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IC Book Club: Stories from Silicon Valley

Three comprehensive accounts that get to the heart of the success of Amazon, Twitter and Facebook
October 21, 2016 (with reporting by Alex Newman and James Norrington)

Amazon (US:AMZN), Twitter (US:TWTR) and Facebook (US:FB) have earned almost mythical and certainly cult status in markets and modern society. But what catapulted them from scribbles in a notepad to Silicon Valley stars?

The books we read

The Facebook Effect: The inside story of the company that is Connecting the World”, David Kirkpatrick (2010)

Former Fortune writer David Kirkpatrick won unprecedented access to founder Mark Zuckerberg to put together this holistic account of the company’s rise to power. The narrative focuses on the in-depth and often fraught decisions, and debates leading to its powerful position today as one of the most important companies in the world. It shies away from the oft-cited personal tensions at the top of the company, instead giving a blow-by-blow account of the – arguably more interesting - nitty-gritty business of Facebook. It was written before the company’s IPO in 2012, so is an unfinished history of the social media giant but remains a thorough account of this company’s rise to power.

The Everything Store: Jeff Bezos and the age of Amazon, Brad Stone (2013)

This widely celebrated and meticulously-researched account of this company’s stratospheric growth put together by numerous interviews with the people at the top of Amazon. Bloomberg Businessweek journalist Brad Stone delves into the heart of this company, including accounts from Jeff Bezos and top executives and is unafraid to criticise as well as celebrate its journey. The IC’s Alex Newman says: “Jeff Bezos did not give his full blessing for Brad Stone’s excellent 2013 study of Amazon. Though apparently supportive of the project, Stone reports the e-commerce giant’s chief executive “judged that it was ‘too early’ for a reflective look at Amazon”. It is a very good thing that Stone ignored Bezos’ advice and chose to write this deeply reported book, because Amazon’s pioneering and controversial story needed telling.”

Hatching Twitter: How a fledgling start-up became a multibillion-dollar business and accidentally changed the world, Nick Bilton (2013)

This is an entertaining page turner written by New York Times columnist Nick Bilton about the behind-the-scenes personal wranglings and corporate machinations which resulted in the growth of Twitter. The book, which was published just as Twitter went public, is a look at the characters behind the company and the conditions of its creation. This pacey tale of the birth of the internet giant goes beyond the usual account to reveal the more complicated history of the company and gives valuable insight into the business decisions, Silicon Valley culture and other players who enabled its existence.

The early days

It is easy to write creation myths about companies such as Amazon, Facebook and Twitter. But not even their founders understood their power or potential when they first emerged. Amazon founder Jeff Bezos’ ambitious aim – to create an everything store – remains its goal today. But Amazon was dependent on an era of change as much as one man’s genius. The company started life within the walls of a hedge fund, in the very early days of the internet. In 1993, five years into Bezos' Wall Street career, the World Wide Web was still far from the radar of most businesses.

But between January 1993 and 1994. The number of bytes transmitted over the web increased by a factor of 2,057. DE Shaw, Bezos's employer, was among the very first Wall Street firms to register a URL. And in early Amazon speeches Bezos used to say it was the “Web’s 2,300 percent annual growth rate that jolted him out of complacency” (an error - the correct figure was actually 230,000 per cent).

Bezos first came up with the idea for Amazon in one of Shaw and Bezos’ brainstorms in 1994, picturing an internet company middle man between customers and manufacture selling nearly every type of product all over the world. Bezos quit DE Shaw later that year at the age of 30, basing his final decision on a now-infamous ‘regret minimisation framework’ – would he regret passing up a Wall Street bonus more than the colossal opportunity offered by the internet. That year he got started, curating a list of 20 categories of possible products to sell and homing in on books as the first stock line for his everything store. By July 1994, he had founded the first iteration of Amazon – Cadabra (soon changed due to the unfortunate similarity to the word cadaver).

Facebook and Twitter both emerged from the heady days of Web 2.0, a new wave of Silicon Valley hype rising from the ashes of the dot.com bust. Twitter’s origins can be traced back to Jack Dorsey, a quiet kid from St Louis with no degree, a stammer and a desperate desire to work in one of the social technology start-ups mushrooming from the anarchic, hacking culture defining Silicon Valley in the early 2000s. He came up with the idea for posting statuses in SMS form when working at start-up Odeo, a podcasting company founded by Evan Williams and Noah Glass. Williams had already sold his company Blogger to Google, and social sites such as Friendster and Myspace were popping up everywhere across the Valley. According to Hatching Twitter author Nick Bilton: “The Valley had the feel of an amusement park that had just re-opened for business. Exciting new social rides were being built on the plots that had once belonged to pet-food Web sites and other pedestrian ideas from the late nineties.”

