks. Fivetran focuses on the extract and load portion of ETL, providing a data integration tool that allows you to connect to all of your operational systems (salesforce, zendesk, workday, etc.) and pull them all together in Snowflake for comprehensive analysis. Matillion is similar, except it connects to your systems and imports raw data into Snowflake, and then transforms it (checking for NULL’s, ensuring matching records, removing blanks) in your Snowflake data warehouse. Matillion thus focuses on the load and transform steps in ETL while Fivetran focuses on the extract and load portions and leverages dbt (data build tool) to do transformations. The data warehouse vs. data lake debate is a complex and highly technical discussion but it mainly comes down to Databricks vs. Snowflake. Databricks is primarily a Machine Learning platform that allows you to run Apache Spark (an open-source ML framework) at scale. Databricks’s main product, Delta Lake allows you to store all data types - structured and unstructured for real-time and complex analytical processes. As Datagrom points out here, the platforms come down to three differences: data structure, data ownership, and use case versatility. Snowflake requires structured or semi-structured data prior to running a query while Databricks does not. Similarly, while Snowflake decouples data storage from compute, it does not decouple data ownership meaning Snowflake maintains all of your data, whereas you can run Databricks on top of any data source you have whether it be on-premise or in the cloud. Lastly, Databricks acts more as a processing layer (able to function in code like python as well as SQL) while Snowflake acts as a query and storage layer (mainly driven by SQL). Snowflake performs best with business intelligence querying while Databricks performs best with data science and machine learning. Both platforms can be used by the same organizations and I expect both to be massive companies (Databricks recently raised at a $28B valuation!). All of these tools are blending together and competing against each other - Databricks just launched a new LakeHouse (Data lake + data warehouse - I know the name is hilarious) and Snowflake is leaning heavily into its data lake. We will see who wins!

An interesting data platform battle is brewing that will play out over the next 5-10 years: The Data Warehouse vs the Data Lakehouse, and the race to create the data cloud

Who's the biggest threat to @snowflake? I think it's @databricks, not AWS Redshifthttps://t.co/R2b77XPXB7

— Jamin Ball (@jaminball) January 26, 2021

Business Themes

1. Marketing Customers. This book at its core, is a marketing document. Sure, it gives a nice story of how the company was built, the insights of its founding team, and some obstacles they overcame. But the majority of the book is just a “Imagine what you could do with data” exploration across a variety of industries and use cases. Its not good or bad, but its an interesting way of marketing - that’s for sure. Its annoying they spent so little on the technology and actual company building. Our May 2019 book, The Everything Store, about Jeff Bezos and Amazon was perfect because it covered all of the decision making and challenging moments to build a long-term company. This book just talks about customer and partner use cases over and over. Slootman’s section is only about 20 pages and five of them cover case studies from Square, Walmart, Capital One, Fair, and Blackboard. I suspect it may be due to the controversial ousting of their long-time CEO Bob Muglia for Frank Slootman, co-author of this book. As this Forbes article noted: “Just one problem: No one told Muglia until the day the company announced the coup. Speaking publicly about his departure for the first time, Muglia tells Forbes that it took him months to get over the shock.” One day we will hear the actual unfiltered story of Snowflake and it will make for an interesting comparison to this book.

