Salman's blog

The “App Store” of Text

2011-09-05T05:10:00.011-04:00

A couple of weeks ago, Albert recommended “The Information” on his blog. 5 clicks, and a few seconds later, I was already reading the book on my phone. (And once I had finished the free sample chapter, it took me only two more clicks to purchase the book and continue reading!!)

5 clicks and I had the book! This wasn’t the first kindle book I had read, nor the first review I clicked on, but I was suddenly struck at how easy Amazon had made it to buy and read books. And it made me think of a few of the many reasons why the iphone / ipod touch / ipad app store has been so successful:

1. Apple made it super easy to buy apps (and for developers to sell them.)

2. Apps were relatively cheap. (I remember when my son wanted to buy the FIFA Soccer game on the PSP a few years ago, it cost CHF50+, while the ipod touch app was only a few bucks.)

Before the apple app store, so called "apps" were stuck between being either free on the internet or too expensive on game consoles. The app store created that middle ground, where apps could be bought (ie they were not always free) but they were still relatively cheap, and they were all only a couple of click away. Cheap and Easy: That expanded the market tremendously and the rest is history.

It strikes me that news content has also been stuck between “free” and “too expensive” for a long time now. And content providers have only been able to play with the price lever, because it is hard for any one content provider to make it easy enough to buy text content.

Sometimes I come across a link to interesting content behind pay walls - an article in a magazine or newspaper, or an in-depth analysis on a blog, or even a recommended academic paper. I would like to read these, and I would be willing to pay something for that content. But to access the text, I am forced to go through the pain of registering on a web site, or paying for a subscription, all of which is way too painful. Imagine how successful the app store would have been if you were forced to buy a subscription to multiple apps every time you thought of downloading one $0.99 app! The same goes with "text" content. I would be willing to pay for it, but I would be willing to invest only so much time, clicks and money to access each article. I don't want to subscribe or even register to read an article I just found –it’s just too difficult, and so I move on to other free content on the web.

But if I was only a couple of clicks away from those texts, I would certainly be far more tempted to pay for the access.

This must be a huge opportunity for Amazon - to sell individual articles by all major publications and many a blog. I can’t believe that my only options on Amazon kindle today are to buy full subscriptions or a full magazine. What nonsense! When I reach the "free summary" web-page of a pay-wall article, I want a “read this on Kindle” button, offering me to download the article in a few seconds and only a couple of clicks, for say $0.09 cents for a news article or a few bucks for research. But I don't want to enter credit card details or even sign in using Google or Facebook or what have you. I am only willing to spend a couple of clicks of time.

Text content providers (newspapers, magazines, blogs etc) have been struggling for so long to find the right balance between providing free link-able content, and being paid for their good work. But they are still stuck between free and too-expensive. And they have not yet adapted to the distributed world of online content, where people don't necessarily want to be forced to "subscribe", whatever the price. It's not easy to subscribe!

Someone has to experiment with an App Store for text, making individual articles and research cheap and easy to access. And Amazon is probably the one big company in an ideal position to do just that.

What's next now?

2011-08-21T18:55:00.005-04:00

Back in 2007, before the iphone had even launched, when Brad Burnham asked ‘What’s Next?’, I pointed to Christensen and said:

“Christensen paints a picture of various elements of a ‘stack’ disintegrating and re-integrating (ie re-aggregating) over time with value moving back and forth between those elements (thus his “law of conservation of attractive profits” referring to adjacent elements of the stack going through cycles of commoditization.) … An obvious example: the PC disintegrated the computing-device stack and pushed value to some of the individual elements of the stack – benefiting Intel and Microsoft among others. More recently, the ipod (and to some extent the mac) has reintegrated the stack arguably shifting value back to the ‘hardware’ or ‘device’ as an aggregated whole.”

Four years on, with the success of the iphone and the Kindle, and now, Google’s decision to buy Motorola Mobility, the “integration” cycle seems to be nearly complete.

"Nearly": First off, it seems unlikely that Google will become an integrated player like Apple is today. My bet would be that Google integrates not only Motorola’s patent portfolio but also much of their technology expertise and talent to create reference architectures designs and may be key hardware for their partners like Samsung. But once Google integrates the key engineering teams, it can only make sense for them to sell the Motorola brand, distribution and a hollowed-out hardware business to a company like HP. Ironically, this Googorola may begin to look more like the wintel of the 1990’s (without the Motorola brand.)

So what’s next then? What is the next big strategic shift (say, 3-4 years from now), which could put us back on a dis-integration cycle?

Purely theoretically, it seems like that value could shift to the network – ie the mobile operators. But that seems so unimaginable at this point, that I will leave it there.

What else, besides Microsoft ( ;-) ), could save us from the constraints of a Google / Apple duopoly, and jump-start dis-integration? The only things I could imagine are (1) HTML 5, and (2) personal information integrators.

1. HTML 5 could finally render the os obsolete… finally(!) That’s what everyone hoped and/or feared from the early days of Netscape, and ironically, it could make a Firefox the new king maker (again.) HTML 5, built on the advanced hardware platforms of a couple of years from now could remove much of the advantages of integrated platforms like Apple and Googorola. Evolving standards would create a seamless experience even in a dis-integrated world. The OS wouldn’t matter to the experience, and nor would the hardware. And the equivalent to the App Store or Android Market would be distributed, like the web is today, but with room for giant market makers like Amazon.

2. Be it Facebook, Google+, or even iCloud or a Dropbox, or rather I hope, a still to be formed startup, one or more companies may be able to build on top of the existing stack and create value by solving one of the other much sought-after holy grails of the internet – to be a repository and manager of your information and interactions across devices, clouds and web services. Such an animal will free us from increasing constraints imposed by the integrated stack duopoly, and shift value creation away from the existing stacks to itself… One can only hope that the winning solution here will be an open-source / open-data P2P platform.

That’s what the world is looking like to me.

(If I turn out to be way off, I will need to blog more often to push this post down beyond page 1 and into oblivion.)

Visionary Perseverance vs Stubborn Stupidity

2009-06-19T17:16:00.002-04:00

A few days ago, I heard a talk by RE-Power’s CFO. He took us through the company’s quite incredible journey. In early 2005, the company was a cash strapped sub ~€70m market-cap company, and no investor was willing to put any money in it. But by 2008, the stock price had gone up ten fold and the company was worth a couple of billion euros.
One of the conclusions of the speech was that if you believe in what you are doing, you should persevere, and you will be successful.
One hears this conclusion quite often in the retelling of success stories. But the problem is that when you hear about stories of failure - and normally such stories do not make it to a key note address – it is told by the investors who were smart enough not to invest. “Every one told the CEO it was a stupid idea, and he just went on wasting his time on it. It was clear it was going to fail.”
It seems that the line separating “stubborn stupidity” from “visionary perseverance” can only be drawn in retrospect.

A Case for CATs

2008-12-17T17:20:00.001-05:00

I have been working on this paper in bits and pieces since the summer. It is a position paper advocating a "Carbon Added Tax" on embodied emissions.

This is the intro:

A Carbon Added Tax (CAT) is like a sales tax on the carbon emitted to produce the goods and services we consume. From the CAT perspective, when you buy say, a computer, you are responsible for the carbon emitted in producing its mother board and the hard disk and each subcomponent in the computer, as well as that emitted from the fuel burnt by ships and trucks transporting it, and to power the electricity in the shop selling it. A CAT levies a tax on the consumer for all this “embodied” carbon, at the point of sale.

This paper argues that a CAT represents a better way to affect global carbon emissions, because it leverages the global nature of the world economy to cut through geographic and legislative boundaries. The paper also addresses the major arguments against the CAT – the assumed difficulty of measuring embodied carbon and administering the tax. It discusses the latest developments in this area, and proposes structural incentives to overcome those obstacles.

And here is what's in it:

The Moral Imperative: Consumer vs Producer Responsibility
The Quantitative Impact of the Consumer Responsibility Perspective
The Economics: A Global Public Good
Structural Problems with the Producer Responsibility Paradigm
The CAT in Practice
Accounting View: Counting Carbon for CATs
A Philosophical Note: Archimedes’ Lever
A Time to CAT?
Conclusions

Macbook Environmental Report

2008-10-15T17:44:00.000-04:00

Kudos to Apple for putting out an environmental report on their new Macbooks (via earth2tech).

Of course, I will have to point out that Apple estimates its embodied emissions (ie emissions from production and transport) to be 60% of the total lifecycle emissions of the product, versus 39% for customer use. Not to repeat myself too often, but why is it every one seems to be focusing on the 39% portion?

The CAT is out of the bag

2008-07-27T12:29:00.000-04:00

I’ve been toying with the idea of a Value Added Tax on embodied carbon, and I’ve been meaning to put some thoughts in writing. So I came up with what I thought was the brilliantly original acronym: CAT for a “Carbon Added Tax”.

Then I did a search, and found that Nobel-laureate Joe Stiglitz recently proposed the same idea:

"A carbon added tax (CAT), levied at each stage of production, would have some of the same advantages that a value added consumption tax has. Each producer would have to show receipts for the carbon tax paid on inputs into its production. The taxes levied at each stage of production would be passed on to consumers. It is as if the tax were imposed on consumers… A carbon value added tax will both discourage production in more carbon intensive ways and discourage the consumption of carbon intensive goods."

His proposal pretty much sums up my thought process…

But perhaps even more interesting is that some one called Ewan O'Leary, registered the URLs for carbonaddedtax.com and .org last February. Now that is some real forward thinking!!! ;-)

OUR personal data on the web

2008-07-17T06:07:00.003-04:00

Our data is born free, but everywhere it is in chains.

We need a new "Social Data Contract" for the web.

Letters to Economist Editors

2008-07-11T16:01:00.000-04:00

I read the Economist religiously - or rather I partly skim and partly read the Economist religiously every week. So it was nice that they published a letter I wrote them. (Of course, it relates to Embodied Emissions.)

What was surprising is how much they edited the letter. At first, I was taken aback: after all, they had lost the nuance of some of my points. On reflection though, it is quite amazing and flattering that they would take the time and effort to completely re-write such letters to drive home the point they think is worth publishing.

In any case, here is the original letter I sent:

Dear Sir,

Your article entitled “Emissions Suspicions” (June 19 2008) ignores the principle of “consumer-responsibility” - that consumers can be responsible for the carbon embodied in the goods they consume. If our society decides to proactively reduce its total carbon emissions, it makes little sense to just focus on the carbon being emitted (or “produced”) directly in our society. For example, a study by Oxford’s Dieter Helm showed that while “UK greenhouse gas [emitted directly in the UK has] fallen by 15% since 1990…on a consumption basis, the illustrative outcome is a rise in emissions of 19% over the same period… Trade may have displaced the UK’s greenhouse gas appetite elsewhere.” Whether this displacement was caused by carbon regulations or other factors is less relevant - What matters is the total amount of carbon that was emitted to produce the goods and services consumed in the UK.

As such, a “carbon tariff” on embodied carbon should not be compared to traditional “import taxes”. The correct analogy is a “Sales tax”. Today, governments tax goods and services both at the point of production (via corporate taxes) and consumption (via VATs or other sales tax). But emissions regulations to-date have been aimed solely at the “production” of green house gases. It is the principle of reducing carbon “consumption” that matters more than the economic implications of leakage (which is the focus of your article.)

But is this principle practicable? Your article also claims that assessing embodied emissions is an “impossibly complicated task.” But much work has been done in this area, specifically by UK based “Carbon Trust” (with the BSI and DEFRA) to create standards and make the process simpler, fair and practical. It would have been more appropriate to reference (if not, assess) these efforts in your article, rather than to dismiss them out of hand, as impossible.

Regards,
Salman Farmanfarmaian
http://salmanff.blogspot.com/
Geneva, Switzerland

And here is how it was reprinted:

Green consumer-taxes

SIR – If a society decides to proactively reduce its total carbon emissions it makes little sense just to focus on the carbon it directly produces (Economics focus, June 21st). For example, a study by Dieter Helm of Oxford University shows that although greenhouse gases emitted directly in Britain had fallen by 15% since 1990 measured by the conventional method, “on a consumption basis, the illustrative outcome is a rise in emissions of 19% over the same period” and that “trade may have displaced” Britain’s “greenhouse-gas appetite elsewhere”.

Whether trade displacement is caused by variances in carbon regulations among countries, which you focused on, or other factors is less relevant than the total amount of carbon that was emitted to produce the goods and services consumed in a single country. As such, plans to introduce a “carbon tariff” on goods imported from countries such as China misses the point. Consumers are responsible for the goods they consume and the carbon emitted to produce them.

Emissions regulations have so far been aimed solely at the production of greenhouse gases, but governments tax goods and services at the point of production and consumption. It would therefore be more sensible to introduce an emissions “sales tax” rather than a carbon tariff.

Salman Farmanfarmaian
Geneva

I wonder which version is better.

The Polluter is the Consumer

2008-06-24T04:47:00.000-04:00

Here is another high level analysis of embodied carbon in imports by Oxford’s Dieter Helm (et al). It looks at the UK’s carbon emissions from the “consumption point of view.” The paper notes that using conventional producer-based carbon accounting-methods,

“UK greenhouse gas emissions have fallen by 15% since 1990. In contrast, on a consumption basis, the illustrative outcome is a rise in emissions of 19% over the same period. This is a dramatic reversal of fortune… It suggests that the decline in greenhouse gas emissions from the UK economy may have been to a considerable degree an illusion. Trade may have displaced the UK’s greenhouse gas appetite elsewhere.”

The same paper has a well-articulated overview of the “consumer vs producer” paradigm:

“Both these [currently used] methodologies are based on the location of the production of greenhousegases. This, however, is a somewhat misleading and partial basis for policy purposes. For a country could have a very low production of greenhouse gases, but at the same time have a high consumption level. It could produce low-GHG-intensity goods, but import and consume high-GHG-intensity goods. Thus, a developed country might cease to produce steel, aluminium, glass and chemicals domestically, but import the manufactured goods from abroad. In the UK’s case, the shift of production in such activities to China, India and other developing countries in the last two decades suggests that this effect may be considerable… China might argue that, although it produces high emissions, these are on behalf of consumers in developed countries, and therefore the consumers should pay for the relevant reductions. In this way, the polluter is not the producer, but rather the consumer.”

Also, the paper finds that “by 2006, the trade deficit in greenhouse gases [in the UK] was 341 MtCO2e, around 50% of domestic UK greenhouse gas emissions.” Another data point in understanding our total carbon footprint.

____________________________
Notes:
Thanks to David McKay’s blog for pointing me to the above paper.
Also - Bold emphasis above added.

Transportation and Carbon-Conscious Consumers

2008-05-03T16:33:00.000-04:00

As a sector, transportation is certainly a significant source of carbon emissions. But perhaps because it is so visible, or even tactile, transportation gets a lot of attention, and people tend to overstate its role in embodied emissions. Some recent NY Times articles make references to some related data which are worth quoting:

From the Green Issue of the Magazine: “It is the locavore’s dilemma that organic bananas delivered by a fuel-efficient boat may be responsible for less energy use than highly fertilized, nonorganic potatoes trucked from a hundred miles away. Even locally grown, organic greenhouse tomatoes can consume 20 percent more resources than a tomato from a far-off warm climate, because of all the energy needed to run the greenhouse.”

The same issue also quoted the famous New Zealand studies, though in a somewhat skeptical tone: “A handful of studies have recently suggested that in certain cases under certain conditions, produce from places as far away as New Zealand might account for less carbon than comparable domestic products.”

Also, when Timberland studied the embodied emissions of its shoes, “the company was surprised to find that transportation may account for less than 5 percent of its greenhouse-gas emissions — while almost 80 percent may come from making the leather, a process buried deep in its supply chain.” (Note however that Timberland seems to have overestimated the emissions related to the leather.)

The above study is consistent with Weber and Matthews’ study on the embodied emissions of imports into the United States, which suggests that “CO2 emissions due to international freight transport are unlikely to increase the totals [of embodied emissions in imports] by more than 10%.”

In an article on the environmental impact of groceries, it was calculated that a bottle of European wine drunk in New York has 1.4kg of embodied CO2, while a Napa bottle would have 2.5kg. Ironically, in this case, the major difference does lie in transportation, since Napa wine is trucked to New York, while French wine is shipped, thus consuming far less carbon per mile shipped.

So much for drinking local (or at least national.)