Dorsey’s original idea was to allow people to post a status about themselves, like those commonly used on blog sites such as LiveJournal. That simple idea finally led to the first-ever Tweet built on a rudimentary Twitter on 21 March 2006 - “Just setting up my Twittr”. Dorsey, along with Williams, Glass and fellow former Blogger employee Biz Stone certainly weren’t looking far beyond 140 characters at the time. Fund manager Nick Train says: “Twitter hatched out of Vodka-Red Bulls and nose-rings; the founders - rebels and loners - net-working at Frisco parties. What came first - the chicken or the egg? Twitter’s inspired name came before any real conception of what it would actually do. The work to set up the service was done by just seven people. Six years later, in 2012, there were still fundamental differences between the principals as to what Twitter is for. Yet little more than a year later, at its peak share price, this today still loss-making business was valued at $48bn.”

While Facebook founder Mark Zuckerberg was famously creating Facemash in his dorm room in 2003, a website enabling college students to the appeal of fellow students, investors had already starting ploughing money into social network sites in a big way. In the autumn of 2003, Silicon Valley investors ploughed $36m into four high-profile social networking start-ups – Friendster, LinkedIn, Spoke and Tribe.

Facebook also flourished on the same souped-up, capital-fuelled wave which defined Silicon Valley in the early 2000s. Its early success was due in part to the relentless rise of social network sites across the world including LinkedIn and MySpace, which enabled it to flourish. The first site to capitalise on the networking potential of the internet was Sixdegrees.com, launched in 1997, and the first college network wasn’t Facebook, but Club Nexus, at Stanford.

Friendster was the first real breakthrough, launched in 2003 and an immediate hit. Even founder Jonathan Abrams conceded he was not using new concepts. But according to Sean Parker, now famous adviser to Mark Zuckerberg and latterly Facebook president: “Jonathan cracked the code. He defined the basic structure of what we now call a social network.” Facebook was nothing intrinsically new then. But it did rise from those humble beginnings to be the most succesful.

Gaining power - fundraising and keeping control

For a new technology company with mushrooming customer bases but no cash, there is only one answer – fund raising. One major difference between Silicon Valley and almost anywhere else in the world is the sheer concentration of venture capital firms willing to take the kinds of risk that come with a tech start-up. The inexorable rise of Twitter and Facebook – both businesses with minimal revenue and profit projections which chose to remain private until very recently - is in large part due to well-timed and well-managed investment.

These companies have been successful not just because they raised money, but also because they retained control of that cash. Former Facebook company president Sean Parker bred in Zuckerberg a distrust of the hand that feeds most start-ups. According to The Facebook Effect author David Kirkpatrick, Facebook’s reticence to engage with “this whole Silicon Valley game of – take VC money, try to go public or sell the company really quickly, bring in professional management on an accelerated time scale – things like that,” (a Zuckerberg quote), explains much of its success in raising capital. Zuckerberg took his first investments from Paypal co-founder Peter Thiel – a $500,000 loan which converted to equity, valuing the company at $4.9m – and LinkedIn founder and angel investor Reid Hoffman. Zuckerberg has said that the only advice given to him by Thiel was “just don’t fuck it up.” By February 2004, 12 venture capital firms, four major technology companies and the Washinton Post were all actively pursuing Facebook for a deal. But Washington Post CEO Don Graham won over Zuckerberg with a deal valuing the company at $60m, for a $6m initial investment and 10 per cent stake.

Zuckerberg respected Graham, an unusual choice for his start-up, and knew he would leave him alone to run the company as he saw fit. But ultimately Zuckerberg abandoned the offer, with sadness, in favour of a coup won by Parker – a stellar negotiation with private equity firm Accel, resulting in a staggering $12.7m investment in May 2005, valuing the company at $98m post investment while retaining three out of five board seats with stock options tied to those seats. In an unheard-of move for a silicon Valley start-up, Zuckerberg and Parker also negotiated $1m bonuses for themselves and fellow founder Dustin Moscowtiz. Accel co-managing partner Jim Breyer has said: “I knew the price was just way too high, but sometimes that’s what it takes to do the deal.”