2. Timing & Building. We often forget how important timing is in startups. Being the right investor or company at the right time can do a lot to drive unbelievable returns. Consider Don Valentine at Sequoia in the early 1970’s. We know that venture capital fund performance persists, in part due to incredible branding at firms like Sequoia that has built up over years and years (obviously reinforced by top-notch talents like Mike Moritz and Doug Leone). Don is a great investor and took significant risks on unproven individuals like Steve Jobs (Apple), Nolan Bushnell (Atari), and Trip Hawkins (EA). But he also had unfettered access to the birth of an entirely new ecosystem and knowledge of how that ecosystem would change business, built up from his years at Fairchild Semiconductor. Don is a unique person and capitalized on that incredible knowledgebase, veritably creating the VC industry. Sequoia is a top firm because he was in the right place at the right time with the right knowledge. Now let’s cover some companies that weren’t: Cloudera, Hortonworks, and MapR. In 2005, Yahoo engineers Doug Cutting and Mike Cafarella, inspired by the Google File System paper, created Hadoop, a distributed file system for storing and accessing data like never before. Hadoop spawned many companies like Cloudera, Hortonworks, and MapR that were built to commercialize the open-source Hadoop project. All of the companies came out of the gate fast with big funding - Cloudera raised $1B at a $4B valuation prior to its 2017 IPO, Hortonworks raised $260M at a $1B valuation prior to its 2014 IPO, and MapR $300M before it was acquired by HPE in 2019. The companies all had one thing in problem however, they were on-premise and built prior to the cloud gaining traction. That meant it required significant internal expertise and resources to run Cloudera, Hortonworks, and MapR software. In 2018, Cloudera and Hortonworks merged (at a $5B valuation) because the competitive pressure from the cloud was eroding both of their businesses. MapR was quietly acquired for less than it raised. Today Cloudera trades at a $5B valuation meaning no shareholder return since the merger and the business is only recently slightly profitable at its current low growth rate. This cautionary case study shows how important timing is and how difficult it is to build a lasting company in the data infrastructure world. As the new analytics stack is built with Fivetran, Matillion, dbt, Snowflake, and Databricks, it will be interesting to see which companies exist 10 years from now. Its probable that some new technology will come along and hurt every company in the stack, but for now the coast is clear - the scariest time for any of these companies.

3. Burn Baby Burn. Snowflake burns A LOT of money. In the Nine months ended October 31, 2020, Snowflake burned $343M, including $169M in their third quarter alone. Why would Snowflake burn so much money? Because they are growing efficiently! What does efficient growth mean? As we discussed in the last Frank Slootman book - sales and marketing efficiency is a key hallmark to understand the quality of growth a company is experiencing. According to their filings, Snowflake added ~$230M of revenue and spent $325M in sales and marketing. This is actually not terribly efficient - it supposes a dollar invested in sales and marketing yielded $0.70 of incremental revenue. While you would like this number to be closer to 1x (i.e. $1 in S&M yield $1 in revenue - hence a repeatable go-to-market motion), it is not terrible. ServiceNow (Slootman’s old company), actually operates less efficiently - for every dollar it invests in sales and marketing, it generates only $0.55 of subscription revenue. Crowdstrike, on the other hand, operates a partner-driven go-to-market, which enables it to generate more while spending less - created $0.90 for every dollar invested in sales and marketing over the last nine months. However, there is a key thing that distinguishes the data warehouse compared to these other companies and Ben Thompson at Stratechery nails it here: “Think about this in the context of Snowflake’s business: the entire concept of a data warehouse is that it contains nearly all of a company’s data, which (1) it has to be sold to the highest levels of the company, because you will only get the full benefit if everyone in the company is contributing their data and (2) once the data is in the data warehouse it will be exceptionally difficult and expensive to move it somewhere else. Both of these suggest that Snowflake should spend more on sales and marketing, not less. Selling to the executive suite is inherently more expensive than a bottoms-up approach. Data warehouses have inherently large lifetime values given the fact that the data, once imported, isn’t going anywhere.” I hope Snowflake burns more money in the future, and builds a sustainable long-term business.

Dig Deeper

• Early Youtube Videos Describing Snowflake’s Architecture and Re-inventing the Data Warehouse

• NCR’s spinoff of Teradata in 2007

• Fraser Harris of Fivetran and Tristan Handy of dbt speak at the Modern Data Stack Conference

• Don Valentine, Sequoia Capital: "Target Big Markets" - A discussion at Stanford

• The Mike Speiser Incubation Playbook (an essay by Kevin Kwok)

February 2020 - How the Internet Happened: From Netscape to the iPhone by Brian McCullough

Brian McCullough, host of the Internet History Podcast, does an excellent job of showing how the individuals adopted the internet and made it central to their lives. He follows not only the success stories but also the flame outs which provide an accurate history of a time of rapid technological change.

