Reading time: 6 – 10 minutes

The big discussion in media for a while has been the growth of smaller media companies (especially those that are web based) and the failure (or imminent failure) of large media companies. While some of the larger media companies still do very well (i.e. The Economist) others, like the Tribune and the Boston Globe, are falling on tough times. Of course part of the problem for larger media companies (really, all media companies) is the current state of the economy but there are more systematic reasons for the failings of larger media businesses.

To understand why large media companies are failing we need to look back into the past and utilize an economics lens when we do so. Let’s think about how the large media companies we know today got to where they were at their height.

Barriers to Entry

As media businesses were beginning to grow they established some solid barriers to entry. The two clear barriers to entry were:

• Printing Presses (i.e. expensive capital equipment)
• Distribution Channels (i.e. very expensive/hard to establish logistics)

Printing presses were expensive and therefore hard for new entrants to acquire. Distributions channels were also expensive (trucks, people, etc.) and hard to build (e.g. look at Amazon today – they have and extensive distribution channel and a slew of servers and they “rent” both to upstart businesses who can’t afford to, nor want to, build their own systems).

Supply and Demand

Barriers to entry led to a favorable supply and demand situation for publishers. They were able to gain a large audience since there were few suppliers and much demand. Publishers were also able to charge high ad rates since they were one of the few games in town. Publishers were also able to get away with not having very solid metrics to tie ad spending to ROI due to there being few media producers. These (potentially) inflated ad rates (relative to ROI – still need data on this) led to very large news organizations with sizable staffs that would not be able to be supported if a large premium could not be charged for advertising.

Where was this headed?

What Microeconomics would have said, if consulted, is that any time there are large economic profits being earned competitors will enter the market and eventually economic profits, on average, will be pulled down to zero. This situation manifests itself in what economists refer to as perfect competition – a situation in which many small firms produce a homogeneous product and choose their level of production based on a price set by the market. Perfect competition also entails low entry and exit barriers.

In reality the news business wasn’t perfectly competitive in its heyday. It had high barriers to entry which lead to a few large firms instead of many small firms. The news business also had differentiated products (as opposed to homogeneous products). Due to these factors publishing firms were able to earn large economic profits for a long time. However, microeconomics is also concerned with the role of technology in the economy and economists know that technology has the power to make things faster, better and cheaper and can therefore lead existing markets closer to being perfectly competitive.

Enter the Internet

As the internet began to come of age the newspapers and the publishing business a whole were not afraid. Why would they be? Internet speeds were too low and penetration amongst consumers was minuscule for a long time. However, as time moved forward more people started using the web and internet speeds became faster and faster. Those facts combined with the fact that the internet was originally conceived to share content, albeit scientific information, made it a perfect vehicle for media and a media revolution.

As the web became more prevalent digital media sites began to spring up at a more rapid pace. Now anyone* could publish. There was no need for an expensive printing press and distribution was digital. The costs (the large barriers to entry for publishing) were exponentially becoming smaller. Then came blog platforms that allowed anyone, and this time I really mean anyone (even people without any knowledge of code), to publish on the web. This lead to an explosion of content on the web that is continuing to this day.

As technology and ease of use increased the amount of content, and ad space, continued to rise at a rapid pace. In economic terms, we could say that the supply of ad space went up and demand did not keep pace driving ad prices lower. Combining that with technology that allowed advertising on the web to be tightly linked to an ROI (e.g. Google’s AdSense/AdWords business) left very little room in the business for advertising that was over priced and not easily measured. Now the print publishers were in trouble.

Today it seems like large print publishers still haven’t figured out that they can still exist but they need to be much smaller organizations since they can’t command the ad rates they once could. There is probably a role for the large players to become aggregators and editors of content from other sources and perhaps specialize in certain things (where they would have reporters producing original work). For example, the Tribune still has a differentiator and that is its brand. People trust the Tribune and a lot can be said for that. Perhaps the Tribune can use that trust to become an aggregator/curator/editor of the news while still producing local Chicago focused news since no one else can do that as well as the Tribune.

The bottom line is that publishing no longer has the barriers to entry it once did and advertising on the web is much more quantifiable and efficient when compared to print advertising. Economic profits have, with the help of technology, been whittled down in a manner that microeconomics essentially predicts. Now it is time to figure out the next model for publishing since news is incredibly important and producing and distributing news is something that needs to continue.

As I expressed above, I believe the new model may simply be smaller, leaner, more focused publishing businesses. However, there are other interesting models out there including Adrian Holovaty’s model. Adrian’s model focuses on parsing and visualizing data to some extent. Adrian can compile and visualize a large amount of local data efficiently (i.e. with few people) and he does so at EveryBlock. His team is lean and the information is very useful. He is clearly beginning to show all of us one way news can thrive inside of the new economic structure it resides in.

