Employee Stock Options: Powerful Tools When Used for Good

Two recent articles prompted me to write a short note concerning employee stock option plans, specifically addressing: (1) the appropriate use of employee stock options; (2) certain misconceptions that have arisen due to the recent options backdating scandal and other historical abuses of stock option plans, and; (3) the SEC's recent adoption of a rule governing how option costs should be presented in proxy materials.

In today's Wall Street Journal
Bosses' Pay: How Stock Options Became Part of the Problem

In today's New York Times
S.E.C. Changes Reporting Rule on Bosses' Pay

It's almost as if the editors of these two esteemed publications went bowling, with the WSJ and NYT coming out with different but related stories on the issue. This is a very difficult topic to be sure, cutting across disciplines such as behavioral psychology,  compensation design, financial engineering, and accounting and taxation, to name a few. We should, however, keep our eye on the goal: the recruitment, retention, motivation and compensation of employees in order to create maximum value for the firm's shareholders, after taking into account the costs of delivering these plans. And it is this "net value" concept that is critical to the determination of appropriate plan structure and quantity of options granted, and should be viewed as a guiding principle to ensure analytical rigor and discipline when designing these programs.

Appropriate Use of Options

So what are the objectives achieved through the use of employee stock options? (1) Recruitment, (2) retention, (3) motivation and (4) reward, right? So why not just use cash? Well, what about the companies that don't have a lot of cash but have attractive growth opportunities? Ok, I guess this is why start-ups have long used options as a compensation tool. But what about companies that have the cash required to accomplish these objectives? Maybe the favorable tax treatment of options versus cash? Certainly. Possibly the clear alignment of motives between a company's share price performance and an employees' compensation? I'd say. Perhaps the more favorable accounting treatment of options versus cash? Unfortunately, yes. Now these are pretty good reasons (with the exception of accounting treatment, which is a real problem), though many will argue that a given employee, unless they are a high-level executive, has little to no impact on a companys' share price.

But is rewarding a direct impact on stock price really the point? Or does granting options at all levels of an organization create an esprit de corps, a sense of ownership and pride that really does positively impact performance notwithstanding the weak relationship between payoff and effort? I personally think it does have a positive effect on performance, even at lower levels of an organization, with one notable exception: when share price performance sucks. And this impacts employees at all levels, from C-level executives to entry level worker bees. A falling stock price  literally transforms an option plan into a karma boomerang, turning what was once a beautiful landscape into an ugly hell hole. And this, to me, is the single biggest weakness of option plans versus, say, restricted stock grants. Sure, the value of your stake goes down if you hold stock and stock price drops, but you've at least got something. With options, in the absence of an ability to monetize time value (which Google has just started to do with its employees), you've got nothing. And instead of fostering motivation and teamwork it creates a depressing, divisive work environment. Clearly not the goal, right? We've seen this story play out across the technology landscape in the wake of the 2001 downdraft, crushing companies like Microsoft in the process.

So what is the answer? Without question, options are both a powerful and necessary tool for achieving the four key objectives listed above for small, rapidly growing companies. This is clear. So what about larger, more established companies? If a company is large but still growing rapidly, options will continue to be a tool of choice because of (1) tax efficiency, (2) alignment of motives and (3) creating a "we're all in this together" culture. Like Google. And this makes sense. But what about the Microsofts of the world, or the Proctor & Gambles for that matter? I'd say some options should be a component of a senior executives compensation package, along with cash and restricted stock, but that options should likely not go too far down the hierarchy as they will not be valued anywhere near their theoretical value and, as such, will only serve to dilute existing shareholders without getting the motivational benefits promised. Principally cash with some restricted stock is likely best for people at lower levels of these companies, in my opinion. And to focus on the tax efficiency angle (or the accounting treatment, for that matter) without thinking about how this particular piece of compensation will be valued by employees would be a grave, grave error. So while I am not a compensation expert, based upon my observations of which option plans have worked, and which have not, I offer you my $0.02.

Popular Misconceptions

There has been a tremendous amount of noise around stock options for a long, long time, and this was very well outlined in the WSJ story. Clearly the volume has recently been turned up due to both the option backdating scandal and the magnitude of options granted guys like Bill McGuire of UnitedHealthcare. And this makes sense. Boards of Directors have done some tremendously stupid, irresponsible, un-shareholder friendly things related to options over the past two decades. And this, to me, is where the problem really lies. Should senior executives of successful companies be highly compensated? Yes. What defines success? Long-term share price outperformance relative to peers (though short-term performance matters as well, just not as much). Should senior executives get sickly rich by running a company in the wake of a massive bull market? Not unless they are outperforming their peers.

I kind of think of a payoff grid akin to GE's grid for employee assessment. Let's say in our case the x-axis is time horizon - short-term, intermediate-term and long-term. And the y-axis is relative stock price performance - outperformance, median performance and underperformance. As a Board member, I would want to develop a plan rewarding senior executives that was skewed towards long-term outperformance, but also gave credit for short-term outperformance. So, at the end of the day, if an executive team could achieve both short- and long-term outperformance, they would max out on their bonus compensation. However, if they missed on short-term outperformance (say due to heavy capital investments necessary to attain long-term goals) but scored on long-term outperformance, then they would capture the lion's share of the potential bonus payout. Conversely, if the team scored on short-term outperformance but whiffed on long-term outperformance, they would only get a fraction of the possible bonus payout. And these bonus payouts could be a mixture of cash, restricted stock and outperformance options (where a base-line value is created for the peer group, and serves as the benchmark against which company share price performance is compared). Again, I am certainly not that knowledgeable in this area, but this seems like a straight-forward, commonsense construct that should be workable from both management motivation and shareholder value perspectives. In other words, the alignment of motives that matters - management and shareholders. BUT IT IS UP TO THE BOARD TO MAKE THIS HAPPEN.

So the punch line is, at the end of the day there has been a lot of bad stuff that has gone on with employee stock option plans. But I trace much of the problem back to Boards of Directors. Sure, you can blame the Congressional restriction on tax deductions for executive pay beyond $1 million, aggressive compensation consultants and lots of other parties for why things spun out of control. But at the core the fiduciary responsibility resides with the Compensation Committee of the Board - and, in general, they have failed miserably. So let's not throw the baby out with the bath water - options, used prudently, are extremely powerful tools for compensating and motivating employees. But when misused they can be virtual WMDs for shareholders.

The SEC

Chris Cox, et al just enacted a rule governing how stock option expense should be presented to investors. They backed off a July ruling that would have showed 100% of the value of a current grant in current years compensation in the summary table, instead opting for a rule that amortizes the value between grant date and vesting date. This creates symmetry with stock option accounting under FAS 123R. Consistency is good. The problem is the asymmetry between, say, a cash bonus, a restricted stock grant and a stock option grant that all have the same value (with the option value measured using Black-Scholes, a binomial model, whatever), though only a fraction of the stock option grant's value is reflected in the current year. This is a very hard problem to reconcile. I am happy at least that some measure of stock option expense is running through the income statement, and that investors will have all the information at their disposal to adjust their models for option expenses how they see fit. As has been the case, I'm pretty happy with how Mr. Cox has handled the issue. Enough about the SEC - let's move on.

The Punch Line

I am sick of the stock option echo chamber. I just wanted to get some common sense thoughts down that hopefully brings down to earth some of the issues thrown around by those with agendas, be they in corporations, lobbying groups, regulatory bodies or politics. Stock options are good. They are. It's just that Boards have to step up and do their jobs. Or step off. Now.

I Guess There is Always a First Time...

...for doing something seriously goofy. Not that this is my first time - only that there is a first time for everyone. Some of you may be aware of this game of cyber tag that is going on (you know, the one where if you are tagged you need to post five things about yourself that most people don't know and then torment five other people by tagging them). I was tagged by Kris Tuttle, who felt it was his sacred responsibility to indoctrinate me into the world of web-geekdom. Thanks Kris - I'll get you later. Though I have never capitulated to the seduction of a chain letter-type thing before, I figure why not? I'm all for more interesting content on the internet. I'm just sorry that this won't fall into that category.

So, five things you wouldn't necessarily know about me. Hmmm.

1. When I was 10 years old I was a really good bowler. So good, in fact, that I was on TV in Rochester, NY. Twice. I even held the high score in my age group for ten weeks, after which I was crowned "King of the Hill" and got a really big trophy. Why am I telling you this? This is really embarrassing. And too bad I suck today.

2. When I was 12 years old I felt I needed to prove my toughness to my bad-ass neighborhood peers (the "local ne'er do wells," as my father called them). My choice of proof? Jumping off a train trestle in Pittsford, NY, into the Erie Canal. I did it and I was fine. And in the process I proved myself - as a complete and utter moron.

3. When I was at the University of Michigan I was in the Honors Program in the liberal arts college. After two years you need to declare an Honors Major, write a thesis proposal, get it accepted, and then write the Honors thesis to get your Honors degree. My preferred path - transfer after Sophomore year to the Business School. Why? Because I was such a lazy-ass student intent on, well, partying, that I knew writing a thesis would be pure torture but that B-school would be easy for me. Minimum effort, maximum return. My parents were extremely po'ed at my chucking a liberal arts education for my last two years, but who could stand in the way of my sacred mission? Nobody.