Finally, a hopeful note in today’s article on transportation’s direct carbon footprint. “A paper presented by Travelport at the World Economic Forum in Davos in January… stated that consumers want information about their carbon footprint as it relates both to business and personal travel. 'That desire for information has the potential,' the paper said, 'to reshape the travel policies companies set and the choices companies and consumers make across a broad range of decisions: how they travel; when and where they travel; what airlines, hotels, and rental car companies they use; where they hold meetings and events — even whether they travel at all.'

Whatever the impact of the transportation sector on global carbon emissions, it will be interesting to watch the impact of carbon-conscious consumers on the transportation sector.

Saul Griffith’s Carbon Footprints Part II – Some numbers

2008-04-20T15:30:00.001-04:00

Following my previous post, I thought to look at Saul’s energy usage / carbon footprint calculations by separating out his personal energy usage from his work related consumption.

See the notes below on how I have separated the work from the personal energy usage. The chart below separates out the numbers into 4 categories, and speaks for itself. Almost half of Saul’s home energy usage comes from “Food and Stuff” which represents the embodied emissions of his consumer purchases. Of course, as Saul has pointed out, he has probably underestimated the energy usage associated with these categories.

Again, people can dispute the difficulty of calculating the embodied emissions of “stuff”, but at almost 4 times the energy usage of his home heat and electricity, Saul’s calculations should at least, again, put the importance of embodied emissions in perspective.

__________________________
A few other notes:

Like the truck driver in my previous post, Saul’s major source of carbon emissions relates to his travel for work. His total work related energy use should be compared to the value of his work, in revenues from his company or at least with the costs associated with the company. This figure should be compared to other businesses in the same sector.
Energy usage of ‘stuff’ related to work would probably need to be more comprehensive, including things like capital goods (servers, furniture), services delivered to his workplace (fedex, as well as consumables (like pencils and paper and printer toner.)

Here is the data:

Some notes on separating work from home usage:

Saul mentions that most of his air travel is for work, so I put in a “wild guess” number of 90% related to work. Inversely, I assumed 90% of his car usage was for personal (ie home) use.
In stuff, I only allocated his laptop to work. As noted above, there are probably other work related goods that should be added to his work “stuff”
The allocation of societal consumption is an interesting one. Here I have assumed it is half for work and half for home. After all, government exists to serve both individuals and to support businesses. Although the actual impact at ~3% in total is not very big, a more thoughtful method may still be needed here. For example, there could be an argument that government is there only to serve the people, so 100% should be allocated to individuals. At the same, this would distort the picture for developing nations (and the goods they export), especially since substantial government resources are probably expended on supporting businesses.

Saul Griffith’s Carbon Footprints Part I – More on Consumer vs Producer Responsibility

2008-04-15T16:45:00.000-04:00

“Power Consumption at work... This... brings up a very interesting point... where do you draw the lines in figuring out your own energy consumption? Does work energy go against you or the product of that work?”

Saul Griffith’s excellent presentation gives a very thorough view of carbon foot-printing, and the particular question above is quite fundamental. I would argue that personal energy consumption should be treated separately from energy use for work. The energy use related to our work should show up embodied in the product of our work.

A few examples could help illustrate why…

Say I am truck driver that delivers apples ( ;-) ) to a local grocery store. It would not make sense to mix my personal energy consumption behavior with my job as a truck driver. Even if I lead a carbon neutral personal life, mixing my stellar home footprint and my work related emissions would give a distorted view of the choices I can make – ie the factors which are under my control, in my personal life.
Now let’s imagine the exact opposite case. Let’s say you are a small business owner, doing most of your work from the office using emails and phones. Again, you could be driving a hummer from home to work, and leave your oven on 24 hours a day, but if you mix your personal and work energy usage, you would still seem more eco-friendly than the me.
Now, to drive the point home, imagine that you are my boss, and you are responsible for deciding the kind of truck I would drive. Clearly, the distortion created by mixing personal and professional energy use and footprints would make the exercise quite meaningless.

This is not to say we shouldn’t worry about our work related energy use. All of us have some say in the energy consumption of our workplace. And we can make choices to affect it. But the energy consumption of my apple delivery business should be compared with the energy consumption of other apple delivery businesses, or delivery businesses in general. The result of our work, and the energy we consume to deliver it, would both be manifested in the product of our work – in this case, an apple. So it would also make sense to use metrics like CO2 emissions per apple delivered…

Or, for practical purposes, so as to be able to generalize (and mix apples and oranges in the same truck), one could measure, CO2 per dollar of revenue delivered…

Or rather, to be able to account for each business’s share of economic activity, carbon emissions per dollar of economic value add.

(To illustrate: Let’s assume I have an apple delivery business using apples from my brother’s farm. And say you have an apple farm and deliver the apples yourself. Ultimately, we would want to compare the total lifecycle emissions for each apple. Say, you sell apples for $2 and emit 2 grams of carbon per apple, from the farm to the final delivery. My brother emits one gram of carbon per apple and sells them to me for $1. If I emit 1 gram of carbon in delivering the apples and sell them for $2, the total embodied emissions of the apples I sell are the same as yours – 2 grams in total. But if I calculate emissions per dollar of revenue, I would get 0.5 grams of emissions for every dollar of revenue – ie 1 gram for every $2 apple – which is the wrong comparison. In effect, I am emitting 1 gram for every $1 of economic value add, since I am buying the apples for $1.)

So, the best way to compare apples and apples is to compare the total embodied emissions in each product, including each part of the full supply chain, preferably in the form of a carbon label. And each part of the supply chain would weigh its emissions against the economic value that it is adding to the product, and compare that to similar businesses - ie comparing apple delivery to apple delivery.

From a consumer responsibility perspective, it would be up to each apple buyer to decide between different kinds of apples and take responsibility for that purchase decision. If an apple delivery company decides to use solar powered trucks, then that should show up on the carbon label of the apples it delivers, and affect the carbon footprint of the buyers of those apples.

Many argue that carbon labels are impractical because the carbon footprint of each product is very hard to calculate. I don’t believe that to be the case, especially if you weigh that difficulty against the total impact of embodied emissions (also see here and here.)

Carbon Emissions in Developing Countries: Producer vs Consumer Responsibility

2008-04-06T04:48:00.000-04:00

“Developing countries, whose economies and populations are growing fastest, [will] contribute 74% of the increase in global primary energy use [until 2030]. China and India alone account for 45% of this increase.”
World Energy Outlook 2007, IEA

So three quarters of all new power production capacity will be in developing countries. Close to half of it in India and China. And according to the same report:

“China, with four times as many people, overtakes the United States to become the world’s largest energy consumer soon after 2010. In 2005, US demand was more than one third larger.”

And...

“In the longer term, [in China,] demand slows as the economy matures, the structure of output shifts towards less energy-intensive activities and more energy-efficient technologies are introduced.”

This last sentence is the most interesting. It sounds like the basic assumption of the report is that China will make a typical progression towards a more advanced economy: As the country becomes richer, not only will it care more about the environment and prioritize more energy efficient technologies, but the economy as a whole will become more service oriented, much like that of the US. Of course, this does not mean that the world will consume fewer goods. It just means that those goods will be produced in a new generation of up and coming developing nations – and those nations would account for the ~30% of the total increased energy use until 2030.

One could imagine that, like China today, those countries will want to use the cheapest (and thus potentially the dirtiest) fuels. They might also argue that it would be unfair to impose environmental restrictions on them since they too have a right to grow their economies. Just as China points to Europe and America’s growth and how they were fueled by dirty coal, those countries may point to China along with Europe and America and make the same argument.

And from their perspective, they would be right, just as China is “right” in its argument today.

The problem is the paradigm upon which the argument relies. It is a “producer responsibility” paradigm of CO2 emissions, looking at emissions based on where they were produced or emitted, not on why they are produced, and for whom. The "producer responsibility" world view ignores the "end-user" or consumer of the products which were created using those emissions.

Many developing countries, especially in their early stages of development, rely heavily on exports. In effect, they are using much of that new energy capacity to produce goods which are consumed in the more advanced economies. A “consumer responsibility” approach to carbon emissions could create a paradigm shift. It could give consumers the leverage to make decisions on whether they want to buy products which were produced using say, a new coal fired power plant. And it would shift the debate away from esoteric arguments about the "right" of government bureaucrats to pursue their nations' best interests.

Socolow’s Wedge vs. Archimedes’ Lever

2007-10-30T17:19:00.000-04:00

On Platforms Versus Prescriptions

It had been a while since I first read Socolow and Pacala’s classic paper laying out the concept of “Stabilization Wedges” – the idea that we can implement several current technologies, each a wedge, to reduce carbon emissions to quasi-sustainable levels.

I didn’t feel comfortable with the word “wedge”, and wondered about its philosophical underpinnings. Why did they choose the word?

According to Wikipedia, “A wedge is… used to separate two objects… through the application of force.” (emphasis added.) Sounds like somewhat of a primitive method. (Little surprise that the wedge “has been in use as early as the Stone Age.” ;-) )

Of course the paper itself is great, in that it sets tangible goals to reduce carbon emissions, and emphasizes that the goals are technologically achievable. But the term ‘wedge’ seems to have been used just because the savings from emissions in the paper’s graph looked like wedges. No deep philosophical underpinning intended!

Except that such terms tend to take lives of their own – and in this case, the problem I have with it, is that it can take on a prescriptive connotation. Take these phrases (from the paper) for example:

“A wedge would be created if twice today’s quantity of coal-based electricity in 2054 were produced at 60% instead of 40% efficiency.”
“a wedge of nuclear electricity.. would require 700 GW of nuclear power with … about twice the nuclear capacity currently deployed.”
“a wedge from photovoltaic (PV) electricity would require 2000 GWp of installed capacity that displaces coal electricity in 2054.”
“An ethanol wedge would require 250 million hectares committed to high-yield plantations by 2054”
etc. etc.

Socolow did not necessarily intend for these goals to have policy implications – but don’t they just sound like they are calling us to use the brute application of regulatory force to implement each of the wedges?

That’s what makes me uncomfortable with the term.

Setting a goal is indeed very different from figuring out how to actually achieve it.

Imagine that, circa 1980, someone thought: “Wow – what if we had cheap computers linked up in a giant network so people could connect to each other, and find all sorts of information and buy things using this giant network. How cool would that be!”
Obviously, the goal would have been achieved less than two decades later with the internet. But that was not because some policy wonk decided to set about trying to create the end to end solution to achieve that goal. If someone had tried to prescribe such an impressive goal in a policy implementation, it would probably not have ended up with the internet… in fact, the French government tried to do exactly that, and ended up with the minitel – quite good for its time, but certainly with no long lasting legacy!

If we are going to use analogies, I much rather a lever, than a wedge… As per wikipedia: “Levers can be used to exert a large force over a small distance at one end by exerting only a small force over a greater distance at the other.” [emphasis added]

So if you want to achieve such a grand goal, I posit that is it much more effective to create the necessary levers – the basic infrastructure and the underlying ‘rules of the game’ that can unleash the power of markets, allowing thousands of individual entities to exert only a small force at great distances. To create the web, no one set out to create wedges like:

“We need 20 million computers networked together by 1995”,
“We need 3 million programmers creating web sites by 1997”,
“We need 100 terra bytes of data by 2004”, or
“We need x miles of fiber laid in the ground”.

Archimedes, the Greek mathematician first known to describe a lever, famously said: “Give me the place to stand, and I shall move the earth”. For the web, that place to stand – that platform – was created with standard protocols like HTTP, TCP and IP, which simply defined the ‘rules of the game’.

So what platform can we stand on to reduce carbon emissions? How can we define the rules of the game? And where on earth(!) is our lever?

Asian Trade and Consumption (more seriously)

2007-08-26T07:50:00.000-04:00

For some time now, I have been wondering if Asia’s economic growth will create a large enough middle class to eclipse the United States as the primary export market it is today. I would often venture that at some point, there could be a major economic event which will bring a paradigm shift in the way that people perceive the US economy’s power. Now, I wonder if the current sub prime crisis and a potential coming US recession will create that event.

First, some data I dug up: Developing countries in Asia imported around $1.4 trillion of goods in 2006, up from $0.5 trillion in 2002 – from the perspective of an exporter of goods any where in the world, that means that the market for imports into the emerging markets of Asia grew from around 43% of the US import market in 2002, to 77% in 2006 – almost doubling in relative size. If we count all of east Asia (including the more ‘developed’ markets of Japan, Singapore, Hong Kong and Taiwan), then that relative market size has increased from 117% of the US market in 2002, to 163% in 2006. (Should some body have been paing attention when the size of the Asian import market surpassed that of the US circa 2000? Or were we all caught up in our own post bubble trauma?)

The Economist also noted recently that “China now takes 22% of the exports of the rest of emerging Asia, up from 13% in the late 1990s.” So Asian economies, heretofore characterized by their power as exporters to the West, are now becoming significant import markets in and of themselves... and thus less reliant on the American consumer.

To date, the power of the American consumer had been such that it seemed like the whole world depended on his/her consumption habits. A recession in the US would be felt by markets all over the world. (A few years ago an American friend had told me, half jokingly, something like this: “The whole world is dependent on the irresponsibility of the American consumer who keeps loading up even more debt on his credit card to buy even more stuff, keeping the world economy afloat.”)

Even though the above data fails to differentiate between consumer goods and say, heavy machinery, the growth and transformation of Asian economies is unmistakable. So today, and if not, in the near future, when the US consumer sneezes, Asia may no longer need to catch a cold.

To some extent, this explains the continued rise in the Asian stock markets, even as European and American markets have gone through significant volatility recently. One would expect a further decoupling of the Asian stock markets from that of the United States over the coming years.

A more important implication of this trend could be the weakening of America’s political and economic position in the world. Today, much of Asia’s foreign reserves are kept in dollars. They are used to buy US government debt, which could be viewed as a rational form of vendor financing. As the non-US consumer becomes a more important part of Asia’s export market, supporting ‘vendors’ across the emerging markets may become more important at the margins. For example, China may decide to shift a small portion of its reserve dollars to buying Vietnamese debt or finance infrastructure there (to help that export market) instead of buying US bonds. Obviously, US reserves can continue to be important for all Asian economies – but the question is: how much will a small shift of attention, and dollars, away from the US, affect the American economy? Will the dollar fall even more precipitously? Will the falling dollar then cause inflation and potential stagflation as US interest rate policy faces conflicts in balancing inflation, growth, and the value of the dollar at the same time? What will it mean for the various sectors of the US economy? The financial sector may benefit from this trend for example, but will a falling dollar hurt the average US consumer even more in the short / medium term as the US economy adjusts to the new structural balance over time? In the mean while, will this trend benefit political populists and economic isolationists - ever ready to pounce from the fringes of the American political spectrum? Would such a political change further delay a real adjustment of the American economy to the new global economic regime? And as Asian economies come to depend less and less on the US, wouldn't American political influence in the region inevitably decrease, creating the possibility of a vicious cycle of all the above conjectures?

For the record, I am a global economy optimist in every way. But one has to wonder what kind of short term growing pain the increasingly global economy will experience as these relative shifts of political economic power take place and each individual economy makes the necessary structural changes to adjust to new market realities.

China as a Dollar grave?

2007-08-24T08:36:00.000-04:00

In the early 18th century, Britain ran a huge trade with China because of its insatiable demand for Chinese goods. It paid for all of these goods – largely tea and silk – with silver. According to this wonderful BBC program, the imbalance became so large that “China was referred to as the silver grave of the world, because every silver dollar that is minted would end up in China sooner or later.”

At some point, the British had the brilliant idea of marketing more opium to China. As per Wikipedia:

“In an attempt to balance its trade deficit Britain began illegally exporting opium to China from British India in the 18th century. The opium trade took off rapidly, and the silver flow began to reverse… when China attempted to enforce her laws against the trade, the conflict erupted.”

.. thus the Opium Wars of 1840-1843 and 1856-1860.

It’s too tempting not to draw a parallel with today, and wonder (with tongue lightly in cheek) about China as the new dollar grave of the world…

Of course, in the 18th century, financial markets were not sophisticated enough for say, the Chinese to use the silver to buy shares in the British East India Company, or finance British government debt.

Nor is Chinese military power in such a relatively weak position today…

Nonetheless, I wonder if there if the Chinese leadership, famous for its long view of history, still has the Opium wars in its conscious memory as it goes on its foreign buying sprees …

Embodied carbon emissions in electronics even more...

