Burn Rate

by Michael Wolff

  This is what Machinist was saying. Invariably, somebody is smart enough and opportunistic enough and powerful enough to set up a system that monopolizes control of the audience. Consolidate TV stations and create a network; gain a cable franchise from a local government and cement a monopoly; use your muscle at the newsstand and elbow everybody else off the shelves.

  Honestly, I didn’t think it would happen this way in cyberspace. Why would you line up and follow the leader on the Web? You had absolute freedom. There were no price barriers, there were no technology hurdles (well, almost none). You didn’t have to wait thirty years for a fourth network. You didn’t need your town wired for cable.

  I was in some sort of denial.

  Machinist sat back then and closed his eyes for a moment.

  “There are too many players,” he said, concentrating, as we analyzed the search engine business. “Who’s number one?”

  “Yahoo.”

  “Number two?”

  “Excite, probably.”

  “Three?”

  “Not clear. Magellan. Lycos. Infoseek.”

  “Hmm . . . differences?”

  “Between them? Minor. Negligible.”

  “Show me.”

  I gave a brief demonstration of search engines. On the basis of my ten-minute demo Machinist would complete his analysis and arrive at his conclusions.

  “All right. All right. Hmm . . .” He closed his eyes again. “I’m waiting for an inspiration.”

  I found myself believing that there were classic business structures and business patterns that explained the seemingly random direction of the Internet. And that Machinist understood them. And that they would yield to his interpretation, as well as to his command.

  Still, his attention span was not long, and his concentration, while possibly deep at a given moment, moved on quickly to other opportunities and dramas. He could easily forget entire conversations.

  But he didn’t forget this one. Machinist (who had offices in London, Paris, and Zurich) returned from his next trip to Europe with a brainstorm. He came with tales of a deal that involved oil, areas of the former Soviet Union, a pipeline route, and Kevin Maxwell, the oft-prosecuted son of Robert Maxwell, the English press baron who had intimidated critics, bamboozled bankers, and looted hundreds of millions from his employees’ pension funds before taking his final dive in the Atlantic Ocean.

  Machinist and Maxwell fils, it seemed, had come to an understanding not only about oil but about the Internet, too.

  “He has a search engine,” Machinist said, slightly annoyed that someone else in his circle would have an Internet company.

  “Yes, Magellan,” I said.

  In some sense, Magellan was the most interesting of the search engines. It had put a rating system in place, it offered some site reviews, and it qualified sites for children. Given the sheer volume of places to go on the Web, a credible and trustworthy rating system would not only do the user a big favor but could potentially achieve a Good Housekeeping or Michelin kind of authority and value. Magellan’s technology was pretty good technology, too. Whereas other search engines went through a lumbering digestive process, Magellan spit back its results in a fairly rapid fire.

  “It’s not bad,” I said. “But it’s totally controlled by the Maxwells.”

  “The Maxwells have always been very smart about the information business,” Machinist offered. “Lehman,” said Machinist, referring to the Wall Street underwriter and brokerage firm, “is prepared to take the company out at one hundred and fifty million dollars.”

  I shook my head. “How could anyone do business with the Maxwells?” I laughed.

  “Can you be over here in twenty minutes?” Machinist was saying into the speaker phone. “David Hayden is in my office.” The order would not have been more crisp if it were the Prince of Wales.

  I put on the emergency tie I kept in my desk and jogged the few blocks around to the Patricof offices on Park Avenue and Fifty-seventh Street.

  Machinist caught me on the way in. I knew that look. I could see my fortune in his eyes.

  “I’ve done all the foreplay,” he said.

  Hayden was on the phone in the study off of Machinist’s main office. His conversation sounded important. I thought I could hear major business moves.

  David Hayden was in his early forties, casually (but expensively) dressed and distinguished by an electric, almost Don King, hairstyle, with spoors shooting straight up and out into the cosmos. He had a Hollywood ease and confidence, with good Italian leather luggage by his side.