4. The most satisfying bonus check I ever got was in 1995, my first year as a lead transactor in derivatives at Citibank. Though I literally got annual bonus checks about 40x higher for several years in the 2000s, I was never as proud of my accomplishments as I was that year. Covering my own accounts, having ultimate responsibility, needing to assess client requirements, designing complex strategies, presenting and marketing the ideas and closing the transactions - it was so intoxicating. And I was good at it. And the magnitude of the check was, at that time, so much money to me and seemed so fair in light of the value I created I could hardly believe it. Until my current role, I was never so happy in work as I was at that time in my career (though my derivatives teams at Deutsche Bank came pretty close).

5. My favorite class at Columbia Business School was a seminar in Quality Management tought by a TQM rock star, Peter Kolesar, with guest lectures by none other than Mr. Quality himself, W. Edwards Deming. I was fortunate to hear Dr. Deming lecture just months before he died. During Professor Kolesar's class we had to write a term paper, and I chose to write mine on the process for selecting a copier vendor at my previous employer, Citibank. Needless to say, their process sucked, but that isn't the point. I used the principles gleaned from Dr. Deming's writings and his legendary book Out of the Crisis to analyze and represent the facts, and what resulted was one of the better pieces of work I had ever produced. I learned so much from Dr. Kolesar as well, which included a consulting project I did for Ciba-Geigy. Very, very formative stuff.

I know by now that you probably think I am a bowling shoe-wearing, trestle-jumping, partying, derivatives and TQM freak. And that is ok. Because I am.

So the five whom I now choose to torment and challenge to bear their souls are:

Howard Lindzon (my friend Mr. Wallstrip), Marc Cenedella (writer of Stone and of theLadders.com fame), Bill Rempel (a.k.a NO DooDahs and my favorite anarchist blogger) Mike Seneadeza (Trader Mike and also a dude) and Jeff Stewart (writer of Applied Disruption, my business partner and a guy who should have five interesting things to share). Sorry dudes. Blow it off if you must. But at least I've done my part.

Hedge Fund Convergence: Strategy versus Structure

Strategy convergence across asset management firms in general and hedge funds in particular is one of the most important and defining trends of the past year. This was most recently highlighted by DE Shaw's increased investment in building a true private equity operation within the $23 billion hedge fund behemoth. And it is, without question, a trend that will continue for the forseeable future. Given its potential for substantially re-shaping the asset management landscape, I have written about several issues either impacting or impacted by the convergence phenomenon over the past six months:

1. 12/07/06 - A Tougher Gate at DE Shaw: Investor Protection vs. Opportunism
2. 09/15/06 - Fortress Going Public? The Writing's On The Wall
3. 08/14/06 - Hedge Funds as Asset Management Complexes - The Day Has Come
4. 08/04/06 - Side Pockets - Use or Abuse?
5. 08/01/06 - Convergence Redux
6. 07/21/06 - Broadening the Multi-Strategy Mandate - Where do Hedge Funds end and Private Equity Funds begin?

Gating restrictions, strategy diversification, institutionalization, side pockets, blurring of the lines between hedge funds and private equity are just a subset of the issues arising from this transformation. To be clear, this is a very complicated, multi-faceted topic. And I'd like to introduce a new, yet critical distinction to the discussion: strategy convergence vs. structural convergence. While strategy convergence is clearly taking place, structural convergence appears to be lagging behind, with serious implications for investors.

For purposes of this post, let me define these terms as follows:

Strategy convergence - hedge funds investing in progressively less liquid assets with private equity firms investing in progressively more liquid assets, leading to a blurring of the historical distinctions between hedge fund and private equity investing

Structural convergence - hedge funds and private equity firms investing in a similar array of assets, with incentive fee/lock-up/redemption characteristics based upon the nature and liquidity of the assets being managed, i.e., quarterly payment of incentive fees on liquid pools and realization-based payment of incentive fees on illiquid pools

The bottom line is - strategy and structure are different, and is something that will need to be reconciled as convergence continues to take root. I believe it is knowledge of this disparity - in structure, in compensation, in liquidity, in culture -  that pushed Jeff Larson's Sowood to separate its private equity activities from its (conventional) hedge fund activities. Why? Because there are very good reasons for why hedge fund and private equity structures have evolved they way they have, and are largely centered around the nature, liquidity and investment horizon of assets in the portfolio. And this distinction has been known for quite some time, probably most commonly manifested through the use of side pockets by hedge funds for certain illiquid investments (which are separated from the more liquid, main fund).

But if hedge fund and private equity assets are commingled in order that structure becomes blurred, it is not hard to imagine how the deck eventually becomes stacked in favor of the hedge fund manager. Why? Because hedge fund managers generally receive quarterly incentive-fee payments versus private equity managers receipt of realization-based incentive fee payments, regardless of the characteristics of the assets in their portfolio. And why is this? Let's first explore the natures of the key risks facing both hedge fund and private equity managers, and then figure out the impact of convergence on these risks. Three of the principal risks facing investors in hedge funds and private equity funds are liquidity risk, timing risk and redemption risk.

Liquidity risk: In conventional hedge fund investing, much of a portfolio could be converted to cash without much trouble. Assets are marketable, there are buyers, sellers and observable prices, and, if need be, can be sold and distributed to investors. This is clearly not the situation with private equity investing. Therefore, all things being equal, would an investor prefer a dollar of returns from a portfolio of assets readily convertible to cash or a portfolio of assets with highly uncertain realizable values? It stands to reason that an investor would place greater value on returns generated from a portfolio with substantially less liquidity risk, arguing for more regular and even potentially higher hedge fund incentive payouts than private equity incentive payouts.

Timing risk: An issue somewhat related to liquidity risk, but different still. Even if one holds a portfolio of liquid assets but chooses to hold on to them for a long time, risk is higher than if one were able to monetize the portfolio more rapidly. It just happens to be that private equity investors, in general, don't have this choice. They can hold onto investments for years on end, by necessity. Conventional hedge fund investors, conversely, have far shorter investment horizons and, therefore, less timing risk. If you think about it, the ultimate investment strategy would be a super high frequency statistical arbitrage program that exploited a broad array of price anomalies across liquid markets thousands of times each day, and ended up net flat at the end of trading (meaning no overnight exposure). This is a strategy that requires little capital, possesses almost zero liquidity risk and almost zero timing risk - in essence, a cash machine. I've known some guys that have done this on relatively small amounts before getting squeezed by other market participants, and it is a beautiful thing. But this isn't reality. Fact is, conventional hedge fund investing has vastly less (though clearly non-zero) timing risk than private equity, and this is yet another reason why one would expect hedge fund incentive fees to be paid more frequently and even trade at a premium to private equity fees.

Redepmtion risk: Clearly related to liquidity and timing risk, redemption risk relates to how easy/difficult it is for an investor get his/her money out of a fund. With conventional hedge funds it stands to reason that redemption terms should be pretty flexible, as the portfolio's nearness to cash and the shortness of the investment horizon argues for redepmtion on, say, a quarterly basis. This is in stark contrast to private equity funds, which hold principally illiquid assets that can't be readily converted to cash under almost any circumstance. Therefore, one would believe that it would be almost impossible to redeem a private equity fund in advance of its maturity, as the illiquid assets need to be converted to cash over time in order to generate returns and distributions for investors. This would also make an investor more willing to pay hedge fund incentive fees more frequently than private equity incentive fees.

Other differences exist, but these are three of the big ones. So given the disparity in nature between hedge fund and private equity investing, what is the problem? The problem is that the risk profiles of hedge funds and private equity funds are beginning to converge, rendering the historical distinctions in incentive compensation and redemption structures obsolete. And this is neither a trifling distinction to the hedge fund investor nor the IRS, which appears to be waking up to convergence (read: hedge funds investing in increasingly illiquid, less marketable assets) which could threaten the favorable "trader" tax treatment afforded hedge funds under IRC Section 162.

And as institutionlization of the hedge fund marketplace continues to progress, it is not hard to see how the most powerful and desirable institutional investors begin to clamor for separate fund structures, compensation schemes and redemption provisions based upon portfolio risk profiles, not whether they are managed under the rubric of a "hedge fund" or a "private equity fund." If a hedge fund is investing in PIPEs, doing venture capital financings, investing in LBOs and other less liquid activities, does it stand to reason that they should be receiving quarterly incentive fees based upon a mark-to-market(?) figure for net asset value? Why should their compensation scheme be any different than the private equity funds realization-based model for these types of investments? Answer: they shouldn't. And this is the rub.

Hedge fund? Private equity fund? These are increasingly artifical distinctions that will eventually be expunged from the investment vernacular. How about "alternative asset managers?" Can you tell me where hedge funds end and private equity funds begin, and vice versa? I can't. So let's stop using language and labels that mis-represent what's really going on here. There is a race for alpha, a somewhat small group of investment professionals that will be able to lay claim to this alpha and a limited number of ways of realizing this alpha. And given the flood of assets into the alternative investment asset class, these professionals will increasingly be pushed to use their skills - be they investment, management, legal, etc. - in other areas. And institutional investors want this. But my betting is that they won't be willing to live with the asymmetry between hedge fund compensation structures and illiquid asset investing. They just won't. They might today. They might tomorrow. But they won't over time. Just my two cents.

