This post will be the first of a number of excerpts from
my book. Over the next month I’ll post as many as I can. This first one is from a chapter I wrote on
Bill Gross, who has founded many search companies (his latest is
Snap), but
Overture (nee GoTo nee Yahoo Search Marketing) was his biggest hit. I think Bill makes for one of the best stories in the book, and I hope I did him justice. This is a small portion of the chapter, titled “A Billion Dollars, One Nickel at a Time.” Each chapter in the book is broken into sections, this excerpt starts with a section, about a third of the way through the chapter, which focuses on Gross’s early insights into market economics. As with all things book related, I look forward to your feedback and clarifications/corrections.
The Sugar Daddy: It’s All About Arbitrage
When he was twelve, Gross lived in an apartment building in Encino,
California, outside of Los Angeles. There were hundreds of kids in
that complex, Gross recalls. “We all roller-skated together, played
baseball together, swam together, did everything together,” he tells me.
And when they had saved up enough money, they all made the pilgrimage
to a local pharmacy, where they’d buy their fix of candy.
“We used to hop the cinder-block wall surrounding the complex and
go buy candy for a dime at the West Valley Medical Center,” he recalls.
“We’d go there all the time.”
Now here’s where it gets interesting. In Gross’s words: “One day
I was at Savon [pronounced Save-on] on Ventura Boulevard and saw
they had a special on candy, three for a quarter. So I bought five dol-
lars worth—at eight and a third cents each—and brought them back
to my apartment, where I sold them for nine cents. I saved the kids
a penny, and they didn’t have to hop the wall. Everyone began buy-
ing from me. I would ride my bike up there to get the candy and
bring it back in bulk in a big Styrofoam cooler box I mounted on the
back.”
In essence, Gross staked an initial capital investment of five
bucks on an arbitrage opportunity in the local candy market, and it
paid off. He was making two-thirds of a penny on every unit—
roughly an 8 percent margin—but he really started cleaning up as
his volume increased. “After I started buying whole boxes of candy,
Savon sold it to me for seven cents. And then finally, when my vol-
ume got really big, and I was selling at the bus stop and at school in
the mornings, I got it for six-point-four cents, as I recall, from Smart
and Final in Van Nuys.”
Volume had driven Gross’s margin up from 8 percent to more
than 40 percent. With the profits, Gross paid for his next project:
the solar energy kits he sold in the back of Popular Mechanics. “I
made a business in candy that allowed me to buy the math books
and solar energy parts I wanted,” Gross explains. Those kits, in turn,
paid Gross’s way into Caltech.
Gross learned several things from his days as a player in the
candy trading market: first and foremost, it pays to be a supply-side
sugar daddy in the middle of a high-demand transaction with clear
market imbalances. Second, Gross realized that you can make sig-
nificant money on pennies a transaction, if the volume is high
enough. And third, he developed a taste for entrepreneurship, a taste
he has clearly never lost.
What Gross spotted in the frothy search market of 1997–1998
was another arbitrage opportunity. As defined in Webster’s,arbitrage is
“the nearly simultaneous purchase and sale of securities…in differ-
ent markets in order to profit from price discrepancies.” Gross ob-
served that the market for any kind of traffic—be it undifferentiated
or intentional—valued clicks at about five to ten cents each, but it
seemed obvious that the inherent value of intentional traffic should be
far greater. If Gross could harness and sell a search engine’s ability
to turn undifferentiated traffic into intentional traffic, he’d make a
killing on the spread.
But Gross had a conundrum. To launch a search site like
GoTo.com, he needed both audience and advertisers—and the more
advertisers the better. (GoTo filled out its search offerings with a
standard organic search feed from Inktomi.) Gross knew he could buy his
audience, and he reasoned he could arbitrage that audience’s inten-
tional traffic—as reflected in the keywords they typed into his en-
gines—against an advertiser’s desire for business. But he needed a crit-
ical mass of keyword-buying advertisers to support his site, and given
the untested and relatively complex nature of what Gross was creat-
ing, it was going to be quite difficult to persuade those advertisers to
come on board and bid for keywords. After all, while Bill Gross un-
derstood the intrinsic value of a keyword, not many others in the In-
ternet world did. Until he could prove otherwise, Gross was selling
theory, and little else.
