David Rosenthal
Appearances
Acquired
The Mark Zuckerberg Interview
And I remember... For listeners, let's just be really clear. You guys shipped this product that I'm holding... before LLMs, or at least before the public consciousness was aware of the ChatGPT moment. And these were not manufactured and shipped as an AI device. That came later when they were already in market.
Acquired
The Mark Zuckerberg Interview
He was like, so I was on the highway with my kids, and I get this call on a Saturday from Mark, and he's like, those glasses... Could we put Meta AI in them running on device and ship that soon so we can see if that's a good idea or not?
Acquired
The Mark Zuckerberg Interview
First, though, a huge thank you to our partners this season. You know our presenting partner, JP Morgan Payments.
Acquired
The Mark Zuckerberg Interview
Okay, so... Thank you for opening up with a story. The question that I would like to try to answer tonight is why has Meta worked as spectacularly well as it has?
Acquired
The Mark Zuckerberg Interview
I mean, one of the most valuable companies in the world, through multiple iterations, multiple technology waves, fighting off, you know, maybe, let's name all the waves in which people said, oh, Facebook and Meta are so screwed, and yet, that is not the way it looks today.
Acquired
The Mark Zuckerberg Interview
That's mine. There is a widely held public narrative every single time Snapchat discovers stories or there's something where people are like, oh, the cool thing that Facebook, the company, did is just obsolete now and they're going to go away. You very much haven't gone away. What do you think is the through line of the DNA of the company that allows you to keep winning?
Acquired
The Mark Zuckerberg Interview
Sounds a lot like meta. And Crusoe, which is the world's best climate-aligned AI cloud and data center operator that is leading the industrial build-out of AI. Find out more about them at crusoe.ai. As always, come discuss this afterwards with us in the Slack, acquired.fm. And if you want to be notified when every new episode drops, sign up at acquired.fm.
Acquired
The Mark Zuckerberg Interview
In one of my research calls to prep for this, someone described you as a master strategist, which we all sort of acknowledge that at this point, but that the... I mean, except for all the stuff that I just thought was not going to be that important that ended up actually being the most important.
Acquired
The Mark Zuckerberg Interview
Like, the apple's gonna fall from the tree in some direction, and if you just set up the game that you have a hand close enough to catch it... The comment that someone made to me was, the reason Mark is such a good strategist is because he plays the company as if it's a turn-based strategy game, and he just makes sure he gets more turns than anybody else, and he makes sure that he learns more from each turn than the next player does.
Acquired
The Mark Zuckerberg Interview
Do you feel like that encapsulates Meta's product development? I do like turn-based strategy. But it does kind of feel like the way that you make bets is like, well, if we have great engineering, then that can kind of take care of the speed part. That's like many iterations or multiple at-bats.
Acquired
The Mark Zuckerberg Interview
And it's just about making sure that the thing that the company is known for or its brand can withstand all the little damage that you do to it by shipping stuff that's not quite ready.
Acquired
The Mark Zuckerberg Interview
Like when you're like, oh, I feel bad because I shipped a product that wasn't good enough, you're sort of...
Acquired
The Mark Zuckerberg Interview
So I'm building to this question of, to you, is product creation an act of invention or discovery? Like is David always inside that marble and you just need the very best tooling and ability to get things in market and get feedback to discover the statue of David? Or do you conceive of David in your head and I'm like, I'm going to make this and put it in the world?
Acquired
The Mark Zuckerberg Interview
That I'm like as I pour through all these historical examples There's like the market discovers some other participant in the Marcus discovers the stories format and suddenly the whole world is like oh my god That is the way that we all that's the social interaction mechanism, and that's like a pretty pure Discovery where you have products that have stories they perform very well
Acquired
The Mark Zuckerberg Interview
Yeah, for those who don't know about JPMorgan Payments, they empower businesses to accept money, hold money, send money, protect money from fraud, and gain unique insights from money flows to help your company grow.
Acquired
The Mark Zuckerberg Interview
that's been discovered. But there's other times, it feels like everything you're trying to do in Reality Labs, all, you know, 50 plus billion dollars that you've put into it, is like, we're gonna freaking will this thing into existence because I have an idea of the way that I want the world to be. I'm not really, like, asking for that much feedback. I'm putting it in the world.
Acquired
The Mark Zuckerberg Interview
David, you... I really am grabbing the wheel here. Is this connected, or did you just decide that it was your turn to talk?
Acquired
The Mark Zuckerberg Interview
Yeah, we've got more to share about their new payments products and technology this season, like the pay-by-face biometric payments that we saw live at Chase Center.
Acquired
The Mark Zuckerberg Interview
Yep, so that you can learn which may be the right fit to solve your payments challenges and grow your business.
Acquired
The Mark Zuckerberg Interview
So let's be clear. The feed ad had not been invented yet. Like, the ad unit of our time.
Acquired
The Mark Zuckerberg Interview
Anyway, where were we? So David asked, hey, can you help us with our research? Can I follow that thread that you just said, hey, that one wasn't so bad? There's been a lot of amazing things the company has done. There's also been like a lot of criticism.
Acquired
The Mark Zuckerberg Interview
Yeah. For the first time, we actually got to experience what it would be like if Acquired was a large world-class organization and not just, you know, our little team. And what happened at Chase Center is really the physical embodiment of that.
Acquired
The Mark Zuckerberg Interview
If you were to be self-critical of your own company, of your own creation, of all the criticisms that have happened over the years, which do you believe is the most legitimate and why?
Acquired
The Mark Zuckerberg Interview
Do you have a reasonable framework at this point for like, okay, here's the stuff where I feel like we actually do want to take responsibility for it, and here's the stuff where we're like, no, that's not our fault.
Acquired
The Mark Zuckerberg Interview
Yep. So please enjoy our conversation with Mark Zuckerberg and to take us in the chairman and CEO of JPMorgan Chase, Jamie Dimon.
Acquired
The Mark Zuckerberg Interview
This is the advantage of being a college dropout founder. Yeah, no, it is.
Acquired
The Mark Zuckerberg Interview
Wow. And being very cash-generative very early, such that you had a very real going concern on your hands, and you just didn't need to cut off your arm and sell it to someone in order to build your business. Yeah, totally. I think this is a fundamentally misunderstood thing about... Facebook the startup. It is the prototypical startup.
Acquired
The Mark Zuckerberg Interview
Of this century. And there's a lot of people that want to start a startup for a lot of the glamorous reasons of starting a startup. You hated being a startup and wanted to stop being a startup as fast as possible and be a going concern.
Acquired
The Mark Zuckerberg Interview
What is your advice to all these founders who sort of romanticize the idea of starting a company and kind of raising all this money? Obviously, starting a company is not bad.
Acquired
The Mark Zuckerberg Interview
It's not making that much money. So I'm going to play Mark back to you. Sure. It's not appropriate to have all these people and resources working on things for more than the stage warrants. I'm being a little facetious here, but I'm curious why you categorize it differently.
Acquired
The Mark Zuckerberg Interview
Was there a moment, like, what changed? Like, when did this become your priority and why? I can't, it feels so radical that it, how could it have possibly been gradual? Or was this just like, Mark all the time and we just couldn't see the real Mark?
Acquired
The Mark Zuckerberg Interview
We're starting to enter, looking at the clock, conclusion lightning round territory. I've had one lurking in the back of my head. It makes sense to me that you would rebrand the company something that is not Facebook, given how broad the family of apps was that you've got. Let's imagine you were going to rebrand it today. You've got AI going on. You've got AR going on. You've got VR going on.
Acquired
The Mark Zuckerberg Interview
Would you pick the name Meta if you were going to rename the company today?
Acquired
The Mark Zuckerberg Interview
And if I were to make the case to you, I feel... the core competency of Meta is you are able to discover products in the world. You have great ideas, you work on them, you discover interesting products. And you, Mark, are not someone who wants to define yourself by anything.
Acquired
The Mark Zuckerberg Interview
You want to have your hands on a bunch of great controls and maximize your degrees of freedom, see where the world's going, and then have the best freaking spaceship possible to go maneuver your way over there. It seems like I would pick a brand that almost doesn't pigeonhole me into a specific future. I might be looking for something that's more like, look, I want to maximize my maneuverability.
Acquired
The Mark Zuckerberg Interview
Oh, to prepare? Yeah. 30 to 40. The best ones are the 04 to 06 vintage, but they're also different. It's almost like every three to four years is a new era that is markedly different from all the previous eras.
Acquired
The Mark Zuckerberg Interview
And in many ways, doing what I just suggested would kind of be running. It's like, well, we don't believe in it that much. And you're like, no.
Acquired
The Mark Zuckerberg Interview
So we have a lot of builders in the audience tonight, a lot of founders. We're in probably the most interesting technology environment since the early mobile days in terms of opportunity.
Acquired
The Mark Zuckerberg Interview
It's been 20 years, you might have to go back a little bit, but what advice do you have for founders today on something that's different than trying to pattern match Mark Zuckerberg from 2004, given we live in a different world today?
Acquired
The Mark Zuckerberg Interview
We made you something that you already have a very amazing, well-designed shirt. I hope you have room in your life for more than one.
Acquired
The Mark Zuckerberg Interview
So David and I made you a custom one-of-one shirt that represents tonight.
Acquired
The Mark Zuckerberg Interview
It is size zuck. So no one else can, you know, it can never be made again. And we've got these coordinates on the back. The first one. GPS coordinates. GPS coordinates. The first one represents Kirkland House, where you wrote the first line of code for Facebook. And the second one is the Chase Center. Awesome. So thank you for joining us here tonight. Thank you for joining us. Wow. What a night.
Acquired
The Mark Zuckerberg Interview
Absolutely crazy. I mean, Mark has done many interviews this year, both with other podcasts and in traditional press, but that felt different. If for no other reason than it happened live in front of a 6,000 person audience in an arena, but I wasn't expecting it to feel that different.
Acquired
The Mark Zuckerberg Interview
Well, listeners, as you may have noticed, thanks to our sponsors, this conversation was uninterrupted. And we do want to reflect a little bit and share some of our thoughts and our, you know, how we're feeling looking back on this conversation with you. But first, we do want to share a word on Statsig and Crusoe. So Statsig.
Acquired
The Mark Zuckerberg Interview
How? Certainly not anymore. And really relative to its peers, not even throughout its past. Yep. Facebook invested hundreds of thousands of engineering hours in a set of internal tools. These tools let any engineer set up new metrics, ship new features, and measure performance in real time.
Acquired
The Mark Zuckerberg Interview
That means anyone could just ship a new feature, but they always had metrics to use as guardrails, and they could always roll back a feature if anything broke.
Acquired
The Mark Zuckerberg Interview
So you're stuck, right? Well, enter Statsig. Statsig has built the world's first product acceleration platform, combining tools like feature flags, product analytics, experimentation, and observability all in one place, helping you move faster and make smarter decisions.
Acquired
The Mark Zuckerberg Interview
David, every time we work with Statsig, this list gets more and more impressive. Like now it is purely, you know, A-list companies.
Acquired
The Mark Zuckerberg Interview
It's crazy. When Acquired first started working with Crusoe, this was a cool idea. Now they're like one of the most important companies in the world with an AI cloud that's superior to the hyperscalers and a whole bunch of the largest companies in the world trusting their AI infrastructure to them.
Acquired
The Mark Zuckerberg Interview
And Crusoe is powering that by producing or repurposing huge amounts of power. We are talking gigawatts in their development pipeline, which is nuclear reactor amounts of power for less cost than other providers and with zero or in some cases actually negative emissions. It's super important.
Acquired
The Mark Zuckerberg Interview
If you listen to Zuck and others talk about what the bottleneck to AI progress is, it's actually not compute, but energy. And Crusoe is solving that problem.
Acquired
The Mark Zuckerberg Interview
OK, so, David, reflections on this conversation. The biggest thing that I kept thinking going into the night as we're talking with Mark, as we're talking with his team, you know, people kept saying, we don't really do this. Mark doesn't really do this. And I kept thinking, yeah, he kind of does because he's done all these podcasts this year.
Acquired
The Mark Zuckerberg Interview
And he does Facebook Meta Connect like he's done big events before, of course. Right. And he does a good number of in-person press interviews, too. It's not like he doesn't talk to the traditional press, even though that has kind of become a narrative. It's not really true. However, Mark has not done an external several thousand person live thing like this.
Acquired
The Mark Zuckerberg Interview
This is a very unusual format and kind of an uncomfortable one, even for you and I. Like, we're so used to stopping, starting, being thoughtful in our answers. And, like, this is a show. You're performing. There are no breaks. There's no retakes.
Acquired
The Mark Zuckerberg Interview
Right. But Mark and, like, all the meta execs really embraced it. A bunch of the executive team came. Like, they took off this whole day and actually some stuff we did the night before, too.
Acquired
The Mark Zuckerberg Interview
Right. I thought this was a big deal for us. I was kind of shocked to the degree that Mark also thought it was a big deal for him.
Acquired
The Mark Zuckerberg Interview
That's one. I was also surprised and delighted that he was willing to dive into history with us.
Acquired
The Mark Zuckerberg Interview
Totally, because you could create these through lines. I mean, as funny as your interjection on let's go back to the IPO moment was, it opened up the door to have like these comparative moments to is what Meta doing today, is that similar to something that you've done over and over? Should we be watching for a pattern here? Or are you very different today than you were historically?
Acquired
The Mark Zuckerberg Interview
The way that he was talking about that stuff on stage felt very authentic. And I just haven't heard him speak in that way before, at least publicly.
Acquired
The Mark Zuckerberg Interview
Yeah, I think the casual observer to Meadow might observe like, you know, Mark's been running it for 20 years and most of the time these founders kind of like go and do something else. They become executive chairman or they like stepped into a board role or they own 4% of the companies. There's some pattern there. And for Mark, I think it was plain as day on stage. Yeah.
Acquired
The Mark Zuckerberg Interview
he is more in it than ever. And I don't think he thinks he's like halfway through his journey. Like, I don't think he's 20 years in. At 40, I'll be done. I don't get that sense either. I think meta is his vehicle by which he wants to live his entire life. And he wants to make things with this group of people that he wants to make, period. And that is kind of the product strategy.
Acquired
The Mark Zuckerberg Interview
Welcome to the fall 2024 season of Acquired, the podcast about great companies and the stories and playbooks behind them. I'm Ben Gilbert. I'm David Rosenthal. And we are your hosts. Listeners, we have something very special for you today. Our interview with Mark Zuckerberg from Acquired live at Chase Center. Mark is the iconic founder CEO of our time.
Acquired
The Mark Zuckerberg Interview
I was appreciative that he engaged with us on the be critical of the company, because honestly, I was asking that as research for when we inevitably do our meta episode. I think he gave us a regret, not a criticism, but we were live on stage in front of 6,000 people, and it's not really the right format for that.
Acquired
The Mark Zuckerberg Interview
I'm glad you caught this, too. Other big tech CEO founders... have their moment running the company, they take a board role, they go do another thing. And oftentimes it's big and important for the world and capital intensive. And Mark is doing that, but inside meta with Reality Labs.
Acquired
The Mark Zuckerberg Interview
I think it'll be super fascinating 20 to 50 years from now to reflect back and say, what were the unintended or perhaps intended outcomes of co-mingling multiple huge swings under one corporate umbrella versus having people who are either CEO of multiple companies concurrently or step down from one to run the other.
Acquired
The Mark Zuckerberg Interview
For Mark, I kind of feel like, again, meta is his vehicle for executing the things that he thinks are awesome products. And of course, it's not just awesome products, but things that could let him have more control over his universe. He's clearly a guy who values having a lot of degrees of freedom and doesn't like being boxed in.
Acquired
The Mark Zuckerberg Interview
Yes. But it'll be interesting to see the knock-on effects of having Reality Labs in the meta organization versus as a new venture.
Acquired
The Mark Zuckerberg Interview
which I think is probably true of like Apple, Steve Jobs, Bill Gates, Microsoft, NVIDIA, Jensen. Yes. But we are right up close to the ways in which meta is a sort of an amplifier, almost like it's a way for you to take the gain on Mark's output and turn it up, you know, 10,000x.
Acquired
The Mark Zuckerberg Interview
Are you saying Meta is still very much a Mark Zuckerberg production? I'll see myself out.
Acquired
The Mark Zuckerberg Interview
Well, listeners, thank you so much for joining us on this journey. Come talk about it with us in the Slack, acquired.fm slash Slack. Would love to hear all of your thoughts as well. Join our email list, acquired.fm slash email. That will let you basically know every single time a new episode drops or when we are doing something like Chase Center again to be the first to know about that.
Acquired
The Mark Zuckerberg Interview
Well, no, let's pull that thread. Yeah. No pun intended, I promise. What does learning through suffering mean to you?
Acquired
The Mark Zuckerberg Interview
God, if we ever do something like that again. We've got a merch store. Check it out on Acquired.fm. We've got ACQ2, our second show where we are always interviewing earlier stage companies than Meta, but where we think there are great, insightful conversations with founders and CEOs. And David, I know you've got some thank yous.
Acquired
The Mark Zuckerberg Interview
Yes, so fun. Thank you to Jamie Dimon, JPMorgan Chase, and JPMorgan Payments for making it all possible. It was truly a dream come true, and that is because of our incredible partnership.
Acquired
The Mark Zuckerberg Interview
Yes, in a couple of weeks with the full show. We are pumped to drop it. We'll see you next time.
Acquired
The Mark Zuckerberg Interview
And this conversation was just too good to hold on to any longer. So we are getting it out quickly before we release the full video of the entire show.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
I can't believe you hadn't been before. I know Jensen is a Denny's guy, but I feel like he would meet us at Bucks if we asked him.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah. Well, when you put it that way, I think the conclusion that we can come to is that Marc Andreessen was right. In what years was this that we were talking about on... It was like 2015 or something. Yeah, like 2015, 2016.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, because they were seeing all of these startups doing deep learning, machine learning at the time, early AI, and they were all building on NVIDIA and they should have just said... No thank you to all of them and put it all in video. Mark is right once again. Strength leads to strength. There you go.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah. We also, as we've alluded to throughout the show, we owe a bunch of thank yous to lots of people who are so kind to help us out, including people who have way better things to do with their time. So we're very, very grateful.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
Absolutely. Also, big shout out to friend and listener of the show, Jeremy from ABC Data, who prepared four PDFs for us. Completely unprompted, like an insane write-up for us about a lot of the technical detail behind this.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, private blog posts. So our acquired community is just the best. Like, you guys continue to blow us away. So thank you.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
All this stuff is coming out of AI research. Some of the other stuff that happens at Google, famously after they acquired DeepMind, DeepMind built a bunch of algorithms to save on cooling costs. And Facebook, of course, they probably had the last laugh in this generation because they're using all this work and Yann LeCun is doing his thing and hiring lots of researchers there.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
Indeed. All right. Carve-outs. Let's shift gears. Carve-outs. What you got?
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
Ben, I never have one more hour at the end of the day. I have a two-year-old. But I really appreciate it. For 16 years from now when she goes to college, I'll keep that on my list.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yes, that's right. This is like the TV version of The Matrix, right?
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
My car route, related for my stage of life, also something I missed and discovered recently, we just watched our first full movie, full Disney movie with our daughter.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
A major milestone. And she freaking loved it. I think we picked a great one. Moana. Which neither Jenny or I had seen before. And in reading just a little bit about it afterwards, you know how super sadly Pixar kind of fell off in recent years? Like such a bummer. I mean, they're still Pixar, but like they're not Pixar.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah. So Moana came out in this kind of generation with Tangled and some of the other stuff out of actual Disney animation after the Pixar acquisition that are just like, these are return to form, Eisner era, Disney animated, just like... Fires on all cylinders. And we loved it. We watched with our brother and sister-in-law who don't have kids and are 30-somethings living in San Francisco.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
They loved it. Our daughter loved it. Highly recommend Moana, no matter what life phase you're in.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
It was so fun. I think you're about to talk about our Slack. It was so fun watching people in Slack talk about the hints for this episode. We wrote the little teaser and I was like, oh, everybody's going to know exactly what this is.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah. Eventually somebody did, but it took a couple days.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
This is just a couple of years after they acquired Instagram. Man, we need to go back and redo that episode because Instagram would have been a great acquisition anyway, but it was AI-powered recommendations in the feed that made that into a $100, $200, $500 billion asset for Facebook.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
It absolutely does. There's this amazing quote from Astro Teller who ran Google X at the time and still does in a New York Times piece where he says that the gains from Google Brain during this period, I don't think this even includes DeepMind, just the gains from the Google Brain team alone in terms of profits to Google
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
more than funded everything they were doing in Google X. Which, has there ever been anything profitable out of Google X? Google brain.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
We'll leave it at that. So this takes us to 2015, when a few people in Silicon Valley start to realize that this Google-Facebook-AI duopoly is actually a really, really big problem. And most people had no idea about this. This is really visionary of these two people.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
I think there are three levels of concern here. One, obviously, is the other tech companies. Then there's the problem of startups. This is terrible for startups. How are you going to compete with Google and Facebook when this is the primary value driver of this generation of technology?
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
There really is another lens to view what happened with Snap, what happened with Musical.ly and having to sell themselves to ByteDance and becoming TikTok and going to the Chinese. Maybe it was business decisions, maybe it was execution or whatever that prevented those platforms from getting to independent scale. Snap's a public company now, but like it's no Facebook.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
Maybe it was that they didn't have access to the same AI researches that Facebook and Google had.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
A fun straw man. Nonetheless, this is definitely a problem. The third layer of the problem is just like, this sucks for the world that all these people are locked up in Google and Facebook.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
So these two people, who are quite concerned about this, convene a very fateful dinner in 2015. Of all places. Is it the Rosewood? The Rosewood Hotel on Sand Hill Road. Naturally. It would have been way better if it were a Denny's or Buck's in Woodside or something like that.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yep. So, of course, those two shadowy figures are Elon Musk and Sam Altman, who at the time was president of Y Combinator. So they get this dinner together and they invite basically all of the top AI researchers at Google and Facebook. And they're like, yo, what is it going to take for you to leave and to break this duopoly? And the answer from almost all of them is no. Nothing. You can't.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
Why would we ever leave? We're happy as clams here.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
Right. Not only are we getting paid just ungodly amounts of money... But we get to work directly with the best AI researchers in the field. If we were still at academic institutions, you know, say you're at the University of Washington, amazing academic institution for computer science, one of the top in the world, or the University of Toronto, where these guys came from.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
You're still at a fragmented market. If you go to Google or you go to Facebook, you're with everybody. Yep. So the answer is no from basically everybody. Except... there's one person who's intrigued by Elon and Sam's pitch.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
And to quote an amazing Wired article from the time by Cade Metz that we will link to in our sources, quote, the trouble was so many of the people most qualified to solve all these AI problems were already working for Google and Facebook, and no one at the dinner was quite sure that these thinkers could be lured to a new startup immediately. even if Musk and Altman were behind it.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
But one key player was at least open to the idea of jumping ship. And then they have a quote from that key player. I felt there were risks involved, but I also felt it would be a very interesting thing to try. And that key player was Ilya Sutskiver. Yep.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
So after the dinner, Ilya leaves Google and signs up to become, as we said, co-founder and chief scientist of a new independent AI nonprofit research lab backed by Elon and Sam, OpenAI.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
So Crusoe, as listeners know by now, is a clean compute cloud provider specifically built for AI workloads. NVIDIA is one of their major partners, and literally Crusoe's data centers are nothing but racks and racks of A100s and H100s.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
And because Crusoe's cloud is purpose-built for AI and run on wasted, stranded, or clean energy, they can provide significantly better performance per dollar than traditional cloud providers.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
Just as one example, Crusoe was one of the first clouds to deploy the 3200 gigabit InfiniBand, which we will be talking about a lot more later on the episode, to dramatically accelerate the performance of large AI training clusters in their data centers.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
The other element that makes Crusoe special is the environmental angle. Crusoe, of course, locates their data centers at stranded energy sites. So think oil flares, wind farms that can't use all the energy they generate, et cetera, and uses that power that would otherwise be wasted to run your AI workloads instead.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
It's super cool that they can put their data centers out there in these remote locations where, quote unquote, energy happens, as opposed to the other hyperscalers such as AWS and Google and Azure. who need to build their data centers close to major traffic hubs where the internet happens because they are doing everything in their clouds.
Acquired
Nvidia Part III: The Dawn of the AI Era (2022-2023)
So as we were talking about a little bit, AI at this point in time, super good for narrow use cases, looks nothing like GPT-4 today. The capabilities that it had were pretty limited. And one of the big reasons was that the amount of data that you could practically train these models on was pretty limited. So the AlexNet example, you're talking about 14 million images.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
In the grand scheme of the Internet, 14 million images is a drop in the bucket.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Well, that is definitely what Jensen believes.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
This is so cool. So at Spring GTC this year, Jensen did a fireside chat with Ilya. And it's amazing. You should go watch the whole thing. But in it, this question comes up. Jensen kind of poses as a straw man. Like, hey, some people say that GPT-3, 4, chat GPT, everything going on, all these LLMs, they're just probabilistically predicting the next word in a sentence.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
They don't actually have knowledge. And Ilya has this amazing response to that. He says, okay, well, consider a detective novel. Yes. At the end of the novel, the detective gathers everyone together in a room and says, I am now going to tell you all the name of the person who committed the crime. And that person's name is blank. The more accurately... an LLM predicts that next word, i.e.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
the name of the criminal, ipso facto, the greater its understanding not only of the novel, but of all general human-level knowledge and intelligence. Because you need all of your experience in the world and as a human to be able to guess who the criminal is. And the LLMs that are out there today... GPT-3, GPT-4, Llama, Bard, these others, they can guess who the criminal is.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Absolutely. Ben, tell us about the Transformer.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And it's from the Google Brain team, right? Yes. That Ilya just left.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
This is why AI and machine learning was so narrowly applicable before. If you anthropomorphize it and you think of it like a human, it was like a human with a very, very short attention span.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Oh, that's giving me the heebie-jeebies back to my intro CS classes in college.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, this is huge and probably for all listeners out there starting to sound very familiar to the world that we live in today.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yep. So this Transformer paper comes out in 2017. The significance is huge. But for whatever reason, there's a window of time where the rest of the world doesn't quite realize it. So Google obviously knows how important this is. And there's like a year where Google's AI work is... Even though Ilya has left and OpenAI is a thing now, accelerates again beyond anybody else in the field.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So this is when Google comes out with Smart Compose in Gmail and they do that thing where they have an AI bot that'll call local businesses for you. Remember that demo from IO that they did?
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
I don't know. Maybe it did. I mean, this is Google here. The capabilities are there. The product sense, not as much. This is when they really start investing in Waymo. But again, where it really manifests is just back to serving ads in search and recommending YouTube videos. They're just crushing it in this period of time. Open AI and everyone else, though, they haven't adopted Transformers yet.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
They're kind of stuck in the past. And they're still doing these really researchy computer vision projects. So like this is when they build a bot to play Dota 2, Defense of the Agents 2, the video game.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
For the past generation. It's a faster horse, basically.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, it was scattershot. And I guess what I'm saying is it was still in this narrow use case world. They weren't doing anything approaching GPT at this point in time. Meanwhile, Google had kind of moved on. Yep. Now, one thing I do want to say in defense of OpenAI and everybody else in the field at the time, they didn't just have their heads in the sand.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
To do what transformers enabled you to do, which Ben, you're going to talk about in a sec, cost a lot in computing power. GPUs and NVIDIA and the transformer made it possible. But to work with the size of models you're talking about, you're talking about spending an amount of money that's certainly for a nonprofit and anybody really except Google was untenable.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
As a parent of a two-year-old, can confirm.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So to give people a sense of why we're saying that the idea of training on very, very, very large amounts of data here is crazy expensive, GPT-1 had roughly 120 million parameters that it was trained on. GPT-2 had 1.5 billion. GPT-3 had $175 billion, and GPT-4, OpenAI hasn't announced, but it's rumored that it has about 1.7 trillion parameters that it was trained on.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So as you throw huge amounts of data at training them... You can also throw huge amounts of NVIDIA GPUs at processing that.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So in defense of OpenAI, they knew all this, but the amount of money that you would have to spend to buy GPUs or to rent GPUs in the cloud to train these models is prohibitively expensive.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
This is great. I can finally get Jenny one of her own so she stops stealing mine.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And, you know, even Google at this point in time, this is when they start building their own chips, TPUs, because they're still buying tons of hardware from Nvidia, but they're also starting to source their own here.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So with this, it starts to look like maybe this whole open AI boondoggle didn't actually accomplish anything. And the world's AI resources are more than ever just locked back into Google. So in 2018, Elon gets super frustrated by all this, basically throws a hissy fit and quits and pieces out of OpenAI. There's a lot of drama around this that we're not gonna cover now.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
He may or may not have given an ultimatum to the rest of the team that he would either take over and run things or leave. Who knows? It's Elon. But whatever happened, This turns out to be a major catalyst for the rest of the OpenAI team and truly a history turning on a knife point moment. It was also a probably super bad decision by Elon. But again, story for another day.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah. And I believe this is mostly, if not all, due to Sam Altman's influence and taking over here. So...
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Oh, man. Well, on the one hand, we only have 18 months to talk about.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
know on the one hand you can look at this sort of skeptically and say okay sam you took your non-profit and you converted it into an entity worth 30 billion dollars today on the other hand knowing this history now this was kind of the only path they had they had to raise money to get the computing resources to compete with google and sam goes out and does these landmark deals with microsoft
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yep, so 2019, they do the conversion to a for-profit company. Microsoft invests a billion dollars, as you say, and becomes the exclusive cloud provider for OpenAI, which is going to become highly relevant here for NVIDIA. More on that in a minute. June of 2020, GPT-3 comes out. In September of 2020, Microsoft licenses exclusive commercial use of the underlying model for Microsoft products.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
On the other hand, we have decades and decades of foundational research to cover. So when I was starting my research, I went to the natural first place, which was our old episodes from April 2022. And I was listening to them and I got to the end of the second one. And man, I had forgotten about this.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
2021, GitHub Copilot comes out. Microsoft invests another $2 billion in OpenAI. And then, of course, this all leads to November 30th, 2022. In Jensen's words, the AI heard around the world. OpenAI comes out with chat GPT. As you said, Ben, the fastest product in history to reach 100 million users.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
In January 2023, this year, Microsoft invests another $10 billion in OpenAI, announces they're integrating GPT into OpenAI. all of their products. And then in May of this year, GPT-4 comes out. And that basically catches us up to today. We eventually need to go do a whole another episode about all the details here of OpenAI and Microsoft.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
But for today, the salient points are, one, thanks to all this, generative AI as a user-facing product emerges as this enormous opportunity. Two, to facilitate that happening, you needed enormous amounts of GPU compute, obviously benefiting NVIDIA. But just as important, three,
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
it becomes obvious now that the predominant way that companies are gonna access and provide that compute is through the cloud. And the combination of those three things turns out to be basically the single greatest moment that could ever happen for NVIDIA.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, if you listen to our ACQ2 interview with founder and CEO Vijay Raji, you know that StatsAge is a platform that combines feature flagging, experimentation, and product analytics. They help teams run experiments in their products, automate the analysis, launch new features, and analyze product performance.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Their focus was on taking these pretty traditional product workflows and making them easier by giving teams one connected tool to move fast and make data-driven product decisions. So how does that relate to AI?
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
I think Jensen maybe wishes we all had forgotten about this in one of NVIDIA's earnings slides in 2021. They put up their total addressable market, and they said they had a $1 trillion TAM. And the way that they calculated this was that they were going to serve customers who provided $100 trillion worth of industry, and they were going to capture just 1% of it.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
In today's generative AI world, product decisions aren't just the product features anymore. They're literally like the weights and temperatures of the models underlying the products. Yep. So whether you're building with AI or not, Statsig can help your team ship faster and make data-driven product decisions.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
If you're a startup, they have a super generous free tier and a special program for venture-backed companies. If you're a large enterprise, they have clear, transparent pricing with no seat-based fees. Acquired community members can take advantage of a special offer too, including 5 million free events a month and white glove onboarding support. Just go visit statsig.com slash acquired.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
That's S-T-A-T-S-I-G dot com slash acquired to get started on your data-driven journey.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Okay, so we just said these three things that we've painted the picture of on the first part of the episode here that A, generative AI is like possible a thing and it's now getting traction. B, it requires an unbelievably massive amount of GPU compute to train. And three, it looks like the predominant way that companies are going to use that compute is going to be in the cloud.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
The combination of these three things is I think the most perfect example we've ever covered on this show of the old saying about luck being what happens when preparation meets opportunity for NVIDIA here.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So obviously the opportunity is generative AI, but the preparation front, NVIDIA has literally just spent the past five years working insanely hard to build a new computing platform for the data center. a GPU-accelerated computing platform to, in their minds, replace the old CPU-led, Intel-dominated x86 architecture in the data center.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And for many years, I mean, they were getting some traction, right? And the data center segment was growing for NVIDIA, but people were like, okay, you want this to happen, but like, why is it going to happen?
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Not only could be, but if you look at their most recent quarter, absolutely freaking is.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Dude, I loved computer science in college.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And there was some stuff on the slide that was... fairly speculative, you know, like autonomous vehicles and the omniverse. And I think robotics were a big part of it.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Ben, are you about to program live on Acquired?
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, it's usually not the right way to think about starting a startup. You know, oh, if we can just get 1% of this big market, blah, blah, blah.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
I thought you were going... And this is why the data center and what NVIDIA has been doing is so important.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So you, Ben, rightly so called this out at the end of NVIDIA Part 2, and you're like... You know, I think to justify where Nvidia is trading at the moment, you kind of actually got to believe that all of this is going to happen and happen soon. Autonomous cars, robotics, everything.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
okay so back to the data center and here's what nvidia is doing that i don't think anybody else out there is doing and why it's so important for them that all of this new generative ai world this new computing era as jensen dubs it runs in the data center so nvidia has done three things over the last five years one and probably most importantly related to what you're talking about ben
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
They made one of the best acquisitions of all time back in 2020, and nobody had any idea. They bought a quirky little networking company out of Israel called Mellanox.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Okay, yeah. And it was already a public company, right? It was, yep. Yeah, but it was definitely quirky. Now, what was Mellanox? Mellanox's primary product was something called InfiniBand, which we talked about a lot with Chase Lockmiller on our ACQ2 episode with him from Crusoe.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, so you said, wait, what is InfiniBand? It is a competing standard to Ethernet. It is a way to move data between racks in a data center. And back in 2020, everybody was like, Ethernet's fine. Why do you need more bandwidth than Ethernet between racks in a data center? What could ever require 3,200 gigabits a second of bandwidth running down a wire in a data center?
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Well, it turns out if you're trying to address hundreds, maybe more than hundreds of GPUs as one single compute cluster to train a massive AI model, yeah, you want really fast data interconnects between them.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yep. So that's piece number one of Nvidia's grand data center plan over the last five years. Piece number two is in September 2022, Nvidia makes a quite surprising announcement of a new chip. Not just a new chip, an entirely new class of chips that they are making called the Grace CPU processor. NVIDIA is making a CPU. This is like heretical.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah. These Grace CPUs are not for putting in your laptop. They are for being the CPU component of your entire data center solution that is specifically from the ground up design to orchestrate with these massive GPU clusters.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yep. I kind of can't believe that I said this because it was unintentional and uninformed, but I was kind of grasping at straws trying to play devil's advocate for you. And we just spent most of that whole episode talking about how machine learning powered by NVIDIA
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
One more piece to talk about the third leg of the stool there, strategy, before we get to what it all means that I think you're about to go to. Spoiler alert, you say solution, I hear gross margin. The third part of it is the GPUs. Up until NVIDIA's current GPU generation, the hopper generation of GPUs for the data center, there was only one GPU architecture at NVIDIA.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And that same architecture and those same chips from the same wafers made at TSMC Some of them went to consumer gaming graphics cards, and some of those dies went to A100 GPUs in the data center. It was all the same architecture. Starting in September of 2022, They broke out the two business lines into different architectures.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So there's the Hopper architecture, named after great computer scientist Grace Hopper. I think rear admiral in the U.S. Navy, Grace Hopper. Get it? Grace CPU, Hopper GPU. Grace Hopper. The H100s. That was for the data centers. And then on the consumer side, they start a whole new architecture called Lovelace after Ada Lovelace. And that is the RTX 40XX.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So you buy, you know, top of the line RTX 40 what have you gaming card right now. That is no longer the same architecture as the H100s that are powering ChatGPT. It's got its own architecture. This is a really big deal because what they do with the hopper architecture is they start using what's called chip on wafer on substrate. C-O-W-O-S.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
This is when a certain segment of our listeners are going to get really excited. So essentially what this is, back to this whole concept of memory being so important for GPUs and for AI workloads. This is a way to stack more memory on the GPU chips themselves, essentially by going vertical in how you build the chips. This is the absolute leading edge technology that is coming out of TSMC.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
ended up having this incredibly valuable use case, which was powering social media feed recommenders, and that Facebook and Google had grown bigger than anyone ever imagined on the internet with those feed recommendations, and NVIDIA was powering all of it. And so I just sort of idly proposed, Well, maybe.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And by NVIDIA bifurcating their chip architectures into a gaming segment that does not have this latest CoWAS technology, this allows them to monopolize like a huge amount of TSMC's capacity to make the CoWAS chips specifically for these H100s, which allows them to have way more memory than other GPUs on the market.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, which, as we know, it takes years for TSMC to do this.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So, these three things that NVIDIA has been building, the... dedicated hopper data center gpu architecture the grace cpu platform the melanox powered networking stack they now have a full suite solution for generative ai data centers and ben when i say solution
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
But what if you don't actually need to believe any of that to still think that NVIDIA could be worth a trillion dollars? What if, maybe, just maybe, the internet and software and the digital world are going to keep growing and there will be a new foundational layer that NVIDIA can power? Is that possible? And I think we were both like, yeah, I don't know. Let's end the episode.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yes. Okay, so let's break down what they're actually selling. So like you were saying, Ben, of course you can, and lots of people do, just go buy H100s. You're like, I don't care about the great CPU. I don't care about this Mellanox stuff. I'm running my own data center. I'm really good at it.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
This is AWS. This is Azure. This is Google. This is Facebook for their internal use.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
I am a world-class data center architect and operator. I don't want your solution. I just want your chips. So they sell a lot of those. Now, NVIDIA, of course, has also been seeding new cloud providers out there in the ecosystem, like our friends at Crusoe, also CoreWeave and Lambda Labs, if you've heard of them. These are all new GPU dedicated clouds that NVIDIA is working closely with.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So they're selling H100s and A100s before that to all these cloud providers.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yes, they do. Full GPU-based supercomputer solution in a box that you can just plug right into your data center and it just works. There's nothing else on the market like this.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Which means that whatever developers you already had who were working on AI or anything else, everything they were working on is just going to come right over and run within your brand new shiny AI supercomputer because it all runs CUDA.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
More on CUDA in a minute. But as we said, you say solution, I hear gross margin. NVIDIA sells these DGX systems for like $150,000 to $300,000 a box. That's wild. And now with all these three new legs of the stool, Hopper, Grace, and Mellanox,
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
these systems are just getting way more integrated way more proprietary and way better so if you want to buy a new top of the line dgx h100 system the price starts at 500 000 for one box and if you want to buy the dgx gh200 superpod this is the ai wall that jensen recently unveiled the huge like room full of ai
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yes, this is 256 Grace Hopper DGX racks all connected together in one wall. They're billing this as the first turnkey AI data center that you can just buy and can train a trillion parameter GPT-4 class model. The pricing on that is... Call us. Of course it is. But I'm imagining, like, hundreds of millions of dollars. Like, I doubt it's a billion, but hundreds of millions easily.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
That's what they're selling to Amazon and Google and Facebook.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So that's essentially an extra $180,000 of margin that NVIDIA is getting out of selling the solution. It's an ARM CPU. It doesn't cost them anything to make that.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
But the crazy thing is that, of course, at least in this time frame, most things on Jensen's trillion dollar TAM slide have not come to pass. But that crazy question just might have come to pass. And from NVIDIA's revenue and earnings standpoint, definitely has. It's just wild.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Jetson makes a big deal about this every keynote that he gives them, like, oh, I can't lift it.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Totally. And this is all part of Jensen's pitch here to customers. Yes. our solutions are very expensive. However, he uses the line that he loves, the more you buy, the more you save. If you could get your hands on some. Right. But what he means by that is like, okay, say you're McDonald's and you're trying to build a generative AI so that, I don't know, customers can order or something.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
You're using it in your business. If you were going to try and build and run that in your existing data center infrastructure, It would take so much time and cost you so much more over the long run in compute than if you just went and bought my super pod here. You can plug and play and have it up and running in a month.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
yep, you mentioned energy here. Like this is also Jensen's argument. He's like, yes, these things take a ton of energy, but the alternative takes even more energy. So we are actually saving energy if you assume this stuff is going to happen. Now, there's a bit of caveat here in that it can't happen except on these types of machines, so he enabled this whole thing, but he has a point.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Let's rewind and tell the story. So back in 2012, there was the big bang moment of artificial intelligence, or as it was more humbly referred to back then, machine learning. And that was AlexNet. We talked a lot about this on the last episode. It was three researchers from the University of Toronto who submitted the AlexNet algorithm to the ImageNet computer science competition.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So hopefully we've now painted a relatively coherent picture of both the advances that made the generative AI opportunity possible, that it has truly become a real opportunity,
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And why NVIDIA, even above the obvious reasons, was just so well positioned here, particularly because of the data center-centric nature of these workloads and that they had been working so hard for the past five years to fundamentally re-architect the data center.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So on top of all this... NVIDIA recently announced yet another pretty incredible piece of their cloud strategy here.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So today, like we've been saying, if you want to use H100s and A100s, say you're an AI startup, the way you're probably going to do that is you're going to go to a cloud, either a hyperscaler or a dedicated GPU cloud like Crusoe or CoreWeaver, Lambda Labs or the like, and you're going to rent your GPUs. And Ben, you did some research on this. So like, what does that cost?
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Right. If you could get access, that's what you would pay for it. Correct. Okay, that's just getting the GPUs. But if you buy everything we were talking about a minute ago, say your McDonald's or UPS or whoever, and you're like, you know, I really like Jensen, I buy what you're selling. I want this whole integrated package.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
I want an AI supercomputer in a box that I can plug into my wall and have it run. But I'm all in on the cloud. I don't run my own data centers anymore. NVIDIA has now introduced DGX Cloud.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yep. So NVIDIA has introduced DGX Cloud, which is a virtualized DGX system that is provided to you right now via other clouds. So Azure and Oracle and Google.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Now, ImageNet was a competition where you would look at a set of 14 million images that had been hand-labeled with what the pictures were of, like of a strawberry or a cat or a dog or whatever.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
They're sitting in the other cloud service providers. But as a customer, it looks like you have your own box that you're renting.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
This is unbelievable. NVIDIA launched their own cloud service through other clouds.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
No. So starting price for DGX Cloud is $37,000 a month, which will get you an A100-based system, not an H100-based system. So the margins on this are insane for NVIDIA and their partners. A listener helped us out and estimated that the cost to actually build an equivalent A100 DGX system was... would be today something like 120K. Remember, this is the previous generation. This is not H100s.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And you can rent it for 37K a month. So that's three-month payback on the CapEx for this stuff for NVIDIA and their cloud partners together. And even more for NVIDIA, more important longer term, for enterprises that buy this,
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
NVIDIA now has a direct sales relationship with those companies, not necessarily intermediated by sales through Azure or Google or AWS, even though the compute is sitting in their clouds.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So all of this brings us to 2023. In May of this year, NVIDIA reported their Q1 fiscal 24 earnings. NVIDIA is on this weird January fiscal year end thing, so Q1 24 is essentially Q1 23, but... Anyway, in which revenue was up 19% quarter over quarter to $7.2 billion, which is great because remember they had a terrible end of 2022 with the write-offs and crypto falling off a cliff and all that.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, it's wild. I mean, until this competition and until AlexNet, there was no machine learning algorithm that could accurately label images. So thousands of people on Mechanical Turk got paid however much two bucks an hour to label these images.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yep, it's actually going to be quite valuable. So speaking of, you know, this Q1 earnings is like great, up 19% quarter over quarter. But then they dropped the bombshell due to unprecedented demand for generative AI compute in data centers. NVIDIA forecasts Q2 revenue of $11 billion, which would be up another 53% quarter over quarter over Q1 and 65% year over year. The stock goes nuts.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Well, and it's even crazier than that. Back when we did our episodes last April, NVIDIA was the eighth largest company in the world by market cap, had about a $660 billion market cap. That was down slightly off the highs, but that was kind of the order of magnitude back then. It crashed down below $300 billion, and then within a matter of months, it's now back up over a trillion. Just wild.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And then all of this culminates last week at the time of this recording when Nvidia reports Q2 fiscal 24 earnings. And this earnings release, we usually don't talk about like individual earnings releases on Acquired because like in the long arc of time, who cares? This was a historic event. I think this was one of, if not the most incredible earnings release by any scaled public company ever.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Seriously, no matter what happens going forward, last week was a historic moment.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So here are the full numbers. For the quarter, total company revenue of $13.5 billion, up 88% from the previous quarter and over 100% from a year ago. And then Ben, like you said, in the data center segment, revenue of $10.3 billion. So 10.3 out of 13.5 for a segment that basically didn't exist five years ago for the company. That's up 141% from Q1 and 171% from a year ago. This is $10 billion.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
That kind of growth at this scale, I've never seen anything like it. No. Neither has the market.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And so this, this is the first time I noticed it. Jensen had talked about this in Q1 earnings, so it wasn't the first time. But he brings back the trillion dollar TAM. Not in a slide, I think, this time. He just talks about it.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
This time it's different. You know, look, we'll spend a while here now talking about what we think about this, but this is very different. This time he frames NVIDIA's trillion-dollar opportunity as the data center. And this is what he says. There is $1 trillion worth of hard assets sitting in data centers around the world right now.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
annual spend on data centers to update and add to that capex is 250 billion dollars a year and nvidia has certainly the most cohesive fulsome and coherent platform to be the future of what those data centers are going to look like for a large amount of compute workloads This is a very different story than like, oh, we're going to get 1% of this $100 trillion of industry out there.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
You were spot on. And the way that they did it, and what completely changed the fortunes of the internet, of Google, of Facebook, and certainly of NVIDIA, was they actually used old algorithms. A branch of computer science and artificial intelligence called neural networks, specifically convolutional neural networks, which had been around since the 60s, but...
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So we have a lot to talk about with regard to that in analysis. But before we move to analysis, I think we should talk about another one of our very favorite companies here at Acquired, Blinkist from GoOn.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
It's almost like a large language model compression for books.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And for those of you who are leaders at companies, check out Blinkist for Business. This gives your whole team the power to tap into world-class knowledge right from their phones anytime they need it, available at Blinkist.com slash business.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Blinkist is a great way for your team to master soft skills, which if you believe that this new AI world is coming, is going to be even more important for the humans in your workforce.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
They were really computationally intensive to train. And so nobody thought it would be practical to actually train and use these things, at least not anytime soon or in our lifetimes. And what these guys from Toronto did is they went out probably to their local Best Buy or equivalent in Canada. They bought two GeForce GTX 580s, which were the top of the line cards at the time, and
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And what is the right way to characterize it today? Because it has evolved a lot.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
This is something we touched on in our last episode, but has really crystallized for me in doing this one. NVIDIA thinks of themselves as, and I believe is, a platform company, especially this week after the blowout earnings and everything that happened this quarter and the stock and whatnot, sort of a popular take out there that you've been seeing a lot is, oh, we've seen this movie before.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
This happened with Cisco. You could say over a longer timescale, this happened with Intel. Yeah, these hardware providers, these semiconductor companies, they're hot when they're hot and people want to spend CapEx and then when they're not hot, they're not hot. But I don't think that's quite the right way to characterize NVIDIA.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
They do make semiconductors and they do make data center gear, but really they are a platform company. The right analogy for NVIDIA also is Microsoft. They make the operating system, they make the programming environment, they make many of the applications.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And they wrote their algorithm, their convolutional neural network, in CUDA, in NVIDIA's software development platform for GPUs. And by God, they trained this thing on like $1,000 worth of consumer-grade hardware.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
You talk to Jensen and you talk to other people at the company, and they will tell you, we are a foundational computer science company. We're not just slinging hardware here.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah. And maybe IBM actually is a really good analogy, like old school IBM here. They make the underlying technology. They make the hardware. They make the silicon. They make the operating system for the silicon. They make the solutions for customers. They make everything and they sell it as a solution.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And I think if I remember right in that interview, Ben picked up on this and was like, wait, are you building your own cloud? And Jensen was like, well, maybe, we'll see. And of course, then they launched DJX Cloud in a, well, maybe, we'll see sort of way.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yes. I mean, I think two things here. One, I really do believe what we were talking about a minute ago, that NVIDIA is not just a hardware company. They're not just a chips company. They are a platform company. And there is a lot of differentiation baked into what they do. If you want to train GPT or a GPT class model, there's one option. You're doing it on NVIDIA. There's one option.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And yes, we should talk about there's lots of less than GPT class stuff out there that you can do. And especially inference is more of a wide open market versus training that you can do on other platforms. But they're the best. And they're not just the best because of their hardware. They're not just the best because of their data center solutions. They're not just the best because of CUDA.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
They're the best because of all of those. So the other sort of illustrative thing for me that shows how wide their lead is, we haven't talked about China yet.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yes. So what's going on? Last year, China was 25% or sales to mainland China was 25% of NVIDIA's revenue. And a lot of that is they were selling to the hyperscalers, to the cloud providers in China. Baidu, Alibaba, Tencent, others.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, everybody before was trying to run these things on CPUs. CPUs are awesome, but they only execute one instruction at a time. GPUs, on the other hand, execute hundreds or thousands of instructions at a time. So GPUs, NVIDIA graphics cards, accelerated computing, what Jensen and the company likes to call this, you can really think of it like a giant Archimedes lever.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Wow, I didn't know that. Yep. That's wild. So then, I believe also in September of 2022, last year, the Biden administration announced pretty sweeping regulations and bans on sales of advanced computing infrastructure. Yeah.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
I mean, yes, that's a fine line. This is pretty close to bands, what the administration introduced. As part of that, NVIDIA can no longer sell their top-of-the-line H100s or A100s to anybody in China. So they created a nerfed SKU, essentially, that meets the regulations, the performance regulations, the A800 and H800s,
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Right, or you can't train them as well or as fast as you could with the latest stuff. The incredibly telling thing is that those chips and those machines are still selling like hotcakes in China. They're still the best hardware and platform that you can get in China Even a crippled version. And I think that's true anywhere in the world.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yep. So, I mean, I can't think of a better illustration of just how wide their lead is.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
There was a super cool demo at a recent keynote. It might have been at SIGGRAPH where NVIDIA created a game environment, you know, fully ray-traced game environment. It looks like a AAA game. It looks amazing. You know, basically...
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
distinguishable from reality but like you really gotta look hard to tell that this isn't real and this isn't a real human you're talking to so there's a non-playable character that you're talking to an NPC who's giving you like a mission and they show this demo it looks amazing then they're like the script, the words that that character was saying to you were not scripted.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
That was all generated with AI dynamically. So you're like, holy crap. You know, you think about you play a video game, the characters are scripted. But in this world that you're talking about, you can have generative AI controlled avatars that are unscripted that have their own intelligences and that drives the story.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Whatever advances are happening in Moore's law and the number of transistors on a chip, If you have an algorithm that can run in parallel, which is not all problem spaces, but many can, then you can basically lever up Moore's law by hundreds of times or thousands of times or today tens of thousands of times and execute something a lot faster than you otherwise could.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
But the scale of the platform that NVIDIA is building is on the order of magnitude of Microsoft's scale.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Which I think translates into the culture there, as we've gotten to know some folks there. It really is a very... unique kind of culture. Like it is a big tech scale company, but you never hear about the same kind of silly big tech stuff that you hear at other companies at NVIDIA. As far as I know, I could be wrong on this.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
There is no like, you know, oh, work from home or return to the office policy at NVIDIA. It's like, no, it's just like you do the job and, you know, nobody's forcing anybody to come into the office here and like they've accelerated their ship cycles.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah. He's talked about this. He's like, I have 40 direct reports. They are the best in the world at what they do. This is their life's work. I don't talk to them about their career ambitions. I don't need to. Yeah, for recent college grads, we do mentoring. But if you're a senior employee, you've been here for 20 years. You're the best in the world at what you do. And we're hyper-efficient.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And I start my day at 5 a.m. seven days a week, and you do too.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, there's actually this amazing quote from Jensen that I heard on an interview with him that I was listening to. Towards the end of the conversation, the interviewer asked him, Jensen, you and NVIDIA do these just amazing things. What do you do to relax? And Jensen's answer is, I'm reading, this is a quote, direct quote. I relax all the time.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
I enjoy relaxing at work because work is relaxing for me. Solving problems is relaxing for me. Achieving something is relaxing for me. And he's 100% serious. Like, a thousand percent serious.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
I don't know if there is or isn't a Jensen and Lori Huang Foundation, but if there is, he's not spending his time on it. He's not buying sports franchises. He's not buying mega yachts, or if he is, he isn't talking about them and he's working from them.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Right. Nobody would accuse Tim Cook of not working hard, I don't think. But you go to those keynotes and it's like, Tim does the welcome and then the handoff. And, you know, a parade of other executives talk about stuff.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
We got to have Tim on the show sometime. That would be amazing.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Not to mention all the data center hardware providers that are their direct competitors now, too.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
I would have agreed with you, but I actually think there is strong counter-positioning in the data center world right now. NVIDIA and Jensen put a flag in the ground several years ago where they said, we are going to re-architect the data center and all the existing data center hardware and compute providers had strong incentives not to do that.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
They're all trying to put GPUs in the data center too.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
I think it's worth saying a bit more here on this too, which we also talked about in our last episode. To me, the dynamics here are a lot like Apple and iOS versus Android. Apple has thousands and thousands and thousands of developers working on iOS. Android also has thousands and thousands of developers working on it across a widespread ecosystem.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
But at Apple, it's all tightly controlled and it's coupled with hardware. At Android, it's not. And like as a user, maybe you'll get the latest operating system update. Maybe you won't.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yep. And I think in the current state of things, it's even more favorable to NVIDIA than iOS versus Android because NVIDIA has had first dozens and then hundreds and now thousands of engineers working on CUDA for 16 years, right? Meanwhile, the Android equivalent out there in the open source ecosystem has only just been getting going.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
You know, if you think about the delta of the timeline between iOS and Android, it was a year and a half, two years. There's probably at least 10, probably closer to 15-year lead than NVIDIA has. And so we talked to a few people about this and we're like, oh, what's going on in the open source ecosystem? Is there an Android equivalent?
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And even the most bullish people we talked to were like, oh, yeah, you know, now that Facebook has really moved PyTorch into a foundation and outside of Facebook, that means that other companies can now contribute, you know, a couple dozen engineers to work on it. And you're like, cool. So AMD is going to contribute a couple dozen, maybe 100 engineers to work on PyTorch.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And so will Google, and so will Facebook, and so will everybody else. NVIDIA has thousands of engineers working on CUDA 10 years ahead.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Now, again, open source is a very powerful thing. The market incentives are absolutely there for this to happen.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, it was pretty useful stuff. And this Alex Knapp moment and these three researchers from Toronto kicked off, Jensen calls it, and he's absolutely right, the Big Bang moment for AI.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And I think NVIDIA totally gets this because part of this, as I was alluding to, is COVID-related. But we talked way back in part one about how NVIDIA... Ended up to save the company moving to a six-month shipping cycle for their graphics cards when their competitors were on a one to two-year shipping cycle. That persisted for several years, and then they relaxed back to an annual shipping cycle.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
There were annual GTCs. Since COVID, NVIDIA has re-accelerated to a six-month shipping cycle. They've been doing two GTCs a year most years since COVID, which is insane for the level of technology complexity that they're doing. Yep. Imagine Apple doing two WWDCs a year. Yeah. That's what's happening at NVIDIA. It's crazy. So on the one hand, that's a culture thing.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
On the other hand, that is an acknowledgement of like, we need to be pedal to the floor right now to outrun competition.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yep. All right. So that's scale economies. Let's move to switching costs now.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, we talked to many people in preparation for this episode, but one of the most interesting conversations was with some of our favorite public market investors out there, the NCS Capital guys.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Oh, they're just so great. And obviously, I've been following NVIDIA in the space for a long time.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
made the point that data center revenue and data center capex is some of the stickiest revenue that is known to humankind just the organizational switching costs involved in data center procurement and data center architecture standardization decisions god that's a mouthful even to say at fortune 500 companies and the like is like they're not changing that more than once a decade at most
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
yeah so basically what we said was it turned out that a natural consequence of what these guys were doing was oh actually you can use this to surface the next post in a social media feed on like an instagram feed or the youtube feed or something like that and that unlocked billions and billions of value and those guys and everybody else working in the field they all got scooped up by google and facebook
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
I completely agree with that. Yeah, I think, you know, again, we didn't talk to Colette, NVIDIA's CFO, about this, but I strongly suspect if I were them, I would be happy to trade some of this gross margin right now for increased throughput on sales.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yep. And I guess to say a little more, though, It's not like this is not a commodity, as we talked about on our TSMC episode. Although TSMC is a contract manufacturer, it is the opposite of a commodity, especially at the highest and leading edge.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yep, totally. Two points on this. Just sticking to the scope of this business and market discussion, this is a major casualty of a strategy conflict at Google. Obviously, the way you want to do this is the way NVIDIA is doing this of like, your customers want to buy through the cloud, you want to be in every cloud.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
But obviously, Google is not going to be in AWS and Azure and Oracle and all the new cloud providers. They're only going to be in GCP.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
But I was going to say, though, through the expanded lens, though, I think this makes sense for Google because their primary business is their own products.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Nothing has changed through all of this with respect to the fact that what the previous generation of AI enabled with machine learning with regard to social media and internet applications being the most profitable cashflow geysers known to man, none of that has changed. That is still true in this current world and still true for Google.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Well, that's true. And then as a consequence of that, Google and Facebook started buying a lot of NVIDIA GPUs. But turns out there's also another chapter to that story that we completely skipped over. And it starts with the question you asked, Ben. Who are these people? Yes.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, I mean, we've talked about this many times on the show, including with Hamilton Helmer and Chen Yi themselves. But for platform companies like NVIDIA clearly is, there is this special brand of power that is a combination of scale economies and network economies. And this is what you're getting at.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, I actually think it's worth talking about this a little bit.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah. Look, I don't feel confident enough to pound the table on this, but given the nature of how the company started, how long they've been around, and the fact that they also have the market-leading product in a totally different business in graphics, which is both consumers but also professional graphics...
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
I think that probably does lend some brand power to them, especially when the CIO and the C-suite at McDonald's is making a buying decision here. Like, everybody knows NVIDIA.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
This is way, way, way down the stack in power, but I don't think it's hurt them. They've always been known as a technology leader, and the whole world has known for decades at this point that the stuff that they can enable is magical.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Nobody is getting fired for buying NVIDIA anytime soon. Yep.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
All right. Then the last one, right, is process power.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
It's always so tricky to tease out. Yep. You know, I think the argument here would just be like NVIDIA's culture and their six-month shipping cycle that clearly they had in the past and they didn't have for a while and now they have again. I don't know. I think you can make an argument here. Is it feasible? Let's do a thought exercise.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So the three people who made up the AlexNet team were, of course, Alex Krzyzewski, who was a PhD student, under his faculty advisor, the legendary computer science professor, Jeff Hinton. I have an amazing piece of trivia about Jeff Hinton. Do you know who his great, great grandparents were?
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Could any of their competitors, really in any domain, move to a six-month ship cycle? That would be really hard. You know, could an Apple-sized company... do two WWDCs a year? Like, no.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, thinking about this more, I think actually brand is a really important power for NVIDIA right now.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Well, let's save that for bull and bear at the end.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
He is the great-great-grandson of George and Mary Boole. You know, like Boolean algebra and Boolean logic?
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, I think there's maybe a related playbook theme here for Nvidia of strike when the timing is right. I suspect that a lot of the inner competitive drive and motivation for Jensen and the company over the past 10, 15 years here has been to really fight against Intel. Intel tried to kill them, as we talked about many times in the previous episodes.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
We talked to somebody who framed it as Intel was the country club and NVIDIA is the fight club. And back in the days, the Intel country club didn't want to let NVIDIA in. Intel controlled the motherboard. Intel controlled the most important chip was the CPU. Intel would integrate and commoditize all other chips into the motherboard eventually.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And if they couldn't do that well, then they'd try and make the chips themselves. And they tried to run all these playbooks on NVIDIA and NVIDIA just barely survived. And then in the data center, Intel controlled the data center for so long. PCI Express, you know, that was the interconnect in the data center for so long. And NVIDIA had to live in there.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And I'm sure they hated every single minute of it. But they didn't turn around 10 years ago and just be like, guess what? We're making a CPU too. They waited until the time was right.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah. But I think for a lot of other leaders, it would have been hard to have the patience that they've had. Totally.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Foundational stuff for computation and computer science.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, Fortune 500 CIOs aren't making buying decisions if none of what you just said isn't true.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Case in point, Microsoft is the exclusive cloud infrastructure provider for OpenAI, which runs, as far as we know, solely on NVIDIA infrastructure, but they buy it all through Microsoft.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, you know, the AND, OR, XOR, NOR operators. That comes from George and Mary. Wild. So he's the faculty advisor. And then there was a third person on the team. Alex's fellow PhD student in this lab, one Ilya Sutskiver. And if you know where we're going with this, you are probably jumping up and down right now in your seat. Ilya is the co-founder and current chief scientist of OpenAI. Yes.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah. Well, this is pejorative here. Cloud is a euphemism for data centers, right? There's so much more to the hyperscalers and public clouds than just data centers, right?
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah. There is a mile of distance metaphorically between like an Equinix and AWS. Yep. But. They're data centers. And there is a fundamental shift, at least according to Jensen, a fundamental shift that is happening in data centers. So I think that probably does create some shifting sands that the cloud market is going to have to navigate.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
But also, like, there's more to this, too. Crusoe exists. CoreWeave exists. Lambda Labs exists. These are well-funded startups with billions of dollars that a lot of smart people think there's a major cloud-sized opportunity for. Yep. That would not have happened a few years ago.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Oh, boy. We've been trying to delay this as long as possible. This is the crux of the question right now.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Oh man, total sidebar. I'm so disappointed. I have standardized my house on the Echo ecosystem and it keeps getting dumber. How in this world of incredibly accelerating AI capabilities are my Echos getting dumber?
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah. But also never underestimate the inability of big tech to execute on stuff that it thinks it can, especially with major strategy shifts.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So you just illustrated, I think, bear case number one, which is... literally everybody else in the technology ecosystem is now aligned and incentivized to say, I want to take a piece of NVIDIA's pie. And these companies have untold resources.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
So after AlexNet, Alex, Jeff, and Ilya do the very natural thing. They start a company. I don't know what they were doing in the company, but it made sense to start one.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yep, for sure. No doubt that that's going to happen. All right, so that's bear case number two, kind of as part of bear case number one.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
It's funny, you know, again, we talked to a lot of people for this episode, including a set of some of the foremost AI researchers and practitioners out there and founders in C-suites of companies that are doing all this. And pretty much to a T, they all said the same thing when we asked them about this question. They all said, yeah, this is overhyped right now. Of course, obviously.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
But on a 10-year timescale, you haven't seen anything yet. The transformative change that we believe is coming, you can't even imagine.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
By Google within six months. So they get scooped up by Google. They join a bunch of other academics and researchers that Google has been... monopolizing, really, in the field. Three specifically, Greg Corrado, Jeff Dean, and Andrew Ng, the famous Stanford professor.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yep. So I think the sub point to that that's worth a discussion right now is like, okay, generative AI. Yeah, is it all it's cracked up to be?
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Still basically there, including forcing myself to try to use it a bunch in preparation for this episode. But also, as we talk to more people, I think I've realized that David Rosenthal's use case doesn't really matter here at all.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
A, because as a business, we are such a hyper-specialized, unique little unicorn thing where accuracy and the depth of the work and thought that we ourselves put into episodes is the paramount thing.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Right. All this stuff. Anything external that we prepare is a labor of love for us. And there is nothing we prepare internal.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Right. Honestly, I think through doing this and talking to some folks and reading, I think there's a very compelling use case for it for writing code right now. No matter what level of software developer you are, from zero all the way up through elite software developer, you can get a lot more leverage out of this thing and GitHub Copilot. So is that valuable? Like, for sure, that's valuable.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yep. And then I think, you know, there's the slightly more speculative stuff, but you can actually sort of see it now of, like, that gaming demo that I mentioned recently from NVIDIA of, like, oh...
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
you're talking to a non-playable character that wasn't scripted we did an acq 2 episode recently with chris valenzuela from the ceo of runway that was used in everything everywhere all at once and he said that's just the tip of the iceberg like the stuff that you can do that is happening that's out there today with generative ai in these domains is astounding
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
The three of them had just formed the Google Brain team within Google to turbocharge all of this AI work that has been unleashed by AlexNet. And of course, to turn it into huge amounts of profit for Google.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah. I think for me, at least again, just speaking personally too, I had a very strong element of skepticism initially because the timing was just too perfect. It was like all UVCs out there. You just told everybody about how crypto is the future and whatever you're talking about. And then interest rates went to 5% and your world fell off a cliff.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And so there was a large part of me that I was just like, come on, guys.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
It's too perfect. But this most recent couple months in this quarter for NVIDIA has shown that, put all that aside, Fortune 500s are adopting this stuff, CIOs are adopting this stuff, NVIDIA is selling real dollars.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And learning also about what it takes to train these models and the step scale function of knowledge and utility going from a billion parameters to 10 billion parameters to 200 to a trillion parameter models. Yeah, like something's going on there for sure.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yep, that makes sense to me. And I think there also is some merit to workloads are shifting to inference. That is happening. I agree with you. I don't think training is going anywhere. But until recently, thinking back to the Google days, training was what everybody was spending money on. That's what everybody was focused on.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
As usage scales with this stuff, then inference, and inference, of course, being the compute that has to happen to get outputs out of the models after they're already trained, that becomes a bigger part of the pie. And as you say, The infrastructure and ecosystems around doing that is less differentiated than training.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Okay, those are the bear cases. There's probably also a bear case around China, which is a legitimate one because that's going to be a problem for lots of people.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
and just what's going to happen generally. Obviously, China is racing to develop their own homegrown ecosystems and competitors, and that's going to be a closed-off market. So what's going to come out of there? What's going to happen?
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yes. So about a year later, Google also acquires DeepMind famously. And then right around the same time, Facebook scoops up computer science professor Jan LeCun, who also is a legend in the field. And the two of them basically establish a duopoly on leading AI researchers.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Ooh, I thought that's a great turn of phrase there. Yeah. You upped your training model on language there. You should see the number of parameters. I love it.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Oh, I have one nuance I want to add to that. On the surface, I think a lot of people look at that and they're like, yeah, come on. But I think there actually is a lot of merit to that argument in the generative AI world and everything we've talked about in this episode. I don't think Jensen and NVIDIA are saying that traditional compute is going away or can get smaller.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
I think what he's saying is that AI compute will be added onto everything and the amount of compute required for doing that will dwarf what's happening in general purpose compute. So, like, it's not that people are going to stop running SharePoint servers or that whatever products you use are going to stop using their whatever interfaces that they use.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
It's that generative AI will be added to all of those things and the use cases will pop up, which will also use traditional general-purpose CPU-based computing. But the amount of workloads that go into making those things magical is just going to be so much bigger.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Yeah, that's great. But so your point is that there's a lot of latent accelerated addressable computing out there that just hasn't been accelerated yet.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Now, at this point, nobody is mistaking what these companies and these people are doing for true human-level intelligence or anything close to it. This is AI that is very good at narrow tasks. Like we talked about social media feed recommendations. So the Google brain team and Jeff and Alex and Ilya, one of the big projects they work on is redoing the YouTube algorithm and
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Okay, wait, that includes the gaming revenue. It's about 40 because the data center revenue is 40, is 10. So 40 annualized.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Are you saying you have one more thing?
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
Right. I mean, it was like that. I mean, it took the PC wave to disrupt IBM, which was a personal computer in today's parlance, edge computing, you know, device-based computing. IBM dominated the B2B mainframe cycle of computing.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And again, if you believe everything Jensen is saying and how he steered the company for the last five years, we are going back into a centralized data center, modern version of a mainframe-dominated computing cycle.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
No doubt. I don't think training is happening at the edge anytime soon, though.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
this is when YouTube goes from like money losing, you know, crazy thing that Google acquired to the just absolute juggernaut that it is today. I mean, back then in like 2013, 2014, we did our YouTube episode not that long after. The majority of views of YouTube videos were embeds on other web pages. This is when they build it into a social media site, they start the feed, they start autoplay.
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Nvidia Part III: The Dawn of the AI Era (2022-2023)
And by a wide margin, too, to this brand, you're not going to get fired for buying NVIDIA anytime soon. Like, this is the canonical, you got to be 10x better than NVIDIA on this stuff if you're going to convince a CIO.
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Charlie Munger
Ben, when we teased this episode in the email about the Jensen episode that we just released, the guesses that we were getting from folks were amazing.
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Charlie Munger
Right. It's interesting. I mean, that's leverage. It's not debt leverage. I mean, how do you think about debt? Like, after we did our Berkshire series... A lot of people do it now.
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Charlie Munger
Yeah, Ben, this was such a special life experience for you and me and you and me together to do this. And the fact that we got to record it and now share it with the world for posterity, just icing on the cake and the whole thing was unbelievable.
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Charlie Munger
No, before. Do you think you and Warren not living in the same city helped your partnership last so long? Well, it may have helped.
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Charlie Munger
Yeah. It's funny. I feel like we have a lot to do now. Well, of course you do.
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Charlie Munger
No, I think it's very poorly done. Charlie elaborated on this point with a few things that we can't air, but the topic did turn to Bitcoin.
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Charlie Munger
Yes, a special conversation deserves a special sponsorship. And longtime listeners will know there's only one company in the acquired universe that is truly appropriate because everything they do is modeled after Charlie and Warren, and that's Tiny.
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Charlie Munger
One of the issues I think in investing right now, you mentioned it about venture capital, but I think it's true everywhere. It's like there's just so much capital and so much competition. We're so far removed from the cigar butt era. We're in the opposite of the cigar butt era these days. Are there opportunities out there?
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Charlie Munger
Yeah, it's like the vertical Home Depot worked so well. But I don't know that it was totally obvious. Like part of the appeal of Costco was it was horizontal. It was everything. Consumers could come, they could make a trip, bring their big wagon, bring their big truck.
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Charlie Munger
Yeah. So Berkshire, as we know, started as a textile mill in Massachusetts nearly 200 years ago. And almost 20 years ago, tiny founders Andrew Wilkinson and his partner Chris took their version of an internet textile mill, the premier design agency Metalab, which designed the UIs for Slack, Uber, Tinder, Headspace, Coinbase, and others.
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Charlie Munger
Japanese trading companies reminds me, we studied another company recently, Nike, that was surprising to me.
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Charlie Munger
And they asked themselves, what would Charlie and Warren do if they were us? And that led to the realization that, just like Berkshire discovered in the physical world, the internet also has wonderful niche businesses with great cash flows.
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Charlie Munger
No. We've spent a lot of time studying these brands. How do you look at the value of a brand?
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Charlie Munger
In fact, they tend to be even better than the old days of See's Candies and Blue Chip Stamps because they require zero capital reinvestment, have software margins, and can build global brands much faster than the, what, 50-some-odd years it took See's to expand around the world.
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Charlie Munger
After that, our conversation turned to Kraft Heinz and why Heinz is able to have pricing power while Kraft is not.
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Charlie Munger
If you were back 30 or 40 years old again today, would you decide to go into the investment business again?
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Charlie Munger
Yeah. Fast forward to today, and thanks to Tiny's success, this opportunity is no longer a secret. Many people have caught on to the idea that this can really work. But just like Berkshire itself, no one else has the combination of experience, temperament, access to capital, and frankly, reputation that Andrew and Chris have built over the past two decades.
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Charlie Munger
We're investors in Tiny ourselves alongside Bill Ackman and Howard Marks. And just like the two of them, Tiny is really the long-term buyer of choice in their niche. Anyone who's looking for a permanent home for their profitable internet business or who needs a capital partner for a co-founder or VC cap table buyout would be lucky to work with Tiny.
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Charlie Munger
We turned off the mics to have dinner and then recorded a little bit more later in the evening about Costco and some life advice from Charlie.
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Charlie Munger
I mean, they talk about the story of the catch-up, that you could increase the price of catch-up by 3% and nobody would notice. But that would destroy everything if you did that, right?
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Charlie Munger
So thanks to Tiny, this is the only sponsor, as Ben said, that you'll hear on this episode. And just like Berkshire, it'll be here in perpetuity. Tiny just became a public company earlier this year, and they can now do deals ranging anywhere from $1 million all the way up to $250 million.
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Charlie Munger
Which brings us to the hot dogs. Is it true, the story, that when Craig took over as CEO, he did try to raise the price of the hot dogs?
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Charlie Munger
Store openings. You mentioned China earlier. Was it 20 years that Costco had the license to operate in China?
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Charlie Munger
So if you want to get in touch, just shoot them a note at hi at tiny.com and just tell them that Ben and David sent you.
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Charlie Munger
When you look back at your and Warren's time together, when did you have the most fun?
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Charlie Munger
Well, and the play in particular with the Buffalo Evening News and the Sunday edition was playing for the local monopoly, right? To be the game in town. And with newspapers, you could do that. Sure, sure. I mean, newspapers for decades had EBITDA margins in the 50, 60% range, right?
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Charlie Munger
I mean, you witnessed its rise with Malone and TCI and Liberty when EBITDA was invented as a concept, right?
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Charlie Munger
Oh, boy. Maybe a final question to wrap up. What are the set of companies that you think are the greatest that you've ever seen, either that you've owned or that you've not owned?
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Charlie Munger
Well, you've said that the best way to have a great spouse is to deserve one.
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Charlie Munger
As long as both parties feel that way, then it's a recipe for success. Of course it is.
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Charlie Munger
I will say with the people we get to talk to who've built great things, every single one of them says it was so hard. It's so hard. You can't build something great without it being so hard.
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Charlie Munger
I can't believe we got to do this. I'm still pinching myself. It's now a couple weeks after it actually happened.
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Charlie Munger
As if the podcast wasn't enough. And actually, for those of you who haven't listened back, what, in 2021, so two-ish years ago, we did a whole three-part series, just us, covering the whole history of Berkshire Hathaway. Part one is on Warren. Part two is on Charlie. Part three is on Berkshire and Ted and Todd all the way up through to today.
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Charlie Munger
I assume many of you have listened to that, but there probably are a bunch of folks who haven't. So if you want another nine or 10 hours of acquired content on Berkshire, I really think it's some of, if not our best work. Go check those out.
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Charlie Munger
So in our Costco episode, we started with the joke at one of the Berkshire meetings probably 10 years ago. Warren told the joke about you were on a plane being hijacked and the hijackers gave you one final request and you said you'd like to give your speech on the virtues.
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Charlie Munger
And he said, shoot me first. We were hoping, could you give us your speech on the virtues of Costco? Yeah.
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Charlie Munger
It all worked. And a capital light business model. I mean, when we were studying it, the difference between price- They had no investment in them.
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Charlie Munger
Our understanding is that Price Club went public initially before the merger. They just listed. They didn't raise any capital. They didn't need any capital.
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Charlie Munger
I'm curious, we wanted to ask you, you know, you've had this beautiful partnership with Warren for half a century. We're a decade into our partnership.
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Charlie Munger
Yeah, that's right. But your relationship with Warren, like, how have you... Well, we were kind of similar and we were both one of the...
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Visa
Yeah, I mean, this is like Berkshire levels of compounding that is happening here. Yep. And it's not like people may think, oh, 17%, like, oh, I have seen IRRs greater than that. Have you seen them greater than that over 51 years? Right.
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Visa
So once you get to a certain scale, nobody's really incentivized to keep making this work. A, because now you're enabling people to shop all your competitors. But also, B, once you get past, I don't know, a couple hundred, a thousand participants here, like are individual merchants equipped to manage a network like this? No, they don't have the resources to do this.
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Visa
This is absurd. All the picture we painted in the whole story, it was all building toward that climax of they have created something with essentially zero marginal costs in... perhaps the largest market out there, certainly one of them, global commerce, both E and non-E commerce.
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Visa
I would have thought Google would be higher. As we were talking in my mind, I was like, well, Google's probably the only one that can come close. But wow, Microsoft is higher. I didn't realize that.
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Visa
It's a weirdly mirror image. Even NVIDIA doesn't have gross margins like Visa. Yeah. It is the ultimate solution. I think that is the takeaway. Yes.
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Visa
Which is wild. I mean, you hear about AWS going down more frequently than you hear about Visa going down.
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Visa
The data envelope, as opposed to the value envelope, although I guess it is sort of the same, is also not that large relative to the importance and the value. Right. This is not YouTube. Yeah. The transactions themselves, in part because this was all architected in the 70s.
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Visa
Or there could be an independent third-party for-profit network that does this. And this is when Diners Club and American Express arrive on the scene. So Diners Club was first. And people might know and have heard of Diners Club. It still exists today. It's like a sub-brand of Discover. Totally. There's a very famous legendary origin story behind Diners Club. And it goes like this.
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Visa
And one of the things we didn't talk about in the story because it was long enough as is, is the whole debit card struggle. Obviously, debit cards are a big part and debit transactions a big part of the Visa network today. But when Visa first tried to introduce them, this was one of the things that led to DeHawk's ouster. The banks were like, no, no, no, no, no.
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Visa
Debit cards, that sounds like banking relationships. Banking relationships are my domain. That's where I make my money. Those are my deposits. You look like you're trying to reach your hand across from being in service of us into competing with us.
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Visa
And obviously debit cards did eventually become part of the system, but not in the way that, you know, it was looking like Dee initially wanted them to.
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Visa
Right. That was the domain of the banks. And actually, there was a big fight between Visa and all the ATM networks. And Dee wanted your Visa card to also be your ATM card. It makes sense, right? Like, why would you have different cards? Mine is today. They basically are now.
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Visa
And there's no denying that is really sad and unfortunate on the consumer debt side of all this. You know, on the fee side, on the one hand, I'm tempted to say like, oh, obviously tripling the amount of fees that merchants are paying for credit card processing over 10 years, like that's ridiculous.
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Visa
Yes, transaction value. But also I have to imagine a big part of that is share of commerce that's happening as e-commerce versus traditional commerce. The credit card networks...
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Visa
really are providing a huge amount of value to e-commerce as you were saying earlier they are to physical commerce too nobody wants to pay with cash or check anymore these days but like e-commerce there's no other way that that can happen so does it make sense that the credit card networks and their associated parties take more value in that world i think so
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Visa
In 1949, you know, post-World War II, economic prosperity, beginning of the Mad Men years in New York and Manhattan, a New York businessman named Frank McNamara is hosting a lavish business dinner in downtown. halfway through the dinner, he realizes that he forgot his wallet at home. He does not have cash to pay for the dinner. So he excuses himself. He goes to the payphone.
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Visa
Yep. And it makes sense. Just do the thought exercise, right? Let's say you're a physical merchant and you decide to walk away from Visa and all the credit card networks. Say you're only cash or check. I mean, you probably are committing suicide as a business, but like you could operate. If you're providing enough value, like ATMs exist, you know, you can operate.
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Visa
Yeah, exactly. Bars. Great example. If you're on the internet and you say, I'm walking away from the credit card companies, you are literally committing suicide.
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Visa
I mean, they're banks. That's the thing. All the way back to the beginning of the episode. What was the motivation for Bank of America in the early days? It was turbocharge my banking operations. What is your banking operation? It's taking deposits, make loans with them, make money on the interest rates on those loans. Nothing has changed in the banking industry.
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Visa
Yes. Because even though they're getting the lion's share of the transaction fee, that's going all right back to the consumer in the form of rewards.
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Visa
He calls his wife at home on Long Island. She speeds into the city with enough cash in time to pay the bill for the dinner. And, you know, face is saved. His reputation as a erudite businessman is preserved. And then afterwards, he's talking to his wife. He's like, oh, there's got to be a better way to do this.
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Visa
I think the one area where there is difference between them And it's probably less so today, but was quite strong through the 90s and 2000s was brand. I do think Visa made a genius move, positioning against American Express, going upmarket in perception and partnering with the Olympics.
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Visa
Well, the brand is like the Intel inside. It's an ingredient brand. So yes, the banks make the decision, but really the consumers make the decision because if consumers have a preference for Visa over MasterCard, they'll demand it from the banks.
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Visa
I think today that's true, but I do think, based on the research, and this may be too biased towards Visa, but I think Visa did accelerate past MasterCard, and I think there was a strong brand element of that. I think it's more equal today.
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Visa
Yeah. I think there's totally also a story that's beyond the scope of this episode, but how banks, and in particular Chase, aid American Express's customer base over the last set of years.
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Visa
There really should be a business person focused charge card network that would work at all the restaurants in Manhattan where business people host dinners.
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Visa
Well, they missed the generational transfer. I think they did retain their highest value, highest margin customers. I think those customers are just 80 years old now.