2007-08-19T17:36:00.000-04:00

Previously, I had done a back of the envelope calculation of the carbon emissions embodied in US imports, and together with Bin Shui, we had dug deeper to estimate the amount of carbon embodied in imports of electronics. Now, two academic papers (also using the eiolca.net dataset) present a more thorough analysis of the same issues and their numbers are staggering.

First, two Carnegie Mellon academics estimated the total amount of carbon embodied in US imports to be 1.3Gt. (That is the total amount of carbon emitted to produce the goods that we import and consumer in the US.) To put that in perspective, that is 22% of total CO2 emitted in the US, and more than all residential and more than all commercial emissions in the US. Below is a comparative chart, similar to the one we used in the VentureBeat article.

The other paper, co-written by the same academics, estimates the embodied emissions in imported electronic goods to be 470 MMT of CO2. To make the same kind of comparison as before, that is more than all of the local carbon emissions in the State of California.

As one of the co-authors said in a related news release:

“The central question is one of responsibility. Over the last decade, the United States' share of global carbon emissions has gone down and China's has gone up. However, if you count not by who makes the goods, but by who consumes the goods, the United States' share of responsibility has stayed constant or even gone up. However, these emissions are not counted because they've been outsourced to other countries.”

Environmentally conscious techies should really be paying more attention to these numbers!!

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Note 1: Unfortunately, none of the above articles are available for free.
Note 2: The estimates in the second paper are much higher than those we had come up with in the VentureBeat article. This is partly because of different definitions of the electronics industry, but more importantly, it is because the paper adjusts for some additional factors to give a better estimate. At the time, we decided to keep our estimates pretty conservative, first because it would require a huge amount of work ;-) to refine the estimates, and second, because the numbers were pretty large already – so we felt that our conservative numbers should be enough to make our point.

Video Discovery 'Market Opportunity' from evoketv business plan

2007-05-11T09:33:00.000-04:00

Here are parts of the evoke tv business plan written in May 2006 - exactly one year ago. It is interesting that despite everything that is going on in the online video space, there are no clear big winners in the video discovery space. I wonder whether that means the opportunity never existed, or that it is still wide open. In either case, I thought it worth while to post the "market opportunity" sections of the evoketv business plan:
_____________________________________________

eVoke TV

The Social Space Between the Internet and Your TV

May 2006

Executive Summary

eVoke TV provides an interactive space for media viewers to connect with each other, and to discover and organize their video content, whether it’s on TV or on the internet. Conceived around the idea of ‘Soft Convergence’, eVoke TV combines social media concepts with the traditionally static ‘TV grid’ functionality, to create dynamic communities around the video discovery experience.
...

Soft Convergence: With the rise of broadband connectivity, more and more TV viewers are watching television while connected to the internet. Many are using their wifi connected laptops to find programs to watch on television, or to look for more information about what they are watching. This virtual connection between the PC and the TV screen is what we call the soft convergence of media - there isn’t a physical connection between the laptop and the TV, but the laptop is helping us find content, and knows what we are watching.

Video Discovery: A virtual connection to TV/video media becomes even more relevant as we try to find the increasing amount of media which is becoming available online. Over the past several months, we have seen thousands of videos posted on sites like YouTube and video.google.com, while at the same time, the major networks have announced that they will make more TV programming available on the internet. Yet, most internet technology companies have solely focused on helping to deliver that content, thus making sure that users have access to a plethora of choices, when they want it, and where they want it. Little has been done to help users make those choices, to help them find content they might like – in other words, to help them discover what they might like to see. That is the opportunity facing eVoke TV.

Our goal is to become the equivalent of the ‘TV Guide’, for this new era of quasi-infinite content choices. We know that current mechanisms for finding content, such as the traditional ‘TV grid’, are hardly satisfying, even to parse the few hundred channels available to us via cable or satellite. The new era of quasi infinite ‘on demand’ content choices, requires an appropriate form of content discovery mechanism, one that is based the dynamism of social media and leverages the rise of social networking.

Market Opportunity

Over the past several months, we have seen an astounding explosion of video content online. Not only have sites like YouTube and Google started to allow individuals and corporations to upload video content on their sites, but the major networks have all announced that they will be offering various popular TV programming available on line. Yet, most would agree that we are only at the beginning of this trend. Over the coming years, there will more and more video content available on line. Many great companies and technologies have positioned themselves to deliver that content to us – the Googles and Youtubes are hosting video content on the internet, cable and satellite providers are hosting it on their networks and delivering it via ‘video on demand’ services, technology enablers like Akimbo are helping content producers deliver it to audiences via the internet and cable, various transport mechanisms like TiVo and Slingbox are allowing us watch TV programming any where and at any time.

With all this investment in the technology of media delivery, we know that there will be a plethora of content available to us through various delivery platforms. But with all that content available, the next important question will be: How will we find our way through this jungle of content to watch something we might like? How will we discover ‘good’ content?

We believe that the companies that provide answers to this question will be in a position to become the ‘Google’ of video – the starting point of choice for consumers to find the video content they might want to watch. As such, the opportunity facing eVokeTV is not dissimilar to the opportunity facing search companies and online portals in the late nineties as internet text content was poised to explode.

Algorithmic Search vs. Social Media

The great winner of the internet “text discovery” battle (aka search) was arguably Google and its search algorithm. But search algorithms may not be the best solution to the “video discovery” problem. (Google’s own video search efforts seem to have taken a back seat on its web site, and although companies like Truveo, acquired by AOL, have shown that there is a market for algorithmic search, it is quite intuitive that algorithmic search is inherently disadvantaged in finding creative content. How can I search for ‘something cool to watch’?)

We believe that social media – that is, ways to find content based on the implicit or explicit recommendation of others – provides the most natural and efficient way to find creative content. We have all passed on funny video clips to each other, and we have all received a link to a YouTube video from friends. We rely on our social circle of friends to tell us about interesting content. We watch the TV shows recommended by our friends or the pundits and critics. We like to watch the most popular shows, just to see what every one else is excited by, and in the process, we can become hooked. Even YouTube and Google Video use community-based navigation (which allow users to see the most popular clips for example) to help us find interesting content. However, we know, be it only because of the very distributed and ad hoc nature of the internet, that neither YouTube not Google, will be hosting all the best video content.

During the past year or so, we have seen various companies such as del.icio.us and digg experiment successfully with social media methods of content discovery, by allowing user generated content to play a part in the discovery process. We have also seen social networking sites such as myspace create powerful ways for individuals to connect with each other online. We believe that the most successful video discovery websites will use lessons learnt from such experiments to create the most conducive environment for video discovery.

The relevance of Television

We also believe that the best place to start creating a guide to online video content is with the medium which currently hosts the most popular video content – that is, television. As the two worlds of online video and television video converge, and as the great technologies mentioned above allow us to see video on either venue, the best video guides cannot but incorporate television content.

There are several important reasons why television needs to be a critical component of the video discovery process. First, consumers are still watching a considerable amount of television programming – more than 8 hours a day according to Nielsen. Second, much of popular online video content is still directly related to television. For example, Saturday Night Live’s “chronicles of narnia” clip was downloaded more than 5 million times. CNN newscasts and online sports programming appear on both mediums. And many programs, such as Jon Stewart’s Daily Show or Lost, are creating specific online content related to the original TV programming. Third, preferences in television viewing are potentially powerful indicators of preferences for online video content. Many technology enthusiasts are sci-fi fans. Someone who watches the Soccer world cup online may also be interested in the latest clip on YouTube showing soccer’s greatest moments, or for that matter, Nike’s latest funny soccer related advertisement.

Finally, perhaps most importantly, with tens or even hundreds of channels available to many cable and satellite television consumers, finding things to watch on television is almost as hard as finding things to watch on line. There is so much content available, so much of which we are not interested in, that current methods of finding television programming are quite unsatisfactory. The traditional ‘TV grid’, which shows us every program on every channel available is simply too cluttered. There is too much irrelevant content. As such, solving the video discovery problem on the hundreds of television channels, can guide us to solve the discovery problem when we are faced with quasi infinite content on line.

Acting Locally To Affect the Environment Globally

2007-02-10T22:40:00.000-05:00

Disclosing the Total Carbon Emitted in Producing Consumer Products

What if every consumer product had a label which stated how much carbon had been emitted in producing it? … like food products that have labels disclosing their ingredients. In the same way that I may want to know how much fat I am eating with my diet yogurt, I may also want to know how much carbon went into the environment to make the yogurt. If I am buying a Dell laptop, I want to know how much smoke Dell put up in the air to manufacture it – the direct emissions – and I also want to know the total amount of carbon that was put into the atmosphere to make each of the components Dell bought from each of its suppliers all over the world – the indirect emissions. I really want to know the Total Carbon Emitted (TCEs) in making all the parts in my computer, including the shipping.

By demanding that all products and services disclose the total carbon emitted in producing them, we could be laying the foundation for a real market based ecosystem to control carbon emissions world wide. We would be pushing power away from the government and politicians, towards the consumers and voters, giving individuals incredible leverage to act locally and affect change globally.

Power to the Consumer

Why have so many people bought the hip and hybrid Toyota Prius? Surely, to help conserve energy by using less gas. But also because it is a statement that they care about the environment – a small palatable step we can all take to try and make a difference. The popularity of the Prius shows that consumers do want to make this statement publicly. The problem is that there aren’t that many things consumers can do to make a difference to the environment, yet cost little enough to be doable, while having a large ‘feel good’ factor.

Total Carbon Emitted (TCE) disclosures mean that many more of us – the majority who want to make a statement with a ‘feel good’ factor, without incurring large costs - can make small choices every day that make a difference. We could buy the diet yogurt that took less carbon to produce because of its packaging materials. We could use the overnight mail service that emits less carbon per package delivered. And so on and so forth…

Leave It to the Marketers

Total Carbon Emitted (TCE) Disclosures on products would allow the increasing number of mainstream environmentally conscious consumers to exercise choice and affect the markets. In turn, this allows companies that emit less carbon in manufacturing their products to advertise this fact, and try to offer more differentiated products to this market segment. They would invest in raising awareness, and in educating the market so as to expand their market segment. In other words, they would create marketing programs that try to increase the number of people who buy products based on their Total Carbon Emitted Disclosures – that is, people who are concerned about the environment.

As an aside, imagine this TV ad for example: Black smoke gushes out of a coal fired power plant in China. Newly manufactured Toyota cars roll out of an adjacent building. A voice says that it would take twice the level of emissions to manufacture a Toyota than the new Chevy hybrid (or whatever – I am making this up obviously)… Pan to a scene of peaceful wilderness around a GM plant and a ‘clean’ hybrid Chevy glides by. “It’s not just the gas you consume – it’s also what went into making the car you drive.”

It would be nice to have companies compete on this issue!

Acting Locally to Affect Carbon Emissions Globally

And in the same way that Hollywood and Silicon Valley trend setters started buying Toyota Prius cars, such trend setters may decide to buy other products with lower TCEs, and start to create a trend. TCE’s would allow Gladwell’s market mavens, connectors and salesmen to do their work. And if consumers pick up on this trend and make more and more choices based on TCEs, companies would then start to factor in TCEs in the choices they make, beyond marketing – in building a new manufacturing plant next to an eco-friendly power source for example, or by choosing suppliers that emit less carbon to produce their goods... Given enough momentum, and a little time, some province in China is going to decide that they are going to scrap their next coal fired power plant project and try to cater to manufacturers that address this market segment by building a more eco-friendly power plant, or at least invest in making the coal plant cleaner by using technologies like “carbon capture and sequestration”.

In other words, the chain of events led by consumer choice can have far reaching effects on decisions made all around the world in a way that a globally negotiated agreement like Kyoto never could. The top-down centrally controlled regulations are just not efficient enough. Yet, given an ecosystem of disclosures, information and marketing, consumer’s power to choose can set in motion a chain of events that create a social and business ‘epidemic’, enabling thousands of micro-level decisions to invest in cleaner technologies.

Wake Up and Smell the Carbon

Such a chain of events may seem like pure fantasy, until you think about the extent of the problem. As I previously discovered, over the next few years, the carbon emissions from new coal plants in China will be so much that they would far overwhelm many of the efforts at cutting local emissions in the US. (Another data point is that by 2015, China will be emitting more carbon than the US, roughly doubling its emissions from 2003, while the US's emissions will only grow by 15% during the same period.)

Yet, we (here in US) are the ones importing and consuming many of the products that are made using energy from those coal plants in China. I made a back of the envelope calculation which guesstimated that the carbon emissions associated with all the goods we import into the United States represents around a quarter of ALL carbon emissions within the US! That means that the carbon that was put into the atmosphere to produce all the things we import is roughly equal to all the carbon emitted by ALL transportation in the US.

Now compare the amount of environmental activism regarding cutting emissions on imported goods versus the activity regarding emissions from cars and trucks. May be, because it is difficult to impose global regulations or caps, we have given up on doing anything about it. We can lobby our government to regulate car emissions in the United States, but how can we ask the government of China to regulate the carbon emitted by power plants there? Well, the lesson from Prius is that we don’t have to use regulations and international protocols! Government initiatives may have helped – but they did not create the Prius phenomena. Consumer marketing did.

All (Environmental) Politics is Local

Of course, that doesn’t mean that there is no role for regulations and politicians. What if a state like California passed a law to force every company selling more than, say, $1 billion of goods in the state to disclose the TCE on each product? Not only would such a move gain popularity among the pro-environment residents of the state, it could also set in motion another powerful chain of events. If companies were forced to invest in calculating and disclosing the TCE of their products in one state, it would be very easy for them to disclose it in other states. Once they decide to partially market their products based on TCEs, they can address other ‘pro-environment’ groups all around the world, and not just California. Such a move may make it easier for other states and countries to pass laws requiring TCE disclosures. It would also prompt other companies competing in other markets to disclose TCEs to compete on this ground. The momentum could be significant.

But Can We Measure TCEs?

Of course, skeptics would say that TCEs are difficult, nay impossible to measure. But companies like Goldman Sachs and Virgin, which have stated they want to reduce their emissions, must be calculating their direct emissions already. And various web sites allow you to estimate your own personal carbon emissions and help reduce it to zero. So standard ways of measuring emissions are becoming common place. Obviously, precisely calculating the amount of carbon put into the atmosphere by all of a company’s suppliers all over the world seems a little more complicated. But in the same way that the ‘personal carbon calculators’ are far from precise, the TCE calculations can also be estimated based on rules and standards that can be set up by the companies themselves to begin with, and by self-regulated private sector institutions (with help from organizations like the United Nations and the World Bank) over time.

In fact, the best model to follow is the one which is currently working for our own financial system. Privately funded accounting industry organizations (like the AICPA and the IASB) try to set the standards for measuring and yes, often estimating financials. Even governmental tax rules allow for estimating expenses by creating rules like the dollar expense per mile driven on a car. Why can't the same kinds of rules for estimating TCE’s be instituted with the goal of making them more and more accurate over time?

Financial Accounting rules and regulations have provided a foundation for creating our global financial markets. Governments, at their own peril, have often used regulations to ‘Cap and Trade’ this or that industry or limit this or that investment vehicle. Thankfully, they have never dared to sit down and prescribe, by decree, how much wealth each country is allowed to produce. And yet, these are the kinds of schemes that are being called for to regulate carbon emissions world wide. Effectively, (as per my previous rant), many environmental regulatory schemes give governments and not-for-profit institutions control over how much Power should be consumed (ie how much carbon should be emitted); and they leave consumers with little power to do anything. It would seem more logical for large not-for-profit institutions to regulate disclosures, for consumers to decide what to consume and how much, and for governments to make sure nobody is cheating, and… well they could have one other role...

If You Can Measure It, They Can Tax It…

The problem with purely local carbon emissions taxes is that they create a competitive disadvantage. If California taxes carbon emissions, then manufacturers can get up and go set up shop somewhere else. Some have suggested a ‘synchronized’ global carbon tax to overcome such problems. (A brief discussion from Davos here in part 6). But such a tax is recognized as being too difficult to realistically coordinate among nations. The source of the problem with such tax schemes is that they try to tax the emissions of carbon at the point of production or emission, rather than the point of consumption.