Tech Themes

1. Form to Factor: Design in Mobile Devices. Apple has a long history with mobile computing, but a few hiccups in the early days are rarely addressed. These hiccups also telegraph something interesting about the technology industry as a whole - design and ease of use often trump features. In the early 90’s Apple created the Figaro, a tablet computer that weighed eight pounds and allowed for navigation through a stylus. The issue was it cost $8,000 to produce and was 3/4 of an inch thick, making it difficult to carry. In 1993, the Company launched the Newton MessagePad, which cost $699 and included a calendar, address book, to-do list and note pad. However, the form was incorrect again; the MessagePad was 7.24 in. x 4.5 in. and clunky. With this failure, Apple turned its attention away from mobile, allowing other players like RIM and Blackberry to gain leading market share. Blackberry pioneered the idea of a full keyboard on a small device and Marc Benioff, CEO of salesforce.com, even called it, “the heroin of mobile computing. I am serious. I had to stop.” IBM also tried its hand in mobile in 1992, creating the Simon Personal Communicator, which had the ability to send and receive calls, do email and fax, and sync with work files via an adapter. The issue was the design - 8 in. by 2.5 in. by 1.5 in. thick. It was a modern smartphone, but it was too big, clunky, and difficult to use. It wasn’t until the iPhone and then Android that someone really nailed the full smart phone experience. The lessons from this case study offer a unique insight into the future of VR. The company able to offer the correct form factor, at a reasonable price can gain market share quickly. Others who try to pioneer too much at a time (cough, magic leap), will struggle.

2. How to know you’re onto something. Facebook didn’t know. On November 30, 2004, Facebook surpassed one million users after being live for only ten months. This incredible growth was truly remarkable, but Mark Zuckerberg still didn’t know facebook was a special company. Sean Parker, the founder of Napster, had been mentoring Zuckerberg the prior summer: “What was so bizarre about the way Facebook was unfolding at that point, is that Mark just didn’t totally believe in it and wanted to go and do all these other things.” Zuckerberg even showed up to a meeting at Sequoia Capital still dressed in his pajamas with a powerpoint entitled: “The Top Ten Reasons You Should Not Invest.” While this was partially a joke because Sequoia has spurned investing in Parker’s latest company, it represented how immature the whole facebook operation was, in the face of rapid growth. Facebook went on to release key features like groups, photos, and friending, but most importantly, they developed their revenue model: advertising. The quick user growth and increasing ad revenue growth got the attention of big corporations - Viacom offered $2B in cash and stock, and Yahoo offered $1B all cash. By this time, Zuckerberg realized what he had, and famously spurned several offers from Yahoo, even after users reacted negatively to the most important feature that facebook would ever release, the News Feed. In today’s world, we often see entrepreneur’s overhyping their companies, which is why Silicon Valley was in-love with dropout founders for a time, their naivite and creativity could be harnessed to create something huge in a short amount of time.

3. Channel Partnerships: Why apple was reluctant to launch a phone. Channel partnerships often go un-discussed at startups, but they can be incredibly useful in growing distribution. Some industries, such as the Endpoint Detection and Response (EDR) market thrives on channel partnership arrangements. Companies like Crowdstrike engage partners (mostly IT services firms) to sell on their behalf, lowering Crowdstrike’s customer acquisition and sales spend. This can lead to attractive unit economics, but on the flip side, partners must get paid and educated on the selling motion which takes time and money. Other channel relationships are just overly complex. In the mid 2000’s, mobile computing was a complicated industry, and companies hated dealing with old, legacy carriers and simple clunky handset providers. Apple tried the approach of working with a handset provider, Motorola, but they produced the terrible ROKR which barely worked. The ROKR was built to run on the struggling Cingular (would become AT&T) network, who was eager to do a deal with Apple in hopes of boosting usage on their network. After the failure of the ROKR, Cingular executives begged Jobs to build a phone for the network. Normally, the carriers had specifications for how phones were built for their networks, but Jobs ironed out a contract which exchanged network exclusivity for complete design control, thus Apple entered into mobile phones. The most important computing device of the 2000’s and 2010’s was built on a channel relationship.