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Visa
I think there's basically like a law of economic nature that if your gross margins exceed, call it 75, 80%, And you are of a certain revenue scale threshold. Our gross margins exceed 75%, 80%, but we're a two-person company with a de minimis amount of revenue in the global economy. But say you're in the billions of dollars of revenue scale, you must have scale economy power.
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Visa
Yeah. But yeah, you must, you simply must, if you have those margins at that revenue scale, have scale economies.
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Visa
Well, I mean, this is even better than the classic two-sided network. This is the classic five-sided network effect.
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Visa
Yep. I think this is also true. With network economies and network power... The more participants in a network, the greater complexity grows and the harder it is to actually pull off the network. There's plenty of single-sided networks, like Facebook is a single-sided network, at least on the user-based side.
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Visa
There's advertisers, you could argue that's a second side, but everybody's the same node in the network. Then there's two-sided networks like Airbnb is the classic one, you know, something like that. There are three-sided networks out there, probably some four, and clearly this is an example of a five-sided network.
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Visa
But as you add sides to the network, the number of successful examples goes like way, way, way, way, way down because it's just so hard.
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Visa
And I think this whole story that we told of how incredibly freaking hard and unlikely it was that this happened...
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Visa
This is true after the first antitrust lawsuit when duality was introduced and banks could multi-home. Before then, yes. After then, zero.
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Visa
Yep. Pretty interesting. Nobody else. Counterpositioning, the last one, none now, I think. Right.
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Visa
Right. But there was incredible counterpositioning back in the day with Bank of America. They were the only institution in America that could pull this off, that could absorb the losses, that had minimum viable...
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Visa
customer base on the consumer side and on the merchant side that had the dynamics that they did within California, that even though New York was still bigger as a state, the market was so fragmented there that none of the banks had enough power to pull this off. They were literally the only one who could do this.
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Visa
The two that jump out to me are one, just like our NFL episode, just like our benchmark episodes, communist capitalism. Yes.
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Visa
Yes. A, it is the best example of communist capitalism. certainly that we've ever studied, probably in the world, hard to imagine one better. And two, it's like a special breed of communist capitalism. You're going to laugh at this, that I foreshadowed as democratic communist capitalism. The ultimate irony, right? It's this idea of like, yes, it's capitalism.
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Visa
It's competitors banding together to create more value than they could alone. But this is at a massive scale. Like with Benchmark, it's five partners. With the NFL, it's 30, 32 teams, something like that.
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Visa
This is thousands of banks that have decided to do this together. It is its own separate class of this, I think. Way, way, way harder to pull off than like... yeah, Ben, you and me together, acquired is communist capitalism for sure. If we were starting a venture capital firm with three of our friends, could we pull it off with five people? Sure. Could we pull this off with 200 banks? No.
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Visa
I think there are two really important points here. One, you said, I pay it. I don't pay at my company. I don't care to the most important point. I get to look super awesome in front of all my colleagues and customers and people that I'm trying to impress. I don't need to bring cash. They know me here. I'm good for it.
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Visa
And Bank of America, the franchisor, D, had to go to them and say, hey, you're going to forfeit the whole asset. That's a great point. Totally. So that's one. And then the other two, you know, I think it's the twin stories of innovation here, which, you know, really hat tip to Dave Stearns for tipping us off on here.
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Visa
The socio-technical innovation, the organizational stuff, the communist capitalism, the democratic capitalism, everything we're talking about. Incredible. Also the technology story here. Incredible. Neither of which, because of this weird nature of who owned it and how it was set up, people really understood. But both of which are just world-class, incredible stories. Yeah, super true.
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Visa
They really deserve this nice... But that's what I find so funny. Nobody knows that. This is a Silicon Valley company.
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Visa
Exceedingly rarely. Well, I take that back. In the tech and venture capital world, exceedingly rarely. In the corner of San Francisco that very much exists, which is the old money, finance, the legacy of Bank of America... Absolutely in that world. And Jenny's in that world because those are the folks who are on the board of the ballet, who are the patrons, who are the donors.
Acquired
Visa
The longtime chairman of the board of the ballet was the CEO of Visa USA for many years. There are a lot of Visa people in that world here. It's funny, though, that you would think it would have bled more into the Silicon Valley world, but it really hasn't.
Acquired
Visa
I mean, any time where your average transaction value is less than $10, that $0.30 is a killer.
Acquired
Visa
Well, before we go into bear and bull where I know you and we have a lot to talk about what could potentially disrupt Visa and MasterCard, I think it is worth just one minute on the value creation side of this. And I really think you hit the nail on the head a while back when you said e-commerce. Yes, all that other stuff we were just talking about, the 30 cents, you know, everything.
Acquired
Visa
That is a lot of value capture. There's a lot of value capture that Visa is doing and MasterCard too. On the other hand, I don't think e-commerce really would have happened alone. There's plenty of other value creation out there, too. Lots and lots and lots. But let's just take e-commerce. I feel like this is Passover. Like, you know, that would have been enough. E-commerce would have been enough.
Acquired
Visa
Yeah. And yeah, you know, PayPal and all that. But that would have been a long slog if PayPal had to get an adoption for all payments on the Internet to happen.
Acquired
Visa
So all that's a very nice story, except it's completely fabricated. Yeah. None of that actually happened. Although stories like that did play out, I'm sure, on a nightly basis in Manhattan. The reality is Frank just thought this would be a good business idea. And he was right. You know, you see this all the time with networks, network effect businesses.
Acquired
Visa
This was the right little node of the network to start with. This was like Harvard and Facebook. Because restaurants in Manhattan... They're competitive with one another, but it's not exclusive competition. This isn't JCPenney's versus Macy's.
Acquired
Visa
Yep. The two things I would want to investigate on the could what happened in China happen here. One, just the build out of infrastructure happened more concurrently in China, like payments infrastructure is already built out here. Technology infrastructure got built out afterwards, whereas it all happened altogether in China. Hmm.
Acquired
Visa
Yeah. Which, you know, I mean, I guess that is an associated bear case, right? China in and of itself. And could other governments around the world start adopting similar postures?
Acquired
Visa
And, you know, I mean, technology and infrastructure and ecosystem is getting built on this, obviously, around the world and here, too. And great friends of the show, Modern Treasury, like, they are enabling a lot of this.
Acquired
Visa
No restauranteur in Manhattan, no matter how good they are, really honestly believes that a majority of their customers are only going to dine at their restaurant.
Acquired
Visa
Yeah. I actually don't even think they'd need to do that. I mean, they're Apple, right? They'd just use iPads and they would have as part of Apple Pay, they would have Apple Pay for merchant software that would be on the iPads.
Acquired
Visa
Agreed. I have a counterpoint to that, but I'll save it for the bull side of the ledger here.
Acquired
Visa
Yep. And Apple Pay and Google Pay along with it are, I think, by like many, many, many orders of magnitude, the most successful... quasi-alternative payment systems that have actually gotten install bases.
Acquired
Visa
Yeah, yeah, yeah. But, like, what else? I mean, there have been other alternative payment systems over the years, and none of them match, at least domestically in the U.S., Apple and Google Pay.
Acquired
Visa
Yeah, totally. And I think the obvious case is this is just an incredibly powerful network effect that's 50 years in the making and is five-sided. And Lord knows I can't think of any other five-sided network effects.
Acquired
Visa
Yeah, riding a secular wave and nobody has ever broken it. And past performance is a strong indicator of future performance in this domain. Yeah.
Acquired
Visa
You're enabling people to spend money in your restaurant easier and more frequently. And you don't really care that they also go to other restaurants because they're going to do that anyway. It's crazy. Like you said, Diners Club is able to charge restaurants and other merchants. They expand to hotels, airlines, anything that a business person traveler would need. 7% of the gross bill.
Acquired
Visa
One other additional I said I was going to add on Bullcase sort of as a response to the Apple and by association Google bear case, you know, pretty much everybody we talked to pointed out as the number one most obvious bear case for Visa right now is Apple and Google and the incredible progress and inroads that they have made into rails and transactions.
Acquired
Visa
But as you say, all those transactions are still just tokenized Visa MasterCard cards. Right.
Acquired
Visa
Yeah, it's a bull case today. You know, there may be nuance that I'm missing here, but if you play out how, let's say Apple decides, okay, we want to go after Visa. I'm not sure how Apple could actually do that really without becoming a bank themselves. You know, Amex is a closed loop system. It's a bank. Discover is closed loop system. It's a bank.
Acquired
Visa
Yeah, sure. They could do that. Apple's finance and fintech operations do not exist in a vacuum. Is Apple going to take on the risk to the Apple franchise of all the regulation and scrutiny that comes from that?
Acquired
Visa
I think, yes, absolutely. And so I'm not saying this won't happen, but Tim Cook board level discussion on this, right? Let's play out the DeHawk thought exercise. Apple succeeds. They do it. They eat Visa. Visa's market cap is now added to Apple's market cap. Great. Apple's market cap just grew by 25%.
Acquired
Visa
Merchants complain about 3% today. 7%. And these are restaurants like that's crazy. Eventually, they have so much power in what they're doing. This product is so good. They also add a fee for the cardholders and it's companies like it's not individual people paying this fee. It's the companies paying this fee. Of course, they're happy to pay it. It enables business.
Acquired
Visa
True. I'm not making the argument that they're still the cute apple. I'm just saying like, I think actually entering this arena introduces a significant amount of risk to the whole franchise that they have to weigh in a way that some of these other markets don't.
Acquired
Visa
As you started to set that up, I was like, I know where you're going with this. I know where you're going with this.
Acquired
Visa
That's amazing. I'll have to check it out. My carve out is a book. I think this is my first fun fiction book in a while. Mistborn by Brandon Sanderson. It is a awesome fantasy novel, the first in the series, but you can read it as a standalone too. It's been out for a long time and has many, many passionate fans out there.
Acquired
Visa
It was recommended to me by great friend of the show, Guy Pajarni, the founder of Snyk. Last time we got together, which was super fun. Snyk is an amazing, very large cybersecurity company that I'm sure many of you know about. Focused on developers, right? Yeah. Developer security. You see their billboards all up and down 101 here in San Francisco. But yeah, he recommended it to me a while back.
Acquired
Visa
And it took me a while to get to it. You know, toddler parenting. But I read it. I thought it was awesome. Jenny read it. She loved it. She's, of course, now done the whole series because she's a voracious reader. The world building, the magical system, all the core fantasy elements are really great. The political intrigue. Highly recommend. Awesome.
Acquired
Visa
And Diners Club would ultimately fade, although it grows to over a million members. It goes national. It gets acquired by Citibank, then sold to Discover in 2008. As we said, it's still a brand today. But it's basically impossible to create a independent from the ground up network of this at the time because you were just talking about the operational cost of running this thing.
Acquired
Visa
Think about the merchant and customer acquisition costs. Nobody knew what Diners Club was. They have to now go canvass the entire island of Manhattan and ultimately, you know, the whole country and world and sign up all of these merchants and go sign up all of these companies to get their employees to use it. That is a very expensive sales proposition.
Acquired
Visa
Whereas from this point on, basically everybody else that comes into the industry already has established relationships, sales channels into one or both sides of the market. Which, of course, brings us to the brand you're all probably thinking about here, American Express.
Acquired
Visa
This is such an insane story. I can't believe we're all the way in season 13 and we haven't talked about this company yet. But as we will get into, it's always been overlooked and underrated.
Acquired
Visa
And so, as you might remember from our Berkshire Hathaway series a couple years ago, Amex at this point in time was primarily a traveler's checks business. That's how they started, right? Well, actually, no. They started in 1850. This is amazing. Do you know who started American Express? This is a version of DeHawk holding up the Visa card.
Acquired
Visa
I did not either until doing research for this episode. It was started by a group of people, two of the most prominent among whom were... Wells and Fargo. Henry Wells and William Fargo. Amazing. Totally amazing, man. 1850. The Wild West. Different time.
Acquired
Visa
Yeah, something like that. The infrastructure of America was getting built out. So American Express, called American Express, it was an express mail company. It was like the Pony Express. That was how they moved stuff around. And I think Wells and Fargo were doing banking. And so obviously banks, as we're talking about, you need to move stuff around the country. It was like a related business.
Acquired
Visa
So Amex by this point in time had become a traveler's checks primarily. That was their primary business. As we talked about on the Berkshire episode, that was a freaking awesome business. Partially because traveler's checks, you know, they made good money. You would buy a $100 traveler's check and pay Amex a little fee or whatever.
Acquired
Visa
But the float and the breakage, like there's traveler's checks out there today that are 50, 100 years old that have never been cashed. And Amex has just been sitting on that cash for decades, investing it. What an amazing business.
Acquired
Visa
And so they're like, well, we don't need to pay you a lot of money because we can just do this too. And like I was just saying, not only can we do it too, we can do it better than you because we're American Express. We have relationships. with companies, we have relationships with restaurants, we have relationships with hotels, we don't need you diners club.
Acquired
Visa
So just within like a year, maybe even two from when Amex launches their charge card, you know, business traveler program, they sign up 700,000 members, which is almost as much as diners club had signed up, you know, many years of working on it.
Acquired
Visa
So this brings us right back to Fresno in 1958 because the timelines match up exactly. This is crazy. Amex launched their charge card program in 1958. B of A sees what's happening. They, of course, had seen everything else going on in the industry before. They understand the transformative power that this can have for their scaled consumer banking business in California.
Acquired
Visa
And they're like, okay, the time is right. Let's do credit cards. Let's go to Fresno. But hopefully, as we painted the picture, their motivation and Diners Club and Amex and even the merchants and retailers motivations are very different. B of A wants two things out of this. One, like we were saying earlier, they want to streamline and simplify all their wildly diverse lending programs.
Acquired
Visa
This is going to be huge operational savings for the bank if they can pull this off. too though the bigger opportunity for b of a is what can this do for our banking business itself because remember how do banks make money they make money on loans and this is going to enable so much more effective loan volume to flow through our system that we can make money on
Acquired
Visa
And it was already happening at B of A. They were doing these loans. This wasn't actually like new behavior. It was just a way easier, way more streamlined on-ramp into this consumer lending that turbocharged it.
Acquired
Visa
And there's one more really, really important sub point here to what this loan is. And it relates to the banks and why this is so powerful for B of A and for all banks. Think back to the old way that B of A was doing this. A California, you know, homeowner wants to go buy a new refrigerator.
Acquired
Visa
They walk into a B of A, talk about it with the lending officer, blah, blah, blah, a bunch of operational costs. Who cares about that? At the end of the process, B of A gives them the money. The money is now out of B of A's hands. It's out the door. The consumer then goes to the merchant and gives the merchant the money and buys their refrigerator.
Acquired
Visa
What's happening now with credit cards is actually a little different. The consumer goes to the store. The consumer buys the refrigerator with the credit card. No money has left B of A's hands yet. They get to keep the money.
Acquired
Visa
And because we're talking about California here, there is a very high likelihood chance. And I think at the beginning, I suspect a 100% chance that the merchant also banks with BOA. So that money is never leaving Bank of America's hands, which frees up more capital, which frees up float, which is just like... The B of A management must have been besides themselves with glee about this.
Acquired
Visa
Yeah, because there's another more pernicious way that this type of lending is different than the previous type of lending that B of A was doing. It's unsecured. If you give a customer a loan to go buy the refrigerator, you don't want to go repossess the refrigerator, but push comes to shove, you can go repossess the refrigerator. this whole consumer credit card land is unsecured lending.
Acquired
Visa
And this all comes back to why it really had to be Bank of America to start this program. Because they do this, they do the drop in Fresno, 65,000 unsolicited cards go out to unsuspecting consumers. Fraud is out of control. $20 million of fraud within the first pilot program.
Acquired
Visa
22% of the credit that they issued to that initial Fresno cohort ends up being default or delinquent, which I think is like five or six times what their delinquency rate was before on traditional lending.
Acquired
Visa
Such a good point. As long as growth is happening in an economy, a society, industry, whatever, you should absolutely use capital to fuel into that growth.
Acquired
Visa
Well, we are starting actually with a big thank you to Dave Stearns, author of what is undeniably the very best book on Visa and its history, Electronic Value Exchange. And we owe a thank you to Dave both for writing the book and for talking to us as we researched and helping us sift through everything as we're preparing here.
Acquired
Visa
Yep. So back to what I was saying about why B of A is so important. B of A can absorb this loss. No other consumer bank at the time, if they had seen $20 million of losses in like a set of months, they would have pulled the ripcord immediately. B of A though, they can absorb this loss, no problem. And they know if we can make this work, this is going to transform our business.
Acquired
Visa
So rather than pulling the ripcord, They expand. They roll it out quickly across the whole rest of California over the next year, all within the first year. They sign up 20,000 merchants in California and get this. Do you know how many cardholders they sign up in that first year? No. Two million California cardholders signed up using the card in the first year.
Acquired
Visa
It took Diners Club years to get to a million. Amex was so proud in the first year or two, they get to 700,000. B of A instantly at scale is the largest charge card credit card program, certainly in America, I suspect in the world. And that's one year and one state.
Acquired
Visa
Yep. And it's even more than that. As we said, this really was a big innovation. Like it wasn't just that they copied Amex and Diners Club or anything else. Like they were adding credit to this. This was a huge innovation. Yep. So by 1961, year three of the program, they're able to get fraud under control enough that the whole program is profitable.
Acquired
Visa
Yes. And it is specifically 1966 when the secret gets out because phase two of Bank of America's grandmaster plan here gets unveiled, which is maybe worth a quick setup. As we said, this was transformative for their business in California. But they're the biggest bank in America, and they have been itching for any kind of way to expand to truly be the Bank of America.
Acquired
Visa
Like, why the hell did they change the name to Bank of America? It's not because they wanted to be the Bank of California. So they're like, maybe this is our path. And California is only like 10% of the US population. In 1966, they create the Bank Americard Service Organization.
Acquired
Visa
with the express purpose of licensing out the Bank AmeriCard program and network to banks across the country, across all 50 states. And this is the seed of Visa.
Acquired
Visa
Yes. Blinkist, as you know, takes books and condenses them into the most important points so you can read or listen to the summaries. It's great if your job, unlike ours, isn't just to sit around and read books all day, but you still want the amazing insights.
Acquired
Visa
So as Blinkist has been doing throughout the season, they are creating blinks of our research books for each episode and making them available to you all for free. You can find our material for this episode, including Dave's awesome book and D. Hawk's memoir, One for Many, at Blinkist.com slash Visa.
Acquired
Visa
So D. Hawk, the founder of Visa, who we will talk a lot about as we go along here. He told this great story of how after his time at Visa in his kind of older age, he would start his speaking engagements with a little thought exercise for the audience. He would get up on stage, he'd hold up his Visa card, and he would ask, how many of you recognize this?
Acquired
Visa
Yeah. So many of you may be wondering, why is Blinkist giving such an awesome deal to the acquired community? I don't say that tongue in cheek. It really is.
Acquired
Visa
The reason is that Go One, where we're investors and which acquired them this year, is an amazing corporate learning and development content platform that if you're a L&D manager, a team lead or a founder, which obviously many of you are, you should absolutely go check out.
Acquired
Visa
Go One is the one subscription, one billing, one stop shop to get literally all of the content that you need for your workforce at companies. So this is HR trainings, specific skill set development classes, everything you need across your whole company. They're the leader in the space. They're just an awesome company that you should definitely work with if you are not already.
Acquired
Visa
This story is so wild because this first chapter that we just told, there's only one entity in the world that could have done this, Bank of America. In this second chapter, there is also only one person in the world that could have taken Bank AmeriCard and turned it into Visa. And that is D-Hawk. So here we are in 1966.
Acquired
Visa
B of A now starts going around to all the other consumer banks in other states and selling them on joining the network as Bank of America card licensees. And the deal is that you pay B of A a $25,000 franchise fee to get your franchise of the Bank of America card. This is like a Wendy's or something. Plus then you pay them a percentage of the gross transaction revenues.
Acquired
Visa
It literally is like a McDonald's. This is wild. I mean, I get the executives must have just been throwing party after party because, A, this whole thing turbocharged their own business. B, now they're like, oh, we're going to make all the other consumer banks in the country essentially into like serfs on our kingdom here.
Acquired
Visa
It was also an intensely like private thing, kind of taboo thing, right? Because when you were using a credit card in these days, you were implicitly saying, I'm using debt to buy this transaction. And so you didn't want other people to necessarily know that.
Acquired
Visa
And of course, every single hand in the room would go up as I assume all of yours listening are going up now too. Then he would say, okay, now how many of you can tell me who owns this company? Every single hand in the room would always go down. And they would say, how did this company start? No hands. Who runs it and who governs it? No hands. Where is it headquartered? No hands.
Acquired
Visa
Well, the bad assumption was that other banks would consent to basically being serfs in their kingdom. Yes. But at the outset, these other banks see the power. And now that B of A is telling them of what this has done for B of A, and they're like, wow, this is already the biggest charge card credit network in America, if not the world. We can now bring this to our state.
Acquired
Visa
And I think B of A offers exclusivity to banks in geographic areas, too, to start. That eventually, of course, gets dropped. But it does tempt a lot of people. So within two years, by 1968... A couple hundred banks have signed up. There are 6 million cardholders across the country and beyond the country.
Acquired
Visa
Actually, Barclays Bank in the UK had signed up to be a franchisee of Bank of America back in the day.
Acquired
Visa
Yeah, it was already out of the US because the system is a great system. But as this expands beyond B of A, it becomes clear that a bunch of stuff that were either just assumptions or ways of business within B of A or things they didn't have to worry about ain't going to scale to hundreds of banks. All 50 states, multiple countries around the world.
Acquired
Visa
One of the examples, I alluded to this earlier, in California, in the Bank of America owned and operated Bank AmeriCard system, usually all parties in the transaction were Bank of America customers. So there wasn't really any difference between the bank of the consumer, the cardholder, and the bank of the merchant. And B of A controlled both sides.
Acquired
Visa
Once they expand the network and let other banks in, all of a sudden, that's almost never the case.
Acquired
Visa
So B of A has no distinction between what ultimately now in the Visa network and MasterCard and others is called issuing banks. These are the banks that give the cards to the customers and merchant banks that are the banks of the merchants. It's all just one for B of A.
Acquired
Visa
So now in this new world where there's different banks on each side of the transaction, this creates the need for... a network and operational services to settle those transactions, this comes to be known as interchange. And interchange fees are obviously what Visa does today.
Acquired
Visa
It's just wild, as we were saying in the intro, how important this company is. And yet still to this day, I think, you know, maybe a few more people than in Dee's time know the answer to these questions, but not many.
Acquired
Visa
So this interchange thing, All of the other banks that are now signing up to become B of A franchisees for the Bank of America card system, they come to B of A and they're like, hey, this whole thing is a problem. Bank of America isn't providing any service to do this. There are also all these costs that these other banks are incurring because they need to figure out this interchange thing.
Acquired
Visa
And Bank of America's response is like, we didn't have that problem because in our corner of the world, we're the bank on both sides. Right. We're closed loop. So I don't know. You guys figure it out.
Acquired
Visa
No, I don't think price was an issue. I think it was this and like a set of other things along these lines where the franchisees were like, hey, we signed up for a franchise. You operate the whole system, right? And Bank of America was like, no, no, no. We sold you a marketing system.
Acquired
Visa
Now, to be somewhat fair to Bank of America here, the golden arches are worth a lot. The Bank of America card, three colored bands, the blue, white, and gold are also worth an incredible amount here.
Acquired
Visa
The network has incredible value. But back to the brand and the marketing. So as all these other banks are considering whether to become franchisees of Bank of America and some of them are like, no, I'm not going to do that. Some of the ones who do become franchisees, well, really all the ones who do become franchisees become very frustrated.
Acquired
Visa
of course people are going to start competing systems and right in this time over this kind of year or two period a bunch of local geographical competing credit card systems by various bank consortiums come together those pretty quickly all merge into a national association called interbank which spoiler alert interbank is mastercard But at this point in time, Interbank is a Franken network.
Acquired
Visa
There's no common brand, mark, visual identity for all of these cards. So now you're trying to make this payments network operate. How do you as a consumer know that my card that I got from XYZ, I don't know, Bank of Illinois, that's part of the Interbank network, supposedly. Now I go somewhere. I've got that card. It looks like one thing. I'm looking at this store at this restaurant or whatever.
Acquired
Visa
They've got a thing on the door that says they take something that looks totally different. I don't know that this is going to work, even though it actually might work because it's part of the MasterCard interbank network.
Acquired
Visa
So our task today is to tackle these questions. And we start where some of you, I suspect, know, but the vast majority of you, I also suspect, don't. We start in 1958 in Fresno, California, with The Drop.
Acquired
Visa
And, you know, that's today with the Internet. You can do that. Back in the 1960s, there's literally no way for a prospective customer of a merchant to know by looking at their card and looking at the sign on the door if that card is going to be accepted unless they all have the same brand and mark.
Acquired
Visa
That's right. But now, like the scale that these networks are starting to be at, like, obviously, that's not tenable. So back to the mark.
Acquired
Visa
what these franchisees are buying from bank of america and what bank of america is like hey this is what we're selling you it has value it's access to the network but the network is homogenous it all is the bank americard name brand and importantly mark so what are the colors of visa i'm sure everybody listening probably around the world knows this it's blue white and gold
Acquired
Visa
There's this amazing origin story to this. It's super reminiscent to the Windows XP Bliss wallpaper, you know, that is the most viewed photo in the world. You know, the hills. It's actually in Sonoma, California.
Acquired
Visa
So the story is the B of A team, when they were first rolling out the program, the guy tasked with card design, he lived in Pleasanton, California, in the East Bay of the San Francisco Bay Area, where, you know, it's pleasant. And one fine spring morning, he looks out his back door at the local hillside.
Acquired
Visa
The sky is this beautiful blue with white puffy clouds, very much like the Windows XP Bliss background. And the hill is covered with beautiful golden colored California poppies in bloom. He rushes back inside. He paints an abstracted version of his beautiful hillside. Voila. The three bands. Blue, white, gold. Bank of America card. Visa.
Acquired
Visa
It's so wild that today, you know, we would think, oh, what's a moat? What's a competitive advantage? What's durable? You know, you need technology advantage, you know, even how we think of brand, all the companies we've covered on the show. It's so much more than this, but it was so simple back in the day.
Acquired
Visa
It was just, could you create a two-sided network where there was a common signal of acceptance? Yep. So from B of A's perspective, they're like, yeah, we did all the work. We created this. This is what you are franchising from us. Take it or leave it. From the franchisees perspective, as we were talking about, they're like, you gave us a marketing program. How do we run this damn thing?
Acquired
Visa
So the banks, they have to resort all the way back to how checks worked back in like the, you know, 1800s, early 1900s in the U.S., where it was all decentralized.
Acquired
Visa
Yep. And the banks would take the sales drafts from their merchants that the merchants had brought to them. And then they would go kind of individually decentralized mail around the country to the issuing banks, the cardholder banks, to get the money. And the way they financed all this was a discount fee, just like checks back in the day. Like, oh, hey, this sales draft is for $100.
Acquired
Visa
This is all really hard to figure out. So like, okay, you give me $97 instead, or you give me $90 instead. And there was no standardization. It wasn't like a set discount fee. It was just whatever they negotiated with one another.
Acquired
Visa
That the people who bought the goods there to their banks with their cards. And there was no standardized discount. This is ludicrously expensive. Totally. I mean, it's chaos. People are so pissed. And again, B of A is like, yeah, whatever.
Acquired
Visa
And you all are paying us now money. So like our empire dreams are coming true. Wow. This is maybe painting Bank of America into poor light. You know, like I said, nobody knew this is the first time that a banking company. charge card credit card system is operating at scale in the country.
Acquired
Visa
And even though Bank of America had been operating for a couple of years internally to B of A in California, now it's going across state lines. This had never been a problem before, you know, the merchant banks versus the consumer banks, the issuing banks, etc. Right.
Acquired
Visa
So all of these tensions come to a head in October 1968 when the licensees, all the franchisees of Bank of America, all these other banks across the country, they demand a summit. They need to air their grievances with, you know, the parent with Bank of America. This is untenable. We can't operate like this. We got to fix this. B of A says, OK, fine, we'll all get together. In Columbus, Ohio.
Acquired
Visa
And the rest of the world has no idea. Yep. All right. So what happened? Well, The then largest bank in America, the San Francisco-based Bank of America, which formerly was called the Bank of Italy, both of which were total misnomers because it was actually more accurately the Bank of California. It was illegal to operate banks across multiple states back then, as we will discuss.
Acquired
Visa
In the middle of the country. You didn't know this? No. Oh, I thought you knew this. Yeah. Columbus, Ohio. Ohio State. Oh, wow. Amazing. This is where the birth of Visa happens. So the summit gets organized and for the franchisee banks, this is sort of becoming existential for their businesses. They're racking up such huge losses. This is such chaos.
Acquired
Visa
They're sending senior representatives from the banks, everybody running their card programs, everybody's converging in Columbus. B of A sends two mid-level marketing managers to go face the angry mob. None of the senior executives from B of A could be bothered enough to go deal with this. Wow. Which just says everything.
Acquired
Visa
And these poor guys who show up, I mean, they are literally facing pitchforks. The franchisees are incensed. And they're incensed both because the situation sucks and they're like... God damn it, B of A, take us seriously. You have meddled in our entire businesses. This is in chaos. Like, we got to fix this. So what do these two poor B of A guys do?
Acquired
Visa
Right before lunch on the second day, they're like, yo, we got to save our skins. We got to get out of here. Let's do the smart thing to make sure that everybody gets placated, but nothing actually happens because they don't have any authorization from Bank of America to do anything. They're just people sent to face the mob.
Acquired
Visa
Let's appoint a committee of licensees to quote unquote investigate all of the operating problems and report back to us. You know, they can come out to San Francisco. They can meet us at B of A headquarters and we'll listen to their problems. Wow. But.
Acquired
Visa
Unfortunately for their goals, their very narrow goals that particular morning, but very, very fortunately for all involved, the franchisees, the world, consumers... In the long term, at least. In the long term, and also Bank of America in the long term. One of the people that gets put on that committee...
Acquired
Visa
is the Bank of America franchisee program manager from a small bank in Seattle, the Seattle National Bank of Commerce, which would go on to become Rainier Bank. And then, ironically, do you know what happened to Rainier Bank? You can't make this stuff up. No, I don't, but I can guess where this is going. Yep.
Acquired
Visa
Once interstate banking regulations get loosened up, they get acquired by Bank of America, of course, in the 1990s. But for the moment, the person running their Bank of America card franchisee program is one D. Hawk. And I think you could really say on this day, the founder of Visa.
Acquired
Visa
No, and we're going to talk much more about Dee in a minute, but just to keep the story going so we don't leave you all in suspense on this day. During the lunch break, Dee has gotten put on this committee. He goes up to the two B of A guys and he's like, hey, rather than us just putting together a list of grievances and reporting back to you at B of A,
Acquired
Visa
what if instead we do examine all the problems in this system but what if we ourselves this committee we design and propose a new way of operating the whole thing and After some convincing, the B of A guys are like, eh, sure. I mean, they're not agreeing to anything. Their goal is just to escape the mob anyway. They're like, whatever.
Acquired
Visa
If this makes you happy, if this lets us escape back to California, sure. And probably, almost assuredly, I mean, this is a committee we're talking about. Nothing is going to come of this. Yep. So the whole summit reconvenes after lunch and D gets up on stage, not the Bank of America guys, and he proposes this idea to the group. Say, hey, we've got this committee.
Acquired
Visa
Rather than us taking a list of grievances back to B of A, what if we try and design a new way that the system could operate and operate better for everyone? They take a vote on it. Everybody agrees. Mostly, I think, just because they wanted to get out of there, go back home and away from this disaster of a meeting. They all get on planes.
Acquired
Visa
They all leave, most of them probably thinking that nothing is ever going to come of this. Certainly the B of A guys thinking nothing is ever going to come of this. But D kind of thinks he just got authorization to go create Visa.
Acquired
Visa
Yes, Crusoe, as you know by now, is a cloud provider specifically built for AI workloads powered by clean energy. Today, right in theme with Visa, we are talking about reliability and some of those details of Crusoe's infrastructure.
Acquired
Visa
So by this point, you know that their cloud is run on wasted, stranded, or clean energy, and they can provide significantly better performance for your dollar than traditional cloud providers.
Acquired
Visa
Yeah, mostly farmers and merchants in San Francisco. It really started as like the Bank of the Little Guy. So Bank of America decides that they are going to mail out little rectangular pieces of plastic to every single one of their 65,000 customers in the city of Fresno, completely unsolicited. Now, a couple things about this. One, it's wild.
Acquired
Visa
It's so cool. I mean, ultimately, this results in a huge win-win. They take what is otherwise a huge amount of energy waste and environmental harm, and they use it to power massive AI workloads. How could you do any better?
Acquired
Visa
Yeah, and he's not wrong. Fortune favors the bold, you know, might you say? Yes. So to say a few more words about why this is so hard to organize this group of now competing banks to collaborate with one another, you've got multiple banks in the same state that are part of this system. Let's take Illinois again to stick with this.
Acquired
Visa
You've got a bunch of banks in Illinois that are now all part of the Bank of America payment network, which is intimately linked with their banking operations. If I'm any one of those banks, I would want to say like, hey, no, I want to be the only bank in Illinois doing this.
Acquired
Visa
And OK, maybe there are a few others here with me, but I sure as hell want to shut the door to anybody else coming in and being part of this network. Whereas when you think about growing the value and power of the network, you want as many merchants and cardholders in the system as possible.
Acquired
Visa
And the merchants obviously want as many cardholders as possible, and the cardholders obviously want as many merchants as possible. That means that you need all the banks because you need all the merchants, you need all the customers, you need all the banks.
Acquired
Visa
Totally. This is a classic two-sided network. You want to race to get ubiquity as fast as possible on both sides of the network. So as Dee goes off and reflects on all this, he realizes that the fundamental problem is you've got this huge and diverse set of banks that both directly compete with one another.
Acquired
Visa
But also, if they're going to make this thing actually work, they need to collaborate and work together. Right. And that sounds like a really, really, really difficult problem to solve. Even if you could do that, how are you going to get the DOJ to let you do that? Antitrust is going to be an issue here for sure.
Acquired
Visa
But, you know, and this is Dee, he's like, okay, if though, if we could do this, what is the opportunity? Well, we've seen what the opportunity is for Bank of America. That is the shining case study. So at a minimum, this could do for all the other banks in the world what it has done for Bank of America. But... Even more than that, though, Bank of America was trying to stretch here.
Acquired
Visa
They got greedy to a certain extent in franchising this out to other banks. But other banks signed up for this and they were willing to pay both a franchise fee and a percentage of transaction volume to Bank of America because the siren song, the reward of doing this was so great to them.
Acquired
Visa
I think the Fresno population at this point in time was like maybe 200, 250,000 people. So like a huge... portion of the city of Fresno banked with Bank of America. And that was true for all of California at the time, too. They just send these things out. Obviously, these are credit cards. People don't know what they are. They have no idea what to use them. Mass chaos ensues.
Acquired
Visa
Yes, absolutely. So in a certain way, this is sort of, I don't want to say inevitable because this is definitely not inevitable. But again, in the thought exercise of could you do this, the actual organization itself, like the network itself, would have so much value.
Acquired
Visa
You know, if you could get every bank in America and then every bank in the world, and Dee is thinking big from the beginning, to be part of this, and you could power this global payments and credit network, and you were allowed to take a fee on the transaction volume for doing that, the value that you would unlock in January, it beggars the imagination to think about what this could be.
Acquired
Visa
So there's this great passage from him in his book, One for Many. He says, any organization that could guarantee, transport, and settle transactions in the form of arranged electronic particles, that's what he calls digital information. 24 hours a day, seven days a week around the globe would have a market Every exchange of value in the world that beggared the imagination.
Acquired
Visa
The necessary technology had been discovered and would be available in geometrically increasing abundance at geometrically diminishing costs. But there was a problem. No bank could do it. No hierarchical stock corporation could do it. No nation state could do it. In fact, no existing form of organization we could think of could do it.
Acquired
Visa
On a hunch, I made an estimate of the financial resources of all the banks in the world. It dwarfed the resources of most nations. Jointly, they could do it. But how? It would require a transcendental organization linking together in wholly new ways an unimaginable complex of diverse institutions and individuals. This is the opportunity. And this is what he essentially takes to Bank of America.
Acquired
Visa
And now we got to say a few words about Dee, because this situation is nuts. Dee is a banker. He is running the Bank of America franchise program at what would become Rainier Bank in Seattle. But He's an outsider. He's kind of a nobody. He's not senior in a small bank in Seattle. He was raised in rural Utah, basically in poverty during the Depression. He didn't go to a four-year college.
Acquired
Visa
He only has an associate's degree. He bounced around in a bunch of random consumer finance jobs on the West Coast, all of which he got fired from because he's too insubordinate.
Acquired
Visa
He now walking into the boardroom in Bank of America, which is what he's going to do, and standing toe to toe with the vice chairman of Bank of America and saying, I think you should give me the Bank of America card program because it is in your self-interest to do so, which almost literally are the words that come out of his mouth in that boardroom, is just absolutely wild.
Acquired
Visa
And this is the thing. Dee is an odd duck for sure, but he is amazingly smart. He's basically all self-taught. He's incredibly well-read. He started reading every book on his little farm in Utah that he could get his hands on when he was seven years old. super importantly, you know, this is a Steve Jobs, you can only connect the dots looking backward moment.
Acquired
Visa
He was not very good at sports in high school. So he got into debate instead. And then he also did debate in college when he did his associate's degree. And so you all of the techniques that he learned from competitive debate and persuasion. He has this amazing quote.
Acquired
Visa
He says, during my years of college debate, I held fast to the notion that until someone has repeatedly said no and adamantly refuses another word on the subject, they are in the process of saying yes and don't know it. I mean, Dee basically is the prototypical Silicon Valley founder. He's just a generation too early and in the wrong industry.
Acquired
Visa
Totally. I mean, cut from the same cloth, right down to every single stitch. There's one other important aspect to Dee that I think we should highlight here that enables him and all of Visa to succeed. And that's that he's about as far from the man and image of JP Morgan as you could imagine. That... is what enables this.
Acquired
Visa
Because if he were the CEO of another bank or a senior executive or some well-respected person marching into the Bank of America boardroom and standing toe to toe with their board and saying, I want you to give me your very precious crown jewel, There's no way it would work. Of course, Bank of America would say, what's in it for you? I don't trust you. I don't believe you.
Acquired
Visa
Even if they did trust and believe this person, they would lose all of their face and reputation if they were subordinating themselves to somebody who could conceivably be their equal.
Acquired
Visa
So Dee's just gone into B of A with this grand vision of like, you should give me this incredible asset because the value that it will create outside of your hands and your fractional ownership thereof will be so much greater than what it could be on its own.
Acquired
Visa
Yep. Totally incredible that Dee actually convinces Bank of America to do this. Nobody in the world would have thought that this could happen. But now the work is sort of just beginning because there's two things now that he needs to do. One, he hasn't actually figured out how to architect this thing such that it works. So he's got to go do that.
Acquired
Visa
Two, though, then now he has to go back to all of the soon to be former franchisee banks and convince them why they should do this. And this is a different argument from what he made to B of A. B of A, he's trying to get them to give him the asset. With the other banks, he actually needs to get them to change their behavior.
Acquired
Visa
He needs to be able to go to, say, the couple banks in Illinois that are existing franchisees of the Make America Hard system and say, hey, the new regulations, the new operating laws for this organization are going to be all the banks in Illinois can join. And we actively want to go convince all of your competitors to come join this system.
Acquired
Visa
So to explain how we got here, we need to spend a few more minutes on Bank of America's history and the history of banking and payment industries in the U.S. more broadly. So like we said, B of A was the biggest bank in America in the 1950s, but it was not like all the other big banks at the time. It was a consumer bank.
Acquired
Visa
You know what this is like? This is like back in our NFL episode. Yes, it's exactly right.
Acquired
Visa
When the NFL started negotiating national television rights collectively as an organization, a bunch of the individual teams hated that because they were like, if I'm the Jets, I'm making more money in my New York metro area doing my own TV deals than I'm going to get as a share from you, the NFL, of a national deal.
Acquired
Visa
But in the long run, it was absolutely the right decision and value accretive to everybody, including the Jets, that the NFL centralized this.
Acquired
Visa
Okay, so how's this whole thing going to work? Dee and a few of his other fellow committee members, they go to Sausalito, California, just north of San Francisco, just across the Golden Gate Bridge, and they do an offsite for a couple days at a hotel in Sausalito.
Acquired
Visa
And there they come up with a number of operating regulations, guidelines for this hypothetical new entity, four of which we're going to talk about here that are super critical.
Acquired
Visa
One, ownership of this new organization that's going to be called National Bank of America Inc., the new owner of the Bank of America program, is going to be in the form of irrevocable, non-transferable rights of participation. So you're not going to own stock in this thing. There's no equity. The way that you have ownership and the percentage ownership that you have in the network is
Acquired
Visa
is by participating in it and the amount of volume that you are contributing to the network. Oh, interesting. So this means a couple things. One, it's sort of like a representation and ownership according to value contributed. Two, It's non-transferable. So you can't sell it. Any individual bank, if they were to say like, oh, this is valuable now, I'm going to go sell it.
Acquired
Visa
And then I no longer have any incentive to participate in the network. If that starts happening, then it'll lead to a cascade for the exits and the network will lose value. So there's no way to do that.
Acquired
Visa
You're making the assumption that this is a cost-only organization, forgetting the fact that it is one of the greatest business models and revenue generators of all time. You are contributing 17% of the volume to this. You are entitled to 17% of the profits. I see. That we are extracting from the merchants and the cardholders.
Acquired
Visa
The other large and influential banks in America back then were like the JP Morgans. They were white shoe corporate banks based in New York. We talked about this a lot in the Nike episode. It was illegal for banks to operate across state lines until much, much later in history.
Acquired
Visa
Yep. Exactly. So the actual legal structure that Dee and his fellow committee members land on for this is a for-profit non-stock membership corporation.
Acquired
Visa
It is. There's a myth out there that Visa was originally a non-profit and then was converted to a for-profit before the IPO in 2008. That's not true. It was always for-profit. It was just a non-stock membership corporation. And that was to get around banks selling their interest. So you don't participate in it, you don't own it. So say it one more time. It is a for-profit.
Acquired
Visa
A for-profit non-stock membership corporation. Your ownership is your membership. Fascinating. It's like a co-op. It's like REI or something like that.
Acquired
Visa
The way that Dee describes it to all the other banks is it is a reverse holding company. The parent entity is owned by the subordinate members as opposed to the top level holding company owning all the subordinates.
Acquired
Visa
Yes, but the NFL sets all the regulations for how the game is played and all the teams submit to it.
Acquired
Visa
Okay, so that's point number one. Maybe the most important one. Point number two. It is a self-organizing body with irrevocable governance rights for each member. And this is, well, I guess also how it's like the NFL. Basically, this means this is a democracy. Every member has a vote. in determining how this organization runs.
Acquired
Visa
Anything that you could conceivably have a vote on, changing our regulations, setting them in the first place, budgets, fees, all this stuff, every single member bank will have a vote. And importantly, every single member bank can call a vote at any time. I mean, it's literally like a pure democracy. Wow.
Acquired
Visa
Well, they set the threshold at 80% for anything to happen. I see. So there's a strong incentive not to call a vote and waste everybody's time unless you really think you can round up 80% of the votes.
Acquired
Visa
Which, in practice, just gives Dee all of the control and power of the company. Because everybody's going to listen to him as the CEO. Point three, we've basically already discussed, and that is that the mission of this organization is to facilitate cooperation and trust among competing institutions to grow the Bank of America payment network larger than any one institution could on its own.
Acquired
Visa
So for banks back then, the only way that you could actually get big for just about everybody else in the industry was to go the corporate route and to go the investment banking route, because you could service very large corporations that obviously were large themselves, would generate lots of deposits, lots of lending activity.
Acquired
Visa
which is the pitch he gave to Bank of America leadership. Also though, this is a implicit kind of forbidding of banks in the network from going off and also forming or participating in competing networks. So to borrow like a crypto phrase here, like no side chains allowed. Everything happens on the main network.
Acquired
Visa
national bank americard inc yes at this point in time a antitrust lawsuit would change that very shortly i see but at this point in time it's like nope you are part of mbi exclusively you don't go join interbank mastercard and you also don't go start your own networks or peel off parts of the network everything that you are doing in payment card operations needs to route into this network
Acquired
Visa
That's a big contract to sign. Totally. Again, this is why Dee needed to paint the picture both to Bank of America and all the other banks. The prize is worth it. Yep. And then finally, point four... there will be a singular universal set of operating and governing procedures that, much like the U.S. Constitution, is infinitely modifiable by a threshold vote of all members.
Acquired
Visa
This is the 80% I talked about. And two, also like the U.S. Constitution to its citizens, all members agree to be bound by its law, both now and as it is so then modified in the future. So like, if you're signing up for this, you are signing up for the regulations and operating procedures as they exist today.
Acquired
Visa
And for any future changes that come, of which you will have a vote in, this is a democracy, but you can't go leave the democracy.
Acquired
Visa
And amazingly, even describing this now, having done all the research, read all the books, written the script that we're talking about here, I still can't believe this actually happens. Dee goes on a tour across the country. He goes and meets with all the banks. Bank of America helps him out. They bring senior executives, too, to help convene meetings with all the banks to persuade them.
Acquired
Visa
The investment banking activities around that were obviously very lucrative. That's how the JP Morgans, the Morgan Stanleys, et cetera, the world came to be. For the most part, consumer banks were kind of backwater, small. There was no way to aggregate enough customers that you could get big enough.
Acquired
Visa
Every single member bank of the previous Bank of America franchisee organization, every single one of them signs up for the new organization led by Dee. Not a single person jumps ship. How many banks were it at this point? Over 200.
Acquired
Visa
Totally. And Dee writes about this too. Bank of America helped him out. They identified the 13 most influential banks and they convened the first summits with them of like, Hey, what do we got to do to horse trade to get you guys involved? And then you kind of spiral out from there. But yeah, every single one. Nobody jumps ship. And when is this? Like 1970-ish? The process starts in 1968.
Acquired
Visa
It all wraps up in either 1970 or 1971. Importantly, we've talked about antitrust and DOJ a bunch here. You would think that this would be setting off massive alarm bells in Washington and with the Department of Justice. They get ahead of this. So D goes to see them and he gives the same pitch to the government.
Acquired
Visa
He says like, look, obviously this is the whole industry, all the competitors in the industry colluding to work together. That's the whole premise of the organization. But what we can create by doing this would not be possible otherwise. And it will be so profoundly useful and important to the American consumer and American businesses that it is worth you letting us do this.
Acquired
Visa
So they actually get a letter from the DOJ saying like, Hall pass. You're good on this one.
Acquired
Visa
America wants both its football and its credit cards. Amazing. And that was a key point in then going and convincing all the other banks to sign up for this, because that was one of the first questions they asked. Hey, if we do this, aren't we inviting the DOJ on our backs? And Dee is able to say like, nope, got the letter right here. We're good. Wow. Amazing.
Acquired
Visa
So very shortly after this, after the creation of NBI, National Bank of America Inc., Dee, in 1972, he's thinking globally from the get-go. He goes and creates a parallel, similar organization of international banks using the Bank of America card system. Visa was global from basically day one. And it wasn't just Barclays in the UK. It was Sumitomo Bank in Japan.
Acquired
Visa
It was other banks throughout Europe. It was Canada. It was Latin America. We won't go into all the detail here except one amazing story we're going to tell.
Acquired
Visa
This was actually harder to pull off, if you can imagine that, than forming NBI because it really is not clear for some of these international banks that it is better for them to be part of the global network than if they could run the table on their entire country. Say you're, I don't know, I'll pick Sumitomo Bank in Japan.
Acquired
Visa
You have to decide, do I want to buy these pitch of it's worth it to me to be a proportional owner of Visa? Or I could be the singular dominant credit card network in my own country, which is more valuable.
Acquired
Visa
Totally. So once again, in Sausalito, this all comes to a head. Dee knows that probably not all of the international banks are going to agree to this, and some of them are going to go their own way. So he calls a final summit in Sausalito. They're going to vote the next morning, final vote, on who's going to join the soon-to-be visa network and who's going to go it on their own.
Acquired
Visa
And Dee gives this nostalgic speech at the end of dinner saying, like, here in Sausalito, looking out at the bay, this is where me and my colleagues, we dreamed up the original vision for what this could be. And it's sad that this won't be extended to the whole world and a true global payment monetary system. But we're all gathered here.
Acquired
Visa
We should celebrate having accomplished so much and had a chance at this dream. Just having the chance is worth it. He's really good with his debate skills. And then he's like, so before we meet one more time tomorrow to obviously disband this whole venture and have the dream just be a memory, we have one more thing for you. One more thing. He's like Steve Jobs.
Acquired
Visa
A small gift of appreciation for you giving your valuable time and effort as part of this global undertaking. Please take this little box out from under your seats. Everybody takes a little box out from under their seat. They unwrap it. And inside are a pair of pure gold cufflinks. that on each of the two cufflinks, there is one half of the globe.
Acquired
Visa
And under one side, it says in Latin, Studium ad prosperidum, which translates as the will to succeed. And the other side says, Voluntas inconvenendum. Apologies to Latin speakers out there that I'm butchering that. Translates as the grace to compromise.
Acquired
Visa
and he explains this all and somebody from the crowd yells out d you miserable bastard because he just pulled on everybody's heartstrings oh and like he gets the votes and the next morning all the holdouts reverse course they all join and what you can't make this stuff up it literally happens the cufflinks are out there you can google him he did this
Acquired
Visa
So the other thing along these lines that he does, which is just hilarious. Once this is all set up, this, the international part of Visa becomes first IBANCO, I-B-A-N-C-O. Shortly after this, they rebrand the whole thing into Visa, which we'll talk about in a minute. For the board, the board is huge because it's like all the representatives from every region, from every country.
Acquired
Visa
There's like 25 people on the board. Dee holds board meetings all around the world, you know, different city all the time. It's a global organization, whatnot. he invites the spouses of all the board members to come to each location. He's like, oh, it's a family trip, you know, et cetera. And then he gets the idea. He invites the spouses into the board meeting itself. Oh, what a nightmare.
Acquired
Visa
So 25 board members plus their spouses in his board meeting. This means two things. One, nothing is going to get done. There are 50 people in the room. Two, though, he needs all these people to behave well together and, you know, be generous and gallant. What better way to make sure they're on their best behavior than to have their spouse sitting behind them?
Acquired
Visa
So, like, are you really going to act like an asshole in front of not only your spouse, but the spouses of all these other global bank heads?
Acquired
Visa
Okay, Visa is so important. It's not just a rebrand. It has to happen once this international organization is set up. Yeah, America can't be in the name. Yeah, Bank of America ain't going to work. And importantly, as we'll get into in a little bit, this is a huge problem for American Express, too.
Acquired
Visa
The soon-to-be Visa knows if we're really going to realize this global vision, we need a truly global brand and mark. Remember back to the blue, white, and gold three stripes. That's iconic. It works internationally. Obviously, the name does not. So... D holds a contest internally within NBI slash iBanko to generate a new name. And he offers a $50 prize for the winning entry that is chosen.
Acquired
Visa
And as legend goes, there are so many submissions of the name Visa that when they finally unveil it, D makes a big deal and writes out a $50 check. Check. Why are they using a check? Made out to everyone in the company. Which is funny. But then they change the name to Visa. Visa, it's the most incredible name ever created. I mean, Nike was so great. This is like even better.
Acquired
Visa
You cannot have a better name for what this is. It's interesting it's in English. I mean, I guess it makes sense it's the most spoken language, but... Well, no, it's not just in English. The name Visa in every, if not almost every language on earth... And when you're traveling and you need a visa for a country, they call it a visa in other languages, too. That's what it is.
Acquired
Visa
Yes, exactly. California was already the second biggest state in the nation at that time behind New York. But the New York banking industry was super fragmented because Bank of America, starting as Bank of Italy with all these immigrants, had built up a consumer base. They really were unique. So, you know, the business of banking is, well, banking.
Acquired
Visa
But when you are traveling internationally, when you're going through customs in any country, it is identified as a visa. That is the name.
Acquired
Visa
Just every dimension. The presumptive close, the implication that this is a global network, that you can bring your Visa with you when you're traveling to other countries and it'll work. The actual definition of the word Visa, that it is your entry pass. This card is now your entry pass to commerce, to experiences, that it works everywhere, as you said, that it's universal. It's amazing. Yeah.
Acquired
Visa
So the Visa name, brand, everything, there's two more levels at which it becomes really important. They do something really, really, really smart. So we talked about the need for the universality of a mark and why early Interbank, that was a problem until they standardized on MasterCard. They've got the three bands, the blue, white, and gold. And now they have a global name.
Acquired
Visa
But all the individual banks, the hundreds, soon to be thousands of banks, they all want their own branding on the card too. So Visa says, okay, here's the operating regulations. Every card has to have the blue, white, and gold. In the middle white band, Visa logo goes there. Nothing but the Visa logo. on the top blue band, you can put whatever you want. You can put your own bank logo.
Acquired
Visa
You banks get creative. You can do literally whatever you want. Banks start going around. They do affinity card programs with NFL teams, with merchants. This is how you get the Southwest card. This is how you get the San Francisco 49ers card. This is how you get the X, Y, Z, everything that they're a bazillion of now.
Acquired
Visa
Yep. And this is kind of the brilliance of the Visa model. They were like, it's open. You can do whatever you want up there.
Acquired
Visa
Of course, it's great. The whole goal is just get more consumers and more merchants on the network. So anything that's going to do that great while maintaining the universality of Visa. Great. We got the middle. You got the top. Go wild. Do whatever you want. Wow.
Acquired
Visa
Maybe the most important thing, though, for Visa really pulling away and becoming, at least for many decades, the dominant global payment card network, the name change ends up becoming this incredible growth hack. Because what happens is, They're the new operating regulations now that mandate that all cards out there, all the previous Bank of America cards, need to be migrated to Visa cards.
Acquired
Visa
I think within like two years of this being declared or something like that. Some banks start to see this as an opportunity to go poach cardholders from other banks. So the competition within the network, obviously this still exists, because consumers now, they know, and Visa runs a national advertising campaign, hey, your Bank of America card is going to switch to Visa.
Acquired
Visa
You take deposits, you make loans, you make your money on the loans. B of A was doing tons and tons and tons of small, little and disparate consumer loans and lending. So obviously mortgages and car loans like those still exist today, but they were doing like washing machine loans.
Acquired
Visa
So some banks, in a version of the Fresno drop, they start sending unsolicited letters to consumers who are already Visa, Bank of America customers with another bank. They're like, oh, hey, it's time to switch over to your Visa card. Here's the application.
Acquired
Visa
Totally wild. But because of this, a whole bunch of consumers start sort of unconsciously switching the bank that issues their Visa card. And then once this starts happening, this kicks off a total arms race where all the banks in the network are now like, shoot, we got to blanket the whole country and preserve our domain and see what we can capture from others.
Acquired
Visa
In the one year between when the visa name change first comes online and takes effect, which is in 1977, and the next year in 1978, the number of banks participating in the visa system grows by 20%. Because everybody who's not in the system now is like, I got to get in the visa system.
Acquired
Visa
Totally. So that was number of member banks grows by 20%. The number of active cardholders in the Visa network in this one year grows by 45%. Wow. Isn't that wild? So as you say, they blow way past MasterCard thanks to this. They're already way bigger than Amex because Amex is a different customer segment, which we'll talk about in a sec.
Acquired
Visa
And this really puts them on the path to becoming the dominant global network that they are today.
Acquired
Visa
It's also worth closing the loop on MasterCard here, too. I mentioned that the DOJ eventually came after both Visa and MasterCard and prevented them from being exclusive systems. That does happen in 1975, and so this concept of duality takes hold for the banks, duality meaning they can multi-home on both Visa and MasterCard.
Acquired
Visa
In all the testimony and case with the DOJ, Dee is obviously 100% against this happening. He doesn't want his banks to be able to join MasterCard 2. But he also makes the surprisingly correct argument. He's like, look, this would be a huge mistake. Because U.S. government, if you do this, you are going to freeze the payment networks in the U.S.
Acquired
Visa
Nobody is ever going to develop a new competing open loop payment network because now there's no more competitive vector between Visa and MasterCard. We'll all have the same features. Banks will be members of both. They're kind of going to operate in lockstep. The prices should be identical for both. All this stuff. And the DOJ is like, no, no, no, no, we're going to do it anyway.
Acquired
Visa
Irony of ironies, later in 1988, the DOJ again sues Visa and MasterCard for being a duopoly and not competitive enough.
Acquired
Visa
Yep. So this basically concludes the full Visa story. Like, how did this incredible thing happen? You know, we've answered these questions. Who owns this? Who runs it? How did it start? We could end the episode here, but we've actually really only told you half the story.
Acquired
Visa
What we've told you is all the incredible business, organizational, social, human behavior innovations that Visa and D created.
Acquired
Visa
And for specific items to like go buy a refrigerator. Wild. It was just wild to imagine today.
Acquired
Visa
Something that is also true, and also I think really underappreciated about Visa, is that is it's also a technology company. And there is a whole technology story in parallel with this too that enabled the Visa we know today to Dee's question of where is Visa headquartered and nobody knowing that. It's headquartered in the Bay Area. It's a Silicon Valley company.
Acquired
Visa
It was started in the same place and time as Intel, Atari, Apple. The only thing that is different about it versus those other companies is it wasn't funded by venture capital. And it thus didn't make anybody rich except the banks who owned it and thus were already rich. But there's an incredible technology story. Yeah, great point. All right. So what is it? Well, that's a great question, Ben.
Acquired
Visa
And before we get into it, this is actually the perfect time to talk about another great technology company and leader. One of our favorite ones, in fact, Statsig.
Acquired
Visa
So you can see why for a bank like Bank of America that is doing this at such large scale, the idea of a consumer credit card, well, it's pretty awesome because you can take all of these disparate lending programs, consolidate it into just one card, cut out a ton of overhead fees and make it way more efficient. So this is what they are launching first in Fresno as the pilot market.
Acquired
Visa
Yep, building reliable infrastructure is a very broad topic, obviously, but one easy way to improve reliability is staged rollouts. So a lot of times, what leads to downtime is unexpected interactions from new releases, which crash a component of your app or service.
Acquired
Visa
By rolling out a new feature in stages, first to employees, then to an increasingly broad set of users, you can test for bugs in a production environment before you actually launch the feature. Most companies don't do this, however, largely because, unlike, say, Facebook, they don't have the right tools.
Acquired
Visa
It's super impressive. So if you're a startup, they have a generous free tier and a special program for venture-backed companies. And if you're a large enterprise like those companies Ben just mentioned, they have transparent and non-seat-based pricing. Acquired community members can take advantage of a special offer, including 5 million free events a month and white glove onboarding support.
Acquired
Visa
Just go visit statsig.com slash acquired. That's S-T-A-T-S-I-G.com slash acquired to get started on your data-driven journey.
Acquired
Visa
So everything we just described up until now, amazing, incredible, unlikely, one in a million. But all it really bought, D and Visa, was the opportunity. Yes. To actually realize what he sold to Bank of America and the other banks of a instant global payment network that a large percentage of global commerce runs on, you had to build a lot of technology to make that happen.
Acquired
Visa
And if you asked the question of Dee back in 1968, okay, let's assume we do this, and we put one of these soon-to-be Visa cards in the hand of every consumer on the planet, do they actually want to use them instead of cash and checks? And the answer to that was probably not. Fascinating. Now, they wanted to use them in specific use cases.
Acquired
Visa
Like, Ben, you pointed out, when you want to make a credit purchase, when you want to essentially do what installment financing was before, when you have any number of XYZ other set of factors. In the case of Diners Club and Amex, when you want to impress your colleagues and your business partners, there were use cases.
Acquired
Visa
But it wasn't like it is today where obviously you're going to use your credit card, which is probably a Visa and maybe a MasterCard to pay for everything that you do everywhere instantly.
Acquired
Visa
Ben, I have really sad news. 1993 was 30 years ago. We remember it, but it's old now. 1993 to today is like the 1950s were to us when we were kids.
Acquired
Visa
And they call it the Bank Americard. Beautiful name. Beautiful name. And it would survive for quite a long time. Now, this wasn't exactly a new idea on the part of Bank of America. Charge cards and credit cards have been around for decades. What was new was this was the first time that a bank had entered this market at scale. So let's talk about the history.
Acquired
Visa
Credit cards are debt. What this woman is saying is really sad if you need to use debt to buy a burger.
Acquired
Visa
That was 1993. I mean, yeah, compare that to today. And I mean, I don't know about you, but I get pissed when somebody ahead of me in line starts breaking out cash and coins. I'm like, oh, my God.
Acquired
Visa
So to get from there to today, three major pieces of technology needed to be built by Visa. One was transaction authorizations.
Acquired
Visa
So when we were talking about transactions happening earlier and the person in Burger King was referencing like, oh, they got a call to New York and they got to authorize the transaction and all that, we glossed over one sort of stopgap slash band-aid that Visa and other credit card networks implemented around authorization. They didn't actually authorize every transaction.
Acquired
Visa
So when you paid for something with a credit card in a store, All merchants had what was called a floor limit. And the floor limit was any transaction over that limit could not be authorized directly on the floor. And say it was, I don't know, 50 bucks or something like that. Anything paid with a credit card under $50, it was basically within the judgment of the cashier to say yes or no.
Acquired
Visa
And so everybody just said yes. I mean, the reality was... This was the threshold below which the banks and Visa were willing to say, okay, we'll accept a certain amount of fraud. Interesting. And then above that limit, the cashier had to go call up the merchant bank, say, hey, we got a card here. It's this number. Somebody's buying a refrigerator.
Acquired
Visa
Then that merchant bank would have to look up that card number, figure out based on the card number what bank issued the card to the cardholder, call up the cardholder bank. Oh, my God. Get somebody on the horn there. Say, hey, I've got your cardholder, Benjamin Gilbert. His card number is XYZ123. Can you look up his credit? And he wants to buy a $500 refrigerator.
Acquired
Visa
Yes. Have they hit their limit? The issuing bank would go look that up. The person there, literally the person, talk on the phone to the person at the merchant bank, give them the answer. The merchant bank then switches the line back to the cashier at the store and says like, yeah, Ben is good for it or no, Ben is not good for it.
Acquired
Visa
People at merchants talking to people at their bank, talking to people at the cardholders bank and then reversing the whole chain.
Acquired
Visa
Historically in the U.S., transferring money was actually not that easy. You had two options. You could use cash or you could use checks. And checks worked, but they also had a bunch of problems. One, until the creation of the Federal Reserve in the 1910s.
Acquired
Visa
And so this is a big part of one of the first things that Visa builds. And that process that we just described, that could take like 20 minutes. And it just didn't work outside of business hours for those banks. So say, you know, now that Bank of America is nationwide, soon to be international.
Acquired
Visa
Imagine you're trying to buy something in Japan and the Japanese merchant bank calls your cardholder bank back in America, close for business. Just no way for that transaction to happen. Wow. That's crazy. Not good. Definitely not good. So Dee and Visa know that this is like the first thing that they have to address.
Acquired
Visa
In 1971, right after NBI is formed, Dee starts a project called the Bank AmeriCard Authorization System Experimental or BASE to build technology to address this problem.
Acquired
Visa
the whole thing actually started rather inauspiciously because right after all the approvals came through for d to form nbi i think it was literally the evening before the first board meeting bank of america comes up to d and they're like can we take you aside there's something you need to know
Acquired
Visa
And they're like, well, it's kind of hard to tell you. We've been in secret negotiations with American Express for months to create a joint venture together, Bank of America and American Express, that will create an automated system for transaction authorization for multiple credit card systems across the whole country. And we're going to do this.
Acquired
Visa
So, you know, D, if you want us to remain part of MBI, remember, this is Bank of America, the most important part of MBI. Oh, my God. I know, you know, that part of the operating agreement is like, you know, we can't really operate outside of the bounds of MBI. But this isn't really outside the bounds of the MBI. This is a separate thing. This is authorization systems. We're going to do this.
Acquired
Visa
Because they and American Express both see that, hey, this is a really, really, really valuable piece of technology. D is, of course, pissed, but what's he going to do? B of A says take it or leave it. D takes it. As D then tells the story... Bank of America and Amex go out and they try and pitch the other banks in NBI and Interbank and MasterCard on joining the system.
Acquired
Visa
But there's all these problems with it and they don't know how to build technology and the whole thing dies on the vine. Maybe. Maybe that might be part of the story. The other thing that happens is Interbank and MasterCard actually get involved in the project.
Acquired
Visa
The whole thing then morphs into a tripartite consortium of Interbank, American Express, and Bank of America, and thus by association, NBI. Right. our old friends at the Department of Justice start sniffing around and they're like, all right, now this is actually collusion and anti-competitive behavior. So if you go forward with this, we're going to sue you. And they all abandoned the project.
Acquired
Visa
The parties cashing the check, receiving the check, didn't actually receive the full face value of the check because there was a bunch of work and like mailing stuff around, traveling around the country that had to be done. And that was taken as a discount out of the check.
Acquired
Visa
And this is huge for Visa because this means they can build it on their own. Fascinating. So they do the natural thing at the time. I mean, these are bankers. Even though they're based in San Francisco and Silicon Valley, these aren't tech folks. They put out an RFP to folks like IBM, systems integrators, you know, the Accentures of the day to go build this technology for them.
Acquired
Visa
Go build a computerized authorization system for the Bank of America Visa network. All the bids come back. And of course they are all way over budget and way over time. So D says, well, screw it. We're going to do it ourselves. How hard can it be? Wow.
Acquired
Visa
So in his very D way, he goes and he recruits the guy from the firm that impressed them the most throughout the bidding process was a firm named TRW and a guy named Aram Tatoulian. D goes back to him and he's like, I like you. You come work for me. Leave TRW. I'm going to hire you. You build this here in-house. Wow. And I'll give you the resources.
Acquired
Visa
You come join us and you'll build out your own tech team here within NBI slash Visa. Aram comes and joins and starts the core of the Visa tech team. Dee gives him nine months to build this entire thing from scratch. And to do this involves building a first nationwide and then ultimately worldwide telecom network so that the electronic communication can happen.
Acquired
Visa
Two, installing computer systems in each of the member banks around the country so that instead of the banks calling the other banks, you know, this can happen over computers. Three, training the people at the banks on how to use these new computer systems. And then four, maybe most importantly for the long run. Building a new centralized data center for Visa in the Bay Area.
Acquired
Visa
And this becomes the San Mateo campus. You can see it right off of 101 as you're driving between San Francisco and Silicon Valley. It is, I believe, still the headquarters of Visa today now. Huge campus in San Mateo where they build the data center.
Acquired
Visa
So, miraculously, Aram and his new Tiger Visa tech team They do it. They do it in nine months. And it works. So Dave Stearns writes in his book about this whole situation and about Dee. Dee maintained that if you give computer people more time, they will just consume it. So he always insisted. It's so true. So he always insisted on shorter projects with uncompromising deadlines.
Acquired
Visa
Yep. Now, importantly, this is only for transaction authorizations. So the cards and the point of sale have not been digitized yet. That's going to be the final third piece of the stool of technology that Visa builds. This is just when a merchant makes a call to their bank saying, hey, is this card good for this amount? This is then the interbank communication. I see.
Acquired
Visa
So how does the settlement happen at this point in history? So that's what's next. That's the next big operational technical problem that Visa needs to solve.
Acquired
Visa
Reconciling the transactions, moving the money, getting everything wrapped up at the end of the day, week, month, sending out statements, all this stuff. You can sort of think of the first piece that we just described as the authorization as sort of the front end of a payment card system. The settlement is the back end. You know, the front end piece consumed a lot of phone time and people.
Acquired
Visa
The back end piece consumed a lot of paper and time too. Maybe more time, but like a lot of paper. Because you're effectively mailing checks. And even more perniciously, as the network grew, and at this point in time, soon-to-be Visa is growing explosively, the complexity of this settlement piece also grows sort of exponentially.
Acquired
Visa
Every new bank node that you add into the system now has to interact with all the other bank nodes. And so, like, this is a hard computer science problem. It's an N squared problem. Well, it's a problem that is easily solved by computers. But when you're doing all this manually with paper, this is a big, big problem.
Acquired
Visa
Yes. So what you really need to do this efficiently, to bring it all the way back to the beginning of the episode... is a clearinghouse. You need an automated clearinghouse. And this is unbelievable. A few people had referenced this to us as we were doing the research, but I kind of forgot about it till the end when I got to this point. And I was like, holy crap.
Acquired
Visa
Visa builds an automated clearinghouse for themselves to do settlement electronically over the network. They end up calling this project Base 2 after Base 1, which was the first thing doing authorizations. This happens at the exact same time and place as when the Federal Reserve is building their own ACH system for checks, you know, automated clearinghouse, ACH, everything in the banking system.
Acquired
Visa
Totally. So problem number one, you didn't get all the money. Right. Problem number two, also a big problem. It took a really long time. Imagine, you know, we're talking like the 1800s, early 1900s. This stuff was on the Pony Express, you know, pieces of paper going around a really, really big country. Not ideal.
Acquired
Visa
Yeah. That was built by the San Francisco branch of the Federal Reserve in the exact same years in the 70s when Visa was building their own essentially automated clearinghouse system.
Acquired
Visa
Now, I've never read anything. I couldn't find anything. I've never heard anybody say that they like talk to each other, that they knew anything about what was going on, that they were sharing practices. I assume they probably didn't. But it's wild. The same place, the same time.
Acquired
Visa
It really is like the exact same problem that both of these teams are solving and with the same users, the same banks. It's totally wild. Once base two is done, and again, it also happens in less than a year that it's live and up and running, average settlement time for transactions on the Visa network go from taking a week on average to happening in batch overnight every single night.
Acquired
Visa
Every transaction on the network settled every single night. So the speed is super important. This has lots of implications for float amongst the banks, you know, like some good, some bad, between the banks, between the merchants, the issuing banks.
Acquired
Visa
Yes, exactly. Exactly. Also importantly, this is from Dave's book, it ends up saving about $15 million in labor and postage costs. Wow. Yep. It is also during this project that one of the most famous Visa tech team stories in history happens. This is a good one. This is in Dave's book. So one of the guys, I think he was working on base one and then maybe got transferred into base two.
Acquired
Visa
He is thinking about the system and reliability is so important. You know, this network can't go down. He's like, huh, we actually have a pretty serious vulnerability in this system. So he goes to CD. I mean, the whole visa organization, I think, is like less than 50 people at this point in time. Wow. Just wild.
Acquired
Visa
He's like, D, you know, all this technology we're building, you know, we've got authorizations running. We're in the middle of getting settlement running. Like the whole Visa network now depends on this technology.
Acquired
Visa
We're providing the service off of one computer in one data center, which is made out of wood and sits on a hillside that has dry grass right by a freeway below a parking lot that is perched on a cliff. And we're also about a mile from the San Andreas Fault. So we really might want to think about having some sort of redundant parallel site data center out there.
Acquired
Visa
And Dee, in his very Dee way, he thinks about it. He's like, all right, let me think about this over the weekend. He comes back on Monday and he's like, all right, you're right. Thought about it. You now have a new job. Your job is to solve this problem. You're marching orders. You are to go move somewhere on the East Coast. I don't care where.
Acquired
Visa
Find a site where you can build a redundant data center, get it all built and have it done within six months.
Acquired
Visa
Yes. So now, D is not technical enough to talk about that, but this is super important. Up until this point in time, state-of-the-art in the sort of fledgling data center world was, yes, to have redundant other location backups. But the way that it was typically done was you had your primary data center that operated at full capacity all the time. The backups were just like cold storage.
Acquired
Visa
They were like dormant backups that only were there to come online if you had to fail over from the primary system. Visa, though, and the Visa tech team, they're like, you know, if we're going to go through all this trouble and expense of building another data center... Let's use it. Let's use it.
Acquired
Visa
So they re-architected base one and completed architecting base two to run concurrently across multiple data centers as like shared operations running across multiple data centers, which I think... may have been either the first or one of the first examples of that ever happening. Wow. Totally wild, right? I don't know that it was the first, but it was definitely not state of the art before.
Acquired
Visa
This whole data center world was still pretty new. And Visa definitely, like, through ingenuity, invented a way to do this.
Acquired
Visa
And of course, this is now how every data center in the world runs today. Yeah. Pretty amazing. So that was data center innovation, which sort of happens in concert with settlement digitization. The third big leg of the technology stool that Visa builds is finally digitizing the point of the transaction itself.
Acquired
Visa
And that requires both figuring out some way to make the cards digital or capable of being read in a digital manner and digitizing the point of sale terminal in the merchants.
Acquired
Visa
Well, this is when Verifone gets built. There was no Verifone before this. Yep. This is huge. This is the holy grail. The base one authorization system that was still only for transactions above the floor limits at the merchant. So, you know, above 50 bucks or 100 bucks or whatever. It replaced the need for phone calls, but it didn't digitize the transactions themselves.
Acquired
Visa
Not only authorization, but just think about all the things that happen digitally around transactions, the data, you know, everything. This is the beginning of it all. So the first step to doing this, as we mentioned, is digitizing the cards. And that really meant making them machine readable.
Acquired
Visa
So before this, the cards were just pieces of plastic with embossed numbers on them, like you had to say or type the numbers into something.
Acquired
Visa
Yep. So Visa makes the decision. They end up going with the mag stripe technology. This is the magnetic strip on the back of still to this day, almost everybody's cards out there. There's a whole bunch of drama around this. Citibank had financed a proprietary magnetic solution that they were trying to push on the industry. I think there are a bunch of lawsuits.
Acquired
Visa
So Visa's like, hey, we're not going to pay you Citibank a skiff on everything that we do here. We take the skiff. You pay us a skiff on everything.
Acquired
Visa
So they standardize on the mag stripe for the cards. The next step then is they have to create a digital point of sale terminal. Now, this is pretty far outside the scope of what Visa itself could do, like mass produce a small, inexpensive piece of hardware that needs to get distributed to millions of merchants around the globe. That is outside their circle of competence. Yes.
Acquired
Visa
We mentioned earlier, and you alluded to, this is when Verifone takes off. So what Visa does is they create a spec. They're like, this is the spec of what we kind of need to be created. And they invite different technology vendors to bid on it. Verifone ends up becoming... the large dominant. I actually don't know what their market share was or is.
Acquired
Visa
Yeah. And it's pretty crazy. They come up with this sub $500 device that can sit pretty easily on a merchant countertop that already has a bunch of other stuff on it and not a lot of space and get it distributed and installed at all these merchants.
Acquired
Visa
Totally. And spoiler alert, ACH doesn't get developed in the U.S. until the 1970s. Wow. Humans, though, are quite ingenious creatures at solving their problems, particularly when motivated by money. So there is sort of an obvious solution to this for merchants and their sort of usual regular customers. And that is credit accounts, charge accounts.
Acquired
Visa
Now, the merchants didn't exactly want this thing necessarily, but the way Visa incentivized them to get it is they gave merchants who used it a discount on transaction fees, I think for a period of time, for transactions that happen digitally over the digital network.
Acquired
Visa
One really fun piece of implementation detail around this, just like with base one and authorization where Visa had to build out a telecommunications network amongst all the banks. Now Visa needs a telecommunications network amongst all the merchants around the whole world, the country and the world. That's another whole step change. That's like single-digit millions of nodes. Yes.
Acquired
Visa
So what are they going to do? For the pilot program, they work with one of the big telecom vendors and essentially build it out themselves. We're now in the 1980s here. But they realized during this that there's this new fledgling kind of consumer networking service out there called CompuServe. And for folks who either weren't alive in the U.S.
Acquired
Visa
at this time or not Americans, CompuServe was like an AOL competitor in the early days of the Internet. I think they invented the GIF. Oh, I think that might be right. Yeah. So as a consumer, you would pay a monthly fee to CompuServe or AOL or whatever, and it would be your internet service provider, but also like your email and, you know, your portal to the web. It was a proprietary internet.
Acquired
Visa
So they somehow get in touch with CompuServe. And they realized that CompuServe has this dynamic where they've architected out their network for peak capacity demand. which is probably when consumers are home at night. The rest of the day, they've got all this capacity that's unused sitting on their network.
Acquired
Visa
Visa ends up renting CompuServe network capacity to send their digital transactions from merchant point of sale terminals. And I think this goes on for like years.
Acquired
Visa
Yeah, pretty cool. So now, finally, with this third step, All the pieces of the transaction are digitized, computerized, fully implemented as part of the network. This has a huge impact on cutting down fraud. So like tons of fraud was happening below the floor limits.
Acquired
Visa
You know, if you're charging a $5 transaction to a card, it's just not worth it to the banks and Visa to like figure out whether that's fraudulent or not. Now, because it's all digital and instant, they can figure out whether that's fraudulent or not.
Acquired
Visa
So during the pilot, banks and merchants that were participating in this program reduced chargebacks to the system by 82% relative to what was happening before. So it's just like a massive amount of fraud gets eliminated.
Acquired
Visa
Yep. Two other results from now having all parts of the system aggregated digitally. One, this is what enables the modern payments world we know today. You walk up to a terminal, you double-click your Apple Watch, or you insert a card, or you tap your reader, whatever, and it just works and it gets authorized and you get your thing immediately. This is the backbone to all of that being possible.
Acquired
Visa
Rather than giving me money or a check, let me just keep tabs on a ledger of what you bought, what the value is. I'll tab it all up. And then at the end of the month, you'll come give me a check or cash for it. I remember even me growing up in the 1980s, we had this at our local gas station near our house. Really?
Acquired
Visa
Two, though, for Visa as a company and Visa as a business, They are now fully digital. They can scale infinitely with essentially zero marginal cost.
Acquired
Visa
This unlocks just like an unfathomably good business model. Before this, some element of adding scale into the system required manual labor. Now, it's all just ones and zeros.
Acquired
Visa
It's digitized. It no longer has a human sitting there. They've got the FastPass system or whatever. Yeah.
Acquired
Visa
There's one more really fun marketing piece that I want to come back to before we move on to today. And that's the Olympics. A lot of people, probably everybody listening now knows Visa is associated with the Olympics.
Acquired
Visa
But that's only in America. NBC doesn't mean anything around the globe. Visa is the Olympics everywhere. So this happens right around the same time as the digitization of Point of Sale on the cards. It's 1986. The Olympics, for the first time, they are going around to companies and offering a global Olympic sponsorship. This is just like the NFL episode.
Acquired
Visa
Before this, you could sponsor the Olympics in specific countries. You could sponsor whatever broadcast, whatever television radio was covering the Olympics in certain countries. You could have billboards and whatnot. But you couldn't do a global sponsorship. And there's no event like the Olympics that could really do this. I mean, certainly not the Super Bowl, not even the World Cup.
Acquired
Visa
You're missing a large part of America. Like, this is the only thing where you're going to reach everybody in the world. And up until this point, one of the mainstay largest Olympic sponsors in America was American Express. Because this fits perfectly with American Express. It's for American business people who are traveling abroad. Yeah. Olympics. Great. Amazing.
Acquired
Visa
We had a credit account, and it was just like, whenever any of our family would go to this gas station, we would get the gas, and then we'd go inside and be like, oh, we have an account here, and they'd just write down what it was. And then at the end of the month, I assumed my dad would go give them some money.
Acquired
Visa
The Olympics, the IOC, goes to Amex to try and sign them up to take this marquee global sponsorship slot. They think it's a no-brainer. They give Amex a sweetheart introductory offer deal. You're the first people we're going to. $14 million. Amex declines. Whoa. So they had their bite at the apple and they missed it.
Acquired
Visa
A couple of years before this, right as the Visa empire was being completed with the full digitization of the network, Dee ends up getting ousted from the company. I think, you know, if he were still alive today, he would probably agree with the characterization that Dee was one of the most amazing zero to one entrepreneurs in history.
Acquired
Visa
Not so much a one to end kind of guy, especially when the industry in which you are going from one to end and your shareholders and board is all some of the most conservative financial institutions in the world. A lot of conflict starts to erupt, ends up with D leaving the company in 1984.
Acquired
Visa
After this happens, Visa brings on a new global chief marketing officer, a guy named John Bennett, who came from 20 years at American Express. So he and his team see that Amex has passed on this new amazing global opportunity with the Olympics. They're also formulating the new Visa marketing strategy.
Acquired
Visa
Up until that point, the marketing strategy had been mostly generate category awareness for consumers around the world. To the extent we competed with anybody, we competed with MasterCard, so we positioned against them. John comes in and he's like, no, no, no, no. The path to victory here is not positioning against MasterCard. The path to victory is positioning against American Express.
Acquired
Visa
Not because we want to kill American Express. We don't actually care. We're way, way, way bigger than American Express. But we need global ubiquity and adoption and people to get comfortable with using Visa and using credit cards. Remember, there's still this social stigma. That woman in 1993 in Burger King who's like, oh, it's sad if you're using debt to buy a hamburger.
Acquired
Visa
Right. And if this were certainly 1986 and still 1993, you would not feel that way. You might feel that way about your American Express card, but you wouldn't feel that way about your Visa card.