Yet Another Misguided Attack on the Blogosphere

I left town for a few days to hang with family, committed to the fact that I wouldn't blog, but a little piece I read in the Wall Street Journal made my hiatus a brief one. Joseph Rago, an Assistant Editorial Features Editor at the WSJ, penned an article titled "The Blog Mob - Written by Fools to be Read by Imbiciles." Needless to say, I don't think Joe and I are going bowling and throwing back a few any time soon, but that's ok. But what's not ok is the sorely misinformed perspective reflected by Joe in his missive, and the swipe he takes at an entire class of media that, to be sure, poses a serious threat to he and his peers in print media. And while my blog post will largely be clinical in its analysis of Joe's twisted and defensive logic, I am more than irritated at having been classified as a "fool" and my many readers labeled as "imbiciles." Especially since I know this to be untrue on both counts. And I'd be happy to engage Joe in a "brain off" any time he wants. And I am sure most if not all of my readers would rise to this challenge as well.

So, where to begin? I've highlighted some of Mr. Rago's more salient and debatable points below, which should serve as a good starting point. From my imbicilic perspective, it appears to me that Joe's view is rooted in orthodoxy, that he has taken a narrow view of the strengths and weaknesses of blogs, and is just plain wrong in his perceptions about the power of group debate and it's ability to arrive at the right conclusion. But please, take a read for yourself.

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The blogs are not as significant as their self-endeared curators would like to think. Journalism requires journalists, who are at least fitfully confronting the digital age. The bloggers, for their part, produce minimal reportage. Instead, they ride along with the MSM like remora fish on the bellies of sharks, picking at the scraps.

More success is met in purveying opinion and comment. Some critics reproach the blogs for the coarsening and increasing volatility of political life. Blogs, they say, tend to disinhibit. Maybe so. But politics weren't much rarefied when Andrew Jackson was president, either. The larger problem with blogs, it seems to me, is quality. Most of them are pretty awful. Many, even some with large followings, are downright appalling.

Every conceivable belief is on the scene, but the collective prose, by and large, is homogeneous: A tone of careless informality prevails; posts oscillate between the uselessly brief and the uselessly logorrheic; complexity and complication are eschewed; the humor is cringe-making, with irony present only in its conspicuous absence; arguments are solipsistic; writers traffic more in pronouncement than persuasion . . .

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The right now is partially a function of technology, which makes instantaneity possible, and also a function of a culture that valorizes the up-to-the-minute above all else. But there is no inherent virtue to instantaneity. Traditional daily reporting--the news--already rushes ahead at a pretty good clip, breakneck even, and suffers for it. On the Internet all this is accelerated.

The blogs must be timely if they are to influence politics. This element--here's my opinion--is necessarily modified and partly determined by the right now. Instant response, with not even a day of delay, impairs rigor. It is also a coagulant for orthodoxies. We rarely encounter sustained or systematic blog thought--instead, panics and manias; endless rehearsings of arguments put forward elsewhere; and a tendency to substitute ideology for cognition. The participatory Internet, in combination with the hyperlink, which allows sites to interrelate, appears to encourage mobs and mob behavior.

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Nobody wants to be an imbecile. Part of it, I think, is that everyone likes shows and entertainments. Mobs are exciting. People also like validation of what they already believe; the Internet, like all free markets, has a way of gratifying the mediocrity of the masses. And part of it, especially in politics, has to do with conservatives. In their frustration with the ancien régime, conservatives quite eagerly traded for an enlarged discourse. In the process they created a counterestablishment, one that has adopted the same reductive habits they used to complain about. The quarrel over one discrete set of standards did a lot to pull down the very idea of standards.

Certainly the MSM, such as it is, collapsed itself. It was once utterly dominant yet made itself vulnerable by playing on its reputed accuracy and disinterest to pursue adversarial agendas. Still, as far from perfect as that system was, it was and is not wholly imperfect. The technology of ink on paper is highly advanced, and has over centuries accumulated a major institutional culture that screens editorially for originality, expertise and seriousness.

Of course, once a technosocial force like the blog is loosed on the world, it does not go away because some find it undesirable. So grieving over the lost establishment is pointless, and kind of sad. But democracy does not work well, so to speak, without checks and balances. And in acceding so easily to the imperatives of the Internet, we've allowed decay to pass for progress.

Wow. Is it just me or does Mr. Rago come across as a, what is it called, a snob? "The internet, like all free markets, has a way of gratifying the mediocrity of the masses." Really? Is this what free markets do, Joe? I thought free markets were the ultimate form of democracy, letting the group arrive at the proper outcome, taking into account all information at its disposal at the individual level? Is this mediocrity, or is this the ultimate in intelligence? What do you call the stock market? Are prices mediocre because everybody gets to, in essence, vote on the outcome? If an issue gains traction in the blogosphere to the extent that it begins to impact the physical world, is this because the idea is mediocre? I think not. Joe, I think you lack the knowledge of the power of groups and the quality of decisions that are made by groups versus those made by individuals. Are groups fallible? Of course. Can mob psychology take hold if certain circumstances are present? Sure. But the same can said of the pathology of individual decision-makers, who are suceptible to at least as many if not more pitfalls than groups. So I don't really buy this argument, either viscerally or empirically. But hey, that's just my (imbicilic - given that I'm a blogger) point of view.

Do blogs vary in quality? Sure. Is there a lot of crap? Yes. Does mainstream media vary in quality? Of course. Are there absolutely terrible writers who do a lousy job of research and their articles reflect their views and not the facts? Tons. So Joe, get off your high horse and look at your peers, and maybe even yourself. And Joe, my friend, why are you so turned off to "instantaneity" (even journalists make up words now and again, I guess)? Some people find speed of reporting to be a virtue, Joe. Sorry if you are not in that camp. And remember how bloggers are often early on the scene, providing early insights, pictures, commentary, and often assistance. Is this a bad thing, Joe? Really not worth much? And what about the stuff of my work, early insights and unique perspectives for investors? That pool of mediocrity of which you refer is, happy to say, is also a font of interesting insights, both on an individual and an aggregate basis. Remember, Joe, bloggers range from Nobel Laureates to novelists, professors to pencil pushers, jocks to, yes, even journalists like you. And sometimes when you look across the sea of seemingly useless data points and connect the dots, you are able to divine things like sentiment about products, brands and companies, which can be really helpful to investors, the companies themselves and advertising agencies alike. So am I missing something, here, Joe? This seems like pretty good stuff. Maybe your painting blogs with such a broad brush wasn't really fair, after all. Just maybe.

Though I could write for hours but will (mercifully) cut it short, I can't help but comment on the statement regarding democracy and its malfunction in light of the lack of checks-and-balances in the blogosphere. Now isn't this the pot calling the kettle black, my friend? How many careers, how many companies, how many reputations has mainstream media destroyed, and what recourse did people have? Wasn't mainstream media often judge and jury? Didn't entire industries evolve around how to help companies and individuals deal with the perceived threat of mainstream media? Did this happen because of the wonderful check-and-balances that were in place, Joe? Sorry. You've got the democracy argument completely backwards. It is the blogosphere that creates the checks-and-balances for mainstream media. Now mainstream media actually has to answer to someone other than to themselves - the general population who happens to be online, aware and possessing a voice. It is funny - I actually wrote about this during a rant at Richard Berke of the New York Times a few months ago. Though it is pretty cheesy to quote oneself, this post and Mr. Rago's piece is so rife with irony that I can't resist. Here are a few of the things I communicated to Mr. Berke on November 2nd:

Richard Berke said: "Some of the blogs take a toll on our reporters. One question on our minds is, 'What are the blogs going to say?"

Roger said: Richie, baby, you've got to be kidding me. There is this thing that has been around for centuries - let's call it mainstream media for kicks. Well, MSM has been known to dig up stories, report the facts, sometimes bend the facts to match a thesis and generally make those who happen to be the targets of MSM writers pretty miserable. As someone who spent nearly two decades on Wall Street working on deals that were often news-worthy, I was often reminded of the old adage "Don't do/say/write anything that you wouldn't be willing to see on the front page of the XXXX (choose your favorite MSM daily publication)." Why? Because of MSM and concern over how what we say and do might be perceived. This was a rational concern, and while it may have been a pain at times to rigidly comply with this directive, it did ultimately build discipline, precision and professionalism. The PR industry grew up around how to handle the potential ramifications of being in the MSM, and how to manage one's image in the media. So, Richard, we have all been worrying about "What are the MSM writers going to say" for centuries; the fact that you and your peers now need to think about your constituencies for a change truly warms my heart. Wake up. The world has changed. Get some thicker skin.

Richard Berke said: "There are people dedicated to analyzing and picking apart whatever we say and do."

Roger said: Awww, people are actually going to be critical about what you write and how you do your job. YEAH, WHAT ABOUT IT? It's called checks-and-balances, Rick, you know, like we have in government and which we really should have in media? Well, now we have it. Kinda means you need to up your game, doesn't it? Maybe dig a little deeper when doing research, interview that extra person to make sure you can confidently corroborate your thesis, anticipate potential holes in your story by thinking about the potential criticisms coming from knowledgeable bloggers? This is a healthy process, RIchard. Sorry if it feels like a burden, but when viewed through the prism of opportunity I think you'll conclude that this can contribute to better journalism and a healthy and necessary balance in a historically unbalanced system.