In a blog post in July 2007, venture capitalist Fred Wilson, about to pour money into Twitter wrote: “The question everyone asks is what is the business model? To be completely and totally honest, we don’t yet know.” In mid-2007, Twitter still had no revenue and no projected business model. But it did have 250,000 active users, an offer from Yahoo and investors lining up to hand it money. Twitter’s first round of fundraising was led by Wilson, a partner at Union Square Square Ventures, valuing the company at $20m.

“Fred understood what Twitter could be. But more important, Fred didn’t care about a business model and wouldn’t pressure the founders of Twitter to come up with one,” says Bilton. “It didn’t matter that Twitter had no business model or even the faintest sign of one. Or that the site was broken. Everyone still wanted a piece. Everyone, including Yahoo, which also offered to buy Twitter for the laughably small - to Twitter - sum of $12m. The team had settled on $80m as the smallest amount they would accept and rejected that deal out of hand. Just one year later, Twitter's second fundraising when it came in 2008, valued the company at $80m – Twitter’s original aim buyout price and $68m more than Yahoo was willing to pay. The company would go on to raise another six rounds of funding before finally going public in 2013. Those fundraisings were undeniably fraught with internal strife, resulting in several management reshuffles within the company. But if power was slipping from the hands of some of its top executives, it did – for a time at least - remain in the company’s hands rather than the behemoths trying to buy it out. Whether that will remain the case appears increasingly unlikely, following the news that Google again is circling the company. But until now control has been key to its success.

Amazon has been a public company since 1997, setting it apart from Facebook and Twitter (in fact it was an early investor in Twitter). However Jeff Bezos deliberately took an unorthodox approach to revenue generation and reporting. Amazon was not expected to turn over a profit for four to five years and between 1997 and 2000, ploughed money feverishly into development with no regard for short-term earnings. The company’s first letter to shareholders read: “We will make bold rather than timid investment decisions where we see a sufficient probability of gaining market leadership advantages.” Bezos was determined to make decisions based on the long-term prospects for boosting free cash flow rather than short-term profitability and the letter was a line in the sand. For years, that was fine by Wall Street, drunk as it was on the promise of tech’s first wave, and Bezos went forth with mammoth offerings. When he set out to expand from books to DVDs and CDs in 1998, he raised $386m in a junk bond offering and in 2009, issued another $1.25bn in bonds – the largest convertible debt offering ever. By the end of 2000 Amazon had raised a staggering $2.2bn in three separate bond offerings, with no profit in sight. “Investors who had been raised on a steady diet of dot.com hype over the preceding year lined up eagerly to buy the bonds,” says Stone. Those years were defined by Bezos’ mushrooming number of outlandish and radical ideas, dubbed ‘fever dreams’ by Amazon employees. This hyped-up era of easy money and frenetic investing saw the introduction of 1-Click ordering, Amazon auctions and new categories including DVDs, CDs and Toys as well as the roll out of Amazon distribution centres.

Until 1999 Wall Street consistently forgave Amazon’s rapacious spending, to the extent that Amazon executives took to writing ‘Humble, humble, humble’ in giant letters on top of their earnings scripts in a bid to sound less smug on calls with analysts. But then the tide turned. Amazon entered 2000 on track to lose more than a billion dollars and all of a sudden, markets fell out of love with Jess Bezos. The next two years of dot.com crash hit Amazon with a slew of criticism from investors demanding returns from their overheated tech stocks. Amazon sold more bonds, signed lucrative new third-party deals with Borders, Toys ‘R’ Us and AOL and cut costs. In January 2002 it came out of the other side, having turned its first profit with a net income of $5m. In the first quarter of 2003, the company cleared $1bn in sales for the first time during a non-holiday period, setting the stage for its first profitable year. “They had won,” says Stone.