Another option could be not-for-profit papers. Since news and good reporting are central to our society we may need to use this type of structure to keep them alive. For example, the St. Petersburg Times is a for-profit business but it is owned by the Poynter Institute, a non-profit organization. This frees the St. Petersburg times up and lets the focus on the news that people need rather than just focusing on the bottom line.

I am very interested in see where we end up when the dust settles. I am not sure where things will ultimately go but there are a couple things that are certain. News and its dissemination must continue for our society to function and microeconomics explains, in some sense, how the publishing industry got to where it. Perhaps some basic economic principles will also help news publishing survive in this new environment.

Related Articles:

• Who will pay for the news?: Olson’s Observations
• Olson’s Observations on Media
• Olson’s Observations on the Future of Content

* People who could do some coding at minimum.

Reading time: 3 – 5 minutes

I was reading The Economist a couple of weeks back and one article really struck me.  The article was entitled “Smooth Operators” and it started off talking about how the worlds poor (roughly speaking, those that live on less than $2 per day) save their money. You might think they simply use savings accounts like people in developed countries do but that isn’t fully correct.  Generally the worlds poor are “unbanked” meaning that they are ineligible for even the most basic financial services you and I take for granted (e.g. savings accounts, loans, etc.). This is exactly why Muhammad Yunus developed what we now know as microfinance.

Microfinance started off as a loan program where a microfinance institution (MFI) would disburse and administer very small loans to poor people who would then take those loans and build businesses that would sustain them and their families.  Microfinance has come a long way since then and now a lot of large MFIs provide many other services to their clients.

However, savings is still an issue.  This is especially true in places where microfinance (including the micro savings account piece of microfinance) has not been fully developed. This is where the innovation mentioned in The Economist article comes in.

It turns out that some poor people in the developing world actually pay someone to look after their deposits.  Yes, you read right.  They pay “interest” on their savings at rates that equate to roughly -30% (India) and -40% (West Africa) interest rates in some cases. While this may strike the developed world as very odd this system works much better than the alternative (i.e. no savings accounts).

One of the main issues the worlds poor face is that of uneven cash flow.  Since these people generally have incomes that are low while also being unpredictable and erratic they need to control their cash flows and smooth them out.  This is what economists call “consumption smoothing,” a term that refers to spreading spending out in such a way that what one consumes today isn’t determined by what they earned that day or the day before.

What is fascinating about all of this is that, of the poor people surveyed in the new book “Portfolios of the Poor,” hardly anyone lived “paycheck to paycheck” because of their use of a combination of savings and loans.  This is clearly evidence that poor people are fairly sophisticated financially.  They also appear to be very aware of common psychological issues that cause all of us, poor or rich, to run into financial issues.

The example the Economist article brings up relating to psychology is our tendency to do what our peer group does (i.e. peer pressure).  Knowing that peer pressure exists some people in developing nations (even those with bank accounts) have begun to form “savings clubs” where the combined peer pressure of the group keeps everyone honest about their savings.  This same principle is also something that Muhammad Yunus used when he started giving small loans to the poor in the 1970s. Yunus had lendees form groups so that peer pressure would keep everyone honest in terms of paying back their loans.  This system has worked incredibly well over the past 30 years as can be seen in the repayment rates of most MFIs.

The worlds poor have proven time and time again to be very creative in solving their financial problems even though they don’t have access to all of the sophisticated financial instruments and technologies the developed world has access to.  Sure, in some cases they use unorthodox methods like paying for things that people in developed countries get for free or get paid to use (e.g. savings accounts) but the flip side to that coin is that small businesses are created (e.g. the people who charge to safeguard the savings of others), which also help to boost the local economy. All in all, it appears that the poor are much more sophisticated than people in developing nations generally think.

Reading time: 5 – 8 minutes

Talk about secondary markets for private company stock has been heating up recently but the thought has been around for quite some time.  In fact I, along with others, wrote about secondary markets for private company stock in 2007 and 2008 and I am certain that the argument goes much further back than 2007 since the idea is essentially low hanging fruit.

Why is talk about secondary markets heating up now?

It seems the secondary market idea, as expected, tends to come back every time startups (and venture investors) have very few exit possibilities.  As of late things have been looking very grim with regard to exits.

The public markets have been virtually shut down in terms of startup IPOs for some time now.  In fact, I saw some numbers (via the NVCA) the other day that showed how bad the IPO market has become.  There were roughly 86 VC backed IPOs in 2007, 6 (yes, that’s a single digit) in 2008 and 0 thus far in 2009 (goose egg).