So you see who was talking about checks-and-balances here, Joe? ME. It seems like you and Richard are the ones that should go bowling together and discuss how the blogosphere is dragging down mainstream media. Maybe between the two of you you'll come up with a cogent argument. Because I haven't seen it yet.

Wall Street Compensation: A Flexible Model for a Changing World

Overview

Well, it's that time of year again. For the bitching and moaning, both within and without Wall Street firms (but mostly without this year given the magnitude of Wall Street bonus pools, with the possible exception of some unhappy folks at firms like Credit Suisse, JP Morgan and Morgan Stanley). And Andrew Ross Sorkin's piece titled "Goldman's Season to Reward and Shock" in today's New York Times was simply the icing on the cake for me. There are so many articles and posts on the topic of excessive bonuses that it is almost nauseating. But my take on this phenomenon is somewhat different.

My thesis - Wall Street firms have morphed into two distinct businesses with two distinct cultures: proprietary trading a/k/a hedge funds that absorb risk, and client-facing advisory/capital raising and asset gathering businesses. And it is only through understanding this structural shift - the ever-increasing emphasis on proprietary trading - that Wall Street compensation can be properly assessed.

My punch line - current Wall Street compensation is both appropriate and necessary, even in light of the stunning absolute numbers. And notwithstanding Mr. Sorkin's contention, stock price performance does matter, and the way he feels Goldman's compensation expense should be adjusted downward shows a distinct lack of understanding of the competitive landscape and the pressures of managing a firm that is, in essence, a microcosm of global society (i.e., with the "superrich" garnering the lions share of the spoils, with the sea of others sharing in a disproportionately small percentage of the total compensation pie). Just as issues of social equity exist in the non-Wall Street world they exist in the Wall Street world as well, and though some might say "Who the hell cares about a bunch of rich, spoiled a**holes," the fact is that the Wall Street community plays an essential role in the capital formation, risk absorbtion and asset allocation process, and not just at the highest levels of these firms. So people should care, and should take the time to understand what is really going on here.

The Wall Street Firm - a new organization for a new world

Without getting all historical, the bottom line is that the way Wall Street firms make money has changed - a lot - over the past thirty years. The proportion of money being made from trading has skyrocketed relative to advisory and underwriting services, and this is reflective of both the needs of the global capital markets and the opportunities for making money that present themselves. And as this transformation of the Wall Street firm has taken hold, it has put them in direct competition with one of their largest and most profitable client segments - alternative asset managers, principally hedge funds and private equity funds. And not just in competition for investment assets and deals, but for talent. And this is the point of my post. For ease of discussion, I will focus on Wall Street traders vs. hedge fund managers and leave the Wall Street Financial Sponsor/Private Equity fund discussion for another day, though the issues are similar.

Wall Street Traders vs. Hedge Fund Managers - different organizations, different jobs

The differences between Wall Street trading businesses and hedge funds are several-fold, including:

The Wall Street trader P&L begins each year at zero. This is distinctly different than hedge funds which have an embedded management fee that is pretty secure, especially in light of lengthening lock-up periods, stiffer gating provisions, etc. This means that the Wall Street trader needs to re-invent themselves each year. This is hard.

The Wall Street trader generally doesn't have the ability to invest in their own strategy on a tax-deferred basis, so gets taxed currently at ordinary income rates which is extremely inefficient. Hedge fund managers, conversely, generally have tax-efficient offshore structures that facilitate tax-deferred compounding of their capital, which can mean enormous incremental wealth for them as compared to their Wall Street counterparts. This is not a trifling matter.

The Wall Street trader is playing with house money, which can faciliate more aggressive and confident risk-taking. The hedge fund manager, on the other hand, is playing with a mix of client money and their own money, which, over time, can become very significant, and can lead to greater risk aversion once a manager achieves a certain level of wealth. The Wall Street trader is unburdened by this dynamic, as the discipline of beginning at zero each year means that legacy gains and accumulated wealth mean absolutely nothing in the coming year.

The Wall Street trader has neither their name on the door nor equity in the business. This differs markedly from the hedge fund manager that has broken away, started their own firm and built their own business. While the Wall Street trader doesn't have to deal with operational/infrastructure irritation of running his/her own business or raising capital, the ego and economic damage of not having one's own gig is pretty significant, especially as one rises to the top of the prop trading pecking order.

So what does this all mean? It means that investors, analysts and critics shouldn't look at headline bonus numbers and say "What the hell?!? $100 million for a trader at Goldman? What is going on here?" Because that is dumb and myopic. What they should look at is the economic value the trader has created, the perceived benefits the trader gets from being in-house (like infrastructure support - is the trader a geek that hates human beings, would be a horrible business manager and basically wants to be left alone to make money, or are they personable, a business-builder and a true risk to start their own fund?) and how much risk the trader has needed to generate their level of returns.

Pretty standard stuff, right? And to be clear, Wall Street traders neither get management fees nor the level of payouts reserved for hedge fund managers. Depending upon level, experience and one's "deal," trader payouts generally range from, say 8% to 15% of P&L, with 10%-12% likely the fat part of the distribution. This is clearly no 20%-25% of profits and includes no management fee, either. And no tax-efficient compounding of capital. And no equity in the business. And having to report to someone. And having to deal with some measure of politics. And on and on. So, to be clear, working at a big Wall Street firm isn't a cakewalk. There is brain damage involved, to be sure.

So that $100 million payday could easily have been double or more, on an after-tax basis, had this individual worked at a hedge fund. So now, Mr. Sorkin, is this looking like a really crappy deal for shareholders now? Really unfair, huh? I would contend that the best Wall Street traders are a virtual bargain, and the reason Goldman's stock has run up so much (even in light of its 10x P/E) is because investors know they are getting a bargain. And the fact you can't see it is because you aren't thinking about it the right way. You need to look at comparables on a tax-equivalent basis, and then factor in non-monetary issues like the lousy and painful aspects of working at a Wall Street firm versus being Eric Mindich or Dinakar Singh, otherwise you are truly comparing apples and oranges. No, check that, apples and basketballs.

And after nearly 20 years on Wall Street, and running a team with many of these super-traders who have subsequently moved on to run their own successful shops, there is no doubt that even super-high Wall Street payouts are frequently not enough to keep the best from seeking greener pastures. So to the extent you've got these super-traders and have a chance to keep them, PAY THEM. Because they're cheap by the only yardsticks that matter - risk-adjusted returns and comparisions with their principal alternative source of employment - hedge funds. Mr. Sorkin's contention that Goldman's comp levels should be compared to those of Bear Stearns, Lehman's or any other Wall Street firm again is ludicrous and not the point. Because Goldman's star trader's employment alternatives aren't Bear and Lehman -  they're Och-Ziff, SAC, and starting their own shops. And trying to compare overall talent pools is certainly beyond his ken or anyone else's. So let's focus our energies on the things we can empirically study - like risk and performance.

So What About the Others? - working in obscurity yet creating value

So many people also seemed to be stunned at the average compensation per employee at Goldman,  some  $623k. The NYT story also went on to describe the lavish holiday parties, etc. I mean who really cares? Ok for selling newspapers and filling column inches but, at its core, completely irrelevant. Good for Goldman that they paid out that much. Clearly these numbers are heavily skewed by the fact that a handful of people likely took home several billion of the $16 billion+ that got doled out across the firm. But hey, it is likely that lots of assistants, associates and VPs got payouts quite unlike any other they've seen during their tenure at Goldman. And Goldman has not historically been known as a firm that paid well except for those at its highest ranks. This was the carrot that was held out to the junior staff, that if they could only work hard enough and generate enough value to make Partner (or PMD in today's public comany parlance) then they'd be on the gravy train after, say, 10-12 years of killing themselves. So now some of these people get to share in the booty of an historic year.

You know what this does? Builds bonds. Builds loyalty. Builds esprit de corps. Makes non-PMDs and super-traders feel like they are being recognized for the hard work they put in, the hard work that sometimes enables the superrich to make their money. And this is what I spoke of previously about Goldman and Wall Street firms, in general, of being a microcosm of society. There are a handful of Bill Gates' and Warren Buffetts', and a whole lot of others plugging away who are key to the operation and its functioning. So if Bill and Warren keep on raking in mega-bucks while the others keep collecting nickels, eventually people will get disenchanted, pissed off, and maybe leave for places like Bear and Lehman. Because those places are their alternative work situations. So what Goldman did, in my opinion, is both enlightened and fair. And smart. Shareholders should praise Lloyd et al. Because they had a golden opportunity to do the right thing and cement the already strong bonds between senior management and the rest of the highly-productive organization - and they did. Smart, f&cking smart.

Conclusion

I am not a philosopher, I am a pragmatist. I believe that Wall Street and its denizens serve a vital function for the global economy and society at-large. Given this mind-set, my work experience and understanding of the transformation of Wall Street from a largely client-driven business to a heavily trading-driven business, I view the Wall Street compensation culture and Goldman's in particular as being reasonable, appropriate - and necessary. And pieces like Mr. Sorkin's do not, in my opinion, shine any new light on the issue as they fail to acknowledge how the world has changed, and how the dollars generated by and paid out by Wall Street firms reflect value created, risks taken and the competitive landscape. Bravo, Goldman. Congratulations on a stellar 2006 and best wishes for a lights-out 2007.