Acquired
Visa
It's the American way. So Jonna just started. The strategy is use American Express to eliminate the stigma around visa and by association, paint MasterCard as having that stigma because we're not even bothering to talk about them. So how do we go after American Express? Well, the network is much smaller. The American Express Merchant Network at the time was about 25% the size of Visa's.
Acquired
Visa
So they design a whole marketing campaign around going after American Express and the tagline of the campaign, you know, they show these exotic locales that the type of customers who would be using American Express, that they would be dining at these restaurants or going to these events or going on these vacations.
Acquired
Visa
And the end, folks who are of our similar age probably remember exactly the words here. If you go there, remember to take your Visa card because they don't take American Express. So great. And then the second tagline to it was Visa. It's everywhere you want to be. So the Olympics come up. After Amex declines, John and the team get in touch with the IOC.
Acquired
Visa
So from charge accounts at individual gas stations or individual branches of a grocery store chain or something like that, it's not a leap to think the next stage of evolution would be, oh, a card or account that would work at all the branches of a given brand. So like the gas stations get into this in a big way. Standard Oil gets into this in a big way.
Acquired
Visa
The price tag has gone up to $17 million just for the rights. That's before any media buys. No advertising. That's just for the right to be a global sponsor of the Olympics. They pull the trigger. They become the founding global Olympic sponsor. They spend another $23 million in media for the 1988 Olympics. So $40 million in total on one global event.
Acquired
Visa
Well, two, there's the summer and the winter Olympics, but like one year of global events.
Acquired
Visa
way more than they spent on any of the technology projects that we were just talking about.
Acquired
Visa
Yeah. What's the line, first-time founders focus on technology, second-time founders focus on distribution? Yep. And then the real kicker, they, of course, become the exclusive payment provider at the Olympics. So everybody now coming to the Olympics, which is like a lot of people, from around the world that are going to the Olympics, the only payment card provider accepted there is Visa.
Acquired
Visa
So they're training all these people that are going to the Olympics year after year after year. It has now been 37 years that Visa is the exclusive payments global sponsor of the Olympics. They're contracted through 2032. So it will be at least 46 years where Visa is the only card accepted at the Olympics.
Acquired
Visa
But the reason we're talking about this, A, it's an awesome story. But to the last outstanding piece of enabling the global visa empire, this last thing is the stigma. How do they get rid of the stigma of I can use my credit card and not feel like it's a taboo? This was it. Position against Amex, go to the Olympics. It's the perfect event. You're around the world.
Acquired
Visa
The type of people who go to the Olympics, the type of people who use Amex, they use their Visa cards and they're proud of it.
Acquired
Visa
Yep. Just about a half a trillion dollar market cap. So the precipitating event wasn't actually the banks trying to get greedy and monetize their asset. Although they did monetize the asset.
Acquired
Visa
Yes. The profits being spit out of the system were just fine. In 2005, there finally was... another huge antitrust lawsuit, I think against both Visa and MasterCard.
Acquired
Visa
There are lots of standard stations across the country. You can have an account that works at all standard stations.
Acquired
Visa
Oh, that's awesome. I didn't realize that in the research. It finally happens in 2008. Visa goes public right as the financial crisis is starting, which obviously wasn't planned, but ends up being great for the banks and probably for Visa too. It becomes the largest US IPO in history. Up to that point, they raised $18 billion at a $90 billion initial market cap.
Acquired
Visa
But that $18 billion wasn't primary capital to the company's balance sheet because obviously Visa was incredibly profitable, did not need capital. It prints money. Why would you want to raise capital and dilute?
Acquired
Visa
That $18 billion was secondary selling to the banks that owned the company, which I think for many of them proved to be a total lifeline through the financial crisis that helped them survive.
Acquired
Visa
Well, at this point, Visa's market cap is significantly larger than any of its former member banks.
Acquired
Visa
Yep. So there was that phase. Then pretty quickly in a given local area, some of the retailers would get together and be like, you know, we compete with each other, but it sucks running these charge account programs on our own. We could collaborate and have a standardized charge account system that we could share.
Acquired
Visa
Which brings up, you know, an obvious point that we perhaps didn't highlight as specifically as we should have earlier. This network is actually a five-sided system. There's the consumer that is buying something. There's the merchant that is selling that something to them. There's the Visa network in the middle. That's the third party.
Acquired
Visa
But then there also are the fourth and the fifth parties, which are the banks for each of the consumer, the issuing bank, and the merchant, the merchant bank. So this sort of envelope of value concept makes sense because those three parties in the middle, Visa and the two banks, They need to split up the value, and depending on who is doing what work, it should be split different ways.
Acquired
Visa
Yep. And for consumers, that's also pretty awesome because do you really want to carry around 57 different charge cards in your wallet? Or would you rather have one that would be like, you know, your visa to everywhere you want to be? Yes.
Acquired
Visa
And for merchants of scale today, they're cut in on this too, right? There's the Alaska Airlines mileage card. There's the Costco card. Like, merchants... are able to, by working with banks, be part of this discussion too, if you're of a certain size.
Acquired
Visa
And I guess at the absolute very highest levels of scale, you have something like the Amazon and JPMorgan Chase relationship where JPMorgan Chase is the merchant bank and JPMorgan Chase is one of the largest issuing banks for cards in the world. And so the Amazon Chase credit card that I have and I do all my shopping on Amazon with and all my shopping at Whole Foods with
Acquired
Visa
is able to give me 5% cashback rewards. So Amazon or JP Morgan, and in this case, the two of them working together represent three of the five parties in this transaction. The only people not party to this are the consumer and Visa, the network itself. And so thus, that's how they're able to do so much special stuff. They can control so much of that envelope of value. Yes.
Acquired
Visa
And famously, Walmart and Target, too, I think, have been trying to do this for years and years and years, and they never can make it work.
Acquired
Visa
And the merchant, in most cases, is really the only party that is not thrilled with this arrangement.
Acquired
Visa
Yeah. I mean, I guess you could take that one step further and say consumers actually do bear the brunt of it because merchants will just raise their prices to compensate for it.
Acquired
Visa
Yeah. Which, I mean, especially us running a business, like, yeah, we put a lot of stuff on cards.
Acquired
Visa
Yep. So this comes to be kind of post-depression in the 1930s, 1940s in the U.S. And this really is starting to sound a lot like Visa, except, as you point out, Ben, there is a problem here. As the size of any given network of retailers that are collaborating on this grows, so does the intensity of competition within that network.
Acquired
Visa
And they were in a unique position at that moment in time in California, where they had such large market share of both consumers and merchants that they could kind of effectively create this network themselves.
Acquired
Visa
Right. If you're going to accept a check from somebody, there's a strong element of trust that you have to have with that individual or entity.
Acquired
Visa
One fun way to think about that that I calculated is if you start from 1971, the first full year that the Bank of America card network was liberated from Bank of America, the growth in payment volume on the network since then has been 17.3% compounded annually for 51 years. Oh my God. Wild.
Acquired
Microsoft Volume II
Yes. Yes. Because I'm just loving, I'm smiling the whole time. I'm imagining, you know, all of you listening being like, $47 billion for Yahoo.
Acquired
Microsoft Volume II
Yes. Yeah. Netscape as a company does not exist yet. There's just the Mosaic web browser at the University of Illinois. Yep.
Acquired
Microsoft Volume II
This is the thing people just always continually underestimate and underappreciate about the search market is it's just so large and so profitable.
Acquired
Microsoft Volume II
Then, and this sort of exponential growth theme, the very next month in February 1994, Bill's technical assistant slash shadow, which is a legendary role at Microsoft, now exists at Amazon too, a man named Steven Sanofsky goes on a recruiting trip to his alma mater at Cornell University. And while he's there, there's a big snowstorm. He gets stuck on campus.
Acquired
Microsoft Volume II
Well, you know, then they do go on and launch Bing, and they actually sign a commercial deal with Yahoo to provide the search on the back. So they're not getting the Yahoo traffic. Yahoo's still monetizing the traffic, but Bing is getting all the data from doing, performing the searches for Yahoo. And I know you know this, but most listeners will not remember.
Acquired
Microsoft Volume II
You know who the leader of Bing was for a brief period in its early days here? Satya Nadella. Satya Nadella, that's right. Other piece of Satya trivia that I very much suspect you do not know, Satya joined Microsoft first in 1992 from Sun Microsystems, and he joined as an evangelist for Windows NT. He joined as an evangelist? An evangelist. Huh. And then he got his first product job.
Acquired
Microsoft Volume II
Do you know what product, it would never ship, but a product in development, that job was? Ooh, no, I don't. Tiger Server, the CableSoft information superhighway fever dream.
Acquired
Microsoft Volume II
Which they had acquired. And then he, I think, ran BizTalk Server, which was another one of these enterprise server products. And then Bing.
Acquired
Microsoft Volume II
So funny. The other big piece of it, honestly, maybe even the biggest piece of it from talking to folks was Hotmail.
Acquired
Microsoft Volume II
Microsoft had acquired Hotmail back in 1997 and ran it the whole time. It eventually became Outlook.com, I think. But, you know, it's running a consumer web service for decades at scale.
Acquired
Microsoft Volume II
But, oh my God, it's so unfortunate that they didn't buy Yahoo just because of the Alibaba stake. Nothing else would have mattered. 40% of Alibaba at IPO in 2014 when Alibaba IPO, that stake was worth $92 billion. Obviously, Microsoft is not a hedge fund, but like... Right.
Acquired
Microsoft Volume II
Yeah, the most Cornell thing ever. The most Ithaca story ever. He notices that all these kids, especially when the campus has snowed in, they're all using the internet. And he knows what the internet is. You know, it was an academic project for years. You know, he was an academic guy before getting into commercial software and joining Microsoft.
Acquired
Microsoft Volume II
It's so funny. Yeah. One of the greatest venture investments of all time.
Acquired
Microsoft Volume II
It's funny, I never thought about it this way, but really what search did and what Google does is you go from selling software as a technology company to selling everything.
Acquired
Microsoft Volume II
Yeah, such a good point. Well, while we're talking about using software to sell everything and not software, that sure makes me think a lot about social and Facebook. Microsoft has some history there during this period too, doesn't it?
Acquired
Microsoft Volume II
They sent in an offer. We'll have to ask Mark about it in Chase Center.
Acquired
Microsoft Volume II
And this is what absolutely floors Stephen. He's like, I remember the Internet as what you're saying, Ben. And now I'm here on campus and all these kids are using it for flirting, registering for classes, messaging each other, sending email that has nothing to do with papers or work or school or academics or anything.
Acquired
Microsoft Volume II
As I said earlier, they're not a hedge fund and money is the least important thing to them.
Acquired
Microsoft Volume II
And a lot of Microsoft people went to Facebook, like friend of the show Vijay Raji, CEO at Statsig now. A lot of great early Facebook folks came from Microsoft.
Acquired
Microsoft Volume II
Which, of course, is right at the time. The iPhone, of course, came out in 2007, but 2008 was when... I think it was iOS 2.0, right? With the... SDK. App Store opening up and the SDK comes out and the world completely transforms. There's a pretty rough quote in Time Magazine from Bill's retirement that was obviously written about Bill here, but I think it's just kind of more applicable to...
Acquired
Microsoft Volume II
all of Microsoft DNA at this point in time, Gates is probably getting out of technology at the right time. Funnily enough, it's not really a business for nerds anymore. Gates was at the center of the personal computer revolution and the internet revolution. But now the big innovations are about exactly the things he's bad at. The iPod was an aesthetic revolution. MySpace was a social revolution.
Acquired
Microsoft Volume II
YouTube was an entertainment revolution. This is not what Gates does. Technology doesn't need him anymore. That's a stupid quote.
Acquired
Microsoft Volume II
Yeah. It is totally too redactious and it's too personally about Bill and that's just completely not right.
Acquired
Microsoft Volume II
He gets so excited that he writes another memo to Bill and the leadership team entitled, Cornell is Wired! Exclamation point.
Acquired
Microsoft Volume II
Right. I said to put a pin in the iPhone and the downside of Microsoft becoming the enterprise juggernaut when we were telling that story. Yeah. And all of the huge advantages in lock-in that Microsoft had built up, the iPhone changed that calculus because the iPhone kicked off shadow IT and bring your own device, and it kicked off the user revolt against IT.
Acquired
Microsoft Volume II
Yeah. Choice and expectations of what that software and hardware is going to be like. And Microsoft, for all of its great victory in the enterprise over this period, just fundamentally did not have any of that DNA in the company anymore. Right. And that's what this quote from Time is pointing out.
Acquired
Microsoft Volume II
Exactly. So let's talk about those things and what's happening in mobile.
Acquired
Microsoft Volume II
Well, it's so funny because some of these memos definitely were like internal memos for exactly what you said. And some of them were like written for publication to the press. Yep. And Bill has a great quote. When I heard Stephen talk about what was happening at Cornell, I began to take the Internet quite seriously.
Acquired
Microsoft Volume II
Yeah, I had a tablet. I had a Microsoft XP tablet edition, I think is what it was called, PC in college.
Acquired
Microsoft Volume II
Yeah. And at some point in this journey here, post-iPhone, but still in this sort of weird Windows mobile era... Microsoft buys Danger, the company that made the T-Mobile sidekick. You remember that?
Acquired
Microsoft Volume II
So Stephen and Bill organize an Internet offsite, quote unquote, with all the top execs, with Jay, Bill, Stephen, everybody who's investigating this Internet thing. And it takes place on April 5th, 1994, which is the very next day after Netscape was incorporated on April 4th. Amazing.
Acquired
Microsoft Volume II
And that was Andy Rubin before he started Android. Oh, you got me. I was hoping I could stump you. I was going to say, do you know who? Of course. Co-founder of Danger was. It was Andy Rubin. What do you think I do for a living? What do you think I do for a living? Amazing. Andy had already left Danger and started Android.
Acquired
Microsoft Volume II
Yes. He says, you know, it's never going to work at $500, which is the full quote. You could totally see that.
Acquired
Microsoft Volume II
Yeah. What it wasn't, the original iPhone didn't have it. It was then later...
Acquired
Microsoft Volume II
And at this offsite, Bill totally gets religion that the internet, as Jay said in his initial memo, is actually an exponential phenomenon. And as Bill puts it to the team gathered there and then the whole company later, It is a core Microsoft company value that exponential phenomena cannot be ignored.
Acquired
Microsoft Volume II
And Google also only really cares about their services that they monetize through advertising. So one of the deal points in there, I think this may be varied by geography, but is, oh, yeah, you got to use Google services on there, too. But by the way, they're best in class and they're free. You don't have to pay anything for that either.
Acquired
Microsoft Volume II
This is such a good point. Microsoft's competitor was not Apple and the iPhone. It was Android.
Acquired
Microsoft Volume II
Yeah. And it's funny, you know, Microsoft did have Bing at this point in time. So they did have a business model that they could have used if they'd been willing to go free on Windows Phone.
Acquired
Microsoft Volume II
Yeah. They sell software. Might be via enterprise agreements, but they sell software.
Acquired
Microsoft Volume II
Yeah. Interesting. And that is totally true. I totally buy it in the consumer world. And in the enterprise world, Microsoft lock-in is still as strong as it ever has been.
Acquired
Microsoft Volume II
So speaking of Netscape being incorporated the day before, remember I said to put a pin in the name Jim Clark. Of course, many listeners already know where we're going here. Jim Clark, legendary founder of SGI, Silicon Valley legend. Well, a couple months before that, in February 94, it's crazy how fast all this happened. It's just insane. Jim is still at SGI.
Acquired
Microsoft Volume II
Excel is still the main way that spreadsheets are done around the world. I bet a lot of listeners use Google Sheets. We do too. We love it. Also use Excel. But if you do use Google Sheets, you are in the minority.
Acquired
Microsoft Volume II
That brings us to Nokia. But I think let's save Nokia for the end here.
Acquired
Microsoft Volume II
Yep. Let's talk about it. Let's start with Surface and Windows 8, which we got to talk briefly about Windows 7 before that. Because Windows 7 was awesome. So Steven Sanofsky, he ends up running Office Product Management. Yeah. After the Vista disaster, he gets drafted to come over and run Windows. And Ben, like you're saying, the office culture was known as we ship, we ship product.
Acquired
Microsoft Volume II
So he comes in for Windows 7 and he does that for Windows. We were talking to him and he had this great analogy of Windows at this point in time didn't need technical vision. It was trying to be the Dodge Viper. That's what Longhorn was. It needed to be the Toyota Camry. And he comes in and he makes Windows 7 the Toyota Camry of PC operating systems. I love that analogy. That's exactly right.
Acquired
Microsoft Volume II
It's so good. It's exactly what it was. And it's exactly what everyone wanted. It's what the consumers who were still using Windows wanted. They wanted it to just work. And most importantly, it's what the enterprises wanted.
Acquired
Microsoft Volume II
He's really frustrated with the board and the company, though, for not pushing even harder on this information superhighway opportunity. So what does he do? He resigns from the company, kind of like in protest. The company he founded.
Acquired
Microsoft Volume II
I have no idea, but I remember I had a Windows 7 laptop when I first joined Madrona, and it was great.
Acquired
Microsoft Volume II
So it's a little bit dangerous to say... But the iPhone has now come out and multi-touch has shown this is the way to do it.
Acquired
Microsoft Volume II
It validates the product vision and it terrifies Bomber and Microsoft leadership because they just watched what happened, what Apple did to the phone market. The iPad sure as hell looks like it's going to try and come do that, too. Microsoft's core PC market. I mean, the original Jobs keynote introducing the iPad lays out his vision, right?
Acquired
Microsoft Volume II
And on his very last day in February 94 at SGI, he cold emails the kid in Illinois, Mark Andreessen.
Acquired
Microsoft Volume II
Of like the PC is going to become the pickup truck and the iPad is going to become the car. And that would be a truly terrible thing for Microsoft, especially if that goes into the enterprise as the iPhone is clearly going into the enterprise on the phone side.
Acquired
Microsoft Volume II
Yes. But back in 2010, that sure looked pretty terrifying as a prospect to Microsoft.
Acquired
Microsoft Volume II
Yeah. So Jim in this email writes, you know, I'm impressed with Mosaic and like clearly this seems to be getting adoption. You know, if there's any way that you and I, Mark, might be able to collaborate, that would be, quote, of interest to me. Yeah. So the two of them get together, and then they found this company on April 4th, 1994, called Electric Media.
Acquired
Microsoft Volume II
And the way the touch-first manifests in the operating system itself is the desktop is now just an app. And when you boot up Windows 8, you are presented with a tablet-tiled start screen. And if you're looking for a desktop, you got to go find it.
Acquired
Microsoft Volume II
There's also just the shock value, though, of I bought a Toyota Camry expecting it to be a Toyota Camry and... I don't even know what this is. It's like a scooter.
Acquired
Microsoft Volume II
I see. Yeah, there can only be one Windows. And so we got to put both of these babies in here.
Acquired
Microsoft Volume II
And the initial goal of Electric Media, soon to be Netscape, is that, oh, Mark is this hotshot programmer. Clearly, the information superhighway is what this web is going to turn into. We're going to do what SGI was supposed to do. We're going to make set-top boxes for the information superhighway.
Acquired
Microsoft Volume II
They can't run x86. They got to run ARM processors. They got to run mobile processors. But you're asking these devices in 2012 to also be able to function as laptops, and the technology just wasn't there. There's a reason why the iPad was a scaled-up version of the iPhone, not a scaled-down version of the Mac.
Acquired
Microsoft Volume II
Today, I think it might be a very different proposition, and the public might be much more ready to accept something like this I wish Apple would do this with the iPad. Oh, yeah. I don't want to have a MacBook and an iPad. I just want an awesome pane of glass that can do everything. And Apple Silicon totally can do everything.
Acquired
Microsoft Volume II
None of which is in the Microsoft ecosystem. Okay. Yeah. I mean, this is the death of Microsoft as a consumer company.
Acquired
Microsoft Volume II
Yeah. Lost mobile. Windows 8, you know, this whole thing didn't work. The stock price has languished. Hasn't moved in 10 years. Stock stuck at 30 bucks.
Acquired
Microsoft Volume II
It's dark and yet the light is shining so bright on the financial statements of this company. And what is going on here? Obviously, it's the enterprise, but it's even more than that. It's Azure. It's the cloud. It's already humming. It's going. Microsoft did reinvent itself. Microsoft did position itself to be at the forefront of technology.
Acquired
Microsoft Volume II
It just did it all within the enterprise context of the company. And the Azure story is absolutely incredible. And I think nobody knows how it really happened.
Acquired
Microsoft Volume II
So when Bill was planning to fully retire from the company, to retire from his chief software architect role, this is all the way back in 2004, 2005, right? He and Steve know that there needs to be a successor in this role. Even Steve will be the first person to tell you he is not a technologist. He can't do both roles. He needs a bill. He needs a chief software architect.
Acquired
Microsoft Volume II
Yeah. So they're casting about. Craig Mundy becomes one of those two bills internally. And they also know who probably the perfect person is to take the other job. And that is Ray Ozzie. Ray, of course, being the author of Lotus Notes. Ray is a legendary developer. And he has great relationships within Microsoft because Ray built Lotus Notes not at Lotus, but at his own software studio startup.
Acquired
Microsoft Volume II
And Lotus was just his publisher. So he's known all the Microsoft guys for years.
Acquired
Microsoft Volume II
So Ray writes the Internet Services Disruption Memo in October 2005. And to quote from it, this is Ray writing, "...the environment has changed yet again, this time around services. Computing and communications technologies have dramatically and progressively improved to enable the viability of a services-based model."
Acquired
Microsoft Volume II
The ubiquity of broadband and wireless networking has changed how people interact, and they're increasingly drawn toward the simplicity of services and service enabled software that just works. Businesses are increasingly considering what services based economics of scale might do to help them reduce infrastructure costs or deploy solutions as needed and on a subscription basis.
Acquired
Microsoft Volume II
I'm telling you that, and I'm telling you they might not even just want to buy the infrastructure. They might just want to buy the solution as a service hosted by us.
Acquired
Microsoft Volume II
And so in January 2006, Ray, with Steve Ballmer's full blessing, goes and starts recruiting for a secret project within Microsoft incubated outside any of the existing divisions. And this is super important. This should have come within server and tools. Like that whole big new business that we talked about that was like the key linchpin of Microsoft's Steve Ballmer era enterprise strategy.
Acquired
Microsoft Volume II
This is amazing. So the way they're going to do this as a startup, this is so great. One of the other big things that SGI had done besides building the graphics workstations that Hollywood ran on and did Jurassic Park and all that was they were Nintendo's technology partner for the N64. Yeah. They made the graphics engine for the N64. And so Jim has this relationship with Nintendo.
Acquired
Microsoft Volume II
Yes. The reason for that is that this is completely disruptive to the whole Windows Server and Server and Tools business model. Their go-to-market and their business model is we sell these solutions to be operated in your data centers, in your infrastructure, where Accenture and all the consulting firms and all the value-added resellers, they're all our partners. They're all our go-to-market.
Acquired
Microsoft Volume II
They're all going to go implement that on-prem for you. And so if we were now to say like, wait a minute, all of a sudden we're going to do that as a service and we're going to sell it to you separately. That is a huge issue risking a lot of my go-to-market motion.
Acquired
Microsoft Volume II
So, Ray is recruiting for this project, codenamed Red Dog, and he brings in the biggest of big guns. That's right, the legend himself, Dave Cutler.
Acquired
Microsoft Volume II
We talked about him a lot on part one. Also, another guy named Amitav Srivastava. Amitav had also come from DEC, which is where Dave came from. Total beast of an engineer. He had experience both in the enterprise server and tools products. And Amitav was also a big part of getting Vista out the door with Brian Valentine before Brian left for Amazon.
Acquired
Microsoft Volume II
And the two of them recruit a team and they build Azure. Cutler builds a new hypervisor. that Azure runs on from scratch without using open source, like himself. Hypervisor, of course, is the piece of software that virtualizes underlying hardware and allows multiple software tenants to run on a single piece of hardware. It's like VMware was a hypervisor company.
Acquired
Microsoft Volume II
It was a whole company building hypervisors. And Dave just was like, yeah, I got this. It's crazy. So great. And Steve Ballmer supported this whole thing, pushed it all through, despite heavy pressure and incentives from inside the company, from Windows, from partners, from the whole go-to-market motion that he built, Microsoft's enterprise go-to-market motion.
Acquired
Microsoft Volume II
Steve, he didn't get it right away, but he started talking to enough customers and realizing that this was the future of enterprise computing that he just flipped a switch and said, I'm all in, we're doing this, whatever resources we need. I mean, we're talking billions and billions of dollars of capital expenditure to build up these data centers.
Acquired
Microsoft Volume II
This is not just a like, oh, some little incubation project, you know, sure, we'll see what happens. This is like, no, we kind of got to like bet the company on this.
Acquired
Microsoft Volume II
The N64 is going to be coming out. It's going to be this amazing box in the living room attached to TVs in consumers' homes. They're going to team up with Nintendo and turn the N64 into an information superhighway box.
Acquired
Microsoft Volume II
We're doing a live Acquired show at the Chase Center, which is the brand new basketball arena here in San Francisco where the Warriors play. We're putting it on with our good friends at J.P. Morgan Payments. And as you can imagine, they know a few people at the Chase Center.
Acquired
Microsoft Volume II
And why I would say this is bet the company, you're right. They didn't go full infrastructure as a service and embrace open source and let people use Azure to run Linux in the LAMP stack on top of it. That was not day one, but they knew they had to and they were going to.
Acquired
Microsoft Volume II
And it was just a, hey, we're not going to do this right away because the company would organ reject this so hard, but we are moving in that direction. And we will be AWS. We will offer everything they offer and more to our enterprises who trust Microsoft.
Acquired
Microsoft Volume II
Now, interestingly, Office and applications and software as a service actually came pretty quickly thereafter, too. Famously, they did a pilot program with Energizer, like the battery company, selling to sort of, I don't think it was like the office productivity suite, but it was like SharePoint and stuff, I think, as a service, as software as a service. Right.
Acquired
Microsoft Volume II
So in 2010, Ray Ozzie actually leaves the company. But as he's doing, he and Steve roll Red Dog, by this point in time renamed Azure, back into the server and tools business. And the two of them go to the University of Washington, and Steve gives a speech at the University of Washington. We are all in, and we are betting the company on cloud and on Azure.
Acquired
Microsoft Volume II
The intended audience, of course, was Microsoft internally of like, hey, we are sending a message to the server and tools team. This is the future. And after that, Steve replaces the division head of the whole server and tools division, who was Bob Muglia at the time. Bob would later go on to be the CEO of Snowflake before Frank Slootman came in. So he did fine. Bob was great.
Acquired
Microsoft Volume II
Bob was crushing it as head of server and tools. Revenue was growing, I don't know, 30, 40% a year. It's a $12 billion business. But... The reason that Steve made the change was he said, we need a new leader who's going to come in and change this organization and make it a cloud-first organization.
Acquired
Microsoft Volume II
And the person that Steve taps to do that from Bing is none other than Satya Nadella.
Acquired
Microsoft Volume II
Totally. It was, let's get this guy the right exposure to the right important things that he could be CEO of this company someday in the not very distant future.
Acquired
Microsoft Volume II
To say that this goes well is an understatement, obviously. But just to put some numbers on this, Microsoft has three reporting segments. Productivity and business process, aka Office, and that includes Office 365 as part of that segment. The more personal computing segment, that's Windows and Surface and their hardware efforts. And then the intelligent cloud segment, and that's Azure.
Acquired
Microsoft Volume II
And I think LinkedIn is part of the Office segment. if I have that right. I think that's right. I don't think LinkedIn is in the cloud segment. Intelligent cloud today is by far the largest segment in the company by both revenue and profit and by very, very far the fastest growing within the company. Windows is declining.
Acquired
Microsoft Volume II
Largest business, most profitable, fastest growing. In fiscal 2023, Intelligent Cloud did $88 billion in revenue.
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Microsoft Volume II
Yes, I think that is both a, especially in the early days when Microsoft and Satya was hyping up how much cloud revenue the company was doing, being able to report the legacy server business as part of that revenue helped a lot. On the other hand, the counterargument to that is this is actually Microsoft's competitive advantage versus AWS.
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Microsoft can go to enterprises and say, we are hybrid cloud, less so today, but in the earlier days of the Azure transition, saying like, hey, you need to be on cloud. We have a world-class public cloud for you, and it works great with our on-prem server offerings, and we can be hybrid for you. Yep, totally agree. We'll talk about this a little more in conclusion.
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It's such a classic case of way, way, way too many cooks in the kitchen and just total slideware.
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We have one more chapter in Nokia in the end of Steve's tenure to talk about here, but it turned out actually that the cloud market was so big that that nothing else really mattered. All the missteps, all the losses, it makes sense, right? Cloud powers everything. Cloud powers tech. Cloud powers all the consumer services. They all run on the cloud.
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So every consumer service that is not owned by Microsoft or Meta or Google or Amazon runs on one of their clouds.
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And again, this is outside the scope of this episode, but it's sure looking like to the extent AI is the next computing wave, that is also happening in the cloud in the data center. So like that's just going to turbocharge everything.
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I mean, really kind of like we got, I don't know, halfway-ish through our research for this, and this just hit me of, holy crap, this era for Microsoft that everybody thinks of is like the loser era. This is the era where they won, you know? Or they built the foundation to win.
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And Steve is the one who handpicked Satya to lead it and get all the credit and the narrative and the win and then become the CEO.
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There's a chance they're not even paying for my enterprise software services like Exchange or like, you know, Windows Server or whatever. Like you're saying, Ben, they might be running Linux on there or my competitors' products.
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Totally. And without taking anything away from Satya, because I think he does absolutely deserve a ton of credit for knocking it out of the park on execution, I kind of think all of the credit for the vision for it and the championing it for the initial seven years within Microsoft goes to Steve and to Ray.
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Totally. So shortly after this, by late spring 1984, Mosaic now has a million active users. Clearly Bill Gates is paying attention here. So shortly after all this, Jim Clark and Marc Andreessen say, wait a minute, let's just go do this Mosaic thing. They scrap the N64 information superhighway. They go raise money from Kleiner Perkins.
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It was an easy win for Satya during his first year to say, culture has changed here. We are shipping Office on iPad.
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Yes, that was the message. And that was a great supporting point to example of the message.
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Well, speaking of transitions and transitioning, I think it is time to wrap up our history of this period of Microsoft and mobile and everything and Steve's tenure and talk about Nokia as we end things here.
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After Microsoft had released this Windows phone, which, like we said, was really kind of doomed to fail against Android, like you just couldn't compete with free. I think Bill Gurley had a blog post about Android back in the day about the less than free business model and why you can't compete with it.
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Totally. So there was one phone OEM that was willing to play ball with Microsoft and Windows Phone, and that was Nokia.
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The then-CEO of Nokia was a guy named Steven Elop. Folks will almost surely remember that name. He was a former Microsoft guy, and he had come over to run Nokia, so there were deep relationships there. In February 2011, Nokia agrees to adopt the Windows Phone operating system as its primary smartphone OS for its devices.
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Like you said, Ben, it didn't have a lot of options and it wasn't willing yet to go Android. Pretty quickly, though, as we get into 2012, 2013, it's clear Windows Phone ain't really working and Android is the future. So as we get into 2013, Nokia comes to Microsoft and says... We got to talk. We're going to go Android unless you make it worth our while or something happens here and changes.
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John Doerr invests, joins the board, most legendary investor of the time. And by October 1994, the newly christened Mosaic Communications Corporation posts the first version of its browser, Mosaic Navigator, for free to download on the web. And their business plan is that they're going to give away the consumer browser for free, and they're going to charge companies for server software.
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It's even less consequential than that. It's not even a percentage of market capital. Microsoft's operating income in 2013 was $27 billion. So it's $7 billion out of $27 billion in just cash that they don't know what to do with and that they aren't getting credit for.
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I mean, sure, but Microsoft stock is in the dumps here. The cash flow geyser is not appreciating the stock price here. Wall Street does not appreciate what's going on.
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And I think it was probably in Steve's mind here of like, I'm not getting any credit for all this cash I'm generating. Like, F it.
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There's actual downside here, right. So that's how the deal comes together. It was super controversial within the company and on the board. Obviously, at one point, Satya talks about in the book, there's a straw poll taken of all the division heads, all the top leaders in the company, whether they're for or against the acquisition. The majority are against the acquisition.
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Satya is against the acquisition. The board basically says to Steve, like, clearly there's not support for this.
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Okay. After that happens... A series of discussions start and culminate. We're in kind of late summer, early fall 2013 when all this goes down. And on August 23rd, 2013, Microsoft and Steve Ballmer announced that he is retiring within the next 12 months and that the board and the company have started the search for a successor as CEO. That was August 23rd, 2013. Yep.
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We don't really know. In any event, here's what happens next. February 4th, 2014, Satya Nadella is introduced as the next CEO of Microsoft. Steve Ballmer steps down. On that same day, Bill also steps down as chairman of the board, and John Thompson becomes chairman of the board. So it's a... wholesale changing of the guard within Microsoft. Bill, Steve, the original folks were retiring.
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We're done. It is a new day. And that needed to happen. The Office for iPad discussion we had a minute ago You know, I think it was emblematic. Like, there is truth to what Satya wrote in his book that we said at the very beginning of the episode of, hey, this company culture needed a reset.
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You know, it's kind of like a bigger version of Brad Smith's presentation to the board of it's time to make peace. Like, it's time to make peace internally. And there just needed to be a reset.
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So if you want to host a website, you know, you're a corporation or whomever, you need server software to do that. They're going to charge companies for the server software.
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And at the same time, everybody knew, hey, there is a huge win that we are sitting on right here. Like a huge, huge, huge win in Azure. And it is going to be really good for everybody's personal net worth, if nothing else. If we can just let that be appreciated and let a new day dawn here. So on February 4th, 2014, on that day, Microsoft stock price was $30.50.
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And as we said a minute ago, the market cap was, I don't know, call it $300 billion, slightly below. Today, 10 years later.
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Well, you know, just to foreshadow, show that this was the right decision. 10 years later, stock is at $465. Market cap is $3.5 trillion. Probably like, I don't know, I haven't done a sum of the parts analysis, but I think you can say probably at least half is Azure propping up that market cap.
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The once and future king, Microsoft. That's our story for part two. We still have a lot to talk about in analysis.
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So Steve comes in at an all-time high multiple, and right before the DOJ verdict and the breakup of the company.
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Not to mention, as we talked about during that period, all the frankly shit going on at the company.
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You know, it's funny. When you asked this question a minute ago, I hadn't prepared for it ahead of time because, as listeners know, we don't share notes. The first thing that popped into my mind about why Wall Street did not appreciate the revenue and profit growth during this time... was just simply like Microsoft did not do a good job telling its story. Horrible.
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Yes, exactly, Ben. So meanwhile, back at the University of Illinois, even though they're an academic and government institution here... they realize that they've got something valuable in the original mosaic.
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And I think you're saying the same version here. Like, it's so funny. I mean, it's part of why I love doing Acquired, part of why I think the show resonates with people. Telling stories is the most important thing.
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If you cannot tell your story right and in a compelling fashion, this is what's going to happen to your stock price, even if you triple revenues and profits and build Azure and all these things.
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And it's for another episode, but it really was brilliant what Satya did and the company did when he came in of they got the story right.
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That was it. That was the key. Just saying those words over and over and over again.
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So they license their mosaic, the original one, to a local company called Spyglass.
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Yep. And that is, I think, particularly resonant, to me at least, in my history, because they used to. They totally used to. They used to be the consumer technology leader. Windows 95, Windows XP, everything we talked about at the beginning of the episode, Internet Explorer, the browser wars, they were the leaders.
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Right. Well, they were their good products, just the enterprise products. They weren't the good consumer products.
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And I think on part one, we said Microsoft in that era had all of these, right?
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Well, in this era, they definitely don't have counter-positioning. That's for sure.
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Yep. Actually, I would say they had some of it in the development of Azure because they could say to Fortune 500s, we will do hybrid cloud with you and we can be your trusted partner in a way that AWS couldn't.
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Yep. I think process power, I would argue, they actually lost during this era. I mean, the Blackcomb Longhorn Vista thing illustrates that.
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Yeah. I think they also definitely lost branding power in the consumer world.
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It's funny, to the extent that the DOJ and governments were concerned about Microsoft being a monopoly when it came to product tying on the consumer side, they really should have been concerned about product tying on the enterprise side where you pay us a dollar amount per device on your network and you get all of our software.
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For sure, there would be way better point solution software for any one of the hundreds of things that Microsoft is providing for you, but there's no way you're going to switch.
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Yeah, I mean, they had the great network economies with Windows that we talked about last time, but that starts to erode here.
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And I think it also illustrates that sounds like an enterprise company to me.
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This is the cartoon org chart of all divisions of Microsoft pointing guns at one another.
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Well, the net of all this is that Mark and Jim's company, let's call it that. changes its name in the fall of 1994 to Netscape. And Mark had a typically great Mark quote about this to the press at the time. You go to school, you do your research, you leave, and then they try and cripple your business. Had I known this would happen, I would have gone to Stanford.
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I just want to double underline and highlight this one because I think also this same dynamic played out in the building and evolution of Microsoft's enterprise business. Really, IT just wanted to control the network and prevent users from messing it up. Eventually, when the iPhone came out, that dam broke.
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And IT could no longer hold back users within their company from doing what they want and having what they wanted. And this is where the shift to the cloud was another reason it was so strategically important.
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Shifting to the cloud is what enabled IT to say, okay, and become a partner to their users in a way that they, you know, paid lip service to before, but they were really antagonistic to their users.
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And it works exactly with what you're saying for Microsoft as a company and its products too. Like you want to use an iPhone? Great. You want to use open source? Great. We can still serve you.
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Not to mention interactive TV looked like YouTube and Netflix and not like, you know, a layer on top of Comcast.
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Yeah, the problem was during this era, that sort of optionality in multiple bits... Kind of collapsed down to like, no, we're going to make one bet.
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I was going to make that analogy, but it's too much... There is no way we could do this on our end. Yes. Too much navel-gazing, but yes.
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Totally. It's also the most marked entries in quote ever, which is awesome.
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Anyway, okay. Meanwhile, remember the online services, the CompuServes, you know, Prodigy, AOL, et cetera. They're not blind. They see that the internet and the web is also becoming a thing. they want to go license a web browser and incorporate it into their platform.
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I have just one big one, but I'm going to save it for takeaway and landing the plane.
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So for me, this only came to me just a few minutes ago, but I think is the right and most complete version of what I've been feeling about this part of the Microsoft story for a long time since we've been doing the research. And the feeling started with this. As we were talking to people and digging in, we were just like, this story is not understood right.
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And this narrative about these were the losing years of Microsoft, yes, there were a lot of Ls during this time, but that's not complete by any stretch of the imagination. And as we were preparing, I really felt a lot of weight on this one of like, man, we really have a responsibility to try and get this right here.
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And I think what I realized a few minutes ago as we were talking is this was the biggest failure of the company during this period. They did not tell their story, right? And so much of what we think of as the losses from this timeframe and certainly everything baked into the stock price not moving was because of that. Yes.
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Steve came to the CEO role at an all-time high multiple and it was the tech bubble and all that stuff. Sure, that's a big thing. But why did the stock price stay in the 30s for his whole tenure? They just couldn't tell the story right. And there are all sorts of reasons for that. But the story does not have to be so negative because there is so much positive that happened during this time.
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And yet the narrative became this self-reinforcing Microsoft sucks narrative.
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I mean, at this point, I feel like standing here today, we can say Alexa.
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And yet the narrative about Amazon is, ah, what a beautiful thing, Jeff and Bute and the company. Yes. And the narrative about Microsoft was they can't get anything right. Yep.
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So Netscape isn't interested in licensing because they have their own business model selling web server software and they want to allow free downloads of the navigator client. Spyglass, though, they start licensing that original Mosaic and they start doing deals with the online service providers.
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And I think this is why I feel so adamant that Microsoft during this era and Steve deserve so much more credit than they get because Microsoft is not IBM today. It is not large but irrelevant. It is very relevant. And what they have done with Azure and in cloud and now with AI is, I mean, hell, they're the most valuable company in the world.
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Right. Yeah, they did that while building this whole new great business.
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Let's do it. Okay, I have two hardware technology products. One is a re-carve-out from you, past carve-out, the Ray-Ban Metas. Oh, yeah. Finally got a pair. They're great. They're awesome. The use case of the ambient audio in my ears without earbuds is great, particularly for a baby monitor.
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When I am talking to my wife or other family members or friends or whatnot, and I want to be able to hear what is going on in the baby crib and not wear earphones in my ears.
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That is great. They're also just a great product in general. Another related hardware carve out is a startup called Oslo and the Oslo Sleep Buds. In the last couple of years, I have slowly and then pretty much every night gotten into using some form of audio to help fall asleep or if I wake up in the middle of the night, get back to sleep. And I used AirPods for years and years and they're great.
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But, you know, if you sleep on your side or do anything, we're like, you know, you got the AirPod jamming into your ears. These are little sleep buds that are made for sleeping. And if you lie on your side on your ear, they don't stick out. And so you can lie.
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Yeah, they're great. So this is the team that was at Bose that made the Bose. I don't even know what the product was called, but Bose had this product. They killed it. The team left, started a startup. And so it's all like Bose engineering. Anyway, it's great. I love them.
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And a small startup company called BookLink goes and codes up another browser that they start licensing to companies as well. So Bill Gates and Steven Sanofsky, they go and meet with BookLink in May of 1994. So coming right off of this internet retreat, we're going to make this a core part of Microsoft and a core part of Windows. And they're interested in licensing BookLink as well.
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Yeah. His blog, Hardcore Software, he published in book form. It's a thousand-page book. It's like a textbook sitting on my desk. It's awesome. We talked to Steven for a few hours. He's great. He's a board partner in Andreessen Horowitz now. That was super fun.
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Didn't Charlie do a great Invest Like the Best interview with Patrick a couple years ago?
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He's such a legend. Delightful. The right way to put it. Ray is now running another startup, a new one called Blues Wireless, and was just so generous to give us a couple hours. He had some amazing, you know, things that belong in a museum in his office that he showed us over Zoom, like old computers and hardware from the 70s, the 80s, the 90s. It was super cool.
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They start negotiating. They're talking about a, call it $2 million license deal. And all of a sudden, AOL comes in and buys the whole company of BookLink for $30 million. Wow. So this now leaves Microsoft without a browser. And there are basically only three real browsers on the market. There's BookLink that AOL just bought. There's Netscape Navigator, which is not available to license.
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And especially being generous with his time as we were entering free agency here. He's got a busy day job these days at the Cliffs.
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Yeah. Super cool. Yeah, a few more on my end. Terry Meyerson, the CEO of Truveta in Seattle. Terry ran Windows and Windows Phone at Microsoft for a long time. To Soma Soma Segar, who is a managing director at Madrona, but is a legend in the server and tools business at Microsoft. Soma, we talked about him on part one, but he's wonderful. To Mary Jo Foley. It was so fun to talk to Mary Jo.
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Mary Jo dedicated her career probably the last... 20 plus years to solely covering Microsoft. And she is the best in the business today. She's the editor-in-chief at Directions on Microsoft. It's a research firm like Gartner, except it only covers Microsoft. She was super kind and generous. And then the last one, Dave Marcourt. It was so fun to talk to Dave.
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The only outside capital into the company before IPO from TVI. And then Dave went on to co-found August Capital, where he's a partner emeritus these days. I think Dave was the longest serving Microsoft board member besides Bill Gates. Three decades plus.
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If you are wondering what you should be doing on September 10th, 2024, there is only one acceptable answer, and that is to be in San Francisco at the Chase Center celebrating with us. It's going to be awesome.
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And then there's Mosaic and Spyglass. So Microsoft goes to who else? Spyglass. They license the source code for Marc Andreessen's original Mosaic browser from Spyglass software for $2 million. And that code base becomes the base upon which Microsoft builds Internet Explorer.
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You ready to hear it? Well, hey, if you click the about menu in the early versions of Internet Explorer.
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A text box pops up that says based on NCSA mosaic distributed under a licensing agreement with Spyglass Inc.
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Yeah, tickets will be available soon, and you can sign up at acquired.fm.sf to get emailed as soon as they go live.
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We're going to get to this in a minute. But when Windows 95 launched, it had either at launch or very shortly thereafter, what was called the Plus Pack. Yes. And Internet Explorer was available as part of the Plus Pack.
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Makes for such a good story, though. It sounds like reality is a lot like the DOS acquisition. Yes, Microsoft bought QDOS, Quick and Dirty Operating System, from Seattle Computer Products. Was that the same thing as Microsoft DOS? Sort of. A lot of work went into it after the deal. Yeah, as you would expect. Same thing here. But it is definitely true that if you click that About box...
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The middle chapter, indeed. And boy, is there a lot to discuss. So, Ben, you covered this in your intro, but I think everybody kind of knows the narrative about what happened to Microsoft between, call it, 1995 and 2014 when Satya took over.
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So this brings us now to the launch preparations for Windows 95. And in the spring leading up to all this, Bill writes another memo, this one intended for publication, so to speak. That is the famous Internet Tidal Wave memo. I just want to do a big quote from it here. Perhaps you have already seen memos from me or others here about the importance of the internet.
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I have gone through several stages of increasing my views of its importance. Now I assign the internet the highest level of importance. In this memo, I want to make clear that our focus on the internet is crucial to every part of our business. The internet is the most important single development to come along since the IBM PC was introduced in 1981.
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It is even more important than the arrival of the graphical user interface. Can't get any more clear than that. Very clear. So that brings us to the August 95 Windows 95 launch, scheduled for the 24th. On August 9th, a couple weeks beforehand, Netscape goes public with a market capitalization of $3 billion. Massive IPO. Massive. I mean, this is like 1995 we're talking about.
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Yeah. In the IPO press cycle, Mark Andreessen is quoted as saying that, quote, Netscape will soon reduce Windows to a poorly debugged set of device drivers.
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There's even a quote from Satya himself in the very first paragraph of the book that he wrote in 2017 called Hit Refresh, which, I mean, that title kind of gives it away right there. He writes, I joined Microsoft in 1992 because I wanted to work for a company filled with people who believed they were on a mission to change the world.
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You can see why it was so important to Microsoft to beat Netscape, to bring the internet in the form of Internet Explorer into Windows and have Windows maintain its role as the dominant platform. So all this stuff will cut off their air supply. It was existential.
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Yeah. So Windows 95 launches a couple of weeks after the Netscape IPO. Internet Explorer is not baked in, at least not in the retail box version. You can buy it for $50 as part of the Plus Pack that I was referencing before and install that and add it into Windows, and Microsoft will make money on the sale of that software, but...
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That, of course, does nothing to make a dent in the free version of Netscape Navigator that is out there.
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But after years of outdistancing all our competitors, something was changing and not for the better. innovation was being replaced by bureaucracy, teamwork was being replaced by internal politics, and we were falling behind. And then he references the famous gun-pointing org chart by cartoonist and software engineer Manu Cornet that probably listeners many of you are familiar with.
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Netscape's run continues. The Netscape stock triples over September, October, November. Netscape is now a $10 billion public company. Insane.
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Yeah. Basically, all of the hype train that had been behind the information superhighway has now completely ported over to Netscape.
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I'm going to make the episode timeless. Okay. And then on December 7th, 1995, Bill Gates announces that Internet Explorer is now free and it will be bundled in with every single copy of Windows 95 going forward. And on that day, Netscape stock drops by about a third and never recovers. That was the high watermark for Netscape. It's over after that.
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Yep. And that's exactly what happened. I mean, this is now the march of Internet Explorer. It doesn't happen overnight, but it's inevitable. By the end of the next year, in 1996, Microsoft has now done deals with AOL, CompuServe, and Prodigy, all the old online services, to ditch whatever browsers they were using and bundle in Internet Explorer.
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And by the end of that year in 1996, Internet Explorer passes 20% market share, 97, it passes 40% market share. 98, it passes 60% market share. And then by the year 2000, Internet Explorer basically has, for all intents and purposes, 100% worldwide browser market share. If you look at the Internet Explorer market share chart over time, it is the most perfectly rounded hill that you will ever see.
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It goes from zero in 95 to like 100 in 2000, and then all the way back down to zero in
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And all the market cap and excitement was all on the come. It wasn't because of the revenue.
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There are a couple more fun little tidbits from this era. In August 1997 is when the famous Macworld happens, where Steve Jobs returns to the company and Bill Gates shows up on the satellite feed. And, you know, of course, this moment is legendary. But studying it from this lens, I realized there's this whole other aspect to it that I didn't know before.
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We will link to that in the show notes. And you can sum this kind of whole narrative up as Microsoft was winning, and then it sucked for a long time, and then it is now winning again, and that's all thanks to Satya. And the question we sort of asked as we were doing our research was, is this true?
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So what Bill and Steve announced on stage, it's also so telling that Bill couldn't even be there in person. He joins by satellite.
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So there are four points to the partnership. One is the $150 million investment from Microsoft and Apple. Two is the five-year commitment on the part of Microsoft to ship Office for Mac. And those are the big ones that everybody talks about.
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So the third deal point was they agreed to end all patent disputes. So this is the end of all the back and forth that we talked about in part one. But then the fourth point, which I didn't even remember at all, was that Internet Explorer would become the default browser on the Mac, displacing Netscape. And that continued from 1997 until 2003 when Safari became the default browser.
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Oh, don't I know it. And knowing this now and knowing the headspace that Bill was in, I got to imagine that's the reason he did the deal.
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And what we ended up learning from the literally dozens and dozens of people that we talked to surprised us a lot, and I think will probably surprise listeners too.
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So, to close the book on Netscape, in November 1998, AOL acquires Netscape in an all-stock deal for just over $4 billion. But, again, all stock. And this is just a little over a year before the Time Warner merger. And this moment here...
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is just the absolute peak of Microsoft as a consumer technology company I mean I think maybe the absolute peak of any consumer technology company ever I mean think about the market power that Microsoft has at this point in time Apple has an existential reliance upon them. They have completely crushed Netscape, you know, quote unquote, cut off the air supply. There's nobody else.
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Yep. And if you zoom out, it's clear that traditional finance folks aren't the only decision makers anymore. It's also your developers, your engineers, your product managers, and so on, who now have a seat at the table when it comes to finding the best payments platform for your company.
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All right. So on the last episode, we left off with the, Ben, as you put it, unabashed celebration of software that was the Windows 95 consumer launch in August of 1995. And it was perfect. It had everything. It had Jay Leno. It had the Rolling Stones. It had the Start button. Or actually, it had almost everything.
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Many of these modern digital-first categories like ride-sharing, e-commerce, or travel couldn't exist without smooth and seamless payments built into the product experience natively.
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Anyone can make an account to create projects, collaborate with team members, generate access tokens, and try out payment APIs that help accept, manage, or send payments in a sandbox environment.
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With J.P. Morgan, you get to rely on their experience and security so you can focus on your core functionality. This season, we've talked a lot about how they've been powering secure innovation with an ecosystem of payment solutions trusted by some of the world's largest and most innovative companies.
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Yes. And I was thinking about it in the transition at the end of the browser wars there. Well, you didn't like my snarky comment. Yeah, well, we were being glib about like, oh, this should be illegal. That's really the question here. All that power that Microsoft had, it had probably never been concentrated in the hands of one company like that and probably never will be again.
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And the question is, was that illegal and did Microsoft do anything wrong?
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And then there's the other dimension, too, of, as a consumer... Am I unhappy that I get a world-class web browser included in my operating system?
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Yeah. So the Microsoft antitrust saga actually started not with the Department of Justice and not in 1998. But with the Federal Trade Commission, the FTC, all the way back in 1990, when they opened an investigation into the company about whether it was violating antitrust laws.
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There was one thing that was missing from Windows 95 at launch that if you were a consumer user of technology, of software, of products, of operating systems, maybe you kind of wanted to have. And that was an internet browser.
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Yep. So in July 1993, the FTC commissioners vote on whether Microsoft is a monopoly that deserves further action and penalties, and they deadlock at two to two, which means essentially a win for Microsoft. No action would be taken against the company. This is a huge victory. The antitrust case of the U.S. federal government against Microsoft should be closed at this point in time.
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Yep. Microsoft, you are good as far as the U.S. federal government is concerned. However, the very next month in August 1993, the Department of Justice picks up the case, which is pretty unprecedented. One department in the U.S. federal government essentially investigates a company about whether it is abusing its monopoly power. declines to prosecute them for it.
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And then another department within the federal government the very next month says essentially, well, we don't think you did it right. We're going to do it. Microsoft is now all of a sudden basically standing trial for the same accused crimes twice.
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And in fact, several members of the FTC commission opposed this whole process and tried to refuse to turn over their notes to the Justice Department. But nonetheless, the DOJ proceeds. And the next year, in July 1994, Microsoft just settles with them rather than going to trial. They're like, all right, We just want to be done. We're going to settle with you, DOJ.
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We're going to be done with the U.S. federal government here. And in that settlement, they agree to enter into what folks may know, the famous words, a consent decree. And that means they consent, in this case, that they are not going to tie the sale of Microsoft application products to the sale of Windows, meaning they can't say like,
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hey, OEMs or businesses or consumers or whoever, if you're buying Windows, you have to also buy Office or X or whatever else that we're selling in our applications group. But importantly, as part of the consent decree, they remain free and clear, Microsoft does, to integrate additional features into the Windows operating system. Which brings us right back to Internet Explorer.
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Yeah. I mean, today, could you imagine purchasing a device that has an operating system and that device not having an internet browser as part of the core system? No, you can't even imagine that. Of course it's a feature.
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This is the gray area. And, you know, look, if you ask Bill and Microsoft and Jay Allard all the way back to the original memo, it was absolutely intended to be a core feature of the Windows operating system, having an internet browser as part of it.
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So in October 1997, the Justice Department files a motion in federal district court stating that by bundling Internet Explorer with Windows, Microsoft has now violated the 1994 consent decree against product tying.
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And also remember the fact pattern here. Isn't exactly great for Microsoft of, well, they did ship Windows 95 without Internet Explorer in the beginning.
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Yeah, a whole bunch of back and forth. Microsoft appeals Judge Jackson's order. And in early May 1998, the appellate court rules that Microsoft can continue shipping Windows with IE bundled into it and also continue to bundle any other features that they want as part of Windows as long as it benefits consumers.
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So then, one week later, on May 18th, 1998, the DOJ announces a brand new... enormous, wide-ranging antitrust lawsuit against Microsoft for violating the Sherman Antitrust Act and abusing its monopoly power to suppress competition.
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At the time, things were changing so fast. There was this phrase called internet time. Things happened in weeks versus years. But if you rewind just a little bit back to like 92, 93, 94, even into early 95, you Going online for consumers meant using a service like CompuServe or Prodigy or, of course, the big one, AOL.
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It is not necessarily illegal to be a monopoly. It is illegal to abuse your monopoly power.
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So this court is examining both of those questions. One, is Microsoft a monopoly? Two, are they abusing their power? This is really bad for Microsoft.
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Yeah, you can see how it sort of goads them into like, okay, we're going to bring the big lawsuit. Right. But this whole scene, you can also see from Microsoft's perspective a feeling of betrayal by their government. You know, like, hey, this is the third time we are being tried for what feels like the same crime. Ben, you said double jeopardy isn't a thing earlier.
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You know, what is this, triple jeopardy? Come on, I thought this was supposed to be a free country where we can build businesses. Yeah. What the hell?
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Yep. And so for all these reasons, including, Ben, as you say, the legal strategy they started with in the first place of we're going to fight everything, they say like, all right, we're fighting this. We're going to fight it hard.
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So, Ben, you've talked to a lot of people here. Take us through what happens in this big trial through the fall of 98 and into 99.
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And when you say tailored for the pretrial ruling, you mean tailored with the assumption that this is only going to be delivered as a written transcript. Right. There will be no video, no recording of these depositions.
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And these services were not what we think of today as the Internet, but they were more like walled gardens with proprietary services that were bundled with access via dial-up modems.
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Yeah. At a certain point, they argue over the definition of definition. Is that right?
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And certainly went a long way towards shaping the decision, but also shaping, more importantly, public opinion about Gates and about Microsoft. How did this hold up, though? Didn't Microsoft appeal the change from recordings not being allowed for depositions to recordings being allowed? Yeah.
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Wow. Interesting. It also sounds like maybe they didn't realize yet how disastrous these tapes getting out was going to be for Bill and for the company. Yeah. I think that's right. Interesting. Well, Okay, all of this starts to culminate in November 1999. These trials take forever. When Judge Jackson issues a finding of fact that Microsoft is indeed a monopoly in the operating systems business.
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Now remember, it's okay to be a monopoly. It's not okay to abuse the power. But simply the fact that the judge has now issued his opinion that it is a monopoly, everybody knows this probably means the other shoe is about to drop.
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So a couple months go by after the finding of fact. And then on June 7th, 2000, Judge Jackson issues the final judgment in the case. And he rules that Microsoft did indeed abuse its monopoly power. And as a remedy for having done so, he orders that Microsoft be broken up. into at least two separate companies. Separate operating system company and a separate applications company.
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Just like the Standard Oil breakup order, however many years it was before. 90, I think.
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Yep. I think the best way to sum all this up is, do you know who owned the CompuServe service at the time? No, but I know it was a Columbus-based company. Oh, interesting. It was owned by H&R Block, the tax prep company. Really? Yeah. Huh. Whoa. Crazy. That's what online was like just a few years or months before the Windows 95 launch.
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Yes. It wasn't just that, oh, Microsoft lost the DOJ case. No, the ruling was Microsoft will be split up by order of the United States government.
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It's totally wild. I mean, can you imagine if there was like the Gates Company and the Bomber Company? I mean, sort of, as we're going to talk about in the rest of this episode, that is what happened, but in a very different way.
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Imagine if a ruling comes out tomorrow that Apple needs to be broken up and iOS needs to be separated from the devices and you need to be able to buy a phone without iOS. What do you think that's going to do to the company's market cap?
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Well, right. But I'm just, I'm making a similar type of scale analogy. Right. Like what the impact would be.
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Right. That is what the world believes, as far as anyone knows. Yep. So the appeals court removes Judge Jackson from the case. They install a new judge to re-adjudicate the matter. She gets up to speed. We're now in the year 2001. She starts pushing the parties toward a settlement.
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Also, there was a political administration change from the Clinton administration to the Bush administration. So then, in November 2001, just a couple weeks after the Windows XP launch, the DOJ and Microsoft finally, completely settled the case.
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Windows 98, you mean the marketing update to sell back-to-school PCs? Yes.
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So Microsoft, of course, as, you know, inheritor of the earth and all things technology, they want to play in this online services arena, too. So in 1993, they start sniffing around AOL and see if maybe Microsoft could acquire AOL. Steve Case, the founder of AOL, isn't interested in selling.
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Right. If you are in the camp of Microsoft was a monopoly, was abusing its monopoly power, you're like, well, this was a complete failure of process because the damage is done, right? Yeah. Meanwhile, also, if you're in the Microsoft camp of what the hell is our government doing, you're also like, what the hell? Nobody is happy here.
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Right, yeah, we have enough existential threat to our business from technology trends happening to try and navigate that with our hands tied behind our back because of these legal proceedings. Like, come on.
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Yeah. No, I don't have anything else. But, okay, that is the letter of the resolution here. The actual cost of this was immense. Nothing could have been bigger. I mean, we spent the whole first section of this episode talking about how Microsoft was so powerful, had never been more powerful, and there probably never will be a more powerful company than Microsoft in the late 1990s.
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Oh, well, the back half of the episode is about the incredible story about how Microsoft rebuilt itself in a completely new market into now, again, the most valuable company in the world. But let's just talk about what the actual cost was, not in terms of money. It certainly didn't actually impact Internet Explorer or Windows. XP was a huge success. Sells over half a billion copies.
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But there's this whole thing where Paul Allen goes off by himself and he buys a large stake and that creates all sorts of headaches because Microsoft is like, well, if we can't buy them, we're going to compete with them. So they start an internal project called Project Marvel to build their own online service that becomes MSN.
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Gets used over its lifetime on probably a billion PCs. It unifies Windows under the NT architecture. Has the Bliss wallpaper. Amazing. But the true cost is what it did culturally and emotionally to Microsoft. I mean, we talked to all these people and... God, it was like death being there.
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I mean, to believe for 16 months that the company was going to be broken up for Bill to have this really embarrassing video of him all over the press and to have the narrative change about Bill, change about the company, change about for every employee working at the company to like, oh, you're the best and brightest in America to you guys are evil. And why are you working at this company?
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Not to mention state attorney generals were also suing Microsoft left and right and international attorneys.
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And obviously the company thrived through much, you know, if not all of that.
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So I said a minute ago, I think it killed Microsoft's immense, dominant consumer technology power. And the biggest reason I say that is We didn't talk to Bill Gates as we were preparing for this, but is what this whole thing clearly did to Bill Gates. Yeah.
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And for whatever sets of reasons, I mean, I can imagine so many thinking about, like, if I were in that seat going through that, Bill at Microsoft was never the same person after this.
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Microsoft Volume II
Yeah. So in July 98, right as this big, huge DOJ antitrust suit is heating up, Steve Ballmer gets promoted to president of the company. Bill is still CEO, but Steve is now promoted to president and is the clear number two. And then they go through the trial, the deposition, the November 99 finding of fact that Microsoft is a monopoly.
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And then, Ben, as you're referring to, on January 13, 2000, Bill Gates announces that he is handing the CEO role of Microsoft over to Steve and that he is moving to a newly created position as chief software architect. And he will remain chairman of the company, but he is... no longer going to be CEO. And then, of course, it's just a few months later that the breakup verdict comes down.
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At the same time, many people in technology, especially at Microsoft itself, and lots and lots of investors on Wall Street, believe that these walled garden online services were just temporary. They were just a bridge to a more utopian networked consumer culture and economy that they called the information superhighway.
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I mean, somebody we talked to characterized this period as like a mental breakdown for the whole company. I think that's kind of the best way to characterize it.
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Yes. And so the transition to Steve Ballmer happens. This is the context under which Steve Ballmer became the CEO of Microsoft. So I talked to a whole bunch of people who are at Microsoft in this era. And one thing that every single person brought up that never gets talked about is is how much Steve was the emotional rock for the company when this was happening.
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All the stuff everybody thinks about Steve, you know, the running around on stage, the yelling, the screaming. Developers, developers, developers. When do you think all this happened? The crazy dancing on stage. I love this company. That was in September of 2000. when they thought they were going to get broken up. And Steve was there trying to keep everybody moving forward.
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Everybody we talked to was like, I don't know how he did it, and it meant so much.
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Right? Knowing that context, for me at least, it completely changed my perception of Steve and of the company during this time. Fascinating. So when Steve takes over, his agenda is three things. And I think in basically priority order. Number one, hold the company together emotionally. I love this company. That was job number one, to keep everybody coming to work. Job number two...
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clean up this antitrust mess. And then job number three, I think, was, hey, let's keep this company growing and winning. And I think it's kind of fair to say he did all three. So we just talked about, one, emotionally holding the company together.
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Two, one of the very first things Steve does when he becomes CEO is he promotes Brad Smith to general counsel, who Brad Smith is still, of course, leading all this at Microsoft to this day. He's now president. And Steve tells Brad, go make peace. So actually, this is amazing. Brad's final interview with the Microsoft Board of Directors.
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Yep. For his job, you know, to be promoted to general counsel, his PowerPoint presentation to the board is just one slide. that has one sentence on it. It's time to make peace. And that is totally what he goes and does. And he says, okay, I'm going to figure out what settlements we can live with, and I'm going to go settle everything. And this company just needs to move forward.
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And it doesn't matter that we all feel it wasn't fair. It doesn't matter that we all feel this was a sham of a process. We just have to move on and we have to live in a new reality.
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And the specific vision of how this information superhighway utopia was going to work was interactive television, all mediated by the pay television providers. So like the cable and satellite companies out there, you know, the Comcast, the charters, the Time Warner cables, the direct TVs on the satellite side. These were going to be the big consumer technology companies. And this wasn't crazy.
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Right. The reversal here is it doesn't get talked about enough what an amazing job Brad and the company did to reverse this perception. So then that leaves job number three on Steve's agenda of be successful. Continue to have Microsoft be a leading technology company and hopefully still grow revenue and profits.
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Yes. And absolutely, Bill was still there and Steve had Bill and they were running the company together. Absolutely. Absolutely. But what's so interesting is Microsoft, right at this time, basically starts a transformational journey from a technology company writ large, a consumer and sort of enterprise technology company to the enterprise technology company.
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And that is a muscle that, as we talked about last episode, Steve had been building for a while, but boy, does he really come into his own here. And Microsoft, the entire enterprise juggernaut that it builds, the bulk of it really is post DOJ. It is like new business and new markets that they are getting into. Yep.
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Yep. ServiceNow is the AI platform for business transformation, helping automate processes, improve service delivery, and increase efficiency. Over 85% of the Fortune 500 runs on them, and over the past few years, they've joined companies like Microsoft as one of the most important enterprise technology vendors in the world.
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Yeah, it's telling for the magnitude of this partnership to see Satya Nadella appearing in the keynote at ServiceNow's big annual event, Knowledge, last month. It had echoes of that Bill Gates' 1997 Macworld video that put Apple back on the Not that ServiceNow needed putting back on the map.
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This actually made a ton of sense because television and in particular cable television at the time was the primary existing consumer medium. The internet was not a thing.
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It's pretty awesome for both companies and especially awesome for enterprise users. So if you want to learn more about the ServiceNow platform and how it can work with your company's Microsoft services, go over to servicenow.com slash acquired. And when you get in touch, just tell them that Ben and David sent you.
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Yeah. which is so funny that Bill thought of it as NT slash back office.
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Microsoft Volume II
The fact that he calls it back office, this is so telling. Okay. So we did talk last time about NT and Dave Cutler and the heroics that he performed to write NT. Windows NT, though, was still a client operating system architecture for a user to use a personal computer with.
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Yes. And discovering this distinction is what Microsoft in this next era really, really nailed. And they discovered that the enterprise is not about users. It's about IT. And it's about systems. For better or for worse. Yes. And discovering that and the products and the sales motions that Microsoft could then go use to sell to enterprise IT and sell systems...
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was a new, you know, multi-hundred billion dollar market that Microsoft could now go attack and play offense in in this post-DOJ landscape, whereas they're playing defense everywhere else. Hey, here, our market share is zero. We can do whatever we want here.
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Yes, really IBM. But Sun, yeah, too. Oracle, etc. And it was perfectly suited to Steve's strengths. So, Ben, if you've ever heard of these now sort of strange-sounding Microsoft products, SQL Server... Active Directory, Exchange, Dynamics, SharePoint. SharePoint was technically within Office, but it is one of these systems types products.
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These are all, every single one of those names I just mentioned, become multi-billion dollar revenue enterprise IT server products. that are built and sold during the Steve Ballmer era of Microsoft. And what's so honestly beautiful about this is they work in concert with Windows and Office on the PC client side. So this is the client-server era that Microsoft really dominates here. And...
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Microsoft within enterprises, all these new server products work best with Windows operating system devices running Microsoft Office applications on them. And those Windows operating system devices and those Office applications work best with the Microsoft server products. You now have a full system solution from one technology vendor as a major enterprise.
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It's like the most incredible three-sided technology flywheel ever built.
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The very, very, very best example of this that most listeners can probably tangibly relate to as well is Exchange email and calendaring service and Microsoft Outlook and Windows.
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And the whole product effort here started with database. In 1998, Microsoft takes SQL Server, and it was the first real enterprise-ready database that can rival IBM and mainframe databases, Oracle databases. And of course, unlike IBM... it runs on x86 Intel architecture.
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So the pitch now to enterprise IT is, everything we just said about why working with Microsoft Server products is better for the whole ecosystem reasons, Also, total cost of ownership. Don't pay IBM tons of money for their mainframes. Just go buy cheap x86 Windows boxes from Dell or whomever and use that as your IT server architecture.
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And here's where Exchange and Outlook and everything comes in. This is right as email is taking off as the killer application in enterprises. And so now Microsoft shows up and says, we've got this great new product for you. It's called Exchange. And maybe you were using Lotus Notes before, which of course... developed by the legendary Ray Ozzie. He's going to come back up here in a minute.
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Lotus gets acquired by IBM for $3.5 billion in 1995. You're buying Lotus Notes from IBM. Come take a look at Exchange. Exchange has email. Exchange has calendaring. Exchange has address book. Exchange has Outlook. It is a first class included in the bundle of Microsoft Office, Office application that you, you know, Mr. and Mrs. Enterprise are now going to get for all your users.
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And it works just beautifully and perfectly with our Exchange email calendaring and address book service. It sells itself, basically. Yeah. And then you were talking about Active Directory. That led to Active Directory. Oh, okay. Well, now you've got your whole database architecture running on Microsoft. You've got your email and your calendaring architecture running on Microsoft.
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You've got your Windows machines out there. Well, you've got all these employees within your company, all these users with all these devices. You kind of need to manage them and you need to know who has what security access and how to find each other and where should the mail get routed and all that. Well, we've got this great new product for you. It's called Active Directory.
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I know it's enterprise software, so it's not as sexy or exciting or thought about as much as consumer software. But truly, the innovation that was happening here was among the most that has ever happened at a technology company because Microsoft was figuring all this out. Again, these were not lessons that people knew. In the IBM era that came before this, in the enterprise, there were no users.
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Totally. And Microsoft, just like they had done in entering the PC software market in partnership with IBM... they're going to partner with these big consumer cable companies. And so starting in the summer of 1993, there are all these rumors flying around that Microsoft is working on a big JV with the cable companies dubbed CableSoft. You can't make this up.
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Microsoft is now figuring out how to build and sell enterprise technology systems in this new era to businesses where there are users of the technology. And on the business side, yeah, what you just said, like, this is crazy. Microsoft said, okay, we're not going to just sell you the software.
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We're going to introduce this thing called an enterprise agreement where you, based on the size of your company, will pay us a certain dollar amount per year per employee. Actually, I think it was per device. But in these days, it was like, you know, most employees just had one device. And we've got you covered. Everything that you would want access to in our whole suite of software products.
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Yep. So now Microsoft has turned a one-time sale of software into an annual annuity that is going to keep growing every year and is going to grow with headcount.
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Totally. Here's something else that you get now as a enterprise IT buyer in the enterprise agreement world with Microsoft. Your needs as IT are actually pretty different than your users. They're actually very different. So like if you are an employee of a large company at this time, you are using a Windows PC at your office. What are the set of things that you want from that device?
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Well, you probably want to be able to procrastinate. You might be able to want to play some games. You probably want to poke around the internet and you definitely want it to be easy to use and you definitely don't want restrictions on there.
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Right. You want to run some VBA macros, you know, etc., etc. Yeah. Okay, now you are a corporate IT administrator, and all of a sudden you have to manage all these rogue agents all over your systems. Rogue agents called your employees. You want the ability to restrict your users from doing what they can do. You want to say, like, no, you cannot upgrade this software without us doing it.
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You cannot install anything. You cannot run these macros. You cannot visit these websites, etc., etc., etc., And part of that is productivity. But a large part of that, Ben, as you said, is security.
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Am I going to get hacked? Am I going to get sued? Are we going to lose data? Well, Microsoft's got a beautiful solution that they can sell you. And with the enterprise agreement, you can customize all of this and we will give you exactly what you want.
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And the idea is that, Ben, like you're saying, the cable companies will control the pipes and the customer relationships and probably a lot of the content. Microsoft will write the software, both for the set-top boxes in consumers' homes and for the servers on the back end. And this software project is codenamed Tiger.
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I joined the corporate workforce in 2007 when I graduated from college, and I was an investment banking analyst on Wall Street at UBS. I started mid-summer 2007, and our corporate IT systems, my Windows laptop was so locked down. We were using XP, of course.
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Yes, we were using Office 2003, of course. And like over everyone's dead bodies would any of that change. Everything was firewalled. We could not access, we couldn't install anything. We couldn't access tons of websites. I remember when I first started, we could still access miniclip.com.
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And so the analysts were playing tons of games that like pretty quickly IT caught on and, you know, that got the kibosh. So... Yeah. And I'm sure UBS as a customer loved every single bit of that.
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And then there's a third company, a third piece of this sort of unholy alliance for the information superhighway. And that was a company called Silicon Graphics that would make all the hardware. Cable companies aren't going to make the hardware themselves. You're going to need pretty powerful hardware here, both at the home and on the service side.
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Yep. One stat and then one point I want to make to highlight all this. By 2007, analysts estimated that 40%, 4-0, of all of Microsoft's revenue, which I think was about $51 billion that year. So 40% of $51 billion came from multi-year enterprise agreements. So these three-year agreements that you're talking about, Ben,
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And that covered Windows, that covered Office, that covered all the products that Microsoft offered except like Xbox. 40% of all dollars were flowing from multi-year EAs. And then another 15% of all dollars that Microsoft was earning as revenue were flowing from single-year EAs.
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And the vast, vast majority of the rest of Microsoft revenues, you know, the other 45% of the company, was the OEM Windows business. That was 30%. So if you look at Microsoft revenue in fiscal 2007... 55% is this new enterprise motion. 30% is the old Windows business, you know, Dell and Lenovo and whoever, like, you know, selling laptops to consumers and paying Microsoft for the operating system.
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And SGI, as Silicon Graphics was referred to, was legendary. They are the graphics company that enabled the CGI in Jurassic Park. And of course, their founder and chairman was legendary in Silicon Valley when Jim Clark put a pin in that name. So pinned. So Wall Street, of course, like nuts over all this, you know, the hype is out of control. It's a trillion dollar opportunity.
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Yes. And one of which they figured out post-DOJ and it became, yeah, by 2007, over half of the revenue of the company, which is crazy. Now, Ben, when you said put a pin in a minute ago, and I know we're going to come back to this after all the consumer failures we're about to talk about. There is a downside to this.
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When IT becomes your customer, when you become an enterprise business, the quality of the software, especially the user-facing software, is no longer priority number one. And this wasn't a problem for the company until in 2007 with the iPhone. But let's rewind and talk about everything that happened in consumer software at Microsoft until then.
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Oh. Got to get the professional. I always got the professional. Did you? Every time I built a new PC, I got to go pro. I didn't even know what pro meant. I definitely didn't need pro because I was not a corporate office worker, but got to go pro.
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There's all these spy shots of Bill meeting with John Malone at TCI and Gerald Levin at Time Warner. And Bill starts spending time with Michael Ovitz talking about how Microsoft can get in on the content game too, either through the MSN project or through other things they're going to do. This leads to MSNBC, the cable network that people are probably familiar with.
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And of course, the thing you need to know about this keynote is the date.
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Yep. And yes, that is true for all the traditional reasons in the XP timeframe. The reason it was also true in part one of our Microsoft series. It's even more true as Microsoft becomes an enterprise company because Windows is at the heart of the enterprise agreement. Right. The whole value prop of all of our server technologies is they work great with your Windows devices on your network. Right.
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Yep. And now might be a good time. Certain Microsoft fans have probably been listening to this episode and gripping their phones with all their strength like, when are you going to talk about Xbox? We're going to talk about Xbox briefly right now. We will do a whole nother episode on Xbox someday.
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Yes, totally. That's funny. Microsoft is so huge. This is one of the things that kind of gets lost to history, but you are absolutely right. DirectX was so important in that late 90s era for PC gaming. You know, Quake, Counter-Strike, everything that happened. Half-Life later. That was...
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enabled, you know, Doom came before and was really just like the genius of Carmack as a programmer to enable a first-person shooter to happen on a PC hardware without something like DirectX and hardware acceleration. But yes, everything that came after that, the birth of the first-person shooter genre, huge story to tell another day.
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But you're right, that leads into Xbox and Microsoft's entry into the home console and Crazy, that happened in November 2001, so just like a couple weeks after the XP launch. It was a big time for Microsoft.
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Which, as we talked about in part one, had always worked so well for the company. Yep. And it's going to work really well here, too. So Bill actually decides at this point that he needs to write a book for the public to evangelize this information superhighway thing.
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Yeah. This is also part of my argument of Microsoft was such a dominant consumer technology company before DOJ, because even though all this stuff comes out right after, it's the momentum still from before that's carrying Microsoft through to it.
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Microsoft Volume II
There's a great quote. I'll bring it up again later. But we got to talk to Steve again, to Bomber, as we were preparing for this episode. And he had this amazing quote to us about some of his acquisitions that didn't go well. He said, we only lost money. It's funny, but it's such an important point in the context of Microsoft. Money is not the scarce resource.
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Microsoft Volume II
Kind of embarrassingly, given how long the book world takes to actually publish a book, it doesn't come out until November 1995, after the Netscape IPO has already happened and Windows 95 has shipped. But in this book called The Road Ahead, I have two copies of it here on my desk, the hardcover copy and the softcover copy, which was revised and came out in 1996.
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Microsoft Volume II
But is absolutely the case, not just for Microsoft, but for all the at-scale tech companies these days, the top five market cap companies in the world.
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Microsoft Volume II
Yeah, totally. I think Xbox Live is debatable. We'll come back to this with Azure. Yes. Xbox Live was one of the original pioneering internet services, subscription services, across any category of software and technology. And the DNA and experience that Microsoft built from that served it extremely well.
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Microsoft Volume II
The hardcover copy is all about the information superhighway, or as Bill likes to call it, information at your fingertips. And then when the softcover version comes out later, basically they control left every instance of information superhighway and replaced it with the internet and the web browser.
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Microsoft Volume II
David, the look on your face. So I remember being like a teenager in high school at this point in time and reading all about Longhorn, Blackcomb, all this stuff on the internet, you know, on these new tech sites, these blogs, feeling like this is going to be amazing. I remember downloading like new shells for Windows XP to mimic the Longhorn UI with the sidebar and the clock of the side. Yeah.
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Microsoft Volume II
Could you imagine if Apple on their developer site, Apple, were just like, hey, here's iOS 23. Here's all the great new features we're building.
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Microsoft Volume II
Well, there were three pillars. I think it was all originally supposed to be Blackcomb. And then they were like, no, no, we're going to pare it down to Longhorn. But it all ended up getting added back into Longhorn. The first of which was called Avalon. And it was a new graphics engine that used direct hardware acceleration.
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Microsoft Volume II
So I think the vision for this was kind of like, hey, we're going to take DirectX and bake it into the operating system and allow the operating system to use GPU hardware acceleration.
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Microsoft Volume II
Yes. Yeah, that was one. The other one was a new web services framework called Indigo, which... I don't know. I did a lot of research and I couldn't figure out what it was supposed to be. I think it was kind of a fever dream of like, let's stuff the internet fully into Windows.
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Microsoft Volume II
In the hardcover version, there are three portions of the book where it is discussed. In the softcover version, the index for the internet takes up an entire page. There needs to be an index for all the sub-indexes of the internet in the softcover version. Amazing. So the hardcover version is the state of play.
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Microsoft Volume II
And what you're talking about here is the third pillar of Longhorn slash Blackcomb, which is WinFS, right?
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Microsoft Volume II
Yep. So, okay, Longhorn Vista, this is truly a disaster for the company.
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Microsoft Volume II
Oh, boy. It's even worse than that. You may have this in your notes, but Microsoft OEMs were so unhappy because consumers didn't want to buy Vista machines. Microsoft had to extend the ability for their OEM partners to keep selling XP machines to consumers for another two years after this.
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Microsoft Volume II
In January 1994, when a young Windows networking engineer named James Allard, or Jay as he goes by, writes a memo to Bill Gates and to the senior leadership at Microsoft entitled Windows, the next killer application for the Internet.
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Microsoft Volume II
Yep. And a couple other things on this. One, so when Vista actually shipped, just sort of process-wise, it was, Ben, as you're saying, a complete reset. So Brian Valentine comes over from Exchange, you know, in Windows Server in the enterprise world to take over managing, getting something out the door and just cut all the features, cut all the pillars of the Windows Longhorn vision.
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Microsoft Volume II
It still takes two years in that process to get it out. And then immediately afterwards, Brian leaves the company. Lots of other great engineers leave the company too. They go down the street to Amazon. And then Brian ends up leading the entire engineering platform team for Amazon.com.
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Microsoft Volume II
Yep. Yep. He went to Amazon. He was like a named top senior level executive at Amazon for a long time.
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Microsoft Volume II
You know, and then the other thing about this whole process, that this is purely my own speculation. Like, nobody said this, but just as I've been thinking and reflecting on how seminal a moment the antitrust stuff was to Microsoft after the height of their consumer power right beforehand...
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Microsoft Volume II
I think this might be a case where Bill no longer being CEO and just being chief software architect really impacted this process. When you're a CEO, you have to engage with your OEM partners. You have to engage with enterprises. You have to engage with customers.
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Microsoft Volume II
And not that it's all Bill's fault by any means, but this Longhorn Black Home disaster, Ben, as you say, was a case of getting high on your own supply within the company.
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Microsoft Volume II
Right. And, you know, remembering back to part one, too, it's not just that Bill was a great engineer. He was a great business person. One of the greatest of all time. He trained from birth. It's like, what company am I going to be CEO of, right?
Acquired
Microsoft Volume II
And in this memo, he points to a new piece of software coming out of the National Center for Supercomputing Applications at the University of Illinois that is spreading like wildfire and appears to be written by some like kid programmer there by the name of Mark Andreessen. In his free time, it's not even like his real job. Yes. And it is called Mosaic. Mosaic.