OK, so what about M&A activity?  From 2004 to 2008 M&A activity has hovered around 350ish VC backed M&A exits per year or about 87 M&A exits per quarter.  Q1 of 2009 saw only 56.  You may think that that number isn’t too far off the average but when it comes to the average size of M&A exits over time the picture becomes clearer.

In 2007 the average M&A deal size was $177mm.  2008 saw a decline to $115.7.  2009, thus far, comes in at a whopping $49.6mm average M&A deal size for VC backed startups.  Ouch!

Where else can we (entrepreneurs and VCs) get liquidity?

That’s certainly a loaded question but one that needs to be taken seriously and addressed.  Why? Well, if liquidity events are rare then VCs won’t make many investments and, therefore, startups will become more rare and, thus, a vicious cycle ensues that severely impacts our economy (especially given that VC backed startups are a large job creation engine for this country).

This is how we get to the idea of secondary markets.  Secondary markets exist for many illiquid assets at this time.  In fact, secondary markets even exist for Venture Capital fund positions (i.e. LPs can sell of their VC investments in a secondary market).

I have to admit that I do find the idea of secondary markets for VC backed (and non-VC backed startups) intriguing but I am starting to see some issues with the whole concept.  That said, before I get into some of the issues I would like to chat quickly about a pain in the butt accounting rule that may actually help to enable secondary markets for private company stock to function.

FAS 157

A lot has been written about FAS 157 and how terrible the rule is. Even FASB didn’t like the first version of the rule they released.  That said what FAS 157 does, in part, is force VCs to value their investments each quarter.  Since this is a giant hassle (for reasons I may take a whole other post to describe – on second thought that would just be tortuous for you and I so I will skip that post) a lot of valuation firms have been springing up to help VCs and other funds (PE, hedge funds, etc.) value their investments.

As a by product of this rule lots of data is being generated on private companies and the valuations over time.  This data could potentially form the backbone of a secondary market for private company stock (i.e. these valuations could be likened to the analyst reports for public companies and the secondary market participants would then go ahead setting the price for the private company stock).

Wow, this sounds great! What could possibly be wrong with a secondary market for private companies?

This is, again, quite a question.  One of my big concerns about a secondary market for private companies was something I initially missed in my thinking about them.  The issue is this:

If private companies begin to be traded on a secondary market and, through FAS 157, are valued regularly, what stops private companies from focusing on the short term (i.e. short term value of the company, etc.) just like publicly traded companies do (to their detriment it seems)?

One thing that is great about startups is that by nature they take the long view.  Startups try to create long term value and they tend not to worry about short term valuations of their stock or short term revenue opportunities.

If a secondary market begins to take that long term thinking away by pushing companies to focus short term doesn’t a private company simply become a defacto public company albeit with less regulation imposed on it?  I think it may.

Some other issues that come up are equally large.  In the words of Fred Wilson:

I understand that there are issues with this development. It will be harder to strike options at low prices when the company’s stock has a price history. It will be harder to control who the shareholders are and it will be harder to keep employees motivated to stick around if they can cash out early. These are all problems companies usually don’t face until they go public. Now they will have to face them earlier.

The issue that is that heart of the couple Fred mentions is continuity.  One reason startups are able to take the long view is that they generally have a stable management team and a stable group of investors/board members. Part of the stability of startups lies in the fact that everyone is in it together for the long term so-to-speak since they can’t liquidate their positions easily. If founders, investors, board members and employees can suddenly liquidate their stock fairly easily what is left to keep them around?

If you can’t keep your people around then you need to bring in new people. Now you’ve lost time and continuity, which is bad enough but you are also going to have a hard time setting option strike prices at a rate that give the potential new employees good upside potential.

In my mind, there is enough to worry about in an early stage startup without having to worry about a lot of the things startups have to worry about only when they go public.  It seems that adding more issues to the mix will potentially decrease the success rate of startups.

In conclusion

Fred and others (VCs and entrepreneurs alike) are fans of the secondary market idea even though they see the issues that come about. Even I can’t say that I am not, at some level, a fan of the idea (we need something that allows for liquidity).  It just seems to me that these secondary markets need to be well thought out so we don’t lose the long term thinking and alignment of interests that are both big parts of the world of startups and necessary for continued innovation and economic growth.