 

The SEC's Silver Bullet - the eInformation Initiative

The eInformation Initiative is Big - awesome

After distilling the news from yesterday's SEC meeting, the item that I feel holds the greatest promise for positively impacting shareholder value is what I refer to as the SEC eInformation Initiative. This incorporates issues raised both yesterday and in prior months, such as Jonathan Schwartz's (the CEO of Sun Microsystems) request to the SEC use his personal blog as the vehicle for communicating with the investment community and the SEC's recently announced XBRL initiative. Salient points from today's Wall Street Journal article are provided here.

The electronic-information rule could affect nearly all shareholders within a year or so. The rule, approved unanimously yesterday, allows companies to distribute via the Internet annual reports and materials on board elections and other matters put before shareholders for a vote, while enabling investors to opt to continue to receive paper reports.

The so-called e-proxy rule will cut printing and mailing costs for corporations. But it will also make it cheaper for activist stockholders to launch fights against corporate boards, because shareholders of companies that distribute information to investors electronically will be able to do likewise.

The agency said it plans to make the e-proxy model mandatory by January 2008, though some members expressed concern about doing that.

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Mr. Cox said the e-proxy rule -- the only one approved in final form yesterday -- was one of several steps toward changing how investors access information. It dovetails with two other technology-based initiatives Mr. Cox is pushing. One will allow investors to quickly compare data in a corporation's financial statement with other companies' data. The other is an upgrade to the search capabilities of the SEC's Internet-based system for storing corporate financial reports, known as Edgar.

"We're trying to qualitatively improve the disclosures investors get," he said.

Business groups have been wary of using Internet-based proxies -- the documents that outline matters put before shareholders for votes. Their main fear is that activist investors would find it much easier to put their proposals before all of a company's shareholders. Consumer groups, on the other hand, have warned that electronic proxies could disenfranchise investors who don't use the Internet.

Some commissioners expressed concern about making the e-proxy rule mandatory, given other changes the SEC is weighing for the proxy process. Commissioners also fretted that a mandatory rule might crimp participation by shareholders without Internet access.

The SEC Moves into the 21st Century - but not without some squawking

This is great stuff. It is nice to see the SEC moving into the 21st century, even if they are dragging some constituencies kicking and screaming. It's the same kind of push-back seen from the wire services when Mr. Schwartz petitioned the SEC for using his blog as a formal investor information dissemination platform. Disintermediating a paid service for the democratizing and flattening (not to mention free) power of the Internet is bad, right? It is if you are either Business Wire or PR News Wire. But it's really great if you are an investor or a company.

The E-proxy Rule - A change with real teeth and a long time coming

So what of this e-proxy rule? This, in my opinion, is huge. How many people who get bulky, annoying proxy materials in the mail actually do anything with them? My guess is very few as a percentage of total proxies distributed. However, if one was to get an email with a link to the issues up for vote at the Annual Meeting of one of their portfolio companies, would that person be more inclined to repond and actually vote? My guess is yes. An unequivocal yes. I think the issue of reduced participation due to those lacking internet access is a red herring. I think the consumer groups and commissioners expressing this view are either way out of touch or on the take. I would contend that a staggeringly high percentage of people to whom proxies are sent have internet access. Further, I'd argue that the goal should be to increase overall participation, and that this represents real democracy. And if the emphasis and resources are placed at the tail end of the distribution, is the greater good really being served? I think not.

Conclusion

Now I know why business groups are afraid of this change, given the greater ease with which proxy fights could be launched. Excellent. This is good, healthy governance. It is high time that the frictions and impediments to shareholder-driven actions are gradually removed. Staggered boards and cumbersome proxy processes. to name two of many. This move is one chip at the edifice of entrenched managements, and if they are scared and lobbying against this change, screw them. And you thought Sarbox made you accountable, how about being accountable to your shareholders, pal? This is awesome.

Once again, I have to applaud Commissioner Cox for this proactive, pragmatic approach to good governance. As I've said in prior posts, he is a dude.

Google and Citadel: Innovation at Work

Overview

Well, Google finally did something many of us in the derivatives business had talked about for years - create a vehicle for transferring and monetizing employee stock options prior to exercise. Why? To capture the time value inherent in an option prior to maturity, which is lost once the option is exercised. And this is something that is easy to do if you are a dealer (by delta hedging, vega hedging, etc., as the price of the stock oscillates, time to maturity shrinks and the probability of the option's exercise changes), but almost impossible to do if you are an individual. Google talks about this program on their blog, and provides an example of how the program would work and the accounting impact of initiating the program. While I have some questions about the financial motivation of this move (separate and apart from the employee compensation/HR implications of this move), it is, without question, highly innovative, very necessary and will invariably be copied by companies everywhere.

I've said it before and I'll say it again: these guys are smart. Really smart. Smart financially. Smart strategically. But, most importantly, smart about how they attract, retain, manage and motivate their human capital. They serve as a model for how growing companies - no, all companies - should be maniacally focused on creating a positive, exciting, stimulating and challenging work experience. Because it is stuff like this that creates long-term, sustainable competitive advantage.

Innovation in the Culture

Citadel's recent bond issuance, while representing innovation in an different kind of company for different reasons, came to mind when I saw Google's announcement. I had blogged about this a week or so ago. Their debt issuance, like Google's new stock plan terms, represents a structural change in the way firms in their industry view risk. While Citadel's move shined a bright light on liquidity risk, and was a shot across the bow of prime brokers everywhere, Google's move shined a bright light on human capital risk, and was a shot across the bow of all employers with whom they compete for talent. Whether one is in the hedge fund business or in the technology/advertising business, innovation is the life-blood of sustainable advantage. Especially when it is ingrained in the culture. As it is at both Citadel and Google.

Google's New Option Plan - What's in it for Them?

So, it is pretty clear that Google benefits from a recruiting and retention perspective by giving current and prospective employees options that offer them the chance to monetize a portion of the options' residual time value prior to maturity. This is good. And due to this new feature, which is simply an add-on to the options' existing terms, they will have to take an accounting charge to reflect this increase in compensation expense. This increase in expense is a function of an increase in the expected life of an option, since, if the option is transferred, the options life is generally reset to two years (the lesser of two years or the remaining life of the option, which will almost always be two years). And they assume that new expected option life is additive - that the current estimate of option life is simply increased by the two year period post-transfer. But behind this charge is a key assumption: the estimated life of an option. It is here where the questions begin.

The key question: how will employee behavior be modified by this new liquidity feature? It seems to me that Google's assumption that expected life will remain at four years is highly tenuous. While I am sure most people at Google have imbibed the Kool-Aid, I am equally sure that many who work there can use a few extra bucks for that cool Trek racing bike, a shiny new windsurfer, etc. So I wouldn't be surprised to see a drop - a substantial drop - in the expected life of an option. And if their estimates of option life are too high, they will essentially "undo" the excessive expense taken today through reduced option expenses in future years. Why not take the big charge now while earnings are rocking, get the PR benefits of this innovative program today and enjoy the benefits of lower compensation expeneses in future years when income growth might not be as prounounced? Am I being overly cynical here? I guess it just in my DNA from my derivatives days, what can I tell you.

Conclusion

None of this undoes the innovative nature of the program or the fact that, at its core, it is a brilliant HR move and, quite frankly, the right thing to do. Does it place a little more pressure on Google to perform, else people take too much advantage of this program and the long-term motivation benefits of the options lose their teeth? Yes. However, from where I am sitting the recruitment and retention benefits of this tool far outweigh the potential costs. And this further reinforces Google as an innovator, and not just in technology but in the cultivation of positive management/employee relationships and the creation of leading-edge HR strategies. They, like Citadel, are blazing the trail. Others should watch and listen. They might learn something.

Microsoft vs. Apple: Is Vista the Answer in the Era of Consumer Computing?

Overview

I am back to share more thoughts about Microsoft. And Vista. And Apple. I have used my company's pretty neat tools over the past few days to do some research, collect some data and develop a view about what is up with Microsoft. This is going to be a pretty long post so I understand if you want to get off here. But there is so much to talk about that requires both historical context and leading-edge perspective that, but necessity, I will write - a lot.

You pretty much know my view of Microsoft - a big, great, bureaucratic, confused company that has lost its way. I'd like to augment this view with some fresh data concerning Vista, how Microsoft is positioned relative to Apple, and how we have ushered in a new era - the Consumer Era of Computing - for which Microsoft is ill-prepared. And my connect-the-dots analysis leads to painful and stark conclusion: Microsoft, for all its financial resources, intellectual capital and historic success, is at risk of being marginalized in tomorrow's world. The terms of trade have changed, and thus far they have seemed to lack the currency necessary to play. With all the brains and money at their disposal the chance of a turn-around certainly cannot be discounted, but it is the embedded cultural and market perception issues that give me the most pause. But see what you think.

What Did We Learn From Netscape? From Linux?

Does anybody remember the original mid-1990s Browser Wars? Old gray-hairs (or no-hairs in my case) like me do. The bottom line was that a little company called Netscape emerged out of nowhere and scared the crap out of big, bad Microsoft. And then, as Microsoft has done so well over the years, it trained its guns on little Netscape and went in for the kill. And yes, eventually IE went on to grab 96% of the browser market (which is currently under assault from the likes of Firefox). But that wasn't the point of the story. The story is that it is possible for small, innovative companies - no, entities -  with great ideas to upset the status quo. And this is what happened with Linux.