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Microsoft Volume II
Anyway, this is really bad. At the same time as Vista actually is coming out in late 2006, this is when Apple starts running the Mac versus PC ads.
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Microsoft Volume II
And oh boy, if you're Microsoft, does that hurt? And like Mac sales are irrelevant. Even today in 2024, Mac sales are 8% of the market.
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Microsoft Volume II
Zero. I don't even know. Like, you know, it doesn't matter. But the point is not that Apple is taking massive amounts of market share from Windows. It's that they are hitting a nerve with consumers, with enterprises, and within Microsoft itself, most importantly. Shoot, we are way behind here.
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Microsoft Volume II
Here's where it mattered. And the timing mattered so much too. This sets the stage for the iPhone. Because Apple now, in stark contrast to Vista and with these ads, is training consumers with the benefits and the joy of it just works.
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Microsoft Volume II
And what did the Mac do? It just works. And what did the iPod do? It just works. And what did the iPhone do? It just worked.
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Microsoft Volume II
Well, it was really a setting of the Apple brand promise at this moment in time.
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Microsoft Volume II
And I think we got to call it here. The death of Microsoft as a relevant consumer technology company. They never recovered from this as a leader.
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Microsoft Volume II
I think with one exception, I think you are totally right. Nobody is writing Vista apps. But the only people left who are writing Windows apps, period, are enterprise developers writing custom software for enterprises.
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Microsoft Volume II
And in this memo, Jay argues that the Internet and this software instantiation of it in the Mosaic web browser. kind of looks like it is going to become an exponential phenomenon given the rate at which it is growing and that it represents an enormous opportunity for Microsoft to, quote, embrace and extend the Internet into Windows itself. And this is the origin of the embrace and extend mantra.
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Microsoft Volume II
A hundred percent. In that conversation that we had with Steve, where he made the comment about my acquisitions, my mistakes, we just lost money on the bad ones. The genesis of that conversation was about Vista. You know, he was reflecting, he said, that probably was the worst moment, actually, in my tenure as CEO. That's right. Because all of that best talent, everything you just said, Ben,
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Microsoft Volume II
Yep. I mean, hell, even taking Brian Valentine off of Exchange. Exchange was freaking killing it in the enterprise. And he goes and spends two years getting Vista out the door and then goes to Amazon.
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Microsoft Volume II
Yeah. Oh, I can't wait to talk about that. Okay, Ben, I'm too excited for Azure. Let's do search. Let's do mobile, Windows 8, Zoom. Let's get all that. Oh, yeah. And then let's talk cloud, baby.
Acquired
Microsoft Volume II
Also, as on our first Microsoft episode, we have to give Pilot CEO Wasim Daher a special shout out here because he is the only acquired sponsor CEO who is also a research source for us on the same episode. Back when Wasim was a student at MIT, he interviewed Bill Gates for the school paper and he dug it up and sent it to us.
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Microsoft Volume II
Bill talked about Microsoft's forthcoming 40 gigabyte portable media center. And it was a pretty fun time capsule. We will link to the PDF in the episode sources.
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Microsoft Volume II
Yep. So enter Pilot. Pilot both sets up and operates your company's entire financial stack. So finance, accounting, tax, even higher level CFO services like investor reporting. Everything from your general ledger all the way up to budgeting and the financial sections of your board decks. And they've been doing this for years across thousands of startups in Silicon Valley and elsewhere.
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Microsoft Volume II
The exact words he uses are embrace, extend, innovate. In popular press and public opinion of Microsoft, that would, of course, get changed to embrace, extend, extinguish.
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Microsoft Volume II
There's nobody better who you can trust to both get your finance right and make it easy and painless for your company.
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Microsoft Volume II
Well, it's funny, the way you phrase that, I'm thinking like, oh, did Microsoft try and buy Google? And I don't know about it, but the number, of course, you're talking about Yahoo.
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Microsoft Volume II
And then it locks in even further because you can spend more capex on the data centers and more on R&D and make the search better and more performant and faster and all that.
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Microsoft Volume II
We may or may not do an episode on Xbox someday, Ben. That's for Ben and I to discuss privately for parents to discuss after the kids go to bed. But we're definitely going to do an episode on Google.
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Microsoft Volume II
Right. The business model is we sell Windows through OEMs and to businesses and the like and to consumers. And we can just bake this into it. Honestly, it's pretty incredible that Jay lays out the whole winning strategy for Microsoft and the Internet here in January 1994.
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Microsoft Volume II
You needed the equivalent of the Jay Allard Windows the Next Killer application on the internet or the Sanofsky Cornell is Wired memo.
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Microsoft Volume II
I'm laughing here. I was hoping I could surprise you and be at the end of it, like, have something to say here, but I think you're going to take my thunder.
Acquired
Novo Nordisk (Ozempic)
But if Kagra Sema, their new kind of next generation GLP-1 product shows the promise that they think it'll have, then that'll be a new patent cycle starting then. And then they'll develop the next generation and it'll play out again, just like insulin. But yes, absolutely cornered resource for sure.
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Novo Nordisk (Ozempic)
Which for sure also apply here. Yeah. I think really on three sides. On the R&D and research side, because that is incredibly capital intensive. $2.3 billion a drug. Yeah. Yep. The production side, as we've talked about for much of the episode, and then also here on the go-to-market side. You can't just, you know, waltz into these markets.
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Novo Nordisk (Ozempic)
It turns out that the answer to that is the key to the first chapter of our story today. Because the actual nomination, I don't know if you knew this, Ben, the actual nomination for that prize was put forth by a previous Nobel Prize winner in physiology or medicine, the 1920 Nobel Prize winner from Copenhagen, Denmark, a animal biologist named August Kroh. Oh.
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Novo Nordisk (Ozempic)
Yep. I think we can say there's no network economies here pretty safely. And I think we can probably also say there's no branding, although Ozempic has become such a buzzword.
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Novo Nordisk (Ozempic)
Yeah. I mean, there's like Tylenol, etc. But like, yeah, it's entering that category. An admission on that front, too. When we very first started talking about potentially doing this episode a number of months ago... I thought the same thing you did about Manjaro about Wegovi. I was like, oh, that must be a crappy knockoff.
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Novo Nordisk (Ozempic)
I did a cursory amount of research and I was like, holy crap, it's the same drug from the same company. Like, I'm an idiot. It's like literally the same thing. It's literally the same thing.
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Novo Nordisk (Ozempic)
Right. And not only that, it is the one that is supposed to be for weight loss. But you're right. Ozempic has become this brand name.
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Novo Nordisk (Ozempic)
I bet you found some fun stuff in there. Totally. Switching costs are a thing.
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Novo Nordisk (Ozempic)
Yep. And especially in this case, where in the vast majority of patients, it does seem that if you stop treatment, you will regain the weight.
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Novo Nordisk (Ozempic)
Oh, I had said I thought there was none, but I want to hear your case for it.
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Novo Nordisk (Ozempic)
I totally agree with you. I would push back a little bit in the classification. I don't think this is actually a network economy. I think this is just incredible word of mouth marketing because I don't think other people actually get a benefit from you taking Ozempic.
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Novo Nordisk (Ozempic)
But I mean, literally you become a walking billboard. Like it is a obvious word of mouth marketing.
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Novo Nordisk (Ozempic)
Right. If Elon Musk tweets that he's taking it... We govee. Yeah. But again, it's the same thing.
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Novo Nordisk (Ozempic)
I believe it is also not quite as effective as the injectable version. But still, it is an amazing feat of engineering that they created an oral version of this.
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Novo Nordisk (Ozempic)
Yep. Wow. There's a lot of power here. I think the only one we haven't talked about yet is counter-positioning, which is interesting. Maybe you can make an argument at the beginning there was because this could disrupt the insulin market, but I don't really think so.
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Novo Nordisk (Ozempic)
Yeah. And it'll be interesting to explore healthcare broadly and specifically biotech more on the show. My sort of arm's length understanding of the industry is that where startups primarily are doing drug discovery and then they get acquired by the big companies for go-to-market.
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Novo Nordisk (Ozempic)
Yeah, I do not think it is a requirement. But, you know, certainly a previous winner and a recent previous winner in the same category you would imagine carries a lot of weight.
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Novo Nordisk (Ozempic)
And really, this model all started going back to Genentech and Eli Lilly. And Genentech ended up getting acquired by Roche. But it was that partnership of Eli Lilly being the go-to-market for Genentech and insulin that started this whole startup big pharma partnership.
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Novo Nordisk (Ozempic)
You know, it's funny. I was thinking the same thing as my main playbook takeaway from this one. It reminds me of our Sequoia Capital episodes a few years ago and Sequoia's kind of historical classic mantra, the Don Valentine ethos of target big markets. Find a big market, target it, and then like stay focused on it for decades and decades and decades.
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Novo Nordisk (Ozempic)
And that's the story of a lot of companies we've covered here. But this is such a pure play example of that. Like one disease, one drug area for 100 years, and now a second drug area that came out of that first drug area.
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Novo Nordisk (Ozempic)
Totally right. And it's so funny. I mean, obviously we weren't in the room as these conversations were happening, but from reading the history, it feels like they understood it more than management at the time. Management was like kind of too close to it and thinking, you know, industry wisdom, we need to merge. Consolidation is happening. And they were like...
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Novo Nordisk (Ozempic)
Yeah. Now, here's the wild thing about August Crowe, founder of Novo Nordisk, the world's premier insulin company focused on insulin and diabetes for 100 years, now world's premier GLP-1 company. He's not a physician. He's not even a human biologist. Yeah, he was an animal biologist, right? Yeah, he was an animal biologist. Fun fact, though, this is maybe my favorite sidebar in the episode.
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Novo Nordisk (Ozempic)
no, there's this incredible wave that we are riding here. Let's keep compounding.
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Novo Nordisk (Ozempic)
Oh, yes. So I kind of can't believe we haven't talked about this yet. Novo Holdings, which is the vehicle by which the foundation holds their stakes in Novo Nordisk and Novozymes, they're sort of assets under management and thus the endowment of the foundation.
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Novo Nordisk (Ozempic)
is worth $120 billion, which makes it the single largest charitable foundation in the world, over 2X larger than the Gates Foundation, which is number two. Unbelievable. Just unbelievable. And through Novo Holdings, it has actually now become one of the largest and most active life sciences and biotech investors in the world too. They hold venture stakes in 80 plus other companies.
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Novo Nordisk (Ozempic)
That's on top of giving out lots and lots of grants to life sciences around the world and fulfilling the foundation's mission. I mean... It's just wild. We're burying this so deep in the episode, but this is the largest charitable foundation in the world. That's wild.
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Novo Nordisk (Ozempic)
And pre-GLP-1 is becoming really huge. It's very easy for them to say that now because they could eradicate diabetes now and still be Europe's largest company just based on obesity alone. But from talking to folks from the outside, my sense is I think that is as true as it can be in a corporation.
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Novo Nordisk (Ozempic)
He studied at the University of Copenhagen. His advisor was a guy named Christian Bohr, B-O-H-R. That name might sound familiar to some people. Descendant of Niels Bohr? Father of Niels Bohr. That Niels Bohr, father of atomic physics, also winner of the Nobel Prize, major contributor to the Manhattan Project. So yeah, his August's PhD advisor was the father of Niels Bohr.
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Novo Nordisk (Ozempic)
Certainly, it is a unique structure in the corporate world and one that has had a huge impact on the company's history.
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Novo Nordisk (Ozempic)
Yeah. I suspect it's probably both. I do think Danish culture plays into this too. You know, it is a much, much more socialist country than America. And actually, um, you know, watching interviews with Lata, she talks about this and sometimes she's asked about it. I'm like, Oh, Hey, didn't you get rich on basically inventing GLP ones? And she's like, no, I've never asked for a raise in my life.
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Novo Nordisk (Ozempic)
Yeah. The key point is long-term focus. And if you can do that, as we've shown time and time again on this show, you can create something great. If you do that, it's not like you will create something great. You still got to get lucky and also be doing the right things in the right areas. But if you're going to build something really, really big, you got to have that long-term focused mindset.
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Novo Nordisk (Ozempic)
Everybody's winning Nobel Prizes. There must have been something in the water in Copenhagen at that time.
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Novo Nordisk (Ozempic)
Yeah, right, right, right. Okay, so back to August Crowe. How the hell does he end up going to Toronto, getting involved in all of this, starting, you know, Nova Nordisk? Well, in 1920, the same summer that he wins the Nobel Prize, his wife, Marie Crowe, is diagnosed with diabetes. And this starts weaving together this whole crazy chain of events that leads to, well, Nordisk.
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Novo Nordisk (Ozempic)
Right. Wow. That's interesting. Whereas you look at almost every other market out there, if it's like a big market, there's insane capitalist incentives to go make a better mousetrap for it.
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Novo Nordisk (Ozempic)
Oh, crap. Wow. The initial part of what you just said jives with our math earlier, the 10% make it to market. I mean, that's a power law right there.
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Novo Nordisk (Ozempic)
I mean, this is another dynamic showing why the market force has led to consolidation in this industry. Like, you just need to be so large and have the capital resources to pull all the risk of these drug pipelines.
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Novo Nordisk (Ozempic)
Novo comes a little later. Marie herself is actually a pretty incredible person. She is a physician. So she's the first woman in Denmark to earn a doctorate in medicine. And Denmark, I kind of suspect, has always been pretty progressive relative to the US.
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Novo Nordisk (Ozempic)
But even still, like we're talking about like the 19-teens, a woman to earn a doctorate in medicine and then be a practicing physician was obviously unique. Yes. So when she's diagnosed in 1920, and you know, She basically self-diagnoses. She knows what's going on. She and August, she knows exactly what this means. She's going to die. This is horrible.
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Novo Nordisk (Ozempic)
Yeah, it's also exponentially harder to get that five extra years of life because you're facing 20 different morbidities out there.
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Novo Nordisk (Ozempic)
You did so much more of this side of the research than I did. Did you get a sense in talking to people like that transition is happening or no?
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Novo Nordisk (Ozempic)
But given that they're both very, very active in the scientific and medical community in Europe, they are able to get her the best care possible. Which at this point in time in Denmark is a young Copenhagen-based physician named Hans Christian Hagedorn. who is widely respected as sort of the best endocrinologist in town, even though he's very young.
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Novo Nordisk (Ozempic)
Oh man, I mean, even like, gosh, this is so close to home. I mean, for me and Jenny and my family, I've talked about this on the show before, but Jenny and I both have genetic cancer predisposition mutations.
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Novo Nordisk (Ozempic)
So, you know, the amount of screening that we get and then for family planning with, you know, having our daughter and other children in the future, the amount that we have used the medical system as very healthy 30-somethings throughout our life would not have been imaginable a few decades ago. So like, yes, I totally buy that.
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Novo Nordisk (Ozempic)
Let's do it. Maybe to start, you know, on this segment of the show, we talk about for a given company, how much value do they create in the world versus how much they capture? And let's start narrowly with Novo Nordisk itself. What do we think? Like, value creation versus value capture.
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Novo Nordisk (Ozempic)
undeniable that over the 100 plus year history of this company it has created incredible value for diabetics and now for a much broader population than just diabetics so the creation amount is large it is also undeniable that is a half trillion dollar market cap company on call it 30 to 40 billion dollars of revenue highly highly profitable revenue that they have also captured a lot of value
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Novo Nordisk (Ozempic)
Right. That's not taking into account all of the research that they did over the past decade.
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Novo Nordisk (Ozempic)
And he's up to date on all the latest workings of the starvation diet and how to maximize quality of life and prolong life as long as possible. Fortunately, Marie diagnoses herself very early. He puts her on a closely monitored starvation diet and they stabilize it enough, enough after a year or so. Now, back to August.
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Novo Nordisk (Ozempic)
Well, you're making me feel better about my career choices here to work in tech. Yeah.
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Novo Nordisk (Ozempic)
Yeah. So interesting. I mean, I'm tempted to say from this whole episode that the moral of the story here is focus and long-term focus. But I feel like we need to uncover this industry more and hear from folks in it. If that were always true, why are there not more Novos out there?
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Novo Nordisk (Ozempic)
Yeah. So that means 87% of healthcare revenue is not going to pharma.
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Novo Nordisk (Ozempic)
Right. It's totally farcical. You know, I think about my scenario and Jenny and my scenario, like, it's both together for sure.
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Novo Nordisk (Ozempic)
Ordinarily, you know, after you win the Nobel Prize, you go on a major international lecture tour. And of course, he's invited all over the world, particularly to the elite universities in America to come give speeches on his Nobel Prize winning research. But because Marie fell ill at the same time, he had to delay his trip. until 1922. So in 1922, August and Marie set sail for Boston.
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Novo Nordisk (Ozempic)
Yeah, I mean, that's like the administrative costs of health insurance are within spitting distance of pharma.
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Novo Nordisk (Ozempic)
This is no surprise here, but like health insurance in the U.S. is not insurance. It's access.
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Novo Nordisk (Ozempic)
So what you're telling me is that pharma are the guys in the arena. They're out there trying things.
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Novo Nordisk (Ozempic)
Yep. And I think that's why, you know, a lot of scientists, including I think Lata and many, if not most folks at Norvo Nordisk, I think that's why they work there.
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Novo Nordisk (Ozempic)
Yeah. I mean, to me, for Novo Nordisk specifically, I think it's pretty simple. Are GLP-1s the next super cycle? If yes, that is the bull case.
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Novo Nordisk (Ozempic)
There is room for everybody here. And the barriers to entry from everything we talked about to competing in this area are very, very high. So like there will be a number of competitors, including Eli Lilly, but there will be plenty of demand and profits for everyone. Yeah. That's the bull case.
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Novo Nordisk (Ozempic)
Totally amazing. So August is going to give a delayed series of lectures here at both Harvard and Yale. While they're in Boston at Harvard, they meet with a guy named Elliot Joslin, who he's actually the inventor of the starvation diet. He is like the world's foremost diabetes physician and researcher at this point in time. And Elliot tells them about what's going on in Toronto.
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Novo Nordisk (Ozempic)
And the bear case is for any variety of reasons, be it health risk or lack of efficacy or whatever, long-term, this just doesn't play out. Or it doesn't play out on the same multi-decade long timeline that insulin did.
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Novo Nordisk (Ozempic)
Yeah. And decade plus with further innovations and iterations that are going to come.
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Novo Nordisk (Ozempic)
Yep. It's probably also worth mentioning quickly here before we wrap, you know, one potential boogeyman that is out there people have talked about is suicidal thoughts. As best as we can tell from the research, it seems like that's not a major risk with these drugs based on the broad population studies. You know, certainly that's what Novo Nordisk says.
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Novo Nordisk (Ozempic)
Regulators have not indicated that that is an actual issue, but that narrative is out there and we don't want to go through the episode and not mention it. That could be one of these boogeymen for these drugs.
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Novo Nordisk (Ozempic)
Yes. Carve-outs. Let's do it. For new folks to acquire it, and since it's the top of a new season here, we do this for fun at the end of every episode.
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Novo Nordisk (Ozempic)
Nice. I bet we will have a lot of folks in Denmark that are interested in that.
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Novo Nordisk (Ozempic)
This is the world that we're living in back then. news of the discovery of insulin hadn't really yet reached Europe and certainly hadn't reached Denmark at this point in time.
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Novo Nordisk (Ozempic)
Yeah. Nice. Well, I have to give you a big thank you because over the last couple of weeks since your recommendation, I have read the book Wool, which is the first in the series that is the silo series on Apple TV Plus because I'm more of a book guy than a TV guy. And it is awesome. Book is so good. New addition to my favorite sci-fi books and sci-fi series.
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Novo Nordisk (Ozempic)
I wouldn't be surprised by that, having now read the book. I'm excited to dive into the rest of the series. Okay, my carve-outs, I've got two. The first one is a fun, timely, in-person carve-out. It's a guest carve-out from my wife, Jenny. San Francisco Ballet, where she works, is premiering a new work at the beginning of the season this year.
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Novo Nordisk (Ozempic)
January 26th here in San Francisco is the premiere of a new ballet called Mere Mortals. And this is pretty cool. She was like, you've got to talk about this on Acquired. It is about A.I., And it is a Pandora's box analogy for AI. Super cool. The music is composed by the British DJ Floating Points. So it's like super modern ballet choreography from a great up-and-coming choreographer.
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Novo Nordisk (Ozempic)
And SFB is going to do after parties in the Opera House afterwards. Should be like a super cool event. So Jenny and I will be there. I think we'll be there on opening night, January 26th. And it runs through February 1st.
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Novo Nordisk (Ozempic)
Yeah, ballet is such a cool art form because of all the classical art forms, it's the most young and modern. You know, like these dancers are athletes. They're like NFL level athletes at what they do. And, you know, they're young. And so there is this like new life in it relative to, I think, a lot of other classical art forms. So anyway, I love it.
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Novo Nordisk (Ozempic)
And obviously it is Jenny's whole life and career. That's one. Two, on some holiday travel flights, I think recommended by an acquired listener, actually. I watched the Blackberry movie. Have you seen this yet?
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Novo Nordisk (Ozempic)
I know. It's so good. It's really, really well done. I just watched it because I was on the flight and it was on the entertainment system and I was like, yeah, sure, whatever. I'll give this a try. Like, I don't know, RIM, BlackBerry. Yeah. But it's really, really well done. I really enjoyed it. It's hilarious. It's also like a good business story.
Acquired
Novo Nordisk (Ozempic)
Yes. Well, and particularly, you know, competitive advantage, like life advantage. Like they're just concerned about Marie's life at this point in time. So Elliot says, you know, I know the guy who runs the lab up there, John McCloud. Let's write him a letter and see if while you're in America, you can go up and see them and see the lab, see what's happening and maybe get some of this insulin.
Acquired
Novo Nordisk (Ozempic)
You know, it's a good example of a, we get asked all the time of like, oh, can you guys cover like a failed company or, you know, a cautionary tale? And it's hard to do unacquired because a lot of these companies are still going and RIM is still going. But BlackBerry is a good one because you're like, it's super obvious that they failed. There's no argument about that one. Yeah.
Acquired
Novo Nordisk (Ozempic)
Yeah, PillPack, super cool company that got acquired by Amazon a few years back, right, for over a billion dollars?
Acquired
Novo Nordisk (Ozempic)
So August and Marie write to MacLeod. Marie also writes back home to Denmark to Hagedorn and tells him about what's going on and about this discovery of insulin. She suggests in that letter that since Hagedorn is kind of the leading diabetes physician in Denmark, maybe Hagedorn. While they're in Toronto, they might be able to secure some rights or ability to bring insulin back to Denmark.
Acquired
Novo Nordisk (Ozempic)
McLeod in Toronto, he gets the letter. He's like, of course, come on up. You and Marie both come. Stay in my personal home. Sadly, unfortunately, Marie falls ill and she can't make the trip up to Toronto. So August goes alone, but he stays with McLeod, observes the insulin production process, sees everything that's happening. They become close and friendly.
Acquired
Novo Nordisk (Ozempic)
Most importantly, McLeod takes August to go meet with the insulin committee and talk about what Marie had suggested to Hagedorn of like, hey, maybe these are the right people to bring insulin to Europe, essentially, but at least to Denmark. Now, funnily enough, at this particular point in time, it turns out you actually can't patent drugs in Denmark.
Acquired
Novo Nordisk (Ozempic)
Yeah, it's wild. I mean, there are no other disease and drug categories besides diabetes and obesity that this could be possible to have a company of this size to have a pharma giant pretty much just focused on this one area. Like this is the Hermes of the pharma industry.
Acquired
Novo Nordisk (Ozempic)
So any blessing or patent licensing from the Insulin Committee to the Crows and Hagedorn for Denmark is sort of pointless because it's not legally binding in Denmark anyway. But the Insulin Committee says, well, you're really the right people to do this. How about we give you rights for all of Scandinavia? Norway, Sweden, Denmark, you have our official blessing and any rights that you need.
Acquired
Novo Nordisk (Ozempic)
Yes. So August and Marie set sail back for Europe. They arrive in Copenhagen. They go tell Hagedorn the news. Immediately, they all go get to work. And by get to work, they go buy cow pancreases at the local livestock market in Copenhagen.
Acquired
Novo Nordisk (Ozempic)
Ah, interesting. It was both. I think pigs may have come later, but certainly it was both cows and pigs that Nordisk and then Novo were using both of them. They were just basically trying to get their hands on any animal pancreases that they could.
Acquired
Novo Nordisk (Ozempic)
Yep. So using the Toronto method, they get a bunch of pancreases. They go to August Crow's lab at the University of Copenhagen, run them through a meat grinder, pour hydrochloric acid over them, and they extract insulin. And then they test it on rabbits and mice, and they confirm, yeah.
Acquired
Novo Nordisk (Ozempic)
we've got it this is insulin certainly for the first time in scandinavia i think maybe also for the first time in continental europe at least insulin is extracted here in denmark so this leaves just one obvious problem, just like insulin in Toronto. This is not going to scale. You know, maybe you could do this to treat Marie, but they want to treat the whole country, the whole region.
Acquired
Novo Nordisk (Ozempic)
Yeah, that's wild. To put that in more real numbers, that means that even by 1980, with all the advances, it took 1 million animals annually for 30,000 diabetes patients. And there are a lot more than 30,000 diabetes patients in the world in 1980.
Acquired
Novo Nordisk (Ozempic)
Ben, we're going to get to this in like two hours. Sorry. Foreshadowing. All good. So, back to the Crows and Hagedorn in 1922-23 in Copenhagen. They need to scale production. So, they go to the Loven's Chemisky Fabrik. And I need to, like, majorly apologize to all Danish people out there. It is... I talked to some Danish folks in research for this episode, and thank you very much.
Acquired
Novo Nordisk (Ozempic)
And I just, I realized in those conversations, I need to give up on trying to pronounce things correctly. Stick to French. We'll stick to French, yes. But that translates to English as the Lion Chemical Factory, and it is owned and run by another man named August, August Kongsted, with a K, K-O-N-G-S-T-E-D. And so they partner together.
Acquired
Novo Nordisk (Ozempic)
And by the summer of 1923, the very same summer that the Nobel Committee is debating on the award for that year. And of course, Crowe at this point has nominated his buddy McLeod, along with Banting. By that summer of 1923, the combo of the Crows and Hagedorn is
Acquired
Novo Nordisk (Ozempic)
and the Lion Chemical Factory have produced enough insulin that they can complete trials with eight human patients with great success there in Copenhagen. And at this point, H.C. Hagedorn, who, remember, was originally Marie's physician to help treat her diabetes, he resigns his medical post and decides that he's going to focus full-time on this project.
Acquired
Novo Nordisk (Ozempic)
And Kongstead from the Lion Chemical Factory. These are the founders of the project, but there's no Novo Nordisk yet.
Acquired
Novo Nordisk (Ozempic)
Absolutely. Eli Lilly had insulin on the American market available to patients at this point in time. Yep. All right, so how does this actually turn into Nordisk? But before we do that, I want to pick up the thread that we left earlier with our new friends at JPMorgan Payments.
Acquired
Novo Nordisk (Ozempic)
Yep. If you think about it, there are whole companies and industries that couldn't exist a decade ago without today's modern payment infrastructure. It's become central to businesses with modern product experiences like ride-sharing, the creator economy, or B2B use cases like SaaS marketplaces or managing supplier relationships. For those types of companies, payments literally is their business.
Acquired
Novo Nordisk (Ozempic)
Yet, thankfully, they don't need to go it alone. J.P. Morgan Payments has been pioneering in this industry for decades. I mean, they're J.P. Morgan. They move $10 trillion a day. Yes, that is trillion with a T. And you can literally never outgrow their capabilities.
Acquired
Novo Nordisk (Ozempic)
Like we said for us at Acquired, the peace of mind of having a single innovative banking and payments partner for the long term is pretty powerful.
Acquired
Novo Nordisk (Ozempic)
So if you're a company or a provider trying to innovate in this space, getting the payments piece right is paramount, which is why J.P. Morgan Payment's array of products, including their healthcare solutions...
Acquired
Novo Nordisk (Ozempic)
and Instamed offering provides a patented cloud-based technology to securely transform healthcare payments by driving electronic transactions, processing payments, and moving healthcare data seamlessly. JPMorgan Payments believes that no matter where your business falls on the care continuum, better payments can help healthcare companies deliver better care.
Acquired
Novo Nordisk (Ozempic)
So the Lion Chemical Factory at this point has established a new production line for insulin. But it's unclear, do they own this production line? Did the Crows? Does Hagedorn? Is the University of Toronto involved? Crow and Hagedorn are sort of consulting on it.
Acquired
Novo Nordisk (Ozempic)
When Hagedorn makes this decision to go full-time, what actually happens is he becomes an employee of Lion Chemical, which isn't really what he wants. August Crow steps back, and he returns to his other research at the University of Copenhagen. But once insulin starts rolling off the line later that summer, under the brand name Insulin Leo, like Lion Chemical Factory, they use the brand name.
Acquired
Novo Nordisk (Ozempic)
And that would continue to be Nordisk's insulin brand name for the next 60 years, I think.
Acquired
Novo Nordisk (Ozempic)
Pretty quickly, demand is just off the charts. And they are, like we talked about, essentially the first mover in continental Europe. So there's a pretty enormous opportunity here. So in 1924, Crow, Hagedorn, and Kongstead, who owns Lion Chemical, they all come to an agreement.
Acquired
Novo Nordisk (Ozempic)
They're going to set up a new independent and self-owning institution to produce and distribute this insulin throughout Europe.
Acquired
Novo Nordisk (Ozempic)
Still not a company. Because other than Kongstead from Lion Chemical, Crow and even Hagedorn at this point, they're not particularly commercially minded. Right.
Acquired
Novo Nordisk (Ozempic)
Yes. So what they do is they set it up as an operating company because that's what they have to do to have employees and make sales and whatnot. But this operating company is 100% owned and controlled by a foundation that they also set up. And the three of them are going to be board members of this foundation. And Hagedorn is going to run it day to day.
Acquired
Novo Nordisk (Ozempic)
And as we'll see, that's just the tip of the iceberg. I mean, this company is 100 years old. The history goes way back and is way more interesting than I think just about anybody knows.
Acquired
Novo Nordisk (Ozempic)
And foreshadowing, there is a moment much later in history where absent the control of this foundation, Novo Nordisk would have ceased to exist. It is only because of this structure. that Novo Nordisk survived and that we have GLP-1s and everything we have today.
Acquired
Novo Nordisk (Ozempic)
Well, I dug into this a little bit. So yes, this is a very common structure in Denmark. mostly for tax reasons, because Denmark has very, very high taxes. So this is a common like generational transfer mechanism. And Novo later, we'll talk about Novo in a sec. Novo actually has this type of structure that you're talking about. The Nordisk Foundation is not just like a foundation of convenience.
Acquired
Novo Nordisk (Ozempic)
It really is like a charitable foundation with a dual mission. So they give it two missions. The first mission is to produce insulin and sell it at cost in Scandinavia in the original kind of territory mandate in order to maximize access and kind of humanitarian public health benefit.
Acquired
Novo Nordisk (Ozempic)
B, though, export it elsewhere in Europe and around the world at market prices and use the profit from those exports to fund further diabetes research and development. So no profits allowed in Scandinavia. Profits are allowed from export activities.
Acquired
Novo Nordisk (Ozempic)
And then all of those profits, literally by contract, get shipped 100% to the foundation to then be used for grants and research about diabetes and supporting diabetes patients in Scandinavia. Fascinating.
Acquired
Novo Nordisk (Ozempic)
Totally fascinating. And, you know, more or less, as you said, that is the same mission and structure that is still in place today. It's obviously changed a little bit.
Acquired
Novo Nordisk (Ozempic)
Yes. The operating company is now publicly traded, but still that foundation controls 77% of the voting shares of Novo Nordisk and 28% of the economic shares.
Acquired
Novo Nordisk (Ozempic)
Yes. So the name that they choose for this new institution or really dual institution is, fittingly, Nordisk Insulin, which Nordisk in Danish means Nordic insulin. It's the insulin manufacturer for the Nordics. Very creative. Very creative. So, you know, you're listening here, you're probably like, okay, that's Nordisk. What's the novo piece of this?
Acquired
Novo Nordisk (Ozempic)
Well, it turns out that that is quite the story too, because among the very first employees of the insulin project, even before Nordisk gets created, are two brothers, Harold and Torvald Peterson. And the Petersons, you know, you got to remember the time we're in. They're sort of like prototypical 19-teens, 1920s kind of engineers and tinkerers.
Acquired
Novo Nordisk (Ozempic)
We're not that far removed from like the Wright brothers and Henry Ford and that kind of stuff here. They're like kind of cast from that mold. So the older brother, Harold, he had been working in August Crow's lab doing all the mechanical engineering stuff to carry out the experiments. Like, you know, you need to build devices and contraptions and set up experiments.
Acquired
Novo Nordisk (Ozempic)
And so Harold was in charge of doing that. Once the insulin project gets going, Harold naturally sort of shifts over and he's the one going out and building and buying and modifying like the meat grinders and figuring out how to pour hydrochloric acid over it in the right way and all that sort of stuff.
Acquired
Novo Nordisk (Ozempic)
When Lion Chemical gets involved and they're spinning up mass production, Harold goes to Hagedorn and August and Kongstead and says, hey, you're setting up an actual production line. I've got just the guy to help you set it up and run it, my brother, Torvald.
Acquired
Novo Nordisk (Ozempic)
Because not only is Torvald a seasoned factory operations manager who's currently running a large soy factory, he is also trained as a pharmacist and studied chemistry. He's like the perfectly qualified person to be like an early employee of this new operation. Except it turns out there's just one problem. Hagedorn thinks he's in charge.
Acquired
Novo Nordisk (Ozempic)
And Torvald, who's just been hired, thinks, hey, I know what I'm doing here. I'm in charge. Hagedorn, you're this pompous physician. What do you know about running a factory?
Acquired
Novo Nordisk (Ozempic)
Yes. In the first six months after Torvald is hired, he and Hagedorn, they're constantly fighting. One day they get into a huge, huge argument and Hagedorn fires him. Six months in. Guess we know who's in charge. Yeah. When that happens, Harold, the older brother, resigns in solidarity and they're super pissed.
Acquired
Novo Nordisk (Ozempic)
They go to see Crow and they're like, hey, August, I've been working for you for a while. Clearly, we know what we're doing here. Why is this happening? And Crowe sides with Hagedorn. He's like, no, no, he's my guy. He was Marie's physician. He's going to run this thing. So they say, well, all right, fine. You know, as you know, here in Denmark, you can't patent drugs.
Acquired
Novo Nordisk (Ozempic)
Oh, that's why this is important. We're just going to go down the street and make insulin too. And the legend has it that supposedly August looks at them and replies, but you're not capable of that. Oh. to which Torvald yells at him, we will show you.
Acquired
Novo Nordisk (Ozempic)
And they storm out of the building and go down the street and they found a new insulin company, a Novo insulin company there in Copenhagen, Insulin Novo. And that is the beginning of Novo. And for the next 65 years, these two companies would compete in blood sport, head to head, hated each other, absolutely hated each other until they finally merged in 1989.
Acquired
Novo Nordisk (Ozempic)
crazy yep now this is such a key part of the novo story that certainly you know crow but then hagadorn develops into this amazing scientist as we'll talk about the advances that nordisk is able to bring to market in the science of insulin and diabetes is huge but certainly without the like bitter competitive motivation from down the street i don't know that they would have moved as fast and you know novo ends up building its own scientific research capabilities and like
Acquired
Novo Nordisk (Ozempic)
these two companies in this unlikely small country in Northern Europe end up leading maybe the most important drug development of the 20th century.
Acquired
Novo Nordisk (Ozempic)
So I think it's worth a quick pause here. We've already talked about some of this, but just to clarify why diabetes and insulin is such an interesting market and large market potential. You know, one, even with just type 1 at this point in time, it's still a very large and widespread disease in the world. So it's kind of a large patient and potential patient market size.
Acquired
Novo Nordisk (Ozempic)
But two, unlike many other diseases and drugs for those diseases, it's chronic. You don't cure it. So what insulin is doing is it is enabling these diabetes patients, who often are diagnosed as children, to live essentially normal, long lives. So you're talking about...
Acquired
Novo Nordisk (Ozempic)
Decades, 40, 50, 60, 70, 80 years of patient lifespan here where they are injecting insulin daily, if not, you know, in most cases, multiple times daily.
Acquired
Novo Nordisk (Ozempic)
Yep. And there's also kind of another aspect that makes it particularly interesting commercially, which is there's also a motivation to constantly improve the insulin product. It's not like insulin is insulin is insulin, right? There are so many new products and improvements, both in the drug itself, but also in the delivery systems.
Acquired
Novo Nordisk (Ozempic)
I mean, this early insulin, as we've alluded to a little bit, it was barbaric by modern standards. Like, yes, it saved lives, but it didn't last very long. So you had to inject a lot of it very frequently. It wasn't super clean. There are tons of impurities in it. So there's swelling, there's infections. There's allergic reactions to all the impurities. Totally.
Acquired
Novo Nordisk (Ozempic)
It wasn't shelf-stable in liquid injectable form. This is wild. I don't know if you knew this, Ben. No. So everything we're talking about in these days and what Nordisk was originally producing were insulin tablets, solid insulin tablets, Now, until recent times, you can't take insulin in tablet form. It doesn't get absorbed by the gut. You have to inject it.
Acquired
Novo Nordisk (Ozempic)
So what patients had to do was take these solid tablets, dissolve them in sterilized boiled water, measure and draw that solution into a syringe themselves.
Acquired
Novo Nordisk (Ozempic)
Yeah, big-ass needle. And, you know, so now you've got patients doing this multiple times a day, And it's really important that they get the right amount of insulin for them. This makes it really hard.
Acquired
Novo Nordisk (Ozempic)
Totally. And actually, it's kind of a side note to the story, but it's Novo in the 1980s that invents the insulin pen.
Acquired
Novo Nordisk (Ozempic)
Yeah, Novo invented the pen and Nordisk focused on pumps. And they were one of several companies, but one of the leading companies innovating in pumps. I see.
Acquired
Novo Nordisk (Ozempic)
I'm quite certain that almost everybody listening right now either is diabetic themselves or has a close family member who is.
Acquired
Novo Nordisk (Ozempic)
We also weren't really designed to, you know, live this long either.
Acquired
Novo Nordisk (Ozempic)
Yeah, we'll be talking about them in depth later in the episode, but we've known JP Morgan for a long time. We both personally bank with them, as does Acquired, but we really uncovered the breadth of JP Morgan payments as we went deep into our industry research for our Visa episode last year.
Acquired
Novo Nordisk (Ozempic)
So when Novo gets established, this starts the competitive race that really leads to 100 years of R&D pipeline that changes all this. So the Peterson brothers, they know right off the bat, they can't really just go clone what Nordisk is doing. I mean, technically, legally, they can in Denmark.
Acquired
Novo Nordisk (Ozempic)
But what physician and what patients are going to buy Novo insulin when right down the street, you've got Nordisk, which has a Nobel Prize winning scientist. the best diabetes endocrinologist in Denmark running it, and the explicit blessing of Toronto and the Insulin Committee. If Novo just sells the same thing, nobody's going to buy that. Right. But...
Acquired
Novo Nordisk (Ozempic)
they do have a pretty significant advantage that Nordisk doesn't have, which is they've got their engineering and tinkering skills. So they go to work and pretty quickly, actually, they come up with shelf-stable liquid insulin. So what I was just talking about, about how Nordisk produced these tablets, you had to boil them. Novo comes out with liquid insulin. You don't have to do that.
Acquired
Novo Nordisk (Ozempic)
Not only that, because the process for producing liquid insulin that they come up with is so much more efficient, they can sell it effectively cheaper per dose than what Nordisk is selling their solid form as. So they go to market, Novo goes to market with their Novo insulin as insulin at half price because it's so much more efficient.
Acquired
Novo Nordisk (Ozempic)
Now, this is so antithetical to like the ivory tower scientists over at Nordisk. You're marketing insulin at half price. Does this liquid stuff work? And is this safe? And all this stuff. The Peterson brothers are like, yeah, whatever, you know, we're going to crush you.
Acquired
Novo Nordisk (Ozempic)
Yes. So then Nordisk strikes back with a new, longer-lasting form of insulin called protamine insulin, or NPH, as it is patented and come to be known around the world, which stands for neutral protamine hagadorn.
Acquired
Novo Nordisk (Ozempic)
Because H.C. Hagedorn, he himself led the research developing this and he puts his own name on it. Kind of tells you what you need to know about him. This is much more stable and needs to be injected fewer times per day, which is a huge benefit for patients. So Nordisk, rather than building up production facilities around the world, what they decide to do is license it
Acquired
Novo Nordisk (Ozempic)
Just like how we say here on Acquired that every company has a story, every company's story is powered by payments. And JP Morgan Payments turns out to be a part of so many of our acquired companies journeys. And it's not just the Fortune 500. They're also helping companies grow from seed to IPO and beyond.
Acquired
Novo Nordisk (Ozempic)
back to basically any interested pharma company. So like Eli Lilly back in the States, other companies in continental Europe. It's the new widely accepted, most advanced treatment for patients. Except there's one company that they refuse to license it to. And that is Novo.
Acquired
Novo Nordisk (Ozempic)
So Novo, undeterred, they go and they work around Nordisk's patents on this. And again, I'm not sure at this point if the laws have changed and you can patent drugs in Denmark, but it kind of doesn't matter because it's clear Denmark is not a very large country. By far, the bulk of the market is in exports at this point. And certainly in other countries, you can patent drugs.
Acquired
Novo Nordisk (Ozempic)
So Novo works around Nordisk's patents, and they come out with an improved version of protamine insulin that they claim is both better and doesn't infringe on the patents.
Acquired
Novo Nordisk (Ozempic)
Yes. To your point though, it is still quite scientifically difficult. It's not like software here. We're like, yeah, yeah, yeah. I write some code and it's like, no, no, you still got to find a molecule that does what you say it does. Yep. So this leads to a whole bunch of lawsuits. It actually ends up going to the Danish Supreme Court where Hagedorn represents Nordisk himself.
Acquired
Novo Nordisk (Ozempic)
In the lower courts, they had lawyers and I think they lost the case in the lower courts and Hagedorn's like, Like, screw this. I'm going to be my own lawyer. At the Supreme Court. At the Supreme Court. Wow. Yeah. Amazing. And they win. Nordisk has won here. This is like a huge, huge blow for Novo, you would think. But then, literally right at the same time, World War II starts.
Acquired
Novo Nordisk (Ozempic)
And Denmark is invaded by the Nazis shortly after they invade Poland. And in April 1940, the Nazis now occupy Denmark again. So this sort of like infighting between these two Danish drug companies.
Acquired
Novo Nordisk (Ozempic)
Much, much less relevant. But what is still super relevant is how is Europe going to get insulin in the middle of World War II? And this is a major, major turning point, both for the two companies vis-a-vis each other, but also I think really what sets Europe Novo on the path to becoming Europe's dominant producer of insulin and then ultimately the dominant producer of insulin in the world.
Acquired
Novo Nordisk (Ozempic)
Well, so what happens is Denmark is relatively unscathed during World War II. It's a small country. The Danish army was quite small. And so when the invasion happens in April 1940, there's basically no fighting. Germany just takes over the country. I mean, there's no destruction. Which means that insulin production continues unabated in Denmark.
Acquired
Novo Nordisk (Ozempic)
Now, Nordisk, remember, like I just said, once NPH comes out, their strategy becomes really like we produce domestically and then we make our revenue and our profits internationally by licensing, not by production. And with World War II, you know, most of the dollars for their licensing revenue is coming from allied countries, right? Well, Germany just took over Denmark.
Acquired
Novo Nordisk (Ozempic)
So all of that revenue, all of those profits go to zero overnight. And Nordisk, for the duration of the war, basically just gets put into hibernation mode. They're still producing a little bit to help supply Denmark, but there's really nothing going on there.
Acquired
Novo Nordisk (Ozempic)
Yeah. Wow. Novo is the complete opposite story. They had been scaling production all throughout Scandinavia, all throughout Europe. And when Germany takes over Denmark, insulin Novo is now, you know, the ethics of this are really complicated.
Acquired
Novo Nordisk (Ozempic)
Yeah, they are now essentially the official Nazi-sanctioned insulin provider for all of Nazi-occupied Europe. So the German government basically directs Novo to massively expand production and supply insulin, you know, not only to Germany, but to France, to Poland, to Austria, to all, everywhere in continental Europe, basically. Yeah.
Acquired
Novo Nordisk (Ozempic)
Yes. Now, they're fine. They can get insulin, no problem, because Nordisk has licensed all the technology and production to them. They just keep doing that. The only problem is for Nordisk that Nordisk can no longer get the payments from them because obviously, you know, transfer payments from allied countries are now blocked. Right. Fascinating. Totally fascinating.
Acquired
Novo Nordisk (Ozempic)
Well, we start in 1921, over 100 years ago, in Toronto, Canada, with the discovery and extraction of the pancreatic hormone insulin by a laboratory group at the university of toronto medical school insulin of course as most of you know regulates the absorption of glucose from the blood into the body and it's the main anabolic hormone in most if not all animals in the world
Acquired
Novo Nordisk (Ozempic)
So again, we said the ethics of this are quite complicated. There is no doubt that Novo's fortunes massively changed and expanded by the German occupation and the Nazis during the war. On the other hand, literally the Nazis ordered them to expand production and provide insulin for Europe. And like if they hadn't done it, all the diabetics in Europe would have died.
Acquired
Novo Nordisk (Ozempic)
Right, right. I definitely agree. It is important to note, though, after the war, the Danish state did require both Novo and the Peterson brothers personally to repay most of the profits that they made during the war back to the Danish state. Fascinating. Again, like the ethics are complicated here. Very. Yeah. Wow. Yeah.
Acquired
Novo Nordisk (Ozempic)
So regardless, after the war, Novo emerges as now both a scaled pharmaceutical company generally and the largest producer of insulin in Europe. And as part of that now, they have the resources to really build up their own scientific and R&D divisions and become a real powerhouse to rival what Nordisk was before the war.
Acquired
Novo Nordisk (Ozempic)
Shortly after the war ends, they develop a new product called Lente insulin, L-E-N-T-E, which is slower-acting insulin, which means it's thus longer-lasting. And this can now be used for diabetics as a basal or background insulin. So they'll still take fast-acting insulin around meals to help process blood sugar from meals, but...
Acquired
Novo Nordisk (Ozempic)
A normal human pancreas is also producing insulin 24-7 throughout the day. This now is a new background insulin that diabetics can take to help stabilize when you're sleeping or not eating.
Acquired
Novo Nordisk (Ozempic)
Yeah, hopefully it's obvious, but like this isn't quite like software. It's like, oh, just you add some new code and you ship a new feature. It's like, no, this is very complicated stuff and you got to make sure that the side effects are not going to kill people. So this is really the first major scientific advance that comes out of Novo. And Eli Lilly licenses this lentil insulin program.
Acquired
Novo Nordisk (Ozempic)
from Novo and kind of rebrands it and makes it part of their flagship insulin offerings in the US. They were doing this with NPH insulin before the war from Nordisk. And now, you know, it's kind of Novo that's taking up this mantle. You know, this will come back up later in the episode.
Acquired
Novo Nordisk (Ozempic)
But Eli Lilly, although insulin was and still is a huge part of the business, what they basically decided is to be a kind of technology follower and license from all the innovation coming out of Novo and Nordisk, license that into their sales and distribution channels in the U.S.,
Acquired
Novo Nordisk (Ozempic)
Yeah. Well, that is going to change in a big way in the 1980s, but during this post-war period, At least that's how Kurt Jacobson's book makes it sound. And we got to give Kurt a big shout out. And he wrote this great history of Novo Nordisk that just came out last year for the company's 100th anniversary. Unfortunately, you can't buy it in America.
Acquired
Novo Nordisk (Ozempic)
So I emailed him a couple months ago and I said, Kurt, is there any way we could buy a copy of your book? And very, very graciously, he just sent it to us. So very, very kind. Thank you, Kurt. Yep. So this is basically the way things stay for the post-war era up until the 1980s.
Acquired
Novo Nordisk (Ozempic)
Insufficient insulin production in the body, of course, leads to the disease diabetes. So this group, if you could call it that, at the University of Toronto, is comprised of the physician Frederick Banting and the medical student, his assistant, Charles Best, along with a chemist and the head of the laboratory there and assistant medical school dean John McLeod.
Acquired
Novo Nordisk (Ozempic)
Novo follows up Lenta insulin in the 1970s with MC insulin or non-immunogen monocomponent insulin, which is the first 100% pure zero antibody potential insulin. That also becomes the kind of new widely accepted best product in the market internationally. So this is the general state of play after the war. Novo is now a scaled pharmaceutical company. Nordisk is mostly in rough shape.
Acquired
Novo Nordisk (Ozempic)
Production capacity has gone down to basically zero, minimal at this point in time. They have resumed the licensing business, and eventually they do get back payments from all the allied countries that they were owed during the war. So, you know, they're not like insolvent or anything, but they're the much, much smaller company.
Acquired
Novo Nordisk (Ozempic)
Now, Novo, interestingly, they're now a large pharmaceutical company. They want to add a second leg of the stool, a new business line. So they get into the enzymes business. This is like laundry detergent enzymes and other industrial uses. They add that on alongside the insulin and diabetes business.
Acquired
Novo Nordisk (Ozempic)
And, you know, that's all well and good to be a diversified, you know, industrial conglomerate, except the enzyme business is both capital intensive and not that profitable. Those don't mix well. Yeah, those don't tend to mix well. Now, it's still a viable business. It actually stays part of Novo and then Novo Nordisk all the way until the year 2000 when it gets spun out. Oh, is this Novozymes?
Acquired
Novo Nordisk (Ozempic)
This is Novozymes, yes. It is still majority controlled by Novo Holdings, which is the holding company of the Novo Nordisk Foundation.
Acquired
Novo Nordisk (Ozempic)
Novozymes as well. But when we get to the 1970s, right as MC insulin is coming online and Novo needs to undertake a huge amount of CapEx to redo its production lines and expand them around the world, the enzyme market crashes. And so this enzyme business that they tried to add as like a diversification and hedge to the company and expansion, all of a sudden it's bleeding cash.
Acquired
Novo Nordisk (Ozempic)
And they don't have enough capital resources to do the CapEx upgrades that they need for the main business in insulin.
Acquired
Novo Nordisk (Ozempic)
Goodness, if only there were such a natural partner right down the street that, you know, it might make sense maybe they could merge with CapEx. So here we are in the early 1970s. Novo approaches the old bitter rival Nordisk. And here's the situation. You know, this is a perfect marriage. Let's get the band back together. You know, everybody's basically dead at this point from the original days.
Acquired
Novo Nordisk (Ozempic)
Let's let bygones be bygones. And Nordisk, they've just gone through a pretty rocky succession period after Hagedorn retired. They're now on their third CEO in seven years. And the new CEO, Henry Brenham, he isn't from the pharma industry at all. He's not a scientist. He was previously the head of a lumber company. So this merger makes perfect sense. Huh.
Acquired
Novo Nordisk (Ozempic)
But they don't merge for another decade and a half. So what went wrong? It's not what happens. So instead, contrary to all sort of what you would think on paper... The new CEO, Brenham, actually turns out to be like an amazing leader and CEO. The lumber guy. For Nordisk. The lumber guy. Huh. He is like the wartime CEO for Nordisk. He rejects Novo's overtures to merge.
Acquired
Novo Nordisk (Ozempic)
Now, there's a whole bunch of controversy around who actually deserves credit for the discovery of insulin. The historical consensus at this point now being that it really was Banting and Best who did all the work. But nonetheless...
Acquired
Novo Nordisk (Ozempic)
And then he goes and convinces the board, both of the operating company Nordisk and the foundation, that this new MC insulin generation, which remember, Novo innovated. that this actually represents a golden opportunity for Nordisk to get back in the game. Because it's going to be a complete reset of all the insulins on the market, whether they're fast-acting or long-lasting insulins.
Acquired
Novo Nordisk (Ozempic)
They're all going to move over to this MC, highly purified method and type of insulin. But... Novo's in this spot where they're going to be delayed for several years in making the transition in their actual factories because they don't have the CapEx.
Acquired
Novo Nordisk (Ozempic)
So Branham convinces the board that rather than merging, they should use their capital reserves to rebuild up Nordisk's own production capacity, go hire a global sales force. Branham, he's really ambitious. He says, we're going to go enter America directly as this forgotten Nordisk company. So he goes and hires a global sales force
Acquired
Novo Nordisk (Ozempic)
Because he knows Eli Lilly is going to have the same dynamics as Novo. Everything's going to have to shift over to MC, and Eli Lilly's this big, large, diversified giant. They're not going to move as fast as he thinks Nordisk can. And even though it's unrealistic that Nordisk is going to overtake Eli Lilly in America... If they can get even a small percentage of the American market, that's huge.
Acquired
Novo Nordisk (Ozempic)
Nordisk is a small company, and America is by far the largest market for diabetes in the world.
Acquired
Novo Nordisk (Ozempic)
Two years later, when the Nobel Committee awards them the 1923 Nobel Prize in Physiology or Medicine for the discovery of insulin, it is Banting and McLeod who get the award. Not best. This will come back up in a minute.
Acquired
Novo Nordisk (Ozempic)
Yeah, this is the right window. So... I don't know how Brenham convinced both boards to do this, but he does. And like, by God, he's right. It works. So for the entire decade of the 1970s, Nordisk's sales grow at 30% compounded annually, which is amazing. Wow. Now they're still small. So by 1980...
Acquired
Novo Nordisk (Ozempic)
Nordisk is still only about one-tenth the size of Novo overall, but they're a third the size of Novo's insulin business. And they've moved from being this licensing company to now an actual production company with capacity all around the world. So this is a huge win from, like, basically they were going to be taken over for cash by their old rivals, and now they're back in the game.
Acquired
Novo Nordisk (Ozempic)
So Novo, in response, they need to do something to get capital. They actually do a small IPO on the Copenhagen Stock Exchange in 1974 to raise the capital they need for the transition to MC Insulin. So by the time we get to 1980, and just to set some scale here, Novo's annual global insulin sales, this is Novo, they're still much larger.
Acquired
Novo Nordisk (Ozempic)
They're about $100 million annually, and Nordisk's are about $30 million annually. That makes them the number two and number four producers in the world by market share behind Eli Lilly in America, who's first with about 160 million in sales.
Acquired
Novo Nordisk (Ozempic)
And this is exactly my point. So you might be wondering, like, wait a minute. If you add all that up, the whole global insulin market is about half a billion dollars here in 1980. And that's crazy. Not exactly tiny, and like you were saying, you know, the drug markets themselves weren't that huge back in this era.
Acquired
Novo Nordisk (Ozempic)
But what is the path from here to Novo Nordisk today being the 15th largest company in the world? Like, what gives? What happened?
Acquired
Novo Nordisk (Ozempic)
Yes. The answer is, one, what you just said, we all got fat and the diabetes market and specifically type 2 diabetes exploded. But two, and this is going to be such a fun story to tell here on Acquired because it's a huge part of Silicon Valley history that we've never touched.
Acquired
Novo Nordisk (Ozempic)
Two, Genentech happened. Oh, yes. Which totally revolutionized everything, launched the biotech market, made drug development and production vastly more scalable, and it all...
Acquired
Novo Nordisk (Ozempic)
Yeah, I mean, ServiceNow has outperformed almost every enterprise software company over the past five years, including Microsoft.
Acquired
Novo Nordisk (Ozempic)
Yeah, we waved hi when we were there to hang out with Jensen. So ServiceNow was started in 2003 by Fred Luddy. And Fred, kind of like August Crowe starting Nordisk, was already the equivalent of a Nobel Prize winning software developer and founder. He dropped out of college in 1970.
Acquired
Novo Nordisk (Ozempic)
totally and he started programming and ultimately built a four billion dollar company as cto he really was part of that original technical crew like waz and others that formed the backbone of silicon valley But all the way back when he first started in the industry at age 17, Fred wrote a simple little program for an order clerk named Phyllis.
Acquired
Novo Nordisk (Ozempic)
Now, this was when he was working at a company that fulfilled building materials orders. And Phyllis spent all day just typing up the orders on these forms. So one night, as a favor, Fred wrote a program that automated it. 80% of each form got filled in automatically. Phyllis comes in the next morning, Fred shows it to her, and she breaks down crying.
Acquired
Novo Nordisk (Ozempic)
He took this incredibly soul-crushing, mind-numbing task that she hated and made it 80% easier, 80% faster, and 100% less soul-crushing.
Acquired
Novo Nordisk (Ozempic)
It's an incredible story. So if you wanna learn more about ServiceNow and connect with the team, go on over to servicenow.com slash acquired. And when you get in touch, just tell them that Ben and David sent you.
Acquired
Novo Nordisk (Ozempic)
Correct. And just to put some numbers on that, the number of type 2 diabetes patients quadruples from 1980 to 2016.
Acquired
Novo Nordisk (Ozempic)
Yes. And specifically what that meant using animals to make insulin was that type two was not treated with insulin. And actually until this point in time, type two used to be called quote non-insulin dependent diabetes because you didn't treat it with insulin because there wasn't enough insulin. There weren't enough animal pancreases in the world to do it.
Acquired
Novo Nordisk (Ozempic)
And it wasn't necessarily that insulin didn't help type two. I mean, lots and lots of type two diabetics these days use insulin. It was that there just wasn't enough of it. Wow. And then in 1980, Genentech and Eli Lilly, as their partner, changed everything with recombinant DNA and genetic engineering of drugs. And I suspect many people don't know this.
Acquired
Novo Nordisk (Ozempic)
I sort of vaguely knew this before researching the episode, but the first drug that that they genetically engineered and that started this whole revolution was insulin.
Acquired
Novo Nordisk (Ozempic)
Yes, because you couldn't really extract human insulin from, you know, humans before this point. And people thought that human insulin would be a lot better to use than animal insulin. It turns out that that's debatable.
Acquired
Novo Nordisk (Ozempic)
Yes. But at the time, nobody really knew that. So in 1980, which is when Genentech and Eli Lilly announced their partnership together, that Eli Lilly is going to be the go-to-market partner for Genentech's new recombinant DNA bioengineering revolution, and they're going to make human insulin. They announced that in 1980. people go nuts and it triggers this race for human insulin.
Acquired
Novo Nordisk (Ozempic)
And Novo gets swept up in it. They're like, oh no, Eli Lilly, they're going to come back into the research game. They're going to innovate in product. We had the chance to work with Genentech. Genentech had actually approached them about being a partner in Europe. Novo had turned them down because they didn't think the science was ready yet and they were wrong.
Acquired
Novo Nordisk (Ozempic)
So they're like, shoot, we got to scramble. They find a team of Japanese researchers who have shown that you can actually chemically modify pig insulin to make it chemically identical to human insulin. What? Really? Yeah. You can't make this stuff up. So NOVA is like, great. We're going to race to market. We're going to beat Eli Lilly with human insulin.
Acquired
Novo Nordisk (Ozempic)
It's not going to be genetically engineered, but... We're just going to take our pig insulin and modify it. It turns out to be a huge boondoggle. You know, it works, but it's not any better than pig insulin. So it's a big flop for Novo.
Acquired
Novo Nordisk (Ozempic)
Well, it's funny you say that. So when the Genentech and Eli Lilly announcement happened in 1980, I mean, truly, this was a bombshell. It's hard to remember now. I mean, we weren't even alive, but this was one of, if not the most important announcement to come out of Silicon Valley ever still to this day. Investors went nuts.
Acquired
Novo Nordisk (Ozempic)
Anything that even you could squint and look like a biotech was suddenly the hottest thing in the world. So Genentech goes public in the fall of 1980. This is well before Humulin, the product that they create with Eli Lilly, comes on the market. They go public, and it is, I believe, the largest venture-backed IPO ever at that time, until it's eclipsed two months later when Apple goes public.
Acquired
Novo Nordisk (Ozempic)
But investors are just mad for biotech companies. So when Novo announces that they're going to be first to market with human insulin... And like, yeah, yeah, just ignore that it's actually pig insulin that we're modifying. They use the hype on the back of that to do a US IPO with Goldman Sachs and raise $100 million. When your currency is expensive, sell it. right?
Acquired
Novo Nordisk (Ozempic)
There are a number of analogies that we could make from the past few years that I'll refrain from here. So as you say, is this a nail in the coffin for Novo? You know, I mean, it's not good for the underlying business. Nordisk, meanwhile, remember, they're in the midst of this aggressive expansion plan and scaling based on MC insulin.
Acquired
Novo Nordisk (Ozempic)
They're like, you know, I don't know that human insulin in and of itself is is all that much more effective. We're going to take a wait and see approach. We are going to invest in building up our recombinant DNA and genetic engineering capabilities because it's clear the whole industry is moving this way for production reasons, if nothing else. And Novo is doing this too in the background.
Acquired
Novo Nordisk (Ozempic)
But Nordisk, like, we're not going to get caught up in the specifically human insulin hype. And this really works out for them. So in 1984, Nordisk passes the German company Hocht to become the number three global player in insulin. Hocht, I think that's how you say it. Today is part of Sanofi, the large international pharma conglomerate.
Acquired
Novo Nordisk (Ozempic)
I mean, we can't overstate how important this was and how terrible, awful diabetes was. I mean, it was truly a death sentence. That treatment that you were referring to, that was the official American and globally accepted treatment for diabetes. It was literally called the starvation diet. And it was just attempt to prolong your life as long as possible.
Acquired
Novo Nordisk (Ozempic)
Yep. So 1984, Nordisk passes them. On the back of that, they do their own share listing on the Copenhagen Stock Exchange. So they change the structure of the operating company and still the foundation controls the majority of the votes. But for the first time, outside investors can hold shares in the operating company of Nordisk.
Acquired
Novo Nordisk (Ozempic)
And by the end of the 1980s, Nordisk is now up to 20% global market share in insulin. And that's really all come at the expense of Novo, which is down to 30% global market share. Whoa, so they're close to matching them. Yeah, they're pretty close. And this brings us finally...
Acquired
Novo Nordisk (Ozempic)
to the summer of 1988, when merger discussions begin for real between these two companies, now on much more equal footing than the last time. Interesting. And this time, there actually is a really compelling reason for both of them to merge and combine scale, which wasn't true before when it was really just like, hey, Novo had a problem and needed cash.
Acquired
Novo Nordisk (Ozempic)
Now, with genetic engineering and the way the whole industry is headed, scale is becoming much more important. It takes huge capex to do this stuff.
Acquired
Novo Nordisk (Ozempic)
And a big part of it is the production and infrastructure side of things. But the other part is the go to market. Pharma kind of almost becomes like the enterprise software industry. Like at the end of the day, there only are a few companies at scale that have the infrastructure and the go to market to operate.
Acquired
Novo Nordisk (Ozempic)
And like, yes, you can build a big company on top of or underneath Microsoft or Oracle or Amazon or Salesforce or Google, but they're the ones with the infrastructure. They're the ones with the channels.
Acquired
Novo Nordisk (Ozempic)
But like you are going to die unless a treatment is found. So, you know, when we say that this group won the Nobel Prize in 1923, this isn't just like a Nobel Prize. This is one of, if not the most important advance in like all of modern medicine that they're discovering here.
Acquired
Novo Nordisk (Ozempic)
Wow. Wait, so who gets the rebates? Is it the PBMs themselves or the consumers?
Acquired
Novo Nordisk (Ozempic)
Yep. All right. So what did Bantig and Best do? So scientists had known, even going back to the 1800s, that diabetes was caused by the misfunctioning of some type of hormone that was created in the pancreas. But until Toronto, nobody had been able to actually isolate what that hormone was, let alone extract it.
Acquired
Novo Nordisk (Ozempic)
So bringing it back to when the Novo Nordisk merger finally happens, this is the background on the go-to-market side, at least in the US. And then there's also the background on the infrastructure side, thanks to genetic engineering, where scale now really matters. And both companies are now on much more of an even footing. Yeah. So in January, 1989, the Novo Nordisk merger is finally announced.
Acquired
Novo Nordisk (Ozempic)
And it's a dual merger of both the operating companies and their respective foundations. So the two foundations merged into one and the two operating companies merged into one as well. And I had to dig a bit to figure out the exact economic splits. I believe that the final ratio was 62% Novo and 38% Nordisk. So Novo was still the kind of larger majority institution here, but...
Acquired
Novo Nordisk (Ozempic)
This is a far cry from when discussions first started 10 years ago and Nordisk was this little, you know, hey, we're buying you for cash, essentially. No, now it's like this is really a 60-40 merger.
Acquired
Novo Nordisk (Ozempic)
Yeah, wild. And they drove each other to create all of this innovation over the years. So the new combined company has roughly a billion dollars in insulin revenue and 50%, 5-0% global market share, with Eli Lilly just behind at 45% and Hosted at 5%. That kind of tells you right there how much the market has grown just during the decade of the 1980s.
Acquired
Novo Nordisk (Ozempic)
You know, that puts the total market size at roughly around $2 billion for insulin. Ten years ago, the total market size was $500 million. Wow. Yeah. Wow. The Enzyme and other businesses within Novo, they stay with the company for now. They would get spun out later in the year 2000. And that contributes another roughly half a billion in revenue, but with lower margins, as we talked about.
Acquired
Novo Nordisk (Ozempic)
The Novo CEO and Henry Brenham from the Nordisk side, they remain as co-CEOs for the next couple years. And Brenham notes that they are still a dwarf compared to the increasingly consolidated pharma market out there. But we are, quote, a specialized dwarf that will probably create a certain furor on the global stage.
Acquired
Novo Nordisk (Ozempic)
And what they're referencing here is, as we were talking about, this is the era when just huge pharma mergers start happening. So Glaxo and Welcome merge around this time. Astra and Zeneca merge around this time. Sanofi buys Horsch. You know, these are all multi, multi-billion dollar, tens of billions of dollar transactions that makes Novo and Nordisk look...
Acquired
Novo Nordisk (Ozempic)
Kind of like small potatoes at the time. And actually, Wall Street and the investment community believes that this is really just the first step, that this is Novo and Nordisk and the leading insulin business in the world sort of preparing itself for a further merger or sale into one of these new diversified global pharma conglomerates.
Acquired
Novo Nordisk (Ozempic)
And actually, this is crazy to think about in retrospect, but Novo Nordisk management agrees with that. That's actually their plan. Like, there's no rush here, but they think that they do need to merge into a larger organization.
Acquired
Novo Nordisk (Ozempic)
Yes. Basically, all throughout the decade of the 1990s and into the 2000s, management is in constant merger or sale negotiations with one of these big pharma giants or another. And kind of luckily, none of them come to fruition. And in the meantime, without anyone including them really noticing...
Acquired
Novo Nordisk (Ozempic)
the combined company just keeps compounding on these tailwinds of the expansion of the insulin market and insulin treatment of type 2 diabetics and all the supply that's unleashed by genetic engineering. So revenue and profit compound again at like 20%, sometimes 20% plus annually for like 15 years there. They're firing on all cylinders. In the year 2000, they signed a huge deal with Walmart.
Acquired
Novo Nordisk (Ozempic)
They land a supply agreement with the VA hospital system for the first time, the Veterans Affairs Hospital System in the U.S., which is enormous. And so by the end of 2003, annual revenue for the company is now over $4 billion. And that's pretty much just on insulin alone. Remember, they've spun out Novozymes. All the subscale pharma businesses that Novo had are all gone.
Acquired
Novo Nordisk (Ozempic)
And that's when management finally decides to sell the company. So in 2004, they have a deal on the table to combine with the Swiss company Sirono. Management is bought in. They've got the operating company board bought in. They're ready to do it. They just need to go get approval from the foundation board.
Acquired
Novo Nordisk (Ozempic)
So by experimenting with dogs and dog pancreases, they're able to extract something that comes to be known as insulin. And not only extract it, they then experiment with it and inject it into human diabetes patients who are at severe end-of-life stages. And miracle, the human body is able to use this extract from dog pancreases. And these patients have miraculous results. recoveries.
Acquired
Novo Nordisk (Ozempic)
But... There's never been a conflict between the foundation board and the management board. Everybody's always been aligned here.
Acquired
Novo Nordisk (Ozempic)
Yes. And there's a clause in the foundation's agreement with the company saying, that there must be a, quote, convincing business argument from the company's board of directors to the foundation board of directors that any merger or sale is a necessary precondition for the business to maintain and expand its position as a competitive business at the international level.
Acquired
Novo Nordisk (Ozempic)
Now in management's eyes, like we've just been talking about, there's so much consolidation happening in the industry. Of course it is a necessary precondition given everything going on that we need to get to a larger scale. And so that's why we have, after 10 plus years, finally found the right deal.
Acquired
Novo Nordisk (Ozempic)
So they go to the foundation board expecting that everybody's going to see the light and just agree here. And the foundation board is like, Yeah. I mean, I hear what you're saying, but have you looked at our revenue and profit growth over the last 15 years? Are you really telling me that we need to do this in order to maintain and expand our position as a competitive business?
Acquired
Novo Nordisk (Ozempic)
Are you really, really telling me that? And management's like, yes. Yes. Isn't this what we've been working to? Why did we spin off the enzyme business? Why did we do all this if we weren't just preparing for a sale? And the foundation board is like, uh, how about you come in and present to us with your financial advisors?
Acquired
Novo Nordisk (Ozempic)
Oh, my daughter loves to say when something doesn't go her way these days, she says, not working. Foundation board is like, not working. So what ensues, management comes in, they present in two board meetings, first in August 2004, and then a second one in September. where they get a do-over and they fail to convince the foundation board. So they block the merger.
Acquired
Novo Nordisk (Ozempic)
This is like the opposite of what happened at OpenAI, where like the foundation here is saying like, no, you must continue as an independent commercial entity.
Acquired
Novo Nordisk (Ozempic)
Absolutely. 100% chance. If this ownership structure were not in place, we would not be doing this episode today.
Acquired
Novo Nordisk (Ozempic)
That didn't happen here, which turns out to be, unbeknownst to pretty much anyone at the time, and I'm sure not even the foundation board, a very prescient decision to Because there is a small group of researchers within Novo Nordisk, led by a woman named Latte Bjerre Knudsen, who is working on a pretty incredible project that is showing a lot of promise. And that would be GLP-1 agonist drugs.
Acquired
Novo Nordisk (Ozempic)
That it is. But I'm pretty sure many of you know what that term means. Or even if you don't, you've probably heard the marketing names for the current class of those drugs that Novo Nordisk has on the market, which would be Ozempic and Wegavy.
Acquired
Novo Nordisk (Ozempic)
It's the perfect example of a quote we talk about all the time on Acquired, Jeff Bezos' maxim to focus only on what makes your beer actually taste better. In other words, spend your time and resources only on what's actually going to move the needle for your product and your customers and outsource everything else that doesn't.
Acquired
Novo Nordisk (Ozempic)
Vanta and security compliance and trust management is this to a T. Every company needs it, especially every company operating in healthcare, and it plays a major role in enabling revenue because customers and partners demand it, but yet it adds zero flavor to your actual product.
Acquired
Novo Nordisk (Ozempic)
And it makes these otherwise static, point-in-time security reviews dynamic, so you can monitor your security posture in real time and share it with your customers and partners.
Acquired
Novo Nordisk (Ozempic)
Well, it really is the story of Lotte Bjerre Knudsen. She started at Novo in 1989, the same year the merger happened, right out of undergrad as a scientist, actually in the enzyme division, which I didn't realize until you sent me an article last night, I think, about this.
Acquired
Novo Nordisk (Ozempic)
Yeah, super cool. We'll link to it in the sources. Yep. So eventually, after a couple years, she switches from the enzyme division to the diabetes business. And specifically, remember, this is not long after the genetic engineering revolution has happened. She gets put on the team that is screening new potential compounds that they could create for treatment of type 2 diabetes.
Acquired
Novo Nordisk (Ozempic)
Right around this same time, oral anti-diabetic medications are becoming a big thing in the market. So these are drugs like metformin. If you've ever heard of that, that's the most commonly used one for type 2 diabetics. They're kind of like the first line of defense for type 2 diabetes before you progress to insulin treatments. And Novo doesn't have a drug in this category.
Acquired
Novo Nordisk (Ozempic)
Despite being like the insulin leader, Novo and Novo Nordisk never had a viable oral anti-diabetic. So Lata's part of this group that's looking for new candidates.
Acquired
Novo Nordisk (Ozempic)
So, in the early to mid-90s, Lata starts digging into the academic research, and there's new work coming out that in type 2 patients, a big part of the mechanism that messes with actual insulin production is a hormone called glucagon-like peptide 1, or GLP-1, Ben, as you were talking about.
Acquired
Novo Nordisk (Ozempic)
And the thought is that if you could somehow get more GLP-1 into these patients' bodies, you could stabilize their insulin production and thus treat the disease. Seems pretty straightforward. You could imagine that you could now just use the same recombinant DNA techniques to genetically engineer more GLP-1, just like you engineer human insulin. No big deal.
Acquired
Novo Nordisk (Ozempic)
Right. No big deal. Except the problem is GLP-1 only stays active in your body for about five minutes before your body completely metabolizes it and breaks it down. So in a normal healthy person, you're just producing GLP-1 all the time and it's regulating your insulin production, etc. In type 2 diabetes, that gets disrupted.
Acquired
Novo Nordisk (Ozempic)
You can't just put more regular human GLP-1 in the body or it's going to go away immediately. So a whole lot of people across the industry kind of bang their heads against the wall. Nobody can figure out how to make this work. And the industry and the academic research community pretty much abandons it as a drug candidate. But Lata is like, if we could make it work.
Acquired
Novo Nordisk (Ozempic)
this would really, really help people and be a great drug. So she faces a lot of pressure inside the company, outside the company. Why are you still hanging on to this? Why are you still pursuing this path? And then finally, a few years later in the mid nineties, management actually gives her an ultimatum. And they're like, you either need to crack this and get an actual drug candidate or
Acquired
Novo Nordisk (Ozempic)
in the pipeline within a year, or we're going to shut down this whole program. And remember, this is even like Novo Nordisk, the world-class most focused on pure play diabetes research company in the world. And even they are like, yeah, we're almost ready to abandon this whole thing. Crazy. What year is this? This is like 95, 96.
Acquired
Novo Nordisk (Ozempic)
Around that. So a few years with nothing to show for it. Yep. So she keeps tweaking the GLP-1 molecule. And again, you can do this with recombinant DNA. You can tweak any molecule. So eventually she develops a GLP-1 analog, analog being, you know, similar type molecule called liraglutide that includes a fatty acid grafted onto the molecule that helps prevent the body from breaking it down.
Acquired
Novo Nordisk (Ozempic)
And importantly, this new insulin substance, while it is a miracle, it's not a cure. Injecting patients with it doesn't magically like restart production of insulin in their own pancreases or cure the disease. It only works until your body uses it all up. which is pretty quickly. So these diabetes patients, they finally have a new lease on life, but it's kind of also just that, like a lease.
Acquired
Novo Nordisk (Ozempic)
And this is the big breakthrough. Lyra Glutide ends up having a half-life in the human body of 13 hours compared to, you know, like a half-life of two and a half minutes for straight-up GLP-1. That'll help. Yeah. That satisfies management's ultimatum.
Acquired
Novo Nordisk (Ozempic)
Yeah. And I think that's how she phrases it too, when she describes it as protecting the molecule.
Acquired
Novo Nordisk (Ozempic)
Yeah. Well, I mean, eventually. But now here's the thing with this stuff. to get a whole new class of drugs to market takes a really long time. So this is a big breakthrough, kind of 97-ish timeframe. But, you know, Nova's like, great, we're going to invest in this. This is promising. We'll see in a decade if we can get this to market.
Acquired
Novo Nordisk (Ozempic)
So they start the clinical trial path first with animal trials for several years, then many phases of human trials, et cetera. And that brings us to 2005. When the world's first GLP-1 analog drug finally comes to market for the treatment of type 2 diabetes, of course, I'm talking about the world-famous, well-known, Bayeta from Eli Lilly.
Acquired
Novo Nordisk (Ozempic)
not Ozempic, not Victoza, not Wagavy, something completely different. This might be the most random occurrence that we've ever had on Acquired.
Acquired
Novo Nordisk (Ozempic)
Knowing this context, I would actually say yes. An actual lizard. Is that where you're going? Yes. Yes. Okay, great. So during this time, in parallel to Lata's work at Novo, two American researchers in the VA hospital system, the Veterans Affairs hospital system. Government employees.
Acquired
Novo Nordisk (Ozempic)
Government employees somehow discovered that a hormone contained in the venom of the Gila monster lizard, literally the lizard called the Gila monster, which has poisonous venom. One of the hormones in its venom was, Also was a GLP-1 analog, acted similarly to GLP-1 in the body, and didn't break down within five minutes.
Acquired
Novo Nordisk (Ozempic)
Ooh. Well, I know one of the scientists at the VA was a guy named John Eng, and I believe he was at the VA hospital in the Bronx.
Acquired
Novo Nordisk (Ozempic)
In order for them to survive, they need to regularly inject an appropriate amount of insulin. And by regular basis, especially in these early days, that's like every couple hours.
Acquired
Novo Nordisk (Ozempic)
The naturally occurring GLP-1 analog. Yes. As opposed to the engineered liraglutide. It actually does become a drug candidate. They license it to Eli Lilly. Eli Lilly develops it into Bayeta and Bayeta hits the market in 2005. It's FDA approved and it works. It's not poisonous. It doesn't kill people. And it is the world's first GLP-1 analog to come to market.
Acquired
Novo Nordisk (Ozempic)
But, like, it is effective, but it's not, like, overwhelmingly more effective than traditional anti-diabetic orals like metformin and the like. And, more importantly, the half-life is not as good as liraglutide. So, bieta requires two injections per day, which, you know, if you're a type 2 diabetic and you're not yet at insulin treatments...
Acquired
Novo Nordisk (Ozempic)
You're like, well, I could stick with oral antidiabetics like metformin. I could go try this new thing, but that's going to be two injections per day. Do I really want to do that versus stick with orals and then transition to insulin injections when I need it?
Acquired
Novo Nordisk (Ozempic)
So that's 2005. So then in 2007, Lata and Novo Nordisk's liraglutide GLP-1 agonist enters phase three human clinical trials.
Acquired
Novo Nordisk (Ozempic)
And my understanding is that most drugs never make it to phase three. And if you make it to phase three, that's like very promising. It's not automatic that you're going to get approved and it's going to work, but it's promising.
Acquired
Novo Nordisk (Ozempic)
But I guess if you look at the kind of lifetime risk of approval for a drug, by the time you make it to phase three, you're pretty far.
Acquired
Novo Nordisk (Ozempic)
Yep. Cool. Okay. So as they're in trials, and Novo knew this, but it's starting to get confirmed, that one, liraglutide is going to be more effective than bietta. Two, more importantly, it's only going to need to be injected once per day because the half-life is longer.
Acquired
Novo Nordisk (Ozempic)
And three, it's also now starting to be observed and confirmed in these human trials, something that Lotta had noticed all the way back in the animal trial phase, that rats who were injected with very large amounts of liraglutide would stop eating. And it seemed to have an effect on appetite.
Acquired
Novo Nordisk (Ozempic)
And if these rats had very large amounts of it, they would literally starve themselves to death and refuse to eat. And this effect is persisting in humans here in the phase three trials.
Acquired
Novo Nordisk (Ozempic)
But nonetheless, it's a pretty interesting thread to pull on, especially because many other anti-diabetic drugs up until this point had actually caused patients to gain weight.
Acquired
Novo Nordisk (Ozempic)
Right. So Lada and her R&D team, they push Novo Nordisk to consider also pursuing a parallel FDA approval and commercialization path for the same molecule, liraglutide, as a weight management drug based on this evidence that they're seeing in the trials.
Acquired
Novo Nordisk (Ozempic)
Yeah. Now, this was truly an out-there idea. There is a huge, huge stigma around weight loss drugs. Enormous.
Acquired
Novo Nordisk (Ozempic)
Yeah. Fen-phen was a combination of a drug with speed. One of the fens is speed, I believe.
Acquired
Novo Nordisk (Ozempic)
Yeah, this was a disaster. It kind of was like a grassroots thing that built up. And the two FENs were independently approved for separate use cases. And a physician got the idea to combine them. And since both drugs were approved, Big Pharma was like, oh, wow, weight loss drug, miracle drug, let's commercialize this.
Acquired
Novo Nordisk (Ozempic)
And so they pushed the FDA to rush the process, which they did thinking, again, both of these drugs are approved. And it turned out that when used in concert, it caused major heart damage. So I think something like six million Americans took this thing and like a large portion of them ended up with major cardiovascular issues.
Acquired
Novo Nordisk (Ozempic)
It's kind of going back to the beginning of the episode and Rockefeller's dad and the snake oil salesman. Like, this is the stigma around this stuff.
Acquired
Novo Nordisk (Ozempic)
Yeah, it's like you need the appropriate amount of activation energy for the reaction to catalyze. Exactly. And just to, you know, put a really close to home, even finer point on this stigma, as recently as 2005, 2005, like same year Bayetta came out, Novo Nordisk's own official position on...
Acquired
Novo Nordisk (Ozempic)
The obesity category, as articulated by the then-CEO Lars Sorensen, was, quote, Obesity is primarily a social and cultural problem. It should be solved by means of a radical restructuring of society. There is no business for Novo Nordisk in that area.
