S-1 Journal

The 10 Questions
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Every S-1, decoded through the same 10 questions.

It Sells Stock. But It Hands Over
Not a Millimeter of Control.

In April 2004, Google filed its S-1 with the SEC. Net revenue was $961.9 million, with a 36% operating margin and $105.6 million in net income. Revenue had grown roughly 11x in three years (it was $86M in 2001).

And yet Google’s S-1 carries a line no ordinary prospectus has: “Google is not a conventional company. We do not intend to become one.” It is the opening of a letter the two founders wrote to shareholders.

95% of revenue was advertising. You type words into a search box, and an ad appears beside them. That alone earned $961.9 million a year. The founders, Larry Page and Sergey Brin, were both Stanford CS PhD students. The company was six years old.

Even the IPO method was unconventional. Ignoring Wall Street custom, Google chose an auction process. What you see is a company run by two Stanford graduate students that declared, in its own prospectus, that it was “not a conventional company.”

Ten questions. We lay out only what the S-1 says.

Question 1

What is this company, really?

In one line: a company that organizes the world’s information and makes it accessible to everyone.

Google states its mission in a single sentence.

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To organize the world’s information and make it universally accessible and useful.

GOOGLE S-1 (APR 2004) — PROSPECTUS SUMMARY, OUR MISSION

What does it actually do? It is a search engine. A user types in keywords, and from an index of more than 4 billion web pages it returns the most relevant results.

What made Google’s search different was an algorithm called PageRank. It treats the link structure between web pages as “votes,” judging a page that is linked to by many other pages as “important.” It is the same principle as ranking academic papers by citation count.

By this point, Google had begun to be more than just a search company: Gmail (launched 2004), Google News, Froogle (product search), Google Print (book search). But 95% of revenue is advertising.

The diversity of its products, and the single-point concentration of its revenue. That contrast is what defines Google as a company.

Question 2

What does it compete on?

Google’s way of competing has three layers.

PageRank (search quality itself as the weapon)

On technology, Google describes itself as a search engine that indexes over 4 billion web pages and uses PageRank to return highly relevant results.

PageRank is the quality of the search results themselves. It is why users use Google, and why advertisers pay Google. The more the web grows, the more link-structure data accumulates, and the more accurate the ranking becomes. It is a network effect that grows stronger the more it is used.

AdWords (a mechanism for selling ads on a pay-per-click basis)

Traditional advertising was a business of “buying a slot.” Google is different. Advertisers bid on keywords, and are charged only when a user clicks (CPC: Cost Per Click).

This was a revolution. Advertisers pay only for the effect they can see. Google’s ad inventory grows as search volume grows. It is a structure that is rational for both sides.

By this point, many advertisers were using AdWords.

AdSense (turning third-party sites into “Google ad slots”)

AdSense (Google Network), which started in earnest in 2003, is a mechanism that serves Google ads on other companies’ websites and shares the revenue. From major portals to personal blogs, sites were folded into Google’s ad network.

Of the $961.9M in 2003 net revenue, $144.4M (15%) came through the Google Network. Search ads on Google’s own sites ($772.2M, 80%) are the main pillar.

Search volume grows ad inventory; partners extend reach. Everything reinforces everything else.

Question 3

How big is the market?

The S-1 gives no market-size number. What it describes is the structural shift that “advertising became measurable.”

Traditional television, newspaper, and magazine advertising made its effect hard to see. Google’s search ads charge only for the clicks a user makes. Advertisers can pay only for the effect they can see. This is the force that moves ad spending toward measurable online channels.

The S-1 frames this trend as “only just beginning.” Google itself already indexes more than 4 billion web pages and handles searches around the world in 97 languages. Even so, the message is that there is ample room for advertising to migrate online.

What the S-1 shows is not a market number but the trend itself: advertising moving online.

Question 4

Who actually uses it?

Google’s “customers” come in three kinds.

What stands out is the low customer concentration. No single advertiser ever exceeded 3% of revenue. A broadly diversified advertiser base. This means stability of revenue.

The Google Network includes a wide range of websites, from major portals to individual sites.

Hundreds of millions of people search; many advertise. Where many ad companies have their revenue held by a handful of large accounts, Google’s earnings spread thinly across countless small advertisers.

A diversification that depends on no single company — that is Google’s strength.

Question 5

How does it make money?

How Google makes money is astonishingly simple.