Business Themes

1. AOL-Time Warner: the merger destined to fail. To fully understand the AOL-Time Warner merger, you must first understand what AOL was, what it was becoming, and why it was operating on borrowed time. AOL started as an ISP, charging customers $9.95 for five hours of dial-up internet access, with each additional hour costing $2.95. McCullough describes AOL: “AOL has often been described as training wheels for the Internet. For millions of Americans, their aol.com address was their first experience with email, and thus their first introduction to the myriad ways that networked computing could change their lives.” AOL grew through one of the first viral marketing campaigns ever; AOL put CDs into newspapers which allowed users to download AOL software and get online. The Company went public in March of 1992 and by 1996 the Company had 2.1 million subscribers, however subscribers were starting to flee to cheaper internet access. It turned out that building an ISP was relatively cheap, and the high margin cash flow business that AOL had built was suddenly threatened by a number of competitors. AOL persisted with its viral marketing strategy, and luckily many americans still had not tried the internet yet and defaulted to AOL as being the most popular. AOL continued to add subscribers and its stock price started to balloon; in 1998 alone the stock went up 593%. AOL was also inking ridiculous, heavily VC funded deals with new internet startups. Newly public Drkoop, which raised $85M in an IPO, signed a four year $89M deal to be AOL’s default provider of health content. Barnes and Noble paid $40M to be AOL’s bookselling partner. Tel-save, a long distance phone provider signed a deal worth $100M. As the internet bubble continued to grow, AOL’s CEO, Steve Case realized that many of these new startups would be unable to fufill their contractual obligations. Early web traffic reporting systems could easily be gamed, and companies frequently had no business model other than attract a certain demographic of traffic. By 1999, AOL had a market cap of $149.8B and was added to the S&P 500 index; it was bigger than both Disney and IBM. At this time, the world was shifting away from dial-up internet to modern broadband connections provided by cable companies. One AOL executive lamented: “We all knew we were living on borrowed time and had to buy something of substance by using that huge currency [AOL’s stock].” Time Warner was a massive media company, with movie studios, TV channels, magazines and online properties. On Jan 10, 2000, AOL merged with Time Warner in one of the biggest mergers in history. AOL owned 56% of the combined company. Four days later, the Dow peaked and began a downturn which would decimate hundreds of internet businesses built on foggy fundamentals. Acquisitions happen for a number of reasons, but imminent death is not normally considered by analysts or pundits. When you see acquisitions, read the press release and understand why (at least from a marketing perspective), the two companies made a deal. Was the price just astronomical (i.e. Instagram) or was their something very strategic (i.e. Microsoft-Github)? When you read the press release years later, it should indicate whether the combination actually was proved out by the market.

2. Acquisitions in the internet bubble: why acquisitions are really just guessing. AOL-Time Warner shows the interesting conundrum in acquisitions. HP founder David Packard coined this idea somewhat in Packard’s law: “No company can consistently grow revenues faster than its ability to get enough of the right people to implement that growth and still become a great company. If a company consistently grows revenue faster than its ability to get enough of the right people to implement that growth, it will not simply stagnate; it will fall.” Author of Good to Great, Jim Collins, clarified this idea: “Great companies are more likely to die of ingestion of too much opportunity, than starvation from too little.” Acquisitions can be a significant cause of this outpacing of growth. Look no further than Yahoo, who acquired twelve companies between September 1997 and June 1999 including Mark Cuban’s Broadcast.com for $5.7B (Kara Swisher at WSJ in 1999), GeoCities for $3.6B, and Y Combinator founder Paul Graham’s Viaweb for $48M. They spent billions in stock and cash to acquire these companies! Its only fitting that two internet darlings would eventually end up in the hands of big-telecom Verizon, who would acquire AOL for $4.4B in 2015, and Yahoo for $4.5B in 2017, only to write down the combined value by $4.6B in 2018. In 2013, Yahoo would acquire Tumblr for $1.1B, only to sell it off this past year for $3M. Acquisitions can really be overwhelming for companies, and frequently they don’t work out as planned. In essence, acquisitions are guesses about future value to customers and rarely are they as clean and smart as technology executives make them seem. Some large organizations have gotten good at acquisitions - Google, Microsoft, Cisco, and Salesforce have all made meaningful acquisitions (Android, Github, AppDynamics, ExactTarget, respectively).