If we can find a standard way to estimate TCEs, a tax on the consumption of TCEs would have none of the issues above. (Such a tax could be like a sales tax, levied when a product is sold to consumers, based on the amount of total amount of carbon emitted worldwide in producing that product.) In fact, even if levied in just one state like California, such a tax could have global implications, re-enforcing the chain of events I described above to affect decisions about clean energy through out the world. Note that this tax could also be made income neutral to the state – meaning that it would be accompanied by tax cuts in other areas. And so, not only would it not hurt production at home, it might spur investments by companies in and out of the state to market ‘cleaner’ products in California.

What Am I Missing?

I am no expert in the environment, or in economics for that matter, but as I have started to read about carbon emissions, I can’t help but think that there must be better market-oriented ways to address the potential problem we all face. TCE disclosure is one way of tackling the issue, with the advantage that it could garner the support of so many different groups that have heretofore been opposed to environmental initiatives for various reasons:

Local industries are not disadvantaged by TCE disclosures because their carbon emissions are disclosed (or taxed) in the same way as those of a manufacturing plant outside of the country. If anything, in the short term, such a scheme would give a large advantage to manufacturing in advanced economies.
For the same reasons, labor unions can also be supportive of TCEs. (Traditionally they have been the losers of proposed local regulations which push manufacturing jobs out.)
Libertarians and free-market ideologues can support environmental regulations which do not directly interfere with market mechanisms. (It would be hard to argue against disclosures.)

I have drunk my own cool-aid and don’t see the downside to this. But I would love to hear where the thinking is flawed.

The Carbon Emitted in Producing the Goods We Import from Abroad

2007-02-04T14:52:00.000-05:00

Many environmental initiatives focus on controlling emissions at the source – that is, they try to impose limits at the point which carbon is put in the air, whether it is coming from a coal fired power plant or a car’s engine. But as I see it, when we use a product made in China, we also become responsible for the carbon emissions related to its manufacturing – in China. My question is: Is this a significant number? How much carbon was out into the air to manufacture all the other products that we consume here in the United States.

I used 2 different “back of the envelope” calculations yielding similar results – that the carbon emitted in the atmosphere in producing the goods we import in the United States is equivalent to around one quarter of the carbon emitted from ALL domestic activities in the US. As the chart below shows, this means that environmental activists who are worried about carbon emissions from transportation in the US, should be as worried about the carbon emitted from the goods they buy which are “Made in China”.

Here is how I came up with the calculations.

Method A: My back of the envelope

We can figure out the dollar value of all the goods produced in the US (Row 3), and we know the total amount of imports of goods into the US (Row 4). We know the amount of CO2 equivalents emitted to produce those goods (Row 6), so if we assume that it takes as much CO2 emissions to produce goods in the US as outside the US, we can calculate an estimate of how much carbon was used to create those goods. However, I imagine that the US has better environmental standards than some of its major trading partners like China, so one could also assume that this is a pretty conservative estimate.

Method B: My back of the envelope based on some real research found on the net

Looking around the internet, I came across references to a study by Shui Bin and who had calculated the following:

“The United States, because of its trade with Canada and Mexico, was responsible for 92 million metric tons of carbon dioxide in addition to what it emitted within its own borders. That's an amount equivalent to 2% of total U.S. emissions that year… The researchers next turned to trade with China. They looked at the period from 1997 to 2003, posing a hypothetical question: if the United States had manufactured the products it imported from China, how would that have affected each nation's CO2 emissions? Their conclusion: American emissions of CO2 would have been 3% higher in 1997, and 6% higher in 2003, if the United States had been manufacturing products that it imported from China.

Unfortunately, I couldn’t find any data regarding the carbon emissions related to ALL imports, but given that Canada, Mexico and China are the US’s top 3 trading partners and responsible for almost 42% of all imports to the US, I thought one could extrapolate based on the amount of trade they do with the US. The chart below shows radically different results, if one extrapolates from Canada and Mexico rather than from China. But if we assume that the discrepancy is due to the kind of goods we import from those countries, and we further assume that the imports from the 3 nations together are representative of the types of goods we import from all countries, then it would be fair to average the two numbers – leading to an estimate of 28%, close to the average used in my calculations.

Now, I imagine that the fact that the results are so close is more coincidental than anything. These are ‘back of the envelope’ calculations. But nonetheless, given that the total value of goods imported into the US is more than 2/3rds of the goods we produce here, there is little doubt that significant amounts of carbon were put into the atmosphere to produce the goods we use here!

[BTW - I am using carbon here to denote all greeen house gases, or carbon equivalents.]

Thinking about Global Warming: Part III

2007-02-02T22:17:00.000-05:00

Why should we do anything to limit carbon emissions?

Continuing my loud thinking criticizing the various efforts to limit carbon emissions, here is a follow up on why it might actually make sense to pursue those efforts (like city wide carbon emissions regulations, and Cap and Trade schemes etc), however flawed they may be:

1. Desperation

It is becoming more and more accepted that we (ie humans) are affecting the environment, and creating potentially huge problems for the planet in the future. The nature of the problem, though, makes it very very difficult to do anything very effective about the problem. Critics would say that we might as well do nothing at all! But, it’s almost like we are so desperate for any solution that the ‘perfect’ solution could be the enemy of a ‘good’ or even less than good solution, specially if we learn how to make those solutions better...

2. Education

After all, we can only learn by experimenting. For example, Europe’s ETS led the effort (as discussed previously in Cap and Trade schemes. However ineffective it may have been in the short run, it provided valuable lessons for future schemes.

So what if some companies get some windfall profits, if our reward is to have created the infrastructure to limit carbon emissions in the future, raised the public consciousness about the importance of limiting carbon emissions, and encouraged social and financial investments that could allow us to move slowly towards better solutions in the future!

3. Momentum

It is very difficult to affect major changes in one try. And certainly, doing anything meaningful about carbon emissions, will need some major changes… in our regulations, our behavior, our investments, our taxes, etc etc. So small steps can set an example, and allow others to follow.

By taking a leadership role in cutting carbon emissions, California would hope to spur other states to do the same, or at the very least, raise the consciousness of other states and countries to follow suit. Without the Burlingtons and Californias of the world setting the example, we would all be less aware of the issues around the environment, and have fewer models to build on.

4. Raising Passions

In fact, given how imperfect the current solutions to cutting carbon emissions are, it is quite surprising that such a momentum has gathered any steam at all. I suppose it took Iraq, $70 oil, many local politicians in places like California and Vermont, years of scientific research to overcome obfuscation of facts and theories, and the PR of Vinod Khosla, Richard Branson, Al Gore and others to get some emotional momentum behind the clean technology movement in the US.

How ironic is that: the wooden Gore of 2000 is now the main cheerleader, the market maven and chief salesman carrying the message about our environment!!

Incidentally, I caught a quote from his inspirational film, that I think illustrates the problem of how difficult it has been to raise passions and create active political momentum. Here is Gore towards the end of his film:

“We have the ability to do this. Each one of us is a cause of global warming, but each one of us can make choices to change that... with the things we buy, the electricity we use, the cars we buy... We can make choices to bring our individual carbon emissions to zero. The solutions are in our hands. We just have to have the determination to make them happen. ”

Here he is inspiring his audience to affect change and “to make a difference” – a paragraph worthy of the greatest inspirational speaker to make people moving, to get them to… well, what does he say next? He shows a slide with a list of countries and says:

“Are we going to be left behind as the rest of the world moves forward? All of these nations have ratified Kyoto. There are only two advanced nations in the world that have not ratified Kyoto, and we are one of them.”

So that’s the plan: Inspire the population to do something about the environment by going out and convincing their politicians to ratify the Kyoto treaty and hand over power to all the regulators and politicians of the world to negotiate a global agreement which is flawed in many ways…!!

How uninspiring is that!

If anything, what is incredible to me is the amount of momentum the environmental movement has actually gained despite all the inadequacies in creating efficient solutions to the problem…

That passion, held by more and more people, regarding the need to do something about the environment – that is a real asset!

Of Kyoto, Net Neutrality, Global Capital Flows and Cap and Trades schemes

2007-01-29T23:30:00.000-05:00

(Thinking about Global Warming: Part II)

In my previous post, I was ranting about the global nature of carbon emissions and how local initiatives to limit carbon emissions and set environmental standards can seem so futile in the grand scheme of things. This means that local carbon emitting regulations abiding by the “Kyoto standards”, like those passed in California, can have limited direct effects on the global environment. (More on the indirect effects in a later post.) To be truly effective, such regulatory measures need to be global. The problem us that, as shown in Kyoto, it is quasi-impossible to impose global regulations limiting carbon emissions.

(Briefly, as background, here is why such a top-down negotiated approach is difficult: Mature economies like the US are moving to services, and emitting relatively less CO2 over time, and fast growing countries like China are poised to emit more and more CO2 as they grow into industrial powerhouses. So it is arguably ‘unfair’ for the ‘developed world’ to impose limits on the emissions of the developing world and thus impede their growth and development. But it would be unfair on the ‘developed world’ to be lax on the ‘developing world’ while restricting their own emissions. Thus the impasse at the negotiating table.)

But even if we could come to a Kyoto-like globally negotiated ‘fair’ amount of carbon each country could emit, the mere notion of some international organization or group of politicians dictating how much carbon each country can be allotted gives my Chicago-sensitized mind the creeps. Here is an analogy to make my point:

Imagine if we allowed an international group of politicians to decide how we should allocate capital (i.e. investment $$) around the world. Say all the investment dollars in the world went to one big pot and the United Nations was allowed to decide how to allocate it to all the countries in the world. Sure you can come up with formulas, and sure you can hope to come to a political solution for allocating the capital. But at the end of the day, you are just going to end up with a terribly inequitable, de-motivating and inefficient system – if you do a great job, the best you can hope for is to become just a little more efficient than the Soviet central planning bureau! :)

The Cap and Trade Schemes at least try to impose some form of ‘market’ mechanism within the carbon industry. And they do this at the cost of generally ignoring the global nature of the environment (because they would have difficulty imposing such a scheme on the Chinas of the world.)

But even within their more limited local scope, Cap and Trade Schemes have proven difficult to implement in practice. The problem with ‘Cap and Trade’ is not in the Trading part – that is the ‘market mechanism’ – it is in the “Cap” part. To-date, the political process has set the emissions caps that are later traded in the market, so the market mechanism is built on a corruptible and non-market foundation. The European Emissions Trading Scheme showed the kinds of problems this root cause can create. Here is a description from The Economist (unfortunately behind a firewall):

Yet even while lauded as a model for others, the [Emissions Trading] scheme is failing at home... For political reasons, the EU left the power of allocation to national governments. As a result, what should have been an exercise in setting rules for a new market became a matter of horsetrading about pollution limits, with powerful companies lobbying for the largest possible allowances.

Last year, governments gave away (ie, did not sell) pollution permits that amounted to more than the pollution companies were actually spewing forth. That risks making the scheme pointless. The European Commission is now reviewing proposals for allocations in 2008-12…

Lax allocations do more than just fail to cut greenhouse gases (bad enough, you might think, given that this is the main point of the scheme). They also damage the market. When it became clear, in April, that most allocations were larger than actual emissions, the price of carbon halved almost overnight. Some volatility is probably inevitable in a new market, but when combined with irresponsible behaviour by governments it hardly encourages people to enter the emissions-trading business.

It gets worse. The plunging price sends a market signal to developing countries that have installed pollution controls partly so that they could sell the resulting “pollution credits” for a nice profit. That no longer looks like a good idea.

Similarly, some countries (Germany, France and Poland) have scattered permits around like confetti while a few (Britain, Ireland and Spain) have been sparing because they want to cut emissions. Companies in the second group are buying permits issued in the first, so the market is transferring resources from places that are using the scheme to curb pollution to those that are not. Brilliant.

The solution around these problems (as advocated by the Economist, as well as the Obama-McCain bills) is to auction the permits, rather than allocate emissions caps to each industry. But even if such bills become law, the risk is that the capping will become distorted as it passes through the political process.

To illustrate the problem, I’ve been thinking about what a Cap and Trade scheme might look like if applied to another industry. If we decided to implement a cap and trade scheme to address internet bandwidth and net neutrality for example, what would it look like? First, we would need to figure out how much bandwidth each company is using today, and we would cap bandwidth usage at those levels. We would limit each company’s future use of internet bandwidth to that amount of traffic. If anyone wanted more bandwidth, they would have to buy it on the ‘market’. Even if we ‘auctioned’ all the rights to the bandwidth, rich cash cow incumbents (like the telcos) could afford it and create a market in the rights to the traffic. We could claim it is a “market based system”, but if a new company wanted to deliver new web based services (say like User Generated Video), they would have to buy the bandwidth rights from the incumbents! Think about what that would do to innovation.

Of course, the analogy is far from perfect. I am trying to draw on extreme example to make a point. My next post will be far more positive.:)

To Be Continued...

Thinking About Global Warming: Part I

2007-01-28T22:45:00.000-05:00

Acting Locally to Affect the Environment… Locally

I am starting to think through some of the issues around global warming and carbon emissions, and one of the things that intrigues me is the amount of support received by initiatives to limit carbon emissions locally – in a state, or in a city for example. After all, we only have one world, and one atmosphere, and whether I am throwing carbon in it from an organic fruit farm in Napa Valley or a coal plant in Kazakhstan, it’s all ending up in the same place.

In the book Field Notes from a Catastrophe, Elizabeth Kolbert describes the valiant efforts by the city and citizens of Burlington, Vermont to cut their carbon emissions. Then she goes on to say:

Most of the growth in energy usage in the next few decades is due to occur in places like China and India, where supplies of coal far exceed those of oil or natural gas… Over the next 15 years, the size of China's economy is expected to more than double. This projected growth, most of which will be fueled by coal, overwhelms not just all the conservation projects that are currently being undertaken in the United States, but also, any that could be reasonably imagined. ... If every single town and city in the United States were to match the efforts that Burlington has made, the aggregate savings would amount, very roughly to 1.3 billion tons of carbon over the next several decades. Meanwhile, the lifetime emissions just from the new coal plants China is expected to build would amount to some 25 billion tons of carbon. To put this somewhat differently, China's new plants would burn through all of Burlington's savings, past, present and future, in less than two and a half hours.

So much for the sacrifices endured by Burlingtonites to affect global warming.

But does it do any good to try to act locally to set stringent carbon emissions standards?

Of course. But in one way, given that we live in a world with quasi-free trade, one could even argue that enacting local carbon emissions caps could make us worse off. If the Burlingtons of the world restrict carbon emissions, large manufacturers have even less incentive to produce their goods there, and even more so to go to parts of the world that have cheap labor and cheap dirty(!) fuel! As we evolve into a service economy – which should be, by definition, less power intensive – we create the comforting illusion of reducing our own local emissions, while all we could be doing is just pushing manufacturing and power consumption to the parts of the world that have little or no emissions standards.. in effect causing more pollution for each dollar of manufacturing good produced.

To Be Continued…

Plug it in!

2007-01-20T23:29:00.000-05:00

Coming in from CES, I remembered a post by Michael Parekh from a couple of years ago on computers on a stick... which got me thinking...

War, Web 2.0, Business and Terrorism

2006-12-27T15:52:00.000-05:00

Some partially disjointed thoughts emanating from the fascinating NY Times magazine article called “Open Source Spying”:

The article explores efforts by some people in the US Defense Intelligence to use more ‘web 2.0’ concepts to try and better address the 21st century terrorist threats. (The phrase ‘open source’ in the title is a bit of a misnomer, as the article mainly deals with blogs and wikis and other web 2.0 phenomena.) In essence, the article highlights the challenges of a centralized command and control organization (i.e. government agencies, army etc) competing against a decentralized force with thousands of motivated and newly empowered individuals (i.e. terrorist networks). The issues are all too familiar to those paying attention to the large technology business battles over the past few years – Microsoft vs. Linux and web-based applications come to mind.

Here is a characteristic paragraph from the article:

On Sept. 12, 2001, analysts showed up at their desks and faced a radically altered job. Islamist terrorists, as 9/11 proved, behaved utterly unlike the Soviet Union. They were rapid-moving, transnational and cellular. A corner-store burglar in L.A. might turn out to be a Qaeda sympathizer raising money for a plot being organized overseas. An imam in suburban Detroit could be recruiting local youths to send to the Sudan for paramilitary training. Al Qaeda operatives organized their plots in a hivelike fashion, with collaborators from Afghanistan to London using e-mail, instant messaging and Yahoo groups; rarely did a single mastermind run the show. To disrupt these new plots, some intelligence officials concluded, American agents and analysts would need to cooperate just as fluidly — trading tips quickly among agents and agencies. Following the usual chain of command could be fatal. “To fight a network like Al Qaeda, you need to behave like a network,” John Arquilla, the influential professor of defense at the Naval Postgraduate School, told me.