Reading time: 3 – 5 minutes

Being back in school and taking statistics and finance classes again has reminded me how much I love data. I am not one of those crazy guys who loves data in an unhealthy way and thinks that more of it will solve of all of the problems in the world mind you.  Nor do I believe it can always be trusted. The world is too uncertain and it is often hard to use data to predict the “once every 10,000 years” events that often do the most to shape the world we live in (read The Black Swan by Nassim Taleb for more on that).

What is interesting to me as of late is that we really have reached the point of having free and ubiquitous data.  In fact, we probably have too much data. I would argue that the financial crisis happened partly due to the fact that too much data was available for humans to effectively analyze and understand. I mean, let’s get real, it isn’t like the data wasn’t there.  If you looked at the right data and crunched the numbers you could have seen, as some did, that we were in for a world of hurt.

So now that we are at the point where data is essentially a commodity of sorts we have to figure out better, faster and cheaper ways of analyzing and visualizing data.  The better we get at this the better decisions we’ll make and the more crises we can avert.

FlowingData posted a quote from Google’s Chief Economist Hal Varian that sums things up nicely:

I keep saying the sexy job in the next ten years will be statisticians. People think I’m joking, but who would’ve guessed that computer engineers would’ve been the sexy job of the 1990s?

The ability to take data—to be able to understand it, to process it, to extract value from it, to visualize it, to communicate it—that’s going to be a hugely important skill in the next decades, not only at the professional level but even at the educational level for elementary school kids, for high school kids, for college kids. Because now we really do have essentially free and ubiquitous data. So the complimentary scarce factor is the ability to understand that data and extract value from it.

I think statisticians are part of it, but it’s just a part. You also want to be able to visualize the data, communicate the data, and utilize it effectively. But I do think those skills—of being able to access, understand, and communicate the insights you get from data analysis—are going to be extremely important. Managers need to be able to access and understand the data themselves.

Hal Varian, The McKinsey Quarterly, January 2009

Since I have been thinking more about data and specifically how the financial crisis could have possibly been averted if we could have had a better handle on the mountain of data crammed into arcane forms like 10-Ks and 10-Qs, I have been reading up on XBRL.

XBRL, or Extensible Business Reporting Language, is an open standard for business reporting that I am very excited about.  It could do for financial data what feeds and xml did for content.  When all of the data is structured we can then start to set up smart software to analyze the large amounts of data that exist.  That’s a big deal.

The good news is that XBRL is slowly becoming mandated for public companies in the U.S. an abroad so we’re not far off from being able to analyze and visualize financial quickly and easily.

XBRL, as I tweeted earlier, is the intersection of some of my favorite things: software, structured data and finance.  I am planning on digging into XBRL much more and will probably write about my findings as I, well, find them. Stay tuned.

Reading time: 1 – 2 minutes

It was about time I automated the “reading time” info that I put at the beginning of all my posts.  Today I whipped up a little wordpress plugin that will add the reading time to the top of any post on any wordpress blog.  Now anyone can add that useful bit of information to their posts.

If you are up for giving the plugin a go please download it and send feedback my way.

Regarding the estimation of reading time: I used 150 words per minute (slightly below average) and 250 words per minute (slightly above average) as the range.  I would love any feedback on whether or not the estimation needs to be augmented.

Updates to come:

• Options dashboard: will allow for changes in words per minute numbers.
• Posting data to the feed: need to figure out how to, if possible, get the reading time data into the feed.

Reading time: 3 – 4 minutes

The Pale Blue Dot: Earth

More words of wisdom from Carl Sagan this week.  I have been thinking a lot about Sagan’s work and his thoughts about life on earth and in other places lately.  I rediscovered his work a few months ago and it couldn’t have been a better time to do so.  With the economic crisis in full effect and a number of other crises of varying degrees going on in the world I needed to get some higher level perspective on things.

Like Sagan, I find that learning more about the Cosmos and astronomy gives one the high level perspective they need.

Take a look at the picture above. See the pale blue dot in the middle?  That’s Earth.

The shot was taken by the Voyager 1 spacecraft on February 14th 1990, almost 20 years ago today and about 12 years after Voyager 1 left Earth. The distance from Voyager to Earth when the photo was snapped was about 3.7 billion miles.  The photo was snapped at the insistence of Sagan who presumably thought it would help all of us gain some perspective, given that the “earthrise” photo from the Apollo missions decades earlier did just that.

Six years later in 1996 Sagan related his thoughts on the deeper meaning of the photograph for a commencement address.  Here are his thoughts:

Look again at that dot. That’s here. That’s home. That’s us. On it everyone you love, everyone you know, everyone you ever heard of, every human being who ever was, lived out their lives. The aggregate of our joy and suffering, thousands of confident religions, ideologies, and economic doctrines, every hunter and forager, every hero and coward, every creator and destroyer of civilization, every king and peasant, every young couple in love, every mother and father, hopeful child, inventor and explorer, every teacher of morals, every corrupt politician, every ‘superstar,’ every ‘supreme leader’, every saint and sinner in the history of our species lived there – on a mote of dust suspended in a sunbeam.

