Google always had excellent search engine indexing technology, but Google’s search technology by itself never generated profits for the company. Google’s profitability comes from its search technology combined with text ads and an ad placement mechanism that allows advertisers to bid for the placement of their ads (bid-for-placement mechanism). From a profitability perspective, the bid-for-placement mechanism is as valuable as Google’s indexing technology. In the absence of the bid-for-placement mechanism, ad pricing can at best be inefficient. The bid-for-placement mechanism frees up extensive resources that would otherwise be required to set ad prices, and it allows Google to charge ad sponsors in proportion to the value Google is delivering to the sponsors.
The bid-for-placement mechanism was pioneered by Overture, a paid search specialist company. In July 2001, the US patent office issued Overture a patent covering the mechanism. Patent 6,269,361 also known as the ‘361 patent was bad news for Google: it threatened Google’s core business model. It was imperative for Google to have access to the ‘361 patent, but Google never managed to negotiate a satisfactory licensing agreement with Overture. Consequently, in April 2002 Overture sued Google over patent infringement.
Google greatly miscalculated the threat posed by Overture and was eventually forced to settle at a most inopportune time. However, at the time, Google likely believed Overture was totally dependent on the ‘361 patent and could not afford any risk of having the patent invalidated in a court. Google calculated that it will win outright, if the courts dismiss Overture’s lawsuit early, but if things don’t go its way, it will still manage to cut a palatable deal. Unfortunately for Google, Overture did happen to have a few other options.
Overture started life as a paid listing search engine. The company was known as GoTo.com when it first began operations. Advertisers placed ads with GoTo.com and in response to queries the GoTo.com website produced a listing of ads ranked by the ad sponsors’ bids for the search keywords. The GoTo.com website never made it big, and the company was forced to pitch the idea of bid-for-placement to outside search engines. The company even changed its name to Overture to better reflect its new business model.
Overture had a bit more success with this new business model. Under this new business model Overture signed up affiliates and managed their ad sales via its bid-for-placement system. Overture recognized the ad sales of its affiliates as revenue on its books. The portion of the ad sales that went to its affiliates was recorded as traffic acquisition costs.
The paid-search market took off in 2001, and Overture prospered in the rapidly growing market. Overture earned $73 million on revenues of $667 million in 2002, but then a disturbing trend became apparent: Overture’s traffic acquisition costs started growing rapidly. Overture’s traffic acquisition costs grew from 53 percent of revenue to over 62 percent of revenue in just the last three quarters of 2002.
Even after handing over 62 percent to affiliates, a 38 percent cut of ad sales for providing access to the bid-for-placement mechanism is hardly unimpressive, and reflects the revenue generating power of the bid-for-placement mechanism. The trouble was the 38 percent number was just an average, and not every affiliate was paying the same amount to Overture. Overture was increasingly growing dependent on fewer and fewer affiliates for more and more of its revenue. Overture’s smaller customers were in decline as advertisers were focusing primarily on highly trafficked websites. Overture’s 2002 annual report reveals that Microsoft and Yahoo were responsible for 60 percent of Overture’s revenue that year. This dependency allowed the big affiliates to claim bigger and bigger chunks of ad sales as their share of the pie.
Overture certainly had a very valuable patent in the ‘361 patent, but the patent had not been tested in court. Overture knew if either Yahoo or Microsoft walked, the company could expect major layoffs and a severely weakened bargaining position with the rest of its affiliates. Worse, Overture could lose it all, if the company suffered a setback in court.
Overture’s management realized that the ‘361 patent was much more valuable to a company not so severely dependent on a single source of revenue. Such a company could bargain better, and could handle setbacks in courts. Yahoo made a lot of sense as Yahoo handled more web-traffic than anyone else. If the paid-search market grew as anticipated, Yahoo was going to generate most of its revenue from paid-search. Essentially, Yahoo would become what Overture wanted to be, but without the handicap of having to hand over vast chunks of revenue as traffic acquisition costs to affiliates. Consequently, it was reasonable to expect that over the long term Yahoo’s stock will perform as well as or better than Overture’s stock.
Yahoo too realized the value of Overture. Yahoo had always outsourced its search functionality to outside search engines. With Google becoming all powerful and no new contenders emerging in the search arena, Yahoo was in a tight spot. Yahoo realized that to be competitive in the search engine space, it needed access to Google’s intellectual property. Overture’s claim on the core of Google’s business model was just the bargaining chip Yahoo needed.
In July 2003 Yahoo acquired Overture for $1.63 billion. This was an expensive deal as Yahoo’s stock was not flying very high at the time. (Yahoo’s stock has more than doubled since then.) Also, Overture did not have anything valuable apart from the ‘361 patent. Yahoo and Microsoft counted for the bulk of Overture’s revenue, and were it not for the ‘361 patent, Microsoft would have certainly walked.
The Yahoo Overture deal meant that Google could no longer expect to cut a deal whenever things turned against it. Yahoo was now in a position to cut a very tough bargain with Google.
Google and Yahoo settled the ‘361 patent dispute in August 2004. Google disclosed the settlement in an SEC filing just before its IPO. The relevant excerpt from Google’s SEC filing reads:
… Overture will dismiss its patent lawsuit against us and has granted us a fully-paid, perpetual license to the patent that was the subject of the lawsuit and several related patent applications held by Overture. The parties also mutually released any claims against each other concerning the warrant dispute. In connection with the settlement of these two disputes, we issued to Yahoo 2,700,000 shares of Class A common stock.