The article ends as follows:

Today’s spies exist in an age of constant information exchange, in which everyday citizens swap news, dial up satellite pictures of their houses and collaborate on distant Web sites with strangers. As John Arquilla told me, if the spies do not join the rest of the world, they risk growing to resemble the rigid, unchanging bureaucracy that they once confronted during the cold war. “Fifteen years ago we were fighting the Soviet Union,” he said. “Who knew it would be replicated today in the intelligence community?”

This reminded me of another NY Times piece, a 2005 editorial called “The Open Source War”, which used the same metaphor to describe the Iraqi insurgency. (Note that in this case, the Open Source metaphor makes perfect sense, though I do not think the conclusions proposed in the article do.) To quote:

The other likely explanation [for the insurgency's ability to withstand high losses while increasing its ‘market share of violence’] is one the military itself makes: that the insurgency isn't a fragile hierarchical organization but rather a resilient network made up of small, autonomous groups. This means that the insurgency is virtually immune to attrition and decapitation. It will combine and recombine to form a viable network despite high rates of attrition. Body counts - and the military should already know this - aren't a good predictor of success… The insurgency uses an open-source community approach (similar to the decentralized development process now prevalent in the software industry) to warfare that is extremely quick and innovative. New technologies and tactics move rapidly from one end of the insurgency to the other, aided by Iraq's relatively advanced communications and transportation grid - demonstrated by the rapid increases in the sophistication of the insurgents' homemade bombs. This implies that the insurgency's innovation cycles are faster than the American military's slower bureaucratic processes. [emphasis added]

It seems like terrorist-like organisms, and elements of the Iraqi insurgency are using informal communications networks and the internet, and they are competing against a bureaucracy which is designed to function within an old and arguably irrelevant paradigm. Incidentally, a failure to make the paradigm shift may be one reason the Iraq war could gain such support in the US early on. Following the shock of 9/11, Saddam the dictator was easier to understand as a threat, because he fit into an old (albeit irrelevant) paradigm that the country had faced, understood and defeated in the twentieth century (eg Hitler, Stalin etc). So Saddam’s centralized army became a proxy for Al Qaeda, even though Al Qaeda itself, much like the post-invasion Iraqi insurgency, was illusive and decentralized. Al Qaeda does not have a home base that a traditional army could attack.

As is often the case in business, when faced with a crisis, we tend to go after the problems we understand, rather than the ones we face!

As usual, Jon Stewart’s Daily Show gets the difference between the types of threats. In a recent show, Ed Helms did a piece on the US Army’s difficulties in fighting the Iraqi insurgency with their ineffective high tech weaponry. His proposed solution: “Right now we are training [the Iraqi] army to fight a conventional war, being that one day when they can stand up, we will be able to mow them down.” [emphasis added]

Obviously, in real life, you can’t easily change the problem to fit the solution you have.

More seriously, I am also reminded of a fascinating passage in “Fiasco” that describes the ad hoc (ie unofficial way) in which US troops leaving Iraq in the winter of 2003, took it upon themselves to communicate with their replacements.

As they prepared to leave Iraq and hand over the mission to other units… the seasoned soldiers who had served for a year sought to pass on their hard won knowledge to their successors, in emails, in essays, in PowerPoint presentations and in rambling memoirs posted on web sites…One essay rocketed around military circles [offering practical ‘how-to’ advice to units]… Other essays were posted on www.companycommand.com, which began as a web site by and for junior Army officers, but became sponsored by the Army and received an unusual kind of semi-official status… Officers in Iraq said the documents tended to be useful, especially because they were more attuned to current conditions there than official publications. [emphasis added]

So interestingly enough, the internet was used by individuals with in the US military in effective ways to better communicate outside of the official channels, but (obviously) social media is far from being integrated into the military as an ‘enterprise’ (!) solution. Clearly, there is an internal tension to try and use open wikis and blogs for military strategy discussions and intelligence gathering, making this a non trivial problem.

Nonetheless, going back to terrorism in general, almost every in-depth news report on AlQaeda also talks about their savvy use of the internet as a communication medium – to spread their ideas quicky, find like minded people through out the world, and to coordinate ‘intelligence’. Clearly, they are on the web, 2.0!

As such, Al Qaeda better resembles a technology enabled social network (i.e. a social networking website) than the mighty armies of Hitler and Brezhnev. But if government and military bureaucracies function within the old paradigms of power, they risk mis-characterizing or misunderstanding the nature of the new challenges they face, and ultimately, they will have a great many opportunities to make extremely costly mistakes in the future.

At the very least, it is a good thing that some people with in the US government are experimenting with social networks and trying to understand their characteristics – their fluidity, decentralization and non-uniformity, as well as their speed and power. But it might also make sense for those who understand these concepts best – the technology communities and social media commentators among others – to pay closer attention to the shifting paradigms of international affairs.
____________________________________

This post is dedicated to James Brown. :)

The TCP/IP of Advertising?

2006-11-27T16:08:00.000-05:00

In “The Search” (which I am finally ‘reading’), Battelle starts out by discussing the ‘database of intentions’. (Briefly: when we search, we are declaring our need or ‘intent’ to find something, and that is why, as first hypothesized by Bill Gross, Search is such a powerful place to attract advertisers that hope to fulfill that need.) Intent is certainly very powerful, but I wonder if, by concentrating too much on the paradigm of Intent / Search in the past few years, analysts, as well as Google’s competitors, missed out on one of the big areas where Google added a lot of value. Some one had pointed out to me a couple of years ago that Google really made it easy and effective for small (and large) businesses to advertise on the internet. “Had you ever tried to advertise on the internet before Google Adwords?” he asked rhetorically.

It seems like it took a while for the internet giants to realize that there is a real demand for making life easier on advertisers and publishers - without necessarily tying ads to Intent/Search, or deep data-driven and behavioral technologies which try to deduce intent. (BTW - I think Adbrite may be trying to do just in the realm of banner ads.)

That is how I view the recent forays by the giants in offline advertising – they are trying to meet that simple demand for ease of use and efficiency, and applying it to other sectors. As per the NY Times: “Google hopes to one day provide a place where advertisers can buy ads in all types of media, said Tim Armstrong, Google’s vice president for ad sales.” Or, as Robert Young of GigaOm put it:

“Simply put, Google is building what is essentially an operating system (”OS”) for advertising… one that will work across all media. Just like Microsoft’s Windows (or any other OS) manages all the hardware and software resources of a computer, Google’s Ad/OS will similarly manage all the critical components of an ad campaign, regardless of media type.”

Ultimately, we can safely assume that one or more of the internet giants will successfully create an integrated advertising O/S. When that happens, the more interesting question then becomes:

How would you compete with an Ad O/S, and disrupt that business model?

One potential answer: You disintegrate the network and open it up. If Google (or Yahoo) becomes the Windows of the Ad O/S world, then what would the Linux of ad networks look like? Can one commoditize the mediation of advertising and shift value to the service providers around the network? Or put another way: Can the “Ad Network” be less of an operating system, and more like a free and open communication protocol? What would it take to create the TCP/IP of advertising on the internet?

___________________________

Note: In thinking about this question, I remembered a great passage from “The Perfect Store”, talking about how eBay bought Up4Sale just before filing to go public. Up4Sale’s founders “had an eBay-like understanding of the importance of community [i.e. the network of buyers and sellers]…Advertiser supported Up4Sale was free for users – a business model eBay considered a threat to its own fee based approach.” eBay then proceeded to kill the Up4Sale business model. One could argue that this effectively held off the real competition until Craigslist came along. A brilliant move by eBay... but at the end of the day, it's just a matter of time: On the web, what can be disrupted will!

Des-Cartes vs Di-Caprio

2006-11-27T15:28:00.000-05:00

When I moved back to Iran in the early nineties, I was astounded at the philosophical sophistication of society. And I am not only talking about a small intellectual elite: Book stores were packed with translations of the Great Western Philosophers, and a variety of literary magazines regularly reviewed and critiqued their great works – magazines that were always the front and center of thousands of the newsstands all around Tehran.

Recently, I enjoyed a pleasant conversation at Umair’s Innovation Wednesday – talking about, among other things, the Western press and the observation that a majority of people in the US and the UK seem to be more interested in tabloids and celebrity gossip rather than ‘real’ news.

But I wonder if there is a reverse correlation between the philosophical quality of journals found on newsstands and the well being of civil society.

Here is a passage from Mangol Bayat’s chronicle of Iran’s Constitutional Revolution of (1905-1909):

“The French diplomat-scholar-essayist Arthur de Gobineau, who was stationed at the embassy in Tehran in the 1850’s and early 1860’s, had observed that Iranians imported books in great number from western Europe, particularly from Germany. He had also expressed his surprise to see how well acquainted Iranian intellectuals were with the works of Kant and Spinoza. Delighted with their positive response on his own lectures on Descartes, Gobineau commissioned the translation of the seventeenth century French Philosophers famous work Discours sur la Methode.”

For the past 150 years, we Iranians have been studying Cartesian methods, and lining our newspapers with utterances from Kant.

One Hundred and Fifty Years!!!

Perhaps we should be more encouraged about the prospect for Iran’s democratic future by those street vendors I encountered a few years ago, who, rather than selling newspapers to cars stuck in traffic, were peddling posters of Leonardo Di Caprio!

:)

Thoughts on Video Distribution and Google/Youtube

2006-10-19T23:59:00.000-04:00

Despite the disruptive and quasi-anarchic nature of Youtube, it’s ironic that the distribution system for Google/Youtube has ended up resembling that of traditional cable television, in as much as it is an integrated content aggregation and delivery system. On the internet, integrated systems seem to work well only in the early phases of technology adoption.

In the late nineties, as internet adoption went through its first growth phase, AOL was also very successful in offering an integrated content aggregation and delivery system for the ‘text-internet’. In the same way, these early days of internet video mass adoption call for an integrated solution like Youtube, which hosts, delivers and controls content. But, as the business model and infrastructure of online video matures, and consumers and media providers find easier ways to create, consume, monetize and interact with online video content, there will be a natural shift to a more distributed / and dis-integrated system with content residing on multiple web sites and intermediaries.

The question then, will be: As online video enters this new phase, will Youtube/Google follow AOL’s path and let its centralized structure and dominance derail it, or will it leverage its current dominance to do to video what it already did to the text-internet and to the AOL of old.

_______________________________

Some diagrams and verbiage to expand on these thoughts:

Below is a diagram showing traditional video distribution, controlled by the cable and satellite players. Companies like Comcast act as integrated content aggregators and distributors. They do deals with institutional content providers – that is the hundreds of channels like CNN and ‘Comedy Central’ – to get access to content and then distribute that content to consumers. In doing so, they host the content on their servers and distribute it through their infrastructure, and they even help monetize that content by charging fees and to some extent via advertising. (Though, it is noteworthy that the content creators are generally responsible for doing advertising deals in this model.)

Compared to cable, Youtube clearly represents some major changes in video distribution – the obvious example being that the Youtube model has allowed thousands of individuals to distribute their content. But in other ways (as seen below), Youtube still acts as an integrated aggregator: It controls the content on its own servers – talk about a real ‘walled garden’ - it distributes the content, monetizes it with advertising, and now, following the recent deals, it is paying fees and royalties to the institutional content creators. In a way, this model is even more integrated than traditional cable distribution, in that Youtube has wrested some control over the advertising from the content creators, and has integrated this critical part of the value chain. (Though, at the end of the day, nothing will stop large content providers from flexing their advertising muscles on Youtube content, dictating, for example, that any clips of American Idol on Youtube can only have Coca Cola ads around it. That creative tension should be fun to watch over the next couple of years.)

Now, let’s compare Youtube/Google to the AOL of the late nineties. When the internet was entering its first growth phase of mass adoption, it made sense for a company like AOL to take a leadership position and become a centralized and integrated hub, intermediating between content owners and consumers – doing deals with the former and providing a centrally controlled, easy-to-use, walled garden to the latter. There was a lot of value in this integrated intermediary role. Content providers had not figured out how to deal with the web. The consumers were new to the web and preferred to be spoon-fed, and the infrastructure of the web was not sophisticated enough to allow for an idiot-proof user friendly experience compared to what AOL’s integrated approach could provide.

Over time, the web dis-integrated AOL’s services, and redistributed them among multiple specialized players. Obviously, one of the most symbolic beneficiaries of this shift was Google. Google provided an easy way for people to find content in a distributed world, and to be found, via advertising - critical services for a distributed environment. AOL tried providing these same basic services in a closed or integrated manner, leveraging and retaining its dominant intermediary position between content and consumers. But ultimately, the power of an open, standards based dis-integrated environment was too powerful, and as the web matured, the ultimate winners were those, like Google, who empowered the players in that distributed environment.

In the video world, Google/Youtube delivers its video technology and content as an integrated system. Even if Youtube’s innovative strategy of allowing embedded videos has the feeling of being distributed, ultimately, its core model is integrated – it still controls the hosting, distribution and monetization of the content.

As video technology, infrastructure and business models mature, there will be less of a need for an integrated solution such as Youtube. As with the text-web’s transition from AOL’s walled garden, video content will inevitably dis-integrate and the value will shift to more specialized players. The beneficiaries of this shift will be the various service providers and technology providers which enable and facilitate the distributed/ disintegrated model. One could argue that Brightcove is playing to be a key technology enabler in this world. Many new players are vying to create services such as ad insertion. And my own evoketv was supposed to be positioned to be the search / guide for this new world.

This does not mean that “Youtube was a bad acquisition” – quite the contrary: the Youtube deal shows Google’s incredible self-awareness regarding its strengths and weaknesses. What other company has overcome NIH with such panache?

It just means that, when / if the video delivery chain starts to disintegrate, Google should be ready to participate within the new structure, and open its services up at the right time, and in the right way. My bet would be that Google totally gets this and that they will not try to keep its video services integrated for ever. But then again, it’s always tough to open up and disrupt yourself when you are sitting in a lucrative intermediary position.

Quotes & Notes from 'Team of Rivals'

2006-10-19T22:27:00.000-04:00

- “There must be courts and law and order or society will be broken up - the disbanded armies will turn into robber bands and guerillas.”

Lincoln on post war policy towards the south

- “I fear you do not fully comprehend the danger of abridging the liberties of the people. Nothing but the sternest necessity can ever justify it. A government had better go to the extreme of toleration than to do aught that could be construed into an interference with, or to jeopardize in any degree, the common rights of its citizens.”

Lincoln, in 1863 when pressured to close down the Chicago Times at the beginning of his presidency

- “Your resignation of the office of Secretary of the Treasury is accepted. Of all I have said in commendation of your ability and fidelity, I have nothing to unsay. And yet you and I have reached a point of mutual embarrassment in our official relation, which it seems cannot be overcome or longer sustained consistently with the public service.”

Lincoln, accepting Salmon Chase's resignation

- Note: The emancipation proclamation was issued on the basis of the constitution, not of higher laws. i.e. Lincoln only issued the proclamation once he realized that he could create constitutional justification for it. In effect, he argued that the constitutional war powers allowed him to over ride the "rebel states' constitutionally protected right to slavery. Also, in 1864, he refused to sign into law the "Punitive reconstruction bill", even though it would have been politically expedient to do so… the bill laid down a 'rigid formula' for bringing states back into the union - suffrage would be denied to people who bore arms voluntarily or were officers in the confederate army. Lincoln preferred a more lenient approach. “I must keep some consciousness of being somewhere near right. I must keep some standard of principal fixed within myself"

- “To be wounded in the house of one's friends is perhaps the most grievous affliction that can befall a man.”

- “Having hope means that one will not give in to overwhelming anxiety, a defeatist attitude or depression in the face of difficult challenges or setbacks. Hope is more than a sunny view that everything will turn out alright. It is believing you have the will and the way to accomplish your goals."

Daniel Goleman, in "Emotional Intelligence" (1995) (As quoted by Goodwin)

From “Team of Rivals: The Political Genius of Abraham Lincoln”
by Doris Kearns Goodwin

Meritocratic Networks vs Inferred Networks

2006-03-10T16:03:00.000-05:00

This is a post about a couple of different kinds of networks – whether they are networks of people or of bits (Data, Code, Content) – and the power of these networks.