  He was the husband of Isabel Maxwell, one of Robert Maxwell’s twin daughters. I tried to imagine the complexities of having married a child of one of the most significant crooks of the epoch. If you regarded Maxwell and his crimes as just somehow larger than life, perhaps it was something that you could deal with, make use of even, dine out on.

  Hayden finished his conversation and we greeted each other with an intimacy created not only by shared business interests but by the embrace of the Patricof offices.

  “Most often Michael and I pass just ahead or just behind one another,” he said to Machinist.

  Six months before, my company had been close to forging an alliance with AT&T. It was a deal that, at least in my imagination, would have put our content in the same relative position that IBM put Bill Gates’s DOS. But then, just like that, AT&T stopped returning our calls. Magellan had underpriced us and gotten the deal.

  “I want you guys to talk,” Machinist said, closing the door to the inner sanctum as he left. “Take as long as you want. You can sit here all day. Then we’ll see if there’s a mutuality of interest.” He said “mutuality” by rolling the syllables the way the British say “sexuality,” and quietly left us alone.

  “Bob is brilliant, isn’t he?” Hayden said.

  “Yes,” I nodded.

  “I’m not sure there’s anything as important as having smart and powerful financial advisors. And you have a personal relationship with Bob?”

  “Yes. We went to school together.”

  “I think we’ve been hampered by not having a strong relationship with an important venture player.”

  “It’s been an invaluable relationship for us. But I doubt seriously that you’ve been harmed. You’ve done very, very well.” I smiled.

  He smiled. “Let me try to give you a sense of the ways we’ve been moving and where we want to be and the kind of timetable we’re on.” Hayden spoke quietly now, without salesmanship, without posture.

  “This business, as you know, the search engine business, when it started to get serious last summer, many people suddenly started to see a way to funnel the Net’s traffic.”

  He told a story I was deeply familiar with. In the retelling we bonded.

  Netscape, during 1995, had inadvertently “aggregated” the largest numbers of users. Then, also inadvertently, it passed that mass of users to the search engines. In an advertising-driven world, the search engines, therefore, owned the main revenue opportunity.

  Yahoo, started in a dorm room by two Stanford undergraduates, announced in the spring of 1995 that, with a significant investment from Sequoia Capital, it would “go commercial” (i.e., instead of being a dorm room hobby, it would now be a real business), a move briefly interpreted as an affront to the Net community, which regarded Yahoo as more or less owned by the Net (it was, after all, just a list of sites, with most entries sent in by people on the Net).

  Meanwhile, Kleiner Perkins, the largest Internet VC specialist, invested in a competing search technology. Backing other Stanford undergrads who’d developed a librarian-type data search protocol, Kleiner began to rapidly aid its client company, called Architext but soon to be Excite, and to position it as an alternative to Yahoo.

  In the fall of 1995, Netscape, understanding that it was giving away one of its own assets—that is, the eyeballs that it inadvertently had come to own, if only for a single click—and that it was giving this patrimony to enterp
rises that would profit off of Netscape’s inadvertent windfall, levied a tax. It offered search engines a headliner position on its home page for a twelve-month period for $5 million.

  It was at this moment that the business coalesced. It separated the amateurs and dreamers from the professionals—Yahoo, Excite, Magellan, Infoseek, and Lycos from those who thought $5 million was an absurd amount. Within a short time, the search engines were realizing twenty million and more impressions a month from their $5 million Netscape deal. At $.02 per impression that’s $400,000 per month. (And on closer inspection, it wasn’t really $5 million per year, but $3 million in cash and another $2 million in advertising credits.) In other words, there was a business here, sort of, maybe, almost—the possibility of $4.8 million in revenue against a cash cost of $3 million. At least there was a clearer business model here than anywhere else on the Net.

