Betting on the House: Five Issues that House Judiciary Should Investigate Against Google–End Supervoting Shares for Publicly Traded Companies

The House Judiciary Committee announced yesterday that it was opening an antitrust investigation into “tech giants” including Google.  Chairman Jerry Nadler said:

[T]here is growing evidence that a handful of gatekeepers have come to capture control over key arteries of online commerce, content, and communications…Given the growing tide of concentration and consolidation across our economy, it is vital that we investigate the current state of competition in digital markets and the health of the antitrust laws.

We’re going to look at five issues Chairman Nadler should consider that relate both to Google and to some others, too.  Let’s start with reforming corporate governance and bring eyesight to the willfully blind.

1.   One Share, One Vote, Not Ten:  Anyone in the music business has had just about enough of government oversight, so I don’t recommend it as a solution in general.  But–in the absence of marketplace transparency, the government is about the only place to go to bring reforms to well-heeled corporations.  So rather than ask the government to fix specific problems on an ad hoc basis, the government would do well to ask what causes the market to fail as it clearly has with Google.

The first question to ask is where was the board?  In Google’s case, the core problem is both easy to find and easy to fix.  It lies in the voting structure of the shareholders.  Shareholder rights and corporate charters are state law matters and don’t relate to the federal government, but–the federal government does have a say about who gets to sell shares to the public and has an interest in protecting the shareholders of publicly traded corporations.  It is this nexus that gives the House Judiciary Committee clear oversight authority over the corporate structure of publicly traded corporations.

While anti-coup d’etat provisions might make sense for private companies whose investors are sophisticated financiers, or newspapers seeking to retain editorial independence, once that company is publicly traded a bald discrepancy that simply mandates voting power to the insiders forever seems like it has to go.  And as we have seen with Google, the lack of corporate oversight has resulted in unbelievable arrogance and a complete failure of corporate responsibility.  And worse yet, because Google got away with it, lots of other tech companies follow essentially the same model (including Facebook, Spotify and Linkedin).

It must also be said that stock buybacks approved by a board where insiders who benefit from the buyback have supervoting shares and control the board is a practice that reeks to high heaven.  Buybacks and dual class supervoting shares have been widely criticized including by Securities and Exchange Commission Commissioner Robert Jackson who is also a critic of supervoting shares.

So how did this happen to Google?  The supervoting structure started when Google was a private company as a way for the founders to preserve control and avoid venture capital investors pushing them around.  OK, fine, I understand that.

Google (which is really its parent company, Alphabet) trades under two ticker symbols on the  NASDAQ: GOOGL Class A and GOOG Class C.

Oops.  What happened to Class B?  Ay, there’s the rub.

Class B shares are not publicly traded and are held by insiders only.  But as you will see, they control every aspect of the company.  So why would Google’s insiders want this share structure?  There’s actually a simple answer.  Class A shares (GOOGL) get one vote per share, Class B shares get 10 votes per share and Class C shares (GOOG) get no votes.

That’s right–Class B shares cannot be purchased and their holders get 10 times the voting power of the Class A holders, often called “supervoting” shares, because their super power is…well…voting.

The Class C shares were created as part of a 1:1 stock split that doubled the number of shares, halted the price per share, but resulted in no change of the voting power of the Class A and C shareholders.

When the dust settled, the Google/Alphabet voting capitalization table looked something like this:

Class A: 298 million shares and 298 million votes, or roughly 40% of the voting power with votes counting 1:1.

Class B: 47 million shares and 470 million votes, or roughly 60% of the voting power with votes counting 10:1.

What this also means is that the holders of Class B shares voting as a bloc will never–and I mean never–be outvoted at a shareholder meeting, their board of directors will never be challenged much less replaced and shareholder meetings are a sham.

Who controls the Class B shares?  The people that Commissioner Jackson might call the “corporate royalty“:

Larry Page: 20 million shares (as of 2017)

Sergey Brin: 35,300 Class B shares plus 35,300 Class A shares (as of 2018)

Eric Schmidt: 1.19 million Class B shares, 40,934 Class A shares, and 10,983 Class A Google shares, plus 2.91 million Class B shares through family trusts.