Making money

After fund raising, and development, comes the tricky task of actually making money. Facebook and Amazon today are internet giants, generating healthy turnovers and profit streams and loved by investors and markets everywhere. So how did they turn users into dollar? For Facebook, the answer is advertising. The shift began in earnest in 2006, when Facebook signed a deal making Microsoft the exclusive seller and provider of banner ads and sponsored links for the site. It was a landmark deal - for the first time, Facebook was profitable. “Instantly, Microsoft turned 2006 from another money-losing year for Facebook into a highly profitable one,” says Kirkpatrick. These ads though, were targeted only at Americans and by 2007 Facebook needed another way to pay for its 50m active users. It was former Google heavyweight Sheryl Sandberg who spearheaded the further ad development which would send the company’s revenue stratospheric, introducing ever-more targeted forms of advertising tapping into Facebook’s enormous data base of user data. Sandberg said in 2009, “There has been this myth that everyone’s waiting for our revenue model. But we have the revenue model.

The revenue model is advertising. That’s the business we’re in and it is working.” In the last quarter of 2015, Facebook crossed the $1bn profit mark for the first time, following that with a $2bn quarterly profit in June 2016, all due to a surge in advertising revenue. In October 2016 Facebook announced a new milestone – 4m active advertisers. In the second quarter of 2016, mobile advertising made up 84 per cent of total sales, up from 72 per cent in the same period a year earlier and the company’s global ad revenue is expected to total $23.31bn this year, making Facebook the largest ad publisher after Google. Meanwhile Twitter languishes behind, with less than a 2 per cent market share in advertising for 2016 according to eMarketer. Sluggish user growth and slower-than expected ad spends have dogged the company in recent years, causing it to miss analyst expectations and fall far behind its tech rivals.

All ecosystems go

A major part of the durability and success of both Facebook and Amazon lies in the fact that both have become platforms and operating systems used by other companies. They have both matured into technology infrastructures, which demand loyalty not just from customers, but from other applications. For Facebook, enabling applications ranging from Fluff Friends – a surprisingly successful application enabling users to virtually pet each other’s animals – to charity application Causes have formed a mammoth ecosystem. James Norrington at the IC says: “One ingenuous product development from the period surveyed in Kirkpatrick’s book was the Facebook platform which enables developers to create their own applications for Facebook free of charge. The brilliance of this Zuckerberg brainchild is that by becoming an ecosystem, Facebook makes itself integral to any future and potentially disruptive innovation.” Facebook started building its platform in 2005. Zuckerberg “wanted to do for the web what Gates did for the personal computer” – “We want to make Facebook into something of an operating system,” said Zuckerberg at the time. The genius of this development is that Facebook does not have to be the best application in every area it covers. Within six months, 250,000 developers were registered on Facebook, operating 25,000 operations, and it by 2010 there were over 500,000 applications operating on the site.

Amazon’s entire business model is essentially a platform. But its launch of Amazon Web Services (AWS) went even further, changing the way technology businesses operated and, crucially, connecting them all to Amazon by enabling them to piggyback on its servers. AWS helped kick-start the nascent concept of cloud computing by enabling other companies and start-ups to run their software using Amazon’s computing power. It's impossible to overemphasise the importance of this move, both for the wider tech community and Amazon itself. By charging low rates, Amazon essentially farmed out its power like a utility, and start-ups flocked. “It is not hyperbole to say that AWS helped lift the entire technology industry out of a prolongued dot.com malaise,” says Stone. Bezos deliberately launched AWS with low margins in order to put off competitors. Today it is Amazon’s largest generator of revenue and was responsible for delivering Amazon’s most profitable quarter ever in April 2016, with sales from the cloud division up 64 per cent on the previous year, representing 56 per cent of Amazon’s total operating income.

 

Amazon: a ruthless journey to the top

There is another ingredient, too, to Amazon’s inexorable rise. Alex Newman, of the IC says: “What is clear from this book is that Amazon’s messianic vision for the customer has only been achieved through ruthless corporate activity. Its acquisition history has been both aggressive and at times underhand, it has ignored established conventions on minimum pricing and its tax arrangements have rightly been condemned for giving it a significant advantages over traditional competitors.” Jeff Bezos’s vision is undeniable, but his company’s practices have been at times far less romantic.

Nowhere is that clearer than his approach to pricing, which has hooked customers but resulted in painful dependency for the book industry and third-party sellers everywhere. When launching the Kindle in 2006, Bezos mounted an aggressive assault on book publishers in a bid to persuade them to digitise their catalogues and then charged just $9.99 for each e-book. That meant a loss for Amazon, which continued to pay the wholesale retail price of $15 price for print and e-books, and forced publishers to sell their books on Amazon below cost. Although the Kindle was slow to take off, the move fundamentally disrupted the book market, demonstrating yet again Amazon’s MO – “relentlessly innovative and disruptive as well as calculating and ruthless.”