Gross solved his problem by adopting the time-honored approach of
dumping—or perhaps drug dealing is a better comparison: the first one’s
free (or nearly so). Gross built not one but two entirely audacious
ideas into GoTo’s initial business proposition for advertisers: first
was the concept of a performance-based model—one in which advertisers
paid for a visitor only when a visitor clicked through an ad and onto
the advertisers’ sites. Instead of demanding upfront money from
advertisers, the way AOL or Yahoo did, GoTo.com’s model guaranteed that
advertisers had to pay only when their ads were clicked upon. Of course,
this is now the standard model for the multibillion-dollar paid search
market.
Second, and even more audacious, was how Gross priced his new engine:
one cent per click, an extraordinary discount to the market. He knew his
price was seven to ten times less than what every Internet marketer was
paying at the time, and in an environment where traffic was crack,
advertisers couldn’t help but look to Gross for a fix.
In short, Bill Gross bought traffic from one place for five to ten
cents, and resold it on his site for a penny. Not exactly a great busi-
ness model. But Gross believed that the market would take over,
and that soon advertisers would compete to be listed first for high-
value keywords like “computer,” “camera,” and book titles. On the
come, Gross was betting that market forces and the greater value of
intentional traffic would push per-click prices past his cost of traffic
acquisition.
Gross’s gamble lay in building out GoTo as a habit for both his
advertisers and his audience. Back at the IdeaLab’s headquarters, he
built out elaborate models showing how GoTo would slowly grow
audience and advertiser share, and how his plan of arbitraging traffic
would eventually turn profitable as advertisers began to bid various
keywords up from one cent to as high as two dollars.
“Eventually, with volume, I was able to drive traffic acquisition
costs down to six and sometimes four cents,” Gross recalls. “Then
people would exit paying a penny, or possibly two, as some might
click on more than one link,” he continued, warming to his tale.
“But people were also bookmarking the site, and using it again,
which drove down my average cost to acquire a searcher/search.
With volume and loyalty, my cost to drive a search was declining
each month, and my earnings for each search were increasing.”
In about six months, Gross claims, the two prices met and crossed—the
average price paid by an advertiser rose past the average price GoTo
paid to acquire a searcher. “Our model had them crossing in about two
years,” Gross says, “so we were way ahead of schedule. I was certain we
could get there, because I knew bid prices would increase to their true
value over time, and I knew the true value was somewhere in the [range of]
twenty-five cents per click to two dollars fifty cents per click and even
higher on some terms. I never knew some would go to one hundred dollars [as
they have for terms like “mesothelioma,” a rare cancer that—in a gruesome
twist of capitalist fate—affords a high chance of recovering damages in a
lawsuit], but I was sure they would beat one dollar or two dollars, and
they did.”
Back in 1998, the idea of basing a business on the idea of pay
per click was viewed as a wild and rather dismissable gamble. After
all, if you’re Yahoo or AOL, why would you ever want to be held ac-
countable for the performance of what you sold to your partners? If
marketers couldn’t turn the traffic into profits, that was someone
else’s problem.
“The more I [thought about it], the more I realized that the true
value of the Internet was in its accountability,” Gross tells me.
“Performance guarantees had to be the model for paying for media.”
Gross knew offering virtually risk-free clicks in an overheated
and ravenous market ensured GoTo would takeoff. And while it
would be easy to claim that GoTo worked because of the Internet
bubble’s ouroboros-like hunger for traffic, the company managed to
outlast the bust for one simple reason: it worked.
Long time readers may recall when I posted a thread on perfect search a year or so ago. I got so many wonderful answers, and I wove much of what I learned into my final chapter. This is a short excerpt from that chapter. Again, please send or post comments, corrections, clarifications – I already see a few things here that I would like to tweak…as usual…a book on topics like search is a never ending work…like a blog!