In short, 95% is advertising revenue. And almost all of that advertising is the CPC (pay-per-click) model. The advertiser is charged only at the moment a user clicks the ad.

For the Google Network (AdSense), Google books ad revenue net of the share it pays partner sites. The S-1 notes that, had these AdSense fees been booked gross instead, 2003 net revenues and costs would each have been $504M higher — so the reported net revenue of $961.9M already nets out what Google hands its partners.

The essence of how it earns is search volume × click-through rate × cost per click. Those three multiplied together were everything. A single click is worth only a few dozen cents — but it repeats hundreds of millions of times a day.

A few dozen cents per click × hundreds of millions of times a day — stacked up to $961.9M a year (net).

Question 6

Are the numbers healthy?

Let’s lay out the financial facts.

Revenue grew roughly 11x in three years. And it was not in the red.

What stands out is the 2003 operating margin of 36% (on a net basis). The main reason it fell from the prior year (54%) is stock-based compensation — the expense recorded for paying employees in stock. That expense ballooned more than tenfold, from $21.6M to $229.4M, jumping from 6.2% to 23.8% of net revenues. Still, a private company posting a 36% operating margin before going public is extremely rare. An ordinary IPO is a ritual for raising money while losing it. Google was different.

At the end of 2003 it held about $334.7M in cash and short-term investments.

Google was already a profitable company before its IPO. The purpose of the IPO was not “to survive” but “to bet even bigger.” For Google, the meaning of an IPO was fundamentally different from other companies.

The purpose of the IPO was not “to survive” but “to bet even bigger.”

Question 7

Who runs it?

Google was built by two Stanford graduate students.

Both came from Stanford’s CS PhD program. They incorporated Google in September 1998.

On the board sit the marquee partners of Silicon Valley’s two great VCs: John Doerr (Kleiner Perkins) and Michael Moritz (Sequoia Capital).

Two graduate students built a company with $961.9M in revenue in six years. That story is written into the S-1.

Larry Page (co-founder, President of Products)

Enrolled (on leave) in Stanford’s CS PhD program, with a Stanford CS master’s. A bachelor’s in computer engineering from the University of Michigan. PageRank was developed while he was at Stanford.

Sergey Brin (co-founder, President of Technology)

Enrolled (on leave) in Stanford’s CS PhD program, with a Stanford CS master’s. A bachelor’s in mathematics and computer science (with high honors) from the University of Maryland. He co-developed PageRank.

Eric Schmidt (Chairman of the Executive Committee & CEO)

Appointed CEO in 2001 at the request of Kleiner Perkins and Sequoia. Previously CEO of Novell and CTO of Sun Microsystems. His role is to be the “adult supervision” for Page and Brin.

A three-person leadership

A three-person leadership of “two founders + one professional manager” ran Google in 2004.

Two graduate students built a company with $961.9M in revenue in six years.

Question 8

Who controls it?

This is the most famous mechanism in Google’s S-1.

Here is the prototype of a structure that many tech companies — Facebook among them — later copied. One Class B share carries 10 times the votes of a Class A share.

Google sold stock. It took the money. But it handed over not a millimeter of control. This is the prototype of the “founder-controlled IPO” established in 2004.

Two founders + Schmidt hold significant influence through dual-class stock

About 40% of Class B (10 votes per share) is held by the trio of founders Larry and Sergey plus CEO Eric Schmidt, and officers and directors as a group hold about 65% (as of March 31, 2004). In the first S-1, the IPO share count was not yet set, so the voting-power ratio is left blank (___%), but the text states plainly that these three hold “significant influence” over the company’s decisions.

Even if their economic stake is limited, the core of the voting power rests with the Class B insiders. Larry, Sergey and Eric alone did not hold a majority, but across the founders, officers and directors as a whole, no matter how many ordinary shareholders gather, the structure cannot be overturned from outside.

The intent is declared in the Founders’ Letter

The founders’ letter placed at the front of the S-1 does not hide this structure. If anything, it declares it openly.

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New investors will fully share in Google’s long term growth but will have less influence over its strategic decisions than they would at most public companies.

GOOGLE S-1 (APR 2004) — FOUNDERS’ LETTER

It goes on to say: we drew on Berkshire Hathaway’s owner’s manual; with the same logic as Warren Buffett, we protect the company from short-term shareholder pressure.