  Yahoo’s IPO went out in April 1996. The eager public valued a company with $1.4 million in revenues for the prior twelve months at $1 billion. Magellan, which had not only its own Netscape deal but deals with AT&T and Time’s Pathfinder, had a chance to be the next search engine to go out. Indeed, Robertson Stephens in San Francisco, perhaps the most eminent of the high-tech underwriters, was willing to lead the Magellan IPO.

  David Hayden told a story as believable as any: Magellan turns to Robertson Stephens, which agrees to underwrite Magellan’s IPO. Robertson Stephens, though, has significant connections to Kleiner Perkins, which suddenly starts to rush to get Excite out (a year later, the Excite people would still be marveling at the thunderbolt that took them from start-up mode to well-funded juggernaut). So Robertson Stephens dumps Magellan and leads the highly successful Excite IPO. (In fact, Excite completes its IPO in April 1996, a week before Yahoo completes its IPO.)

  David Hayden shrugged.

  I was impressed that he had handled the purported Robertson Stephens betrayal with what seemed to be a certain grace under pressure.

  Now, as impressively, he had put it together again. Lehman was ready to take Magellan out in six to eight weeks. The S-1, that magical, rite-of-passage document necessary to sell shares to the public, was almost completed.

  The next step was to close on another round of financing—called the mezzanine round, or the “mezz” round—prior to the IPO. This round would include players like Ameritech, GTE, and other big-name technology and telecommunications companies and would value the company at $75 million to $100 million.

  Lehman believed that with those name strategic investors in place it could sell the company to the public for double that value.

  So what was our company to Magellan or Magellan to us? What was this conversation about? Where was it heading? I had no idea, no sense of where we fit in. I did have a dull ache that I was missing out yet again on another really big score.

  But then, just then, Machinist rejoined us. And he told us that, coincidentally, Alan Patricof, the firm’s fevered senior partner, was at that moment talking to a counterpart at Lehman. I shifted my attention to Hayden, looking for a sign that perhaps he had overstated Lehman’s interest in leading a Magellan IPO. I had become quite sensitive to signs of hedging, restating, or damage control. I had found, during my few years in cyberspace, that misrepresentations, especially when it came to numbers, were the rule and that my own, which kept me up at night, were small potatoes compared to most. But Hayden was not covering or qualifying. He seemed very comfortable with what Lehman might have to say to Alan Patricof.

  “Alan says they’re very enthusiastic. They would be, of course,” Machinist said, giving a small back of the hand to underwriters.

  “Listen,” Hayden said, “I wouldn’t mind at all if you used your relationship to feel them out on their true sense of how the market will value us.”

  “They’ve indicated one-fifty?” Machinist clarified.

  “As high as two hundred, in fact,” Hayden confirmed.

  “Let me see what Alan can find out.” Machinist looked at his watch. “Should we have lunch?”

  “Let me tell you what I think,” said Machinist to Hayden after we had settled at the table in the partners’ dining room and the uniformed waiter had served the appetizer and poured the sparkling water, iced teas, or diet sodas. “Yahoo is the four-hundred-pound gorilla that you have to beat. The way to do that seems to be self-evident: combine topflight technology, which Magellan has, with the gold standard content that Wolff New Media has. Magellan has put in place key alliances with ISPs, Wolff has millions of books in the marketplace ready to move consumers from the aisles of Borders and Barnes & Noble onto the Net,” he said. “And, if I’m not mistaken, your revenue base and our revenue base would together make us the largest of the search engines. One more thing, which I think will have a special appeal, particularly on the Street, is that if you put these two companies together, you unite West Coast and East Coast, Silicon Valley and Manhattan, technology and software development, with content and marketing.”

  Hayden was taking this under consideration. I sympathized with him. It was a lot to be handed. It bordered on a hard sell. I wondered if Machinist hadn’t overstepped. Hayden chewed long and carefully.

  “We have,” Hayden said as he swallowed, “a two-step process in front of us—to close on our mezz round and then to go into our quiet period and complete the IPO. Obviously, a business combination with you presents attractive possibilities. I think the whole deal might become much more interesting to Lehman if they think they’re looking at a three-hundred-million-dollar offer.”

