The Challenge of Being Google

Yet again, a question on Quora was the inspiration for this post. The question: What are the key challenges and risks Google currently faces? The answer: read on.

Google (GOOG) is most directly threatened by scale. Every other problem is derivative – lack of focus, monopolistic behavior and heightened government scrutiny, challenges to recruiting as its stock becomes less of an “entrepreneurial currency” are the big ones. These problems certainly aren’t unique to Google, and are largely a function of moving from a small, highly nimble technology-driven organization to one characterized by layers of management, a mind-bendingly complex infrastructure and huge challenges related to attraction and retention of human capital. Some of the perils of success: a real estate footprint akin to a large REIT; a staff numbering in the tens of thousands, requiring an hr and recruiting apparatus similar to a global search firm; infrastructure requirements that have put it squarely in the power business; and a compensation scheme more heavily weighted towards cash and large restricted stock grants than significant option grants with the promise of 100x returns (and, most importantly, where employees can actually have a demonstrable and material impact on company-wide outcomes).

This is a movie we’ve seen many times before. Xerox (XRX). Kodak (EK). And more recently Intel (INTC) and Microsoft (MSFT). Diversification seldom works, unless it is in closely related areas that can truly leverage the core IP and culture of the firm. But the standard corporate response to fears of slowing growth is to enter new businesses, make acquisitions and attempt to seed growth in other ways. It is hard to stay laser-focused, acknowledge the harsh truth of the math that monthly double-digit growth cannot continue forever and to give a bunch of cash back to shareholders. because in our markets, paying out cash is akin to giving up the promise of that growth-stock luster. Why pay 40x earnings for a business that can no longer deploy its cash to that end? Maybe we should only be paying 20x. Shifting from growth to value is the death-knell for many a high flier, and regardless of the corporate financing logic (and investing discipline) associated with dividending out excess cash, entrenched managements are loathe to do this. They’d rather invest in risky projects, hoover up other companies and spin stories of continued greatness that strain the belief of any self-respecting analyst. But buy the stories the analysts do – all the time.

One need look no further than Microsoft to see the risks associated with this approach. It could have created a substantial dividend 20 years ago to return excess cash to shareholders in a predictable and clearly communicated way. Rather, they wanted to try and time the stock market and mitigate the dilutive impact of employee stock option exercises by using both cash and derivative purchases of stock. This created a lumpy and often ill-timed series of buybacks that didn’t serve shareholders well. Further, they invested far afield, buying large but non-control positions in companies such as AT&T (T), Comcast (CMCSA) and Nextel (S). They also went on a $30 billion+ home & entertainment spending frenzy, creating enormous losses in the tens of billions of dollars which may or may not pay off down the road, but the riskiness of lack of synergy of the strategy cannot be overstated. How much has Microsoft squandered by attempting to preserve its growth stock appearance? $100 billion? More? The amounts involved are staggering.

Without question Google (and Microsoft, for that matter) have squadrons of some of the brightest people on the planet. But as the stock becomes less of a draw and the distance between a new engineering hire and the CEO widens, exactly who are the brainiacs joining these companies? The kind with entrepreneurial verve that are looking to code 100 hours a week to find answers with the promise of changing the world, or those for whom academia is the other principal option but who want to both make more money and to be in a more dynamic, market-driven environment than chilling around a college quad? Door #2, anybody? Those with the drive to open door #1 are NOT going to Microsoft any more, and I’d posit fewer and fewer are choosing Google as well. Why do you think Google has been sucking up start-ups before they ripen? Answer: it’s merely a form of recruiting. Buy a company, get a group of entrepreneurial, high-performing technical talent. This kind of behavior isn’t sustainable, however, as once non-competes run out those same people who originally opened door #1 are back opening it once again, outside the company. This is reflective of the growth cycle of any company: slow ramp up, rapid growth, inflection point, slowing growth, slow ramp up…

Can this dynamic be conquered? No company – or entity, for that matter – has really figured it out. A few ideas: keeping laser focus on core IP and extensible ideas; breaking the company into groups of no more than 150 people; coming up with compensation schemes that more closely mirror start-up economics within each of these groups; religiously returning cash to shareholders rather than spending it on ill-fated and disruptive acquisitions. This is a generational problem that warrants additional research thought, but let’s be clear: The perils of scale represents THE SINGLE BIGGEST THREAT TO GOOGLE’S SUCCESS NOW AND IN THE FUTURE.

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