Acquired
Novo Nordisk (Ozempic)
Right. So, you know, what's going on here and why is Lada pushing for this? You know, she's a great scientist, well-respected, you know, and at this point she's made her career on the development of liraglutide and GLP-1 against all odds just for diabetes. Why is she pushing this? This is a very, very different situation than what happened with Fen-Phen.
Acquired
Novo Nordisk (Ozempic)
liraglutide like the drug the same drug the same thing has now been through 12 plus years of super rigorous trials starting with animals now with humans international approval processes you know there were issues along the way like there are with any drug dude the 2010 trial was 9 000 patients across 32 countries this is a big expensive almost two-year trial Yeah.
Acquired
Novo Nordisk (Ozempic)
She's like, yeah, I mean, we're pretty sure here this is about as safe as any drug possibly could be. And at least in the medium to short term, like, this is not a cause for worry in terms of safety. It's just that all that testing and everything was done for a different use case, but it's the same drug. So she eventually convinces the company to push forward with this.
Acquired
Novo Nordisk (Ozempic)
And in 2007, so only two years after the CEO made that statement, Novo enters a slightly higher dose version of liraglutide into human trials for weight loss. And why do minds change quickly on this? Like the commercial opportunity here, if you can get approved, if you can get it to work, if it's safe, is unlike anything else the pharma industry has.
Acquired
Novo Nordisk (Ozempic)
has ever seen, like if you could really crack this market. So at this time, back here in the mid-2000s, already about a third of the U.S. population is medically obese, you know, defined as a body mass index over 30. Two-thirds are medically overweight. The World Health Organization estimates that 500 million people worldwide are obese, you know, so that's
Acquired
Novo Nordisk (Ozempic)
a total addressable market here of like 100 million people just of medically obese people in the US alone, half a billion plus, probably more like a billion worldwide. There are no other drugs and diseases that affect this many people, not even diabetes. Yep. And just like diabetes, it turns out that in most cases, obesity also is a chronic disease.
Acquired
Novo Nordisk (Ozempic)
So yes, you have this huge team of people, but it's also people that are then going to be taking the drug probably for the rest of their lives.
Acquired
Novo Nordisk (Ozempic)
This is annual recurring revenue here. Yeah. So in early 2010, Novo gets final approval for Victoza, which is the marketing name for the diabetes version of liraglutide. So five years after Bayeta, Victoza is finally officially hitting the market in the U.S. And remember, this is just FDA approved for diabetes.
Acquired
Novo Nordisk (Ozempic)
But of course, everybody knows about these trials going on for weight loss and the ability to lose weight. It hits the market, and it is an enormous hit. It doesn't just overtake Bayeta as the leading GLP-1 drug on the market for diabetes. It massively expands the market. So year one, in the first year that it's on the market, Victoza does roughly $300 million in sales.
Acquired
Novo Nordisk (Ozempic)
The next year, the first full year it's on the market in 2011, it does over a billion dollars in sales just in that year. So there's this concept in the pharma industry of a quote-unquote blockbuster drug. And these are drugs that achieve a billion dollars in annual revenue.
Acquired
Novo Nordisk (Ozempic)
Yeah, Banting and Best and McLeod aren't going to go, you know, today they would go like start a company, you know, around this. Like that's not going to happen back then. But all of a sudden the world needs a lot of this animal insulin and in a supply chain that can't go down because once you start patients on this, they need it forever.
Acquired
Novo Nordisk (Ozempic)
Yeah. And Victoza hits it in its first full standalone year on the market, which is super fast. So what's going on here, obviously, is that people are not using Victoza just for diabetes. I mean, people are using it for diabetes, but people are also using this for weight loss.
Acquired
Novo Nordisk (Ozempic)
Right. And that's not illegal. And let's be honest here. Some of this is doctors, but a lot of this is patients going to doctors and being like, hey, I heard that this Victoza thing could help me lose weight. What do I got to do to make you prescribe it for me?
Acquired
Novo Nordisk (Ozempic)
Right. So at the end of 2013, Novo submits Saxenda, the official weight loss version of lyroglutide, to the FDA and EU for approval. And it's a slightly higher dose version and expectations are at an all-time high for this. Novo's market cap has already been running. It now passes $100 billion on the anticipation of Saxenda's performance. And it's not that big a hit. It's a hit.
Acquired
Novo Nordisk (Ozempic)
It has good sales. To be fair, I think a large amount of the early adopter GLP-1 weight loss market was already just using Victoza. So clearly a lot of the Victoza revenue was actually sex ender revenue that was pulled forward, so to speak. But Ben, like you're saying, the big issue is that even with the slightly higher dose of liraglutide,
Acquired
Novo Nordisk (Ozempic)
It yields long-term on average across populations about an 8% BMI reduction, you know, which is meaningful, but it's not that meaningful.
Acquired
Novo Nordisk (Ozempic)
So what the University of Toronto does do is they license production and development rights to a large American drug company based in Indiana. Eli Lilly. And they give Eli Lilly a one-year exclusive development license to try and mass produce this substance.
Acquired
Novo Nordisk (Ozempic)
So regardless, the next year, 2015, is a record year. Total company revenues for Novo Nordisk hit $16 billion, which is incredible for a pure play diabetes and now diabetes and relatedly obesity pharma company. But the stock flatlines almost.
Acquired
Novo Nordisk (Ozempic)
Yeah, well, the CEO change, I think, was a result of this. So what you're leading up to is in 2016, the stock takes a 40% hit, which is wild. You know, today at the beginning of 2024, this is a half a trillion dollar company. And a few years ago, it was a well less than $100 billion market cap company.
Acquired
Novo Nordisk (Ozempic)
Yeah. So, in September 2016, the then-CEO Lars Sorensen resigns. Current CEO Lars Jorgensen takes over. Amazing. So wonderfully Danish. Sidebar, this is wild. So right now, today as we record this, Novo Nordisk is the 15th largest company in the world by market cap. And when I was doing research for this episode, I of course Googled Lars Jorgensen. When I did, the results that Google gave me
Acquired
Novo Nordisk (Ozempic)
Results one through six were for the University of Kentucky swimming coach, who is also named Lars Jorgensen.
Acquired
Novo Nordisk (Ozempic)
Who I'm sure is a great and storied, you know, NCAA swimming coach. But it wasn't until number seven when I actually got the CEO of Novo Nordisk. That is how like underappreciated this company is. It's crazy. Anyway, right around this same time, Novo begins phase three trials with their new next generation improved GLP-1 analog, semaglutide, which I think is pronounced semaglutide.
Acquired
Novo Nordisk (Ozempic)
We've also heard semaglutide. We did an obscene amount of research on this and don't have a good answer. So if you know, get in touch with us.
Acquired
Novo Nordisk (Ozempic)
Acquiredfm at gmail.com if you disagree. And semaglutide has several benefits over liraglutide. One, it is much, much longer lasting in the body. So it only needs to be injected once per week instead of once per day. Massive benefit just on patient convenience there with the half-life being so much longer.
Acquired
Novo Nordisk (Ozempic)
And again, like you said, this is like a big step for the University of Toronto to do this, but the need in the world is so great that they're willing to work with industry here.
Acquired
Novo Nordisk (Ozempic)
Two, and much more important for the near term, it is twice as effective as liraglutide for weight loss. So we're talking 15% plus long-term BMI reduction, which is well beyond... Ben, as you were saying, the 10% magical threshold.
Acquired
Novo Nordisk (Ozempic)
And there's some more benefits, potential benefits, that we'll talk about in a little bit here. But this compound, this GLP-1 agonist, semaglutide, is, of course, ozempic and agonist. Wegavy. All the same thing, all semaglutide. Ozembic is the diabetes marketing product and Wegavy is the weight loss marketing product.
Acquired
Novo Nordisk (Ozempic)
Yeah, wasn't Elizabeth Hughes one of these famous first patients, the daughter of the Secretary of State of the U.S., right? Charles Evans Hughes, yeah. Yeah, wild. So it's obviously not practical or maybe not ethical that's beyond the scope of this podcast to use dog pancreases for scaling mass production here.
Acquired
Novo Nordisk (Ozempic)
Right. So 2018, Ozempic finally hits the market for diabetes. And then in 2021, Wegevi gets approved for weight loss. Right. Ozempic does over a billion dollars in revenue in 2019, its first year on the market. It's clear it's going to be a huge hit. And it's like even more than that. This is like even more than Victoza back in the day.
Acquired
Novo Nordisk (Ozempic)
It does a billion dollars in revenue, but like it's massively supply constrained. Like it could have done a lot more. These drugs still, Ozempic and Wegabee, could do a lot more revenue than they are doing right now.
Acquired
Novo Nordisk (Ozempic)
Yes. So at this point, you know, it's funny, I think for most people that are discovering Novo Nordisk now, us included, I didn't know anything about this company until a few years ago.
Acquired
Novo Nordisk (Ozempic)
Right. If anything, we think of this company as like, oh, it's the GLP-1 company. It's the weight loss drug company. And like, no, for 100 years, it was the diabetes and the insulin company. But it's clear at this point now that, no, this is now a GLP-1 company.
Acquired
Novo Nordisk (Ozempic)
And that grew naturally out of the diabetes and the insulin research and Lada's work and sort of in this organic fashion that is so different than the rest of the pharma industry. But the net result of this now is that, yes, insulin is still a large business within Novo Nordisk, but it is a GLP-1 company. So when Wegevi finally launches in the U.S.
Acquired
Novo Nordisk (Ozempic)
in 2021 as the official FDA-sanctioned weight loss version of semaglutide... It gets the same number of prescriptions written for it by doctors in the first slightly over one month than Saxenda had in its entire drug lifetime. People were already quote unquote misusing Ozempic for weight loss before this. So like Ozempic supply was fully exhausted. And then now Wegovy Supply fully exhausted.
Acquired
Novo Nordisk (Ozempic)
Yeah. And we'll talk a lot more about pros and cons and all of that and everything around that in a minute here in analysis. But just to wrap up the story, the company's market cap basically goes vertical. In 2020, right before all this hit and as Ozempic was coming online, the market cap had climbed back up above $100 billion. Summer 2021, it hits $250 billion.
Acquired
Novo Nordisk (Ozempic)
But it turns out there actually is an abundant ready supply of animal pancreases that happen to be just sort of lying around in the American heartland and just about every human food production center in the world. And that is cow and pig pancreases from all the meat that we eat.
Acquired
Novo Nordisk (Ozempic)
By the end of 2022, it hits $300 billion. which, mind you, is against a market and macro backdrop of massively rising interest rates and stocks and equities being down across the board. Like, Novo Nordisk is up during this period. And then this past summer in 2023, it passes $400 billion market cap, and it is currently flirting with the half a trillion dollar mark.
Acquired
Novo Nordisk (Ozempic)
Revenue goes from $20 billion in 2019 to $25 in 2021, $30 billion in 2022. And in 2023, so far in the first three quarters that they've reported, it is up another 30% year on year. Of course, with Ben, as you said, years worth of supply constraint demand pipeline.
Acquired
Novo Nordisk (Ozempic)
How is Google's gross margin 56%? They must be stuffing a lot of other revenue besides search into the top line.
Acquired
Novo Nordisk (Ozempic)
Yes. And also, it gets better. So because semaglutide has such a long half-life relative even to liraglutide, I mean, it's a once-weekly injection, so the half-life in your body is days. It's staying in there for a long time. Remember, natural human GLP-1, your body processes that in like five minutes. So having GLP-1s active in your body for so long...
Acquired
Novo Nordisk (Ozempic)
it's reaching other tissues in your body that normally GLP-1s wouldn't. And indications are showing that that is beneficial for those organs. So currently, Novo has clinical trials going for semaglutide, like same drug, same GLP-1s, use case in treating cardiovascular disease, in treating Alzheimer's, in treating kidney disease, many others.
Acquired
Novo Nordisk (Ozempic)
Again, this is all for like a molecule that through FDA processes and EU processes has been deemed safe enough to be on the market for the accepted use cases. Same drug. Now is showing evidence that it can also attack these other major disease areas. This is the gift that keeps on giving here.
Acquired
Novo Nordisk (Ozempic)
It really might. Now, Not a scientist at all. This is just my thought looking at this. But yes, could be a miracle drug for humanity and certainly already is a miracle drug for Novo Nordisk in terms of financial performance. Like no doubt about that one.
Acquired
Novo Nordisk (Ozempic)
Oh, man. So if I'm an insurer, I'm like, great, I'm going to offload all that onto Medicare.
Acquired
Novo Nordisk (Ozempic)
Interesting. Do you know if this was a result of the Fen-Phen debacle?
Acquired
Novo Nordisk (Ozempic)
Yeah, I could see the argument of, like, why is the whole taxpayer base covering, you know, people who should just be exercising more?
Acquired
Novo Nordisk (Ozempic)
Even though, like, it's definitely been proven that that is not the case. It's not their fault.
Acquired
Novo Nordisk (Ozempic)
Right. That is kind of the crux of the broader societal debate and issue here is obesity leads to such a huge amount of comorbidities and disease and health problems and issues. And that's even just talking about the medical system, let alone everything outside of the medical system that it leads to. And
Acquired
Novo Nordisk (Ozempic)
Is it worth a certain amount of both risk in terms of the drugs and cost and tax on society to save those expenses later? That's the question here.
Acquired
Novo Nordisk (Ozempic)
Yep. Which might be a good time to talk about Eli Lilly and other companies out there that are also bringing GLP-1 drugs to market.
Acquired
Novo Nordisk (Ozempic)
Yeah, so obviously other big pharma companies have not just been completely ignoring this incredible development slash cash gusher that has emerged in Novo Nordisk land. Eli Lilly now has a GLP-1 diabetes-approved treatment on the market under the diabetes brand name Monjaro that seems to be as if not more effective as semaglutide in terms of weight loss when used for obesity.
Acquired
Novo Nordisk (Ozempic)
So that's showing great promise. It was approved in the U.S. for diabetes treatment in May 2022, and approval just came recently in November 2023 for official FDA-sanctioned weight loss use case under the marketing name ZepBound. So look for that in 2024. What this really shows, though, between Eli Lilly and Novo and other companies that are almost certainly going to get into the GLP-1 business is
Acquired
Novo Nordisk (Ozempic)
I think this is going to be like insulin all over again, where there's just going to be a series of product improvements and companies will drive innovation and increase supply. I mean, the demand is so huge out there that Monjaro can be a huge hit. Ozempic and Wegabee will continue to be huge hits. Other companies getting into the game will be huge hits.
Acquired
Novo Nordisk (Ozempic)
Novo has next-generation GLP-1 drugs in the pipeline themselves. Cagrasema is the big one that they're currently working on that they think will be as good, if not better, than what Eli Lilly has with Terzibetide. So I think we're basically just assuming that everything continues to be proven safe in the long run.
Acquired
Novo Nordisk (Ozempic)
We're kicking off a new super cycle here in pharma development around these compounds, just like played out with insulin over the last century.
Acquired
Novo Nordisk (Ozempic)
Yeah, we're going to talk a bunch more about Eli Lilly here as we go. But this moment, this insulin moment, this is what really turbocharges them and makes them into one of, if not the first kind of leading American and international pharmaceutical company, which it still is to this day. Still bigger than Novo Nordisk. Yep. Although not by too much.
Acquired
Novo Nordisk (Ozempic)
Interesting. Obviously, as we've shown throughout this story, it's not like Novo Nordisk planned it that way. However, this is really to their great benefit, right? Because of all the insulin manufacturers, I mean, I guess Eli Lilly was first to market with GLP-1s, but...
Acquired
Novo Nordisk (Ozempic)
Novo really created the true GLP-1 market and were the ones to really benefit from these early years while the competitors are catching up.
Acquired
Novo Nordisk (Ozempic)
Yeah. I certainly didn't find anything in my research that suggests it was anything but a coincidence.
Acquired
Novo Nordisk (Ozempic)
Yeah, let's talk power. And for folks who are new to the show, this is borrowed from our great friend Hamilton Helmer and his wonderful book, Seven Powers, where he talks about the means by which a company can achieve persistent differential positive returns versus their competitors in an industry.
Acquired
Novo Nordisk (Ozempic)
Okay, so back to this whole Nobel Prize thing, which, as we said, was awarded to Banting and Assistant Medical School Dean John McLeod. Now, how did McLeod end up being the guy who shares the award with Banting and not Best? And years later, actually, the Nobel Committee would basically admit that they messed that up.
Acquired
Novo Nordisk (Ozempic)
Yep. I think how this GLP-1 kind of super cycle is going to play out if it continues, and what's interesting about the insulin history and the analog to that is It's looking like it's going to be like this ever stacking waves of patentable innovation and product innovation happening here. So like, yes, the semi-glutide patent will expire in 2032.
Acquired
Costco
Which again, to the supplier dynamics, it's the same thing here. Like on the surface, if you're XYZ e-commerce player, that'd be crazy. But then you think about it and you're like, well, we could get a lot of very high value traffic. Maybe we should do this.
Acquired
Costco
I mean, Costco was sort of technically founded in 1976 with Price Club. You can really say it was started with FedMart before that. Let's just say it was 1976. Here we are in 2023. There have been three CEOs in the history of Costco. Saul Price, Jim Senegal, Craig Jelinek. All of whom worked at FedMart.
Acquired
Costco
Wow. So there's some fun Seattle history around this. Do you know where the inspiration Nordstrom? Yeah, for this policy came from?
Acquired
Costco
Yeah, so Jim and Jeff Brotman, before he tragically too young passed away a few years ago, they would talk about this, especially Jeff and the Brotmans being Seattle retailers. They were hugely influenced by Nordstrom, and Nordstrom famously has the same return policy.
Acquired
Costco
Amazing. Okay, well, while we're on Costco trivia and tires, there's a famous Sol Price story. I think this was in the Price Club days when they were opening one of the early non-San Diego locations, the first new expansion sites. He showed up and he saw tires. Their tires was one of the things that they sold at Price Club. And the tires were all neatly stacked on the warehouse shelves.
Acquired
Costco
That is the perfect analogy. That's exactly what FEDCO is. Yep. So as you can imagine, Fedco becomes quite popular amongst government employees in the L.A. area. And then not just the L.A. area. People start driving from all over Southern California, including San Diego, sometimes up to like hundreds of miles round trip to do the majority of their shopping at Fedco. It was time to expand, yeah.
Acquired
Costco
And he walks up and he starts throwing them off the shelves onto the floor. And the police are like, Saul, what are you doing? Have you gone crazy? What's happening? And he's like, you effing idiots. How are the customers going to be able to pick up the tires when they're up high on the shelves? They got to be down on the floor.
Acquired
Costco
Oh, man. Jim talks about this a lot in the talks I watched on YouTube, that when he was CEO, and I think Craig does the same thing to this day, he visited every store every year. Yes, he did. And there are hundreds of stores around the world. There are way more Costco stores out there than there are days in the year. Yep.
Acquired
Costco
We'll link to it in the show notes. All right, inspired by you, since you did two carve-outs, I'm also going to do two carve-outs. The first is a great episode of Invest Like the Best. Friend of the show, Patrick, over there with Jeremy and Jifan. So good. Also friend of the show.
Acquired
Costco
Yeah, it was so good. One of the best podcast episodes, just period all year, I think, but especially because we know Jeremy pretty well from Tiny and, you know, we know Patrick very well, like even hanging out with them a lot, learned a ton still listening to their conversation.
Acquired
Costco
Yeah, it's just awesome. Go listen to it. Well, well, well worth your time. Yep. My second carve-out, this is a fun local one. Jenny and I did a date night last week. Highly recommend for any parents out there. We have a standing babysitter who we love. Friday night, weekly date night, unless something changes. Wow, good for you. Highly recommend that.
Acquired
Costco
But we went out in Dogpatch in San Francisco, which I hadn't been to in a long time. It's become such a cool neighborhood. Went to this awesome wine bar there. We walked around. We got ice cream at Humphrey Slocum afterwards. Dogpatch is right on the water in the bay. It's got an interesting history. It was the headquarters, I think, of Hell's Angels for a long time during like the 50s and 60s.
Acquired
Costco
That's right. But yeah, you probably remember back then, I mean, Dogpatch was kind of like a random outskirts of San Francisco, sleepy little neighborhood. It's become awesome. Walked by a game shop where they had ladies D&D night going on. Like, it was just super cool. Gonna hang out there more often. So if you come to San Francisco, don't hang out downtown. Downtown is not a good place.
Acquired
Costco
So Saul and the jewelry guys, they see what's happening with all of the wholesale business that they're sending to Fedco up in L.A., and they're like...
Acquired
Costco
man we gotta find a way to open a fedco here in san diego and saul's like actually i might have just the location it turns out that helen's family owned a 21 000 square foot warehouse in san diego's industrial district that's currently sitting empty so the three of them go over they check it out and they're like oh yeah we could totally recreate fedco in this building right here in san diego
Acquired
Costco
So if Saul were Sam Walton, that would be the end of the story right there. He'd just be like, great, I'm going to clone Fedco. No, this is how Saul is different than Sam. And I think probably harkens back to his upbringing in New York and, you know, everything that was happening. He calls up the FedCo board of directors in LA and he says, hey, we want to partner with you guys.
Acquired
Costco
We think that a FedCo would do great in San Diego. Can we create a joint venture together? We've got the building. We'll operate the store. Let's go into business together and be partners. Fedco, though, like you said, they're a nonprofit. They're not interested in expansion. So they turn him down.
Acquired
Costco
And Saul, God bless him, he calls them back and he's like, no, no, no, guys, we really want to do this. How about this? You can own the whole business. We'll just be a franchise down in San Diego. You get all the upside. You get all the enterprise value. Like, we don't care. We just want to bring this to San Diego. And they say no again, because it's like a nonprofit board of directors.
Acquired
Costco
There's a really funny Saul quote from later in his life. He's asked about how he feels about essentially being the father of modern American retailing. And he thinks about it and he sort of laughs and says, you know, maybe I should have worn a condom. Oh, Saul. Oh, Saul.
Acquired
Costco
but it's not that he's a rube he's a really good businessman he's just also incredibly principled yep and this is going to flow through directly into costco as we'll see Okay, back to Fedco. So after this second rejection, Saul and the guys are like, I guess we now can go do it ourselves.
Acquired
Costco
So in November 1954, they open the store in this warehouse location and they had to think about what to call it. And they're like, well, basically, this is a clone of Fedco, but we can't use that name, and it's kind of a bad name anyway. What if we draft off the same brand recognition, though, and call it FedMart?
Acquired
Costco
An equally bad name that would have historic impact. So why do you think Walmart is called Walmart? Why do you think Kmart was called Kmart?
Acquired
Costco
I mean, Sam Walton talks about this in Made in America. By the time Walmart was starting, people knew what Fedmarts were. They were expanding across the country. And he was like, oh, great, we're going to draft off the Fedmart brand. And it was the same thing with Kmart. FedMart becomes the first scaled quasi-national discounter. And people are like, what are discounters?
Acquired
Costco
Discounters are Walmarts, Kmarts, Targets. That is the industry that Saul births here.
Acquired
Costco
Yes, correct. And on the one hand, FedMart is obviously a clone of FedCo. On the other hand, the huge single key difference that makes all the difference, it's a for-profit company. It's not a nonprofit. And so just like all capitalist for-profit companies, Saul and the Jewelry Guys and FedMart have the impetus to expand.
Acquired
Costco
Well, so it is still a membership club. You do still have to be a federal employee. You do still have to buy a membership. I think they maybe took the lifetime membership price down to $2, so they undercut Fedco or something like that. But obviously, it's not about the membership. The reason they did this, and the reason that no other discounters had really scaled before... This is crazy.
Acquired
Costco
There were actually laws on the books in the U.S. at the time that manufacturers of goods could set a minimum selling price for retail. And it was actually illegal for retailers to offer products below that price to the general public. Whoa. So the term discounters, discounting meant selling below the manufacturer's minimum price. How did you get around this?
Acquired
Costco
Well, Saul kind of stumbles into figuring out that if you are a membership club, you're not open to the general public. So you can skirt these laws and sell below the manufacturer's minimum price. Interesting, huh? So this is crazy. And this is why I think there's a strong argument that Saul really is the goat among American capitalist retailers.
Acquired
Costco
We haven't even gotten to price club and wholesaling and Costco yet. He also invents that later. first he invents the discounter which then sam walton kresge with kmart dayton with target copy and becomes the dominant retail form of america two totally separate things he invents both of them crazy so when sol and the guys opened the first fed mart in 1954 in san diego
Acquired
Costco
It is a huge and immediate success. Their sort of wildest dreams expectations are that they do a million dollars in sales in the first year. The store does $3 million in sales in 1954 in one year. Wow. And why do you get the sense that it worked? It worked because it was already working. This was a no risk bet. Clearly, Fedco had proved the model in L.A.
Acquired
Costco
They just did the same thing as a for profit company. Makes sense. So a year after San Diego, they opened the second Fed Mart in Phoenix, Arizona, right off the bat going multi-state. They want to go big here. It's another absolute banger. Literally, when they open it, there are lines half a mile long to go get into the parking lot of the store, like going out in every direction from the store.
Acquired
Costco
They take it to Texas. They go to San Antonio. They go to Houston. They go to Dallas. All of these stores are huge successes. So at this point, two things happen that are going to prove very fateful, both for FedMart and for Costco. One, Saul fully stops practicing law and goes full-time with FedMart. He becomes the president of FedMart.
Acquired
Costco
Oh, does he ever. You know the great Warren Buffett joke about Costco, right? Ooh, no. Okay, so here it goes. Warren and Charlie are flying on a plane that gets hijacked. It's kind of macabre. The hijackers each grant one of them one last wish. And they ask Charlie first. And Charlie says, I would like to give my speech on the virtues of Costco one more time before I die.
Acquired
Costco
Two, he hires a young college student from San Diego City College as a part-time bagger in the San Diego store. One, Jim Sinegal. And Jim would end up working for the next 22 years at FedMart directly for Saul.
Acquired
Costco
eventually jim ends up running fedmart's entire distribution and centralized warehousing operations warehouses you can see the costco picture coming together here put a pin in that so fedmart goes public in 1959 they raised two million dollars they plowed that money into both expanding the number of stores across the country
Acquired
Costco
But also, remember back to Seven Seas Locker Clubs, the suite of goods and services that they're offering under the roof, or in some cases, not under the roof. This is when they add gasoline to FedMart. So the Costco gas lines, like this started with FedMart. They would intentionally price a few cents lower than whatever the other gas stations were charging in the area.
Acquired
Costco
And a few cents at that time was a lot because gas was like 25 cents. And unlike gas stations, FedMart is making money on consumers shopping in the store as well. So they can price at cost on the gasoline, get all the traffic coming to the store, and then monetize through the store. They add a pharmacy to FedMart. Costco Pharmacy today, people are religious about it. So there's a crazy story.
Acquired
Costco
The guy who sets up the pharmacy division for FedMart starts getting death threats from people in the industry. He has a rock thrown through his window. It's literal mafia stuff because they're undercutting the fat margins in these pharmacy counters so much.
Acquired
Costco
That guy's protege, who then takes over the pharmacy division for FedMart when he retires, that guy goes on to start Costco's pharmacy division and run it. Amazing. Most importantly for the Costco story here, After they go public, FedMart uses part of this capital to develop their own house brand for some of the popular products that they're selling on the shelves.
Acquired
Costco
The FM brand. Yep. If you ever see FM branded old photos and stuff of like newspaper articles referring to FM, Cola, FM, whatever, that's what it is. It's FedMart. And then one more piece of FedMart playbook, shall we say, that clearly makes its way over. As Saul is running the company during these first few years, he starts to codify some retail management philosophies.
Acquired
Costco
And he famously sort of canonizes these as FedMart's four priority order principles. And he teaches every new employee throughout the whole company about this. Number one, first priority, provide the best possible value to customers. Number two, second priority, pay good wages to employees and provide good benefits, including health insurance. This is in the 50s, like this is progressive stuff.
Acquired
Costco
Number three, maintain honest business practices. And then number four, the last one, make money for investors. So if you're a Costco nerd out there, and there are probably many Costco investor nerds listening right now, Those all probably sound very familiar to Costco's priority order values.
Acquired
Costco
And then the hijackers turn to Warren and he says, shoot me first. It's so great. This actually happened at a Berkshire annual meeting. It's on YouTube. We'll link to it in the show notes.
Acquired
Costco
So you might be listening and saying like, yeah, yeah, yeah, that sounds good. But I'm thinking about, you know, I don't know, maybe I go to Walmart today or I walk into Target and I see some similar things written on the walls there. Isn't this kind of all the same? If you really mean them, no.
Acquired
Costco
There are some very, very clear tradeoffs that Sol is going to make with FedMart that Costco makes today that are very different from what their competitors do. Like one, do you sell loss leaders in the store? Loss leaders being when you mark down items below your cost in order to attract people into the store with sales.
Acquired
Costco
If you're those other retailers, yeah, of course, this is like a time-honored tactic in retailing. Of course, you're going to use this.
Acquired
Costco
Right. If you're Saul and Costco today, you're absolutely not going to do this stuff. No, they won't sell something unless they can make money on it. Because the flip side of doing loss leaders is that you got to make up for it somewhere. You got to mark up other goods in the store to fat margins to make it worth doing the loss leader for you.
Acquired
Costco
Totally. This is anathema to Saul. He passes that down to Jim Senecal. It's anathema to Jim. Okay, so that's one trade-off. Here's another really big one. What do you pay your employees? So in 2006, Harvard Business Review published a really great piece called The High Cost of Low Wages, where they very directly compare Costco and Walmart employee salaries and benefits.
Acquired
Costco
So obviously, the trade-off of this is for FedMart at the time and straight through to Costco today, this creates meaningfully higher per-employee labor costs for the company.
Acquired
Costco
And this is truly unique, I think, about Costco among major American, at least, corporations and was true at Price Club and FedMart before it. The senior, senior management, this is the same story. I mean, Jim started as a grocery bagger in the 50s at FedMart. Craig Jelinek started his career as an hourly employee at FedMart.
Acquired
Costco
So what happens? FedMart truly was the first discounter that scaled nationally. All of these innovations, even though Saul came up with them, as these other companies are scaling, and I think particularly Kmart, they don't really have the... large-scale operational expertise, nor the access to capital to really fend off the competition.
Acquired
Costco
Kmart, if you remember back to our Walmart episode, came out of the Kresge department store chain, which was huge. So they had so much more access to capital, certainly than FedMart, and even than Sam Walton and Walmart. Sam had to fight bitterly, last mile by last mile, building out his distribution network to beat Kmart. Sol and FedMart, they don't really have the firepower to compete.
Acquired
Costco
Yeah. In the biography, Saul comments to his son, Robert, who had also joined the company, joined FedMart at this time. He says, quote, we're good at creating businesses. We're not as good at running businesses.
Acquired
Costco
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Acquired
Costco
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Acquired
Costco
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Acquired
Costco
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Acquired
Costco
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Acquired
Costco
So like you say, by the time we get to the end of the 60s, early 70s, Saul's burned out. He and Robert, they don't want to be running this business at scale. First, he brings in, quote unquote, professional management and moves up to chairman of the board. Second, he starts looking around for a capital partner to help the business compete on a more level playing field with the other discounters.
Acquired
Costco
They end up going to Europe. And this is super important both for the drama that happens, but also leading into Price Club and Costco. At the time, in the 70s, this new retail concept in Europe was getting going, actually pioneered by the French company Carrefour, which is still a huge global retailer today. And that concept is the hypermarket. So what are hypermarkets?
Acquired
Costco
Hypermarkets are smashing together everything we were just talking about with the discounters, the general goods retailing. with a full-scale grocery store supermarket. So fresh food, everything. This is what almost every Walmart is today, the super centers. It's grocery and hard goods in one huge, enormous warehouse, you might say.
Acquired
Costco
It was the French, of all people. Yeah. So this concept didn't exist yet. And it wasn't until the late 80s that Walmart would really embrace it and roll it out across America. So as Saul and Robert are looking for partners to take FedMart to the next level and going across Europe, they're meeting with all these hypermarket operators.
Acquired
Costco
Yes, which is a misnomer because like they sell everything. You know, most other brands only sell like shoes.
Acquired
Costco
So they end up getting into bed with one of the German clones run by a retail entrepreneur named Hugo Mann. The idea was that Mann was going to help Saul and FedMart take this hypermarket concept and morph the existing FedMart stores into hypermarkets, which Walmart would do to great success, but like 15 years later. Had this happened, we would be telling a very different story today.
Acquired
Costco
So within a few months of when the deal actually closes, perhaps predictably, Saul and Hugo get in a huge fight. At the very first board meeting. The very first board meeting, they're like yelling at each other, this is not going well. Man fires Saul, literally fires Saul, I think, and Robert too, and changes the locks on their office doors. Literally boots Saul out of his own company.
Acquired
Costco
It's super ugly. And then the person at FedMart of the remaining executives who they task with, you think like doing an all hands or the equivalent of and, you know, inform the rest of the company what's just happened. You know who that was? No. Jim Sinegal. No way! Yes! Wow. Isn't that hilarious? Oh, my gosh.
Acquired
Costco
Yep. So, had this not gone down like this, I think Saul probably would have just retired as new management took over at FedMart and all would have been amicable. He wasn't really interested in continuing his career, but because of how this went down with him getting locked out of his office... He is pissed. He is now 60 years old at this point, and he is a man on a mission.
Acquired
Costco
Great time to be a founder. Totally. Amazing. I love that. He's like the Morris Chang of American retail. Yes. Morris Chang, of course, being the founder and CEO of TSMC, who was booted out of Texas Instruments at age 56, I think. Something like that.
Acquired
Costco
And then would go on to start TSMC. So Saul and Robert together... They get a lease on an office literally the next day after they're booted out and they're like, we're doing it again. We're back in the saddle. Let's go. But they know they're not going to compete directly with FedMart because FedMart is failing at that.
Acquired
Costco
They're going to get steamrolled by Walmart and Kmart and Target and everybody else.
Acquired
Costco
Yep. So Saul and Robert are sitting around in their new office brainstorming what's their angle of attack here. And they keep coming back to one part of the FedMart business that they felt was underappreciated and they didn't really exploit enough while they were at FedMart. And that is the division that Jim Senegal ran, the centralized warehousing operations.
Acquired
Costco
So the two of them are like, you know... If we zoom out, there really is kind of a different and orthogonal way to think about the FedMart business. You really could say that Jim ran our warehouse operations kind of like its own business. They were supplying the individual FedMart stores, which were sort of smaller businesses.
Acquired
Costco
And when you look at it that way, almost all of the margin that we made at the company was at the warehouse level. The stores themselves were not particularly profitable. And pretty hard to compete with the competition out there.
Acquired
Costco
Yeah. So they're like, well, is there a way that we could take Jim's operation and recreate it and make that the core business instead.
Acquired
Costco
And so the business plan that they come up with is literally that, create warehouses for other individual small businesses, other retailers, and they're envisioning like gas stations, restaurants, small variety stores and the like, independent chains that they can come and shop to stock their own shelves and at this centralized warehouse that we're gonna operate.
Acquired
Costco
So just business owners can be members. Just business owners. And they're like, man, if we did that, I think that would be providing a huge service to these small businesses because one of their big problems that we know from operating the FedMart stores is actually how you manage your inventory, like physically where you put it. You need a centralized warehouse to hold your inventory.
Acquired
Costco
If you're a small gas station, you don't have your own warehouse. We can be your warehouse.
Acquired
Costco
Yep. All of that totally true and amazing parts of the Costco model. There's one piece in particular that really, really makes this a crown jewel. And it's the reason why they were so enamored of what Jim was doing. If you're operating a wholesale warehouse, you don't have to operate any logistics. The manufacturers deliver the product right into your warehouse. You don't need to run trucks.
Acquired
Costco
You don't need to operate other warehouses. You don't need to move stuff around the country.
Acquired
Costco
And because of all this, because this new business, this Costco Price Club, going to be called Price Club, is providing such a valuable service to the small businesses that are shopping there in managing all these logistics for them. Or I shouldn't say managing because Price Club doesn't manage it either. The manufacturers do. Right.
Acquired
Costco
They're like, we can actually go back to that original Fedco membership idea. And instead of having it just be like a way to skirt around the law, we can charge real money for this membership because we're providing real value out of this to the businesses. Yep.
Acquired
Costco
So once they hit on this business plan, Saul and Robert poach a few people from FedMart and elsewhere, including they hire this super bright young guy from Harvard Business School named Giles Bateman as their CFO. And then they go get started. Giles would later go on to become chairman of, do you know this, Ben? No. Comp USA. Really? A big part of my childhood.
Acquired
Costco
And part of the enormous diaspora of retailers that come out of not only FedMart, but Price Club. Jim Senegal, after I think he was probably locked up at FedMart under new management for a while. After that, he would come over and briefly work at Price Club a couple years later. So like the best of the best are coming through this place.
Acquired
Costco
So they decide as they're getting started that in order to keep the operations really tight and realize the maximum benefit, Ben, of everything you were describing of how these warehouses operate, they're only going to stock about 3,000 of the highest volume items that they think most other retailers are going to sell to their customers.
Acquired
Costco
So at the time, Walmarts and Kmarts had on the order of about 50,000 SKUs, and even FedMart had probably close to that many at the time. Going all the way down to 3,000, this is a non-consensus move.
Acquired
Costco
Right. Super important. Remember, they are not thinking about consumers just yet. However, when they launch the first store, when they open the first price club in San Diego, unlike FedMart, It's not an initial gangbuster success. Turns out it's a lot harder to sell and recruit businesses to come be your customers than it is just putting out a shingle and attracting consumers.
Acquired
Costco
So they're worried after a couple months that this thing might not work. They might need to shut it down. And then they have the greatest stroke of luck. So they're going around San Diego trying to sell memberships to businesses. And they get a meeting with the San Diego City Credit Union. And the credit union management are like, We're a credit union. We're not a retailer.
Acquired
Costco
We don't really buy much stuff. We're not interested in this. But you know what? Our members, if we could find a way to get them access to what you're doing here, that might be a really good benefit that we could offer of like, oh, you can get wholesale prices on goods.
Acquired
Costco
So Giles, the wunderkind young CFO, he goes over to the credit union, hammers out a deal whereby any credit union member can qualify for a new quote-unquote group membership plan at Price Club and be allowed to shop there just at slightly higher prices than the business members. It turns out that this does two things. One, this unlocks the gusher of consumers into Price Club.
Acquired
Costco
Exactly. And it's even better than that. Because not only do consumers tell other consumers, it turns out that a lot of small business owners are also consumers. So it also drives small business owner membership.
Acquired
Costco
And because the business members get slightly better pricing on things, all of a sudden, all these consumers are running around being like, oh, hey, I think my aunt owns a nail salon or something like that. Like, let me get her to go sign up and get a membership, and then I can use her card and get better prices. Yep. And David, do you know what I did this week?
Acquired
Costco
So Costco was founded, as many people know, in Seattle, lovely city of Seattle, in 1983 by retail veterans Jim Senegal and Jeffrey Brotman. Now, Jeff came from a long line of Seattle retailers. His dad was a retailer. His brother is a retailer. Jeff was one of the first investors and board members of Starbucks. Super cool. Yeah. And Jim, well, we'll talk about Jim as we go here.
Acquired
Costco
Hey, we are a small business. That's right. I love it. Another fun story. As this unlocks the viral consumer word of mouth channel, of course, traffic at this first San Diego Price Club store starts growing and growing and growing. Saul and Robert start getting calls from local hot dog vendors that want to set up carts at the store's exit.
Acquired
Costco
You're going to attract hot dog vendors. That's right. So at first they ignore them. Eventually, though, they start getting enough calls. They're like, huh, maybe we should do something about this. And maybe rather than letting these guys come set up their carts, what if we do it ourselves?
Acquired
Costco
So Saul calls up Hebrew National Hot Dogs and asks them if they can supply them with hot dogs to sell at the stores. And Hebrew says, not only will we sell you hot dogs to sell, we'll supply the cart too. And thus... The Costco $1.50 hot dog and soda deal is born. And still, to this day, it's $1.50 47 years later.
Acquired
Costco
Yeah, they're a little cagey about what the actual costs are. I do know that they've gone through many, many iterations in-housing all the operations to try and keep their costs down.
Acquired
Costco
It turns out that there is really one pretty sure thing, at least in America, probably the whole world, that if you sell something at lower prices than anywhere else, you're going to sell a lot of it, no matter what hoops people have to jump through.
Acquired
Costco
One of the many, I'm sure, that Howard Hughes had. Yes. We got to cover Howard Hughes at some point on Acquired. Definitely. So on the back of this wild success in San Diego, once again, Sol and Price Club quickly expand, just like with FedMart, first to Arizona and then beyond. This time though, it's way different than FedMart vis-a-vis competition and capital dynamics.
Acquired
Costco
So whereas FedMart was capital constrained relative to the competitors, because of the genius aspects of this Price Club model, They are cash flow geysers, these stores. So the suppliers handle the logistics, deliver directly into the warehouses.
Acquired
Costco
But the minute that the pallet gets dropped off in the warehouse, those goods are for sale. Right.
Acquired
Costco
So in many, if not close to all cases with Price Club and then with Costco today, Those goods are sold before Price Club has to pay the invoice to the supplier.
Acquired
Costco
But if you were around and kind of of shopping age, shall we say, in 1983, you know that the true history of Costco dates way further back than that to someone that we talked a lot about on our Walmart episode, the legendary Saul Price and his two companies, FedMart and Price Club.
Acquired
Costco
You know what? I'm in. I capitulate. I'm with Charlie on this one. He can come in here and give the speech 10 times in a row about how great Costco is. I will listen to all of it. I am in love with this company.
Acquired
Costco
It's just so awesome. I mean, like, if you look at a price club then, and certainly a Costco today... Capital light, quote unquote, would be the farthest thing from your mind. You're like, these are massive structures. There must be so much money that goes into this. Well, yes, that's true. But it's a capital light business model. It's wild.
Acquired
Costco
All right, so let's take the story now from this price club moment of genius initial success through to Costco today. But before we do, we have one of our very favorite companies to tell you about, Blinkist. And we are doing something pretty special with them this season.
Acquired
Costco
And although Costco, quote unquote, was founded in 1983, the organization that we know and love today is actually the result of a merger between Costco and its predecessor company, Price Club. And Price Club is really, of course, the actual result of Saul's previous company, FedMart, which FedMart itself really came out of FedCo in the 1940s.
Acquired
Costco
Blinkist, as most of you know by now, takes books and condenses them into the most important points so you can read or listen to the summaries. It's really great if you want to read more books and just don't have the time.
Acquired
Costco
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Acquired
Costco
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Acquired
Costco
So on the back of these eighth wonder of the world like cash flow dynamics that these Price Club warehouses have, Price Club goes public in 1979, three years after founding. And I say go public, not in an IPO, not in a direct listing. They don't list anywhere. They don't raise any money because they don't need any capital.
Acquired
Costco
So what happens is there's so much buying and selling activity among the original shareholders because this thing has become so valuable that this is the first time I've actually ever heard of this happening. Price Club crosses the 500 shareholder mark that at the time the SEC mandated. If you had more than 500 separate shareholders of a company, you had to start filing as a public company.
Acquired
Costco
So Price Club's just like, OK, we'll file. We'll be a public company. They don't list on an exchange. They're just like, really?
Acquired
Costco
Yeah, it's traded over-the-counter. They're not on the New York Stock Exchange or on the NASDAQ or anything like that.
Acquired
Costco
Yeah, there probably are some market-making systems. I think this is what the over-the-counter market kind of does. But yeah, you can't just go trade it on an exchange. Wow. Hilarious. So 1982, they do ultimately list on NASDAQ probably just to get more liquidity in the trading. Also in 1982, Saul gets a call from his old buddy, Sam Walton. He wants to come out.
Acquired
Costco
He wants to see Saul, wants to have dinner with the two Helens, get the families together.
Acquired
Costco
Yeah, you know, and he's like, you're doing so great with these price clubs. I love your second act. I want to come see it in action. And Saul is like, sure, come on out. I think he knows what Sam is up to, but he doesn't really care. What's he going to stop him from going into a store, you know? Totally. So Sam and Helen come out. They all have a nice dinner in La Jolla.
Acquired
Costco
Saul tells them all about Price Club, how the model works, the cash flow dynamics, everything. Sam, of course, goes back to Bentonville. And within 12 months, guess what pops up? Sam's Club. Amazing. And this is really the major difference here between Saul and Sam. Saul doesn't care. He's like, sure. You know, again, what am I going to do? Stop you? They stay friends forever.
Acquired
Costco
There's this amazing story that Sam tells in Made in America where a few years later, Sam is going around again to Price Club shopping his competitors with his tape recorder, making notes about how they're doing pricing and inventory and stuff. And the security at the store confiscates Sam's tape recorder. Saul ends up just mailing it right back to Sam and he's like, keep your notes.
Acquired
Costco
It's all good. It's so funny. Right around the same time, another person comes out to San Diego to visit Saul and Price Club, a guy named Bernie Marcus. And for some listeners, that is going to ring a lot of bells. Bernie has a story very much like Saul's. He was the president running the Handy Dan Club.
Acquired
Costco
hardware store chain and he had gotten kicked out by the board and was pretty salty about it and was looking for a second act so saul has him out to san diego he shows him the price club warehouse he gives him the playbook and he says look bernie you've got all this hardware expertise take the price club playbook go kick their butt and open the price club of hardware stores
Acquired
Costco
Now we have to. So this now brings us finally to one more call that Saul gets also in 1982. There are these like years in retailing. 1962 when Walmart and Kmart and Target start. 1982 when all this is happening. Another Bernie, this time a Seattle retailer named Bernie Brotman and his son Jeff call up Saul. And they say, Saul, This Price Club thing is fantastic.
Acquired
Costco
We're retailers up in the Northwest, up in Seattle. We'd love to open a franchise up here, a Price Club franchise in Seattle. This is just like the FedCo, FedMart days. And Saul and the Price Club management team think about it, and they make the very poor decision to say no. And in a same echo of what happened, gosh, 30 years earlier, Bernie and Jeff say, okay, we understand.
Acquired
Costco
We're going to do it anyway. We're going to clone the Price Club model and start the same thing up in Seattle. And again, I think Saul is totally fine with this. Because was Price Club growing aggressively before? They were, but they weren't planning to go to the Northwest.
Acquired
Costco
Totally. We start, history and facts. in january 1916 in new york city in the bronx where one solomon saul price is born now saul's parents were jewish immigrants from belarus they'd arrived just a couple years before at ellis island as teenagers they had absolutely nothing they spoke no english they had no money nothing and
Acquired
Costco
They were following the old sort of trade routes of the FedMart playbook of Arizona, Texas, Florida, going out across the South and the Midwest. So what happens next is pretty hilarious. Jeff Brotman cold calls Price Club's head of merchandising. and says, hey, my family and us, we're starting up a Price Club clone up in Seattle. We actually think the Northwest is a great market for this.
Acquired
Costco
Would you be willing to leave Price Club and come up and be my co-founder? And the head of merchandising is like, Well, no, not because I don't think it's a good idea, but you see, Saul Price is my uncle. He's like, but let me give you the number of somebody else who you really should call. I think this guy is the right guy for you.
Acquired
Costco
We've worked with him for a long time here at FedMart and Price Club. He's now left. He's doing some retail consulting, so he'll probably be willing to talk to you. His name is Jim Sinegal. And this is how it all comes together. Jeff calls Jim, convinces him to come up to Seattle. He's ready. He's ready to run his own show, as they say.
Acquired
Costco
So Jim moves up to Seattle, they start Costco, and the business plan is really pretty much exactly just Clone Price Club.
Acquired
Costco
And not only was he Saul's protege, not only is he a tremendous generational talent executor, he also is the guy who ran the division that inspired the whole thing. He really is the perfect guy.
Acquired
Costco
Yep. So great. So within a couple months, they opened the first Costco warehouse in Seattle. Then a few months later, they opened the second in Portland. Of course, both of them take off immediately. Then they go to Utah, to Northern California, to British Columbia.
Acquired
Costco
And this is where you can see that what Saul said about being really great creatively in business at the prices and price club, but not great at execution. Why was Price Club not in Northern California, given that they started in Southern California? These are the kind of mistakes that they made.
Acquired
Costco
So this new Costco under Jim hits a billion dollars in revenue in less than three years after getting started.
Acquired
Costco
Crazy. Once this plays out, and of course Sam's Club is also becoming a juggernaut at this point in time, Price Club is doing fine. Again, capital is not the competitive vector here, but they're not being as aggressive. They're not expanding as fast as Costco and Sam's Club. What happens with Price Club is in some ways sort of the same as what happened with FedMart.
Acquired
Costco
As Saul readily admits, he and Robert are great at creative ideas in retail. They're not so great at scale execution. Now, it's different in that capital is not a competitive vector here. Back in the FedMart days, FedMart was constrained. The whole reason they went looking for a capital partner was they needed more capital in order to be able to grow stores and compete with Walmart and Kmart.
Acquired
Costco
These price club warehouses were paying back their capital investment. quite quickly, especially relative to FedMart because of the cash flow dynamics that we were talking about. So Price Club was certainly doing fine. It wasn't declining. But Jim and Jeff at Costco and certainly Sam at Walmart and Sam's Club, they are pedal to the metal, aggressively expanding.
Acquired
Costco
so saul's parents like many jewish immigrants around then in new york ended up getting jobs in the garment factories in the lower east side and the conditions in these factories were like terrible just absolutely terrible if you went to school here in the us you might remember learning an american history class about the triangle shirtwaist factory fire yes in 1911 you remember that this is like the start
Acquired
Costco
Yep, totally. And Saul, at this point in his life, he's sort of proved himself again. He's made his point after his terrible exit out of FedMart. He steps back from the day-to-day of the business. He hands that over to Robert. He gets really into real estate. He's not as aggressive as he once was. So in June 1993, Costco and Price Club merged together to form the United Price Costco.
Acquired
Costco
Now, interestingly, the transaction really is about as close to a merger of equals as I think we've ever seen on the show, with the caveat that Jim is clearly going to be the CEO that's going to run the combined company. At the transaction, 52% of the equity in the combined company goes to Costco shareholders, 48% to Price Club shareholders.
Acquired
Costco
They're about the same size, about 100 stores each at the time of the transaction. But Costco is growing way faster. So had they just waited a couple of years, the balance of favor would have been way far in the Costco side of things.
Acquired
Costco
Yep. And there was a forcing function to this. It wasn't just that Jim had a soft spot for his mentor, Sol, and for Price Club. Sam's Club and Walmart was aggressively expanding at this point in time. And so if they had waited too much longer, Sam's Club would have just gotten huge and potentially run away with the market. So after the merger happens, even the newly combined Price-Costco
Acquired
Costco
is still only a hair bigger than Sam's Club in terms of number of stores and revenue. So they kind of needed to do it pretty quickly or Sam's was going to run away with it.
Acquired
Costco
Well, you know, it's a second business line under Walmart, of which the main Walmart super center business line is one of, if not the greatest retail business of all time. It's certainly the biggest still to this day. Yep. Saul, kind of amazingly, lives to be 93 years old. He passes away in 2009.
Acquired
Costco
After the merger, he really devotes the rest of his life, the next 15 plus years, to philanthropy and politics. So he does a ton of charitable development in San Diego. He gives back to USC. USC's public policy school is the Price School of Public Policy because he also becomes super involved in democratic politics.
Acquired
Costco
of the American labor movement and the Communist Party and the Socialist Party emerge as a reaction to this in America, because it's a terrible disaster. Literally, the factory owners had locked the doors to keep the workers in the building so they wouldn't steal. And then a fire breaks out. 146 people are killed, mostly women and young girls. This is terrible. Terrible.
Acquired
Costco
And actually, when Obama is running for president in his first campaign in 2008, he's He comes through San Diego and meets with Saul Price, you know, 92-year-old Saul Price. That's how influential he is, how much money he's giving to the Democratic Party in this kind of last chapter of his life.
Acquired
Costco
Yeah, this is one of the most surprising things about Costco. They have the lowest prices, but they have the wealthiest consumers of any major retailer.
Acquired
Costco
I think this is called the endowment effect, if I remember back to my psychology classes.
Acquired
Costco
Yes. Now you mentioned getting a good deal. We talked earlier back in the FedMart days about how loss leaders and sales was kind of an anathema. to solve price. How does that play into this?
Acquired
Costco
So Saul's parents didn't work at Triangle, but they worked at other factories just like this. Crazy. And you can't make this up. Saul, maybe the most influential American retail capitalist in history, comes out of the Triangle Shirtwaist Factory movement and communism and socialism and everything that's happening in New York and the Jewish community at this time.
Acquired
Costco
Well, and I think also, back to the membership, it all comes back to member trust. The members have to trust that they are going to get the absolute best price on everything and that Costco isn't going to be playing these games. Otherwise, they would just go shop at Amazon or Walmart or wherever.
Acquired
Costco
Totally. It's worth double-clicking on the supplier relationship for a sec. Costco's relationship with their suppliers is worlds apart from Walmart's relationship with their suppliers. You go to Bentonville as a supplier and you are getting put through the gauntlet. It is designed to squeeze you as much as possible. That is not how the supplier relationships work with Costco.
Acquired
Costco
They'll work with their suppliers. They'll understand your business. They'll come see you.
Acquired
Costco
Sam Walton actually wrote in Made in America that he stole more ideas from Saul than anyone else in his business career.
Acquired
Costco
So there's a really fun acquired canon, acquired cinematic universe story related to this, which is the famous, as chronicled by Brad Stone in The Everything Store, coffee date between Jim Senegal and Jeff Bezos in 2001, which occurs at the Starbucks inside of the Bellevue Barnes & Noble. Yeah. Of all places. That's right. Jeff has this coffee with Jim and Jim explains this philosophy to Jeff.
Acquired
Costco
Jim Senegal, of course, co-founder, CEO of Costco. Jim tells the story that a reporter once asked him if he learned a lot from Saul. And Jim replied, no, that's inaccurate. I didn't learn a lot. I learned everything. Absolutely everything I know I learned from Saul. So we found this awesome biography of Saul that's like really rare. It's out of print. It was written by his son, Robert.
Acquired
Costco
Jeff comes back to Amazon HQ the next day and is like, I'm reversing the policy and says exactly what you just said. There are two types of companies in this world, companies that work hard to charge their customers more and companies that work hard to charge their customers less. Henceforth, as of today, Amazon is a company that works hard to charge its customers less.
Acquired
Costco
It's so funny going back to our previous episode and Rob Strasser's 10 principles at Nike. And like, on the one hand, the Nike principles and the Costco principles are about as far apart as you could imagine. On the other hand, Rob Strasser Nike principle number 10 is if we do the right things, we'll make money damn near automatic.
Acquired
Costco
So back to the story. At the time of the merger, the combined company was about $16 billion in revenue. That was up from Costco alone was $3 billion in 1989. So by the merger in 93, Costco and Price Club are each about $8 billion in revenue and then $16 together. So fast-growing, impressive scale already.
Acquired
Costco
Yeah, a combined 200 stores. So pretty large footprint. They're in Canada. They're in Mexico. They've already started international expansion, which then is going to become huge throughout the 2000s, as we'll see for Costco. But right around the time of the merger, Costco takes a pretty important step that unlocks a huge part of the next chapter for the company.
Acquired
Costco
And that is the creation of the famous Kirkland Signature house brand. And there's a fun story around this. When they were talking about creating their house brand, the company's corporate headquarters was in Kirkland, Washington, right near Bellevue, right across the lake from Seattle. And so that's where the Kirkland Signature name came from.
Acquired
Costco
And if you are a fan of Costco or want to learn about retailing or just like all these business practices, you absolutely should try to get your hands on this thing. It's self-published too. It's self-published. I don't think there's anywhere else in the world that lays out in detail exactly how Costco works and its predecessor companies. It's amazing.
Acquired
Costco
I think by the time they actually launched it, they had relocated to Issaquah, a little farther south, and they were like, we can't call this Issaquah Signature.
Acquired
Costco
But it was tied in with international expansion because they needed a brand name and a trademark that they could clear across all the countries that they were operating in and planning to operate in. And so Kirkland Signature, like, that works in Japan, that works in Korea, that works in Taiwan.
Acquired
Costco
And maybe the most obviously and perhaps most famously where this comes to bear is in wine and liquor sales. The Kirkland Signature wine, you know, you'll get people who are wine snobs that'll drink Kirkland Signature wine. They're like, yeah, yeah, yeah, it's Costco. But like, this is actually good stuff. And tequila and vodka, it's the same thing.
Acquired
Costco
Yep. Now, they also have a pretty unique opportunity, they realize, with their house brand. Because of the very small number of SKUs that they're putting in the warehouse, there's much less competition on the shelves for any given product category for the house brand.
Acquired
Costco
So like, yeah, you mentioned, you know, Whole Foods has the 365 house brand, Walmart has their house brand, you know, blah, blah, blah. All these big retailers do. Safeway certainly does. But in a standard retail environment the house brand is going to be one of like five or six or ten different brands of a given product category on the shelves at costco it's one of two three or
Acquired
Costco
So... At the same time, too, as they're spinning up Kirkland Signature in the kind of mid to late 90s, they also start expanding internationally. So first they go to the UK, then they go to Korea, to Taiwan, to Japan, ultimately China, which is now a big initiative for them.
Acquired
Costco
What's interesting is I think at the time, I suspect there were very few other Western-style global or globally aspiring retailers that were entering Asian markets because it's not exactly obvious that... A huge warehouse with bulk packaging would work in cultures like, say, Japan, where people live in tightly packed, dense urban environments, much smaller houses and apartments than in America.
Acquired
Costco
Yep, just like Costco warehouses are purpose-built to drive down their costs and sell high-quality products at the absolute lowest prices, Crusoe does the same thing with their data centers. So for many AI workloads, you'll get significantly better performance for your costs from Crusoe than any traditional cloud provider and with a really cool environmental benefit.
Acquired
Costco
They've gone out to energy sites, think like Texas, Montana, Argentina, and more, and built their data centers right on top of oil and gas flares. Which, before Crusoe, was just an enormous waste of energy that generated tons of unnecessary greenhouse gas emissions. It takes some crazy ingenuity to pull this off. True vertical integration.
Acquired
Costco
Crusoe manufactures their own designs of modular data centers. Like, building data centers out in oil fields. They own the servers, the networking, the software stack, even trenching last mile fiber to get connectivity out to these sites. And bonus, they also improve rural connectivity for the communities that they work in.
Acquired
Costco
They do all the work to build the data centers, build the onsite infrastructure, and then ultimately power Crusoe Cloud all in-house. Crazy.
Acquired
Costco
Oh, amazing. That's how rare this thing is. So back to Saul's growing up years. He says in the book, there's a quote from him, in the New York Jewish community at the time, there was no such thing as Republicans. The socialists were the conservatives and the communists were the radicals.
Acquired
Costco
Yeah, it comes back to trust. And part of this, too, also harkens back to Saul and the FedMart days. Saul developed this kind of principle back in FedMart that he called the intelligent loss of sales.
Acquired
Costco
Yeah. So this isn't necessarily the number of brands in terms of the selection out there. This is about product sizes. So today, Costco has taken this to the extreme of like, you can only buy the two and a half pound jar of nuts. There's no like eight ounce jar of nuts. Well, you could buy a whole bunch of little packs of afternoon packs of nuts. Either way, you're walking out with a lot of nuts.
Acquired
Costco
But other retailers and everybody back in the FedMart days had all sorts of different sizes of products. And the idea was that by having different sizes, you would maximize the surface area of customers in market that you could reach. Like Saul uses the example in the book of household lubricating oil, like kind of WD-40 type stuff.
Acquired
Costco
He's like, we only carried the eight ounce can, even though there was like a three ounce can out there. We lost some sales from customers that only needed one or two ounces and thus would only buy a three ounce can and they just didn't buy the eight ounce can.
Acquired
Costco
But it was worth it to us to forego that because by only having the eight ounce can, we could reduce the number of SKUs that we had and get all these benefits that you're talking about, Ben.
Acquired
Costco
Absolutely. So as a young child, he develops an eye defect that causes his left eye to droop. He's really self-conscious about this, as you can imagine. But as a result, he channels all of this insecurity into being like a massive overachiever in school. So he skips two grades in school growing up.
Acquired
Costco
Totally. If we didn't do it this way, we would need to have an ad sales team or work with an outsourced network or something like that. That would add way more overhead to our business that we don't want.
Acquired
Costco
And it's not like Walmart hasn't invested many tens of billions in their distribution and logistics systems.
Acquired
Costco
I love it. This is the bricks and mortar retail version of the SaaS business fallacy, which we fall prey to all the time on the show, which is if you invest in or build or around SaaS companies and SaaS company margins, you can fall into the trap of thinking, well, why would I ever want to be involved in a business that doesn't have 90% margins?
Acquired
Costco
And then in the middle of his high school years, his parents moved the family from New York City to San Diego, California. Now, San Diego, it's a town of like 150,000 people. This is not the San Diego we know today. There's no Qualcomm. There's no Illumina. There's only like just the beginnings of the U.S. Navy and the defense industry there. But it's a small town.
Acquired
Costco
But actually what you should really care about, especially as an investor, is not your margin percentage, but your absolute margin dollars. And so yes, Costco has much lower margins than their competitors, but the volume that they drive and the actual dollars end up being worth it.
Acquired
Costco
Yeah. Okay. I think it's time to talk about investing nerds' favorite aspect of the Costco story, which is that there really are two different businesses here under one roof. There is the retailer and then there is the membership business. It's almost like way back, Saul and Robert sitting in the office after FedMart thinking, you know what? We actually had two different businesses at FedMart.
Acquired
Costco
Costco is also two different businesses. There is the operations of the retailer, and then there is the membership business.
Acquired
Costco
I mean, when we were talking about the FedMart days, like it was $2 for a lifetime membership.
Acquired
Costco
I mean, that sounds like a venture capital management company. It's pretty wild. All right. Speaking of membership, let's talk about the last big innovation piece of the puzzle before we get to the business today. And that is the two-tiered Costco membership system and the executive memberships, which they launch in 1998.
Acquired
Costco
when saul gets out there to san diego in a parallel moment to sam walton's early life saul meets his future wife while he's in high school and it turns out that saul's future wife's first name is helen just like sam's wife name is also helen and sam's wife would be very influential on him along with her family same thing with saul
Acquired
Costco
Which is so awesome and also different than other retailers. I mean, now there's all sorts of fancy technology systems to do this, but Costco has always been able to track customer spend at the individual level because they're all members. They have accounts for all of them.
Acquired
Costco
Amazing. And you can really see the fingerprints of this DNA in Amazon Prime. Obviously, the whole thing is inspired by the Costco membership writ large, but these same dynamics definitely play out for Prime members at Amazon of order more frequently, much more likely to renew, access a whole suite of services.
Acquired
Costco
so just like helen walton helen moskowitz soon to be price comes from one of the wealthiest families in san diego this is literally just like san diego walmart literally that's what's about to happen here just like 10 years before sam and walmart wow so helen's family owns and operates a scrap metal business
Acquired
Costco
Yeah, I imagine there's not a lot of defaults in the Costco customer segment base. There's also some fun history to all this, too. So that deal, which you may know, Ben, used to be with American Express. And then they essentially kind of held an auction, as you say. I think the origins of this, though, start all the way back with the original Price Club business plan.
Acquired
Costco
not to offer credit, but specifically not to offer credit. Another one of the big benefits of moving to this business wholesale model was they could get out of the credit card game that they had to play at FedMart. When they were only selling to businesses, when that was the plan, it was like, hey, cash or check, that's it. No credit card exchange fees that we're going to have to bear.
Acquired
Costco
And then when they opened to consumers in the group model, they kept that. So for a long, long, long time, you couldn't use credit cards at all in price club Costco's.
Acquired
Costco
A scrap metal business in the 1930s in San Diego is about as well positioned as you can possibly be because San Diego is about to go through a huge transformation during World War II. It's going to become the principal port of the U.S. Navy's Pacific Fleet, which is going to be the main naval operations of World War II. The city is going to absolutely boom and it's going to be shipbuilding.
Acquired
Costco
And you operate in arguably the second or maybe third biggest market in the world, which is global retail.
Acquired
Costco
once Saul got things figured out in the second iteration with Price Club. Really straight line to today. So let's paint the picture today. And then I think what's interesting to talk about next is, okay, everybody knows how this all works. How is it defensible? Why does only Costco do Costco? But first, tell us about Costco today.
Acquired
Costco
Yeah, that's wild. If I remember from our Walmart episode, Walmart, I think, has over 2 million employees. I believe Amazon has well over a million employees.
Acquired
Costco
The individual warehouses these days, you may have these stats exactly, but I think an average Costco warehouse generates over $200 million in revenue. And the top ones generate $300-$400 million of revenue for a single store. Single Costcos could be scaled public companies on their own.
Acquired
Costco
It's also wild that these stores are still growing at those rates year over year, given that many Costco stores have been open for like 30 plus years at this point.
Acquired
Costco
Yeah, and exactly to that point, you know, one of the sort of famous aspects today of the Costco shopping experience is the treasure hunt nature of it. And this is something that they've learned over time. You know, the original Sol Price, Price Club business plan was just the 3000 core SKUs for businesses and then opening that up to consumers.
Acquired
Costco
Along the way, they kind of realized that, hey, if in addition to the core staples we have, which pretty much don't change, we could change the brands, we could change the exact details of what they are, but we're always going to have nuts. You know, we're always going to have chicken, stuff like that.
Acquired
Costco
If we have a small number of additional ooh-and-ah, wow, one-time items such that every time as a member you come into the store, there's something new and different for you to find and buy at a really low price, that would drive repeat traffic and make coming to Costco more of a novelty, more of an entertainment event. And so today, I think about 25% of their SKUs are these treasure hunt items.
Acquired
Costco
During and after the war, all these sailors and GIs come through the city. And then when the war is over and they come back home, wherever they lived in the country before, they're like, wait, why am I living in Kansas? I should be living in San Diego. San Diego is pretty great. It's really nice there. So from 150,000 people, when Saul moves there...
Acquired
Costco
Yep. And I think for the items, again, the non-staples, the treasure hunt type items, they intentionally want to run out so that they're not going to be there next time you come.
Acquired
Costco
Well, because as we were talking about, for most, if not all of their suppliers, they are by far the biggest buyer of their goods, even bigger than Walmart because they have so many fewer SKUs in the store. Yep. This is so fun. I feel like there is such a resonance between Costco and Nike, even though on the surface they're so different. Maybe this is like a Pacific Northwest thing.
Acquired
Costco
But I really think Nike has incredible brand power, but they choose not to use it to increase their margins. They choose to use it to keep prices low and accessible for customers. And Costco does the exact same thing here.
Acquired
Costco
Costco could definitely make a higher margin than they do now and still charge lower prices than Walmart, but they choose not to, and instead they share that benefit back with customers.
Acquired
Costco
After the war, San Diego is on a path to becoming today it's the eighth largest city in America. It's larger than Seattle. It's larger than San Francisco. Oh, I wouldn't have guessed that. Yep. So this is going to become quite the fertile market, shall we say, for a new retail enterprise in post-war America. But before then, Saul goes to USC and gets his law degree.
Acquired
Costco
Lower our overhead and lower the prices that we're paying suppliers so we can pass that on to customers too. This is amazing. So this might be the first example I think that we've found in the history of the show. I think Costco has incredible counter-positioning power today as a large incumbent in a way that they did not have when they got started. Ooh, this is rare.
Acquired
Costco
They probably had some counterpositioning in other ways, but today I think they have huge counterpositioning versus Amazon and e-commerce. And we should talk as we go here about Costco's e-commerce operations, but they are famously Spartan, shall we say. To me, the whole point of Costco is you go to the Costco.
Acquired
Costco
Yeah. It is completely counter-positioned to Amazon's whole reason for being, which is convenience. Certainly, if price is no object, it is way more convenient to just click, click, click in the shopping cart in Amazon and have it show up at your door.
Acquired
Costco
So as we've been researching this episode, naively in the past, I always thought, oh yeah, Costco's great, but they really don't get the internet.
Acquired
Costco
Yep. But I think where they've ended up is actually in a pretty good place and in a better place, I think, than Walmart. Yeah. And that place being that, no, no, no, the whole point is we are not an e-commerce company. And the whole point is you come to the warehouse.
Acquired
Costco
And because you come physically to the warehouse and you take the stuff off the shelves, you're going to be able to get absolutely the best price versus anywhere else. And Amazon today has really become something else from what Jeff wanted it to be after his coffee with Jim Sinegal.
Acquired
Costco
Far, far from it. You are very much paying for the convenience of shopping on Amazon. I think on almost every product these days.
Acquired
Costco
Yep. So yeah, I really think that Costco, amazingly as this huge incumbent, has developed a lot of counter-positioning power.
Acquired
Costco
Yep. I don't think there's a cornered resource, but branding is an interesting one. Let's talk about that.
Acquired
Costco
They come back to San Diego and he starts practicing as a lawyer. Now, Saul's timing is just, I mean, you could not script this any better. He becomes a lawyer right before this boom. When you're a lawyer in a small town, I mean, my parents were lawyers in a small town growing up. You're a lawyer for your clients, but you're kind of also consigliere.
Acquired
Costco
And this has always been part of the strategy, even going back to the FedMart and Price Club days. Saul and then now Costco doesn't advertise either at all or like very, very minimally. But they very intentionally back in the day tried to get local six o'clock news stories about like, oh, the lines at Costco. Oh, this crazy treasure hunt item at Costco. And it always worked.
Acquired
Costco
Whenever there was a store opening, news crews would go nuts. And it's kind of like the Nike athletes wearing the shoes on the cover of Sports Illustrated sort of thing. Yeah. That's worth a lot more in earned media than anything you could ever buy.
Acquired
Costco
And it's classic Costco. Like, I'm sure this didn't actually happen. They just kind of like made up this story. It might have actually happened. Oh, I mean, Craig has been working in FedMart since the 70s. He would never raise the price of the hot dog.
Acquired
Costco
You're advising on business, real estate, negotiations, divorces, trusts, estates. You're like super deep with your clients. So after the war, Saul starts counseling all these entrepreneurs with these new retail concept startups that are emerging in San Diego. One of these startups is called the Seven Seas Locker Club, which
Acquired
Costco
Totally. I mean, let's just say, I don't think we've talked market cap yet. Costco does what, $240 billion in revenue today?
Acquired
Costco
There you go. Costco obviously trades at a much higher multiple than Walmart. You are exactly right. I think it's because of this. It's because of the durability. It's because of the membership model. It's like... you know that that revenue is not going anywhere.
Acquired
Costco
Yes. Costco, I think, is pretty uniquely positioned in that they're going to do well, I think, in any economic climate. Because in a recessionary environment, they're going to do well because they are the lowest priced retailer of goods out there. In a boom environment, I think they're also gonna do well because of the nature of their customer base.
Acquired
Costco
Whereas Walmart is kind of getting squeezed on both directions, I think. In recessionary times, they probably do well, but not as well as Costco because they don't have the absolute lowest prices. And then in boom times, I think people migrate out of Walmart into shopping on Amazon, shopping at Costco.
Acquired
Costco
Ostensibly, the premise for this business is literally a club of lockers where Navy sailors can store their uniforms when they're on leave and wearing their civilian clothes. And then when they go out to sea, they can store their personal clothes and effects while they're away on the ships. Yep. But actually, that's just a Trojan horse to get all of these consumers into the door.
Acquired
Costco
Yeah, I think this is a critical playbook theme for them. They've managed to create this sort of walled garden inside of Costco. And I use that in not the typical walled garden term of being like, consumer-unfriendly, you're keeping them in the walled garden. It's exactly the opposite.
Acquired
Costco
Within the garden walls of a Costco warehouse, whatever price products are doesn't, in consumers' mind, equate to their value or what their price should be outside of the walls of the garden.
Acquired
Costco
Yes, I knew you were going to get to the chickens. I was just waiting the whole time. I was like, when is Ben going to talk chickens? Oh.
Acquired
Costco
And then they offer all kinds of goods and services to them within the locker club. So there's laundry, there's dry cleaning, there's clothing, there's jewelry, there's food, there's haircuts. This might start to sound a little familiar here. Another client is a jewelry store called Four Star Jewelers.
Acquired
Costco
A few billion here, a few billion there, you know, whatever. We're talking 70% gross margin business for NVIDIA.
Acquired
Costco
Yeah. Well, it's so fitting to the nature of the business and their margins. When you have 11% gross margins, you're like, yeah, I care about every penny.
Acquired
Costco
Now, in addition to operating their own jewelry store, these guys also sell jewelry wholesale to other retailers. And it turns out that there's one account in particular that accounts for like the vast majority of their outside wholesale business. And it's this odd retail concept operating out of Los Angeles called Fedco. And you're like, Fedco? What is a Fedco? What is happening here?
Acquired
Costco
Yes, it's so great. A few more things to say on this. One, I literally just looked up as you were talking Craig Jelinek's LinkedIn profile. It still says he's an EVP at Costco. The dude has been CEO for like a decade. Amazing.
Acquired
Costco
The reason I looked up his LinkedIn profile is that the backgrounds of these people are so different too than what you would typically think of as like the management team of an American Fortune 50 company. Jim went to San Diego City College, right? Craig went to San Diego State University.
Acquired
Costco
They started as baggers at FedMart when they were teenagers and they've just worked through the business all the way through. Yeah, occasionally there's somebody like Giles Bateman who comes in who went to Harvard Business School, but like that is the exception, not the rule.
Acquired
Costco
While we're talking about the people here, I think a related but separate playbook theme is truly the promoting from within culture there. It's always been the case going all the way back to FedMart and really carries through to this day. And it's just astonishing to me that a $250 billion market cap company, this is so ingrained in the culture.
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Other companies talk about this, but then you'll see like, oh, they go do a CEO search and they bring in somebody from McKinsey or something like that. Nobody walks the walk on this except Costco.
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Costco
You know, there are no hard and fast rules in investing, obviously. And if you think there are, that's a great way to lose your shirt. But it's funny to note that every time we've used a version of that phrase on Acquired when studying a company that Wall Street analysts think XYZ company is a charity being run for the benefit of X, turns out that those are pretty great stocks to own.
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Costco
How are you ever going to find a bear case about this company? I mean, God, I'm like, can we bring Charlie in here and lecture you on this?
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Costco
Yeah, exactly. Well, Fedco, it turns out, was a non-profit membership club. It was a customer collective, and it was called Fedco because it was only open to federal employees, primarily postal workers. After the war, about 800 postal workers in the Los Angeles area decided somehow that they wanted to pool their buying power together and their federal employees.
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Costco
Yeah. Maybe part of that is because Walmart has just been placing their resources elsewhere, particularly in the e-commerce fight against Amazon. Like, I think Walmart has basically decided, look, we're not going to kill the Sam's Club business, but this is not where we're focusing our competitive energies right now.
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Costco
Yeah, how big is this market? Exactly. And that, I think, is actually a bull case for Costco. Yeah. Because you could argue maybe they are, maybe they aren't saturated in like North America, but... They're not. They're totally not. Yeah, I think they're not. And they are definitely not saturated in Asia, in the rest of the world, in Europe, in Africa, in Australia.
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Costco
And so they start this club so that they can pool the buying power and get better prices on goods that they can all participate in together. Well, it turns out there are a lot of federal employees out there, especially in San Diego. They charged a membership fee. They charged dues to join. But unlike Costco today, they didn't really make any money on the memberships. Remember, they're a nonprofit.
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Costco
China, right? I miss doing our China Tech episodes because I feel like every 10 minutes in those episodes, we'd just be like, China, like things are of a different scale there.
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Costco
Well, A, they're playing the long game. B, the executives at the time probably were reasonably assured they were still going to be the executives 20 years from then. So, like, why not?
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Costco
This is sheds, this is refrigerators, this is washing machines, this is water heaters. Right. Didn't you almost just order a fridge this morning on Costco? Exactly. I'm saying this because I almost had to replace my refrigerator. Turns out I was able to get it repaired, thankfully. But I was briefly in the market for a refrigerator, and it was super interesting dynamics.
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Costco
Costco had the lowest price on the model that I was looking at, but only by like $20 versus Best Buy and Home Depot.
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Costco
Yeah, like a $1,500 refrigerator, which I'm glad I didn't have to buy. But all the other players, clearly the manufacturer was a Samsung refrigerator, was running a promotion. So the MSRP was $2,000 and all those other retailers were saying, oh, this week only it's on sale for $1,500 and Costco had it for like $1,470. Next week, Costco will still have it for $1,470 and it'll be $2,000 at Best Buy.
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Renaissance Technologies
Oh, I thought you were going to say you've typed it so many times now over the past month.
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Well, they probably got margin called by all their counterparties.
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Totally. Not just is this the start of his entrepreneurial career, the seeds of this financially are what go on to start Rentech. It's wild. Totally wild. So Jim takes a year off and goes down to Bogota.
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Well, I thought where you thought you were going with this. I was like, yes, I would totally agree. They're not in the investment business. They have no idea how to invest. The model does.
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Now, I think where you're going with this is perhaps similarly along the lines to Caesar's Palace or a casino. They are not in the investment business, but they are providing a service. Sure. Is this where you're going with this?
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Well, where I was going with the service provider, I think casinos are service providers. They are providing entertainment to their customers. Everybody knows that the games are stacked in the casino's favor. Similarly, I think you could make an argument, and I think this is probably quite accurate, that Rentech and all other quant firms like them are providing a service to the market in
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in that they are allowing trades that people want to make to happen faster and at much lower spreads.
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And any single one of us can go buy a security in just about any market at just about any time of day pretty much instantaneously and get a very very very granular price on it yep none of which used to be true nope
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Right. Lots of them lose money. You too, listeners, could beat the market. Not investment advice. Please don't try.
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Renaissance Technologies
Oh, there's this great, great vignette at the end of Greg's book. When was it? It was during one of the like sell-offs in the mid 20 teens in the market where Jim calls the head of his family office. He's long retired from rent tech at this point, calls the head of his family office and says, what should we do with all the sell-off in the market? And it's like, you're Jim Simons. Right.
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Yes. Accurate. So he does that for a year. They get it set up. He gets bored again. He's like, all right, I don't want to just run this company. I've helped set it up. I have an ownership stake in it now. He bounces back to Boston, this time to Harvard as a professor there for a year. He's really racking them up. But he spends a year there and he's like, ah.
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Oh, yes. This is such a really mind-blowing point here in value creation, value capture. Go for it. Take it away.
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Yep. These are all great points. They all came up in the research. I totally agree with all of them. It is, in my opinion, false to say that quantitative finance does not create value for the world. It definitely does, in my opinion.
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They're really, really good at value capture. This is not Wikipedia here. This is about as far away on the spectrum as you can get.
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the itch again and you know the junior professor's salary isn't that much and like we said about him back from his childhood days he sees the appeal in being rich and he's like this is not a path to being rich so he's like I'm gonna go put my skills out on the open market
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The bull case for the GP and LP stakeholders in Medallion, which is, I don't know, 500 people in the world, and none of the rest of us can get any exposure to it.
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Right. There's no way for us to know any of this because there's no way to know any of this.
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Yep. Okay. Our new ending section, the splinter in our minds, the takeaway. The one thing you can't stop thinking about. What is the one thing for each of us personally from doing this work over the past month on Rentech that sticks with us? For me, perhaps this is obvious from my little diatribe on the tapestry.
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He gets a job in Princeton, New Jersey, not at Princeton University, but at the Institute for Defense Analyses, which is a nonprofit organization that consults exclusively for the U.S. government, specifically the Defense Department, and specifically the NSA. These are the civilian codebreakers. Yes.
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I just think this is such a powerful example of the power of incentives and getting them right and setting them up right. And culture, too. I don't want to shortchange that. I think the culture of managing an academic environment in a fashion like a lab, but without letting it spin into the frivolity of a lab that Jim Simons set up.
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Yeah, this is like early Google. Exactly. There historically has not, from our research, and as best as we can tell currently, is not anything going on at Rentech that is frivolous. They are all very focused, which again to me then speaks back to the power of incentives.
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When you're there with less than 400 people, and on the research and engineering side, less than 200 people, and those colleagues who you work with are the sole purveyors, supervisors, and beneficiaries of all of this that you're doing. That is so powerful. I can't think of anywhere else like that in the world.
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I mean, maybe some venture funds or other investment firms, but not on a day-to-day, fully liquid with returns like this. There's nothing like it.
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Yeah. Which is not to say I would necessarily want to work there. I think I would not. But it is truly unique.
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It does make you wonder, to what you were talking about with the tech industry catching up, quote unquote, in recent years, how hard is it to build this now, given the technology, open source and otherwise, that's available for sale out there?
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Yeah. And then what's going to happen? By nature, given that it's a complex adaptive system, if you can now buy and build this, well, the returns will get arbitraged down.
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Well, there's the whole crazy thing with Chanel where the company ends up getting bought by Chanel the Perfume Division, which is the two Jewish brothers in New York.
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As you and listeners know, I'm not a TV guy, but this is so up my alley.
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My carve-out is related to the new look in a very different way, but both video consumption and fashion and luxury and style. It is the class of Palm Beach Instagram and TikTok account. This is so great.
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This is amazing. So Ben and I went to Palm Beach for a couple of days for a speaking event recently, which was amazing. I'd never been to Palm Beach before. Oh, it is nice. So great. We didn't knowingly spot any rent tech people there, but we may have.