The Earth is a very small stage in a vast cosmic arena. Think of the rivers of blood spilled by all those generals and emperors so that, in glory and triumph, they could become the momentary masters of a fraction of a dot. Think of the endless cruelties visited by the inhabitants of one corner of this pixel on the scarcely distinguishable inhabitants of some other corner, how frequent their misunderstandings, how eager they are to kill one another, how fervent their hatreds.

Our posturings, our imagined self-importance, the delusion that we have some privileged position in the Universe, are challenged by this point of pale light. Our planet is a lonely speck in the great enveloping cosmic dark. In our obscurity, in all this vastness, there is no hint that help will come from elsewhere to save us from ourselves.

The Earth is the only world known so far to harbor life. There is nowhere else, at least in the near future, to which our species could migrate. Visit, yes. Settle, not yet. Like it or not, for the moment the Earth is where we make our stand.

It has been said that astronomy is a humbling and character-building experience. There is perhaps no better demonstration of the folly of human conceits than this distant image of our tiny world. To me, it underscores our responsibility to deal more kindly with one another, and to preserve and cherish the pale blue dot, the only home we’ve ever known.

Reading time: 3 – 5 minutes

Being a long time student of finance (starting digging into the markets at the age of 13) I have been particularly interested in the financial crisis that we are in the midst of.  I have been thinking through why something as large as this crisis happens.  Of course, for something so large and complex, there are a number of things that had to come into play to create the scenario but one macro theme in particular leaped out at me.

The theme I am talking about is removing faces from finance.

What do I mean by that?  My thinking is this: once you remove relationships from financial transactions and instruments things start to get messy.

If you are once removed, for example when you buy the stock of a company that you don’t have any personal relationship with, you are probably OK and you hope that the management is giving you quality data to asses.  There’s trust there.  However, when you get further and further away from a face to face relationship with, say, derivatives like CDOs, things simply get out of hand.

I have never been a fan of derivatives and other “abstract” financial instruments.  I always found it odd that no one really knew what the underlying assets were.  Was it Joe’s house, Acme Corp., both? To the creators and traders of these securities it was just paper (digital “paper”) with an assigned value.

I am not the only one who was worried about the issues that could be caused by abstracting finance.  Warren Buffett was worried too.  He once referred to derivatives as “financial weapons of mass destruction.”  Buffett also referred to derivatives this way:

“There is an electronic herd of people around the world managing an amazing amount of money who make decisions based on minute-by-minute stimuli,” said Mr. Buffett, adding, “I think it’s a fool’s game.”

His partner Charlie Munger was also not a fan.  Munger once said:

“The accounting being deficient enormously contributes to the risk,” said Munger, lamenting that executives and shareholders were getting paid on “profits that don’t exist.”

Exactly. Profits that don’t exist and assets no one really understands or can put a face to is a recipe for disaster.

At this point I should note that when I say face to face I don’t necessarily mean it literally.  I am more or less referring to the relationship one has with an asset and how close they are to it.  That being said, let’s take a look at the banks.  I will keep it short since I all of you already know what I am going to say.

Banks, given the market’s appetite for CDOs, were able to grant loans and then immediately get rid of them to someone who would package them up and send them off to a big bank like Merril Lynch who would then create CDOs, etc. etc.  Do you see the issue here?

A bank’s business is to take in money in the form of savings and distribute it (and thus take on risk) in the form of loans on which they make their interest (i.e. their profit).  Normally the banks have to look someone in the eye and really figure out if the person will pay the bank back since the bank is stuck with a bad loan if the person doesn’t pay.  The loan default is the bank’s risk.

With CDOs the bank can make a loan and immediately offload their risk (although as we saw a lot of banks didn’t offload the risk fast enough).  Now, as you can see, the bank isn’t incented to look at borrowers as closely.  They are incented to give as many loans as they can and then ship them out the door.  That is when finance becomes faceless, and also “risk-less” for one party, and when one persons transaction is viewed as risk-less the outlook becomes bleak since nothing is really inherently risk-less (just like there is no such thing as a free lunch).

We need to get back to face to face finance where people make deals with people they know and trust and they have to since they have to hold that risk.  We should really think twice the next time we try to abstract finance and create derivatives.  While cool and intereting to finance wonks creating derivatives is probably not a good practice nor does it create long term value for society.