3. Google and Excite: the acquisition that never happened. McCullough has an incredible quote nestled into the start of chapter six: “Pioneers of new technologies are rarely the ones who survive long enough to dominate their categories; often it is the copycat or follow-on names that are still with us to this day: Google, not AltaVista, in search; Facebook, not Friendster, in social networks.” Amazon obviously bucked this trend (he mentions that), but in search he is absolutely right! In 1996, several internet search companies went public including Excite, Lycos, Infoseek, and Yahoo. As the internet bubble grew bigger, Yahoo was the darling of the day, and by 1998, it had amassed a $100B market cap. There were tons of companies in the market including the players mentioned above and AltaVista, AskJeeves, MSN, and others. The world did not need another search engine. However, in 1998, Google founders Larry Page and Sergey Brin found a better way to do search (the PageRank algorithm) and published their famous paper: “The Anatomy of a Large-Scale Hypertextual Web Search Engine.” They then went out to these massive search engines and tried to license their technology, but no one was interested. Imagine passing on Goolge’s search engine technology. In an over-ingestion of too much opportunity, all of the search engines were trying to be like AOL and become a portal to the internet, providing various services from their homepages. From an interview in 1998, “More than a "portal" (the term analysts employ to describe Yahoo! and its rivals, which are most users' gateway to the rest of the Internet), Yahoo! is looking increasingly like an online service--like America Online (AOL) or even CompuServe before the Web.” Small companies trying to do too much (cough, uber self-driving cars, cough). Excite showed the most interest in Google’s technology and Page offered it to the Company for $1.6M in cash and stock but Excite countered at $750,000. Excite had honest interest in the technology and a deal was still on the table until it became clear that Larry wanted Excite to rip out its search technology and use Google’s instead. Unfortunately that was too big of a risk for the mature Excite company. The two companies parted ways and Google eventually became the dominant player in the industry. Google’s focus was clear from the get-go, build a great search engine. Only when it was big enough did it plunge into acquisitions and development of adjacent technologies.

Dig Deeper

• Raymond Smith, former CEO of Bell Atlantic, describing the technology behind the internet in 1994

• Bill Gates’ famous memo: THE INTERNET TIDAL WAVE (May 26, 1995)

• The rise and fall of Netscape and Mosaic in one chart

• List of all the companies made famous and infamous in the dot-com bubble

• Pets.com S-1 (filing for IPO) showin a $62M net loss on $6M in revenue

• Detail on Microsoft’s antitrust lawsuit

June 2019 - Zero to One by Peter Thiel

Peter Thiel’s contrarian startup classic, Zero to One, is a great book for understanding and building startups.

Tech Themes

1. Zero to One. As Thiel explains in the opening pages, Zero to One is the concept of creating companies that bring new technology into the world: “The single word for vertical, 0 to 1 progress is technology.” This is in contrast to startups that simply copy existing ideas or other products and tackle problems 1 to n. In Thiel’s view, the great equalizer that allows you to create such an idea is proprietary technology. This can come in many forms: Google’s search algorithms, Amazon’s massive book catalog, Apple’s improved design of the iPad or PayPal’s faster integrated Ebay payments. But generally, to capture significant value from a market; the winning technology has to be 10x better than competition. To this end, Thiel says, “Don’t disrupt.... If your company can be summed up by its opposition to already existing firms, it can’t be completely new and it’s probably not going to become a monopoly.” The true way to become a massively successful company is to build something completely new that is 10x better than the way its currently being done. This 10x better product has to be conceived over the long term, with the idea that the final incremental feature added to the product gives it that 10x lift and takes it to monopoly status.