Linux essentially proved that the Microsoft OS was vulnerable, depending upon the application. This free and open challenge to ubiquity was something much harder for Microsoft to deal with. How could they simply crush something that was open source, benefiting from legions of developers from all over the world that weren't burdened by traditional platforms or corporate legacies? Answer: they couldn't. Linux has created a platform shaped by consumers for consumers, which is really the point. It represents the antithesis of the "People will buy what we build" ethos of GM, Ford and other formerly great companies. The key question is if Microsoft is now in this camp. 

The Consumer Era of Computing

With the Internet, cheap storage and massive processing power, the playing field has flattened measurably. One doesn't need thousands of developers, hundreds of man-years and tens of millions of dollars in "big iron" to develop applications people want. People want to connect. People want to be able to share. People want to discover. Pictures, movies, music, email, web pages, files, spreadsheets, and more. This means that people want programs and applications that are easy to use. And fun. And open. People and companies became dependent upon Microsoft because the lack of computing power and bandwidth called for a high degree of desktop integration. However, this isn't the case any more. Big, heavy OS and related applications simply aren't necessary. Google threatens Microsoft in search and email. Apple is chipping away with consumers. And these are only two of many companies that are relentlessly challenging the Microsoft franchise. Further, I think what Apple is doing is actually pretty profound.

Apple has control over its entire value stack, while Microsoft only controls the software. In most places I'd argue that "vertical integration" is a bad thing, but Apple has created a total user experience second to none, which is evidenced by their intensely loyal and growing following. Apple is all about the consumer, and if the Mac wasn't enough the iPod certainly drove the point home. It is this laser-like focus on the customer intersected with innovation and out-of-the-box thinking that has led Apple to the position it's in. Apple is an innovation leader - what about Microsoft?

Innovator or Follower? Has Microsoft Lost its Way?

The online edition of the Wall Street Journal 12/1/06 had an interesting discussion between Dave Winer and Robert Scoble on the topic. Says Winer:

Microsoft isn't an innovator, and never was. They are always playing catch-up, by design. That's their M.O. They describe their development approach as "chasing tail lights." They aren't interested in markets until they're worth billions, so they let others develop the markets, and have been content to catch-up. This worked well for them in the 80s and through the mid-90s, when they were a more nimble company with stock options that were attractive to bright young people, when Bill G had something to prove, and was current on the latest technology. Maybe it still does work (obviously I have doubts), but it sure isn't innovation, in any usual sense of the word.

Microsoft is troubled. They've grown to the size of IBM when they ran circles around them, and they behave like IBM, they even talk about themselves like IBM used to talk about themselves, showing a dangerous confidence that is very un-Microsoft. Their strength, even charm, was their lack of hubris. Gates could always see their demise, vividly and clearly, this was a picture he drew for the people of Microsoft so they would always be looking for the angle that would save them from their demise. Today they seem to believe they're as permanent as IBM thought they were in the 80s, when the conventional wisdom said that no one got fired for buying IBM. That didn't save them when the PC industry changed the rules on them, much the way the rules are being changed on Microsoft.

Further, the one thing they used to do better than most tech companies, empathize with the user, is now a weak spot. I was an exclusive Windows user myself until mid-last year, when I switched to the Macintosh, because the malware situation had become so awful on Windows. I feel Microsoft could have done something about this before it became so bad, but they didn't.

While it may seem that Dave woke up on the wrong side of the bed, his criticisms kind of ring true. But it is the last paragraph that I find most troubling. Losing the pulse of your customers is the kiss of death. Especially when you are undertaking multi-year, multi-billion dollar projects. Like Vista.

Vista: It Takes (More Than) a Village

10,000 programmers. 5 years. Building pyramids, building operating systems, whatever. Check out this recent post from a Longhorn-cum-Vista beta freak, who has dorked around with the various builds dating back to November 2002. When you consider that YouTube, Digg and literally hundreds of commercially successful, relevant services have been created, bootstrapped, funded, bought and sold for a fraction of the cost and in a sliver of the time of Microsoft's latest OS project, it is hard to imagine how the development team members could possibly have stayed close to the market when the market has undergone a sea change over the past five years. Check out these keen insights from THe.CODiST[] 12/5/06:

The development of Microsoft Vista apparently took 10000 employees 5 years. This is even more people than I would have expected (assuming it's close to the truth, estimates are usually way off). Big Bang projects always seem to attract huge budgets and massive headcount, but there are few companies out there who could even field such a large workforce and invest so many billions.

The Vista development story has been covered heavily over the 5 year period, starting off with a bang (of course) of new directions, technologies and features, and ending with a whimper of reduced expections. That it even shipped at all is a miracle, although the real test will be when people start using it for real. Big Bang projects usually fail completely.

It would be interesting to know how many actually programmers and architects were part of this horde of people. Copland's engineering team was about 500 people, but I know not all were actually programmers. The largest team I ever worked with in my entire career was about a dozen people, in two states, and even that was fraught with communications issues. 12 people have 66 potential conversations; 10,000 people have 50,000,000. I have a hard time imaging any way to effectively manage a group of people that size working on a single project in any industry.

The Manhattan project ultimately employed around 130,000 people and cost (in today's dollars) something like $20 billion; however the core team was relatively small (a few hundred at most) and run under heavy military discipline. In the earliest days it was really the work of a handful of people and this team essentially created the basis of the entire project.

I think this is the core (!) of how to organize a software project of Big Bang size, an inverted pyramid: small team of highly capable, experience folks, building (not just designing) the core of the system on which the lower, larger teams build additional functionality. I still think the size of the team needs to be as small as possible, even to the point of emaciation. When people are faced with too few resources, but are highly skilled, and most importantly, have a high latitude in their choice of technologies and tools, they will find a way to make it work. The sad part of this is that in most places, your choice of technologies and tools, and even the way you go about building a software system, is highly constrained.

In the vase of Vista, Microsoft's team at first was excited about using managed code (basically the .Net CLR) but apparently not enough of the team agreed, and ultimately they fell back to using native code (C ), which in my experience is a pain in the butt in large teams. Of course any technology they want to use either had to be in-house or developed from scratch; unlike Apple's OSX, which uses many open source technologies (BSD, Mach, etc) in the core OS, Microsoft never considered such an approach.

So why was Vista such a nightmare? Too many people, too much "must be invented here", too many new untried technologies and the ultimately difficult requirement of supporting old API's in the core OS (a fundamental issue with Copland).

Oddly enough the Big Bang project that was The Manhattan Project actually produced two successful big bangs (killing 150,000 people is a sad success) while Vista is mostly producing a Big Thud.

Ooof. Brutal.

Vista: OS X Wanna Be?

So after all the twists, turns and travails, how does Vista roll? Like the Mac OS X!?!

From Lifehacker 6/12/06:

After playing around with my newly-installed copy of Windows Vista Beta 2 for a couple of hours, the thought that kept popping up in my head over and over again like a persistent mole was: "Wow, that's a lot like the Mac."

From the emphasis on searching and not browsing (Spotlight) to the Windows Sidebar (Dashboard) which runs Gadgets (Widgets), to the built-in Windows Calendar (iCal), the similarities are striking.

From OSWeekly.com, "Windows Vista vs. Mac OS X: The Copycat Olympics" 8/17/06:

During the keynote, they presented comparison screenshots of interface elements and software from Tiger and Vista side by side. The results were eerily similar, and if I was from Microsoft, I would have been squirming in my seat right at that very moment. The composition of the elements and the color palettes used made the competing products look like twins, and since Apple was the first to get these things to the market (years ahead of Microsoft, in fact), then they have bragging rights, and they sure know how to use them. When Microsoft essentially takes an idea from OS X, copies the look and feel, and then re-brands it under some horrible name (Microsoft Windows Live Widget Maker 2.0 Edition), then they're just setting themselves up for this type of mockery.

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All of this just goes to show that Microsoft is running out of fresh ideas, and even though they spend billions of dollars each year on R&D, you'd almost think that they should just pay other companies to come up with the ideas and then decide on inclusion based off of user reaction. In my mind, I envision their R&D department consisting of a large room with one iMac on a desk in the center and chairs surrounding it. As funny as that may seem, it sure looks like that's what they're doing. I guess the rest of those billions of dollars go to fully stocking a warehouse where Steve Ballmer can go to throw chairs for therapy.

In Microsoft's defense, though, why wouldn't you want to "borrow" ideas from other successful products?  Vista, Leopard, and Linux are all competing against each other, although in reality, each one is better for a different set of users.  Apple may go on and on about the similarities between Tiger and Vista, but they're there for a reason. When innovation fails, then you need to try and learn from the best, and that's what Microsoft is doing. However, they're a little late to the game, and the competing follow-up usually isn't as good as the original.

This "me too" approach doesn't really seem like the Microsoft of the late 1980s/early 1990s, especially given the massive commitment of human and financial capital. But hey, you do what you've got to do to survive, right?

And this from the Detroit Free Press 11/30/06:

Such a feature-rich operating system could be a tough sell for PC users who may like it but aren't willing to fork over the dough to buy a PC to take advantage of Vista, analysts say. "Unless you've bought a high-end computer the past few months, you may need to buy a new (PC) or video card to take advantage of all of Vista's features," King says. "That will be a hindrance to a lot of people.