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The style in Palm Beach. We had just recorded the Hermes episode and oh man, I was so pleased to be there. And then I got home and Jenny, my wife was like, do you not know the class of Palm Beach TikTok account?
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I live under a rock. I'm a dad. And she showed it to me. This is a woman who lives in Palm Beach and she goes around, she posts on Instagram and on TikTok, and she just interviews people on the street about what they're wearing, what brands they're wearing, their style. It is magnificent. My favorite is, we'll see if we can find it and link to it in the show notes.
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Yep. So the IDA there in Princeton kind of functioned like the Institute for Advanced Study, which is also in Princeton. That's where Einstein went when he came to America, kind of an independent think tank research group, except it's solely focused on code breaking and signal intelligence with the Russians during the Cold War.
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There's a video of one woman who's being interviewed who has a mini Kelly inside her Birkin.
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And that's when I was hooked. I was just like, this is the greatest thing I have ever watched. I'm obsessed.
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Renaissance Technologies
No, you can get it on Instagram too. Oh, all right. Good. I actually subscribed the Acquired account on Instagram to Class of Palm Beach. I don't know how many people we're following. It's not many, but we are following Class of Palm Beach.
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Yes. For sources for this episode who were so generous with their time and thoughts. First, huge thank you to Greg Zuckerman, author of The Man Who Solved the Market. the canonical book out there about Rentech and Jim Simons. Greg was super generous, spending time talking to us, emailing with us, making sure we're getting things right.
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He also, he and the book is the canonical source of Medallion's investment returns. And I know he worked so hard to get that table together that is now all over the internet as it should be.
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Yes. Truly a service to us and to corporate historians and financial historians everywhere that he did that research and got those returns.
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It's a funny moment where Peter's like, where are you getting these questions? How do you know all this stuff? And I'm like, come on. They read the book. Clearly. Yeah.
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Other people to thank, Howard Morgan, who we spoke to, which was so fun to get a bunch of the first round history from him. And then, of course, the founding of Rentek and partnering with Jim and investing in each other's funds and all that. So fun. Brett Harrison, who you mentioned, Ben. Brett is now building Architect, which I love this. This is so needed in the world.
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Renaissance Technologies
It's the interactive brokers for the 21st century. Yeah. Well, anybody who uses interactive brokers knows exactly the opportunity there. So thank you, Brett. And then Matthew Grenade, who I spoke with. Matt is the co-founder of Domino Data Lab, which is a great enterprise AI ops platform backed by Sequoia and many others.
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It allows model-driven businesses and products to accelerate research, increase collaboration, rapidly deliver new machine learning models. All of the sorts of things that we were talking about here with Rentech. Matt, before starting Domino Data, came out of the quant world.
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He was at Point72 and Bridgewater, which isn't really quant sort of its own thing, but he was a longtime senior employee at both of those firms. And he gave us great, great perspective on the landscape of everybody out there and where Rentech fits in.
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Yes, this is so, so key. And this culture ends up getting translated whole cloth right into rent tech. So the way IDA worked, and I assume still works to this day, is they recruited top mathematicians and academics to come be codebreakers there. They would double their salaries.
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They figured out that they needed to attract the smartest people in the world who weren't going to come just go work for the Department of Defense. This was the way to do it. So like you said, Ben, The charter of the group was that employees had to spend 50% of their time doing code breaking.
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But the other 50% of the time, they were free to do whatever they wanted, like research, pursue whatever they were doing in academia, publish papers. Kind of the appeal of going there was, hey... It's the same thing as being a professor at MIT or Princeton or Harvard or whatever, except you're doing code breaking instead of teaching. And there's no bureaucracy to worry about. There's no politics.
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It's just like, hey, you do your code breaking work and then you publish and you can collaborate with your colleagues there.
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Now, this is pretty crazy. Very quickly after Jim arrives at IDA, remember he's in money-making mode at this point in time, he recruits a bunch of his very brilliant colleagues to come work with him in their 50% free time on an idea to apply the same work and technologies that they're using in code breaking and signal intelligence to trading in the stock market.
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So they come together and they publish a paper called Probabilistic Models for and Prediction of Stock Market Behavior. And everything that they suggest in this paper really is Rentech.
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fundamental analysis was then as in most of the world today still is the primary way of investing in things of hey i know this company i'm going to analyze their revenues their price multiple or i'm going to think about what's happening in the currency markets or in the commodity markets and why copper is moving here or the british pound is moving there and i'm going to invest on those insights
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Renaissance Technologies
Yes, fundamental investing. There also existed in the 60s technical investing, which kind of is voodoo. This is like I'm looking at a stock chart and I've got a feeling that it's going to go up. Like I'm tracing this pattern and like it's going up, baby. Or no, no, no, this pattern is going down.
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And what Jim and his colleagues here are suggesting is that, but just not really done by humans. It's that with a lot more data and a lot more sophisticated signal processing.
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Totally. When Jim started working on code breaking, I think he just looked right back to his experience trading in the markets and was like, whoa, this is the same thing.
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Yes, there's all this noise in this data, and it is impossible for a human to sit here and look at this data and say, oh, I know what the Soviets are saying. No, no, you have to use mathematical models and statistical analysis to extract data. the patterns.
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Yes. What they are really doing here at IDA and then soon in Rentech is early machine learning. And Jim just had this incredibly brilliant insight that you can use these techniques and this technology for making investments. Which makes this the perfect time to talk about our presenting sponsor for this season, J.P. Morgan Payments.
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Renaissance Technologies
Unsurprisingly, JPMorgan Payments has been in the AI game for years now. Similar to Rentech, they were also early to recognize the value of AI to gather, process, and analyze those massive troves of data to provide solutions for their customers and mitigate risk. Like when they incorporated AI into their cash flow forecasting tool, which helps businesses manage liquidity.
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Renaissance Technologies
Yep. We were doing some research to prep for this segment, and we came across something pretty wild. The United States Treasury Department has started using AI to detect suspected check fraud and recovered over $375 million in 2023 utilizing the new tools. The U.S.
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Treasury Department disperses trillions of dollars annually, so if they continue to employ new technologies like this, it could really add up to the tune of billions. So how does this fit in? Well, the Treasury Department recently selected J.P. Morgan to provide account validation services for federal agencies.
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Renaissance Technologies
Obviously, payment integrity and this issue of improper payments is top of mind for them. and at enormous scale. So whether you are one of the largest institutions in the world or a small business like us here at Acquired, JP Morgan offers you peace of mind and protection.
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Renaissance Technologies
When it comes to payments technology, businesses of all sizes can benefit from having end-to-end AI-powered solutions that are constantly learning. And J.P. Morgan's API-first infrastructure across all aspects of treasury and payments is a one-stop shop solution.
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Renaissance Technologies
Yep. So then the natural question is, okay, what is the model here? How are they going to do this? And it turns out that one of the employees of IDA at this time and one of the members of this sort of rebel group, shall we say, within the organization is a guy named Lenny Baum.
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And Lenny just happens to be the world expert in a mathematical concept called a Markov model, specifically a version of the Markov model called a hidden Markov model. Now, a Markov model is a statistical concept that's used to model pseudo-random or chaotic situations. Basically, it says, let's abandon any attempt to actually understand what is going on in all of this data that we have.
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And instead, just focus on what are the observable states that we can see of the situation? Can we identify different states that the situation is in? And if we just do that, can we predict future states based on what we've observed about the patterns of past states? And the answer to that is usually yes, even if you don't know anything about fundamentally how the system operates.
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Renaissance Technologies
So we brought up machine learning and AI a minute ago. This is a foundational concept to modern day AI. If you think about large language models and predicting what comes next, it's not like these large language models necessarily understand English. They're just really, really good at predicting states and the next state, i.e.
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characters and the next character or pixels and the next set of pixels or frame, etc.,
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Yes, totally. And that is what they were using at IDA to do code breaking. And that's what they propose in this paper that they could use in the stock market too.
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Oh, we are going to talk a lot about that towards the end of the episode, because I think it's kind of the key to the whole thing.
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Renaissance Technologies
Yes, exactly. So Jim and Lenny and this whole little crew, they're pretty fired up. They're like, oh, great. Let's go raise a fund and invest in the markets using this strategy.
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Well, in the mid-60s, the idea that some wonky academics at some random secretive agency in Princeton, New Jersey could go raise money... was non-viable. I mean, it was hard enough for Warren Buffett to raise money at this point in time for his fund. And he was Benjamin Graham's anointed appointed disciple.
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And here are these academics who are working at some random unknown nonprofit saying, give us money. We don't know anything about these companies that we're going to invest in. We don't know anything about fundamentals, but we've got a really good algorithm. People are probably like, what is an algorithm? And So they just have no access to capital.
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Renaissance Technologies
Yes. So a bunch of kind of Keystone Cops-style fundraising happens here. They're going around in secret. They're trying to keep the IDA bosses from knowing what they're doing. One of the group ends up leaving a copy of the investment prospectus on the copy machine at work one night, and the boss discovers it and calls them all into his office and is like, guys, what are you doing here?
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Yes. So they end up abandoning the effort, both because they can't raise money and because IDA has found out about this and they're not too pleased. Shortly after all this, though, Jim ends up moving on anyway because the Vietnam War starts and he, as you can imagine from his background, is not a supporter of the Vietnam War at this point in time.
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Jim writes an op-ed in the New York Times denouncing the Vietnam War and saying like, yeah, he's, you know, sort of part of the Defense Department, but like not everybody in the Defense Department is for the war.
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Even more than that, amazingly, nobody really paid attention to it except a reporter at Newsweek who then comes to interview Jim and ask him some more questions. And he just doubles down on this. And when the Newsweek piece comes out, that's when the Department of Defense is like, all right, you got to fire this guy. Yeah. So Jim gets fired in 1967.
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Renaissance Technologies
Even though he's a star codebreaker, he made supposedly huge contributions to the group, which are still classified. But at age 30, with a wife and three kids, he's out on the street. And even though he's super smart, his colleagues love him. Clearly, he's now bounced out of MIT. He's bounced out of Harvard. He's gone to this seemingly final home for him. Great place at IDA.
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He gets bounced out of there, too. His job prospects are not great.
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So he takes pretty much the only halfway decent paying job that he could get, which is to be the chair of the newly established or maybe reestablished math department at the State University of New York Stony Brook, which is the Long Island campus of the State University of New York. This is not Harvard. This is not MIT. No, it is not.
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But it did have one very important thing going for it, which is why Jim ended up there. And that is that Nelson Rockefeller, who was then the governor of New York, had launched a campaign, a $100 million campaign, to try and turn this Long Island campus of the State University of New York into a mathematical powerhouse to become the Berkeley of the East.
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I sort of thought MIT was the Berkeley of the East already, but Rockefeller is waging a campaign that he wants Stony Brook to become a math and sciences powerhouse. And Jim is the key. He wouldn't be able to recruit somebody like Jim otherwise, but because he's now kind of tarnished his career, Here's a very talented mathematician that they can convince to come be chair of the department. Yep.
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So they basically give Jim an unlimited budget and leeway to go try and poach math professors from departments all over the country and the world and bring them there to Long Island. And part of how Jim goes and recruits folks is money, like the old, hey, I'll double your salary line. Right.
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But the other part of it, too, is he's given such leeway and Stony Brook is so different from the politics of an MIT or a Harvard or a Princeton. He says, hey, come here, I'll pay you more. But even more importantly, you can just focus on your research. You're not going to have to deal with committees. You're not going to have to do all this stuff. There is none of this stuff here.
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You might have to teach a little bit, but that's not even the point. Rockefeller doesn't want this necessarily to become a great teaching institution. He just wants to assemble talent there. Yep. And amazingly, it works. Jim starts getting a bunch of great talent, including James Axe, who is a superstar in algebra and number theory from Cornell.
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And he ends up at Stony Brook recruiting and building one of the best math departments in the world. Amazing. Totally amazing. But in true Jim fashion, after a couple of years of this, and also his marriage with Barbara falling apart... he starts getting restless again.
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He decides that he wants to go on a sabbatical and go back to Berkeley and reunite with his old advisor there and go spend some time out on the coast in California.
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And this is where Chern and Simons end up collaborating and developing the Chern-Simons theory that ends up winning the highest award in geometry from the American Mathematical Society and really kind of is Jim's personal mark on mathematics. Yep. Now also, right around this same time, Remember the Columbian Flooring Company? It gets acquired.
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And Jim and his buddies who are partners in it come into a good amount of money. And Jim is newly divorced. He's restless in academia. He has these ideas back from when he was an IDA about what you could do in the markets if you had capital. He starts trading again. And he gets more and more into it. Meanwhile, like we said, he's becoming disillusioned again and restless at academia.
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And in 1978, he leaves to focus full time on trading, which is a huge shock to the academic community. Remember, he's assembled this superstar team there at Stony Brook. There's a quote in Greg's book from another mathematician at Cornell. We looked down on him when he did this, like he had been corrupted and had sold his soul to the devil.
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But the idea that you would leave to do anything commercial, you're doing a disservice to humanity.
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Right. Yeah, I don't think it was that the rest of the math world was skeptical that it could work. They probably were like, oh, yeah, this could work. But they were like, ew.
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Now, Stony Brook, we should say too, like it's a very nice place. Yes. But it's in the middle of Long Island on the North Shore. This is not the Hamptons. It's like the Long Island suburbs. Yep.
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Yes, the wooded Long Island suburbs. Here's Jim in a strip mall next to a pizza joint setting up his trading operation that he decides very cleverly to call monometrics, a combination of money and metrics or econometrics. And he recruits his old IDA buddy, original partner in crime on the trading idea, Lenny Baum, to come and join him.
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And this time, though, they have some capital from the sale of the flooring company.
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I think together with Jim, his partners, and whatever money Lenny put in, they had a little less than $4 million in this initial capital. In 1978. Yep. Now, Jim also has another advantage at this point in time, which is he's right down the street from Stony Brook, And he's just recruited all of these superstar mathematicians. The table has been set. Yes.
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And those folks are more loyal to Jim than they are to Stony Brook.
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Yes, in general, but some of them, and in particular, the superstar James Axe, Jim convinces to come join him in his trading operations.
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Yes. And it's led by Jim, who's somebody that they respect as an academic, but even more important is somebody they want to work for and they look up to and they think is cool. And he's out there being like, hey, I think we can make money. Right. Now, at this point. They're primarily trading currencies, not stocks.
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And currencies are obviously large markets, but they aren't impacted by as many signals and as many factors as stocks are, or really even slightly more complex commodities like, I don't know, soybeans or whatever.
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Yes. And this is super important. At the end of the day, they build some models there. They're getting the early versions and infrastructure and scaffolding of this quantitative approach set up. But in terms of the actual trades they're putting on, they're still doing all of it by hand. And they're still all really going on a fundamental type analysis. They'll take some signals from the model.
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They'll see it's interesting what they spit out. But they're not going to act on anything unless they can be like, oh, yeah, I see what is going on here. I have a hypothesis. Right.
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By no means at all. Yeah, they're just suggesting patterns and ideas. And Jim and Lenny and James, they have to then decide, hey, are we going to do this or not? Or are we going to do something just totally different that we think is what's going to happen? Yep. And this actually does make sense. Really for two reasons.
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One, computers and computing power just wasn't sophisticated enough yet to really build AI in a way that's powerful enough that it could work well enough you could really trust it. That's one part. The other part is these folks are mathematicians. They're not computer scientists. Right.
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And they're really, really good at building models, decoding signals, obviously, but they're much more from this realm of theory. And I actually spoke with Howard Morgan, who's going to come up here in a second, and he made this point to me. He's like, in math, there's this concept of traceability that's a really, really important cultural tenet.
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It's like proving a proof or proving a theorem or something like that. You really need to understand why to get ahead in the field. It's not like you can just say, oh, hey, the data suggests this. It's like, no, no, you need proof. And that's the world that these guys are coming from. They're like, oh, we can use data to sort of help us here.
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But ultimately, we want to have a rock solid theory of what is fundamentally happening here.
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Yes. And so much so that even Jim is ringleader here. He's far from convinced that he should put all of his wealth into this thing. He's like, oh, yeah, this is interesting. We're building. We're experimenting. Like, great. But I also want to put my money somewhere else, too, for some diversification. So this is where Howard Morgan comes in.
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We used to talk about this on old Acquired episodes that in the early days of Silicon Valley, there were only 10 people out here and they all knew each other and they were all doing the same thing. This was also the case in East Coast finance and technology in early VC in these days. Howard Morgan would go on to be one of the co-founders of First Round Capital.
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Yes. So here's how it all went down. And this is so poorly understood out there. Yes. Howard was a computer science and business school professor at the University of Pennsylvania. So he taught CS at Penn and business at Wharton. And he had been involved in bringing ARPANET to Penn and was kind of like early, early internet pioneer.
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And so as a result, he was super plugged into tech and early startups and really early, early proto internet stuff. And Jim gets excited about investing together with Howard. So they say like, hey, maybe we should partner together.
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And in 1982, Jim actually winds down Monometrics and he and Howard co-found a new firm together that's going to reflect both of their backgrounds and be a great diversification. Jim and his group are going to bring in the quantitative trading thing.
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And Howard's going to bring in private company technology investing. And they pick a name for a firm that is going to reflect this. Renaissance Technologies. It's crazy. And that is why Rentech is called Rentech.
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Yeah, just like how we say every company has a story, every company's story is powered by payments. And JP Morgan Payments is a part of so many companies that we talk about on Acquired. It's not just the Fortune 500, too. They're also helping companies grow from seed to IPO and beyond.
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But when you know the whole background and history, it kind of makes sense because this is their personal money. This is Jim and his buddies, Lenny and James and Howard. There's not institutional capital here. They're not out pitching LPs of like, oh, you should invest in my diversified strategy of currency trading and private technology startups.
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We'll get into what multi-strategy today means later. But in these early days of rent tech... 50% of the portfolio was venture capital and 50% was currency trading.
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And in fact, a couple of years after they get started, the currency trading side of the firm almost blows up when Lenny goes super long on government bonds and the market goes against him and the whole portfolio drops 40%, which is wild. That ends up triggering a clause in Lenny's agreement with Jim, and they sell off Lenny's entire portfolio, and he leaves the firm. This is crazy.
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I mean, blow-up risk is always an issue in the markets, but this happened to Rentech.
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Totally. And again, also shows they weren't doing model-based quantitative trading, really, at this point in time. No, so much gut. So as a result of that, for a while, Rentech is truly almost entirely a venture capital firm. At one point... On the venture side, just one investment, Franklin Dictionaries. Do you remember, Ben, the Franklin Electronic Dictionaries?
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Yeah, that was one of their biggest investments. That one investment is half of Jim's net worth.
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Yeah. So in the book, Greg talks about, oh, Jim was focused on venture capital. And that's kind of the story out there. It's like, well, he was focused on venture capital because that was the only thing working and making money.
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So I think perhaps in part because of the trading losses, James Axe starts to get a little disillusioned too. And he tells Jim that he wants to move out to California with Sandor Strauss, who started working with them at this point. Sandor was another Stony Brook alum that joined them. And the two of them want to move out to California and do trading out there. Jim says, sir, fine.
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I'm here with Howard. I'm doing venture capital stuff. Why don't you go move out to California? You can start your own firm, which they do. It's called Axcom, A-X-C-O-M. And we'll contract with Axcom to run what's left of the trading operations here for Rentech.
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No. Nobody would have done what they did had they known what was coming.
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No. So once Axe and Strauss get out to California, Strauss, he's kind of on the computing data infrastructure side. That's what he was doing at Stony Brook. And that's what he came into Renaissance to build. He starts getting really into data and he starts collecting intraday pricing movements on securities.
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At this point in time, I think really the best data you could get from providers out there was maybe open and close data on securities pricing. Strauss finds a way to get tick data, like every 20 minute data on these securities throughout the day.
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Ah, well, we start in 1938 in Newton, Massachusetts, which is a fairly wealthy suburb just outside of Boston, where one James Simons is born. And both of Jim's parents were very, very smart, especially his mother, Marsha. His dad was a salesman for 20th Century Fox, the movie company. His job was he went around to theaters in the Northeast and sold packages of movies to them. Super cool.
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So that's one thing that happens. The other thing is Jim says, oh, you're going out to California. Let me hook you up with my buddy who's a Berkeley professor out there, Elwin Berlekamp. And Berlekamp had studied with folks like John Nash and Claude Shannon at MIT.
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So cool. And most importantly for this specific use case, Burlakamp had worked with John Kelly, who developed the Kelly criterion on bet sizing, which poker players will likely be well familiar with. Yep. So with this combination now of much, much, much better and deeper data from Strauss...
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And Burlakamp coming in and working with Axe on the models and saying, hey, we should be smart about the bet sizing that we're doing in the trades that are coming out of these models versus, I don't know what they were doing before. Maybe it was naive of like every trade was the same or just like we should actually be systematic about this. The models start really working. Yep.
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Yeah. In these kind of mid-80s years, Axcom is generating IRRs of like 20 plus percent on the trading side. You know, not necessarily going to beat venture capital IRRs, but liquid. Yes. Reliable.
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Yes, but the early results are really good. And Jim and Burlakamp especially are very encouraged by this. So in 1988, Jim and Howard Morgan decide to spin out the venture investments. And Howard goes to manage those with basically their own money. Fun coda on this. When Howard starts first round a number of years later with Josh Koppelman, Jim, of course, is a large LP.
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And Howard, of course, remains an investor in Rentech. The first institutional fund that First Round ended up raising was a 50x on a $125 million fund. It had Roblox, Uber, and Square. So I believe this is right. I think Jim made as much money from his investments in First Round as Howard did from his LP stake in Rentech.
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Yeah, it was super fun talking to Howard about this and just the history of how first round started and early super angel investing and everything that became.
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Totally wild. So when Howard spins out the venture activities, Jim then decides to set up a new fund as a joint venture between Rentech and Axcom. And they decide to name it after all of the collective mathematical awards that Jim and James and Berlichamp and all these prestigious mathematicians have won in their careers. They name it the Medallion Fund.
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By the way, we know all this because we have to thank Greg Zuckerman, author of The Man Who Solved the Market, which is the only book out there that is solely dedicated to Rentech and Jim Simons. And we actually got to talk to Greg in our research. He helped us out a bunch. Thank you, Greg.
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Those ideas had all existed before. This is the first time that it's all brought together and actually working and operationalized.
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Yeah, I don't know that Strauss could have done his data engineering too much earlier in time. Yeah. But before we get into the just absolutely insane run that this medallion fund is about to go on that continues right through to this day, now is the perfect time for another story about ServiceNow. ServiceNow is one of our big partners here in Season 14 and is just an incredible company.
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So we talked on our Novo Nordisk episode about how ServiceNow founder Fred Luddy discovered this core insight that software can transform and eliminate manual tasks. And on Hermes, we told the story of how current CEO Bill McDermott came in and turbocharged that into an absolute monster 150 billion market cap global behemoth.
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The key thread that connects those two eras is that from day one, Fred knew the ServiceNow platform could be used across the whole enterprise. But at the same time, he also knew from his decades of prior software experience that launching a broad horizontal offering right out of the gate as a startup was a recipe for failure. You need to start with a specific vertical use case.
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So that was Jim's parents, but really a major influence on him growing up was his grandfather, Marsha's dad. There's already kind of echoes of the Bezos story here with the grandfather, the mother's father, and spending a bunch of time with him and rubbing off on young Jeff or young Jim in this case. And Bezos, of course, would get his start in his career at D. Shaw.
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Yep. Once those other departments do pull the trigger on joining the ServiceNow platform, who is in charge of rolling it out for them? Of course, it's IT, who are already true ServiceNow believers. I'm honestly not sure that there's a better enterprise software playbook in history than ServiceNow's.
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So once they established the beachhead in IT, they then took the same platform to HR with employee experience. They took it to CSM with customer service requests. They took it to finance with regulatory reporting, audit, and expense approvals. And now they're adding AI, which will take everything to the next level.
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So they've got this grand new plan and vision with the Medallion Fund. Unfortunately, right out of the gate, the fund stumbles a bit and Axe ends up getting burned out. Burlakamp, though, is like, no, no, no, no. This is an anomaly. We're going to fix this. I really, really believe that what we're doing with these models is going to be extremely profitable.
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So he buys out most of Axe's stake in the summer of 1989. And he moves the offices up to Berkeley. And there he comes up with the idea that, hey, we should trade more frequently, a lot more frequently.
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Because if what we're trying to do is understand the state of the market from the data we have and then predict the future state of the market and then combine that with figuring out the right bet sizing to make. We actually want to make a lot more trades to get a lot more data points and learn a lot more about the bets we're making so that we can then size them up or size them down.
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There is a great Bob Mercer quote about this later. He says, we're right 50.75% of the time.
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Right. But we're 100% right 50.75% of the time. You can make billions that way.
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A lot, yes. And then back to the Kelly criterion, adjust your bet sizes over time as you're making those bets. Yep.
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A quant fund coming up at the same time as Rentech. But back to Jim here in the 1940s, his grandfather Peter owned a shoe factory that made women's dress shoes. Jim spends a ton of time there growing up at the factory. So Jim's grandfather Peter was quite the character. He was a Russian immigrant, and he's kind of like still more Russia than Boston at this point in time.
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Yes. And as time goes on and the whole quant industry emerges and becomes much more sophisticated, I think it's particularly the slippage there that becomes the governor on how high velocity you can actually be on this. And the slippage is that once you are at a certain scale, you are going to move the market with your trades.
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Yeah. We're going to come back to this in just a minute. But this certainly for early rent tech and then even now still for all of quantitative finance is a really, really, really important thing.
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I feel like there's this metal lesson that I've been learning through Acquired and my own personal investing over the past couple of years. Every market is dependent on supply and demand. You can see quoted valuations and quoted price streams, but oftentimes that's like the mistake of just looking at averages.
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Yes. Now, at this point in time, when the Medallion Fund is first starting to work in, say, late 1989, early 1990... It's small enough that this isn't a big consideration yet.
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Medallion was about $27 million under management when Burleigh Camp bought out Axe. In 1990, the first full year after that, the fund gains 77.8% gross, which after fees and carry was 55% net. Now, what were the fees and carry?
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Hell yeah. Let's go. And indeed, it was a hell yeah, let's go situation.
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So Cary, I've seen different sources of whether it was 20 or 25 percent in the early days. But the management fee on the fund was 5%, which is crazy. The top venture capital firms in the world charge a 3% management fee. And even that is like everybody holds their nose and is like, this is ridiculous. How on earth were these nobodies charging a 5% management fee out the gate to their investors?
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Well, a couple of things. One, their investors were not sophisticated. It was mostly their own money and their buddies' money. So they set that precedent. They set that precedent. But two, though, they actually needed the money because Strauss's infrastructure costs were about $800,000 a year.
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As Greg puts it in the book, Peter reveled in telling Jim and his cousins stories of the motherland involving wolves, women, caviar, and vodka. And he teaches young Jim when he's a child here in the factory to say Russian phrases like, give me a cigarette and kiss my ass.
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So they just backed into the management fee based on like, hey, we need $800,000 a year to run the infrastructure. Plus we need some money to, you know, pay folks and whatnot. Like, great. 5% management fee.
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Yes, high management fee, normal-ish carrier performance element. Yep. So at the end of 1990, Simons is so jazzed about what's going on that he tells Burlakamp, hey, you should move here to Long Island. Let's re-centralize everything here. I want to go all in on this. I think with some tweaks, we can be up 80% after fees next year. Burleigh Camp is a little more circumspect.
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A, he wants to stay in Berkeley. He doesn't have any desire to move to Long Island. And B, I couldn't tell how much of this is just he's a little more conservative than Jim or how much of this actually might be his, hey, whole poker bet sizing thing. He turns to Jim and he says, well, if you're so optimistic, why don't you buy me out?
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So Jim does at 6x the basis that Burlakamp had paid Axe a year earlier.
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Renaissance Technologies
On the other hand, this is the equivalent of when Don Valentine sold Sequoia's Apple Steak before the IPO to lock in a great gain. but miss out on all the upside to come.
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Yeah. That's just on the carry side. I mean, the owners are the principals. So just like dollars out of the firm, it's probably twice that. I would estimate probably $150, $200 billion that have come out of Medallion over the last 35 years. So Jim buys out Burlacamp. He rolls everything in the Medallion Fund back into Rentech itself, moves everything back to Stony Brook.
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Yes, that's right. And Strauss had a stake as well. So once Jim takes control and moves everything back, he basically decides that he's going to turn Rentech into an even better, even more idealized version of IDA and the math department at Stony Brook.
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He's going to make this an academics paradise where if you are one of the absolute smartest mathematicians or systems engineers in the world, this is where you want to be. So, of course, he starts raiding the Stony Brook department itself again. And this is when Henry Laufer joins full-time.
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If you watch interviews with Jim, his hands are always twitching because he has chain smoked his entire life, probably going back to like age 10 in the factory.
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Laufer had been consulting with Medallion in the early days and working with Burleigh Camp as they're doing bet sizing, as they're making more frequent trades. But now, once the whole operation is moved back to Long Island, Lauford's like, oh, okay, great. I'll come full time. I'm here at Stony Brook anyway.
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A lot of people and just a lot of time, too. This is 25 years. This is a quarter century from the time that Baum and Simons write the paper at IDA until Medallion really starts to work. It takes a long time.
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Well, let's get to that. So Jim moves everything back to Long Island, sets it up as this academic paradise, is recruiting the smartest people in the world. In 1991, the next year, the firm does 54.3% gross returns and 39.4% net returns after fees. So not Jim's bogey of 80%, but still pretty freaking great.
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The historic run has begun, let's just say. So 1992, gross returns are 47%. 93, they're 54%. At the end of 1993, Simons decides to close the fund and not allow new LPs in. So if you're an existing LP, you can stay in, but they're no longer open for new inflows.
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He has so much confidence in what they're doing that he thinks they're all going to make more money without accepting new capital by just keeping it to the existing investor base. 1994 gross returns are 93 freaking percent. Medallion at this point is stacking up cash. It is a... Meaningful fund. It's about $250 million total at this point in time, which is small.
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I mean, there's these famous stories of the conference rooms at Rentech and the war rooms when the market is going through like a crazy gyration and it's just filled with cigarette smoke and it's all Jim. Different time. Different time. So back to Jim's childhood, though, here in the Boston suburbs. He grows up certainly not uber wealthy or uber rich, but very, very solidly upper middle class.
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But we're talking about 1994 with a bunch of outsiders and academics that have managed to amass a quarter billion dollars here. People start to pay attention.
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Yes. But as they get into that, call it on the order of magnitude of a billion dollar scale. They start bumping into the moving markets problem and the slippage that we were talking about earlier.
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And that's sort of in the mid 90s. Yeah. As they're hitting this 250 million, half a billion dollar scale.
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Yeah. Up to this point, the vast majority of what Medallion is doing is trading currencies and commodities, not equities. Because you might be thinking, okay, yeah, I hear you. The 90s was a different era, but... Half a billion dollar fund doesn't sound that big. How are they moving markets with half a billion dollars? It's not the equity markets. It's because they're in these thinner markets.
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It's not that commodities and futures are small markets. They're large, but they're thin compared to equities. There's just not that much volume and you just can't trade that much without slippage becoming a huge issue. And Medallion is now hitting that limit.
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So, Simons decides the only thing we can do here to expand, which I'm such a believer in what we're doing, we need to expand, is we need to move into equities. Equities are the holy grail. If we can make this work there, the depth in those markets will let us scale way, way, way bigger than we are now.
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And there's so much more data about equities pricing that we can feed into our models and the signal processing that we can do and the signals that we can find are going to be even better.
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Yes. And this brings us to Peter Brown and Bob Mercer. And in 1993, one of the mathematicians that Jim had recruited to Rentech, a guy named Nick Patterson, gets especially passionate about going out and recruiting new talent along with Jim. And this is, I think, one of the keys to Rentech and the culture there. People want other smart people to come be there too.
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Nick's sitting there like, this is a joy. I want to go find other best people in the world to hang out with. And he had read in the newspaper that IBM was going through cost cutting and was about to do layoffs. And he also knew that the speech recognition group at IBM had some absolutely fantastic mathematical talent.
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And really, what they were doing was, again, another vector in the early AI machine learning research. Specifically, IBM's deep blue chess project of the time had come out of this group. And Peter Brown there was the one that actually spearheaded the project.
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And especially he's an only child. He has all the resources of his parents, his family, his grandfather's this sort of well-to-do entrepreneur. And Jim, you know, he gets to rub shoulders in the Boston area with people who are really rich. And he says later, I observed that it's very nice to be rich. I had no interest in business, which is not to say I had no interest in money.
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It's not just kind of, it's exactly the same signal processing. Right.
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Yes, at operational scale. And this is what's so important and why the two of them become probably the most critical hires in Rentech's history, even including all the great academics that came before them. Because they're good on the math side, but they have this large systems experience.
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And Jim and Nick know that if they're going to move into equities, because of the volume of data and because of how much more complex that market is, they need more complex systems. And the current talent at Rentech coming from academia has just never experienced that or built anything like it.
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Yeah. And the universe of equities is so much more multidimensional and interrelated. There are only so many currencies in the world, and there are especially only so many currencies that are large enough trading markets that you can operate in. There's not infinite, but thousands and thousands of equities in the world that are deep enough markets that you can operate in.
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And to some degree, they're all correlated with one another. Yeah.
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Yes. Very, very important. And what he means when he says he has no interest in business, it's because from a pretty young age, he gets really into math. So the legend has it when Jim is four years old, he stumbles into one of Zeno's famous paradoxes from ancient Greek times.
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So Patterson and Simons go raid IBM. They're like Steve Jobs raiding Xerox PARC. They bring Peter and Bob and one of their programming colleagues, David Magerman, over from IBM into Rentech. And they get started on building the equities model. But it turns out, A, they're obviously very successful at that.
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But the impact that they have and what they build is even bigger because Bob and Peter realize that, hey, actually, we should just have one model for everything here. For currencies, for commodities, for equities, everything is correlated. Everything is a signal.
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It's not like the equities market is wholly independent and separate from what's happening in currencies or what's happening in commodities. There are relationships everywhere. We really want just one model. This is like a fantastical undertaking, especially in the early to mid 90s.
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It turns out that this was actually the second most important innovation that Bob and Peter bring to Rentech, the actual product and performance of having one model. The most important thing is that if you have only one model, one infrastructure, Everybody in the firm is working on that same model.
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You can all collaborate all together, which is especially important when you have the smartest people in the entire world all in one building. Before this, there were separate models within Rentech. So insights and innovations and work that one team was doing on one model wouldn't get applied or translate over to Rentech.
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No other at-scale investment firm, period, and especially quant firm, operates this way today with just one model. They're portfolio managers and teams and multi-strategy. People are culturally competitive with one another, but even if they're not, the work that you're doing on this side of Citadel is not impacting the work that you're doing on that side of Citadel. Right.
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What Bob and Peter do is they unify everything at Rentex. So all the wood is going behind one arrow.
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Renaissance Technologies
Yep. Vanta is the perfect example of the quote that we talk about all the time here on Acquired. Jeff Bezos, his idea that a company should only focus on what actually makes your beer taste better, i.e. spend your time and resources only on what's actually going to move the needle for your product and your customers and outsource everything else that doesn't.
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In Rentech's case, this would be the model. Every company needs compliance and trust with their vendors and customers. It plays a major role in enabling revenue because customers and partners demand it, but yet it adds zero flavor to your actual product.
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And perhaps most importantly, your security reviews are now real-time instead of static, so you can monitor and share with your customers and partners to give them added confidence.
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Renaissance Technologies
Yes, and indeed a machine it is. So Peter and Bob come in in 1993. In 1994, 1995, they're building this. Rentech is getting into equities.
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Yes. And here's what's amazing. Returns go down maybe slightly, certainly a bit from the blowout year that 1994 was, but they're still above 30% every single year, most years above 40%. This is unbelievable that they're maintaining this performance as they're going into this hugely more complex market and they're scaling assets under management.
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So by the end of the 1990s, Medallion has almost $2 billion in assets under management. while maintaining roughly the same performance by getting into equities. This is huge.
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Yes. And then in the year 2000... They just totally blow the doors off. 128% gross returns. Net returns after fees of 98.5%. This is bananas.
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Yes. While the whole rest of the market is down big time, Medallion is up 128% gross on the year. And this becomes a theme. High volatility is when Medallion really shines.
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So there's a really fun story around this that really illustrates Jim's genius in managing the firm and the people that and how this year was when they really figured this out. So the first couple days of the tech bubble bursting, Medallion actually takes a bunch of large losses.
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And part of it might be that the model wasn't tuned right yet because nobody at Rentech had seen this type of behavior in the market before. Part of it might also be, too, that it didn't perform well for those couple days. It's a really stressful time for everybody. Everybody's in Jim's office. Jim's smoking his cigarettes. It's a cloud of smoke. And they're debating what to do.
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So Jim's dream is to go to MIT down the street in Cambridge and study math. He graduates high school in three years. And during the second semester of Jim's freshman year there, he enrolls in a graduate math seminar on abstract algebra. So pretty heady stuff.
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And Jim makes the call to take some risk off. He's worried about blowing up. We're not very far removed at this point from long-term capital management. The model may be saying we should stay long here, but let's not blow up the firm. Yep. After this goes down, Peter Brown comes to Jim and offers to resign, given the losses that they incurred over these couple days.
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And Jim says, what are you talking about? Of course you shouldn't resign. You are way more valuable to the firm now that you've lived through this, and you now know not to 100% trust the model in all situations.
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It totally does. There's a parallel story when Jim ultimately does retire in 2009 and Peter and Bob take over as co-CEOs, where a year or so before the quote-unquote quant quake had happened, where similar to the tech bubble bursting, there was all of a sudden very large drawdowns among all quantitative firms in the market and rent tech gets hit.
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And during that period, Peter argued very strenuously that we should trust the model, stay risk on, this is going to be an incredibly profitable time for us. And Jim pumped the brakes and stepped in, intervened and took risk off.
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And Peter goes to Jim again around the CEO transition and says, hey, Jim, aren't you worried that with me running the place now, I'm going to be too aggressive and blow it up one of these days? And Jim says, no, I'm not worried at all. I know you were only so aggressive in that moment because I was there pushing back on you. And when you're in the seat, you're going to be less aggressive.
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Yeah. So back to the year 2000 and this incredible performance. Ben, to what you were saying earlier about uncorrelated returns, not only do they shoot the lights out that year, they're doing it when the market is down. We got to introduce this concept of a sharp ratio now, which for all of you listeners that are in the finance world, you'll know this.
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Yes. And so the Sharpe ratio is a measurement combining these two concepts.
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Yeah. Pretty smart. But it turns out that that freshman year grad seminar he took actually has a big impact on him because he doesn't do well in the class. He can't keep up. And Jim's pretty self-aware here. There are other people at MIT... who never run into problems. They never hit a limit. They never struggle understanding any concept. And he realizes that, oh, I'm smart. I'm very, very smart.
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And I believe, if I have my research right, in 2004, they actually achieved a Sharpe ratio of 7.5. Astonishing. You know, again, back to our sports analogy here. These aren't Hall of Fame numbers. These are like, I don't know, make Tom Brady look like a third stringer. Yes, exactly.
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So on the back of 2000 and this rise, the next year in 2001, they raise the carried interest on the fund to 36% up from either 20 or 25%, whatever it was before. Now, remember, they've already closed the fund to new investors. So they're still outside investors in the fund, but no new investors are coming in. And then the next year, in 2002, they raised the carry to 44%.
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Renaissance Technologies
I mean, great work if you can get it. But for context, the Sequoias, the benchmarks out there, they have obscene carry of 30%. 44% is unprecedented.
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Renaissance Technologies
You should pay 20% carry for a firm that delivers you 15% annual returns. We're delivering you 50% annual returns.
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Renaissance Technologies
Okay, once again, I'm sorry, audience. I have to say, hold on one more minute for another perspective that I have to offer on the carry element. But I want to finish the story first. Okay, so 2001, they raised the carry to 36%. 2002, they raised it to 44%. And then in 2003... They actually say, hey, we can't incentivize you out of the fund, outside investors. We are going to kick you out.
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Renaissance Technologies
So starting in 2003, everybody who's an outside investor, who's not part of the rent tech family, you know, current employee or alumni of the firm gets kicked out.
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Renaissance Technologies
Yes. Now, why did we do this? I'm going to talk about one reason in a minute. But one reason is super obvious. The Medallion Fund is now at $5 billion in assets under management that they're trading. Even in the equities market, they are now hitting up against slippage. Yep. And so if they want to maintain this crazy, crazy performance, they just can't get that much bigger.
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Renaissance Technologies
I'm smarter than most other people here, but I'm not one of those people.
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Renaissance Technologies
So in 2003, they start kicking all the outside investors out of Medallion. But clearly, there's still lots of institutional demand to invest with Renaissance.
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Renaissance Technologies
Yeah, there's a fun story around this that Peter Brown tells of Jim came into his office one day and said, Peter, I got a thought exercise for you. If you married a Rockefeller, would you advise the family that they should invest a large portion of their wealth in the S&P 500? And Peter says, no, of course not.
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Renaissance Technologies
Yes. So Jim's own words on this are, I was a good mathematician. I wasn't the greatest in the world, but I was pretty good. But he recognizes, like you said, Ben, that he has a different advantage that most of the super geniuses lacked. And that's that, as he put it, he had good taste. So these are his words. Taste in science is very important.
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Renaissance Technologies
And so Jim says, yes, exactly. now get to work on designing the product that they should invest in.
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Renaissance Technologies
And the marketing is built in. It's not like there's any lack of demand of outside capital that wants to invest with Rentech.
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Renaissance Technologies
Yeah. That has not performed anywhere near how Medallion has performed.
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Renaissance Technologies
To distinguish what's a good problem and what's a problem that no one's going to care about the answer to anyway, that's taste. And I think I have good taste.
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Renaissance Technologies
Yes. The way that some folks we talked to described the difference between the institutional funds and medallion to us is that medallions average hold time for their trades and positions is call it like a day, maybe a day and a half. Whereas the average hold time for the institutional funds positions is like a couple months.
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Renaissance Technologies
So across 4,300 stocks in the portfolio, there's a lot of trading activity that happens on any given day, but it's a lot slower in any given name than Medallion would be. Yep. Which makes sense. Again, it gets back to this slippage concept.
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Renaissance Technologies
If you have a bigger fund and you're investing larger amounts, which the institutional funds are, you can't be trading as frequently or all of your gains are going to slip away. Yep.
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Renaissance Technologies
0% chance. Speaking of the fund that is the reason why we are covering this company on this show, we set up during the tech bubble crash that volatility is when Medallion really shines. Well, there's no more volatile periods than 2007 and 2008. Yep. 2007, Medallion does 136% gross. 2008, Medallion does 152% gross. Like, get out of here. Crazy.
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Renaissance Technologies
This is 2008 while the rest of the financial world is melting down.
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Renaissance Technologies
Yes. Well, there's one slight nuance to that, but I don't know how much it holds water. And the apologist nuance would be, well, Warren Buffett could be on the other side of the trade, and Medallion could make money on that trade with Warren over its time horizon of a day and a half, and Warren could make money over his time horizon of, you know, 50 years. Super fair.
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Renaissance Technologies
So I think the argument against that, though... is that Medallion sold after a day and a half to somebody else who bought at that lower price. And so somewhere along the chain, that loss is getting offloaded to somebody. The direct counterparty of Medallion and the quant industry writ large might not take the loss, but somebody is going to take the loss along the way.
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Renaissance Technologies
So after the historic performance during the financial crisis, as I alluded to earlier, Jim retires at the end of 2009 and Peter and Bob become co-CEOs, co-heads of the firm in 2010. They take the portfolio size up to $10 billion when they take over. It had been at five for the last few years of Jim's tenure. They take it up to $10 billion.
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Renaissance Technologies
I think the analogy here is like sports. There are all-star players, there are Hall of Famers, and then there's LeBron and MJ. And Jim ends up being a Hall of Famer mathematician, but he's not Tom Brady. I mean, he's got a pretty important theorem named after him. That goes on to become a foundation of string theory and physics, which isn't even Jim's field. Crazy.
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Renaissance Technologies
And really with no impact, which I assume means that Rentech was getting better and the models were getting better because otherwise they would have gone to 10 before.
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Renaissance Technologies
Yeah. And importantly, during periods of peak volatility, like say 2020, Medallion continues to shoot the lights out. So from at least the data that we were able to find on Medallion's performance over the past few years, 2020, they were up 149% gross and 76% net. So the magic is still there.
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Renaissance Technologies
And one way to look at it, which may not be the be-all and end-all, but I think is a good way to compare Jim's era at Medallion versus Peter and Bob's era is
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Renaissance Technologies
During Jim's tenure, Medallion's total aggregate IRR from 1988 when the fund was formed to 2009 when he retired was 63.5% gross annual returns and 40.1% net annual returns, which of course did include many periods of lower carry, 20% versus the 44%. During the post-Jim era, the Peter and Bob era, from 2010 to 2022 was when we were able to get the latest data. IRRs are 77.3% gross and 40.3% net.
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Renaissance Technologies
So better on both fronts, even with much higher average fees. So yeah, I think Medallion is doing fine.
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Renaissance Technologies
Yeah. And at the end of the day, this is all just insane. So as far as we can tell, Ben, you alluded to this a bit at the beginning of the episode, And as far as anybody else can tell, Medallion has by far the best investing track record of any single investment vehicle in history. So give me those net numbers. So during the entire lifetime so far of Medallion, from 1988 to 2022, that's 34 years.
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Renaissance Technologies
The total net annual return number is 40%, 4-0 over 34 years after fees. It's 68% before fees, which equates to total lifetime carry dollars for the whole firm of $60 billion just in carry by our calculations. Astonishing.
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Renaissance Technologies
Yeah. I still know how to use Excel. Barely. It's going to be a dying art now with Copilot and GPTs. That's right.
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Renaissance Technologies
So this realization that Jim has about himself, though, both that he's not the smartest person in the room at a place like MIT, but he can hang with them, and that he has this taste concept. I think becomes one of the most important keys to the secret sauce that ends up getting built at Rentech, which is that he can relate to everybody. He understands what's going on.
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Renaissance Technologies
So $60 billion in total carry is a lot of money. And, well, speaking of a lot of money, we do need to mention before we finish the story here that that Rentech money has bought a lot of influence in society. So Bob Mercer, that name may have sounded familiar to many of you along the way.
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Bob was the primary funder of Breitbart and Cambridge Analytica and one of the major financial backers of both the 2016 Trump campaign and the Brexit campaign in Great Britain. Now, lest you think that Rentech dollars are solely being funneled into one side of the political spectrum, Jim Simons is a major Democratic donor, as are many other folks at Rentech.
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Renaissance Technologies
Yeah, tens of millions of dollars, many tens of millions of dollars on all sides and through many campaign cycles here from Rentech employees and alumni. This did become a flashpoint for the firm in the wake of the 2016 election. Mercer obviously became a controversial figure, both externally and internally within the firm.
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Renaissance Technologies
Yes. Ultimately, Jim asked Bob to step down as co-CEO in 2017, which he did, but he did remain a scientist at the firm and a contributor to the models, even though he wasn't leading the organization with Peter from a leadership standpoint any longer.
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Renaissance Technologies
Yes. Okay. Speaking of, let's transition to analysis. And I have a fun little monologue I want to go on, if you will bear with me, Ben. Ooh. I think this qualifies as the Rentech playbook, but I really kind of think of it as the Rentech tapestry.
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And I was inspired by Costco here because we were talking to folks in the research and everybody said, you know, Rentech, it just has these puzzle pieces that fit together. On the surface, Rentech does the same things that Citadel, D. Shaw, Two Sigma, Jane Street, others, etc. do.
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Renaissance Technologies
They hire the smartest people in the world and they give them the best data and infrastructure in the world to work on. And they say, go to town and make profitable trades. Those are very expensive commodities, those two things, the smartest people in the world and the best data and infrastructure, but they are commodities.
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Renaissance Technologies
Citadel can say the exact same things, just the same as Walmart and Amazon can say, we too have large-scale supplier relationships that we leverage to provide low prices to customers, just like Costco. But it's underneath that where I think the magic lies. There are three very interrelated things that make Rentech unique.
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So number one, they get the smartest people in the world to collaborate and not compete. Pretty much every other financial firm out there, employees and teams within the firm quasi-compete with one another.
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Renaissance Technologies
Let's take like in a venture firm, you've got your lead partner on a deal or a deal team. They're working that deal and maybe some of the other partners help a little bit, but mostly they're off prosecuting their own deals. Yep. And I think that's the most collegial way that this happens in finance. Yeah.
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Renaissance Technologies
Any person off the street probably couldn't even really have a conversation with these folks, but he can. And yet, he also has the perspective, maybe some of this is from his grandfather, of what is important out there in the real world. And as a result...
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Renaissance Technologies
Then you've got multi-strategy hedge funds out there where literally firms are being pitted against one another to be weighted in the ultimate trading model for the firm. Yeah. At Rentech, though, because of the one model architecture, everyone works together on the same investment strategy and the same investment infrastructure. That means everyone sees everybody else's work.
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Renaissance Technologies
Everybody who works at Rentech on the research team, on the infrastructure team, they have access to the whole model. That's not true anywhere else. Right.
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Renaissance Technologies
And that also means because it's just one model, just one strategy, when somebody else improves that model's performance, that directly impacts you as much as it impacts them. This is really different than any other hedge fund out there.
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Sure, but you don't love it as much as your team because either compensation or career-wise, you are much more dependent on your performance than you are other people's performance.
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Renaissance Technologies
What did you find on LinkedIn? At least the median tenure of employees is like 16 years.
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Renaissance Technologies
Okay. This brings me to point number two, which he said, this is an absurdly small team. There are less than 400 employees that work at rent tech, only half of which work in research and engineering. And the other half are either back office or institutional sales for the open funds. So let's call it, I don't know, 150, 200 people max who are like hands on the wheel here for medallion. Yep.
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Renaissance Technologies
Every other peer firm of Rentech, Citadel, D. Shaw, Two Sigma, et cetera, all of them, you lump Jane Street, jump the high-frequency guys in here. Minimum 2,000 to 5,000 people work at those places.
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Renaissance Technologies
All of his friends at MIT and these super smart people, they look up to him because you aren't like the kid in the corner at the high school dance. You're cool.
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Renaissance Technologies
It is an order of magnitude more people who are working at the other firms versus who are working at Rentech.
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Renaissance Technologies
Yeah, so AUM is like the same as these big funds. This has all sorts of benefits. Number one, there's like the Hermes Atelier Workshop benefit. Everyone knows each other by name. You know your colleagues' kids. You know your colleagues' families.
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Renaissance Technologies
Yes. Then there's the related aspect to all this. The firm is in the middle of nowhere on Long Island. You actually know your colleagues' families and kids because you're not going out and getting drinks with someone from Two Sigma in New York City. You're not comparing notes or measuring parts of your anatomy with someone else. You're like hanging out at the swimming pool.
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Renaissance Technologies
Yes. So he was elected class president in high school. You know, he smokes cigarettes. He's popular with the ladies. He kind of looks like Humphrey Bogart. He's a popular dude, especially at this point in time. We're now in the late 50s when Jim's at MIT. You know, this is kind of James Dean rebel without a cause era. Yep.
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Renaissance Technologies
And Rentech's hiring established scientists and PhDs. They're not hiring kids out of undergrad like Jane Street or Bridgewater is. My sense is that the place is like a college campus without any students.
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Renaissance Technologies
Yep. So then there's the last piece of the small team element, which is just the magnitude of the financial impact, which I don't think is true. But let's say that there were another quant fund that made the same number of dollars of...
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Renaissance Technologies
performance returns that rent tech does at rent tech you're splitting that a couple hundred ways at citadel you're splitting that five thousand ways it just doesn't make sense to go anywhere else we were chatting with someone to prep for this episode and they told us you can't ever compete with them but they'll pay you enough that you won't want to yes okay
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Renaissance Technologies
So this brings me to what I've been kind of teasing and I'm super excited about. I think the third puzzle piece of what makes Rentech so unique and defensible is Medallion's structure itself. That it is a LPGP fund that with 5% management fee and 44% carry.
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Renaissance Technologies
So here's my thinking on this. Now, I don't know how it is actually structured, but there was something about this whole crazy 44% carry that just wasn't sitting with me right throughout the research. Because I kept asking myself, why? Why?
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Renaissance Technologies
Right. It's all themselves. It's all insiders. Why do they charge themselves 44% carry and 5% management fees? I think Jim talks about this, that, oh, I pay the fees just like everybody else.
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Renaissance Technologies
So, okay, here's my hypothesis. This is not about having crazy performance fees. This is not about having the highest carry in the industry. This is a value transfer mechanism within the firm from the tenure base to the current people who are working on Medallion in any given year. So here's how I think it works.
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Renaissance Technologies
When people come into Rentech, they obviously have way less wealth than the people who've been there for a long time, both from the direct returns that you're getting every year from working there and just your investment percentage of the Medallion Fund.
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Renaissance Technologies
Which, by the way, I think they took, it was either the state of New York or the federal government to court to be able to have the 401k plan at Rentech be the Medallion Fund.
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Renaissance Technologies
Totally. I mean, depending on your definition of set for life, I think it happens very, very quickly.
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Renaissance Technologies
Okay. So given that though, how do you avoid the incentive for a group of talented younger folks to split off and go start their own medallion fund?
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Renaissance Technologies
So after graduation, Jim leads his buddies on a road trip with motor scooters. You can't make this stuff up from Boston down to Bogota, where one of his classmates is from. The idea is that they're going to do something so epic that the newspapers are going to have to write about it. So they all load up on scooters and drive down to Bogota. They get into all sorts of adventures.
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Renaissance Technologies
So I think it's the 44% carry structure that does it. Because basically what you're saying is every year, 5% management fee, so 5% off the top, and then 44% of performance. So let's say Medallion is on the order of... Call it doubling every year.
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Renaissance Technologies
Let's round that up and just add them and say 49% of the economic returns in any given year go to the current team and 51% of the economic returns go to the tenure base. I was like, what is the equivalent here? I think it's kind of like academic tenure kind of thing. The longer tenure you are at the firm, the more your balance shifts to the LP side of things. Interesting.
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Renaissance Technologies
And the younger you are at the firm, the more your balance is on the GP side of things. But at the end of the day, it's 51-49. So there's this very natural value transfer mechanism to keep the people that are working in any given year super incentivized. And as you stay there longer, you are paying your younger colleagues to work for you.
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Renaissance Technologies
Why? Why do they have this if there's no outside LPs? And this was the best thing I could come up with.
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Renaissance Technologies
Right. Which is how I think most prop shops work. Like Jane Street is mostly a prop shop. I think it is mostly the principal's money. But that's a static situation. It's not like, you know, if that were true, then Jim would just own this thing forever. And I don't think that's true here at Rentech.
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Renaissance Technologies
Yeah. And at the end of the day, I think these three pieces... to me are the core of this sort of tapestry of rent tech. One model that everybody collaborates on together, a super small team where we all know each other and the financial impact that any of us make to that one model is great to all of us.
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Renaissance Technologies
And three, this LPGP model with very high carry performance fees that creates the right set of incentives, both for new talent on the way in and old talent on the way out.
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Renaissance Technologies
When I was in college, I actually took an economics class with Burton Malkiel, who, of course, you know, was involved in starting Vanguard and is a big proponent of all that. And that is what I learned, Ben.
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Renaissance Technologies
Totally crazy. So after he's done at MIT and after the road trip, Jim heads out to Berkeley in California so that he could do his PhD with the professor Xingxian Chern. And much later in life, Jim would collaborate with Chern for the Chern-Simons theory that we talked about earlier that becomes one of the foundational parts of string theory in physics.
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Renaissance Technologies
Yeah, the unlevered returns if you were running this strategy would be much lower.
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Renaissance Technologies
Yeah. It's an important point, though. Nine out of every 10 companies that we cover on Acquired, leverage is zero part of the story. Right. And for us coming from the world we come from in tech and venture capital, leverage is like a dirty word. Like, I'm scared of it.
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Renaissance Technologies
But before Jim leaves for the West Coast, he meets a girl in Boston, and they decide to get engaged in four days. I mean, this is him back then. These were the times. And when they get to California and they get married, Jim takes the $5,000 wedding gift that I believe they got from her parents, and he decides, I want to multiply this.
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Renaissance Technologies
It's not. Which, again, as we spent a long time talking about, it's all the same thing.
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Renaissance Technologies
Now, I think there are a lot of expenses on the infrastructure side.
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Renaissance Technologies
I wonder too if the fee element of Medallion basically pays the base salaries for the current team.
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Renaissance Technologies
Well, I think it's lifelong NDAs and non-competes as long as the state of New York legally allows for. But that is not lifetime. I've heard various figures, six years, five years, something like that. Yep. I mean, at the end of the day, non-competes are more like, what is one side willing to go to court over?
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Renaissance Technologies
But the reality is people don't leave. People don't leave, period. And people especially don't leave and start their own firms. Yep. I was thinking about this in the middle of the night, and I think there's three layers to the effective non-compete that happens with rent tech. There's the legal layer, the base layer that you're talking about. It's like the agreements you sign.
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Renaissance Technologies
So he starts driving from Berkeley into San Francisco every morning to go hang out at the Merrill Lynch brokerage office and just be a rat hanging around the brokerage and find ways to trade and turn this money into something more.
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Renaissance Technologies
Then there's the economic layer of what we spent a long time talking about in Tapestry of competition. It would just be dumb to leave. You are better off staying there as part of that team with a smaller number of people than going to Sigma with a lot more people.
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Renaissance Technologies
I think that's the next level of, and then I think the highest level is just probably the social layer. You're there with the smartest people in the world in a collegial atmosphere where you're all working hard on something that has direct impact on you. Right. It's your community. It's your community. Totally. You're not in New York city. You're not in the Hamptons. You're not in Silicon Valley.
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Renaissance Technologies
You are selecting into that. And I think if that's what you want, they're like, what better place in the world?
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Renaissance Technologies
Well, I mean, I think the people specifically you would put into cornered resource, but I'm not actually sure that fully captures it here. I was thinking more process power because I think it is the combination of the people and the model and the incentive structures.
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Renaissance Technologies
Yeah, I totally agree with that, particularly in the model itself. I mean, maybe you could argue the model is a cornered resource.
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Renaissance Technologies
So one, I think it probably is true that they have better data than any other firm, thanks to Sandor Strauss and the work that he started doing in the 80s before anybody else was really doing this. So they have that and other firms don't. That said, certainly all the other quant firms are throwing untold resources at all this too.
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Renaissance Technologies
So in chatting with a few folks about this episode, I had more than one person say to me, there's two ways that Rentech could work. And one version of how it works is they discovered something 20 plus years ago that is a timeless secret, and they've been trading on that for 20 plus years.
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Renaissance Technologies
Isn't that crazy? Right. Now, Rentech will say, they will all say that is 100% not the way that it works. It's not that at all. If that were the way that it works, they would, of course, still say that because they don't want anybody to know.
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Renaissance Technologies
Right. So let's accept that there is a possibility that that might be true. More likely, though, is that what Rentech does say is true, which is no, there is no holy grail. What we do here is we completely reinvent the whole system continuously on a two-year cycle. Two years is kind of what I heard. The model is fully restructured every two years. It's not like on a date every two years.
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Renaissance Technologies
It's being restructured every day. But collectively, it's about a two-year cycle.
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Renaissance Technologies
It's also an argument that there is no actual cornered resource here in terms of either the model itself and maybe not the data either.
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Renaissance Technologies
I think that's fair. I think there might also be some argument to the data that that older data is helpful, but its value decays over time as markets evolve.
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Renaissance Technologies
The broader point I want to make here is just that every other major quant firm out there is also spending hundreds of millions, if not billions, on this stuff too.
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Renaissance Technologies
Exactly. Yeah, you couldn't just log into Yahoo Finance or something or open the Stocks app on your iPhone, which even the information they were getting was God knows how long delayed from New York or from Chicago for the futures and commodities that are being traded that Jim gets into. He's as close to the action as he can possibly be, but he's a long, long way from the action. Yep.
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Renaissance Technologies
Yep. So I think we can rule out scale economies for sure. If anything, there are anti-scale economies here.
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Renaissance Technologies
Yeah, you get slippage. I don't think there's any network economies here. I mean, they literally don't talk to anybody.
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Renaissance Technologies
Switching costs I don't think apply. Branding maybe applies in their ability to raise money for the institutional funds, but that's not a big part of the business.
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Renaissance Technologies
Totally. So for me, this kind of leaves counter positioning. I actually think there's some counter positioning here. And I think we're going to have two episodes in a row of counter positioning at scale.
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Renaissance Technologies
They're direct competitors in the market, the other quant firms. And when I say direct competitors, I obviously don't mean for LP dollars. I mean for like the same type of trading activity.
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Renaissance Technologies
I don't think they are counterparties. I think they are all seeking to exploit similar types of trades. I think the counterparties are the people there, the dentists that they're taking advantage of.
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Renaissance Technologies
That's true. But I think, yes, adversaries in finding the similar types of trades. And I think the counter positioning for Rentech or for Medallion specifically is one. I do think the single model approach versus the multi-model, multi-strategy approach that most others have does have benefits, like I was talking about in the tapestries.
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Renaissance Technologies
But I think also and maybe bigger is every incentive at Rentech is fully aligned to optimize fund size for performance in a way that is not true just about everywhere else. I think they have the most incentive of anybody to truly maximize performance we're able to achieve.
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Renaissance Technologies
Yes. Particularly because it's all the same people on the DP and LP side.
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Renaissance Technologies
Oh, that's another argument I heard from people. And that Rentech basically is a math department in a way that none of these other firms are.
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Renaissance Technologies
When he starts out doing this, Jim hits a hot streak and he goes up 50% in a few days. Trading is easy. Trading is easy. He says, I was hooked. It was kind of a rush. I bet. Except he ends up losing all of his profits just as quickly.
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Renaissance Technologies
Yep. I think that could be. So maybe that feeds into process power.
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Renaissance Technologies
Okay. For me, it is some combination of process power and counter-positioning, and I don't think it's any of the other powers.
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Renaissance Technologies
Well, if you buy the whole thing gets reinvented continuously every two years, then yes.
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Renaissance Technologies
There's this really funny line that Jim and Peter and others will say when asked about why they only hire academics and not from Wall Street and whatnot. And they're like, well, we found it's easier to teach smart people the investing business than teach investing people how to be smart. Right. That's ridiculous. They don't teach anybody anything about investing.
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Yes. And also right around this time, Barbara, his wife, gets pregnant with their first child and is like, you can't be driving into San Francisco every morning at Gambling Our Future like this.
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Renaissance Technologies
They're just doing signal processing. I bet at least half the people at Rentech on the research side could not read a balance sheet.
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Renaissance Technologies
Yeah, exactly. So Tim's like, okay, okay, I'll stop. I'll focus on academia for now. So he finishes his PhD in two years. They come back to Boston and he joins MIT as a junior professor at age 23. So they stay one year in Boston. But Jim, even though he's got a family, even though he's super successful as a young academic here, he's got kids, he's restless.
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Renaissance Technologies
Yes, and I think when I've heard people from Rentech talk about this, they will all say... The model does not actually understand the market, but it can predict and we can be so confident in its predictions about what the market will do that we rely on it. Whether it understands or doesn't understand doesn't actually matter. Like it can't tell you why.
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Renaissance Technologies
This is such a tough answer to tell. We actually emailed some friends who are very prominent AI researchers and AI historians and sort of asked this question. And the answer we got back is unsurprising. They said, we don't know because they don't share anything.
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Renaissance Technologies
If that were the case, we should have a very different answer to powers.
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Renaissance Technologies
Yes. Oh, I'm so glad we brought this up. Yeah. It was the exact same stew and the exact same cohort of people and social group and academic groups that Rentech came out of, that AI came out of.
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Renaissance Technologies
Yeah. I mean, it's like we were talking about with Markov models and hidden Markov models. That is the foundation of Rentech. That is one of the foundations of AI and generative AI today.
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Renaissance Technologies
So one of his buddies from the scooter trip to Bogota is from Bogota and lives there. His family's there. He has an idea to start a flooring tile manufacturing company because he's like, you know, the flooring at MIT and in Boston, it's so much nicer than a Bogota. We should start a company and make the same kind of flooring here.
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Renaissance Technologies
Such a good point. And many, if not most of the other quant firms are not doing that. Some of them maybe, but I think most of them are the model is suggesting things and there is a person or persons who are the master portfolio allocators that pull the trigger or don't pull the trigger.
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Renaissance Technologies
Yep. Totally. And that was surprising for me in the research. I sort of assumed that was the whole quant industry. And it was very surprising to me to discover that I believe, no, it is pretty much only Rentech and maybe a couple other people.
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Renaissance Technologies
Yeah, the way he phrased it to us was smart versus dumb, but dumb doesn't mean dumb.
Acquired
Renaissance Technologies
My sense is rent tech is not a high frequency trading shop. They are not front running things. You know, they are not flash boys compared to you and me. They still operate incredibly fast, but it's more about the smartness and less about the fastness.
Acquired
Renaissance Technologies
Oh, this is another thing that we heard. Rentech is world-class at disguising their trades.
Acquired
Holiday Special 2023
And now you have a whole closet in your house filled with Louis bags. Yeah.
Acquired
Holiday Special 2023
Ooh, okay. All right. You heard it here first. There will be at least one luxury episode in 2024. Is that what you're telling me?
Acquired
Holiday Special 2023
Yeah. You're talking about an item that is truly a luxury item, which is on a whole different rubric.
Acquired
Holiday Special 2023
It has a sense of place. It is not a premium item. You could look at it through a certain lens and say, this is utterly ridiculous. Correct. And like, how on earth is this, you know, piece of raw material worth that?
Acquired
Holiday Special 2023
Yeah, I have some watches. But honestly, those are mostly from my dad. My dad is really into watches, and a few of those sort of have trickled to me over the years. I was thinking about it in preparing for this. I do not. And maybe part of that is having a two-year-old, which is not good for the health of the objects in your home.
Acquired
Holiday Special 2023
But I was thinking about that and I was like, you know, I would like to change that and have something that is meaningful on a different level beyond just what it physically is.
Acquired
Holiday Special 2023
I was thinking about this. To not bury the lead, my favorite episode was Nike. But I don't think it was our best episode. I think our best episodes this year were LVMH, Costco, and Visa. And I've come to think that there's a sweet spot for you and me in terms of preparation and our sort of emotional states preparing for and leading up to an episode that leads to it being good.
Acquired
Holiday Special 2023
And I don't think Nikki was bad. I think it was perfectly acceptable. But my level of work... preparation and emotional concern and stress heading into Nike was the peak that it has ever been about an acquired episode.
Acquired
Holiday Special 2023
I mean, how many books did you read? Over 10. And part of that was, it was the first episode of the season. Part of that was I went to Stanford Business School, which is the Knight Management Center. And this is Phil Knight. And I've never met Phil Knight, but I felt an extra debt of gratitude to him and obligation to do it right.
Acquired
Holiday Special 2023
And then part of it, too, was our friend David Litsky at Fast Company was trailing us, following along with us as we were making it, which was super cool. The article that he wrote was fantastic.
Acquired
Holiday Special 2023
wonderful and very complimentary yeah he's a talented writer but all of that stew you know i felt like okay i really gotta bring it on this one and what was interesting that's why it was my favorite i'm proud of all the work that i and we did for it but i think i finally went too far if you look at that episode i was trying too hard
Acquired
Holiday Special 2023
This is going to sound incredibly self-aggrandizing here, but this is how I've come to think about it. Like NFL Sunday, when we're going out there. We go back to our NFL episode at the beginning of the year. It takes me right back to playing football in high school. The games that I prepared the hardest for felt like I really put the effort in. Those were not the ones where I played the best.
Acquired
Holiday Special 2023
The ones where I played the best are when you play loose, you know? You go out there and you have fun and you enjoy yourself and you let it flow. And, like, it is the exact same with acquired episodes.
Acquired
Holiday Special 2023
And those things are so important, I think. Again, for folks who are listening who are or have been athletes, I suspect this will resonate. That's the past part of my life that it resonates with. All of those are important. have fun. You're going to play your best when you're having fun, you know, laugh related to that.
Acquired
Holiday Special 2023
Happy holidays. Cheers. Cheers. I've got my cinnamon-infused hot chocolate here. It's delicious.
Acquired
Holiday Special 2023
But also it kind of, to me, makes me think about your team, your teammates, you know, you and I, we're a team. And then the last piece, maybe it's the most important, the you're good at this, the sports psychology element, the self-confidence element is huge. Yep. I mean, who are we to think that we can go make these ridiculous episodes?
Acquired
Holiday Special 2023
So that's why Nike is my favorite episode. Cause I feel like this way of thinking about what we do finally clicked for me. It's like, you gotta like take yourself past the breaking point before you realize I might need to think about this differently.
Acquired
Holiday Special 2023
I want to talk about this later in the episode, but my quick take is we are not a luxury product, but we share a lot of traits.
Acquired
Holiday Special 2023
We got to be careful or we're going to turn into Dan Carlin here and do one episode a year.
Acquired
Holiday Special 2023
So The Luxury Strategy, which was part of our preparation for LVMH was reading this incredible book, The Luxury Strategy, which contains the 24 anti-laws of marketing. And I just want to call out anti-law of marketing number 18. You just have this on your desk? Well, I put it on my desk ahead of recording this episode, but actually I've had it on my desk for large portions of this year. Yeah.
Acquired
Holiday Special 2023
Anti-law of marketing number 18, do not relocate your factories. This is our version of that. We're never going to relocate our factories.
Acquired
Holiday Special 2023
Yep. So to put a bow on the very easy question of what was your favorite episode?
Acquired
Holiday Special 2023
No, I did. It was Nike. Nike was my favorite. But I think the other part of the coin question of what was our best episode, I think Visa was our best episode. Nice. There were others that are more impactful. I think LVMH, that episode alone, I think completely changed Acquired. As did Costco. As did Costco. But Visa, I think, was the perfect blend of like an NFL Sunday gone extremely right.
Acquired
Holiday Special 2023
We prepared the right amount and we played least. We had fun. We laughed. We remembered that we were good at this. I think you can see it in the finished product.
Acquired
Holiday Special 2023
Yes. And man, it has been a big year for Statsig, too. When we had Vijay on ACQ2 earlier this year, they were already a pretty impressive kind of Series B stage startup with a killer team and early product market fit and all that. But what's happened since and the scale that they're operating at now is pretty wild.
Acquired
Holiday Special 2023
So I asked them for some fun stats that we can share publicly with everyone to kind of give folks a sense of scale of what happened in 2023 for stats sake. So the first one, in the past month, Statsig shipped actual live product experiments to over 1.2 billion end users around the world. Now, that stat is not deduplicated across apps, so there's some overlap in terms of actual people.
Acquired
Holiday Special 2023
But I mean, even if you cut that in half to approximate actual flesh and blood human people out there, that's almost 10% of the world's population. Yeah. Crazy. Okay, so that's one. Two, Statsig now processes about 130 billion, that's with a B, events per day from its customers. That is 1.7 million events every second.
Acquired
Holiday Special 2023
So the infrastructure that Statsig now has to support these data volumes is pretty wild. especially since the company was founded less than three years ago. And it's not like they just execute these events.
Acquired
Holiday Special 2023
They then take all the data from them, run huge statistical jobs across the whole corpus to compute the experiment results that their customers are running for all these 1 billion plus end users. It is just wild. At this rate, they're going to need to call up Andy Jassy and talk about some of those AWS bills.
Acquired
Holiday Special 2023
So that's on the metrics side that they can share publicly. On the customer side, Statsig added arguably almost all of the most important AI companies in the world this year, including Microsoft, Atlassian, Anthropic, many, many others, along, of course, with regular old companies like Notion and UiPath and Lattice and Brex and friends of the show, Rec Room, many, many others.
Acquired
Holiday Special 2023
The team also kept shipping super fast. At the start of the year, they had just one core product, which was hosted product experimentations. Today, they're a full-fledged product understanding platform. They have dedicated feature flagging, warehouse native experimentation, and product analytics.
Acquired
Holiday Special 2023
Specials is what we called the non-season episodes that we did on the feed until this year. And they were almost all interviews in practice, but anything that wasn't a canonical season episode.
Acquired
Holiday Special 2023
And also there are other people and other podcasters out there who are world-class interviewers. Yep. And they are incredible masters of their craft. And we were kind of looking at what we were doing and be like, why are we doing this too?
Acquired
Holiday Special 2023
To your point about analytics, that was telling us something and that was screaming at us in the face for years.
Acquired
Holiday Special 2023
I know it's going to come full circle. We started both at Madrona investing together. And well, we'll just have to talk about this later in the episode.
Acquired
Holiday Special 2023
Yeah. We had made the decision that there was never going to be another interview on Acquired.
Acquired
Holiday Special 2023
What we had decided, you know, we have ACQ2, and we started calling that the Acquired Interview Show. Yeah, briefly, for like two weeks. Legitimately, this is where the rubber hit the road. We were going to put Daniel Andara on ACQ2. And that was the decision, and we were ready to do it. Then we just kind of looked at each other and we're like, what are we doing here?
Acquired
Holiday Special 2023
It all kind of stumbled into real time with Daniel and Dara. Those interviews actually happened on the calendar pretty close to one another. And then I think we kind of crystallized this by the time Jensen and Charlie happened. We still can do something unique and special.
Acquired
Holiday Special 2023
And in most cases, I don't want to say this will be every case going forward, but if you look at those four interviews that we did this year, they were all the CEOs or, you know, sort of protagonists in Charlie's case of companies that we had covered extensively on Acquired. And I think that, to me, is at least one example. There may be more of how we can do something unique and special.
Acquired
Holiday Special 2023
And that's not to take away from all the other many masters of their craft out there, like Patrick O'Shaughnessy and many others that are world-class interviewers, of which I don't think we are in a vacuum. But in cases where we've done...
Acquired
Holiday Special 2023
a hundred hours of work, or in Nvidia's case, in Berkshire's case, many hundreds of hours of work on these companies, I think we then can do something special with the protagonist that other people can't do.
Acquired
Holiday Special 2023
I think that was your idea to do it. You were just like, of course, we have to start with the Revo 128.
Acquired
Holiday Special 2023
Ben, Jenny and I are so, so, so happy for you guys. Parenting, as you know now, is the most joyous, difficult, wonderful, biggest thing you will ever do in your life. And there is no way to understand or describe it until you become one. So welcome to the club. Thank you.
Acquired
Holiday Special 2023
Sometimes I think we save ourselves from ourselves here, but I'm glad that we didn't cut these. And I think it can end up, well, we'll get to the stats in a second, but clearly they have ended up being something special. But the cool thing about the core thing that we do, our season episodes, is that is the natural byproduct.
Acquired
Holiday Special 2023
It's not like we need to go carve out time to do 100 hours of work to go interview Jensen or Charlie. It's like, no, no, we've already just done that as the core thing that we do. So to throw out the opportunity to continue doing those would have been really silly. Yeah.
Acquired
Holiday Special 2023
It was broken. It was slot filling. You know, and again, not to take away from our guests, we had incredible guests, but the conversations themselves were slot filled. We had slots that we needed to fill. That works for us with the season episodes because we're going to make an episode once a month that's in our control. But with interviews, you can't slot fill if you want them to be special.
Acquired
Holiday Special 2023
You can't have pre-sold a commitment to your partners that you're going to do six of those every six months.
Acquired
Holiday Special 2023
So I completely, obviously agree with you on the implications for the business model and not slot filling. And you can't predict when serendipitously you're going to get a chance to interview Jensen or interview Charlie. But this is our opportunity. What interviews do we want in a perfect world to do in the next set of time here for Acquired?
Acquired
Holiday Special 2023
Ben, I'm going to give you a hall pass on this one because you're literally one month into parenting and Lord knows I have empathy and sympathy for you. But you missed the obvious one that I was teeing you up for there, which we're going to make our appeal. We're going to shoot our shot right here. Taylor, if you are listening.
Acquired
Holiday Special 2023
Or Travis, if you can make an intro, we'll maybe have you on for a little segment of it.
Acquired
Holiday Special 2023
You're on the South American leg of the tour. You know, we'll fly down there literally anywhere, anytime.
Acquired
Holiday Special 2023
First, we just have to, you know, we said in the episode, but again, say a huge thank you to Andrew Marks, who's become such a good friend of the show.
Acquired
Holiday Special 2023
The minute that we solidify what the next episode is going to be, we text Andrew and say, you know, like, all right, what do you got? And he's always got something.
Acquired
Holiday Special 2023
So big, big thank you to Andrew. He is literally the acquired MVP of 2023. It's not you. It's not me. It's Andrew. And also our other friend, too, who knows who he is. Thank you to them for making that happen. I mean, it was just... It was a life experience. I don't know what else to say. I can't believe we got to do it.
Acquired
Holiday Special 2023
And I guess I have no idea what Charlie would say to that, obviously. But I think for people who find themselves in those positions, you know, Steve Jobs was that for sure. Obviously, Warren and Charlie are that. Jensen may be on his way to becoming that.
Acquired
Holiday Special 2023
All these people are both people and symbols. And I'm just imagining, once you become a symbol, you kind of have two options, right? you could bemoan it or you could embrace it. And I think Charlie would say, look, it's going to weigh on you no matter what, no matter which one you choose, there's no going back. It's going to weigh on you. And so you might as well embrace it.
Acquired
Holiday Special 2023
Well, it turns out of all those four cast characters, only one has a professional podcast studio in his office, and that would be the one who runs a podcasting company.
Acquired
Holiday Special 2023
And the people at Spotify were so nice hosting us. I mean, just rolled out the red carpet.
Acquired
Holiday Special 2023
Yeah. That was the price of entry. And like we see it in our analytics. Spotify is the majority of consumption of acquired out there.
Acquired
Holiday Special 2023
Absolutely. Yeah. Well, so great. That is big, big change number one since we last reconvened here. Big change number two is GeekWire reported about this already, but you are joining me full time next year on Acquired. I'm so, so excited.
Acquired
Holiday Special 2023
And I think the corresponding stat is we grew something like 176% on Spotify or something like that, often already decently sized base.
Acquired
Holiday Special 2023
I think the other side that we see of it is this will lead into some of our discussion of acquired the franchise in 2024. Podcasting is a great business. I do not doubt that it is a very valuable, very large market for them to be in.
Acquired
Holiday Special 2023
Well, no one has done yet. And the previous scale player, almost like a did not start, you know, like didn't even run the race.
Acquired
Holiday Special 2023
Yes, Crusoe, as you know by now, is a cloud infrastructure provider specifically built for AI workloads and powered by clean energy. So NVIDIA is one of their major partners, and Crusoe's data centers are filled with all the latest Hopper GPUs linked up with InfiniBand and optimized for the best possible performance for all of your workloads.
Acquired
Holiday Special 2023
Yep, and do it all using stranded energy that otherwise would cause environmental harm and instead use that energy to lower the cost of running your AI workloads.
Acquired
Holiday Special 2023
Yep. Together AI is actually itself a cloud that allows customers to train and run their own instances of open source models like Lama two and stable diffusion. And their secret sauce is that they've enabled really fast and performant inference. So once the models are fine tuned and trained to customers use cases, they can scale their applications really fast and really big. And guess what?
Acquired
Holiday Special 2023
Part of that performance optimization under the hood comes from together building on Crusoe's infrastructure. It's a huge success.
Acquired
Holiday Special 2023
Yeah, well, to kick things off on that front, I feel like you had a little more to say on our discussion earlier about is growth good? I mean, certainly this is relevant.
Acquired
Holiday Special 2023
Yeah. This has become more evident to me too in some of our episodes this year, like particularly the Portia episode that we did with Doug DiMero have blown up on YouTube. YouTube, let's completely put Acquired aside for a second. My feelings about YouTube are like, it is an amazing platform. It is an incredible gift to the world that YouTube exists.
Acquired
Holiday Special 2023
And one of my carve outs later in the episode is going to be the QB school on YouTube, which is a former NFL quarterback who makes amazing detailed breakdowns of what is actually going on every week on your like favorite teams. Oh, that's awesome. It's incredible. Like the fact that that is available and accessible for free.
Acquired
Holiday Special 2023
Oh, it's amazing. JTO Sullivan. We'll talk more about it later. Go subscribe if you care at all about football, even if you don't. That said for our episodes that have gotten big on YouTube, if you go look at the comments, it's awful. It is a hundred percent, not even the same universe of experience that the acquired Slack community is.
Acquired
Holiday Special 2023
And like this kind of crystallized for me, what you're talking about of like anybody who is the type of person who really cares about knowledge, understanding these great businesses, these stories we tell and learning from them. come on in. Like, we want as many people of those in the world. The YouTube comment world out there is not what we want.
Acquired
Holiday Special 2023
This had never happened to any of our episodes before. Until this year, we were not exposed to this part of the internet.
Acquired
Holiday Special 2023
Yeah. I think for both of us, this really kind of clarified what we really want and meant by this we're a little wary about growth. Like, it's not that we're wary about growth. It's that we want to keep this, you know, place that's about knowledge.