  Machinist’s body moved at that moment. It was a subtle repositioning. As an animal to affection. I had heard what Machinist had heard. We would have put the value of our company, on the most optimistic day of the year, at no more than half the value of Magellan, but if Lehman was taking them out at $150 and Hayden had just speculated that a combined company could go out at $300 million, then he had set our value at equal to his company’s value.

  “But I’m reluctant to slow down the process. If we combined, we’d have to redo the mezz round offer and S-1. I’m certainly not philosophically opposed to that in any way, I’m just concerned about the practicalities at this point.”

  “Let’s put aside for a moment how we achieve the procedural goals and see if we have a two-plus-two business equation that can make five,” suggested Machinist.

  “Let me add another element which I think gives you guys an undeniable level of strength,” said Hayden. “That’s the Patricof involvement.”

  I was surprised to hear the pyramid acknowledged so openly: we were sitting on Patricof’s shoulders; we were more valuable simply because Patricof said we were more valuable.

  “Obviously, I think it would strengthen the overall position of the deal if Patricof came in,” Hayden analyzed.

  “We’re totally committed to this company,” Machinist said (meaning my company). “We’re in now and we intend to be in later. Whether this deal works out or the next deal, we’ll be a part of it, I hope an important part. If this company continues to operate independently, that’s also a strategy we’re prepared to support.”

  Hayden nodded. He was impressed. I think I seemed to him—and to myself—to be a chosen child. A rich man’s son. The world is as it is, and I was fortunate enough to have been born into the manor house. I had vast reserves here of support and strength.

  “The notion, then, is to merge you into us or us into you,” Machinist said to Hayden as though just recapitulating what we’d already agreed to, “and to achieve fifty-fifty positions. Your burn rate is running at—what? I would figure near a million a month. Whereas ours is much closer to breakeven. That means we’ll have to complete the mezz round. Do we complete the round before or after a merger, I wonder?” he asked rhetorically.

  “I have no definite feelings either way,” Hayden said, appearing to accept Machinist’s notion of a merged entity, “but I think I’d like you in before the round. We’d like to do the round at seventy-five million dollars, which
does not seem to be an issue, and I think actually with Patricof participation, even if you came in at sixty-five million, we have a strong shot at doing the round at eighty to ninety million.”

  I was working, frankly, at about a 50 percent comprehension rate. In hindsight, though, I can offer the following explanation:

  Machinist began with the fifty-fifty leap, wanting to see if he’d be shot down on that. Taking no fire, he went on to characterize Magellan as losing $12 million a year and ours as near to a break-even position. Never mind that we were losing less money than they were losing only because we had less money to lose. Fleetingly, that seemed like a virtue. Where he was going with that—and I guess would have kept on going until he was definitively shot down—is that Magellan should raise the money they needed and suffer the necessary dilution accordingly (i.e., they’d be selling part of their company), so when a merger occurred our company would have the full 50 percent and they’d have divided their 50 with other parties.

  On his part, Hayden seemed to have one thing and one thing only on his mind, which was to bring in Patricof, a blue-chip venture fund, at a high valuation. If Patricof came in at $65 million, the financial community would accept that value and be ready to take the next step.

  It was unlikely, I knew, that Patricof would go into an Internet company at anywhere near full value. First, Patricof did not make its money, nor its reputation as a firm of tough financiers (sons of bitches and proud of it), by putting money in at the top of a deal. Second, Machinist would have to convince Alan Patricof, as technologically suspicious and maladroit as your average sixty-something-year-old who was rich enough never to have touched an appliance, to suddenly get the cyber faith and passion. Still, Patricof owned a significant chunk of our company, much of it gained at a $2 million valuation. Depending on how little they could put in at $65 million and how surely a mezz round could be completed at something more, they might be in a position to realize a paper profit of what looked like something close to thirty times their money.