Sundar Pichai: 6,317 Class A shares and no Class B shares.

The House Judiciary Committee has a chance to correct the supervoting system as bad policy and implement a long-term fix across the board for all dual-class companies that want to trade on the public exchanges.

 

 

The Elusive Obelus: Streaming’s Problem With Denominators

“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually and then suddenly.”

Ernest Hemingway, The Sun Also Rises.

No matter how much people would like to deflect it, the unvarnished per stream rate is an ever diminishing income stream.  Given the number of calculations involved for both sound recording and song, it is likely that the total end-to-end cost of rendering the accountings for the streams costs more than the royalty earned on that stream by any one royalty participant.  Solving this problem is the difference between a short-term stock-fueled sugar high and a long-term return of shareholder value for all concerned.  So now what?

If you’re someone who receives or calculates streaming royalties, you’re already familiar with the  problem of the ever-decreasing per-stream rate.  The Trichordist’s definitive “Streaming Price Bible” for 2018 confirms this trend yet again, but simple math explains the problem of the revenue share allocation.

Remember that the way streaming royalties are calculated in voluntary agreements (aka “direct deals”) revolves around a simple formula (Formula A):

(Payable Revenue ÷ Total Service Streams) x Your Streams = Per Stream Rate

Which may also be expressed as Formula B:

Payable Revenue x (Your Streams ÷ Total Service Streams) = Your share of revenue

(Formula A and B are also known as “the big pool” in the user-centric or Ethical Pool models.)

Here’s the trick–it’s in the correlation of the rate of increase over time of the numerator and the denominator.  If you focus on any single calculation you won’t see the problem.  You have to calculate the rate of change over time.  Simply put, if the numerator in either Formula A or Formula B increases at a lower rate than the denominator, then the quotient, or the result of the division, will always decline as long as those conditions are met.  That’s why the Streaming Price Bible shows a declining per-stream rate–a contrarian fact among the hoorah from streaming boosters that sticks in the craw.

Services make these accounting calculations monthly for the most part, and they are calculated a bit differently depending on the service.  This is why the Streaming Price Bible has different rates for different services, rates that vary depending on the terms of the contract and also the amount of “Payable Revenue” that the service attributes to the particular sound recordings.

The quotient will also vary depending on the copyright owner’s deal.  If you add downside protection elements such as contractual per stream or per subscriber minimums, then you can cushion the decline.

This is also true of non-recoupable payments (such as direct payments that are deemed to be recoupable but not returnable, or “breakage”).  Nonrecoupable payments are just another form of nominal royalty payable to the copyright owner, and increase the overall payout.  And of course, the biggest nonrecoupable payment is stock which sometimes pays off as we saw with Spotify.  These payments may or may not be shared with the artist.  (See the WIN Fair Digital Deals Pledge.)

So each of the elements of both Formula A and Formula B are a function of other calculations. We’re not going to dive into those other elements too deeply in this post–but we will note that there are some different elements to the formulas depending on the bargaining power of the rights owner, in this case the owner of sound recordings.

So how is it that the per-stream rate declines over time in the Streaming Price Bible?

Putting the Demon in the Denominator

Back to Formula B, you’ll note that the function “Your Streams ÷ Total Service Streams” looks a lot like a market share allocation.  In fact, if the relevant market is limited to the service calculating the revenue share allocation, it is a market share allocation of service revenue by another name.  When you consider that the customary method of calculating streaming royalties across all services is a similar version of Formula B, it may as well be an allocation of the total market on a market share basis.

Note that this is very different from setting a wholesale price for your goods that implies a retail price.  A wholesale price is a function of what you think a consumer would or should pay.  When a service agrees to a minimum per stream or per subscriber rate, they are essentially accepting a price term that behaves like a wholesale price.

For most artists and indie labels, the price is set by your market share of the subscription fees or ad rates that the service thinks the market will bear based on the service’s business goalsnot based on your pricing decision.