Acquired
Holiday Special 2023
Yep. So as we've started experiencing some of the growth that we talked about, we realized that we'd kind of hit a scale now where Acquired is a viable platform and partner to new sponsors that we can work with. And just to talk about what those are for season 14, starting in January, two of our three sponsors are going to be JP Morgan, specifically JP Morgan's payments division and ServiceNow.
Acquired
Holiday Special 2023
both of which are incredible companies. We are super excited to work with them. But in both of those cases, we knew those companies and knew those people there for several years now.
Acquired
Holiday Special 2023
Yep. It would have been odd for Fortune 500s to work with us before recently. And now starting to work with their teams, how JP Morgan thinks about their brand and their positioning and their kind of whole set of marketing activities is a completely different animal than how startups and, you know, earlier stage tech companies do.
Acquired
Holiday Special 2023
Yeah. And just as importantly, dozens, if not more than dozens that are going to be coming up over the next set of years.
Acquired
Holiday Special 2023
I'm so happy not only for as a, you know, 50% shareholder and acquired, but you even more so like you're my best friend and this means we're going to spend even more time together and uh just outside of the show outside of anything that that means for us our business you know the episodes all of which are going to get so much better it just it brings me joy i'm so happy thanks man
Acquired
Holiday Special 2023
Yeah. And as an early example of this, our great friends over at Vanta and their CEO, Christina, have been very, very kind guinea pigs for us. So Vanta has been a longtime partner of the show. We've helped grow their business.
Acquired
Holiday Special 2023
And last year, Kindergarten Ventures, the early stage AngelList fund that I run with my friend Nap, we did a $10 million SPV in Vantage Series B. And that was a great test of can we invest in a market-leading company and put meaningful capital to work? So that's a playbook that we're now going to be able to run more often.
Acquired
Holiday Special 2023
Yep. This is all part of you coming full-time, and it's time. It's time for all this to happen.
Acquired
Holiday Special 2023
All of which we are super excited about. But you and I are super clear with each other and we want to be super clear listeners with all of you too. The show is the most important thing. Acquired is the show. That is what you and I love doing. That is why you and I are full-time podcasters now. And all of our effort is going to go into the show.
Acquired
Holiday Special 2023
Yes. So on that front, we've got some fun stuff planned for next year. Episode one, we are already deep in research for. We're not going to give it away what it is, but it is a new category for Acquired, which is... I don't think we've ever touched it in all 280 episodes or whatever.
Acquired
Holiday Special 2023
Anyway, we're already deep in the research. The story itself, like industry aside, financials aside, you know, market cap aside, this is a century-long incredible story too. So I'm really, really pumped.
Acquired
Holiday Special 2023
This year it was brands and luxury and retailers. It'll be, you know, this other thing hopefully next year. But like we look around the corner and there's a whole new category of companies to cover. Yep. So we're pumped for that. Ben, you have already spilled the beans that another luxury brand is in the works.
Acquired
Holiday Special 2023
And we're going to try our best not to set ourselves up to do something like that again in the future.
Acquired
Holiday Special 2023
I would even go so far as to say, you know, something... that I've taken from especially the last couple of years of Acquired is the story is always deeper than you think. And so let's even say we were set up to do investigative journalism and deep diligence that we would then share with the public on a company. In real time. In real time, I still think it's impossible to get it right.
Acquired
Holiday Special 2023
All the parents out there will understand and appreciate you being here, as do I. Yeah. Well, let's start the 2023 acquired year in review recap. Dude, this has been freaking wild. I mean, you were talking about like acquired has been a slow burn. You know, we have doubled every year and we've always been this example of exponential growth that like it starts small.
Acquired
Holiday Special 2023
I mean, look at the best VCs out there. They are, at least on the diligence and investing side of the equation, making these calls in real time. And the very best of them only get it right, what, 20% of the time at most, you know, 30% of the time. I don't think it is possible to do anything.
Acquired
Holiday Special 2023
Yes. I'm not talking about fraud. I'm just talking about getting the story right. Like the story of Uber that we did on, you know, IPO day back when we did that episode, like that was not the full story of Uber.
Acquired
Holiday Special 2023
Totally. And as much as I want to take as a kind personal compliment, all the things you're saying and apply it to myself too, but I really got to give credit to you. I think this is a big part of the demeanor that you bring in your personality to the show. Like you are a optimist as we both are, and we've talked about a lot on the show. But a skeptic.
Acquired
Holiday Special 2023
Well, in the big picture, you're an optimist. Yeah. And so I think this is one of the things that makes us a really good team. In terms of the actual goal and what we're trying to do here and acquired and what it is and what we want it to be, we are 100% aligned. And you do a really good job keeping us in check on this front.
Acquired
Holiday Special 2023
You know, reflecting on this too, I think, ironically, moving to this role as our and, you know, my over the past couple of years, official, you know, job function and identity of being historian versus venture capitalist investor has made me a much better investor. Yeah, ain't it the truth.
Acquired
Holiday Special 2023
And for me specifically, when I was only an investor or investor was the primary thing, everything we were just talking about were both strengths and weaknesses for me. I would fall in love with companies, deeply in love with companies. And obviously for people who listen to us, I still do this with Acquired episodes with the companies we cover. And that was a great strength, too.
Acquired
Holiday Special 2023
And, you know, first year we doubled from two to four listeners, you know, like, but no, it wasn't exactly that.
Acquired
Holiday Special 2023
Like you can really help companies and founders can really feel like you are on their team and aligned and pulling with them. And also, just purely in terms of making the right investments, having a bit more arm's length objectivity and perspective helps. Shifting my focus to the show. certainly has made me a better investor.
Acquired
Holiday Special 2023
I just look at the investments that I've done and I've been more active in the past few years than I was when I was a VC. And you and I are going to be even more active together going forward. I never would have expected this, but it has really helped me.
Acquired
Holiday Special 2023
Yes. And just having this other thing be my obsession has allowed me to have a little more arm's length.
Acquired
Holiday Special 2023
We were having this discussion, you and me, on Zoom a couple months ago with... a world-class investor. And the sort of frame that we put on it was taste.
Acquired
Holiday Special 2023
You can't really teach it. You certainly can develop it, but this is a version of that.
Acquired
Holiday Special 2023
Well, keeping on this topic of audience Q&A, a couple of weeks ago, we got this kind email from listener Martin from Scotland. In it, he had a list of questions for us and said, if you have time to answer a few of them, I would really appreciate it. And we looked at it and we said, yeah. Gosh, these are awesome questions. Should this be the entire episode? This should be our holiday special.
Acquired
Holiday Special 2023
Feels very appropriate. Yes, I purchased this holiday sweater at the Seattle Nordstrom for our 2019 live show at the University of Washington. It's like two months before the pandemic hit. That's right.
Acquired
Holiday Special 2023
So thank you, Martin. We are going to dive into a bunch of them here, and they are just fantastic. So number one, what is the book or books you've given most as a gift and why? Or what are one to three books that have greatly influenced your life? Ben, you want to go first?
Acquired
Holiday Special 2023
There were many years where nobody would have imagined that this would be either of our full-time gigs.
Acquired
Holiday Special 2023
And I actually went and I looked it up last year on our holiday special. Yeah. I was both pretty excited and proud to announce and also terrified that we had hit a quarter million listeners to the pod. Felt like, holy crap, that's a big number. This is like real what we do. And I was terrified because I was like, we talk all the time. Ben talks all the time about how we double every year.
Acquired
Holiday Special 2023
I have a bunch more books to talk about later in the episode, but the one that I've gifted the most is a book called Transitions by William Bridges, which was first given to me by Ben and my good friend Mark in Seattle. Ben, have I given you this book?
Acquired
Holiday Special 2023
We need to rectify this right away. Watch your Amazon deliveries. I'm going to send it to you.
Acquired
Holiday Special 2023
Right. You'll find it again in like six months or so when you're cleaning out your basement. This book is a super cool concept. It was written, I think, in 1980. And the idea, it's about major transitions in your life. Could be a good transition like having a baby, welcoming a new family member.
Acquired
Holiday Special 2023
Could be a bad transition like a death in the family or career related, losing a job, something like that. But the thesis of the book is that when this happens in your life, and it will many times, it's going to sound a little gruesome, but you need to sort of kill your old self and be reborn as your new self. That sounds super woo-woo, but if you actually think about it, it makes sense.
Acquired
Holiday Special 2023
Your identity, who you thought you were before a major transition, it has to change. There is no way around it. And you'll go through the five stages of, you know, denial, anger, blah, blah, blah, all this stuff. This book is a great sort of way to streamline that process. But you have to accept that that you that you were before is no longer and then you can create the new you.
Acquired
Holiday Special 2023
And I found it incredibly helpful, both for big challenges in my life and for great positive stuff like having a baby.
Acquired
Holiday Special 2023
Ben, there is a very fun Easter egg that is going to be buried later in this episode for you to find related to this book recommendation. Ooh, sweet. So Ben and listeners can go on a little treasure hunt. Great. All right, next question. What purchase of $200 or less has most positively impacted your life in recent memory? This is a super easy one for me. No-brainer, my Zojirushi hot water heater.
Acquired
Holiday Special 2023
For people who don't know about these, and I think this is probably most of the world outside of Japan, This is a device that sits on your kitchen counter and keeps several gallons of water at a set temperature constantly. I am a huge tea drinker. I use this thing four or five times a day and have for the past decade plus. It is amazing. I set it at 195 degrees. I drink green tea every day.
Acquired
Holiday Special 2023
I re-steep my teapot constantly throughout the day. And it is unquestionably effective. made my life better, and probably will extend my lifespan by like several years from drinking tons of green tea every day.
Acquired
Holiday Special 2023
We'll link to it in the show notes. Zojirushi is the brand. It's a Japanese company. Everybody in Japan has one of these things.
Acquired
Holiday Special 2023
Amazing. Okay, next one is the Tim Ferriss question. I don't think anybody's ever asked us that before. If you had a gigantic billboard anywhere with anything on it, metaphorically speaking, what would it say and why? Maybe the most random fact about me, I was a French literature major in college, particularly a 17th and 18th century French literature expert.
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Holiday Special 2023
I'm hardly an expert, but that's what I majored in in college. And Something that has stuck with me from then, and the older I get and the world we live in becoming more the world it is, has stuck with me more and more, is the last line of Voltaire's Candide, « Il faut cultiver notre jardin ». We must cultivate our own garden.
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Holiday Special 2023
And especially today, like there's just so much in the world that you don't have any control over. The only thing you have control over is your garden and cultivating your own garden. And for us, that's acquired. And for me, that's acquired in my family and, you know, maybe some other things over time, but just focus on what is in your control and be great at that and be good at that.
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Holiday Special 2023
Be great and be good. at those things, and that is what you can do. At least those are the words that I have come to live by.
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Holiday Special 2023
Of course. I mean, unless literally we start expanding galactically or something like that.
Acquired
Holiday Special 2023
There's never any reason not to be kind. Right. I love that. That's so good. What is one of the best or most worthwhile investments you have ever made? It could be an investment of any type.
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Holiday Special 2023
Aw. I have the same answer. I actually didn't write down Jenny, but I should. Thank you for reminding me. Yes. Jenny, I love you. Yeah, ditto. Nothing more to add. And probably therapy.
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Holiday Special 2023
Yeah, I agree. I started doing weekly therapy. I'd done it off and on before, but I started doing it weekly, committing to that this year, and it's just immensely helpful.
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Holiday Special 2023
Yep. All right. What is an unusual habit or absurd thing that you love?
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Holiday Special 2023
We were in the airport flying back from LA. We were at LAX after interviewing Charlie Munger. And you got one of these at the Starbucks at LAX. And I've known this about you for years. And I just kind of looked at you and I was like, Ben, I think you have eaten more spinach feta wraps than any other human being in the world. And you thought about it and you were like, yeah, I think that's right.
Acquired
Holiday Special 2023
This is amazing. This is the very best Ben Gilbert trivia that exists. When did you start?
Acquired
Holiday Special 2023
Speaking of special, unique interviews that only we could do... I don't even need to finish that sentence. We're just going to leave it.
Acquired
Holiday Special 2023
Yes. I was going to say adding weekly therapy this year and related to that, just listening to my instincts in particular, my physical reactions to things. I've found it takes a while to train your instincts. So I don't know if I just listened to my instincts and followed my instincts when I was 25 that that would have been the right thing. But
Acquired
Holiday Special 2023
I'm pretty dialed at this point on like what's right for me. And I find that I have physical reactions in my body to things and like listening and tuning into that usually is the right way to go.
Acquired
Holiday Special 2023
Yes. So the big news, we hit half a million listeners this year, which is pretty wild. Hopefully we can put up the chart, the Ben Gilbert acquired chart that you make obsessively every month showing our episode, Growth Over Time.
Acquired
Holiday Special 2023
Yeah, right. Easier said than done when, you know, you're on hour like three of intense feelings, shall we say. What advice would you give a smart, driven college student about to enter the quote unquote real world and what advice should they ignore?
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Holiday Special 2023
Yeah, this is kind of be greedy when others are greedy and, you know, build when others are fearful.
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Holiday Special 2023
Yeah, reflecting on the 2020 to 2022 timeframe, that is a huge takeaway for me. Bill Gurley has for years said this, you got to play the game on the field.
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Holiday Special 2023
Yes. Yes, yes, they are. My answer, I would just repeat what I said on the Art of Investing podcast that we went on a few months ago, which those guys have just built such a great show. I mean, they're teachers. They've been teachers for years.
Acquired
Holiday Special 2023
What I said there literally to college students was both that following your own path has never been more rewarding in this world that we live in and never been harder. Like there's so much pressure out there, social media, everything else about the world we live in. There's so much pressure to conform and that makes standing out and following your own path that much more valuable.
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Holiday Special 2023
All right. In the last five years, what have you become better at saying no to? Distractions, invitations, etc. What new realizations and or approaches helped? Any other tips?
Acquired
Holiday Special 2023
Yeah, I was going to say the same thing. And you said it for me. Like I said, this is not my most flattering natural tendency. But as I've thought about this over the years, what I've come back to is I reach out to lots of people. how do I feel if I don't get a response to all of those? I feel fine. And, you know, I assume that folks that I reach out to have something going on. They're busy.
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Holiday Special 2023
And especially now having kids, it's just like, I get it for them and I get it for me more. It's like, you know, There's nobody more important to me than my daughter. Nobody. My wife, you know, like, and you, you know, like, okay, outside that circle, like you are my most important people. And there's only so many hours in the day.
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Holiday Special 2023
It's like a version of, you got to put the, your mask on before helping others. It's like, I got to put those relationships on before others.
Acquired
Holiday Special 2023
Yep. Okay, last one. When you feel overwhelmed or unfocused or have lost your focus temporarily, what do you do? What questions do you ask yourself? This is so easy and this is the perfect one to end on. We go make a great Acquired episode. And...
Acquired
Holiday Special 2023
This has been such a gift to me in my life because up until we started doing Acquired and up until Acquired became my full-time job three years ago, I didn't have anything that I could control like that. I don't know what I would have answered to that question. Like so much of everything was out of my control. When you're a venture investor, you don't control anything.
Acquired
Holiday Special 2023
Right. Exactly. We're so lucky now that we have this thing that we do, that we can do, and we're good at, and we know how to do, where no matter how bad things get or no matter what's going on, we can just go in a lab and we know we can make a great episode. And we also know it's the best thing we can do. No matter how good or bad things are going, it's always the best thing we can do.
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Holiday Special 2023
This is another one of those paradoxes, I think, in that the way the world works today, this has, on the surface, kind of never been harder. Organizations are bigger. Things are more complex. Things are more interdependent. The idea that you could as a person and especially a young person be able to do that is hard to fathom. And yet it's also never been more true than ever.
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Holiday Special 2023
All you need is an internet connection and you can find and learn some version of this.
Acquired
Holiday Special 2023
All right. Well, as we sort of drift towards the end, to borrow a Ben Gilbert phrase, drift towards the close of our 2023 holiday special and our traditional extended carve-outs, We have a very special carve-out to kick things off.
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Holiday Special 2023
So for our last segment for this year with Blinkist and their parent company, Go1. We have something really, really special.
Acquired
Holiday Special 2023
Yes. So one of the many amazing things about doing Acquired is the people, all of you who listen, and then we get to meet many of you and build relationships with you. Sometimes this really blows us away.
Acquired
Holiday Special 2023
So we asked Blinkist if we could highlight two of those people who have been important to us over the past couple of years and have Blinkist build bookshelves for them to share with you all of the books that have been most important to them in their lives and careers.
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Holiday Special 2023
So the first of those people is someone that is kind of surreal for me to say here, but has been a huge supporter of the show and a mentor of mine now for the past few years. He told me when we first met that he will never come on the show.
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Holiday Special 2023
Yes, once we tell you who this is, you'll understand why, or many of you will understand why. But he did say that if there ever were another opportunity to pass along some wisdom, he would love to do it. And this is the perfect venue. So our first holiday bookshelf is from Mark Leonard, the founder and CEO of Constellation Software.
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Holiday Special 2023
So if you go over to Blinkist.com slash Mark, you'll find an annotated list of Mark's favorite books with some very rare insights from him on why he values them.
Acquired
Holiday Special 2023
Yeah. We're very lucky to get to know him. So our second holiday bookshelf is from another good friend who, in the opposite vein of Mark, is I think maybe more publicly well-known as a business biography expert than just about anybody in the world. And we'll let him tell you his own top favorite books here. I think maybe for the first time ever that he's done this.
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Holiday Special 2023
David Senra, welcome to the Acquired Holiday Special. Thanks for thinking of me. Thanks for having me, David. I know this is like picking your favorite children, but your favorite business biographies of 2023.
Acquired
Holiday Special 2023
Okay, you're number two. I'm looking forward to because this was actually my personal favorite episode that you did this year.
Acquired
Holiday Special 2023
Well, and related sidebar to that, thank you to all of you, the half a million of you now for spending all this time with us this year. There's a lot to discuss. So You know, for me, I've kind of gone back and forth. You started saying, I think about two years ago, growth is not a goal. I don't know that growth is good for acquired. And I sort of nodded my head, but I wasn't totally sure.
Acquired
Holiday Special 2023
So fun. The taste of luxury, Bernard Arnault and the Moet Hennessy Louis Vuitton story.
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Holiday Special 2023
This year, I think, has really helped crystallize my thoughts on this as we've grown so much. I do completely agree with you. Growth in and of itself should not be a priority and in fact can be very detrimental to what I think we both want to do here if we optimize just for growth. What I think we've done this year goes back to the very start of this episode and you changing the intro.
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Holiday Special 2023
Well, I got to tell you, giving you the book was a selfish act on my part. Because I had already read the book. I wanted your episode on it. I didn't just do it out of the goodness of my heart. Okay, speaking of, number five.
Acquired
Holiday Special 2023
Well, for Ben, you're in my traditional extended carve-outs to end the holiday special. I have a special family one that I want to start with, if that's okay. So my brother-in-law, Dave, Jenny's sister's husband, Dave is the most beloved member of our entire family, including my daughter, who no doubt about it loves him way more than mom and dad. He's the best.
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Holiday Special 2023
He, until this year, was an early employee at a venture-backed startup here in San Francisco. He changed jobs, and he joined a company called Mill this year. He was telling me about the company. I was pretty skeptical, honestly, to start. Mill was founded by Matt Rogers, who Matt was Tony Fadell's co-founder at Nest back in the day. And Mill is the Nest thermostat version of a compost bin.
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Holiday Special 2023
And at first I was like, okay, Dave, I'm glad you're passionate about this. I can't imagine how many people out there really need an internet connected compost bin. Then he joined the company and he was saying, this is really great. So I was like, okay, I'll support the family. We'll get one. This thing is freaking awesome. I was totally wrong.
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Holiday Special 2023
I mean, obviously this is, you know, sort of a luxury good. I mean, it's not a luxury good. It's a compost bin, but like it's a premium good. I did not realize how much I needed this thing. For basically my entire adult life, I have had fruit flies in my kitchen on and off in the compost bin. And if I didn't have fruit flies, you know, it's a compost bin.
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Holiday Special 2023
Like, you know, it's compost in your kitchen. This thing roasts your compost overnight and and is internet connected. It runs overnight. You put all the food scraps in there. It roasts and churns it. It turns it into chicken feed. And every morning it gets fully roasted, which means no smell, no mess. And it absorbs, this thing is like a black hole of compost. It's a big bin.
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Holiday Special 2023
We will go weeks as a family of just putting everything in there. No emptying, no going to the garbage, no smell, no nothing. And then when it gets full, your app tells you, you put it in a box. They send you a bunch of boxes, like in a bag in a box. You send it off to them and they sell it as chicken feed. This is like the most brilliant thing ever. I was so skeptical and now I'm 100% convert.
Acquired
Holiday Special 2023
We went from a podcast about great technology companies and the stories and playbooks behind them to a podcast about great companies and the stories and playbooks behind them. And yes, we have continued to grow in the tech world and sort of our core niche. And I think that
Acquired
Holiday Special 2023
Mill.com. I'm not just saying it because Dave's my brother-in-law. Actually, this is the best thing I've bought this year. Did you or did you not get yours for free? No, I paid for it. I didn't get any discount.
Acquired
Holiday Special 2023
The only connection I have to the company is that my brother-in-law joined them and I thought it was a really bad idea.
Acquired
Holiday Special 2023
I recognize that I just recommended an internet connected compost bin, but it really is awesome.
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Holiday Special 2023
audience and audience potential is way bigger than we ever realized but we've also added everybody else in the world now who is interested in business and runs a brand and thinks about brand management or runs a retailer or runs a large hardware business like Home Depot or something like that, you know, and also all around the world, too.
Acquired
Holiday Special 2023
Yeah. One of your carve-outs I picked up recently, Hoka Slides. I actually didn't get the Slides. I got the Ora, the recovery shoes. Hoka Slides, so good. Yeah, I got the same technology in the kind of more shoe, more enclosed form factor. I think they're also called the Oras, O-R-A. So great. Best house shoes I've ever had, per your recommendation.
Acquired
Holiday Special 2023
Yeah, this is... We did that ACQ2 episode with Chris from Runway. Like this sector application of AI in image and video, we're only just scratching the surface. The surface is already unbelievable. And like, I just can't wait for what's coming. Yep.
Acquired
Holiday Special 2023
I mean, some of our biggest episodes this year were, A, not American companies. B, even if they were American companies, they were truly global brands and global companies. A lot of what we do, if we just wanted to optimize for growth, we would do differently. We would not make four-hour episodes. We would release more frequently, etc., etc.,
Acquired
Holiday Special 2023
Love it. All right, I'll jump in with a couple before we get back to you. First, a book that I alluded to earlier in the episode, The Luxury Strategy by Jean-Noël Capferer and Vincent Bastien. This book was a core part for both you and me in LVMH prep. And it's so good.
Acquired
Holiday Special 2023
It's so counterintuitive and worth reading for anybody who has a brand, any company that has a brand, which is everybody, even, you know, like enterprise software, SAS company, you have a brand, you should read this book. I am just going to read, you have tweeted this. And I think maybe even on air said them all, but I'm going to say them again. This book contains the 24 anti-laws of marketing.
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Holiday Special 2023
One, forget about positioning. Luxury is not comparative. Two, does your product have enough flaws? Three, do not pander to your customer's wishes. Keep non-enthusiasts out. Do not respond to rising demand.
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Holiday Special 2023
dominate the client, make it difficult for clients to buy, protect clients from non-clients, the role of advertising is not to sell, communicate to those you are not targeting, the presumed price should always seem higher than the actual price, luxury sets the price, price does not set luxury, raise your prices as time goes on in order to increase demand, Think about that one.
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Holiday Special 2023
Do not relocate your factories. We talked about that earlier. And then it continues. Do not hire consultants. Do not test. Do not look for consensus. Do not look after group synergies. Do not look for cost reduction. Just sell marginally on the internet.
Acquired
Holiday Special 2023
That's one. The next one I want to mention I also talked about earlier in the episode is the QB school on YouTube. So JTO Sullivan, who was like a 10 year long journeyman backup quarterback in the NFL, he briefly started for the 49ers, I think in like the late 2000s. After he finished playing, went and got a PhD in leadership studies.
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Holiday Special 2023
and then started this youtube channel where he breaks down quarterbacks performances every week and does behind the scenes of like basically just lets you ride along with how a quarterback and an nfl offense from like the offensive coordinator down to the quarterback's coach down to the players like what is actually happening.
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Holiday Special 2023
There was a quote that I think we cut from our NFL episode, but that kind of sums up what's going on here from one of the books that we read. It said that baseball fans love baseball because they think they understand the game. Football fans love football because they know they don't understand the game.
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Holiday Special 2023
I played football for 10 years and this is the first time I'm like getting a glimpse of understanding the game. It's so good. This guy is awesome.
Acquired
Holiday Special 2023
You just watch these games and the drama is so compelling. But what's going on is at such another level.
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Holiday Special 2023
I would say like if you think about the NFL broadcasts, that's one level. Then there's like Manningcast that's like several clicks deeper in getting a window into what's going on. And then QB school is like as far to the other side of the spectrum as you could go while still being really fun. Like JT is a great host, but like it's technical. It's very technical.
Acquired
Holiday Special 2023
Is that okay with you? I've got one other first that I want to throw out. Lay it on me. Which is going to be a recommendation to nobody because you've already seen it. The Heiress Tour.
Acquired
Holiday Special 2023
Well, like we said, open invitation, Taylor. You know, we will fly to wherever you are. It is true. Dude, you got to watch it like when the baby's sleeping, maybe over the course of two naps because it's a long movie. But she's just on another level from anybody. I mean, she's Time's Person of the Year this year. And it is one of the best movies, period, that I've ever seen.
Acquired
Holiday Special 2023
I am super pumped for your recommendations because I really trust you on this. Ben, you are such an optimizer. When it comes to this stuff, this is your wheelhouse, so I can't wait.
Acquired
Holiday Special 2023
Yeah, yeah, yeah. You do not want to be transferring baby out of car seat when baby is asleep ever.
Acquired
Holiday Special 2023
I was literally waiting with bated breath for your opinion on the Duna.
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Holiday Special 2023
Bury the lead here. Also, Jenny and I are expecting number two this year.
Acquired
Holiday Special 2023
Obviously, Ben already knew, but I appreciate the faint surprise there. And we are considering, this is among the considerations set and whether we would change our strategy at all. So, okay, lay it on me.
Acquired
Holiday Special 2023
Well, this is niche Acquired here. Like, for the right niche, this is riveting content.
Acquired
Holiday Special 2023
I was thinking about like, oh, what are my kids? You know, my daughter's two now. She's like, you know, she's certainly not an adult, but like it's, you know, it moves fast. She eats people food. Yeah, she especially. She is basically an adult at this point.
Acquired
Holiday Special 2023
Well, let's be clear. The bun. I ate the hot dog. She ate the bun, which was her choice. My kid-related carve-out, I was having trouble coming up with any of them, and this isn't even that kid-related, but it's her favorite movie, which everybody should watch. I can't believe I hadn't seen it till now, is Coco, the Pixar movie. Oh, yeah. Coco. It's good. About Dia de los Muertos. It's so good.
Acquired
Holiday Special 2023
I've now seen it like 10 times. I will probably see it about 500 more times in my life. And... Disney Plus, despite all the turmoil and Eiger and all that, it's a hell of a drug. It's a hell of a drug for a parent.
Acquired
Holiday Special 2023
All right, well, that's it for extended carve-out slash holiday present suggestions this year from Acquired. We have one more section to close out the year, and that is thank yous. First, we owe just the biggest thank you in the world to our wonderful editor, Stephen. Stephen, you are, and everybody listening I'm sure will agree, the single best podcast editor in the business. It's unbelievable.
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Holiday Special 2023
I think that's been what's so cool for me. And my big lessons and takeaways from everything we've done this year is that those stories and studying the LVMHs, the Costcos, the Nikes of the world, if anything, that's like even more important than studying the great technology companies for building a great technology company. Yeah.
Acquired
Holiday Special 2023
Immaculate. Stephen, you are the man. Thank you for making the show what it is. Second, thank you for this year is once again, MVP of Acquired, Andrew Marks, not only for Charlie, but really for being our thought partner behind every episode and relationships that we've built and now heading into next year and investing, helping us think through that.
Acquired
Holiday Special 2023
Yes. Speaking of LVMH, Adam Pritzker helped us a ton on LVMH. Adam, of course, was one of the founders of General Assembly and now has assembled brands and Kate, which they just sold and was a fantastic outcome for everybody there. Adam really gave us a window into actually building and running one of these companies.
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Holiday Special 2023
I don't think Doug knew what he was getting into when he agreed to this.
Acquired
Holiday Special 2023
He also totally set the bar for if and when we ever have another voice on a season episode, that is how we're going to do it.
Acquired
Holiday Special 2023
10 out of 10. Just such a high quality guy on every dimension. And then on the research dimension, thank you to dozens, dozens of people who helped us with research for our episodes this year.
Acquired
Holiday Special 2023
Too many to name here, and many of you don't want to be named, but people who have way better things to do with their time than chat with me and Ben about a podcast episode we're working on, CEOs and CFOs of public companies, et cetera. Immensely grateful.
Acquired
Holiday Special 2023
We found this just incredible response, especially to the LVMH episode of like, wow, here are these lessons that are not well talked about and known in our world.
Acquired
Holiday Special 2023
Yeah, thank you. Speaking of the last and most important thank you to all of you, this whole thing would not happen without you listening. You all are just an amazing community and we really appreciate you. Have a wonderful, wonderful holiday season. Yes. All the best for a happy, successful, wonderful new year ahead.
Acquired
Holiday Special 2023
All right. Well, it's a good thing that there are no other board members required besides you and me because I am in full agreement. Unanimous. And otherwise we would have had a deadlocked vote there one to one.
Acquired
Holiday Special 2023
This is great. Maybe they didn't even listen to the episode. But what was cool is that enough people now... have been consuming this and talking about it and getting value out of it.
Acquired
Holiday Special 2023
It gets in the water. Yeah, it's wild. My favorite was a friend of mine who's a VC at Lightspeed texted me about two weeks after the Costco episode came out and said, dude, I have gotten three pitches this week from startups where at some point in the deck they talk about how their business model is similar to Costco.
Acquired
Holiday Special 2023
Yeah. All right. So let's talk about the episodes. So we started the year actually with the NFL, which I think a lot about that episode still to this day. And the Visa episode that we finished the year with was like the NFL CODA part two episode. Then we did LVMH, which I feel like we have even more to talk about. Nintendo, Lockheed, Porsche, Nike, Costco, NVIDIA Part 3, and then Visa.
Acquired
Holiday Special 2023
And then our interviews this year, and we should talk about our kind of change in strategy from what used to be specials last year to acquired interviews this year. Danielek... Dara Khosrowshahi from Uber, Jensen from NVIDIA, and then Charlie. But let's stick with the season first. Of that, what was your favorite that we did this year? Like Ben Gilbert's personal favorite episode?
Acquired
NVIDIA CEO Jensen Huang
This is where I was going to go with that. I love the examples you pulled. Toothpaste, ketchup, music, movies.
Acquired
NVIDIA CEO Jensen Huang
So that's where we are today. And that's where NVIDIA is today. But I'm curious, there's a couple of years after AlexNet, and this is when Ben and I were getting into the technology industry and the venture industry ourselves.
Acquired
NVIDIA CEO Jensen Huang
There were those couple of years there where to a lot of the rest of the world, these looked like science projects. Yeah. The technology companies here in Silicon Valley, particularly the social media companies, they were just realizing huge economic value out of this. The Googles, the Facebooks, the Netflixes, et cetera.
Acquired
NVIDIA CEO Jensen Huang
And obviously that led to lots of things, including OpenAI a couple of years later. But during those couple of years, when you saw just that huge economic value unlock here in Silicon Valley, how were you feeling during those times?
Acquired
NVIDIA CEO Jensen Huang
When OpenAI was founded in 2015, that was such an important moment that's obvious today now. But at the time, I think most people, even people in tech, were like, What is this? Were you involved in it at all?
Acquired
NVIDIA CEO Jensen Huang
Because you were so connected to the researchers, to Ilya, taking that talent out of Google and Facebook, to be blunt, but reseeding the research community and opening it up was such an important moment. Were you involved in it at all?
Acquired
NVIDIA CEO Jensen Huang
Yeah, just the gear. I mean, the drives that came out of the camera.
Acquired
NVIDIA CEO Jensen Huang
Yeah, I got new perspective on the company and on him as a founder and a leader just from doing this, despite, you know, we thought we knew everything before we came in advance. And it turned out we didn't.
Acquired
NVIDIA CEO Jensen Huang
Yes. So in our NVIDIA Part 3 episode, we talked about how the AI research teams at Google and Facebook drove incredible business outcomes with cutting-edge ML models. And these models powered features like the Facebook News Feed, Google Ads, and the YouTube Next video.
Acquired
NVIDIA CEO Jensen Huang
recommendation in the process transforming google and facebook into the juggernauts that we know today and while we talked all about the research we didn't touch on how these models were actually deployed yeah the most common way to deploy new models was through experimentation a b testing
Acquired
NVIDIA CEO Jensen Huang
Yep. So now you're probably thinking, well, that's great for Facebook and Google, but my team can't build out our own internal experimentation platform. Well, you don't have to, thanks to Statsig. So Statsig was literally founded by ex-Facebook engineers who did all this. They've built a best-in-class experimentation feature flagging and product analytics platform that's available to anyone.
Acquired
NVIDIA CEO Jensen Huang
And surprise, surprise, a ton of AI companies are now using StatSig to improve and deploy their models, including Anthropic.
Acquired
NVIDIA CEO Jensen Huang
Have you always thought about the company this way? Even from the earliest days.
Acquired
NVIDIA CEO Jensen Huang
And when you say mission, do you mean mission like... NVIDIA's mission is- Build Hopper. Yeah, okay. So it's not like further accelerated computing. It's like we're shipping DJX Cloud.
Acquired
NVIDIA CEO Jensen Huang
When we did our most recent episode on video part three that we just released, We did this thought exercise, especially over the last couple of years. Your product shipping cycle has been very impressive, especially given the level of technology that you are working with and the difficulty of this all. We said, could you imagine Apple shipping two iPhones a year?
Acquired
NVIDIA CEO Jensen Huang
You can't really imagine that, whereas that happens here. Are there other companies, either current or historically, that you look up to, admire, maybe took some of this inspiration from?
Acquired
NVIDIA CEO Jensen Huang
I love this tee-up of learning but not imitating and learning from a wide array of sources. There's this sort of... unbelievable third element, I think, to what NVIDIA has become today, and that's the data center. It's certainly not obvious.
Acquired
NVIDIA CEO Jensen Huang
I can't reason from Alex Nett and your engagement with the research community and social media feed recommenders to you deciding and the company deciding we're going to go on a five-year all-in journey on the data center. How did that happen?
Acquired
NVIDIA CEO Jensen Huang
Rewind to 2015 and OpenAI. If you hadn't been laying this groundwork in the data center, you wouldn't be powering OpenAI right now.
Acquired
NVIDIA CEO Jensen Huang
Was that the plan all along? When did you realize that only eight were going to work?
Acquired
NVIDIA CEO Jensen Huang
When we were researching particularly part three of our NVIDIA series, we talked to a lot of people and many people told us the Mellanox acquisition is one of, if not the best of all time by any technology company.
Acquired
NVIDIA CEO Jensen Huang
Yes, Crusoe, as you know by now, is a cloud provider built specifically for AI workloads and powered by clean energy. And NVIDIA is a major partner of Crusoe. Their data centers are filled with A100s and H100s. And as you probably know, with the rising demand for AI, there's been a huge surge in the need for high performing GPUs. leading to a noticeable scarcity of NVIDIA GPUs in the market.
Acquired
NVIDIA CEO Jensen Huang
Crusoe has been ahead of the curve and is among the first cloud providers to offer NVIDIA's H100s at scale. They have a very straightforward strategy. Create the best AI cloud solution for customers using the very best GPU hardware on the market that customers ask for, like NVIDIA, and invest heavily in an optimized cloud software stack.
Acquired
NVIDIA CEO Jensen Huang
Yep. Ultimately, this results in a huge win-win. They take what is otherwise a huge amount of energy waste that causes environmental harm and use it to power massive AI workloads. And it's worth noting that through their operations, Crusoe is actually reducing more emissions than they would generate.
Acquired
NVIDIA CEO Jensen Huang
In fact, in 2022, Crusoe captured over 4 billion cubic feet of gas, which led to the avoidance of approximately 1%. 500,000 metric tons of CO2 emissions. That's equivalent to taking about 160,000 cars off the road.
Acquired
NVIDIA CEO Jensen Huang
I've heard you or others in NVIDIA, I think, use the phrase zero billion dollar markets.
Acquired
NVIDIA CEO Jensen Huang
I'm so glad you brought this up because I wanted to ask you. In my mind at least, and it sounds like in yours too, NVIDIA is absolutely a platform company, of which there are very few meaningful platform companies in the world. I think it's also fair to say that when you started for the first few years, you were a technology company and not a platform company.
Acquired
NVIDIA CEO Jensen Huang
every example i can think of of a company that tried to start as a platform company fails you got to start as a technology person when did you think about making that transition to being a platform like your first graphics cards were technology they weren't there was no cuda there was no platform yeah what you observed is not wrong however inside our company we were always a platform company and the reason for that
Acquired
NVIDIA CEO Jensen Huang
So wait, so was the original business plan to like- Sort of like to build DirectX.
Acquired
NVIDIA CEO Jensen Huang
But DirectX didn't exist when you started NVIDIA, right? And that's what made your strategy run for the first couple of years.
Acquired
NVIDIA CEO Jensen Huang
I mean, that's what Microsoft did back in the day. They're like, oh, that could be a developer platform. We'll take that. Thank you.
Acquired
NVIDIA CEO Jensen Huang
And is this why you were so... Militant, and I think from our research, it really was you being militant that every NVIDIA chip will run CUDA.
Acquired
NVIDIA CEO Jensen Huang
I mean, and I guess kudos was a rebirth of UDA, but understanding this now, UDA going all the way back, it really is all the way back to all the chips you've ever made.
Acquired
NVIDIA CEO Jensen Huang
Is it fair to say though, maybe on the luck side of the equation, thinking back to 1997, that that was the moment where consumers tip to really, really valuing 3D graphical performance in games?
Acquired
NVIDIA CEO Jensen Huang
The problem with Doom, though, was you needed Carmack to program it.
Acquired
NVIDIA CEO Jensen Huang
I want to come back real quick to, you know, you said you told these stories and you're like, well, I don't know what founders can take from that.
Acquired
NVIDIA CEO Jensen Huang
I actually do think, you know, if you look at all the big tech companies today, perhaps with the exception of Google, they did all start, and understanding this now about you, by addressing developers, planning to build a platform and tools for developers. You know, all of them. Apple, Amazon.
Acquired
NVIDIA CEO Jensen Huang
Well, I guess with AWS, that's how AWS started. So I think that actually is a lesson to your point. That won't guarantee success by any means, but that'll get you hanging around a tree if the apple falls.
Acquired
NVIDIA CEO Jensen Huang
This is appropriate. There's a version of something we talk about a lot on Acquired. We call it the Moritz Corollary to Moore's Law after Mike Moritz from Sequoia.
Acquired
NVIDIA CEO Jensen Huang
The great story behind it is that when Mike was taking over for Don Valentine with Doug, he was sitting and looking at Sequoia's returns and he was looking at fund three or four, I think it was four maybe that had Cisco in it. And he was like, how are we ever going to top that? You know, I can't, I can't, you know, Don's going to have us beat, we're never going to beat that.
Acquired
NVIDIA CEO Jensen Huang
And he thought about it and he realized that, well, as compute gets cheaper and it can access more areas of the economy because it gets cheaper and can get adopted more widely, well, then the markets that we can address should get bigger.
Acquired
NVIDIA CEO Jensen Huang
Now is a great time to share something new from our friends at Blinkist and Go1 that is very appropriate to this episode.
Acquired
NVIDIA CEO Jensen Huang
Yes. And we also have an offer from Blinkist and Go1 that goes beyond personal learning. Blinkist has handpicked a collection of books related to the themes of this episode. So tech innovation, leadership, the dynamics of acquisitions. These books offer the mental models to adapt to a rapidly changing technology environment.
Acquired
NVIDIA CEO Jensen Huang
Yes. So to claim the whole free collection, unlock the 50% discount, and explore Blinkist's enterprise solution, simply visit Blinkist.com slash Jensen and use the promo code Jensen. Blinkist and their parent company, GoOne, are truly awesome resources for your company and your teams as they develop from small startup to enterprise. Our thanks to them. And seriously, this offer is pretty awesome.
Acquired
NVIDIA CEO Jensen Huang
Go take them up on it. We have a few lightning round questions we want to ask you. And then we have a very fun... I can't think that fast.
Acquired
NVIDIA CEO Jensen Huang
What car is your daily driver these days? And related question, do you still have the Supra?
Acquired
NVIDIA CEO Jensen Huang
Today, in a way, you kind of do that here at NVIDIA too. You were a consumer products company back then, right? It was end consumers who were going to have to pay the money to buy.
Acquired
NVIDIA CEO Jensen Huang
Plenty of time in the day, plenty of time- To do anything. To achieve things.
Acquired
NVIDIA CEO Jensen Huang
What point did you realize that you weren't going to have another job? That, like, this was it?
Acquired
NVIDIA CEO Jensen Huang
I got the sense from remembering back to part one of our series on NVIDIA.
Acquired
NVIDIA CEO Jensen Huang
I got the sense that LSI Logic might have also changed your... perspective and philosophy about computing to the sense I we got from the research was that When right out of school and when you first went to AMD first, right?
Acquired
NVIDIA CEO Jensen Huang
Yeah, you believed that like kind of a version of that was it the Jerry Sanders real men have fabs like you need to do the whole stack like you got to do everything and that LSI logic changed you what LSI logic did was was realized that you can express
Acquired
NVIDIA CEO Jensen Huang
And it sounded like the CEO of LSI Logic put a good word in for you with Don Valentine too.
Acquired
NVIDIA CEO Jensen Huang
If you were magically 30 years old again today in 2023, and you were going to Denny's with your two best friends who are the two smartest people you know, and you're talking about starting a company, what are you talking about starting?
Acquired
NVIDIA CEO Jensen Huang
I don't get the sense though that you're planning to retire anytime soon though.
Acquired
NVIDIA CEO Jensen Huang
I can only imagine how meaningful that is. I mean, I know how meaningful that is in any company, but for you, I feel like the NVIDIA journey is...
Acquired
NVIDIA CEO Jensen Huang
And like, you know, you went through two, two if not three, 80% plus drawdowns in the public markets. To have investors who've stuck with you from day one through that must be just like,
Acquired
NVIDIA CEO Jensen Huang
Ben had an appropriate comment on our most recent episode on you all where we were talking about the current situation in NVIDIA. I think he said, for any other company, this would be a precarious spot to be in, but for NVIDIA.
Acquired
NVIDIA CEO Jensen Huang
What is the acquired solution that we can sell? That's true. We got to find that.
Acquired
NVIDIA CEO Jensen Huang
How much of this was you and how much of this was like your co-founders, the rest of the company, the board? Was everybody telling you you were crazy?
Acquired
NVIDIA CEO Jensen Huang
We talk about this a lot. We were just talking about this on our Costco episode. You want to push your chips in when you know it's going to work.
Acquired
NVIDIA CEO Jensen Huang
Are you paying attention to the ImageNet competition every year leading up to this?
Acquired
Lockheed Martin
Those two movies are so freaking good. Yeah. It's so shocking how good Maverick is. So many years later in such a different environment and then like delayed due to coronavirus.
Acquired
Lockheed Martin
So the Stealth Fighter, the Nighthawk, was angular and looked like a Super Nintendo Star Fox plane because the computational ability to model it at the time, it wasn't that you needed to have just flat surfaces. It's that you could have... three-dimensional rounded looking surfaces. You just needed to be able to model it for the radar signature.
Acquired
Lockheed Martin
And computers weren't advanced enough at the time to be able to build a 3D modeled version of a radar stealth structure. As they advanced, you are now able to do that in much the same way that in video games, you can now build lifelike looking 3D models out of the same polygons before.
Acquired
Lockheed Martin
And so the Sega, I think it was the Model 3 arcade board that we talked about that was part of the real 3D revolution in video games.
Acquired
Lockheed Martin
Virtua Racer, Virtua Cop, Virtua Fighter being the big one were on that. Sega co-developed those boards with Lockheed Martin.
Acquired
Lockheed Martin
My understanding is the engines that airplanes were flying before then, even the P-38, as sophisticated as it was, were basically automobile internal combustion engines.
Acquired
Lockheed Martin
Wow. It's the R&D, but also the tooling, like we were talking about with the Blackbird. Totally. The infrastructure that you need to spin up to make a new airplane is a lot.
Acquired
Lockheed Martin
And contrast that with the team of, you know, what, 50 engineers and 100 machinists that built the U-2? Yeah, of course, the F-22 is a much more advanced airplane than the U-2. But the size of the engineering challenge relative to state-of-the-art technology was way less than the size of the U-2 engineering challenge relative to state-of-the-art technology.
Acquired
Lockheed Martin
So that's one problem, and we're going to focus on that first. The other problem, to put a pin in for later, we start to get worried that our ally, the Russians and the Soviets, our relationship with them might not be quite what we think it is. And we might have to address that in the coming decades. So keep that in the back of your mind as we go along here. But let's start with the JET problem.
Acquired
Lockheed Martin
It's just so clear, listening to you talk about that and contrasting it with... Everything we talked about in the story portion of the episode, this is a different world than the Lockheed of World War II and the Cold War and the military of World War II and the Cold War. Like, it's very unclear to me what the threat-based need is here for this. Well, yeah, hopefully deterrence.
Acquired
Lockheed Martin
Well, I guess, I don't know, I'm not a military strategist, but, you know, you mentioned drones. Drones are a thing now, and they're a lot cheaper.
Acquired
Lockheed Martin
So the German plane that had started appearing in the skies over Europe was the Messerschmitt Me 262, nicknamed the Swallow. And it was the world's first operational jet-powered aircraft. It flew close to 550 miles an hour, which is over 100 miles an hour faster than any Allied plane, including the Lightning P-38. So the U.S.
Acquired
Lockheed Martin
Well, I guess it is, you know, to the point of consolidation in The Last Supper, the government was clear. We're going to spend a lot less. We're just going to spend it in a much more concentrated fashion.
Acquired
Lockheed Martin
I knew they were the largest defense contractor, but I didn't realize they were the largest government contractor, period.
Acquired
Lockheed Martin
government turns to, of course, the very best person for the job to start the U.S. jet fighter program. Kelly Johnson and Lockheed. And they tell him, go make us a jet fighter as soon as possible and by any means necessary. And when we say as soon as possible, we want a prototype in 180 days with the spec that it must go faster than the German Swallow. So at least 600 miles an hour.
Acquired
Lockheed Martin
Which we should probably talk a little bit about the rationale for that. I'm no expert in this, and we should probably have an economist on ACQ2 at some point in time to talk about it. But my understanding is that while Warren Buffett and Charlie Munker hate cost plus contracts, and in general, they set up terrible incentives...
Acquired
Lockheed Martin
They are useful in cases where you don't know what the cost is going to be, but it's an incredibly important investment to make. And traditionally, that has been defense expenditures. Like, we need the U-2. We don't know what the cost is going to be, but we need it to happen. We need the corona program. We don't know what the cost is going to be, but we need it to happen.
Acquired
Lockheed Martin
Right. This is sort of the great irony in the government together with Lockheed really seeded Silicon Valley. The modern Silicon Valley and the modern defense industry are in many ways kind of incompatible from a business model perspective. Right.
Acquired
Lockheed Martin
And now I think this is probably changing, and certainly there are smart people in the government that recognize this and their pilot programs to be able to buy software and technology online. But if you look at some of the most successful Silicon Valley-style startups that are selling defense to the government, whether it's SpaceX or Android or others, yeah, they're selling hardware.
Acquired
Lockheed Martin
Which is sort of scary when you think about it, because I suspect most acquired fans will not find this a controversial statement, but I think it's quite likely that modern warfare is going to occur more in software than in hardware, just like the Cold War occurred more in capabilities than actual fighting.
Acquired
Lockheed Martin
Yeah, there's also a huge difference now versus certainly World War II, but also the Cold War. The motivation of people who were going to work at Skunk Works, they were doing it out of patriotism for their country. Like the clear and present threat of the Cold War was an extremely motivating factor. That's not there in the same way today.
Acquired
Lockheed Martin
What is so funny about this whole thing, the Cold War and now, perception is reality. nobody really knew then and nobody really knows now what the reality of the threat is. But the perception is what drives people's behavior and that's what drives the economy.
Acquired
Lockheed Martin
You need to pull out all the stops, bypass any red tape, do absolutely anything necessary to make this happen.
Acquired
Lockheed Martin
Yes, I totally agree with everything you're saying. I also think there's another layer to this, which is really a huge theme of this journey with the research and doing this episode for me with Lockheed. And that is the phenomenon of competition and its impact on human behavior, probably for both the Soviet Union and the US, although I'm less equipped to talk about the Soviet Union.
Acquired
Lockheed Martin
The fact of that competition led to tremendous advances for society. I mean, all the things we just talked about, Silicon Valley itself, for God's sakes, wouldn't have existed without this. So there is sort of a rational argument for having an adversary. Technology and society was pushed forward in America by the Cold War and by Lockheed as part of that.
Acquired
Lockheed Martin
Yep. So Johnson handpicks 23 of Lockheed's very best engineers and designers and about 30 of the best shop people, the people that actually build the airplanes, and And get this, he rents a literal circus tent to house them in the parking lot next to a plastics factory that is nearby to Lockheed's headquarters in Burbank, California. And it is because of this...
Acquired
Lockheed Martin
Which, as we talked about on the SpaceX episode, really opened the door for SpaceX to come in and compete.
Acquired
Lockheed Martin
I was really smiling as you were defining that as persistent differential returns versus their competitors, because I'm not sure that Lockheed has differential returns versus their competitors.
Acquired
Lockheed Martin
Yes, correct. For this, maybe it's more useful to talk about the prime contractor industry as a whole versus any specific player. Well, all the players have the same profit margins, too. I guess where I was going with this is I think there's a cornered resource and process power that the prime contractor industry as a whole has. The cornered resource is...
Acquired
Lockheed Martin
that the name skunkworks is born because of the outdoor nature in the tent and the smell coming from this plastics factory at the time there was a very popular comic strip called little abner and a character in this comic strip had a outdoor moonshine still making bootlegged prohibition era alcohol and this still in the comic strip was called the skunkworks I think it was called the Skunk Works.
Acquired
Lockheed Martin
They are the ones that get the prime contracts from the government. And then the process power, which I think probably is really legitimate. We talked to some folks in preparing for this. They are incredible systems integrators at what they do. What did you say? They're 4,000 or 3,000 subcontractors for the F-35?
Acquired
Lockheed Martin
To orchestrate that and coordinate that into an airplane that does the things that that airplane does in practice, that's hard.
Acquired
Lockheed Martin
Didn't you say that different parts of the fuselage are made by different companies?
Acquired
Lockheed Martin
Yeah. There's definitely process power in that. You can't just pick that up out of Lockheed and go put it somewhere else and expect it to function. Right.
Acquired
Lockheed Martin
Yep. Maybe impossible. Yeah. You know, Palantir has sort of done it. I guess Andruil is kind of doing it. But these, I think, are still pretty small scale compared to the big primes.
Acquired
Lockheed Martin
Which is so funny. You know, you really, I think, kind of nailed it at the beginning when you said this isn't a market. It's not a market. And I guess, duh, obviously it's not a market because there's only one customer. You can't really have a market when there's only one player on one side of it.
Acquired
Lockheed Martin
That's right, the Skunk Works with an O. And eventually the publisher of Little Abner sues Lockheed over using Skunk Works, so they change it to Skunk Works. So in this circus tent in a parking lot, Kelly and this super elite team from Lockheed build the first prototype US fighter jet named the Lulu Bell in 143 days, start to finish. This is just wild.
Acquired
Lockheed Martin
The government didn't let Lockheed go out of business in the 1970s. This was right as the Kenan satellite project was getting going. We could not let Lockheed go out of business because we needed that.
Acquired
Lockheed Martin
Yeah. Well, globally competitive is an interesting way to pray, safe and globally dominant. Maybe let's put it that way. That's probably the right way to put it.
Acquired
Lockheed Martin
That's not a market-driven organization, nor, I think, would anybody argue it should be.
Acquired
Lockheed Martin
It is as far to the side of the scale of like the military industrial complex is bad and evil is the Prophets of War book.
Acquired
Lockheed Martin
It's kind of like I'm thinking about the recent period in tech companies in Silicon Valley that we are – mercifully exiting out of now where it was all about employee headcount and capturing engineers and Facebook had God knows how many people working on Oculus and like why, you know, that was the equivalent of the F-35.
Acquired
Lockheed Martin
It's interesting, right? Two things. One, I think that was maybe in part from observing what was happening in the Soviet Union where the military and military spending overran the whole rest of the economy. Clearly, as we're talking about here, like, yeah, I think this is a nuanced issue and certainly a lot of degree of non-market-based dynamics are warranted here.
Acquired
Lockheed Martin
But you can't let the military-industrial complex get so big it overruns the rest of the economy. That would not be good. The other thing I was going to say is I think the end of that quote or speech or at least part of it is, you know, Eisenhower sort of, I think, very naively puts forth the solution is, what does he say, like an engaged and vigilant citizenry, you know, a populace.
Acquired
Lockheed Martin
For years, the US had been working on this technology and they hadn't gotten it operationalized. The Germans beat them to it. And then in 143 days, Kelly and Lockheed go from zero to flying prototype. Wow. crazy. What a testament to him and to this organization in the circus tent that he has built, the Skunk Works.
Acquired
Lockheed Martin
Especially this day and age where things are so complex, that's kind of not possible, right? You know, is the average person really going to dive into the details of how the F-35 program works?
Acquired
Lockheed Martin
Well, I can't think of a better place to talk about what I think are really the takeaways, for me at least, and I hope for many people listening, of this episode. And it's really like the heyday, glory days, whatever you want to call it, of Lockheed, both with Skunk Works and LMSC, of how these small Skunk Works-type organizations achieved,
Acquired
Lockheed Martin
unbelievable, unfathomable things with a small number of people in an unrealistically tight timeframe with very constrained resources. And that mindset is certainly not the only way that you can achieve great things, but it's a really damn good way to do it. And that mindset got injected into Silicon Valley by these people, by the military and by Lockheed.
Acquired
Lockheed Martin
And it's just so funny that the military industrial complex has now become the opposite of that, has become like what you're talking about with NASA. Again, there's many ways to succeed in different situations, call for different things. But like, if you really need to or want to achieve something great bordering on impossible in a tight bordering on unreasonable timeframe...
Acquired
Lockheed Martin
Kelly's 14 laws and LMSC's seven tenants are a pretty damn good way to do it.
Acquired
Lockheed Martin
And, you know, I guess what is sort of heartening, at least as an American, is the capability to do this definitely still exists. It just happened with vaccines for the coronavirus.
Acquired
Lockheed Martin
Yeah. You know what? That's a good way to put a threat. Kind of the back to the LMSC tenant number one that we talked about so long ago in the story of focus on a threat-based need. Yeah. I maybe want to evolve some of my comments earlier about competition into that. Competition creates threats. It's not always competition that leads to a threat.
Acquired
Lockheed Martin
Human beings and organizations tend to perform at their best in response to threats. Otherwise, how are you going to be motivated to go to unreasonable extremes if you're not facing a threat?
Acquired
Lockheed Martin
Which is kind of a, you know, to this playbook of like, I certainly don't want to say artificially manufactured threats, but if you're building a company, certainly this exists in startup world.
Acquired
Lockheed Martin
You have an implicit existential threat all the time as a startup before you reach cashflow profitability, which is like, you got to make payroll and you got to like either get profitable or raise another round of funding or you're done.
Acquired
Lockheed Martin
I like that a lot. It's probably a good thing that the nature of that motivation and the introduction of those threats to spur human ingenuity and creativity has moved forward. for now, at least, mostly out of the war arena. It's probably good that it's not threat of nuclear war that is motivating people to achieve great things. Most people, yeah.
Acquired
Lockheed Martin
Yeah, most people, at least, right now, mercifully, thankfully. And that mindset was directly transferred from Lockheed and the military into Silicon Valley. That's how Silicon Valley operates today. And that's what makes it special. And it doesn't have to be because of threats of war. And it's a good thing that it's not.
Acquired
Lockheed Martin
Yeah, let's do it. My carve-out is a fun one I was reminded of because my favorite video game history podcast series, Resident Ark, is covering it as their game right now. I think I might have had this as a carve-out a couple years ago. The game Nier Automata is a super fun game, and the series that Resident Ark is in the middle of is their... video game storybook club going through it.
Acquired
Lockheed Martin
It's both a really fun game to play and was kind of ahead of its time. The sort of theme of the game is all about can machines think and feel and what does that look like? And like, oh, it was like really thought provoking at the time. It's particularly thought provoking right now in our era of, you know, open AI and GPT and generative AI and all that.
Acquired
Lockheed Martin
So it's really fun to revisit that along with the great resonant archives right now, talking about the themes of that story.
Acquired
Lockheed Martin
Yes. This prototype, the Lulu Bell, would go on to become the P-80 shooting star. Lockheed would ultimately make about 2,000 of them. And while they weren't really used in World War II because the war ended, they would be used in Korea, and it would be the first jet fighter plane in the U.S. military.
Acquired
Lockheed Martin
Well, and the nature of a yard in San Francisco is a little different. I'm not sure I'm capable of maintaining my yard given everything that's back there. It requires more technical expertise, more systems integration.
Acquired
Lockheed Martin
And particularly too, I think there's a good chance with this episode that we'll have a lot of new to Acquired folks who are listening. We unexpectedly had that in huge numbers with our LVMH episode. All sorts of new people coming in and experiencing Acquired and listening to us for the first time. If you're doing that now here with this Lockheed episode, definitely
Acquired
Lockheed Martin
Definitely go check out some of our other episodes on other industries. And I just want to second what Ben said. Join the Slack and come talk about it with us. We love hearing from people. We're obviously not in the defense industry. We love hearing from people who are.
Acquired
Lockheed Martin
Tell us about your experiences, what it's like, what we got right, what we got wrong, and educate all the rest of us in the community too.
Acquired
Lockheed Martin
You raise a really important point, though, that we didn't cover earlier about Lockheed and Skunk Works. They are not engine manufacturers. All of the engines that were going into the planes before, during, since, they're getting from other companies.
Acquired
Lockheed Martin
Yeah, very different from how the automobile industry evolved where like obviously Ford and GM and whatnot, they're making their own engines. Yep. So this amazing feat, building what becomes the P-80 Shooting Star and the U.S. 's first jet fighter plane in less than six months, this is the beginning of Skunk Works. And Kelly realizes, hey, this is something pretty special here.
Acquired
Lockheed Martin
So I want to read a little quote from the Skunk Works book. That primitive Skunk Works operation set the standards for what followed. The project was highly secret, very high priority, and time was of the essence. The Air Corps had cooperated to meet all of Kelly's needs and then got out of his way. And boy, did they deliver.
Acquired
Lockheed Martin
So after the war, Kelly says, hey, this is special. We should keep this going. And the Gross Brothers and Lockheed's management agree. And they say, yes, you can keep this quote-unquote Skunk Works division going as long as it doesn't take too much money. And it doesn't distract from your duties in the rest of the company as now the new chief engineer.
Acquired
Lockheed Martin
So Kelly is both the chief engineer of all of Lockheed and running Skunk Works at the same time.
Acquired
Lockheed Martin
Yeah, going back and learning all this and soaking in the history of the times when Lockheed was really forged, gave me at least a whole new perspective on this killing machines and deterrence question.
Acquired
Lockheed Martin
Yeah. So I'm going to read a little more from Skunkworks here. So Kelly and his handful of bright young designers that he selected took over some empty space in building 82. This is a building on the Lockheed campus, which is right next to the Burbank Municipal Airport. It's an unmarked building. Literally, like this is a commercial airport that...
Acquired
Lockheed Martin
average people are taking off of every single day so that it continues those guys brainstormed what if questions about the future needs of commercial and military aircraft and if one of their ideas resulted in a contract to build an experimental prototype kelly would borrow the best people he could find in the main plant to get the job done that way the overhead was kept low and the financial risks to the company stayed small his small group were all young and high-spirited who thought nothing of working out of a phone booth
Acquired
Lockheed Martin
if necessary, as long as they were designing and building airplanes. All that mattered to Kelly was our proximity to the production floor. A stone's throw was too far away. He wanted us, the engineers and designers, only steps away from the shop workers to make quick structural or parts changes
Acquired
Lockheed Martin
These people should all be together, all of them building relationships, collaborating, working together to produce the very best product.
Acquired
Lockheed Martin
To tell the full story of Lockheed and Lockheed Martin and all the predecessor companies that came before it, because I think it's like 17 companies all merged together at this point, would probably require a full season of Acquired, so we're not going to do that. Instead, we're going to focus on two interwoven stories from Lockheed, not Martin, but Lockheed's golden eras.
Acquired
Lockheed Martin
All right, listeners, this is a great time to talk about one of our big partners, ServiceNow. ServiceNow is the AI platform for business transformation, helping automate processes, improve service delivery, and increase efficiency.
Acquired
Lockheed Martin
Over 85% of the Fortune 500 runs on them, and over the past few years, they've joined companies like Microsoft as one of the most important enterprise technology vendors in the world.
Acquired
Lockheed Martin
Yeah, it's telling for the magnitude of this partnership to see Satya Nadella appearing in the keynote at ServiceNow's big annual event, Knowledge, last month.
Acquired
Lockheed Martin
It's pretty awesome for both companies and especially awesome for enterprise users. So if you want to learn more about the ServiceNow platform and how it can work with your company's Microsoft services, go over to servicenow.com slash acquired. And when you get in touch, just tell them that Ben and David sent you.
Acquired
Lockheed Martin
Well, to start, all that mattered, literally the only thing that matters is rapid delivery of superior products. And that was driven by the expedient requirements of World War II, literally saving America and the free world, and then the Cold War, which is going to come in in a big way in a second here. Listeners might be thinking,
Acquired
Lockheed Martin
Isn't all that matters in any business rapid delivery of superior products? Like, why is this new and unique and different? The reality, though, is that that's almost never the case. There's politics. There's personalities.
Acquired
Lockheed Martin
Competition and existential competition kind of has a way of bringing out the best in people. So Ben, you already talked about rule three.
Acquired
Lockheed Martin
The next one I want to talk about is the Skunk Works manager must be delegated practically complete control of his program in all aspects.
Acquired
Lockheed Martin
And the first of those stories is the famous Skunk Works. The second one, I'm not going to say what it is so we don't spoil it just yet, but as a teaser... It's unbelievable and is directly tied in to the birth of Silicon Valley.
Acquired
Lockheed Martin
And yet it's most productive. Skunkworks, I think, was about maybe 50 designers and engineers and maybe 100 machinists and shop people. Like, this is not a large organization. It's crazy. My last one is the last one of the rules.
Acquired
Lockheed Martin
Because only a few people will be used in engineering and most other areas, ways must be provided to reward good performance by pay, not based on number of personnel supervised. So Kelly has a quote about this in the book. In the main plant, they give raises on the basis of the more people supervised. I give raises to the guy who supervises the least.
Acquired
Lockheed Martin
That means he's doing more and taking more responsibility. But most executives don't think like that at all. They're empire builders. This is so important.
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Lockheed Martin
So there's one more thing that isn't in any of the rules, because I think it's just sort of a implicit unspoken assumption. All of this only works if the small group of people that you've brought together are highly motivated. And
Acquired
Lockheed Martin
I think the reason this was taken for granted for all of Skunk Works' heyday was, hey, the mission here is preserving your life and the lives of your loved ones and America from losing World War II and then having nuclear bombs dropped on it by the Soviet Union. You don't really need a lot of extra cajoling or motivation here.
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Lockheed Martin
So if you're in the tech world and you think Lockheed Martin and defense and fighter planes doesn't apply to me, think again, because pretty much everything you do came out of this. So I can't wait to tell it.
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Lockheed Martin
No, there's this great quote in Skunk Works where Ben Rich tells the story of his first day in Skunk Works where he's shown the U-2 prototype. We're gonna talk all about the U-2 in a minute here. But literally day one, he's shown the prototype of this top highly classified, highly secret airplane that nobody can know about.
Acquired
Lockheed Martin
He says, the full weight of government secrecy fell on me like a sack of cement that day inside Kelly Johnson's guarded domain. learning an absolutely momentous national security secret just took my breath away. And I left work bursting with both pride and energy to be on the inside of a project so special and closely held, but also nervous about the burdens it would impose on my life."
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Lockheed Martin
This is exactly to your point, you know, with great power comes great responsibility here.
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Lockheed Martin
Yeah. All right. So a minute ago, I was talking about the two problems that America and its allies have at the end of World War II. One was the jets. Skunk Works addresses that with the P-80 shooting star. The other problem is, yeah, we're going to win this war, but there's a whole new war that's just about to start.
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Lockheed Martin
And this is so hard for us to process today, but doing the research, I really felt it. I think for a lot of people, the stakes and the pressure and the worry about the Cold War was greater than World War II.
Acquired
Lockheed Martin
I think we had good reason to believe we were not going to win. So right after the war, Churchill comes to America and gives his famous Iron Curtain speech in Fulton, Missouri, that an Iron Curtain has descended over Europe in the form of the Soviet Union.
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Lockheed Martin
And then before the end of the decade, I didn't really realize the timeline on this, in August 1949, the Soviet Union detonates its first nuclear bomb. And nobody believed that they were going to have the bomb that quickly or that powerfully.
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Lockheed Martin
And not only did they have the bomb, but whether this was real or not or positioning, people really believe that the Soviets and Khrushchev's intention is to use the bomb against America. If they ever believe that they could do so without fear of retaliation, that they could knock us out first, that they would... do a first strike and use nuclear weapons on America.
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Lockheed Martin
And this kicks off the Cold War arms race. And people probably know and learn about mutually assured destruction and deterrence. This really was the policy of the military and the American government that we need to have capabilities to deter the Soviet Union from launching a first nuclear strike against us by being able to guarantee that
Acquired
Lockheed Martin
And have them know that we guarantee that if they do so, we will destroy them. So they can't do this because if they do, they will be destroyed. That was the whole policy. And that's like a really scary place to be. This is like if somebody over there in the Kremlin decides one day that they think they can win, we're all going to die. Right.
Acquired
Lockheed Martin
In 1955, there was a national poll that asked the question, what do you think you are most likely to die from? And over half of America responded that they thought they were most likely to die in thermonuclear war. Wow. Above any other cause. Let that sink in. Over half of the country thought they were going to die in nuclear war.
Acquired
Lockheed Martin
bingo. It is the most important thing. Even more important than your ability to strike and wage war is your ability to know what the current state of the opponent's ability is to strike and wage war. So that means that the battleground is no longer the use of weapons, but the intelligence about the existence and positioning of weapons. And nobody is better suited than Skunk Works to be the U.S.
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Lockheed Martin
government and military's primary, sounds cliche to say, but sword and shield during this war.
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Lockheed Martin
Okay, so it would be really great if you could fly a plane over Russia and take pictures and understand all this. Because there's no satellites yet. Oh, are there satellites? We'll talk about that a little later. But you can't just fly a plane into Russia and do that. It's a closed country. The Russians are going to shoot you down if you do it.
Acquired
Lockheed Martin
Exactly. So the first thing, it's funny, it's kind of in the news now that China's doing this now. The first thing we try is unmanned spy balloons. We send balloons over Russia. Failed weather experiments. Yeah, failed weather experiments. Yeah, that fails on many fronts, including actually returning usable photos of Soviet nuclear installations.
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Lockheed Martin
So really, it becomes clear that what's required is an entirely new type of airplane that can either do one of two things, and ideally both. Fly over Russia stealthily and undetected by radar, or two, fly high enough or fast enough that they can't shoot it down even if they do.
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Lockheed Martin
Yeah, great. So this is interesting. What government agency contracts them to do this? It's not the military. We're in the spy game now. It's not the Army, not the Navy, not the Air Force. It's the CIA. They are building their own air capabilities. And all of the work that Skunk Works does here and for many years to come is for the CIA. Yep.
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Lockheed Martin
So what exactly is the challenge that Skunk Works has laid out in front of them for designing this new spy plane? Well, at the time, the maximum altitude that airplanes flew was about 40,000 feet.
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Lockheed Martin
Yep. And we also thought that their radar wouldn't function above like 55,000, right?
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Lockheed Martin
Right. So the CIA's spec for Skunk Works for the U-2 is to fly at 70,000 feet. Now, there are a couple problems with it. One is that normal jet fuel doesn't work at that altitude. You know, at that altitude, the pressure, the temperature, everything about the environment, you're getting to be closer to space than you are to normal Earth atmosphere, and things start going wrong.
Acquired
Lockheed Martin
So that one, they actually subcontract with Shell Oil to make a new formulation of jet fuel that does work up there. So, you know, that problem is solved. Problem number two is maybe a little bigger, and that is that humans cannot survive at that altitude.
Acquired
Lockheed Martin
Yeah, and I don't know the technical details, but I think even the cabin pressurization technology that existed then was not going to cut it at 70,000 feet. So you basically need a spacesuit. Exactly. Some of this technology came from like diving suits and some other things that came before this. But I think this was the big coming together of the technology that created the spacesuit.
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Lockheed Martin
And that's what they put these pilots in. Wow. So Lockheed and Skunk Works win the contract from the CIA. They start working on this plane sometime in 1953.
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Lockheed Martin
I mean, this is like the quote from earlier that we read from Ben Rich when he started working on this project day one and saw the prototype and it hit him like a sack of cement, you know, how important this was. So Skunk Works completes and delivers the plane by July 1955. So like a year and a half and for a total project cost of three and a half million dollars.
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Lockheed Martin
That's an M. That is not a B. A year and a half and three and a half million dollars for one of the most important products and pieces of technology in American history. Astounding. This is what Skunk Works is capable of.
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Lockheed Martin
Indeed, the U.S. did, and that was Dr. Edwin Land and the Polaroid Company, who subcontracted and created all of that. And actually, I believe it was Edwin Land himself that helped convince President Eisenhower to even pursue this project in the first place. He was like, we can build the camera that can do this. If we can get the airplane built, we can do this project.
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Lockheed Martin
Oh, just wait. We are going to have a lot more tech in Silicon Valley and Apple stuff that's going to come up here in just a little bit. So they build the plane. You got to test this thing. They're not going to roll it on the runway in Burbank and take off and, you know, just head for the Soviet Union. You got to test it and, you know, it's got to be secret and whatnot.
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Lockheed Martin
And remember, Kelly Johnson, one of his big principles is like, we test our products. You, the government, don't test our products. We test our products.
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Lockheed Martin
Oh, this is so fun. Oh, the smile on our faces is like... You can't see us, but it is stretching out of the room here. Yeah, you can't just paint this thing like a school bus and pretend it's something else. So they need to find a suitable test site. They go scouting all across the western U.S. in kind of remote areas.
Acquired
Lockheed Martin
So for many of you listening, one thing you may not know that I didn't really know till we started the research is that the company that eventually became Lockheed Martin today was two companies. It was Lockheed and Martin Marietta, and there was a huge merger in 1995. Lockheed was actually the second Lockheed company, or really maybe the third.
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Lockheed Martin
Kelly Johnson is sort of like Sam Walton in his prop plane, scouting out for, you know, Walmart locations, flying sideways.
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Lockheed Martin
So they find a dry lake bed in Nevada called Groom Lake. And there's a quote from Kelly Johnson here about this in the book. We flew over it, and within 30 seconds, you knew that this was the place. It was right by a dry lake. Man alive, we looked at that lake, and we all looked at each other. It was another Edwards, like Edwards Air Force Base.
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Lockheed Martin
So we wheeled around, landed on that lake, taxied up to one end of it. It was a perfect natural landing field, as smooth as a billiard table without anything being done to it.
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Lockheed Martin
Yeah, it's insane. And not only were there recently nuclear tests happening right nearby, I believe that nuclear testing continued right nearby while they're using this site, Groom Lake, to test the U-2.
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Lockheed Martin
Wow. So listeners, if you haven't caught on already, the location that we are talking about.
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Lockheed Martin
Nuclear, some really strange looking flying aircraft. This is Area 51. Skunk Works creates Area 51.
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Lockheed Martin
It's even better than that. I can't remember which plane or when this was, but at one point in time, one of the test flights crashed and the pilot survived and somebody saw him. He was wearing a spacesuit. Nobody knew what a spacesuit was. Of course, he looked like a freaking alien.
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Lockheed Martin
Yeah, it's so funny. Amazing. Yeah, it's all skunk works in the U2. Wow. And then the Blackbird and everything else we're going to get into later in the story, all happening out of Area 51.
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Lockheed Martin
The first Lockheed company was founded in 1912 by one Alan Lockheed. But if you were to look at the spelling of his name, it would look like loghead. L-O-U-G-H-E-A-D. Yes, but it was pronounced Lockheed because it is Scottish like lock, like Loch Ness. Lockheed, not loghead. He eventually changed his name to Lockheed and the name of the second company to Lockheed to avoid mispronunciations.
Acquired
Lockheed Martin
Yeah, crazy. Okay, so they test the U-2 at Area 51. So great. They get it up and running and in active service as an operational spy plane, pretty much the world's first, at least of this type, within a year, the first Soviet Union overflight happens on July 4th, 1959.
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Lockheed Martin
Now, this is so interesting. There's a whole bunch of things that happen when they take off. They don't know what's going to happen. Is this thing going to work? Are the Soviets going to see us? We're going to learn so much here. You can't script this stuff. The Soviets tracked it on radar. even at 70,000 feet. The whole way. The whole way.
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Lockheed Martin
Right from it takes off, the whole flight path through Russia, they knew everything that we were doing.
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Lockheed Martin
Yeah, which we had no idea. So we learned this as part of it. So here's what's funny. We know... that they see it from takeoff. They track the U-2 the whole way. This whole top secret program, like, oh no, it's busted. They see it, but it turns out they can't hit it. So, you know, a whole bunch of fighter jets scramble and the fighter jets, they can't get up that high. So they can't intercept it.
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Lockheed Martin
They launch surface to air missiles. The missiles can't hit anything that high up. So the U-2 just flies along. They're tracking it the whole way. There's planes flying along behind it and they can't do anything.
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Lockheed Martin
Yes. But here's what's so interesting. Remember, this whole war, like, God, it's fascinating. It's a war, but it's not a war. It's a war of perception. So in that flight, we get incredible photographic observational evidence, and we would fly so many missions over Russia for the next few years, getting this incredible intelligence. The Soviets never say anything.
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Lockheed Martin
Because if they were to say anything and say that they tracked us into it, then they would be admitting that they were powerless to stop it. This war of perception, like it's so crazy, the incentives and motivations here, but it makes sense. They're not going to say anything and reveal the program. So it remains top secret.
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Lockheed Martin
Because if they did, their sort of position and posturing of strength would be compromised.
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Lockheed Martin
And I actually think there may be military historians that understand this better than us, but I think this was actually an optimal outcome for the U.S. Because remember, just like you were saying, Ben, nobody actually wants to go to war here. The goal is for both sides to keep each other in check.
Acquired
Lockheed Martin
And so this, the U-2 and these reconnaissance missions, become a major chess piece for us on our side of the board to keep the Soviets in check. We like this state, I think. that they know about it, but nobody talks about it.
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Lockheed Martin
The engineering all around that went into this is... Just incredible. You could do a whole podcast just about the technical aspects of the engineering advances.
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Lockheed Martin
We talked earlier about the cost of three and a half million dollars. I think you could make an analogy to like the Louisiana purchase in terms of like best deals that the United States government ever got relative to like the benefit to America. This is huge.
Acquired
Lockheed Martin
Well, no, there's some more that we're going to talk about in a minute. So this all continues. We fly dozens, maybe hundreds of U-2 missions over the next few years. The Russians are constantly trying to shoot them down. They fail. Nobody says anything. And then on May 1st, 1960, ironically on May Day, we launched the U-2 program on July 4th.
Acquired
Lockheed Martin
And it ends, at least over the Soviet Union, on May Day, 1960. The Soviets finally have developed a missile program. that can reach 70,000 feet with accuracy, and they shoot down a U-2. This was the first time in history that a ground-to-air missile had shot down an airplane. I didn't realize this. I read that. I was like, oh, whoa.
Acquired
Lockheed Martin
Yes. So great. So he started the first company with his brother, Malcolm, and they were more or less contemporaries of the Wright brothers. It was based in San Francisco, of all places, and it was mostly kind of a tourist attraction. They had one plane, the Model G, and they flew tourists around over the bay and evangelized this new flying technology. It had a bunch of ups and downs.
Acquired
Lockheed Martin
I guess maybe the technology didn't exist during World War II, the Korean War. And so this was a major historical moment in so many ways. America and the CIA and the government, the president, they're like, okay.
Acquired
Lockheed Martin
Right. But we know now that the motivation for Russia not to talk about it now is gone. Now they can position this as like, hey, we're so strong that we can keep people out. We expect them to say something right away. A couple of weeks go by. They say nothing. Quite surprising.
Acquired
Lockheed Martin
But we don't really know. And we presume that if this plane was shot down, as we think, probably the pilot was killed. I mean, like, you shoot down a plane from 70,000 feet. Right. Probably the pilot was killed. Well... That's 14 miles in the air. Yeah. Yeah. No, the pilot was not killed. The pilot's name was Francis Gary Powers, Pilot Powers.
Acquired
Lockheed Martin
If you know anything about US history, you probably know his name and you probably know that he miraculously did survive and was captured and interrogated and probably tortured by the Russians and that this was the revealing of the U-2 program. So what happens? Turns out that there was a big summit in Paris scheduled for later in May between Eisenhower and Khrushchev.
Acquired
Lockheed Martin
And Khrushchev announces on the eve of the summit that they have captured an American pilot. They have captured this new plane that the U.S. has been illegally and in a provocatory manner flying over Soviet airspace. They have defended their country and shot it down. And this creates a huge mess.
Acquired
Lockheed Martin
Eisenhower first denies this and then admits it when we realize that like, oh, shoot, this pilot is still alive. He's confessed like, wow, this is a disaster. Yeah. So I guess there probably was a path where this could have led to escalation. Fortunately, it does not. But it does mean that the U-2 program, at least over Russia, is done. We don't fly any more U-2s over Russia. We can't.
Acquired
Lockheed Martin
I mean, if we were to do it at this point, we know they can see us. They now can talk about that they can see us and they can shoot us down. Like it would escalate to war if we kept doing this. We have to stop.
Acquired
Lockheed Martin
This, though, is a huge, huge problem. This was the most important thing in the war, and now it's gone, right? We now have no way to take photos of military sites in Russia because we can't fly planes over there anymore, right? We're blind. What do we do? What do we do? Well, the world would not know until 1995 when this would all become declassified under the Clinton administration.
Acquired
Lockheed Martin
But that was only true for about three months, thanks to another super secretive Lockheed division that figured out another way for us to take pictures of the Soviet Union.
Acquired
Lockheed Martin
Malcolm leaves the company and goes to Detroit to seek his fortune in the automobile industry, where he invented the modern hydraulic brake system for automobiles. So every time you press the brake in your cars, you're using Malcolm Lockheed's technology. No way. Yeah, super cool. They also end up hiring into this first Lockheed company one John Northrup.
Acquired
Lockheed Martin
Yep, Vanta is the perfect example of the quote that we talk about all the time here on Acquired. Jeff Bezos, his idea that a company should only focus on what actually makes your beer taste better, i.e. spend your time and resources only on what's actually going to move the needle for your product and your customers and outsource everything else that doesn't.
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Lockheed Martin
Every company needs compliance and trust with their vendors and customers. It plays a major role in enabling revenue because customers and partners demand it, but yet it adds zero flavor to your actual product.
Acquired
Lockheed Martin
And perhaps most importantly, your security reviews are now real-time instead of static, so you can monitor and share with your customers and partners to give them added confidence.
Acquired
Lockheed Martin
Yeah, well, and it's even lesser known than that. Only certain versions of that talk that Steve has given contain the Lockheed story. Because so much of it has only recently been declassified. A lot of it even after he first started giving this talk. So what really turned me on to this was some of the chapters in Beyond the Horizons. Even though that book was written in the late 90s.
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Lockheed Martin
I started digging in and then I started watching some YouTube videos with some of the people involved in this. And I was like, oh my God. there is this incredible story here that we don't realize.
Acquired
Lockheed Martin
I honestly can't believe it, and I'm so glad that we get to tell it here. All right, let's set the context. So if we rewind back to World War II, one thing we kind of mentioned here now as we were talking about the U-2 and the Russians tracking it on radar, but we didn't talk about during World War II, was the importance of radar.
Acquired
Lockheed Martin
So much of World War II was an air war, both in Europe and then especially in the Pacific. And the development of both radar and anti-radar technologies was paramount in the war efforts. Yes, there was lots of land-based fighting and tanks and all that stuff, but World War II was the first real air war.
Acquired
Lockheed Martin
And obviously that importance of radar continued into the Cold War, just like we were talking about with U-2 flights. Now, during World War II, where was all of the U.S. and allied radar work and research being done? It was primarily being done out of two institutions in Boston, MIT with the Radiation Laboratory or the RAD Lab, and Harvard with the Harvard Radio Research Laboratory.