2. Beliefs and Contrarianism. Thiel begins the book with a thought-provoking question: “What important truth do very few people agree with you on?” To Thiel, however you answer this question indicates your courage to challenge conventional wisdom and thus your potential ability to take a novel technology from 0 to 1. Extending this idea, Thiel defines the word startup as, “the largest group of people you can convince of a plan to build a different future.” This sort of Silicon Valley contrarianism is exactly the mindset of Internet bubble entrepreneurs. Thiel continues on this thinking, with another question: “Can you control your future?” and to that question he answers with an emphatic, “Yes.” People are taught to believe that “right place, right time” or “luck” is the greatest contributor to individual success. And as discussed in Good to Great, while many CEOs and prominent executives make this claim, they often don’t believe it and use it much more as a marketing mechanism. Thiel firmly believes in the idea of self-determination, and why shouldn’t he? He’s a white male, Rhodes Scholar and Stanford Law School graduate who has now made billions of dollars. In his mind, you either believe something novel and create that future or you waste your time tackling the problems that exist today. This also conveniently mirrors Thiel’s investing focus and he even calls this out in a chapter detailing venture returns. Venture takes informed speculative bets on which technology will ultimately win out in a market – the best bets are the ones that differ so greatly from the established norm because the likelihood of landing in the monopoly position (though still small) is much greater than a Company that is recreating existing products.

3. Looking for Secrets and Building Startups. The answers to the Thiel question posed above are secrets: knowable but undiscovered truths that exist in the world today. He then poses: “Why has so much of our society come to believe that there are no hard secrets left?” He provides a four part answer:

• Incrementalism – the idea that you only have to hit a minimum threshold for pre-determined success and that over-achieving is frequently met with the same reward as basic achievement

• Risk Aversion – People are more scared than ever about being wrong about a secret they believe

• Complacency – people are fine collecting rents on things that were already established before they were involved

• Flatness – the idea that as globalization continues, the world is viewed as one hyper competitive market for all products

Sticking on his contrarian path, Thiel emphasizes: “The best place to look for secrets is where no else is looking…What are people not allowed to talk about? What is forbidden or taboo?” This question is especially interesting in the context of the latest round of startups going public. A lot of people have argued that the newest wave of startups are tackling problems that are of lower value to society, like food delivery – focused on pleasing an increasingly on-demand, dopamine driven world. Why is that? Have we reached a local maximum in technology for a given period? While you may not completely believe Ray Kurzweil’s Law of Accelerating Returns, the pace of technological evolution has probably not hit a maximum. It could be argued that we have enjoyed a great run with mobile as a dominant computing platform (PCs before that, Mainframes before that, etc.) and that the next wave of startups tackling “important" problems could spring out of such a development.

Business Themes

1. Monopoly profits. Thiel plainly states the overarching goal of business that is normally obfuscated by cult-like Silicon Valley startups: monopoly profits. This touches on a point that has been bouncing its way through the news media (Elizabeth Warren, Stratechery, Spotify/Apple) in recent months with Elizabeth Warren calling for a breakup of Apple, Facebook and Amazon, Spotify claiming the App Store is a monopoly, and others discussing whether these companies are even monopolies. He claims monopolies deserve their bad press and regulation, “only in a world where nothing changes.” Monopolies in a static environment act like rent collectors: “If you corner the market for something, you can jack up the price; others will have no choice but to buy from you.” This is true of many heavy regulated industries today like Utilities. It’s often the case consumers only have one or two providers to choose from at max, so governments regulate the amount utilities can increase prices each year. Thiel then explains what he calls creative monopolists, companies that “give customers more choice by adding entirely new categories of abundance to the world. Creative monopolies aren’t just good for the rest of society: they’re powerful engines for making it better.” Thiel cites a few interesting examples of “monopoly” disruption: Apple iOS outcompeting Microsoft operating systems, IBM hardware being overtaken by Microsoft software, and AT&T’s monopoly prior to being broken up. It should be noted that two of these examples actually did require government regulation – Microsoft was sued in 2001 and AT&T was forced to break up its monopoly. What’s even more interesting, is the prospect of the T-Mobile/Sprint merger being blocked because while the consolidation of the telecom industry could mean increased prices, both T-Mobile and Sprint have struggled to compete with guess who, AT&T and Verizon (who started as a merger with former AT&T company, Bell Atlantic). Whether monopolies are good or bad for society, whether its possible to call tech companies with several different business lines monopolies remains to be seen – but one things for sure – being a monopoly, tech monopoly, or creative monopoly is a great thing for your business.