Why is this important?  A cynic might say it’s because Internet companies are in the free lunch crowd–they would give everything away for free since their inflated salaries and sky-high rents are paid by venture capitalists who don’t understand a thing about breaking artists and investing in talent.  You know, the kind of people who would give Daniel Ek a million dollar bonus when he hadn’t met his performance targets, stiffed songwriters for years and gotten the company embroiled in multimillion dollar lawsuits.  But had met the only performance target that mattered which was to put some cosmetics on that porker and push it out the door into a public stock offering.  (SPOT F-1 at p. 133: “In February 2018, our board of directors determined to pay Mr. Ek the full $1,000,000 bonus based on the Company’s 2017 performance though certain performance goals were not achieved…”)

But long-term, it’s important because one way that royalties will rise is if the service can only acquire its only product at a higher price.  Or not.  The other way that royalties will rise is if services are required to pay a per-stream rate that is higher than the revenue share rate.  How that increase is passed to the consumer is up to them.  Maybe a move from World Trade Center to Poughkeepsie would help.

The Streaming Price Bible is based on revenue for an indie label that did not have the massive hits we see on Spotify.  In this sense, it is the unvarnished reality of streaming without the negotiated downside protection goodies, unrecoupable or nonreturnable payments, and of course shares of stock.  While some may say the Bible lacks hits, that’s kind of the point–hits mask a thousand sins.  Ask any label accountant.

Will Consumption Eat Your Free Lunch?

Let’s say again: The simple explanation for the longitudinal decline of streaming royalties measured by the Streaming Price Bible is that the rate of change across accounting periods in the “Payable Revenue” must be greater than the rate of change in the total number of streams in order for the per-stream rate to increase–otherwise the per-stream rate will always decrease.  Another way to think of it is that revenue has to increase faster than consumption, or consumption will eat your lunch.

What if you left the formula the same and just increased the revenue being allocated?  Services will probably resist that move.  After all, when artists complain about their per-stream rate, the services often answer that the problem is not with them, it is with the artist’s labels because the services pay hundreds of millions to the labels.

We don’t really have much meaningful control over what goes in the monthly payable revenue number (i.e., the mathematical “dividend” or numerator).  What kinds of revenue should be included?  Here are a few:

–all advertising revenue from all sources
–e-commerce transactions
–bounties or referral fees, including  recoupable or non-refundable guarantees
–sponsorships
–subscription income
–traffic or tariff charges paid by telcos
–revenue from the sale of data

Services will typically deduct “small off the tops” which would include
–VAT or sales tax
–ad commissions paid to unaffiliated third parties (usually subject to a cap)

Indie labels and independent artists may not have the leverage to negotiate some of these revenue elements such as revenue from the sale of data for starters.  Other elements of the revenue calculation for indie labels and artists will also likely not include the downside protections, subscriber target top up fees and the like.

And of course the biggest difference is that indie labels (at least not in the Merlin group who may) typically do not get nonreturnable advances,  nonrecoupable payments, or stock.

Is That All There Is?

Why should we care about all this?  There is a story that is told of negotiations to settle a lawsuit against a well-known pirate site.  One of the venture capitalists backing the pirates told one of the label negotiators that he could make them all richer through an IPO than any settlement they’d ever be able to negotiate.

The label executive asked, lets’ say we did that, but then what happens?  You say we should adapt, but you’re still destroying the industry ecosystem so that there’s nothing left to adapt to.  The most we could make from an IPO would cover our turnover for a year at best.  And we would be dependent on your success, not our artists’ success.

Then what?

 

 

 

 

 

@alibhamed: Pre-Seed Investing is Not About Check Size

[Interesting post by Ali Hamed about the goals of a pre-seed investment round]

Pre-Seed Investing, in my view, should not be defined by check size. I think a lot of people are tempted to describe a pre-seed investment as a “sub $1M investment,” or a ~$500k investment. And while directionally correct, or associated with seed rounds, likely isn’t their definition.

To me, a pre-seed round is a round of capital used for proving whether or not a product can be valuable to a customer.

One thing that has always bothered me is when seed investors, or pre-seed investors ask super cookie-cutter questions, like:

  • What is your monthly revenue?
  • What is your MoM growth?

To many investors, these are almost formulaic questions that define if they will take a meeting or not.

Read the post on Medium