Steve Raymond’s weblog

Finance 101: Defending Corporate Harakiri

The intellectual output coming from Peter Strauss‘s cabana is truly impressive.  It must be the water.  In Jonathan’s latest post (with graphs!) he makes a compelling argument that introduces the “Piracy gap” that exists between a passive/defensive online content strategy and an online aggressive strategy.   The theory clearly illustrates what happens in the space between trying to lock your content down and embracing the future in which all content is ubiquitously indexed and freely available.  I would tweak the graph slightly (see below) to account for Ian Rogers’ attention scarcity theory so the gap becomes defined by both piracy and people moving to the next most marginally valuable piece of content on the infinite playlist that is the internet.  I.E. if you make your content a pain in the ass to use people will either steal it or consume something else.  Which makes Jonathan’s point even more salient (piracy is better than no eyeballs at all!).

Jonathan’s excellent post does however repeat a somewhat faulty point of view that is shared in countless articles, blog posts, and music industry forums about the state of the music industry and just how wrong the labels got it.  It is *not* true that investors value the long term survival of the company over short term profits.  They actually value the net present value of all future cash flows – classical Finance 101 is about trying to predict what those cash flows might be and correctly assign a present value to them in order to make investment and management decisions.  So as the CEO of a company (both public or private) you have a fiduciary duty to your shareholders to try to maximize that number within the constraints of myriad other variables.  I find that critics often make this mistake when breaking down the recent history of the music industry.  Put another way:

Sometimes the most profitable/ethical course for a business is one that sets it on a path to obsolescence.

One of the best 5 or 6 classes I took at Anderson was a Business Ethics course given by Bill Cockrum (a legendary finance/entrepreneurship professor at UCLA).  The framework he taught for ethical problem solving was essentially one in which we identified all of the stakeholders for a given issue and detailed the outcome from each point of view.  So a hypothetical problem involving gender equality in the workplace would be looked at from many points of view:  shareholders, male employees, female employees, residents of the local community, etc…  Interestingly, one common theme that came from our casework is that managers often incorrectly overvalue a company’s survival at the expense of creating shareholder value.  Most executives try not to work themselves out of a job.

To oversimplify, consider a case in which a CEO has to choose whether or not to create a new product that will require expensive-to-the point- of-bankruptcy new R&D and marketing.  All of his analysis tells him that the product’s probability of success is a binary coin flip:  50% of the time it will be incredibly profitable and increase earnings 5X, 50% of the time it will put the company out of business.  Given those odds the right answer from the shareholders perspective is to green light the product – they’d gladly flip a coin to risk $1 to make $5.  But from management’s point of view its not such an easy decision.  Heads I get some kudos and maybe a bonus, tails I lose my job in disgrace.  This ethical problem is pretty much why companies like to compensate their executives with stock and stock options, and also why big companies are typically not good at taking risks (its one thing to bankrupt a startup with a few dozen employees, quite another a big public company with 100o’s of employees).

Now lets take a look at what happened in the music industry.  Say you could wind back the clock to the Napster era in 1998 and provide the heads of the labels with perfect clarity about their probability weighted expected returns for 3 courses of action.

  1. Lock It Down and Sue Your Customers:  If you follow this strategy, you slow down the death of your existing CD sales line of business to the greatest extent, but you alienate your customers and allow smaller nimbler players to take all of the future online profits, putting you out of business in 10 years.
  2. Hybrid: You drag your heels somewhat, slowing down the rate of cannibalism of the CD sales business and developing alternate forms of business that allow you to fumble your way into an evolved but less profitable business model in 10 years time.
  3. Open It Up and Survive:  You clearly embrace a customer-centric view of the future, and rapidly develop long-term winning strategies for content consumption that hasten the demise of your existing business but put you on a long term path to sustained profitability.

Now lets calculate the net present value (discount rate=10%) of your hypothetical expected cash flows.

Clearly, given this spectrum of expected returns, the best course of action is the one in which you drag your heels into planned obsolecence.

NOTE: I’M NOT SAYING THAT THIS IS WHAT DID HAPPEN OR WHAT SHOULD HAVE HAPPENED!! IT’S AN OVERSIMPLIFICATION.  The labels did not act rationally in possession of omniscient foresight, just as the other media companies actions wrt Boxee etc. are not likely profit maximizing.

In most cases profits are maximized by reinvesting profits from cash cows into evolved business models that strike a balance.  The intended take-away is that in the case of killing highly profitable cash cows, its incorrect to argue that all decision making should be predicated on long term viability as a business.  Sometimes the most profitable (and correct) course kills you.

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  • http://jonathanhstrauss.com jonathanhstrauss

    Glad you enjoyed my post, and I like your addition to the graph. I totally agree with you that abandonment of the content altogether is even worse than piracy. But, I was trying to minimize complexity in an already dense essay.

    The one correction (or rather clarification) I offer is that I am *not* one of those people who believe there is inherent value (let alone shareholder value) in the long-term survival of a given company. When I said: “But, that’s ok because they value the long-term survival of the company over short-term profits. Right?”, I guess I should have used the old <sarcasm> tag.

    That's why I start my conclusion with: “If I were the head of a studio, I would stop trying to figure out how to grow the buggy whip business by keeping down the automobile. I would also recognize that transforming my profitable if shrinking buggy whip business into a money-losing automobile business making it up in volume is probably not in the best economic interest of my shareholders.” I then go on to recommend an option that you don't have in your list of 3 above:
    4. Manage your own company out of business profitably (by downsizing along with your market) and pass all the earnings directly back to your shareholders. Let them choose if they want to get into the new version of the business and the best horse that is bred for that version to bet on.

  • http://jonathanhstrauss.com jonathanhstrauss

    Glad you enjoyed my post, and I like your addition to the graph. I totally agree with you that abandonment of the content altogether is even worse than piracy. But, I was trying to minimize complexity in an already dense essay.

    The one correction (or rather clarification) I offer is that I am *not* one of those people who believe there is inherent value (let alone shareholder value) in the long-term survival of a given company. When I said: “But, that’s ok because they value the long-term survival of the company over short-term profits. Right?”, I guess I should have used the old <sarcasm> tag.

    That's why I start my conclusion with: “If I were the head of a studio, I would stop trying to figure out how to grow the buggy whip business by keeping down the automobile. I would also recognize that transforming my profitable if shrinking buggy whip business into a money-losing automobile business making it up in volume is probably not in the best economic interest of my shareholders.” I then go on to recommend an option that you don't have in your list of 3 above (it's actually just a variation on your 1.):

    1a. Manage your own company out of business profitably (by downsizing along with your market) and pass all the earnings directly back to your shareholders. Let them choose if they want to get into the new version of the business and the best horse that is bred for that version to bet on.