1. Active Meritocratic Networks

Everything starts with Open Source…. The network of people developing open source software is very active and participatory by nature - people are actively participating and writing / debugging code to be part of the network. It is also very meritocratic. Eric Raymond once told me that if you want to join the open source development process, you can best do so by creating fixes to the most mundane bugs and gain credibility and stature within the community, thus climbing up (what I would call) the meritocratic ladder of the open source development community.

The Open Source Devleopment network is also a meritocratic organism in the way that any one can rewrite code and fork the development. If you write a better module, it can become recognized and then re-integrated into the main code base (or develop its own sub-following), just because it is better. Open Source development can be quite Darwinian. That’s how Firefox was created and became the dominant strain of the Netscape browser.

Another interesting example of a meritocratic network is the development of the Oxford English Dictionary, as chronicled in “The Professor and the Madman”. The OED used the combined knowledge of thousands of correspondents who sent in words via snail mail to create the OED in the span of some 40 years. One of the major contributors was a Dr. Minor, who happened to be locked up in a Lunatic Asylum. (See wikipedia description). In this revolutionary effort to coordinate ‘user generated content’, no one could know if you were a dog, a genius, or a madman, but you could be judged by the quality of your contributions. (Ironically, in its modern incarnation, this meritocratic anonymity is enabled by the extreme advances of communication and connectivity on the internet, while at that time it was made possible because of the difficulty of communicating. The difficulty in traveling distances allowed the ‘madman’ to express his genius without revealing his real identity for years.)

Back to the internet era, Slashdot is also a good example of an active and meritocratic network. Slashdot members build karma over time as they participate ‘positively’ on the site. And one can also argue that the blogosphere itself represents a meritocratic network of sorts, in that bloggers gain reputation over time. But unlike Slashdot and the Open Source movement, there are no rules or hierarchy bestowing recognition or karma on the participant. Blogs gain credibility and prominence when people read them and talk about them, or when they link to them. Although it seems like little sub networks of mutual admiration (ie excessive interlinking) do naturally form (not unlike little cliques with in organizations or even open source developers) we have seen the natural meritocracy of the blogosphere in many instances. Some times a post by a completely unknown blogger becomes very prominent and read, and sometimes new sub networks of interlinked blogs grow and gain prominence. All of this is enabled by the blogosphere’s openness and points to its meritocratic nature. (Of course, blogs are active by nature too – in that the blogger has to actively create a blog, and even promote it, for it to be read.)

In the fabulous “Coase’s Penguin” (referred to by Union Square Ventures, Benkler refers to this idea of meritocracy by talking about the notion of self-identification:

“The widely distributed model of information production will better identify who is the best person to produce a specific component of a project, all abilities and availability to work on the specific module within a specific time frame considered.”

Benkler describes this phenomena from the detached bird’s eye view. I like the word meritocratic because it emphasizes the power of the individual to enable this. In other words, the self identification takes place because the networks are active and meritocratic.

2. Passive Inferred networks

On the opposite diagonal from active and meritocratic networks are what we can call passive inferred networks. And the best example of these is the Google search algorithm. Let’s ignore search engine optimization, or the various attempted abuses of the Google system. The intent of the google algorithm is to find out how various web pages link to each other. Ignoring efforts to game the system, people are not supposed to be actively climbing a meritocratic ladder. Google infers the importance of a web page (i.e. its page rank) from what people are already doing (ie linking to each other). So web pages are on the google ‘network’ by default, without any specific participation from their creators.

Obviously, Google built a pretty impressive business model around this concept. More recently, we have seen a couple of other start ups using this passive inference to build their business models. Last.fm is one example. Although you have to download a piece of software to participate in the last.fm network, you do not need to actively participate in the network to reap its benefits. Last.fm does its own work to infer preferences and suggest new music to you.

Root markets is doing something similar. Again, once you have downloaded the software, you can remain passive. Root Markets infers conclusions about your online behavior without asking you to be an active participant. The network benefits ensue… hopefully.

These passive inferred networks are very powerful because they do not ask you to change your behavior. Rather, they learn from your existing behavior and leverage the power of the network to deliver new value to you and your users.

3. Active Inferred Networks

Using this framework, sites like delicious and flickr (both now part of yahoo) can be regarded as active inferred networks. They are active in that you have to take specific actions to be part of the network. You tag a site, or upload a photo specifically to participate on these sites. Of course, one attribute of these networks is that your participation in them has immediate personal utility – delicious tags allow you to organize your web sites, and flickr helps you share and organize your photos.

These networks gain further ‘inferred’ value beyond the immediate personal utility. People don’t necessarily tag web pages to participate in a community – they do it to organize web pages for themselves. But once they have done so, the community and other third parties can benefit because they can use the aggregate data (ie the network) to discover new content.

---------------------------------

Note: eVoke TV is somewhat of an active inferred network, though we hope that there will be aspects of it that will be passive too. In fact, as way of background, as can be inferred (sic) from the reference to the USV blog from October, I wrote the first version of this post back in the fall as I was trying to think of the value that eVoke TV would bring to its users. The thoughts above have helped me form my own thinking around eVoke TV. But the post lingered on my desktop until now. Having seen a presentation by r0ml and Seth on Root Markets at etech, I was inspired to do this draft and post it.

eVoke TV launch at DEMO

2006-02-11T12:18:00.000-05:00

It's been more than two months since I've blogged... where did the time go?
Well - we just launched evoke TV (www.evoketv.com) in open beta, at the DEMO conference in Phoenix. I completely re-wrote my presentation at the 11th hour!
... I am looking forward to feedback from the blogosphere on the site, and what we are trying to achieve.

Google Print Business Model

2005-12-04T01:14:00.000-05:00

Here’s how I would think about monetizing Google Print :

Web-Search : AdWords = Print-Footnotes : Google-Print-Ads

The way Google seems to be thinking about it is:

3rd-Party-Web-Pages : AdSense = Google-Print-Books : Google-Print-Ads

In other words, Google seems to be using the adsense model (judging the context of the book to place ads) rather than allowing users to place ads on specific books, or paragraphs within books. The former is a technology based model, while the latter is a market based model. I would argue that not only would the market based model be better, it would also be truer to the origins of Google’s success.

Google’s search provides users with FREE links related to the words they are searching for, sorting the links based on the “merit… of [other] pages linking to them.” If I remember correctly, the premise was based on the academic system of ranking a paper’s importance by the number of referrals it gets from other academic works of merit. In effect, Google’s search algorithm recreates the idea of ‘footnotes’ for the web. But (non-fiction) books already have footnotes. If I am reading an academic book on the web, I don’t need AdSense to tell me what the relevant links are, I already have footnotes that can refer me to other works which relate to a particular word, sentence or paragraph in the book (ie via the footnote)

So first of all, if I were Google, I would make those footnotes live. Live Footnotes are in effect, like non-paid search – unless of course Google enters the Amazon Associate program. (I couldn’t resist that one.) Let’s take the easy example first. If I am reading Chernow’s “Alexander Hamilton” and a footnote refers me to a book about the history of the US department of Treasury, I may want to click on that to find out more… those references are already there in the book’s footnote – they just need to be hyperlinked.

But let’s say, I am the publisher of “American Sphinx: The Character of Thomas Jefferson” and I see a reference to Jefferson in Chernow’s book, which “American Sphinx” has talked about at length, taking a different view on the matter. Would that not be the ideal place to place an ad for the book – along with a reference that says: “American Sphinx discusses this issue at more length arguing that…. etc etc. Click here to see more / buy”?

So why not create a live marketplace for people to put text ads, comments and references next to specific ‘micro-chunks’ of text – allowing users to create dynamic ‘free’ content out of books. (Clearly some serious technology will be needed to filter out spam, and rank commetns etc, but that's not a show stopper for Google's scientists.)

User Comments first: If I am reading a book on Google Print, I may want to post a comment or note directly on it and cross post it to my blog, thus creating an extra layer of non-commercial footnotes… (This is like a microchunked version of Amazon user comments.) Google’s books would then show the links to the highest page-ranked comments, if a reader chooses to view them. Such comments could obviously make the reading experience much more dynamic and web-like, and create a loosely structured wealth of user comments for context.

But would people actually put ads on books? I imagine that when AdWords started, only the most obvious words were bought. The same would happen with such a system. Finance books would probably attract early adopters - Vanguard might buy ads on sections about diversified portfolios. Schwab might buy links related to “Beta”, and offer advice etc. Morgan Stanley may link to some of its research products. (But the same ad buyers may not want to buy ads on ALL books and passages relating to 'diversification' or 'beta' - which is partly where adsense would fail.)

AdSense was brilliant because it solved a large problem for millions of small web sites and (blog) publishers trying to monetize their pages. For these small sites, it was not other wise economical to create an effective market of advertisers. But for more popular books, one should be able to create a market for advertisers to show highly relevant and USEFUL links related to the text. It would seem strange to use an automated system to show Ads for say, Keynes’s “General Theory of Employment, Interest and Money” - there would just be too many people who would want to buy text ads around it.

(Thx to Umair for the Google Print Link)

(Isn't it fun to play 'if I were Google' every once in a while?)

Valuing Preferred Stock

2005-11-20T13:19:00.000-05:00

For some reason, my paper on LendingTree and valuing preferred stock, which I had posted on this blog last year, seems to be getting a few hits... So I thought I would also post this follow up paper, which I had written a few years ago, in case any one finds it useful. A less mathematical, and much more useful explanation of liquidation preferences can be found in Feld Thoughts' term sheet series, here.

Preferred Stock in Venture Capital A Valuation Methodology

This paper outlines a methodology for valuing preferred stock and other complex financial instruments used primarily in ventre capital. Although venture capitalists appear to have a solid understanding of the capital structures they create, the analytical framework described here, as well as the graphical interpretations used to show the payout to stakeholders in a liquidation event, can serve in explaining some seemingly complex capital structures to management teams or stockholders who might have less sophisticated financial backgrounds.

Conversion to common stock
Standard terms for an investment in preferred stock would specify a conversion rate into common stock. If a company sells 10 million shares of preferred stock for $10 million at $1 per share, and each share of preferred stock is convertible into one share of common stock, and the company had 30 million common shares outstanding before the financing (with no debt), then the implied valuation of the firm after the financing (or the ‘post money value’) would be $40 million (assuming that the preferred stock had no other significant features). So,

Common Stock Equivalent Shares of the Preferred Stock,
CSES = # shares of preferred x conversion rate = 10 million
Common Stock Price,
CSP = Preferred stock price per share x conversion rate = $1
Common Stock Equivalent Ownership Percentage of the Preferred Stock,
CSEOP = CSES / (CSES + Number of common stock equivalent shares
outstanding before the transaction) = 25%
Post Money Value of the Company
PMV = CSES x CSP / CSEOP = $40 million

Liquidation preference The above framework provides the base case, which becomes more complex with the various provisions of the preferred stock. The liquidation preference is probably the most effective downside protection feature as it allows the investors in preferred stock to recover their investment (or a multiple of the investment) before the common stock receives any value. As the investors normally have seniority on this preference, and they may opt to treat the sale of the company as a ‘liquidation’ event, this preference is equivalent to the company taking on some debt. Liquidation preference is like a super-subordinated debt – the amount of preference is subordinated to all debt as well as to the creditors of the company, but senior to all equity in case of a liquidation of the company. (Note that for valuation purposes, one should value this debt by discounting the face value back from an assumed exit date, rather than at the face value of the liquidation preference.)

In the case above, a two times (2x) liquidation preference (and an immediate exit) would create $20 million of quasi-debt obligations that the company has to pay before the common stock is paid out. So each share of preferred stock would actually be equivalent to $2 of debt and one share of common stock. The post money value of the firm becomes:

PMV = LP + ( CSES x CSP / CSEOP )
where LP = Liquidation Preference
= Liquidation Pref. Multiple x Amount Invested = $20 million

But in this case, the Common Stock Price no longer has a direct relationship with the Preferred Stock Price (CSP  Preferred Stock Price x conversion rate). Both PMV and CSP are unknowns in the above equation. In financing a company, a new investor would normally determine the post money value of the company using fundamental analysis and adjust the capital structure using the tools at his or her disposal. Or, if the capital structure is already in place, common stock holders can use the formula to determine the implied value of their holdings. For example, if we determine that the company’s PMV is $50 million, then the common stock is worth $0.75 per share, compared to the nominal value of the preferred stock of $1 per share. On the other hand, if a preferred stock investment has already been made in a publicly held company, we can use the traded value of the common stock to determine what the market believes to be the enterprise value of the firm.

In the above analysis, I have assumed that the preferred stock investors get what is called a ‘double dip’ liquidation preference, or a ‘participating preferred’ stock – that is, the investors receive both the liquidation preference as well as their common stock equivalent ownership share of the firm. But in many cases, investment terms dictate that the investors get the greater of their liquidation preference or their common stock equivalent ownership – a ‘simple preferred.’ For valuation purposes, this structure would imply that the investor receives the liquidation preference, but instead of getting straight common stock shares, in effect the investor acquires options on the common stock. That is, the investor will only receive compensation for the common stock equivalent ownership if the value of that stock is higher than the liquidation preference. Since the value of the investor’s common stock would be the ownership percentage (CSEOP) multiplied by the value of the firm, the company is in effect issuing options to the investor with a strike price equal to the liquidation preference divided by the common stock equivalent ownership. In the case above, still assuming a 2x liquidation preference, the strike price of the options would be at a firm value of $80 million ($20m / 25%.) In other words, each share of preferred stock would be the equivalent of $2 of debt and an option on common stock with a strike price of $2.

Note that it makes more sense to think about the preferred stock as debt plus common stock options from a new investor’s perspective. But if one is analyzing a publicly traded company , and the stock is trading above the conversion price of the preferred, it probably makes sense to think about the preferred stock as common stock plus a put on the common stock with a strike price equal to the conversion price of the preferred stock – which would be analytically equivalent to ‘debt plus common stock.’

The chart below shows the difference between a simple and a participating preferred liquidation on the distribution of funds in case of a liquidation event. For companies with a number of classes of preferred stock, graphing out the remuneration to the different investors based on exit values can be illuminating to such investors and allows for clearer decision making. For example, one observation regarding the graphs is that the greater ownership stake an investor has in a company, the greater is the angle b and thus the less effective are the preferred stock’s downside protection features.

Options and warrants
From a practical point of view, it is important to have a method for valuing options within the framework laid out above. The easiest method for doing this is to value each option in common stock equivalent terms, so that each option is viewed as the equivalent of a portion of one share. As seen above, this portion can be calculated using reasonable assumptions in a simple Black-Scholes framework. As a result, we would have to recalculate the CSES.

In the example of the participating liquidation preference above, we noted that each share of preferred must be treated as $2 of debt plus one option for common stock at a strike price of $2 per share. If the common stock share price is $0.92 and we assume that the options have a 10-year expiration, volatility is 30%, and the simple interest rate is 5%, Black-Scholes tells us that each option would be worth $0.25, or 27.5% of the common stock value of $0.92. So,

Common Stock Equivalent Shares of the Preferred Stock,
CSES = # shares of preferred x Value of each option/CSP = 2.75 million

Then, although the formulas for CSEOP and PMV remain the same, their values change because of the recalculated value for CSES:

Common Stock Equivalent Ownership Percentage of the Preferred Stock,
CSEOP = CSES / (CSES + Number of common stock equivalent shares
outstanding before the transaction) = 8.4%
PMV = LP + ( CSES x CSP / CSEOP ) = $50 million

To illustrate the relationship between the different variables, we assumed a common stock price of $0.92 and reached the same PMV of $50 million. In practice, we would need to solve for the common stock price using the above formulas and our assumption for PMV, the fundamental value of the firm. Also, remember that in the case of the participating preferred stock, the same PMV of $50 million implied a common stock share price of $0.75.

This same methodology can be used for incorporating all of a company’s outstanding warrants and options in a total common stock equivalent capitalization table for the company. One interesting case is the value of warrants for preferred stock. In the above example, where the preferred stock has a 2x liquidation preference, each warrant for preferred stock would be worth $1 of liquidation preference (i.e., debt) plus one share of common stock. So warrants on preferred stock are more like debt and common stock, not warrants on common stock.