"Why upgrade from Windows XP, which is a perfectly fine OS?" he says.

Whether Vista is compelling enough to draw millions of instant converts is debatable, according to the army of consumers and analysts who have tested it.

But there is little debate it will eventually gain widespread acceptance, tech analysts say.

Forrester Research's Ted Schadler predicts U.S. homes will adopt Vista at the same pace as they did Windows XP in its first four years. Schadler forecasts 12 million U.S. households will have Vista in 2007, escalating to 73 million households by 2011. The use of XP in U.S. households surged from 3.7million in 2001 to 56.4 million in 2005.

"Most consumers follow the same path: They buy computers when old ones break, when prices come down, or when a lifestyle event triggers the purchase," Schadler says.

I guess the question is whether or not those 73 million households are a gimme. A lot has happened in the consumer market since the release of XP: the rise of the Mac Book,  the popularity of iTunes, the ubiquity of the Apple consumer experience. Analysts frequently love to base projections on previous product adoption cycles. Is Mr. Schadler correct in assuming that Vista will enjoy the same uptake as XP did when it went live? Today's world is clearly different, my friend, and woe be those who are bounded by yesterday's thinking in projecting tomorrow's reality. Even a small dent in Microsoft's OS market share would have a huge impact on its P&L (with the benefit going straight to Apple). I'm just saying it's a possibility, but apparently not to Mr. Schadler.

Microsoft's: Out of Step with the Market

As we have seen, the Zune has gotten completely skewered: mainstream media, blogs, product reviews, pretty much everywhere. While Vista hasn't exactly met with the same fate, it certainly isn't setting the world on fire, either. This confluence of high profile duds is weighing on the future of the stock, as well as the future of the current management team. Check this out from Rob Frankel's blog from 12/3/06:

And it's no wonder. Microsoft, one of the world's largest brands with no brand strategy, has no legions of fans eagerly anticipating its next move. In this case, its next move is actually two moves: The release of its Vista operating system and the retail launch of its so-called iPod killer, the Zune. Both of which are being welcomed into the market with a flurry of yawns.

When you read about the launch - or should I say overly-delayed, overly-announced launch - of Vista, there's not a whole lot of good news orbiting the news. Normally, you hear all kinds of spin, mainly about increased functionality or greater resources or lowering the costs of operation. Not this time. This time, the planets circling the press release have more to do with the increased hardware and testing costs of deploying Vista and speculation on the difficulty of its deployment.

That's just what you find in paragraph number one, before anyone even approaches the gossip on how few people actually plan on deploying it.

Meanwhile, in Microsoft's version of retail reality, it has launched the Zune music player, just in time for nobody to buy it for Christmas. You know that you're fighting a losing battle when the best reviewers can say about your new product is that "it could be good, if only...." Of course, there's no brand behind the Zune, so what could people expect? I'll tell you what they can expect: The usual Microsoft spin, where derivative products follow the market instead of leading it.

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Microsoft is not a brand. It's a warehouse with an identity. There's no Microsoft fan base, only hostages held in check by their accounting departments' insistence on purchasing the lowest cost items for their short-term gains. If Microsoft were really a brand, it would have its fans and defenders. As it is, nobody lines up for preview copies of Vista. Nobody rushes down to Best Buy before all the Zunes sell out.

If They Don't Want the Kool-Aid, Make Them Drink It Anyway

From IT-Director.com, 12/5/06, "Buy Microsoft, it's your patriotic duty"

That seemed to be the message at the London launch of Microsoft Vista, Office 2007 and Exchange 2007 on 30 November 2006. Gordon Frazer, Microsoft’s UK managing director, devoted most his opening speech to a gallimaufry of statistics and quotations intended to show that buying these new offerings would somehow make Britain more competitive.

Nowhere (of course) was there any suggestion that making better use of organisations’ existing computer investments might be just as effective in improving their efficiency. Nor (ditto) was there any acknowledgement that the wholesale adoption of these new products would lead inevitably to a productivity decline for a period, as it would with any large software installation.

In the dream world proposed by Microsoft, users don’t have to spend working time and ingenuity getting used to new software; systems departments don’t need to drive themselves to distraction ironing out the wrinkles in the new systems; and trading partners don’t have to run around in ever-decreasing circles trying to get their systems to work with them. These are petty details.

This isn't necessarily earth-shattering stuff. It's just the tone. The tone of defeatism. The tone of rationalization. When's the last time Apple released anything where people said "Who cares?" After five years and so much hype, how could the result be anything other than a let-down? And Microsoft's internal folks aren't helping, either, saying things that don't illustrate a whole lot of confidence in the Company or its products. And possibly the cruelest cut of all, this Forbes.com article dated 12/12/06 about comments from James Allchin, the head of the Vista development team, who said a few years back that he would purchase a Mac if he weren't at Microsoft:

Are Apple computers better than Windows PCs? The guy who led development of Microsoft's new versions of Windows apparently once thought so.

In a January 2004 e-mail to Microsoft (nasdaq: MSFT - news - people ) chiefs Bill Gates and Steve Ballmer, Vista boss Jim Allchin said he would buy a Mac if he wasn't working at Microsoft.

Allchin, who is now a co-president of Microsoft, was complaining to Gates and Ballmer that Microsoft had lost its way in developing Vista and lost sight of what customers wanted.

The e-mail has become public since it was cited by attorneys in Iowa who are pursuing an antitrust case against Redmond, Wash.-based Microsoft.

Allchin oversaw development of Vista, the new version of Windows. The new operating system looks a lot like Apple (nasdaq: AAPL - news - People )'s OS X operating system. This hasn't escaped the notice of Apple executives who delight in pointing out similarities.

On Monday night, after reporters began making inquiries about the e-mail, Allchin published an item on a Microsoft blog in which he claimed the e-mail statement was being taken out of context.

He said that he'd made the comment about buying a Mac "for effect," that the e-mail was nearly 3 years old and that he was trying to shake things up at Microsoft. "We needed to change and change quickly," Allchin writes. Today, he says, "Vista has turned into a phenomenal product, better than any other OS we've ever built, and far, far better than any other software available today."

Allchin has announced plans to retire from Microsoft after the commercial version of Vista ships at the end of January. Note to employees of Apple retail stores in Bellevue, Wash., and Seattle: On or around Feb. 1, be on the lookout for a white-haired man wearing a Groucho mask, furtively purchasing an iMac.

This simply isn't funny. Can you imagine Steve Jobs saying, "Hey, I can't wait for those cool whiz-bang graphics on Vista to come out" or "Man, I can't wait to zap my other Zune friends a few tunes from my device." No f*cking way this is happening. People at Apple drink the Kool-Aid and they're proud of it. People at Microsoft hear that their team leader wants to use the competitor’s product. Sorry, thought Mr. Allchin makes some interesting excuses for why he made these remarks I'm not buying. I run a company and let me tell you, that isn't something I'd joke about. Because it's not funny. It kills morale and kills team spirit. It's not right. And it's symptomatic of a much larger problem. If insiders aren't believers, how can customers possibly believe? It just doesn't add up.

And not only Microsoft's faithful are believers in the Mac - how about Intel's? From The Unofficial Apple Weblog 12/1/06:

Hexus has an interview with Pat Gelsinger, Intel's GM of their Digital Enterprise Group, in which he describes crossing "the religious boundary" by purchasing a Mac. Note how the interviewer reacts and grimaces around 1:41 when Pat drops the bomb, and how he has to interrupt Pat to announce his newfound "Mac fanboy" status. Pat also mentions he's buying a second for his wife, along with a copy of the upcoming Windows Vista and Parallels Desktop, of course.

This is a really interesting statement to hear from someone so high up on a business ladder, especially since he's specifically spending the money to buy Parallels, instead of using Apple's free but workflow-intruding Boot Camp. Pat joins other business notables - like the recent CIO who picked Mac OS X after comparing to Linux and Windows for a month - in voicing their fondness for Apple's OS, even while the big fruit seems to be spending most (if not all) of their marketing on advertising to the home creative crowd.

So, when you've got your own executives as well as those of one of the most powerful suppliers in the tech sector singing the praises of your competitors' products, all cannot be good. It also raises the interesting question that if Vista requires so much memory and processing power that current XP users would actually need to upgrade machines to properly use the new software, then why not try a Mac? Allchin likes it. Gelsinger likes it. Millions of people love it. And Steve Jobs loves it. These are not good tea leaves. For Microsoft, that is. And this from the blog Switch to a Mac from 12/1/06:

Apple's Mac operating system market share continues its upward move and data in for November 2006 demonstrates that it has risen 31 percent year-over-year from November 2005 to November 2006.  Data rounded to the nearest whole percent, actual rise is 31.1 percent.

Please note that this does not mean that Apple's market share is 31 percent.  The number represents percent increase. Data used in this post has been obtained from market research firm Net Applications (Market Share).  The total Mac OS X market share number comes in at 5.39 percent.

Based on the firm's calculations the following metrics can be calculated.