Even the IPO method is unusual: an auction process

Google did not use the normal IPO process (investment banks allocating shares to institutional investors on a roadshow). It adopted an auction process, in which investors bid their desired price and number of shares, and everyone buys at the same single clearing price.

It is a clear message to Wall Street: “You don’t get to set the price. The market decides.”

It took the money. But it handed over not a millimeter of control.

Question 9

What is it afraid of?

Here are the five things Google itself says it worries about most.

Dependence on advertising

“We generate our revenue almost entirely from advertising, and the reduction in spending by or loss of advertisers could seriously harm our business.” 95% of revenue is advertising. If the ad market shrinks, Google shrinks.

The Microsoft threat

Google names Microsoft directly as a threat. “Microsoft has announced plans to develop a new web search technology.”

As of 2004, Microsoft had publicly disclosed development of its own search engine. An opponent with overwhelmingly greater financial firepower was preparing to enter Google’s core market.

Click fraud

“We are exposed to the risk of fraudulent clicks on our ads.”

It is the act of competitors or bots meaninglessly clicking ads to waste advertisers’ budgets. If it spreads, advertisers will leave Google.

Dependence on key personnel

“If we were to lose the services of Eric, Larry, Sergey or our senior management team, we may not be able to execute our business strategy.”

If even one of the three left, the company’s direction would waver.

Regulation and privacy

“People have raised privacy concerns relating to the ability of our recently announced Gmail email service to match relevant ads to the content of email messages.”

The S-1 also discloses that data protection laws in Europe and elsewhere are still uncertain and in flux, and that if they are applied in a way that conflicts with Google’s data practices, the company could face fines and be ordered to change those practices. Privacy concerns and government regulation are risks that touch the foundation of the advertising model.

A single ad leg, Microsoft’s entry, click fraud, dependence on three people, and regulation — five fears.

Question 10

What becomes of the money it raises?

Note: This analysis draws only on the facts in the S-1. The final IPO price, the listing date, post-listing share performance and trading demand are not in the filing and fall outside its scope.

Here is the IPO plan as written in the prospectus.

Here is what the reader should notice. Google was a company that would not die without IPO money. It was already profitable in 2003, and held $334.7M in cash.

A declaration that it will not give quarterly guidance

Google writes directly a policy that is unusual for a company on the eve of an IPO.

“

We do not plan to give earnings guidance in the traditional sense.

GOOGLE S-1 (APR 2004) — FOUNDERS’ LETTER

It is a declaration that, even after listing, it will not yield to Wall Street’s short-term pressure.

An IPO to bet even bigger

The use of proceeds is “general corporate purposes,” “capital expenditures,” and “potential acquisitions” — all written to leave broad discretion.

Google went public as “a company that was already profitable, going public to bet even bigger.” The freedom in its use of proceeds and the declaration against quarterly guidance tell that intent.

It went public as “a company that was already profitable, going public to bet even bigger.”

In closing

Beyond the ten questions

What Google sells is not only a “search engine that organizes the world’s information.” At the time of its S-1 it had $961.9M in net revenue, roughly 11x growth in three years, a 36% operating margin, and profitability before listing. Its advertisers were many, with no single one above 3%, and PageRank, AdWords, and AdSense formed a self-reinforcing loop — it went public with an already-finished business in hand.

But at the front of that S-1 sits the founders’ letter, declaring “Google is not a conventional company.” Through dual-class stock of 10 votes per Class B share, the two founders plus Schmidt hold significant influence, and control rests with the insiders as a whole; even the IPO method rejects Wall Street custom with an auction process; and it declares it will give no quarterly guidance. “We take the money. But we hand over not a millimeter of control” — it wrote that openly, in the prospectus.

95% of revenue depends on advertising, and it discloses, in its own Risk Factors, the entry of Microsoft, click fraud, and dependence on the three key people. It is the moment two Stanford graduate students, citing Berkshire Hathaway’s owner’s manual, created the prototype of the founder-controlled IPO.

The prospectus writes that it will “organize the world’s information and make it accessible to everyone.” The market expects “the biggest winner of the online advertising revolution.” At the intersection of the two, Google sells stock. It is the moment two Stanford CS graduate students go public while rejecting Wall Street custom.

Source: All facts are drawn from Google Inc.’s S-1 (accession 0001193125-04-073639, filed 2004-04-29), together with the company’s IPO roadshow presentation and factsheet where noted.