Dividends
Most preferred stock provides for some kind of dividend distribution. At first glance, it could be argued that mandatory dividends should be treated like the interest on debt and thus ignored in a valuation exercise. But this would only be the case if we value the preferred stock separately from the common stock of a company. By converting preferred stock into common stock equivalents, we reduce the number of unknowns from three (debt, common equity, and preferred stock) to two (debt and equity.) So the most reasonable approach to valuing the dividends in terms of common stock is to calculate the amount of dividends outstanding at the time of a potential exit and to include them in the number of common stock equivalent shares outstanding. So the inclusion of dividends depends on the method one uses to calculate the value of the company. If valued today, only accrued dividends would be counted – if fundamental analysis is used with an exit in three years, then three years of dividends should be calculated. And of course, this same logic would also apply to any liquidation preference that comes with those dividends.

Sometimes, investors agree to cancel their rights to dividends if the company achieves an exit that is above a certain valuation. In such a case, the value of the same dividend shares have to be calculated, but each potential dividend share should be treated as a put option on the value of the stock at the specified valuation.

Anti-dilution protection and ratchets
Most private financings have some sort of anti-dilution rights – the right for the investment to be re-priced at the next round of financing if that price is lower. Although this is a valuable right, there is no easy way to quantify it bar using Monte Carlo simulations or probability trees. One could also treat anti-dilution rights like out-of-the-money puts. But in practice, for new investors, these puts should be out of the money and of little value, unless there is a high probability of such dilution taking place.

Whose Content Is It (2)

2005-11-20T13:15:00.000-05:00

Following my previous post on content ownership below and the difference between message boards (which are all about the subject) and blogs (which are all about the person), I came upon this message on Fox’s message boards (eg see here), related to their TV shows...

“By posting your message, you agree that Fox Broadcasting Company, its affiliated companies, and their successors and licensees have the unlimited and irrevocable right, without further consideration, to use any portion of your message and your first name in all media now known or hereafter created, worldwide and in perpetuity in connection with the advertising, promotion and publicity of the series or any of its episodes.”

(The text isn’t just in the background in some user agreement – it is the only text that appears ont eh front page when you click on ‘message board’ from the show’s site, which does drive home the point.)

BTW - I just hope the spirit of myspace permeates fox, and not vice versa…

Whose Content Is It? (Yours if you want to claim it)

2005-11-05T14:47:00.000-05:00

I was trying to explain to a group of students what a blog was, and they asked me if that is different from a forum. (Besides taking note that college freshman may be more involved with forums than blogs, my answer was…)

For me, the fundamental difference between a blog and a forum is about who controls the content. In a forum, you are posting data on a third party site (forum) which is about a certain subject, and the site host controls the data. It is less about YOU than about that subject - you are one of many quasi-anonymous participants generating value for the forum (and the site host). With a blog, you are writing on YOUR site, about various subjects, and all of your writings are yours. You are at the center of the interaction about those subjects. At the same time, blogs can emulate the functionality of forums in a less structured way with links, comments and track-backs.

On the other hand, blogs require active participation, and are (at least psychologically) harder to set up and run. And this may explain why sites like thefacebook, which are easy to set up and can be run with minimal participation, are so popular among college students (ie as opposed to them setting up their own blogs.)

From a monetization perspective, to further comment on Umair’s question on property rights: on the web today, people can claim their property rights by becoming active participants and controlling their content. As per Anil Dash, a passive flickr participant can leave money on the table (sic) for flickr when people go to see his photos at flickr.com, but an active participant can have her flickr photos posted on her web site and claim the related ad revenues.

The Value of Networks

2005-11-01T20:37:00.000-05:00

Nothing like a late night cross country flight to think about things like what the equation for a value of a network should be. To summarize from my last post: Metcalf and Reed calculate the theoretical potential value of a network, while its real or realized value should be based on the actual number of links in the network.

So let us a say there is one sub-network on the internet (say, a social networking site), and it has “a” number of people in it. According to Metcalf, the value of the network is a^2. If a second site, say Skype, is added with “b” subscribers, its value would be b^2. So the total value of the internet becomes a^2 + b^2.

To generalize, the total value of the internet should be the sum of its sub networks.

∑(s=1 to n) a(s)^2, where
n is the total number of sub-networks, and
a(n) defines the number of nodes in each of those sub networks.

[Side Note: I hope I got the notation right. It's been years since I last wrote a formula.]

A few insights about this equation:

1. n can be larger than the total number of nodes in the network. So for example if there were N people on the internet, and they all only participated on two social networking sites, then the total value of the network would be 2 * N^2, twice the (simplified) Metcalf value.

2. I think this partially addresses some of the issues Evslin had raised regarding the math of Reed's law.

3. Given a critical mass of population, each incremental node added to a sub network, (a(s)=a(s)+1), can add more value to the total than an addition of a new node to the network (n=n+1). In other words, over time, the size of the internet becomes less important than the networking connections within it.

This last conclusion is important for the implications of openness. Assuming that by opening yourself up (ie allowing your subnetwork to be connected to other sub networks), you increase the reach of your network… then the cost of remaining a closed network C is the difference between the value of a combined network ((a+b)^2) and the value of two separate networks (a^2 + b^2)

C = ((a+b-o)^2) - (a^2 + b^2)

(I have added an adjustment term, "o", to indicate overlap, or any other adjustment…)

Of course, the interesting tension here is that if subnetwork 'a', say Skype, grows its network by itself, it can monetize the full value of the subnetwork, but as pointed out, again by Evslin, if they open up their network, even if they maximize the over all value of the network, they would be decreasing their ability to monetize it. Further more, as a dominant network, they can create the most value by acting like a monopoly. The problem is that businesses can fall into the fallacy of thinking they are Skype, even they don't have the dominance to justify acting like that. And if you don't have the dominant position in a networked market, C can become a problem!

The Blog Reed-ing Law of Networks?

2005-10-23T00:29:00.000-04:00

So I was doing my weekend blog-reading, and came across Fed Wilson’s blog on Reed’s law – and he pointed me to Bubble-Generation and Nivi, neither of which I was familiar with, and who had excellent posts. I have subscribed to their blogs and if I continue to find them inspiring, I am sure that they will point me to other posts and blogs that I might find interesting, some of which I will subscribe to. This is the power of the blogosphere network, and in this network, the ‘peer-produced’ content is not so much the blogs themselves as the links to the other blogs – they determine the value of the network!

All those bloggers could have been there happily blogging in their sub groups, but I would have probably never found them (Certainly not via a google search – what would I be searching for?) had it not been for Fred’s post.

All networks are formed of sub networks, and blogs are a perfect example of this. A group of mutually-admiring friends may be blogging for ever and ever – no thousands of such groups may be blogging for ever and ever with out really adding to the value of the network exponentially. So the main issue I would have with Reed’s law is that it does not account for the connection between the various sub groups. And that is where I think the real value lies (not the fact that they can be formed). Reed and Metcalf calculate a theoretical value for a network (and its subnetworks) but as these sub-networks become more and more specialized, what matters more is the actual interconnectedness of the sub-networks.

Take ebay’s example from Bubble-Generation: Could it be that ebay has turned into a series of unconnected sub-networks which don’t add value to each other exponentially, thus accounting for their lack of “network scale economies”? Are ‘car sellers’ and ‘antique dealers’ on ebay simply two completely disjoint sub-groups adding little value to each other? The fact that I would go to ebay.com to find either does mean that there are branding economies of scale in the traditional (pre-internet) sense, but not necessarily anything exponential (unless ebay-car-dealers want to barter for antiques.) (Interesting that Reed’s original paper, which is admirable in its vision, cites ebay as the prime GFN.)

I would argue that the blogosphere is the ultimate social network, in the way that traditional(!) internet social networking sites can never be (unless, of course, they totally open up to each other.) Each social networking site adds a sub network with structured links between each other. (eg User question: “What school did you graduate from?? We’ll try to connect you to people from the same school who answered this question.”) Compare that to the blogosphere network (and the web in general) which is all about unstructured network connections via a variety of tags, search possibilities and most importantly direct linking to other bloggers. (After all, it is those links that made Google’s search algorithm possible!)

So, back to reed’s law – I wonder if there is way to mathematically model the connections I mentioned in the first paragraph above. Or perhaps there is a way to measure the value of that interconnectedness using empirical data on the way that bloggers and blog readers travel from one sub network to another and sometimes create hard connections between these networks, making them even more valuable. For example, let’s assume that bloglines (and/or other rss readers) allowed us to see the historical data on their users’ subscriptions (in the way that sourceforge allows researchers to study the behavior of the open source community). By mining this historical data, we could then see the progression (over time) of the various blogs the users are subscribed to. We can then correlate that with the various hyper-links and trackbacks that each of the subscribed-to bloggers has created to the others over time, and see to what extent these links create added readership and subscriptions. Since each subscription by a user adds value to that user by definition – why else would they subscribe? – we can get a sense of the actual practical value of the blogosphere as a “Group-Connecting Network”…

And there we have it: A new “blog-Reed-ing law of networks”…

__________________________

Note: I realized that I have been talking about the value created in general, not the monetized value accrued to a single company. Of course with open networks such as the blogosphere (or open source communities for that matter), extracting $S from the value created is not necessarily straight forward… except if you recognize the potential of that value early on and build new monetizable value on top of it!

Declining Price of Software / Web 2.0

2005-10-09T00:48:00.000-04:00

Somewhat inspired by all the Web 2.0 Conference discussions, here is my take on Web 2.0:

The price of creating new web based applications is plummeting, largely due to the Open Source Software and the Open Source movement's cultural influence.

Think of what it takes to build some pretty sophisticated functionality using 'free' open source infrastructure (like LAMP or RoR), and support it with minimal resources. Compare this to the money you would have to spend to buy and support a Solaris/Oracle platform prevalent in the late nineties for example, and the point is made.
What's more, the culture of sharing freely (which I think has been enhanced by the success of open source) allows for more and more new offerings which are free... while the companies creating them figure out their revenue models, which in turn, do not need to be outrageously high to cover their low costs!( I liked this related post on ning.)
This creates a virtuous cycle of low cost tools enabling low cost apps, some of which are low cost tools...

Plummeting costs of supplies inevitably result in experimentation and innovation

This is not the first time this has happened. I go back to the chart I had used before, which continues to amaze me. (Credit goes to Kurzweil for thinking of a way to quantify this, and Larry Augustin who first got me thinking about it in this way.) It's pretty simple grade school economics - lower the cost and demand goes up! And this is on a logarithmic scale.

The form this innovation is taking is that you get a lot of small groups (2-10 people say) that are creating very interesting software with minimal overhead. They sustain low burn - sometimes, these are people who became somewhat independently wealthy during web 1.0, and themselves may have low overhead lifestyles, and thus have a longer time frame before they need to monetize their creation. The idea is that they can sustain the burn and get ad-sense revenue or something while the site becomes more popular and then sell it for a few million to one of the internet giants
The low cost infrastructure also means that web 2.0 businesses can go after smaller segments of the market to become real businesses (and potentially expand from there) - thus the long tail.
It is a great environment for creative destruction. And before the destruction comes, you have a growing and immense supply of low cost applications being built on the web.

I think the cost issue is a critical piece of web 2.0 (as I see it.) Clearly there are some other pretty important common themes.

Broadband: Certianly, the web is 2.0 because it is relying on the infrastructure (actual mbps) and user base (network effects) that came on with web 1.0.
Openness: ... as in open source, or APIs. It's all about linking content, code in innovative ways.

Participation: I think a critical central theme to web 2.0 is the concept of participation by users, whether it is to contribute to the infrastructure (bit torrent), to the marketing (skype) or in the O'Reillian architecture of participation (with tagging, sharing, amazon reviews etc.)
Revenue model: So all this is somewhat enabled by the micro revenue models specifically enabled by google ad-sense and Amazon affiliate programs... I recently talked to abusiness school student who created a site before bus school, and the site is "self sustaining" while he does his bus school and gets another job. Now how cool is that???

That's all for now - the question I really need to be thinking about is: Is all this good for venture capital, and investing in general?? And for how long? When will the destructive part of 'creative destruction' start to rear its necessary head?

Tim O'Reilly - Visionary

2005-10-04T22:57:00.000-04:00

Reading Tim's recent article, I remembered his presentation at OSBC last year when he was talking about his ideas on the architecture of participation. He went on about the difference between Amazon applying principles of participation, as opposed to B&N which did not... and then continued to talk about how mapquest (and the other mapping services at the time) had not figured out a way to do that and so they were not able to create value. It marked me that he should single out mapping the way he did. Why pick on mapping? It just seems so visionary for him to go on about how mapquest was failing when he could have picked so many other examples... visionary because 'Google maps' is, for me in any case, the poster child of Web 2.0, not only because it helped to popularize Ajax, but also because of its use of APIs, which has made it a staple of so many mashups today.

Liquidation preferences / LendingTree

2005-01-11T16:10:00.000-05:00

Here is my 2002 article on preferred stock - perhaps it still has some relevance, if not some vestige of humor:
(Update: Now with charts and pictures! :) )

VALUING STOCK OPTIONS AND PREFERRED STOCK: A CASE STUDY OF WALL STREET ANALYST REPORTS
Journal of Applied Corporate Finance - Vol. 15 - Number 2 - Fall 2002

In the past few years, a number of publicly traded companies have raised money from venture capital and private equity funds, often by issuing some form of preferred stock. Preferred stock allows the investor to earn an attractive return on an investment with lower risk (as compared to common stock, for example) and typically grants other kinds of investor rights frequently seen in traditional venture capital and private equity transactions, such as the right to veto mergers or the right to seats on the board. (1) But because these securities are not part of the “simple” (debt plus common equity) capital structure of a public company, SEC reporting rules are not designed to cover them adequately. As a result, they are sometimes overlooked by analysts who can fail to understand the implications of these securities for a company’s capital structure and how to account for them when valuing a company. To a lesser extent, but with far wider implications, the same issue affects the large number of public companies that have issued stock options either to employees or to customers, new investors, or other business partners—particularly when the issuing companies are incurring losses, because the accounting treatment then becomes even murkier.

In this paper, I analyze the capital structure of a public company that has both preferred stock and stock options outstanding, and examine investment banking equity analyst reports on the company following a major preferred stock financing. In the reports, analysts’ misunderstanding of capital structure resulted in a 36-74% miscalculation of the company’s market value.

The Case of LendingTree, Inc.

LendingTree, Inc. (Nasdaq: TREE) went public in February 2000, just a few months before the equity markets melted. Had the equity markets remained robust, LendingTree would almost certainly have done a secondary offering of common stock to raise the money it needed to execute its business plan. Instead, LendingTree’s stock price plummeted from $16.75 on its first day of trading to a low of $2 at the end of the year, before rebounding somewhat in 2001 as investors seemed to regain confidence that this “dot-com” has a sustainable business plan. To survive the market downturn, LendingTree went back to its principal venture capital investor, Capital Z, for financing. In September 2000, Capital Z invested $10 million in the company in return for preferred stock convertible into 1.25 million shares of common stock at a price of $7.98 per share. In March 2001, Capital Z led another $13.4 million preferred stock financing. As part of that deal, Capital Z also exchanged its September 2000 preferred shares for $10 million of the new preferred stock—resulting in a total of $23.4 million of preferred stock convertible into 6.69 million shares of common stock at $3.50 per share. (Additionally, the CEO of LendingTree received a $700,000 loan to purchase another $700,000 of preferred stock convertible into 200,000 common shares—giving him, in effect, an option on the preferred stock, and increasing the total amount of preferred stock issued to $24.1 million.) The preferred stock pays an 8% dividend, and has a one times (1×) “simple” liquidation preference.

The liquidation preference of preferred stock makes it in effect like super-subordinated debt—the preference amount is subordinated to all debt as well as to the creditors of the company, but senior to all equity in case of a liquidation of the company. The debt-like feature of the preferred stock is emphasized by an optional redemption schedule similar to bond offerings, starting at 118% of par in March 2004 and ending with a mandatory redemption in March 2006
for 105% of par. Prior to such redemption dates, preferred stock holders have the right to treat any merger or acquisition of the company as a “liquidation,” permitting them to receive the liquidation preference amount (in this case, one times the value of their investment) before common stock holders receive any consideration. Alternatively, preferred holders can convert to equity at will. So the preferred stock is at least as valuable as the number of common shares into which it would convert.