Key Percent Increases

• Up 58.1 percent since January 2005
• Up 53.1 percent since April 2005 (Mac OS X Tiger launched April 29, 2005)
• Up 28.0 percent since January 2006
• Up 3.5 percent since October 2006
• Up 14.2 percent since September 2006

The November 2006 Key Percentages outpaced the growth reported for October 2006 which were as follows:

• Up 52.8 percent since January 2005
• Up 48.0 percent since April 2005 (Mac OS X Tiger launched April 29, 2005)
• Up 23.8 percent since January 2006

While working off a low base, these percentage increases are pretty impressive indeed.

Ok, So Apple's Not Perfect, Either

This post on the Mac Observer gives an excellent critique of Apple's strategic weaknesses, centered around five principal issues:

1. High performance computing
2. Enterprise
3. Music industry
4. Entertainment industry's plans
5. iPhone's stress and meddling

There were some very interesting comments to this post, including the following:

From Tiger

Well written and thought out. Two points. Apple is making inroads to HPC. They've been co-sponsoring seminars on HPC at universities. They were at mine early this spring. The clusters are out there, being built by visionaries who see the value of cutting costs by 75%.

Second, consider enterprise a non-entity. After so many years, it should be evident that Apple doesn't WANT to go into this realm again. The margins are too small in fact for the amount of effort it takes to placate IT managers who don't have a clue about what to do with their hardware. Opportunity missed? Sure. But the time to dwell on it is over.

There is more easy money to be made in entertainment.

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Second, consider enterprise a non-entity. After so many years, it should be evident that Apple doesn't WANT to go into this realm again. The margins are too small in fact for the amount of effort it takes to placate IT managers who don't have a clue about what to do with their hardware. Opportunity missed? Sure. But the time to dwell on it is over.

I agree that Apple has long since made the decision that supplying data processing to big enterprise is not an area Apple wants to go. Apple is concentrating - and very well, mind you - on being the computer for the common folk. Their entire current ad series focuses on the difference between business computing and home computing.

Expanding into enterprise computing is not necessarily a lost opportunity. Instead Apple is in the process - again very successfully as of recent - EXPANDING their niche. Home computing is becoming more and more common, and Apple is out there grabbing a larger share of this expanding "niche". Several recent moves, such as dual boot capability, is aimed at grabbing the home computing market. Now the consumer can be compatible with work AND have all those easy-to-use FUN goodies (iPod, iLife, etc.) Apple is famous for.

Now, if Apple could get a handle on gaming, they would have the complete package to OWN the home computing market.

Tiger, I think you're on to something here. It's all about building on your core strengths, bridging the gap between those historic strength and new markets, and gradually setting your sights on new markets after you've established a firm foundation. No grand gestures. No flights of fancy. Just good, fundamental, risk managed business strategy.

There was a very interesting post on ZD Net Australia dated 12/8/06 concerning a Gartner report indicating "...that administrators will most likely have to prepare for more Mac systems in their environment even though OS X is "not a suitable enterprise wide platform." Even more interesting was a comment to the post dated 12/10/06:

From Anonymous

When talking to a Windows user who is interested in switching to the Mac I do make them aware of certain "gotchas". Every -- EVERY -- platform has them in several forms or others; some platforms' list are just longer than others, but I always end my little list of "gotchas" with the biggest one and it is this:

The biggest problem with using a Mac... is telling other people you use a Mac.

The general body of perceptions out there regarding the Mac are outdated and biased at best or just plain WILLINGLY INCORRECT at worst. While I agree that the enterprise needs to see greater commitment from Apple in order to build trust -- and such building takes time -- there's nothing intrinsically missing from the Mac platform to prevent it from being a very viable option in many IT deployments.

The conundrum for EVERYBODY (Apple and the IT sector) is... why should Apple put effort into a sector of industry that (generally) isn't interested in them? OTOH, solid research and an open mind within the IT industry would result in a growing interest... which would solve this problem of Apple's. Does a company try to sell snow in Alaska? No. No one is interested in BUYING SNOW in Alaska. But, if demand grew from within the IT industry, then Apple would sit up and take more serious notice of them. To quote Nike, just do it. Let the grassroots grow, people! You start to build the Mac IT world and Apple will come. I promise ;)

IMHO, the IT industry suffers from a bizarre disconnect from their own sense of self, that being that, if they're such technically savvy people interested in the best of tools available to them... then why do they for the most part limit themselves to existence within the Windows hegemony? Bill Gates pulled several licensing masterstrokes, and Apple's technological superiority (I'm talking even back in the 1980's) was the crown they blindly gave away (there goes that trust I mentioned, above), ceding dominance to an inferior product -- one that was under the control of someone who saw a Big Picture based on pervasive licensing... despite Microsoft's products being FAR LESS than perfect. MS succeeded on one thing and one thing only: Bill Gates' balls... and the IT industry has surrendered to them lock, stock and barrel.

The biggest problem with the IT community lies within itself.

Bottom line for Apple: it's not about the enterprise, it's about the user. If the user wants a platform that melds their personal and professional lives, Apple will deliver this reality. If the enterprise follows from the users, that will be their way in. But make no mistake: Apple is focused on what matters - their users. Markets, per se, are secondary. Their users will take them where they need to go.

Give Microsoft Credit: They're Trying

Giving a guy like J Allard, a hard-charging, opinionated design and development zealot a lot of rope must be hard for Microsoft v2006. But hey, they are, and he has made some real progress in effecting change. From Business Week 12/4/06:

The soul of the new Microsoft, though--its Geek 2.0--may just be Allard, the vice-president for design and development at its Entertainment & Devices unit. Allard looks and acts nothing like the prototypical Microsofty. Over the years he's swapped his plaid shirt and khakis--something of a Microsoft uniform--for edgy jackets made by Mark Ecko and other designer wear. He loads up his nine iPods, and now his Zune, with songs from hardcore bands like A.R.E. Weapons. And he's a downhill mountain biking maniac who has broken several bones after flying off his bike.

More important than his cool quotient, though, is that Allard gets things done--fast. Zune is only the latest example. At the turn of the decade, he led the software giant into the video game business with Xbox, a risky gambit that's just starting to pay off. Xbox is now a solid No. 2 to Sony Corp.'s PlayStation, and analysts expect it to turn its first profit in the next fiscal year.

Allard is one of more than 100 Microsoft vice-presidents, but he has played an outsized role in shifting perceptions about whether the company can innovate in areas other than packaged software. In June, when Gates announced his plan to focus full time on his charitable foundation, he anointed Allard, along with a handful of others, as the leaders he expects to clear new paths.

Already, Allard and those like him are having an impact. They're showing that strategies to move the company beyond Windows can emerge and be accepted by top brass as nonthreatening. A key moment came six years ago, when Allard insisted that the new Xbox video game console be developed without using Windows. In one meeting, Gates berated him for suggesting that the operating system wasn't up to snuff. But Allard argued that it wasn't specialized enough to handle video gaming. Gates eventually relented, in a decision that is widely seen today as a key to the console's success.

Even Ballmer, once pigeonholed as a micromanager, seems increasingly willing to distribute power and let those underneath him try new approaches. "I would have been hell-bent and determined six years ago to call Xbox the Windows Game Machine," he says. "My natural tendency would have been to call Zune something that was related to Xbox, since we had some consumer franchise. And yet we're really building consumer marketing muscle, and those guys are really teaching and educating us on new ways to do things."

Never afraid to speak his mind, Allard started pushing buttons way back in 1994, when, as an eager 25-year-old programmer only three years on Microsoft's payroll, he penned a sea-changing memo titled "Windows: The Next Killer Application on the Internet," which found its way to Gates. The note, now part of Microsoft lore, helped awaken Gates to the potential and threat of the Web. "I'm a pain-in-the-ass change agent," Allard says.

It is great to see this kind of passion from Mr. Allard and commitment from Microsoft. Unfortunately, there are forces working against the kind of change the Company sorely needs:

That's exactly what Microsoft needs if it hopes to again set the tech agenda. Windows and Office will deliver more revenues in coming years than the exports of many small nations. But Web spitfires such as Google Inc. and Salesforce.com have the wind at their backs. And while Microsoft continues to recruit top talent, it also continues to see key leaders move on: executives such as Vic Gundotra, a top evangelist in its developer division, who will soon join Google, and Brian Valentine, the longtime leader of the Windows server business, who now works for Amazon.com Inc.

This gets back to the issue of culture, giving people the ability to do exciting things and grow. And Microsoft has not demonstrated, on a wide scale, that it can offer these types of opportunities to today's young technology visionaries. And its lackluster stock price doesn't help, either. Question: if you don't have the structure to support rapid decision-making, creativity and innnovation, and you don't have robust stock price prospects, either, what do you have? Answer: an uphill battle.

Conclusion

Microsoft has to decide what it wants to be. "Bet the ranch" projects like Vista are not the future. While the Company can say it beta tested Vista to death, if it takes 5 years, billions of dollars and millions of man-hours to kick out a commercial product you've got a problem. What top young pro wants to be part of that? The problem is deeper than business model and who your customer really is (though these are, without question, two of the most critical issues to Microsoft's future), but how you attract, retain, excite, challenge and incentivize the best people. Without this, the battle is lost. And right now, Microsoft needs to focus on those dimensions if it wants to maintain its role in shaping the technology of tomorrow. Because we have firmly entered the Era of Consumer Computing, an era with which Microsoft has little experience and even less success. And based upon what I am hearing from the corners of the Internet, they've got a seriously uphill battle.

The author does not hold a position in this company's securities.