2. Prioritizing Near Term Growth at the Risk of Long Term Success. Thiel begins his chapter on Last Mover Advantage with an interesting discussion on how investors view LinkedIn’s valuation (since acquired by Microsoft but at the time was publicly traded). At the time, LinkedIn had $1B in revenue and $21M in net income, but was trading at a value of $24B (i.e. 24x LTM Revenue and 1100x+ Net Income). Why was this valued so highly? Thiel provides an interesting answer: “The overwhelming importance of future profits is counterintuitive even in Silicon Valley. For a company to be valuable it must grow and endure, but many entrepreneurs focus on short-term growth. They have an excuse: growth is easy to measure, but durability isn’t.” Thiel then continues with two great examples of short-term focus: “Rapid short-term growth at Zynga and Groupon distracted managers and investors from long-term challenges.” Zynga became famous with Farmville, but struggled to find the next big hit and Groupon posted incredibly fast growth, but couldn’t get sustained repeat customers. This focus on short-term growth is incredibly interesting given the swarm of unicorns going public this year. Both Lyft and Uber grew incredibly quickly, but as the public markets have showed, the ride-sharing business model may not be durable with each company losing billions a year. Thiel continues: “If you focus on near term growth above all else, you miss the most important question you should be asking: will this business still be around a decade from now?” To become a durable tech monopoly, Thiel cites the following important characteristics: proprietary technology, network effects, economies of scale, and branding. It’s interesting to look at these characteristics in the context of a somewhat monopoly disruptor, Zoom Video Communications. CEO Eric Yuan, who was head of engineering at Cisco’s competing WebEx product, built the Company’s proprietary tech stack with all the prior knowledge of WebEx’s issues in mind. Zoom’s software is based on a freemium model, when one user wants to video chat with another, they simply send the invite regardless of whether they have the service already – this isn’t exactly a google-esque network effect but it does increase distribution and usage. Zoom’s technology is efficiently scalable as shown by the fact that its profitable despite incredibly fast growth. Lastly, Zoom’s marketing and branding are excellent and are repeatedly lauded within the press. The question is, are these characteristics really monopoly defining? Or are they simply just good business characteristics? We will have to wait and see how Zoom fairs over the next 10 years to find out.

3. Asymmetric Risk & VC Returns. Thiel started venture capital firm, Founders Fund in 2005 with Ken Howery (who helped start PayPal with Thiel). Thiel notes an interesting phenomena about VC returns that several entrepreneurs don’t truly understand: “Facebook the best investment in our 2005 fund, returned more than all the others combined. Palantir, the second best investment is set to return more than the sum of every investment aside from Facebook…The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined.” Venture capital investing, especially at the earliest stages like Seed and Series A (where Founder’s Fund invests) is a game of maximizing the chance of one or two big successes. In the past five to ten years, there has been a significant increase in venture capital investing, and with that a focus among many firms to be founder friendly. As discussed before, these founder friendly cultures have led to super-voting shares (like Snap, FB and others) and unprecedented VC rounds. Even with these changes, there is still a friction at most VC-backed companies: the supposedly value added VC board member doesn’t believe that Company XYZ will be the next Facebook or Palantir, and because of that chooses to spend as little time with them as possible. This has fueled the somewhat anti-VC movement that several entrepreneurs have adopted because as with Elon Musk at PayPal and Zip2, being abandoned by your earliest investors can be devastating.

Dig Deeper

• Facebook Chris Hughes co-founder calls for the breakup of Facebook

• Thiel wrote the first check into Facebook at a $5M valuation

• An overview of the PayPal Mafia

• A new book on scaling quickly by PayPal Mafia member Reid Hoffman