In this case, the preferred stock is convertible into 6.9 million shares of common stock (including the CEO’s shares). Together with the 18.7 million shares of common stock actually outstanding as of the 2001 financing, the total shares outstanding for LendingTree should have been at least 25.6 million on a fully diluted basis. However, most analysts reported shares outstanding of around 19 million in their equity reports, even after the filing of the company’s 2000 10-K which contained all the relevant deal documentation on the preferred financings. During the LendingTree earnings conference call on March 7, 2001, where 2000 earnings and the recent
financings were discussed by the company’s management, the first question asked by the audience—in this case, an analyst from Merrill Lynch—related to how one should calculate the total shares outstanding. In his answer, LendingTree’s CFO, Keith Hall, stated both numbers—the 18.7 million common shares outstanding as well as the 25.6 million shares on a fully diluted basis, but then he went on to say that according to GAAP, “18 million [should be] used for calculating a loss on net income. When we get to profitability we will be using all shares for calculating earnings per share.”

Therein lies the problem: the relevant SEC rule, FASB 128, which deals with reported earnings per share (EPS), does not permit a fully diluted number of shares to be used to calculate EPS when a company is showing a loss. The logic here is that the more shares outstanding, the lesser is the magnitude of the loss per share on a fully diluted basis. So in trying to be more conservative, FASB 128 requires the smaller number, or the total shares actually outstanding, to be used for the “fully diluted” EPS. (In other words, the “basic” and “fully diluted” number of shares is the same.) However, as is common practice, analysts often use the fully diluted number of shares outstanding not only to calculate EPS but also to calculate the value of a company, either by multiplying the number of shares outstanding by the per-share market price to get to the market’s valuation of the company, or by dividing their estimate of the equity value of the company (derived by using discounted cashflow analysis, for example) by the number of shares outstanding to get to a target share price. For calculating market values, it would not only be “conservative” but correct to use the larger number (that is, the fully diluted number of shares outstanding), rather than the smaller one. An analyst who used the smaller number of shares to calculate per-share market value would be overestimating the value of the shares, making the company’s stock look more attractive than it really is and tending to generate more “buy” recommendations.

This same problem arises with any options and warrants outstanding. Although options are largely disclosed in various public documents, they are in no way included in the fully diluted number of shares outstanding for a company showing losses. In the case of LendingTree, public documents from mid- 2001 showed that the company had 6.1 million options outstanding, which made the total potential shares outstanding 31.7 million—almost 70% more than the 18.7 million share number used by analysts. But is 31.7 million the right number to use in calculating the company’s market value?

Interestingly, venture capitalists often use the total potential shares outstanding (31.7 million in this case) to calculate the per-share value of a company. But for a fair valuation, the number of options would have to be discounted in some way to reflect the degree to which the options are in or out of the money. For companies incurring losses, FASB 128 does not allow any options to be counted in the fully diluted number of shares, again because doing so minimizes the loss per share. For companies showing profits, FASB suggests the treasury method based on the average share price of the stock over the past quarter to calculate the dilutive effect of the options. The treasury method effectively calculates a common stock equivalent number of shares based strictly on the intrinsic value—the difference between the strike price and the stock price—of all options that are in the money, without taking account of the value of their “optionality.”(2) Again, this approach may be appropriate for SEC financial statements, which like all financial statements are historical in nature, and show a snapshot of a company at a point in time. But the value of a company is forward looking in nature, and so investors and analysts need to calculate the full value of the options. The analysts’ job should be to find a method that uses available information to analyze and quantify such a value, rather than ignoring the problem. Note that this is a separate issue from the recent controversy regarding the methods used by companies to price options for the purpose of expensing them on their income statements. The latter problem concerns standardization and consistency of reporting across all companies, while the analyst’s challenge is to interpret those same standards and adjust them to paint a more accurate picture of an individual company.

In the case of LendingTree, I used the standard Black-Scholes option-pricing formula to calculate the value of the options at a given share price. But whatever method is used to value the options, that value is then divided by the current price of the stock to obtain a common stock equivalent (CSE) number of shares outstanding at the company. This CSE methodology, similar to the treasury method, provides the number of common shares outstanding that reflects the value of the options and, therefore, the dilution that would result from the potential realizable
value of those options.

Table 1 presents LendingTree’s fully diluted shares outstanding using the FASB’s treasury method as well as an estimation using Black-Scholes. In the case of the treasury method, the dilution is almost insignificant because the average stock price for the first quarter of 2001 was below the strike price of most of the options. But using Black-Scholes ascribes value to those 6.1 million options; they would be equivalent to 2.3 million shares of common stock. Added to the 6.9 million shares into which the preferred stock is convertible, this makes the total common stock equivalent number of shares 27.9 million, 49% more than the 18.7 million number of common shares actually outstanding.

An alternative method for arriving at a forward looking CSE value of the options is to use an adjusted treasury method, with either the current stock price or a target price. (This more conservative method would avoid any controversy arising from the use of a formula like Black-Scholes.) Clearly, if an analyst uses fundamental analysis to conclude that LendingTree’s stock is worth $10 per share, then those options that are “in the money” at that price would have some intrinsic value, and would be dilutive even if one didn’t assign any value to them beyond their intrinsic value (that is, any optionality value).

A look at equity research reports from five investment banks following the disclosure of the March 2001 preferred stock financing shows that none of them incorporated any dilution resulting from the preferred stock in their calculation of the firm’s market price or enterprise value. In effect, the analyst reports seem to suggest that LendingTree raised $23 million of convertible securities without causing any dilution to the common shareholders or incurring any debt on the balance sheet. Table 2 shows that as a result of this error (compared to the CSE methodology using Black-Scholes values for options as outlined above), the analysts miscalculated the market capitalization and enterprise value of LendingTree by 36-74%. Even on the basis of the adjusted treasury method and the analysts’ target prices, the margins of error are a very significant 41-73%.

In these comparisons, I have not included any value for the additional features of the preferred stock, such as the liquidation preference or dividends. (3) Dividends are significant if one is valuing a company based on an exit date a number of years in the future, because of any accrued dividends until that date. The liquidation preference can be viewed as a put on the common stock and could be included in the common stock equivalent capitalization table. Of course, the inclusion of these features would have shown the analysts’ miscalculation to be even more severe. (4)

As it is, if the options and warrants outstanding are not taken into account, the valuation error relating to the preferred stock alone is 28-60%. Or, as seen in Table 3, even if the analysts had correctly taken the preferred stock into account and used a 25.6 million share count, the error associated with the stock option calculation alone would have amounted to 7-13% of market capitalization using the adjusted treasury method (with the target price), and 6-12% using the CSE Methodology (with Black-Scholes).

Many analysts use the market capitalization of a company in relation to a financial measure like earnings or EBITDA (earnings before interest, taxes, depreciation, and amortization) to derive an earnings “multiple.” This multiple is then compared to multiples of other similar companies, on which basis a price target can be set for the stock. To the extent that analysts miscalculate the market capitalization of a company, their basis of comparison and thus their price targets are also mistaken. As seen in Table 4, for the three investment banks that discuss at least one of the measures they use to judge the comparative value of the firm, the correct share count would result in a 37-46% difference in the target price. Perhaps coincidentally, LendingTree’s multiples without these errors are much closer to those of the target or comparable companies mentioned by the analysts. So even though the analysts do not understand the capital structure of these companies, the “market” itself seems to.

Interestingly, many of the analysts did mention the dilution resulting from the preferred financing in their research reports relating to the financing, but for some mysterious reason the dilution effect failed to make its way from the text of these reports to the numerical analysis. The only exceptions (to some extent) were Putnam Lovell and Friedman Billings. Putnam Lovell included a pro forma calculation of shares outstanding to project its earnings per share estimates. In the reports from March and April 2001, the analyst gave an EPS estimate using the total shares outstanding of 20 million, but also a pro forma EPS which included full dilution of 25.5 million and another pro forma figure which included an additional 2 million shares “due to warrants and dividends on the convertible preferred stock and debt issuance.” However, as seen above, this same report failed to include the more accurate pro forma fully diluted shares outstanding figure in its calculation of the firm’s value. Furthermore, these pro forma share calculations disappeared from the Putnam Lovell reports by the end of 2001.

In the case of Friedman Billings, the analyst seemed to discover the importance of the preferred shares as time went by. In the reports from early to mid-2001, no reference was made to the dilution from the preferred stock. In October 2001, the Friedman Billings report stated that “we have not included approximately 7M in preferred stock in our share count for 2002 as GAAP rules would not permit it. However, as time goes on these shares will ultimately need to be incorporated… the preferred shares will start to count by 2003.” But by March 2002, the analyst had understood that it made little sense not to include the additional shares in the share count before 2003—they are part of the capital structure whether LendingTree is profitable or not. And so Friedman Billings came to the correct conclusion that “to address TREE’s valuation, we believe it is appropriate to include the 7.0M shares in the market capitalization of the company” (March 14, 2002).

In May and June 2002, two other Wall Street firms, Ladenburg Thalman and Salomon Smith Barney, initiated coverage of the stock and accounted for the preferred stock in their share count calculations. Perhaps due in part to the probing by these two banks, and in light of the company’s projected return to profitability in the third quarter, LendingTree’s reports for the second quarter of 2002 made the fully diluted shares outstanding in the company far more apparent than did previous reports. In the company’s earnings conference call, the management noted an increase in the shares outstanding for the company: The actual number of shares outstanding increased due to a new common stock share offering in the second quarter of 2002, as well as the exercise of stock options and the conversion of some of the preferred stock.
“You’ll note that our basic and diluted share count figures have increased for the third and fourth quarters. This reflects a number of stock option exercises and a few conversions of our convertible preferred stock into common shares [in the] 2nd quarter. The adjustments in the number of basic shares outstanding has caused the EBITDA per basic share for the third quarter to round down to 12 cents from the previous guidance of 13 cents. Note however that the absolute number for the EBITDA earnings of $2.6 million for the third quarter remains unchanged from our previous guidance.” In that same conference call, the chief financial officer also explained the projected 2002 EPS numbers as follows: “Let me just go into a little footnote there. The fully diluted share count next year is estimated [to be] an average of 34.8 million shares which includes the preferred shares outstanding. As we’ve discussed on previous conference calls, GAAP accounting requires the use of the highest share count when the company becomes profitable.” As per the company’s earnings release, that number includes an increased number of common shares at 22.1 million,(5) 6.6 million shares from the potential conversion of the preferred stock, and an increase in options outstanding resulting in 3.9 million additional common equivalent shares using the treasury method. But again, these additional shares are part of LendingTree’s capital structure and should be used to calculate market capitalization whether the firm is profitable or not.

Following management’s “footnote” that the share count had increased 79% from the first quarter’s “weighted average common share” count of 19 million to a projected 35 million in 2003, the investment banks dutifully followed LendingTree’s guidance and adjusted their reports to reflect this update. In its July 25th 2002 report, Merrill Lynch stated: “One key difference between our [original] forecast and the company’s was a much higher level of average shares in the company model than we were using ($0.03 per share impact).” Luckily, LendingTree’s better-thanexpected performance helped disguise the analysts’ miscalculation of share count. UBS Warburg’s July 25th report states: “As the company achieves profitability, our per share figures will reflect fully diluted shares as opposed to basic shares. In TREE’s case, this calculation was complicated by a series of convertible preferred shares TREE issued in March 2001… In short, these shares will be included in our 2003 fully diluted share count. As a result, our EBITDA per share estimate falls from $0.80 to $0.50. The impact of the greater marketing expense is $0.07; therefore, if there were no change in share count, our EBITDA/share estimate would have fallen to $0.73.” In other words, this represents a 32% decline in 2003 EPS due to the preferred shares that had been issued in 2001.

Conclusions

The significant share count errors encountered in the equity research reports for LendingTree have some important implications. First, the magnitude of the problem—up to 74% in measuring LendingTree’s enterprise value—suggests that analysts should pay greater attention to the implications of financial instruments like preferred stock and stock options. As shown in this paper, accounting rules for the number of shares outstanding in a company may be appropriate for historic EPS reporting purposes, but cannot be used blindly in valuing a company with a complex capital structure. The problem is especially severe for companies that show negative earnings, because in these cases the accounting rules exclude convertible securities in calculating EPS.

With regard to stock options, the magnitude of the error was no more than 13% in the case of LendingTree, but the problem may be more relevant in other companies. Given the number of publicly traded companies with negative earnings and significant option pools, as well as a cursory glance at various analyst reports on these companies, one can safely deduce that this problem may have been quite widespread in recent years and could certainly be a contributing factor to the overvaluation of venturefunded, option-laden technology stocks with negative earnings during the recent stock market bubble.

It is interesting that most of the recent controversy regarding the accounting for stock options has centered on the fact that the granted options are not expensed in a company’s income statement. One of the arguments often put forth by opponents of expensing stock options is that it would constitute double counting if options were expensed in the income statement in addition to being reflected in the fully diluted number of shares outstanding. But given the results outlined in this paper, advocates of expensing stock options could argue that for companies with negative earnings, stock options issued as compensation show up neither in the income statement nor as a dilution to the number of shares outstanding—at least as far as the analysts are concerned.

Finally, in a larger context, this paper may also shed some light on the recent controversy surrounding investment banks and their analysts’ stock recommendations. The errors highlighted here seem to suggest that naïveté or a lack of knowledge (rather than willful deception) can affect analysts’ perception of stock valuations. LendingTree’s analysts certainly show great vertical expertise in the industries they cover and great prowess in understanding the complicated business models and operating metrics used by a company like LendingTree — their reports are packed with sophisticated measures of the progress of the company’s business. Yet the same analysts can fail to accurately count the number of shares outstanding in the company. Friedman Billings was the only firm covering the stock at the time of the financing to use a correct share count without company prompting (albeit long after the financing was announced), which suggests that analysts may not be spending enough time addressing the capital structures of the companies they cover. The fact that most of the analysts only adjusted their share counts more than a year after the financing, after management led the way, suggests that the analysts were following the company’s earnings guidance numbers too closely, without applying much independent judgment or analysis. But if analysts ignore a critical, yet simple, measure like the number of shares outstanding, then it should come as no surprise that the investment community might fail to understand the implications of Enron’s special purpose funding vehicles, for example.

Investment banking analysts as well as auditors and the companies themselves must provide clearer disclosure on the balance sheet or income effects of complex financial instruments — including the common stock equivalent of any convertible instruments or the debt equivalent liability inherent in any offbalance sheet financing—even if some judgment is required in making the relevant calculations. The “common stock equivalent” share calculations in this paper could help to simplify the complexities of capital structures and defeat their potentially obfuscating nature.

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Footnotes:
(1) All such rights would typically appear as additional terms or provisions relating to the preferred stock of the company, in the documentation of the transaction.
(2) Methods like the Black-Scholes formula are used to assign additional value due to the ‘optionality’ feature. The treasury method effectively assumes an immediate exercise of the options and calculates the number of shares that could be purchased from the proceeds of the option exercise.
3. In another paper (“Preferred Stock in Venture Capital—A Valuation Methodology,” unpublished) I describe a simple methodology to interpret various features of more complex financial instruments that are quite typical in private equity and venture capital transactions. In brief, many complex structural features can be translated to debt, common stock, or options on common stock, and so one can value a company by reducing the capital structure to debt and common stock equivalents.
4. The amount of dilution due to the value of the put would be approximately 3.4 million shares, or 12% at a stock price of $4, but only 0.4 million or 1% at a stock price of $10.
5. The actual number of shares outstanding increased due to a new common stock share offering in the second quarter of 2002, as well as the exercise of stock options and the conversion of some of the preferred stock.

Some thoughts on Open Source Software

2004-12-09T16:53:00.000-05:00

Christensen is amazing. Here are some slides inspired by his work, and other stuff I've found out about open source software.

2004-12-09T16:40:00.000-05:00

Here is Clay Christensen's view of how the computer industry "disintegrated" or became more modular in the 80's and 90's.

2004-12-09T16:39:00.000-05:00

Standards enabled modularity - and drove innovation. Huge price declines resulted in increased demand. Here is some data from Ray Kurzweil.

2004-12-09T16:38:00.000-05:00

Open Source software development has some inherent cost advantages... By nature it encourages modularity and standardization.. so is there a parallel cycle of innovation coming up due to reduced software prices?

2004-12-09T16:33:00.000-05:00

Here is one view of how we could look at the disintegration of computing devices (PC, cell phone, PDA etc.) in the past few decades.