The company’s relationship with its acquisition targets and retailers has been just as bitter. When shoe company Zappos refused to be bought, Bezos set up an entirely new shoe website, Endless, to squeeze his prey. In 2006, the company set up loss-making Amazon Mom to out-compete children supply store Diaper.com, owned by new target Quidsi. Executives said Amazon would “drive diaper prices to zero if (Quidsi) went with Walmart.” Amazon ultimately bought both businesses. The company has also ignored pricing accepted practices, causing friction with companies including Dyson and Figleaves. Usually retailers are able to wield some power over the price of their goods via minimum advertised price (MAP) floors, which applies to any retailer ad or online site. Amazon has frequently sold products at below MAP using loopholes and its third-party marketplace means that even if sellers withdraw from the market, the company often continues to stock produce on its third-party marketplace. “Amazon’s own employees have compared third-party selling on the site to heroin addiction,” says Stone. “Sellers get a sudden, euphoric rush and lingering high as sales explode, then progress to addition and self-destruction when Amazon starts gutting sellers’ margins and undercutting them on price.” Add to this Amazon’s long-standing battles over its tax practices and reputation for long working hours at low pay, Jeff Bezos’s frugality – employees are still made to pay for parking – and it is clear that the company is far from cuddly. The company once hired private ambulances to stand outside warehouses during heat waves instead of paying up for extra air-conditioners.

 

What is the common thread among these Silicon Valley stories? Each has been led by visionary and eccentric leaders, has been deft with fund raising and determined to retain power. Each has also been a products of a culture of risk-hungry venture capital and market hype defining the two periods of hype-fuelled tech boom times. But while Facebook and Amazon continue to glean power among competitors and from rapacious users willing to give up ever more privacy and control to internet behemoths, Twitter appears to be fading into the background, risking being transformed from star to yesterday’s Silicon story.

 

 

Jeff Bezos’s greatest hits to employees

“Why are you ruining my life?”

“Are you lazy or just incompetent?”

“I trust you to run world class operations and this is just another example of how you are letting me down.”

“Does it surprise you that you don’t know the answer to that question?”

 

Amazon and Facebook’s special sauce, by James Anderson, manager of Scottish Mortgage Investment Trust

Many believe the success of the few extraordinary growth companies is hard to predict, but that is not the case. It simply requires all involved to think differently, both from the point of view of the management and the company’s shareholders. Key amongst these attributes is the willingness to take a long term approach. Building a great businesses is not a smooth road and it certainly does not revolve in smooth, predictable 12 week cycles.

To produce such truly great companies, you also need truly great ambition by those leading the charge. It is no accident that both Jeff Bezos and Mark Zuckerberg are still very much in charge of their respective businesses and both are almost evangelical in their belief that they have only just begun. To succeed in this way, ambition should be defined by something other than simply financial reward. You have to be optimistic. It is much easier to worry about what might go wrong, than to have the vision to understand the potential returns available, if you succeed.

Is Twitter dead? Who cares, by Nick Train, manager of Finsbury Growth and Income Trust

“You read this entertaining account of a business built out of happenstance and preening egos; then note that the shares are down 2/3rds from their peak. And you might assume that here is just another of the sort of pernicious “Extraordinary Popular Delusions and the Madness of Crowds” that are thrown up so often in stock market history, most ending in tears.”

“However it’s wrong to be dismissive. First, Twitter’s story shows what is truly valuable in a digital economy – eyeballs. Nobel economist Herbert Simon pointed out “A wealth of information creates a poverty of attention.” We live amongst unparalleled amounts of information. The prize to be the location where that information is accessed and discussed – to be the place where attention is drawn to – is extraordinarily high. Yahoo, Microsoft and Facebook know this and all tried to buy Twitter before it became public. So, setting out today to build a huge audience before having a business model, let alone profits, is not as silly as it sounds.

Next and more important, I’m not predicting Twitter will rise again, phoenix-like, to justify its hype. I have no idea.

But from a socio-biological perspective stock markets exist to provide a forum where new ideas to improve the lot of humanity are funded and tested. The Railroads, Automobiles, Biotechnology, even Credit Derivatives and now the Web.2 all needed stock market manias, with their distasteful greed and madness, to get commercialised. The excesses, the lunacy, the booms and busts are in fact integral to markets and necessary for them to do their job.