At the time of the patent settlement disclosure, 2.7 million shares of Google represented roughly 1 percent of the company. Google estimated that the shares were worth somewhere between $260 and $290 million. (The estimate was based on Google’s proposed initial public offering price range of $108 to $135.) Yahoo had spent billions to corner Google so why would the company settle for such a paltry sum?
Actually, Google exaggerated the value of the shares it issued to Yahoo. Only a few days after the disclosure of the patent settlement, Google lowered its proposed initial public offering price range to between $85 and $95. Moreover, Google attempted to muddle up the math even further by jumbling together the numbers of the patent licensing settlement with the settlement of a separate second dispute with Yahoo.
In the second dispute, Yahoo claimed that a warrant it held, in connection with a June 2000 services agreement between the two companies, entitled it to 3.7 million shares of Google. Google disputed that claim and argued that it compensated Yahoo fully on the warrant account by issuing 1.2 million shares in June 2003.
Google’s 2004 annual report has the settlement value pinned down to $229.5 million, and it sheds some light on how much was paid for what. The section about the Yahoo settlement reads:
In the year ended December 31, 2004, the Company [Google] recognized the $201.0 million non-recurring charge related to the settlement of the warrant dispute [with Yahoo] and other items. The non-cash charge associated with these shares was required because the shares were issued after the warrant was converted. The Company realized a related income tax benefit of $82.0 million. The Company also capitalized $28.5 million related to certain intangible assets obtained in this settlement.
In the IPO filing the focus was on the patent dispute, but here the emphasis is clearly on the warrant dispute and ‘other items’. The attempt to fudge is there, but it is obvious the ‘other items’ do not cover the patent settlement. This because the $201.0 million amount was expensed all at once, whereas patents have a life and are expensed over that life. Google recorded the rest $28.5 million as intangible assets on its books. Patents are recorded as intangibles, so the $28.5 million amount is all Google paid for the patent licenses.
Why did Yahoo charge only $28.5 million for patents it acquired for $1.63 billion? The $28.5 million seems to cover Yahoo’s legal expenses associated with the patent litigation and likely does not represent any payment for patent licenses. Google must have compensated Yahoo in some other way, and the company is not being forthright about the settlement terms.
Yahoo certainly craved Google’s intellectual property, but the terms of the settlement make no mention of Yahoo licensing any of Google’s patents. Obviously, Google could not expect to get away with hiding an IP licensing agreement with its biggest competitor; therefore, it is reasonable to assume that Yahoo did not get such an agreement. But, Yahoo had an indirect way of achieving access to Google’s intellectual property.
Google’s SEC filings mention a “fully-paid, perpetual license,” but they omit the word non-revocable. Nowhere is there any mention of the patent license being, “fully-paid, non-revocable, and perpetual.” It is unreasonable to expect Google to inadvertently miss the word non-revocable, so Google’s license to the ‘361 patent has to be revocable. (Non-revocable patent licensing deals are nothing exotic.)
Now, there remains the question of the terms which if violated cause Google’s patent license to become revocable. Yahoo was in a very strong bargaining position as its patents covered the core of Google’s business model, so it must have asked for something big. The only obvious thing that makes sense was for Yahoo to have conditioned the revocability of Google’s patent license on Google’s not litigating against Yahoo. Such a condition puts Google on a leash, and effectively grants Yahoo the authority to use Google’s IP with complete immunity. Of course, there are other possibilities, but again there is no reason for Yahoo to let Google off the hook. Whatever Google is hiding is more than a little embarrassing.
The disclosure of any embarrassing patent licensing deal could have derailed Google’s IPO, so Google chose to cover it up. But why did Google settle for such poor terms? Why not go for an IPO without settling with Yahoo?
At the time the deal was being negotiated, Google was having a hard time selling its IPO to investors. Worse, a preliminary ruling concerning the Overture lawsuit was due, and Google expected extensive saber rattling from Yahoo if it did not settle. All these factors combined with market conditions could have derailed Google’s IPO or could have caused Google’s shares to tumble after they started trading. Clearly, some people at Google were excessively worried about the value of their options; greed was certainly at work.
Interestingly, Google had no need to go through an IPO. The company was profitable and doing quite well. The pressure to do an IPO was coming from the venture capitalists and employees. The VCs wanted to show impressive gains on their Google investment, and the employees wanted to cash out their stock options. The company could have made a better deal had it stayed private. Under this scenario, there would be no incentive to rush the deal, and Google could have held out for better terms.
Sadly, selfish interests have pushed Google to the brink of disaster. As a public corporation, Google was obligated to inform its shareholders of all significant risks to its business. Google not only failed to disclose the risks, but it intentionally tried to mislead its shareholders and potential investors. Google is certainly asking for an SEC investigation into its business practices and might have to pay fines. Worse, if ever Google’s stock takes a nosedive, Google can expect shareholder lawsuit hell. Shareholders are going to claim that Google intentionally hid potential risks from them, and they are going to be right about that.
Google is a great company but it needs new management. Managers who misrepresent information and manipulate investor expectations with an intent to profit from such actions are certainly not fit to run Google. Google’s shareholders must demand the complete dissolution of the current ineffective board of directors. (Some of the directors might be complicit in the cover-up.) New, responsible directors should be brought in to rid the company of unscrupulous managers and the culture of greed which is threatening to destroy the company.
by Usman Latif [Apr 29, 2005]
LASTE Updated: May 07, 2005