Acquired
Lockheed Martin
That name might ring some bells to help them design their future airplanes. John would go on to be a co-founder with Allen of the second Lockheed company, then leave to strike out on his own where he founded the Avion Corporation. That gets acquired by Douglas and becomes a big part of Douglas. Douglas, of course, is now part of Boeing.
Acquired
Lockheed Martin
Now, here's what's interesting. Neither of these two labs at MIT and Harvard existed before the war. The government directed MIT and Harvard to set them up as part of the war effort. They didn't exist before, and then MIT and Harvard, very fortunately for California and Silicon Valley, shut them down after the war.
Acquired
Lockheed Martin
Now, it turns out that the head of the Harvard lab was a professor named Frederick Terman. might ring some bells for people, especially people who went to Stanford. Terman was probably the world's leading expert on radio engineering and also vacuum tubes and early computing. Except Terman wasn't actually a Harvard professor. Terman was a Stanford professor.
Acquired
Lockheed Martin
He was just on loan to Harvard during the war years because that's where the government set up the radio labs.
Acquired
Lockheed Martin
Yes, they assembled all of the world's experts, and Terman was arguably one of, if not the leading world expert in radio engineering, assembled them there in Boston, or I guess in Cambridge at Harvard and MIT. Cambridge residents would get mad at us if we say Boston. So after the war, Terman comes back to Stanford because Harvard shut down the lab.
Acquired
Lockheed Martin
He comes back to Stanford and he does three things. First, he recruits away all of the best people that he worked with at the Harvard Radio Lab from universities all over the country. He recruits them to Stanford.
Acquired
Lockheed Martin
Yes. Of the highest order. So that's one. Two, soon after he gets back to Stanford, he becomes the provost of the entire university. And as provost, he completely changes the way tech transfer is done at Stanford. No other university has as good of a tech transfer policy as Stanford. They're notoriously friendly.
Acquired
Lockheed Martin
Yes, notoriously friendly and everywhere else, including Harvard, MIT, Princeton, blah, blah, blah, are notoriously unfriendly and hard to work with.
Acquired
Lockheed Martin
And then after that, John, as you might imagine, founded, you guessed it, Northrop, which is now Northrop Grumman. So this one dude was responsible for founding or playing a major role in three of the remaining five defense prime contractors today. But anyway, the first Lockheed company goes under. They start the second one a few years later. They have some success with the Vega company.
Acquired
Lockheed Martin
Now, I sort of in the back of my mind knew this because I had watched Steve Blank's talk many years ago, but I kind of forgotten. I just thought it was like, oh, well, that's because Stanford and Silicon Valley, like, we get it. We're smart.
Acquired
Lockheed Martin
Not that we're smarter, but there's this attitude of, you know, if you're in Silicon Valley, even to this day, you're like, yeah, we get how the culture works here. And like the East Coast doesn't get it.
Acquired
Lockheed Martin
Not at all. It's all thanks to Terman and World War II and his experience at the Radiolab. When he becomes provost, he's still a super devoted patriot. He knows how important this work is, that it was during World War II, and he knows it's just as, if not more important, during the Cold War.
Acquired
Lockheed Martin
So what he does is he encourages students and professors to leave Stanford and go set up companies and work for defense firms and work for the military
Acquired
Lockheed Martin
Instead, at Stanford, it becomes the best thing you can do for your career. Because, in Terman's mind, it's the best thing you can do for your country. Okay, so that was number two. Number three. He carves off a big part of the Stanford campus. Now, if you've ever been to the Stanford campus, my God, I was so lucky to spend two years there. It's like paved in gold. It's literally Shangri-La.
Acquired
Lockheed Martin
They have so much land. It's the most beautiful, like idyllic place in the world. And like 80% of the land is still undeveloped. Yeah, they own like all the way out to the ocean, I think, like it's crazy.
Acquired
Lockheed Martin
So he carves off a part of the Stanford campus and develops it to be leased out as commercial space to corporations and the government to come, people to start companies, companies to come, to build, to participate on this. ecosystem all right there on campus. It's initially called the Stanford Industrial Park. Today, it's called the Stanford Research Park.
Acquired
Lockheed Martin
It still exists, if you've ever been there. It's basically all of the office buildings up and down Page Mill Road in Palo Alto. So it's HP and Hewlett Packard. We'll talk about that in a minute. It's Tesla's landlord today. It's VMware. It's where Xerox PARC was. It's where Next was and Steve Jobs. It's where Facebook's office was for a while. This is where Theranos was. Oh my God.
Acquired
Lockheed Martin
So you might be listening like, well, this is cool. Maybe I knew this stuff. Maybe I didn't. This is really fun Silicon Valley history. What does this have to do with Lockheed? Well, one of the very first tenants of Stanford Industrial Park, Ben, you were talking about customers, customer who would go on to become the single largest employer in the area, in proto-Silicon Valley, by a huge margin.
Acquired
Lockheed Martin
airplane. People might be familiar with that. It becomes a favorite of Amelia Earhart and Wiley Post, famous early aviators. It becomes successful, this second Lockheed company. They end up selling it to a consortium of Detroit auto moguls, maybe through the relationships from Malcolm or something, that have formed the quote unquote Detroit Aircraft Corporation or the DAC.
Acquired
Lockheed Martin
was a new secret division of Lockheed. This blew my mind. This secret division is called the Lockheed Missile Systems Division, later to be renamed the Lockheed Missiles and Space Company. And what LMSC, Lockheed Missiles and Space Company did I honestly think it is bigger impact to the country, to the world, and certainly on business to Lockheed and to Silicon Valley than Skunk Works.
Acquired
Lockheed Martin
This story is of a scale I don't know that we've ever really told on Acquired.
Acquired
Lockheed Martin
Well, let's talk about it. Listeners, you can judge. They patterned themselves after Skunk Works and took so many of the Skunk Works management principles up to Silicon Valley. I was reading Skunkworks. I'm like, oh yeah, so many of these principles, they sound like Silicon Valley principles. Well, there's a reason for that.
Acquired
Lockheed Martin
Okay, so Lockheed makes the decision to start this new missile systems division in 1954. But it becomes so much more than that. Obviously, this is also top secret stuff, just like Skunk Works. So just like Skunk Works, they set up the new missiles division in Burbank, also in an unmarked building. They literally just copy-paste Skunk Works right there in Burbank.
Acquired
Lockheed Martin
And so it starts in Southern California. It does. But there's two problems with that. First, it's kind of unwieldy for a big company like Lockheed to have not one, but two super secret unmarked divisions right there on the main campus, you know, that aren't supposed to know about each other or anything else going on. Like you start getting into weird territory quickly.
Acquired
Lockheed Martin
But it's important that the missiles division did start there because they took, as I said, a lot of Skunk Works management practices. The bigger problem is that it turns out that building missiles is a very different discipline than building airplanes. Because unlike airplanes, you don't have a pilot in the missiles. So you need missiles guidance systems.
Acquired
Lockheed Martin
And that means that you need radar and you need computing. And those two things are not what Southern California is good at. But you know what's really good at those things? Fred Terman up at Stanford and everybody that he's recruited, literally the best minds in the world at all of that, who are now at Stanford and who are now being encouraged
Acquired
Lockheed Martin
to go spin out and start companies who might just be subcontractors to a big missile system that you're trying to build.
Acquired
Lockheed Martin
So the next year, in 1955, Lockheed moves the Missile Systems Division out of Burbank and up 101 to the Stanford Industrial Park. The very same Stanford Industrial Park that Fred Terman just carved out of the Stanford campus and developed. on page mill road and Lockheed becomes one of the very first and biggest tenants of the Stanford now research park and is still there to this day. Wow. Now,
Acquired
Lockheed Martin
They can't actually do everything they want to do on the Stanford campus. You're not going to build a missile and test it on the Stanford campus. So Lockheed, pretty quickly after they established themselves in Palo Alto, they also buy 275 acres just down the road in Sunnyvale, and they build a huge campus there, 137 buildings.
Acquired
Lockheed Martin
This is including Charles Kettering, the founder of Delco and head of research at GM as part of this.
Acquired
Lockheed Martin
So when Lockheed buys this, the population of Sunnyvale is less than 10,000 people. What? Lockheed built Sunnyvale.
Acquired
Lockheed Martin
So by the end of the decade in 1959, just four years later, Lockheed Missile Systems employs almost 20,000 people in Palo Alto and Sunnyvale. And a few years later, by the mid-60s, they would employ 30,000 people. This makes Lockheed by far the largest employer in this brand new proto-Silicon Valley. I mean, remember, I just said Lockheed built Sunnyvale.
Acquired
Lockheed Martin
You think of Sunnyvale, Silicon Valley today, like Yahoo and Intel and all that. Cisco. There was none of that. Lockheed built it. So Hewlett-Packard was the largest tech company, computing company, Silicon Valley company at the time. Hewlett and Packard were students of Fred Terman, and Fred encouraged them to spin out and start Hewlett-Packard. They were the largest new tech company.
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Lockheed Martin
Exactly. Same dude. So the idea was they were going to build the General Motors of the Air. There was just one problem with that is that aviation did not become a consumer industry like the automobile industry.
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Lockheed Martin
Yeah, they had this huge structure called the Blue Cube that has since been disassembled. It's not there anymore. But you need a big hangar that you're going to build missiles in. And they end up building a lot more than missiles we're going to talk about.
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Lockheed Martin
So we talked about this a bunch actually on the first Sequoia Capital episode when we were telling Don Valentine's story. And at the time when we were telling the story, we were like, oh, you know, Don, he was so legendary before he started Sequoia. He was the head of sales at Fairchild Semiconductor and the head of sales at National Semiconductor. And we sort of glossed over it.
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Lockheed Martin
We were like, yeah, you know, he was mostly selling to defense companies, right? Well, who do you think he was selling to?
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Lockheed Martin
Yes. Now, he was also selling around the country to other defense contractors, too. Lockheed wasn't the only company that was working on missiles, but I think they were the only one that was working on missiles in Silicon Valley. Wow.
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Lockheed Martin
And by God, did they buy a lot of product out of all these startups and all of these Silicon startups that are coming out of Stanford and coming out of Shockley and just getting sprung up right there in Silicon Valley.
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Lockheed Martin
Alan Lockheed departs at this point in time and is kind of tangentially involved, but this company that to this day bears his name, after this point in time, he doesn't really have a lot of impact on.
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Lockheed Martin
Yes, it is totally insane. And so many people came through Lockheed into Silicon Valley, including one Jerry Wozniak, right? who moved himself and his young family out to this new Silicon Valley to become an engineer at Lockheed Missiles and Space Company. That's right, Woz's dad. The reason that Steve Wozniak grew up in Silicon Valley is directly because of Lockheed Martin.
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Lockheed Martin
Yeah. And before this time, before the 50s, there was no Silicon. It was called the Valley of Heart's Delight. That was the name for it. It wasn't Silicon Valley. Huh. Wild. Okay. So what was Lockheed actually doing there? We talked about them working on intercontinental ballistic missiles, ICBMs, and missile defense systems. I think they probably did continue to work on that.
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Lockheed Martin
Now, shortly after this maybe harebrained GM of the air idea comes together and Lockheed gets sold to the Detroit Aircraft Corporation, the stock market crash of 1929 and the Great Depression happens and DAC predictably goes bankrupt. They sell off the Lockheed division, which is actually still fairly profitable, out of bankruptcy to an entrepreneurial young businessman named Robert Gross.
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Lockheed Martin
But there were two projects that this new division of Lockheed took on that really changed history. And both of them together became, for Lockheed at least, and the parent company, by far the biggest driver of profits for the coming decades. And really, as we'll see, this division, you know, not Skunk Works, this division kept Lockheed alive.
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Lockheed Martin
Lockheed would have absolutely died without this division. So what were these projects? One went up to space, as perhaps is obvious and we foreshadowed and literally is in the name of the company, the Lockheed Missiles and Space Corporation. And the other one went down under the oceans. So let's talk about that one first, because I think it happened first chronologically.
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Lockheed Martin
So submarines had obviously been a thing since World War II and even before that, back to World War I. There's lots of advantages to submarines during wartime. They're stealthy. They can basically travel anywhere in the world. You can stay hidden for long periods of time, especially once nuclear submarines are developed that can stay underwater for months at a time, self-powered.
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Lockheed Martin
They're both a great offensive and a great defensive weapon during periods of active war.
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Lockheed Martin
But during the Cold War, they're kind of useless because if you wanted to have a chess piece in position to strike a land-based target, if you could even do that at all with a submarine, you got to get the submarine pretty dang close to the land, which means close to Russia, which means they know you're there and that's a provocation.
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Lockheed Martin
Unless somebody could maybe somehow figure out a way to fire an intercontinental ballistic missile out of a submarine and go up into, you know, the air and into space and then hit a land-based target far, far away. Now this seems crazy. It's hard enough to make this happen from the ground. You're talking about doing this from the sea with all the like waves and the lack of stability.
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Lockheed Martin
Oh, well, you're making the leap already that you would fire it underwater. At first, when the Navy contracts Lockheed to work on this in 1955 to build the Navy's Fleet Ballistic Missile System, its FBM, The idea is they're going to fire these things from the surface of the ocean. The submarine's going to rise up.
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Lockheed Martin
They're going to like stabilize it in water and they're going to fire off a missile from the deck of a ship or a surfaced submarine.
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Lockheed Martin
Yeah, this is a big challenge. The reason that it was worth trying was that if you could create a naval-based intercontinental nuclear strike capability, It completely changes the strategic landscape of deterrence and first strike versus second strike and retaliation. So what we were really afraid of, we thought the Soviets would pursue a first strike policy if they felt they were able to.
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Lockheed Martin
The way that they would do that is if they felt that they could, in that first strike, knock out all of our nuclear capabilities. If they could target all of our land-based ICBMs, incapacitate them, then we would be incapable of responding with a second strike, and then they could blow up our cities and whatnot. Now, if all of a sudden you have a mobile naval-based missile system
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Lockheed Martin
Well, that completely changes the chessboard. It's quite the deterrent. Quite the deterrent. You can now pretty much guarantee, as long as you can keep a fleet of nuclear submarines operating at all times, that you can't take them out and they can move around and be anywhere. And so if you launch a strike, they're going to launch right back. And first strike is now off the table.
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Lockheed Martin
This is a huge strategic win if you could put this actually operationally in practice. The other medium, if you will, location that could change the dimension too for doing this would of course be space. If you had nuclear missiles up in space, that also changes the dimension.
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Lockheed Martin
And this, among many, many reasons, is why when the Soviet Union launches Sputnik into space in October 1957, even though Sputnik itself was far from having nuclear ICBM capabilities, The Soviets getting to space first was truly terrifying.
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Lockheed Martin
It turned out, like we were talking about a minute ago, that firing ICBMs from the deck of a surfaced ship, be it a submarine or otherwise, bad idea. Basically impossible. But firing missiles from under the ocean was doable. And Lockheed did it with the help of Silicon Valley. So in December 1955, the Navy awards this contract to Lockheed. The name of the project was Polaris.
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Lockheed Martin
People might have heard of Polaris missiles. Just over four years later, after the contract is awarded, in 1960, the very first U.S. nuclear ballistic missile-equipped submarine sets sail on its patrol, and everything we just talked about
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Lockheed Martin
is operationalized, equipped with Lockheed Polaris A1 undersea fired nuclear warheads, ballistic missiles, could reach land-based targets up to 1,200 nautical miles away from wherever the submarine was when it launched it. And it was all built out of Silicon Valley with many subcontractors all over the place.
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Lockheed Martin
Yeah, Lockheed did not make the submarines, nor did they make the nuclear warheads. I think a lot of this work was done out of Sandia, which we talked about on the Amazon episode. Oh yeah, Bezos' dad worked there, right? Grandfather, Bezos' grandfather, was the head of Sandia, which was in New Mexico, the military nuclear program, the division of the U.S. overall nuclear program.
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Lockheed Martin
Yeah. To enable this strategic chess piece, the key thing is the missiles. Nuclear submarines already existed. Nuclear warheads already existed. The challenge here was create a system by which you could launch a missile from under the ocean out of a submarine.
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Lockheed Martin
Well, this is one of the things that I mentioned at the top of the episode. Doing this research sort of changed my mind on the war machine aspect of Lockheed and the military and the military-industrial complex.
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Lockheed Martin
But I think people really believed, and I think there's a good chance this was reality, it was building all of these systems and advancing all of this capability that prevented it from being used. If we hadn't built this stuff, there's a good chance Russia would have done a first strike.
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Lockheed Martin
So amazing. Everything you know of Lockheed today got bought out of bankruptcy for $40,000. It's crazy. So under Robert Gross and his brother Cortland, who gets involved... They really are the ones who turned Lockheed into the great company it became. So before World War II, during the 30s, Lockheed builds the famous Electra airplane, which is absolutely iconic.
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Lockheed Martin
And then that quickly leads to more successor programs and developing the technology further. The Polaris becomes the Poseidon is the next program, and then the Trident. The Trident missiles had a 5,000-mile range and carry a hugely destructive nuclear payload. Unbelievable. Terrifying. All right, so we just told this incredible story about LMSC taking Silicon Valley under the ocean.
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Lockheed Martin
This program, you know, Polaris, Poseidon, Trident, for most people listening, especially if you're American, these names aren't surprising to you. You've heard of these programs. You are aware that the U.S., starting in the 1960s, had nuclear submarines carrying intercontinental ballistic missiles. Yep.
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Lockheed Martin
It was, if you think back to the kind of the chess game, it was in the government's best interest for the Soviets to know that we had these. The point was deterrence.
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Lockheed Martin
Maybe all the money that went into Silicon Valley. No, I don't think that was the case. Either way, you don't want to find out.
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Lockheed Martin
Yeah, I think it was spy planes and also during World War II, bombers. If bombers ever made it to the West Coast, they wouldn't know where to bomb. I'm pretty sure that Disney Imagineering was involved in creating these sets like they made for Disneyland.
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Lockheed Martin
Okay, so if you remember back when we pressed pause on the skunk orc story and moved up the state of California up the coast to Silicon Valley... We'd said that when Gary Powers and the U-2 was shot down in May 1960, that supposedly this was the end of U.S. observational capabilities in the Soviet Union, and that it was for about three months, but nobody knew it.
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Lockheed Martin
I think a lot of people in the military who did know about this stuff—this is heretical to say because it's so beloved— But I think the Blackbird was a decoy. We were getting everything we needed from space. We just didn't want anybody to know about it. And so everybody now is like, oh, the Blackbird, it's such a shame the government shut it down. You know, it was never used to its potential.
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Lockheed Martin
Yeah, yeah, yeah. I know. I'm getting mad over here. People are probably getting very mad. Here we go. So when you think about America in space and the U.S. space program, you think, of course, about NASA. Gemini and Apollo. Mercury, Kennedy, putting a man on the moon, all that amazing stuff, which for sure happened and was happening. All of that was basic science research, right?
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Lockheed Martin
This is the plane that Amelia Earhart disappears in. Perhaps even more timelessly, this is the plane at the very, very famous scene at the end of the movie, Casablanca, when Rick puts Ilsa... on the plane with Victor to escape the Nazis and says, here's looking at you, kid. That plane is an Electra, I believe an Electra Junior.
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Lockheed Martin
Nobody working on those programs, public observing it, like, it would be crazy to think there were going to be actual applications in space anytime soon. There's no infrastructure. Like these are science missions. This is research. And even, you know, Sputnik on the Russian side, Sputnik was a research festival. It was like the size of, I don't know, like a bowling ball or something.
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Lockheed Martin
I think it was a little bigger, but like it was very, very simple. It was a long, long, long, long time before you went from those initial science missions to applications in space. Or so everybody thought. Yeah. Because in parallel, there was a secret U.S. space program being run by Lockheed Missiles and Space Corporation out of Silicon Valley.
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Lockheed Martin
And in basically the same timeframe as the initial NASA missions, the initial Mercury, I think, were the first missions.
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Lockheed Martin
Yeah, basically concurrently with that, they got a fully operational mission observational spy satellite system. up into space and functioning at the same time.
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Lockheed Martin
There was a cover story for what these things were. I think it was called the Discoverer Program. I believe the cover story was that this was like life form research in space, like they were sending animals up to space, like monkeys, to prepare for manned space flight. That was the cover story. They may have sent some monkeys up there, but that was not the point.
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Lockheed Martin
The point was to get these reconnaissance satellites up to space. So the first program was called Corona. And you should Google about it and read. There's a great declassification document story that the government put out in 1995 when they declassified this stuff. And the Wikipedia page is pretty good.
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Lockheed Martin
I think what the CIA and the National Reconnaissance Office does, I think they write these stories, maybe quasi in real time, so that there's documentation of all this stuff and then they stamp it secret and then it never gets out until it gets declassified.
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Lockheed Martin
Ah, let's get into it. Okay, so the name Corona. There are conflicting stories of whether it comes from the Corona typewriter or the Corona type of cigar that apparently the Pentagon official that championed this program really liked. We'll never know. It's all classified. So these satellites, like we've been alluding to, had cameras on them. The first one went up in August 1960.
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Lockheed Martin
It was built in the years leading up to that by LMSC and then went up in August 1960. While everything else happening in space was, you know, research vessels. This first Corona satellite had a camera system on it that was able to photograph any ground location that it passed over in its orbit around the earth at a resolution as low as five feet from space. These were film systems.
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Lockheed Martin
Now, the U2 camera system did have a higher resolution than that, higher ground resolution, but five feet was still plenty good. And more importantly, the Corona system could take photos anywhere in the world on its orbit. And if you had multiple of these satellites up there, you know, you could pretty much blanket the earth or at least everywhere you cared about pretty quickly.
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Lockheed Martin
At basically any point in time. You know, they're spinning around the Earth. Like, yes, you can't do it in real, real time, but, like, it doesn't take that long for the thing to fly around the Earth and then fly around again. Right. The very first Corona mission, that very first satellite that went up in August 1960...
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Lockheed Martin
produced greater photo coverage of the Soviet Union than all of the previous U-2 flights combined. Five years of operating the U-2 program, one satellite in one kind of month-long mission, I think it was about a month before it decayed, the orbit decayed, got more than all of that.
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Lockheed Martin
No need to fly a plane, no need to worry about getting caught, no need to worry about the Soviets knowing what was going on, no need to worry about being shot down.
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Lockheed Martin
Now, you might be thinking as you're listening, you know, oh, I know how satellites and satellite imagery works today. You know, you got Google Maps, you got Starlink, you know, blah, blah, blah. Starlink's communication, but like... Communication, yeah. How did they beam these images down from the ground? These were not digital photography. This was film freaking photograph.
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Lockheed Martin
Oh, absolutely beautiful. The Electra and Casablanca brings us to the first core part of our story, which is World War II, which transforms everything. And a man named Clarence Kelly-Johnson who started the famous Lockheed Skunk Works division.
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Lockheed Martin
They had retro rockets built into the film canisters to reaccelerate out of the orbit and move it down to go into the atmosphere.
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Lockheed Martin
It's like those claw games in the arcades, you know, like, oh, you pick up a... Literally, they had a freaking C-130 flying around with a big-ass claw to snatch this thing out of the sky.
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Lockheed Martin
Because obviously, what would the biggest disaster be would be if somebody else or the Russians got their hands on this and were like, holy crap, somebody's taking photos from space of us.
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Lockheed Martin
I believe it wasn't just one C-130. I think they had a whole fleet of C-130s all flying around where they thought this thing was going to reenter the atmosphere.
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Lockheed Martin
And all this happened in 1960. Oh, my God. Wow. So all told, the Corona satellite program and LMSC also designed the Agena rocket, which was the kind of upper stage rocket booster that the Corona satellite and other satellites, future satellites attached to.
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Lockheed Martin
So that system of the Corona and the Agena was the first spacecraft in history to do all of the following things. Achieve a circular orbit, achieve a polar orbit, be stabilized on all three axes in orbit, because you kind of needed to be stabilized if you're going to take photos at five foot resolution of the ground, be controlled by a ground command,
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Lockheed Martin
return a man-made object from space, propel itself from one orbit to another.
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Lockheed Martin
I mean, any one of those things that I just mentioned, if this weren't a top secret black classified program for, what, three and a half decades... We'd be all over the history books and as is like nobody knows about this stuff.
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Lockheed Martin
Yeah, crazy. So Corona would then lead to three follow-up programs that we know of. I'm sure many, many more, but there are three follow-on ones that LMSC did that have been declassified so far. Some of these only very recently. So the strategy of the program evolution over time followed the four stages that we know of. First, it was what they called see it. That was Corona, just period.
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Lockheed Martin
Can we see the Soviet Union from space? Corona proved that. The next phase was, can we see it well? And then the phase after that was, can we see it all? And then the last phase, which is a lot of the last phase is still classified, is see it now. So let's talk about all of these. Corona, like we said, was just see it, get photos.
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Lockheed Martin
But the photos were at a worse resolution than what the U2 was able to achieve. In 1963, only three years after the first Corona satellite goes up, LMSC and the government launch the Gambit program. This is the see it well. So Gambit's max resolution still has not been declassified. We don't know how sharp it was. This thing launched in 1963 and it is still classified how good it was.
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Lockheed Martin
So there's a wonderful book. There are a bunch of wonderful books around Lockheed, but a book titled Skunk Works that was written by Ben Rich, who was Kelly's second in command for a long time at Skunk Works and then took it over when Kelly retired. And this book is like the Top Gun of historical autobiographies. You read it and you are just fired up. It is amazing what these people did.
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Lockheed Martin
But it has been confirmed that the resolution was under two feet, which was better than the U2 cameras. Whoa. Less than two feet from space in 1963. Next was Hexagon. Hexagon was the, quote, see-it-all program. Now, this is starting to eclipse a little bit my technical knowledge, and I think there's also just less known about this because a lot of this is still classified too.
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Lockheed Martin
I believe the hexagon satellites had longer orbit lifespans and had more film capacity before they decayed. And so I think they were able to kind of like see more longer, I think is what a hexagon was.
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Lockheed Martin
Then in 1977, they launch Kennen, K-E-N-N-E-N, which this is still like very classified. Some of it is out so we can know a little bit about this. There actually was an incident in, I think it was 2019, when Trump was president. He tweeted... No. An intelligence photo that was just like this incredible photo of, you know, incredible resolution of something that happened somewhere, maybe in Iran.
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Lockheed Martin
And he tweeted like, oh, see, like it isn't what you thought it was like. And people went nuts. People believe, it's never been confirmed, that this photo was from a future version of the Kennan program. Huh. So what was Kennan? Kennan was see it now. Yeah. It's the first real-time space-based surveillance system. I guess maybe the first real-time surveillance system period. I don't know.
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Lockheed Martin
By 1977, there were enough communication satellites up in the sky and digital photography had come along far enough. The Canon satellites are like what we think about like Google Maps, like it's real-time digital photography beamed down via a ground link to stations in real time. Whoa.
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Lockheed Martin
And Lockheed has to build their own digital workstations to process these photos, to display them, to manipulate them. I think these might have been the first or really early digital photo processing manipulation workstations that were sold to the CIA. Yeah. I didn't know about any of this.
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Lockheed Martin
Which is one of the companies that Google acquired that became Google Maps.
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Lockheed Martin
It very well could have been because it was 1995 when that was declassified, and I'm sure Keyhole was started after that. Yep. Just super cool. Along the way, LMSC also does a lot of pioneering work in weather satellites, and they launch weather satellites. Because it turns out that most of Russia is under cloud cover most of the time.
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Lockheed Martin
So they got to know when, you know, the weather is going to be clear enough to look pretty awesome.
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Lockheed Martin
It's Top Gun for engineers. Yes, it's so great. I also highly recommend Lockheed. a book called Beyond the Horizons, which is hard to find and most people don't know about, by Walter Boyne. And that is an amazing history of Lockheed during all these eras that we're going to talk about.
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Lockheed Martin
Yep. They're part of the positioning satellites that the military puts up and that goes on to be opened up to commercial use. And that's the GPS system that we use today. And of course, I'm sure LMSC is part of many, many other things in space that we still have no idea about. Wow. Yeah. One thing that we have a lot of idea about that they built that I had no idea until researching all this.
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Lockheed Martin
So, you know, we're now in the 70s as this is going along. And we'll come back and talk a little bit about this as we come back to Skunk Works here in a sec. But we're getting towards the end of the Cold War and this stuff is less urgent. Lockheed and LMSC start moving into non-military applications or trying to. But LMSC gets a contract from NASA and builds the Hubble telescope.
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Lockheed Martin
And this isn't the first time we've partnered with them. So we are excited to bring them back. to the show. We have become quite the payments nerds this year and have a much deeper appreciation of just how important the modern payments industry is to the world. Money movement fuels literally everything in modern society, and Modern Treasury is right there at the heart of it.
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Lockheed Martin
Yep, and that's where Modern Treasury comes in, a payment operations platform designed for this new era. Think of it as money movement supercharged. There's faster payment rails, smart workflows, and real-time visibility, technology that modernizes your existing financial infrastructure. With Modern Treasury, your company can move money faster and more efficiently than ever,
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Lockheed Martin
boosting business performance and enhancing customer experiences. Payment operations go from manual and slow to automated and continuous, from isolated to fully connected, all in real time, tracking every cent.
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Lockheed Martin
We keep doing this. Uh, this one, I think I only paid like 40 bucks for on Amazon. So it's not quite like taste of luxury and LVMH, which I think that's now like three, four or $5,000. Oh yeah. No, we definitely spiked the price. We did. All right. So who is this Kelly Johnson? He's basically the Shigeru Miyamoto of airplane design.
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Lockheed Martin
Okay, two other things that I want to talk about with LMSC before we come back to the coda on Skunk Works and the Blackbird and all that. One, I think I alluded to this earlier. LMSC listeners, you be the judge. The stories that we've just told, is this more impactful to America and the world than what Skunk Works was doing? Personally, I kind of think yes, but you know, maybe you can debate.
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Lockheed Martin
What is undebatable is that LMSC from a business standpoint within Lockheed became the crown jewel of the company.
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Lockheed Martin
Well, I think at times in the 60s and 70s and 80s, LMSC was the largest business by revenue. But almost through the whole time, it was by far the most profitable division within Lockheed. And at times, when we'll get into, Lockheed fell on some really hard times in the 70s. There were years where LMSC generated more than 100% of the profits of Lockheed. No way.
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Lockheed Martin
So all of the rest of Lockheed, Skunk Works included, was in the red, unprofitable, bleeding money, and LMSC was keeping the company afloat. And if you think about it, I guess one, just what they're developing and the scale of it and these contracts are huge, both under the ocean and up in space. Two, though, what they're doing, it's different than building airplanes.
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Lockheed Martin
And I alluded to this when I was talking about it's a different talent set. This is much more technology problems and computing problems that LMSC is tackling here. Yes, they're building missiles. Yes, they're building rockets and all that. But the core value components of those rockets is computing and silicon and ultimately software.
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Lockheed Martin
And as we talk about all the time on this show, like, well, that's really good margins. definitely better margins than building airplanes. So the stats I have, this is from Beyond the Horizons, which also is where a lot of the story, especially of Corona, came from. During the 12-year period from 1960, when Corona first launched, to 1972,
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Lockheed Martin
Lockheed as a whole did $26 billion in revenue over that 12-year period and just $255 million in total profit. Not a high-margin company during that period. LMSC accounted for over a third of that revenue and 128% of the profit. So that's what I was talking about. Whoa. Everything else in Lockheed lost money, or at least in aggregate lost money.
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Lockheed Martin
And then during the early post-Cold War period from 1983 to 1992, LMSC accounted for 46% of revenue, so growing percentage of revenue, and 72% of profits during that 10-year period.
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Lockheed Martin
It was a great business, just from a business standpoint. So the other thing I want to talk about before we come back to Skunk Works is LMSC's operating principles and philosophy. And so much of that was built off the shoulders of Skunk Works. And a lot of the guys in the YouTube videos that I found talk about this. Their philosophy, though, they codified into seven tenets.
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Lockheed Martin
So Kelly had his 14 rules. LMSC had seven tenets. And most of them are very similar to the Skunk Works rules. We'll link to an image of them in the show notes. One of them, though, that I want to highlight and discuss that to me stands out as different from Skunk Works is tenet number one. And that one is focus on a threat-based need. And I think that's really interesting. Huh.
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Lockheed Martin
His nickname is Kelly because when he was in grade school growing up in Michigan, his real name was Clarence. An older boy called him Clara on the schoolyard, and Johnson attacked him so viciously that he broke this kid's leg. And so after that, all of his schoolmates never called him Clarence or Clara again, and they nicknamed him Kelly. Okay, so not Clara, but why Kelly?
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Lockheed Martin
To me, when I read that and thought about it, That element is missing from Skunk Works and Kelly's philosophy. This is conjecture here. There's no Skunk Works book about LMSC, so we have very little information to go on. But if that really was tenant number one for the company...
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Lockheed Martin
I think you could maybe extrapolate that a little bit to the market context is really important for what you're doing and don't lose sight of the market context for what you're building. Kelly's philosophy of all that matters is rapid delivery of superior products. Nowhere in that statement is there room for the market. Well, who decides what's superior?
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Lockheed Martin
Maybe a small number of people want this, but do a large number of people want this? Like, how important is this? Obviously, what Skunkworks was doing was really important.
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Lockheed Martin
Okay, let's do it. But keep that in mind, though. A threat-based need. Was there a threat-based need for the SR-71? Maybe. My computer wallpaper needs to exist, so that's a need. Oh, there was a market need.
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Lockheed Martin
So, when Gary Powers is shot down in May 1960, of course, as you would expect, the CIA and Skunk Works is already hard at work at the successor airplane to the U-2. Everybody believes it's kind of a miracle that they were able to fly for five years like they did. They knew that this day was coming when the Russians would be able to shoot it down.
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Lockheed Martin
So as we talked about, the U-2's primary defense as it so happened, wasn't intentional, but as it happened in practice, was how high it flew. It was obviously trackable on radar. 70,000 feet. Yep. It's not like you could evade enemy fighters or missiles in this thing. It had a hundred foot wingspan. It turned like a school bus. It was how high it flew.
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Lockheed Martin
So if you remember back to the original spec for the program, there were three sort of vectors that were possible for how you could operate a program like this. One was fly high enough. That's what the U-2 ultimately did. There was also, though, fly so that it can't be seen by radar, stealthy. We'll come back to that in a few minutes here.
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Lockheed Martin
If you can't evade them, outrun them. Yep. It's like the Sonic the Hedgehog of airplanes. So this program, if you know anything about the SR-71 Blackbird, you're like, well, that's an Air Force airplane. We're talking about the CIA here. The Blackbird was not a CIA airplane. The program that the Blackbird ultimately came out of was the A-12 Oxcart. This was essentially the same airplane.
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Lockheed Martin
We'll talk about the differences in a minute. But this was the CIA contract that they had Skunk Works working on. And it was, yeah, the goal, make this thing so fast that whether they see it or not, they're not going to shoot it out of the sky.
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Lockheed Martin
There was some character of Kelly, kind of an Irish tough guy that they named him after. That really was his personality. So after every Skunk Works test flight for the rest of his tenure running Skunk Works, they'd throw a big party and Kelly would challenge anyone, all comers, to an arm wrestling match. And even when he was like 60 years old, he was still beating people.
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Lockheed Martin
Yep. And to be able to avoid surface-to-air missiles, that basically meant that the specs for this thing were that it had to go Mach 3 or faster. Now, to outrun any, you know, missiles, it had to do that with a pilot. There had to be humans in this thing. Faster than Mach 3 is faster than 2,000 miles an hour.
Acquired
Lockheed Martin
For being placed in the National Air and Space Museum? Yep. Coast to coast in an hour. Wow. Wow. I remember being a kid and looking at this thing like, well, why didn't we commercial this? You can't commercialize this thing. You've got to be in a spacesuit to fly this.
Acquired
Lockheed Martin
And hopefully this is obvious, but just to make the point again, you know, some of you might be sitting there being like, well, you just told me about how the sister company LMSC did all this amazing stuff in space. You go a lot faster than that to get to space and whatnot. And like, yeah, but you don't have humans on there. So a pilot's got to fly this thing.
Acquired
Lockheed Martin
Okay, so when Skunk Works and Kelly and Ben Rich and everybody sit down to work on this, the current state-of-the-art fastest plane at the time, this is late 1950s when they start working on this, is the McDonnell Douglas F-4 Phantom. which is able to hit just over Mach 2 with its afterburners on. So not sustained flight, like when you punch the afterburners, it can barely touch Mach 2.
Acquired
Lockheed Martin
And the F-4 itself was only a bit faster than the Skunk Works-built F-104 Starfighter that Ben, you mentioned earlier, which was the first Collier trophy that Kelly Johnson won. So the idea that you were gonna achieve cruising speeds, like sustained speeds above Mach 3, This is a big piece to bite off here.
Acquired
Lockheed Martin
Only a handful of planes have ever been able to do this since, and I'm pretty sure no other plane has been able to do this at cruise speed without engaging afterburners.
Acquired
Lockheed Martin
The only way you can do this in a jet-powered plane is to essentially design something that can run with afterburners on all the time. Like, they're not afterburners, they're just burners. It's how the thing goes. To do that, you A, required a tremendous amount of fuel, and B, you also produced heat in doing so that's like... rocket-level proportions.
Acquired
Lockheed Martin
Yes. And the engines, I think, inside the engines get to close to 3,000 degrees, I believe. So they had to build the whole plane out of titanium to make this work.
Acquired
Lockheed Martin
Right. This is really funny. There wasn't enough titanium in the United States to build all these Blackbirds, or raw titanium that they could easily source.
Acquired
Lockheed Martin
Yes. And they source a large amount of the titanium that goes into the Blackbirds, the A-12s and then the Blackbirds, Out of the Soviet Union. Too funny.
Acquired
Lockheed Martin
Oh, my God. This is one of the reasons why it is maybe spoiling it a little bit. But to flash forward, the Air Force hated operating these things. Yeah. I mean, it costs, I think, $300 million a year just to maintain these things. These were beasts from hell in every sense of that phrase. The good and the bad. Yep. Okay, so that's some of the materials challenges.
Acquired
Lockheed Martin
Another problem was on the engines. So the most advanced jet engines in the world at the time was the Pratt & Whitney J58. And I believe actually they weren't even able to get the J58 in the first generation. A-12s, and then only later in the Blackbirds did they put it in.
Acquired
Lockheed Martin
couldn't produce nearly enough thrust on their own to get to and sustain the Mach 3 plus speeds that they needed to hit spec. In fact, at least according to Ben Rich at Skunk Works, they could only produce about 25% of the thrust required. So Ben leads a team that engineers the spike inlet system.
Acquired
Lockheed Martin
The quote from his first boss, Lockheed's chief engineer at the time, Kelly would become the chief engineer. But his boss at the time, Hal Hibbard, would say, that guy can see the air. So Kelly ends up winning the Collier Trophy twice, one of only two people to do so in history. The Collier Trophy is the equivalent of like the Oscar for best picture. It's the best airplane design of the year.
Acquired
Lockheed Martin
So if you're looking at a Blackbird and you look at the engines, they've got these like cones in front, these spikes, these big spikes. I mean, I'm sure everybody listening has seen a photo of a Blackbird.
Acquired
Lockheed Martin
You owe it to yourself if you have not seen one of these things in person. It's just one of the most amazing objects ever created. But these cones, what do they do? So the engines get the thing up. And then once it's up in the air, the cones expand and retract. First suck in and then compress and then superheat massive amounts of air that they then mix with fuel in the engines and ignite.
Acquired
Lockheed Martin
Essentially, this is the world's most badass supercharger ever created. These things are superchargers. That's what they are. The spike system is a supercharger for the engines. It provides three quarters of the thrust needed to get to Mach 3 plus and sustain it. Unbelievable.
Acquired
Lockheed Martin
Yeah. So fortunately, you know, Scott Gorkson, the CIA, had started working on the A-12 Oxcart before Gary Powers was shut down. It takes, I believe, quite a while to engineer this beast. They start test flying it in April 1962. Of course, at Area 51. Where else are they going to do this?
Acquired
Lockheed Martin
Once they start test flying it, that's when the Air Force finally gets interested in the project and is like, oh, we want our version of this. And that's how the Blackbird comes about. A fun little bit of trivia. Within the Air Force and the Pentagon, the project originally was called the RS-71. Not the SR.
Acquired
Lockheed Martin
It happened because President Lyndon Johnson actually announced the existence of this thing in a national speech. And during the speech, he calls it the SR-71 instead of the RS. There's some speculation that it wasn't that he messed up and made a mistake, but that his speechwriter... wanted it to be called the SR-71 and intentionally modified the speech. Who knows?
Acquired
Lockheed Martin
What is relevant, though, post-Cold War, politics become a huge thing here. So once Johnson says this... Nobody is willing to contradict the president. So Skunk Works has to go and like redo all of their documentation for the whole damn thing. You can imagine Kelly Johnson's reaction to this. Yeah. So the first official flight of the Blackbird happens on December 22nd, 1964.
Acquired
Lockheed Martin
It reaches a top speed of Mach 3.4. God. The airplane wins Kelly his second Collier trophy. I mean, still, to this day, people lose their minds over this thing. It's stunning.
Acquired
Lockheed Martin
He wins it twice. He ends up being bestowed the Presidential Medal of Freedom by Lyndon Johnson later in his career. He is a true American hero. So he ends up joining Lockheed right out of the University of Michigan Engineering School. I'm sorry, University of Michigan, you know, Ohio State. Sorry, Ben. In 1933 at 23 years old.
Acquired
Lockheed Martin
There's stuff you can find out there on the internet. Obviously, nobody really knows, but supposedly, according to internet lore, over 4,000 missiles have been shot at blackbirds and none of them have ever hit.
Acquired
Lockheed Martin
It's especially awesome when you know as the highest levels of the government It's kind of all a decoy anyway. You're getting what you need from other sources.
Acquired
Lockheed Martin
Yeah. Well, here's one area where I'm wrong. I do think that statement is mostly right, but you could argue with it, and people do and did, in that satellites are not real time. You know when they're coming. You know when they're about to fly over. If you need to instantly get somewhere that maybe you don't have the right orbit coverage for, or where there's a dynamic situation,
Acquired
Lockheed Martin
If an enemy knows that a satellite is flying over it and doing reconnaissance, they know when the satellite is going to fly over so they could hide stuff during those times. If you need full flexibility, you need a Blackbird. So it does have a use. It's not like it's useless. But unlike the U-2, which was everything, it's more of a niche use case here.
Acquired
Lockheed Martin
Now, I don't know the details of stealth with the Blackbird. I imagine a big part of that was the height, was the altitude and the speed of it.
Acquired
Lockheed Martin
And Kelly is really one of the, if not the principal engineer that designs and builds the Electra. So he becomes the star of Lockheed's then only six person aviation design and engineering department. There were six people that were making these things. Crazy. And he does basically everything himself. Engineering, designing, testing, even flight testing. There's this amazing quote in Skunk Works.
Acquired
Lockheed Martin
Super cool. Keep in mind for a minute from now, that idea of flat surfaces and planes and radar. Planes, not airplanes, planes like a flat plane and surfaces. Okay, to close out on this amazing airplane, amazing and sad in a lot of ways, it's hugely expensive to build these things. $33 million per plane, which was a lot back then. I mean, planes now cost more, but a lot.
Acquired
Lockheed Martin
And then, as I said, $300 million a year just to keep them operational and run the program. You couldn't use it as a fighter or a bomber. It was only reconnaissance. It's not super popular with the military and the Air Force. They kind of don't like it as an operational plane. Right. It's a lusty airplane. Yes. It's not a daily driver. Let's put it that way.
Acquired
Lockheed Martin
In 1970, the Pentagon cancels further orders and they order Skunk Works to destroy all of the titanium tooling for it so that no more can ever be built. I assume that's so that it doesn't fall into enemy hands or something like that.
Acquired
Lockheed Martin
Yep, the existing ones do stay in service, but obviously this is like a big blow to Skunk Works' revenue. They're not producing these things anymore. On the back of that, Skunk Works has to do layoffs, the Skunk Works division, after the contract is canceled. In 1972, two years later, Lockheed and Skunk Works lose the bidding for the F-16 fighter.
Acquired
Lockheed Martin
General Dynamics wins that, ironically, the later Lockheed right before the merger with Lockheed Martin. would acquire General Dynamics' fighter plane business. So it does come back into Lockheed.
Acquired
Lockheed Martin
So here's what's interesting about this contract and Lockheed and Skunk Works losing it. This is an example, I think, to that first tenant from LMSC of threat-based need and real need, market need. Maybe you want to adapt that to. Kelly Johnson, as amazing and a genius as he is, is a very stubborn man. And the stated purpose, the Air Force's goals with the F-16 was to have a cheap fighter.
Acquired
Lockheed Martin
It didn't need the best. It needed to be cheap and that they could make a lot of these and they could use them all over the world. That's not Kelly's MO. And so he and Skunk Works bidding on this project, they kept trying to give the Air Force what they didn't want. And they lost it.
Acquired
Lockheed Martin
This is Ben Rich talking. Kelly once said that unless he had the hell scared out of him at least once a year in a cockpit, he wouldn't have the proper perspective to design airplanes. So great. Okay. So the start of World War II rolls around. And the first thing that Kelly and Lockheed do is they adapt the Electra into a bombing vehicle called the Hudson. And even before the U.S.
Acquired
Lockheed Martin
And by this point in time, to bring some context back of where the country was, we're now basically post-Vietnam War. The Cold War is for sure still going on, but it's not the same level of urgency in Americans' minds as it was back in the 50s.
Acquired
Lockheed Martin
Yeah, totally. And this is not a challenge that LMSC, at least with the Corona Project, had to face, because nobody knew about it. Right. So, this is a really bad time for Lockheed. This is the period, like we were talking about at the end of the LMSC chapter, where it's LMSC that keeps the company afloat. Kelly retires. Kelly retires. Ben Rich takes over as head of Skunk Works.
Acquired
Lockheed Martin
Skunk Works is doing layoffs. Lockheed really stupidly decides to try to get back into the commercial aviation business.
Acquired
Lockheed Martin
They make the L-1011, which by all accounts was a great airplane, but turns into a disaster project. They're trying to compete with Boeing and with McDonnell Douglas here. The DC-10, I think, was the McDonnell Douglas competitor. Lockheed partners with Rolls-Royce to make the engines right as Rolls-Royce goes bankrupt and gets nationalized by the UK government.
Acquired
Lockheed Martin
All told, we won't go into the whole history here, but the L-1011 airliner project loses Lockheed $2.5 billion. And as we said a few minutes ago, this is not a super profitable company. They don't have $2.5 billion in other earnings just sitting around to soak up the losses here. At the same time, Lockheed also gets caught up in really nasty bribery scandals around the world.
Acquired
Lockheed Martin
But these are nasty political scandals themselves. And basically, Lockheed comes out looking, at least to the American public, like kind of a corrupt arms dealer. So what happens is, you know, Lockheed and lots of people would argue that this is just the way you needed to do business in foreign countries or allies that...
Acquired
Lockheed Martin
Lockheed sold these weapons to in the Netherlands, in Japan, and in Saudi Arabia. It comes to light that Lockheed employees and contractors are paying bribes to political officials to win contracts. This actually brings down the Japanese prime minister at the time. Whoa. This is a huge scandal in Japan, on the order of Watergate in the U.S. Huge scandal.
Acquired
Lockheed Martin
Sega actually makes an arcade game about it called I'm Sorry about the prime minister at the time. Like, so funny. Lockheed also, on the military side, kind of the main Lockheed division's engage with a couple helicopter projects with the military, and then the C-5 Galaxy transport plane. Those projects go horribly. They have huge cost overruns.
Acquired
Lockheed Martin
The C-5, at least, I think does ultimately become a good airplane, but costs way more than the initial bidding. All of this conspires that, especially post-Vietnam period, the American public starts to view Lockheed as this corrupt vampire octopus military industrial complex, squid sucking on America. Things get real bad.
Acquired
Lockheed Martin
enters the war, the British Royal Air Force ends up buying about 3,000 of these Hudsons from Lockheed.
Acquired
Lockheed Martin
Lockheed's finances at the same time are so bad, they need a bailout from the government. So the government has to guarantee a $250 million loan to Lockheed to keep them afloat, mostly because of the L-1011 disaster. It requires a vote of Congress to do this. It almost doesn't pass. This is real bad. Hmm.
Acquired
Lockheed Martin
It got real, real dark. And again, it was only the profits from LMSC that kept the company from probably going under.
Acquired
Lockheed Martin
Or a ball bearing, famously. Or a ball bearing. So that Skunk Works employee was then 36-year-old Dennis Overholzer. who was a mathematician. And he, like you said, reads this paper and brings it to Ben Rich, who just six months earlier had taken over from Kelly as head of Skunk Works.
Acquired
Lockheed Martin
And even Kelly himself, he's retired, but he stays on as an advisor. So he still has his fingers in everything. He's so disillusioned at this point. He tells Ben Rich, he says, don't even pursue this. It's not worth it. Missiles are where the future is. Nobody's making planes anymore. Don't invest the money on this.
Acquired
Lockheed Martin
He's such an aesthetic snob. He's like, that's not an airplane. We can't make it. It doesn't look beautiful.
Acquired
Lockheed Martin
Yes. Also correct. Or, well, I think the bigger problem was less about lift, although I'm sure that was a problem, but more about could you control it?
Acquired
Lockheed Martin
So then once the U.S. enters the war, and as they're gearing up to enter the war... Kelly designs the amazing P-38 Lightning Fighter, which was the US's elite, fastest, most maneuverable aircraft during World War II. They made over 10,000 of them during the war, and all of the top aces in the US Army Air Corps flew them.
Acquired
Lockheed Martin
Yes. You know what this thing looks like if you aren't already intimately familiar with images of it? I actually think it looks really cool. Totally.
Acquired
Lockheed Martin
Totally. To me, it looks like the planes in the first Star Fox game for the Super Nintendo when... Nintendo and other 16-bit game developers during that generation were trying to make 3D games with 16-bit hardware, and you didn't have enough processing power and polygonal power to make rounded shapes, so you had to have flat surfaces.
Acquired
Lockheed Martin
Big-ass triangles. That's what this thing looks like. It literally looks like a, not a Star Fox 64, a Star Fox Super Nintendo plane.
Acquired
Lockheed Martin
Yeah, and take a risk and make this. So he goes to the Air Force. The Air Force says, well, you know, on the one hand, your timing is good. We actually also think stealth technology is worth pursuing. We have an active RFP out there. We didn't come to you guys because Skunk Works hasn't made a fighter plane in God knows how long. You guys just had layoffs. We don't like the Blackbird.
Acquired
Lockheed Martin
Sorry, you guys are old news. And Ben Rich, like you said, he risked his career six months into the job pursuing it at all. He risks it even further. He goes back to Lockheed Corporate and says, I want to pursue this and make a prototype immediately. anyway without a research contract. We're going to fund this internally.
Acquired
Lockheed Martin
It's so funny reading, less so in the early history, but when you read about Lockheed today and the industry today, there's all this talk of the customer. The customer, there's only one customer. The DOD. The DOD is the customer. It's like the Amazon, like, oh, the empty seat for the customer in the room. It's not a metaphorical customer. It is a specific customer.
Acquired
Lockheed Martin
And this is how crazy this situation is. It is literally the opposite of what you just said. This is Ben Rich's neck on the line. This is Skunk Works on the line. This is everything. So they go and they build a prototype. It's nicknamed the Hopeless Diamond. The code name is Have Blue, H-A-V-E-B-L-U-E. And I mentioned ball bearings earlier. They make a model of this thing, a wooden model.
Acquired
Lockheed Martin
They put it up on a pole. They test it in a radar range alongside the other prototypes from other contractors for a stealth fighter that the Pentagon has put out. And this thing is invisible.
Acquired
Lockheed Martin
The way that the Air Force inspectors come up with testing it is they get a set of ball bearings of increasingly smaller diameters, and they attach them to the nose cone of the wooden model at the radar range. And they see if you can detect the ball bearing or if it's blacked out by like this massive plane model behind it.
Acquired
Lockheed Martin
It was the plane that shot down the transport that was carrying Japanese Admiral Yamamoto, the guy who had kind of masterminded and overseen the Pearl Harbor attack. This is a legendary airplane.
Acquired
Lockheed Martin
And they can detect a ball bearing down to a diameter of an eighth of an inch. So the radar signature of this plane is less than an eighth of an inch sphere.
Acquired
Lockheed Martin
Yeah. So out of that, the Dark Horse Skunk Works wins the contract to build the Air Force's stealth fighter. They do. They solve the challenges you just mentioned, and they solve them with computers.
Acquired
Lockheed Martin
For the first time, or at least that we know of really, the first time in Skunk Works history, the way you control this thing is with fly-by-wire, which I'd heard that term before, but fly-by-wire means that the plane's systems are controlled by a computer, and when you move the controls as a pilot, you are not directly moving the mechanics. The computer decides how to translate your intentions
Acquired
Lockheed Martin
Well, yeah, it's even more than... It's like doing all sorts of stuff that you have no idea. Right. To make it do what you want to do. Right. I mean, it's a Tesla, basically.
Acquired
Lockheed Martin
Yeah. So they win the contract. They start testing this thing at, of course, Area 51. And the stealth fighter really looks like an alien spaceship. So, like...
Acquired
Lockheed Martin
I don't blame them either. The Air Force starts taking delivery in 1983 of the stealth fighter from Skunk Works. They ultimately buy 59 of them, of the F-117A Nighthawks, at $43 million each. So that is $2.5 billion in revenue for a Lockheed. A time when they desperately needed it and Skunk Works desperately needed it. Huge win for Ben Rich. Huge win.
Acquired
Lockheed Martin
The real combat debut for the Nighthawk is during the Gulf War, during Operation Desert Storm.
Acquired
Lockheed Martin
Well, where are they going to use it? We're not really fighting any wars. And this is a fighter. This isn't a reconnaissance plane. This is a fighter slash tactical strike plane. Which, again, Skunk Works hasn't built one of those since, I guess, what, the 104 Starfighter?
Acquired
Lockheed Martin
So the plane is never really tested in combat of what it can do until Operation Desert Storm. And I remember watching this live when this happened. I don't know if you remember this, Ben, but I vividly remember when this happened. the first night of the war, Operation Desert Storm. I mean, this is broadcast live to the world.
Acquired
Lockheed Martin
The US Air Force completely knocks out all of Baghdad's defenses and infrastructure. And the way they do it is with the Nighthawks.
Acquired
Lockheed Martin
Yeah, so a few quotes here that are in Skunk Works. First, from the Secretary of the Air Force at the time, we learned that night, the first night of the Gulf War, and for many nights after that, that stealth combined with precision weapons constituted a quantum advance in air warfare.
Acquired
Lockheed Martin
Ever since World War II, when radar systems first came into play, air warfare planners thought that surprise attacks were rendered null and void and thought in terms of large armadas to overwhelm the enemy and get a few attack aircraft through to do damage. Now we again think in small numbers and in staging surprise, surgically precise raids.
Acquired
Lockheed Martin
And then another quote here from one of the pilots that flew that night. To put it in domestic terms, if Baghdad had been Washington, that first night we knocked out their White House, their Capitol building, their Pentagon, their CIA, their FBI, and took out their telephone and telegraph facilities.
Acquired
Lockheed Martin
We damaged Andrews Air Force Base, Langley, and Bolling, and we punched big holes in all the key Potomac River bridges. And that was just the first night. So this thing is deadly. The Nighthawk very much worked. The Nighthawk flew 1% of the air missions in Desert Storm, but accounted for 40% of all damaged targets.
Acquired
Lockheed Martin
This is the incredible paradox of this. The most overwhelming and terrifying weaponry ever created and weapons capabilities ever created was never used and was created so that it would never be used.
Acquired
Lockheed Martin
Wow. Crazy. Yeah. Let's just divorce any value judgments here for the moment. In terms of the airplane itself and Lockheed and Skunk Works and the company, while Desert Storm was, on the one hand, this great success story for the airplane... There's also kind of the end. That's the end of the Cold War. Yep.
Acquired
Lockheed Martin
There is no doubt after Desert Storm and all the other things that happened and the falling of the Berlin Wall by the early to mid-90s, it's done. And this success of the Nighthawk and success of the U.S. military from a military standpoint during the Gulf War You know, that sets the conditions to bring us to the modern era and Lockheed today, which is not Lockheed, but Lockheed Martin.
Acquired
Lockheed Martin
Right. And Northrop, which is not Northrop, but Northrop Grumman, and which very closely almost was part of Lockheed Martin. Yeah. But got blocked by the DOJ?
Acquired
Lockheed Martin
So the Gulf conflict, I think, ends in 91, I believe. And it becomes really obvious that the Cold War era of arms buildup in the U.S. is over. And defense budgets are going to shrink massively. Yeah.
Acquired
Lockheed Martin
Right. And everybody in the industry knows it, and then it becomes super explicit. This is kind of an amazing event that happens. In July of 1993, the then Deputy Defense Secretary William Perry calls the CEOs of all the major prime defense contractors to a dinner in Washington. at which he explicitly tells them defense spending is going to shrink massively. Duh, you know that.
Acquired
Lockheed Martin
Okay, so that was kind of Lockheed and Kelly during the war. Fast forward now to kind of the waning days of World War II, end of 1944 into 1945. It's pretty clear that America and the Allies are going to win the war at this point in time. But it's also becoming evident that there are two big problems that are emerging. One very immediate and one sort of longer term.
Acquired
Lockheed Martin
And he instructs the CEOs present that you all need to consolidate and start merging with one another. We, the Defense Department, are no longer going to be able to feed all of the metaphorical mouths at this table. And the CEO of then Martin Marietta, soon to be Lockheed Martin, refers to this dinner, tongue-in-cheek, as the last supper. And indeed it was. This is an amazing event.
Acquired
Lockheed Martin
American industry, and I think as we saw during the Cold War era, era, America functions on competition and thrives in competition. And here the government is saying less competition.
Acquired
Lockheed Martin
Yep. So this sets off an amazing series of events, kind of similar to hearkening back to the LVMH episode when Louis Vuitton and Moet Hennessy merged, not because they liked each other or because there was a business reason. They merged for, like, practicalities and to avoid dying and getting taken over by hostile raiders.
Acquired
Lockheed Martin
In 1993, Lockheed buys General Dynamics' fighter jet business that we already talked about, the F-16 business. And then in 1994... The big shoe drops. They announce a, quote, merger of equals with Martin Marietta. That goes through in 1995.
Acquired
Lockheed Martin
So the assets that do merge of Lockheed and Martin in January 1996, shortly after the big merger goes through, they then acquire the defense business from Loral for almost $10 billion. And then, as we said a minute ago, in July 1997, they attempt to merge with Northrop Grumman.
Acquired
Lockheed Martin
The immediate problem is that in the skies over Europe, in the air theater of the European front, A new technology is appearing on the German side. Jet-powered fighter planes have begun to pop up. And we're not a military history podcast. Save this for Hardcore History and Dan Carlin. But my understanding of this is that the German jet fighters entered the war too late to make a difference.
Acquired
Lockheed Martin
Yeah. They misread the tea leaves on that one. That merger gets announced. Everybody's signed off. The DOJ blocks it, I assume, with tacit approval from the DOD on that.
Acquired
Lockheed Martin
Would have been so fitting, right, given that Northrop was a co-founder of Lockheed. But all the way back to the beginning of the episode. So the DOJ blocks that. But also in 1997, Boeing merges with McDonnell Douglas and becomes the giant that it is now.
Acquired
Lockheed Martin
Yeah, that was probably the end of McDonnell Douglas once they got eliminated.
Acquired
Lockheed Martin
Do you know the size of the F-35 Joint Strike Fighter program, like in terms of dollars?
Acquired
Lockheed Martin
So yeah, if you lose this contract, this is literally life or death whether you get this or not. Right. So losing this creates some extreme combination. And obviously this sets the stage. I'm going to hand it over to you in a minute to lead the discussion of all the dynamics around this and the military-industrial complex and defense contractors today. But...
Acquired
Lockheed Martin
To set the stage, I have a few quotes from Norm Augustine, who was CEO of Martin Marietta. When the merger happens and Dan Tellop, the CEO of Lockheed, is the first CEO of the combined company. Dan came up through LMSC, started there, worked in LMSC for decades, and then became the CEO of Lockheed. He's the first CEO of the combined company, and then Norm takes over for a few years after that.
Acquired
Lockheed Martin
In 1997, Norm is a character. He's a serious character. He writes a Harvard Business Review article. I want to read a few quotes from this. Following the Last Supper, which he termed it the Last Supper, it became evident that there were only two potential survival strategies. One was to move into new markets—he's meaning commercial markets—
Acquired
Lockheed Martin
A difficult and time-consuming option that has rarely succeeded. And as we talked about, definitely Lockheed tried that in the 70s and failed miserably with the L-1011. The other strategy entailed something almost as difficult, increasing market share in existing markets during a period of severely declining businesses. This is what we're talking about. And he says, here's what happened.
Acquired
Lockheed Martin
He just lays it all out here. Lockheed soon purchased General Dynamics aircraft business and Martin Marietta purchased General Electric's aerospace business. All told, our company comprises 17 previously independent entities, like independent until recent times as he's writing this.
Acquired
Lockheed Martin
General Dynamics, Sanders, Gould Ocean Systems, GE Aerospace, RCA Aerospace, Xerox Electro-Optical Systems, Goodyear Aerospace, Fairchild Westin, Honeywell Electro-Optics, Ford Aerospace, Libroscope, IBM Federal Systems, Unisys Defense, Lockheed, Martin Marietta, and L'Oreal. What a Franken-company. As we've been alluding to, these were not very profitable entities.
Acquired
Lockheed Martin
So Lockheed at the time of the merger did $13 billion in revenue and only $422 million in net income. Martin Marietta was slightly more profitable, did $9.4 billion in revenue and $450 million in net income. So both of these are like 10% or less net income margins.
Acquired
Lockheed Martin
But if they had entered service earlier, it would have been a big problem. So the U.S. and the allies, they're like, oh, crap, we need to step up our game and get a jet fleet in service for us ASAP.
Acquired
Porsche (with Doug DeMuro)
It's interesting, right? Like, I mean, you're Doug DeMuro. You own a Carrera GT. You don't own a Macan.
Acquired
Porsche (with Doug DeMuro)
There's a bunch of dark stuff. Everything, Doug, you mentioned earlier, forced labor, concentration camps. This was the Nazi war effort. It all happened. We're going to skip over this period for our purposes today, but note, it happened. After the war, though, a whole bunch of really interesting stuff happens that basically...
Acquired
Porsche (with Doug DeMuro)
fractures and separates out the Volkswagen operations from the Porsche operations for the next, the rest of the century and into the 21st century. So ironic, given that they are now one company again. Right. First off, where are they? Well, where are they? That's the question.
Acquired
Porsche (with Doug DeMuro)
Going into doing this episode, I sort of wondered in the back of my mind, has Bernard Arnault and LVMH ever made a run at any of these luxury auto companies? And if they have not, maybe this is the reason why. Like they're just in a better business.
Acquired
Porsche (with Doug DeMuro)
Yeah, they definitely, especially relative to Ferrari, have scale economies being part of the VW group. Right. That they can be in SUVs in a way that Ferrari can't.
Acquired
Porsche (with Doug DeMuro)
Yeah, I think that... is a differentiating factor against Ferrari, but obviously lots of other car brands are in the SUV business.
Acquired
Porsche (with Doug DeMuro)
Yes. So first on the Volkswagen side, I alluded to this a minute ago, it's a pretty amazing story what happens. Because you would think like there's no way, you can't imagine that Volkswagen would survive post-World War II given what we now know the origin of the company. So what happens is Wolfsburg ends up in the hands of the British at the end of the war.
Acquired
Porsche (with Doug DeMuro)
And does that, I think for a long time, that expressed itself in reliability of Porsches relative to other luxury car manufacturers, right? Today, is reliability as much an advantage for Porsche as it was in the past relative to other brands?
Acquired
Porsche (with Doug DeMuro)
No, like there's there are like they're not making any more heritage automotive brands.
Acquired
Porsche (with Doug DeMuro)
Maybe. I mean, like the there is never going to be another situation where the link between racing and production cars is like it was when Porsche was getting started.
Acquired
Porsche (with Doug DeMuro)
Porsche ads have been some of the most iconic just brand advertising of all time.
Acquired
Porsche (with Doug DeMuro)
I'm thinking of two in particular. Do you have any particular favorites?
Acquired
Porsche (with Doug DeMuro)
So good, so good. The other one that I'm thinking of is, nobody's perfect.
Acquired
Porsche (with Doug DeMuro)
And there's this whole crazy thing in Germany of like all the allied armies are coming in and literally Germany and Berlin ends up getting split into East Germany, West Germany, East Berlin, West Berlin. Wolfsburg is in the hands of the British. Remember, because it was a political organization, it wasn't a company before the war. Nobody owns it. It's this orphaned organization.
Acquired
Porsche (with Doug DeMuro)
For me, the racing thing is interesting, even though we didn't spend that much time on the details of it throughout the history. I don't know that we've covered any other companies where there is this kind of like adjacent activity to the core business of the company that adds so much to the brand value and is worth investing in. I'm just trying to think if there's anything else like this.
Acquired
Porsche (with Doug DeMuro)
But I mean, Porsche has invested billions in racing. In all sorts of racing. But it's not like there's software competitions out there that you could enter your software in to build your brand prestige.
Acquired
Porsche (with Doug DeMuro)
You know what is like this? Is the athletic apparel industry and Nike. Like they spend all of their marketing budget on athletes.
Acquired
Porsche (with Doug DeMuro)
It's super unclear. There's no proprietorship of it. The initial plan that the British come up with, they were going to dismantle the factory and ship it over to Britain and essentially have Britain appropriate the Volkswagen technology and operations. The Beetle was almost a British car.
Acquired
Porsche (with Doug DeMuro)
It gets back to the 40, 50-year sales cycle with this, too. Right.
Acquired
Porsche (with Doug DeMuro)
Right. Doug, you've talked about this when you worked at Porsche a decade ago and you were much younger. Like... they didn't pay you much, but you got to drive a 911. And that was like the coolest freaking thing.
Acquired
Porsche (with Doug DeMuro)
We simplified this down to, um, to, to just three categories for the acquired Doug score. Um, revenue growth, profitability, and defensibility. Like, would you want to own Porsche as a stock? And I think those are the three components.
Acquired
Porsche (with Doug DeMuro)
All right, so let's do revenue growth first. Growth has been impressive at this scale, not at the rate of the highest growers that we have seen, but still nonetheless impressive. Prospects going forward, though, for revenue growth, I think are still quite strong. We're obviously in a very different market environment than we have been the past few years, but...
Acquired
Porsche (with Doug DeMuro)
Porsche is incredibly well positioned on EVs relative to other traditional manufacturers.
Acquired
Porsche (with Doug DeMuro)
Yep. So I think there's strong, as they electrify the rest of their lineup, strong bull case for revenue growth there. I also think that even as we're heading into a more depressed macro environment than the past few years, I suspect Porsche will be more resilient in their growth than other luxury brand manufacturers. So I give it a seven on revenue growth potential.
Acquired
Porsche (with Doug DeMuro)
Yeah, totally. Ferrari really isn't a league of its own, though. The broader universe of BMW, Mercedes, all the Japanese brands, Tesla, et cetera, in America, Ford, you know, all the Ford brands, the Chevy brands.
Acquired
Porsche (with Doug DeMuro)
Seven out of 10. Yep. Next is profitability. Quite, quite strong for the automotive industry.
Acquired
Porsche (with Doug DeMuro)
Very strong. Not strong relative to the technology industry and software or Apple.
Acquired
Porsche (with Doug DeMuro)
And I believe Porsche's operating margins are in the high teens, low 20s.
Acquired
Porsche (with Doug DeMuro)
When you're earning $40 billion. Yes, that's a great business. I think I'd go seven again on profitability.
Acquired
Porsche (with Doug DeMuro)
Wow. Wow. Wow. So, okay, the British government kind of lacked vision for this. But a singular British person did see the vision for this. And that is the officer who was in charge of the territory where the factories were, like on the ground, managing it. Major Ivan Hurst, a legendary figure in Volkswagen history. Yeah. He finds one of the pre-war production Beatles, the 200 that were made.
Acquired
Porsche (with Doug DeMuro)
I think that's right. So my barometer for this is something I took from the LVMH episode of evaluating brand power. Can you kill it? Is there anything that could happen that would completely kill Porsche? I don't think so. Nothing that they would realistically do. I mean... But even, okay, let's say they did. Because, you know, this is what we learned from the LVMH episode.
Acquired
Porsche (with Doug DeMuro)
Gucci, everything you could think of to kill a brand, they did that. But the heritage there, it can always be resurrected.
Acquired
Porsche (with Doug DeMuro)
And once you reach that level, that's when you have real brand power. Yeah. And I think Porsche is at that level. Because let's say they make a bunch of decisions and they kill the company. It goes bankrupt. Somebody will buy it out of bankruptcy.
Acquired
Porsche (with Doug DeMuro)
All right. 10 out of 10. So that gives the acquired Doug score for Porsche a 22 out of 30.
Acquired
Porsche (with Doug DeMuro)
Which, by Doug grading standards... The Doug score stands pretty good.
Acquired
Porsche (with Doug DeMuro)
Your highest Doug score ever is 72 or 74, something like that. Somewhere in that range.
Acquired
Porsche (with Doug DeMuro)
do this we will we'll do the same thing you do but like i didn't know there was a platform for it i'd we just call the hotel and see what you're like oh hey yeah or we'll book a massage at the spa and be like oh and then with the massage you get the like right but now i'm just analog resort pass over there you're like the carrera gt of resort pass Oh, great.
Acquired
Porsche (with Doug DeMuro)
My carve out is I go down these YouTube rabbit holes, which is probably how originally I got to you. But I've been on a Seinfeld cast interview rabbit hole. And there is an amazing compilation of all four of the cast members doing Charlie Rose interviews. And he was so good. I mean, problematic person, but like he was one of the legendary best interviewers of all time.
Acquired
Porsche (with Doug DeMuro)
And he did a bunch of interviews with all four of them. Surprisingly, naively for me coming in, Jason Alexander is by far the best interview. He is so articulate, like incredible.
Acquired
Porsche (with Doug DeMuro)
He is... You would never know because he's so different than the George character.
Acquired
Porsche (with Doug DeMuro)
He starts driving it around and he's like, hey, this thing's actually pretty good. I think we can maybe do something with this here. He also sees, and this becomes increasingly obvious as the post-World War II state of world affairs takes place here in Germany of like, hey, the Cold War is about to start. He realizes that West Germany needs an economic revitalization here.
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Porsche (with Doug DeMuro)
Right. And then, like, you must be, you've talked about this a lot, that, like, you feel, and we're gonna do a whole other episode of just you and us chatting, but... That, like, you started at a time, and we started at a time where you didn't have to do this stuff.
Acquired
Porsche (with Doug DeMuro)
You know, the short version is like you are one of the most successful YouTubers in the world. You are also an entrepreneur who built a tech marketplace, internet marketplace business, and just took a very large investment from The Churning Group, one of the best investors in marketplace and content businesses out there. Incredibly impressive.
Acquired
Porsche (with Doug DeMuro)
Thank you for spending so much time with us doing this collab. This has been super fun. It's really rare that we get to chat with somebody who is not an executive at the protagonist company. And also deeply gets both the products and the kind of business aspect of something. I don't think there's anybody else we could have done this with. Maybe Vita King himself.
Acquired
Porsche (with Doug DeMuro)
We need to restart German industry because, hey, the Iron Curtain is falling just to the east here. So he amazingly proposes and convinces the British command
Acquired
Porsche (with Doug DeMuro)
Yeah, or Avla Koli, the CEO of AngelList. That was a great conversation with him. We had David Hsu from Retool.
Acquired
Porsche (with Doug DeMuro)
To leave the factory in wolfsburg may be easier than I thought because the british didn't want it apparently And also to place an initial order a seed order to restart the company for 20 000 beetles That the british military is going to adopt and use as their main military transport So not as like a tank, but like not an armored beetle, but like they're going to use it to drive officers and stuff around yeah from that seed order like
Acquired
Porsche (with Doug DeMuro)
that is now the new Volkswagen. So it's like, yes, Hitler started it, but then Ivan Hurst restarted it.
Acquired
Porsche (with Doug DeMuro)
Yeah. Super interesting. So that's Volkswagen. But put a pin in them. We'll come back to them in about 50 years. Because there's a lot more to say on Volkswagen.
Acquired
Porsche (with Doug DeMuro)
Yes. The new Beetle would get introduced, I think, in 1998. And the first ones post-war were made in like 1948. So yeah. Crazy. Crazy. Isn't that wild? It's insane. Okay. So what about Porsche? Well, they have a bit of a different path.
Acquired
Porsche (with Doug DeMuro)
He designed the elephant anti-tank tank, the most powerful land-based tank ever created. A, terrible, but B, like just the range of design talent that he had. Like he designed the beetle and he designed the largest anti-tank tank ever created.
Acquired
Porsche (with Doug DeMuro)
He was a genius. This is also, it runs in the family too. Many of his descendants are both engines and cars geniuses. After the war, Ferdinand and the son-in-law, Anton Piège, are both arrested by the French as war criminals. Tried in France, they end up being imprisoned for two years in France. And Ben, you did a little research on that.
Acquired
Porsche (with Doug DeMuro)
Quick two-year trip. Out of war criminal prison. Yeah. So, Ferdinand's son, Ferry Portia, who had been working in the business, I think a little bit before the war and then during the war, too. He's also arrested for war crimes, too, at the end of the war. He gets released after six months in the summer of 1946. And he and his sister Louise are like... What are we going to do?
Acquired
Porsche (with Doug DeMuro)
You know, we got to rebuild the family. Are we going to restart the business? Let's go figure things out. They return to the family's kind of ancestral home in Austria. And that happens to be quite convenient because during the last days of the war, as Stuttgart and other large-scale German military production facilities were getting bombed by the Allies,
Acquired
Porsche (with Doug DeMuro)
porsche took about 20 or so of the best most talented engineers and production people that they had and they moved them out of stuttgart and they moved them to the austrian countryside so that they wouldn't be you know targeted by the so that the allied bombers wouldn't know where they are and uh this is pretty crazy they are literally operating
Acquired
Porsche (with Doug DeMuro)
out of a sawmill in a farming village in southern Austria named Gmund. We're talking about like a couple thousand people maybe that live in this area.
Acquired
Porsche (with Doug DeMuro)
So there is this incredible history of Porsche called Excellence Was Expected. that was written by Carl Ludwigsen. And we have to owe a big thank you to him for the research for this episode. This work is like, I mean, the photos, the archive work that are in this volume, it's incredible.
Acquired
Porsche (with Doug DeMuro)
you want a visual history and so it's not like there's audiobooks and kindle books that we could do our normal amount of research on all this stuff is in these like huge heavy bound pictorial books these are amazing objects that like are being produced there's just such a like um like visceral tangible quality to them that is that we don't usually cover unacquired right okay so ferry and louise
Acquired
Porsche (with Doug DeMuro)
go back to Austria. They're there in Gmünd. And they're like, well, what if we start a new company and see what we can do around here? I mean, there's some vehicles we can start fixing. This is literally like the Sony story. If you remember when Sony first got started in Tokyo at literally the same time, they started by fixing radios. Yeah.
Acquired
Porsche (with Doug DeMuro)
The second Porsche company, Porsche Construction in GmbH, which is an Austrian company that they start to do this. They start up fixing old military vehicles that are around there in Austria. Unlike Sony in Tokyo, though, where there were a lot of radios in Tokyo, there weren't a lot of cars in Gmünd. So pretty quickly, they're like, huh, we don't have any more cars to fix up. Bad business. Yeah.
Acquired
Porsche (with Doug DeMuro)
Well, not a large market, shall we say. At this point, Ferry has an idea, and it turns out it's a pretty damn good one. He definitely liked and agreed with his father's vision for a small car, a car for the masses, a Volkswagen. Yeah. But he always had one major problem with the Beetle, which was that it was slow. And it just was not fun to drive.
Acquired
Porsche (with Doug DeMuro)
So during the war, he actually had a custom Beetle made that he drove during the war with a supercharged engine. And Ferry said later in a 1972 interview, I saw that if you had enough power in a small car, It is nicer to drive than if you have a big car, which is also overpowered. And it is more fun.
Acquired
Porsche (with Doug DeMuro)
On this basic idea, we started the first Porsche prototype to make the car lighter and to have an engine with more horsepower.
Acquired
Porsche (with Doug DeMuro)
I went in research when I looked up, you know, some of those sports cars pre-Porsche. And you look at them and things are like Franken cars. They are huge. Right. And the engines are like the engine bays in the front of the cars are two thirds of the length of the car. Right. There's this one Ferrari from that era, and I look at it, I'm like, how do you even steer this thing?
Acquired
Porsche (with Doug DeMuro)
It literally forced more air in. Yeah. And then I don't think turbos had been invented yet. And turbos would obviously become a big thing for Porsches much later.
Acquired
Porsche (with Doug DeMuro)
Those couple years after the war when everything was kind of getting figured out. Yep. So Ferry has this idea. He's like, oh, I liked driving my supercharged Beetle. This was really fun to have a small car that also had a lot of power in it. What if we take this small operation of our, you know, elite team here in Gamund and we try and build a car that does that?
Acquired
Porsche (with Doug DeMuro)
And hey, it also, you know, turns out that, well, we built the Beetle. So we know how to work with the Beetle. There are a bunch of Beetle parts around. The Beetle was the main kind of chassis platform for a lot of military vehicles for Germany during the war.
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Porsche (with Doug DeMuro)
I think that even though it's a marketing phrase, the German engineering thing, it's worth sharing a little bit of history because it is more than just a marketing phrase. So there's a pretty long and incredible history of science and engineering in Germany and Austria. It goes all the way back to the scientific revolution and Johannes Kepler.
Acquired
Porsche (with Doug DeMuro)
what if we take a lot of those parts and um the basic architecture of the beetle which is a rear mounted air cooled engine on a small car and we try and put something together here and this becomes the legendary porsche 356. for some context on this you can buy an old beetle today for I don't know, $10,000, $15,000 at auction, maybe even a beetle, like a classic one from the 50s or 60s.
Acquired
Porsche (with Doug DeMuro)
356s regularly sell for about $300,000 at auction, and special ones go for well, well, well above a million. This is a big idea. The gulf between a beetle and a 356 is large.
Acquired
Porsche (with Doug DeMuro)
Yeah, this was another thing. So obviously, in Gemund and then even when Porsche moves back to Stuttgart here in a minute, their production capability is not nearly as large as Volkswagen. So they need to price these things pretty high. They price them at $3,750, the German equivalent of $3,750 in the late 40s. That's about $42,000 today.
Acquired
Porsche (with Doug DeMuro)
But we're talking about war-torn Europe that you're trying to sell this in. Like, that's a lot of money. Here's the crazy thing. There's a market for that. Even in war-torn Europe, for a $40,000 sports car, there are enough people who, it turns out, are interested enough in Ferry's vision for a small, fun, fast sports car.
Acquired
Porsche (with Doug DeMuro)
So that takes us to the late 40s here. They're starting to produce the 356 in Gimun. At the end of 1947, Ferdinand Porsche and Anton Pietsch get released from French prison. They come back to Austria, the families all together, and they kind of got to decide what to do here. Right around that same time, Volkswagen's getting back up and running, you know, Hearst is running it.
Acquired
Porsche (with Doug DeMuro)
It's like the vision they're going to, you know, make the Beetle for Germany and for the world. They come back to the Porsches and they say, hey, we still want to do business with you.
Acquired
Porsche (with Doug DeMuro)
And actually, before World War II, Germany had produced more Nobel laureates in scientific fields than any other nation in history. the world. Folks like Max Planck, Erwin Schrödinger, Kurt Godell, and, you know, Albert Einstein. These are all German and Austrian scientists. And this tradition extends also, of course, to the auto industry.
Acquired
Porsche (with Doug DeMuro)
And in fact, we actually want to expand the scope of our business with you guys even more than it was before the war, because we could still really use, you know, technical design, consulting work and really leadership from you individual Porsches here at Volkswagen. I mean, after all, you designed the Beetle.
Acquired
Porsche (with Doug DeMuro)
Two, though, now, you know, we're not a government organization in the same way anymore, but We need distribution. And you guys have this new Austrian Porsche company that you've set up. So how about this? They propose two things. One, they say, let's reinstate that old German Porsche company, the doctor, engineer, honoris causa, blah, blah, blah. We'll recreate the German Porsche company.
Acquired
Porsche (with Doug DeMuro)
It'll resume doing the technical design and consulting work for us here at Volkswagen. In return, they give that German Porsche company literally the sweetheart deal of a lifetime, a royalty on every Beetle sold worldwide. No way. Yes, yes. This is how intertwined these two companies are.
Acquired
Porsche (with Doug DeMuro)
Okay. But Ben, you're on the right track. This is a hell of a sweetheart deal for the Porsche family. I mean, you are right to be saying, why would the German government do this? Do you know what kind of royalty? It was enough that it was... It was very meaningful, very meaningful cash flow.
Acquired
Porsche (with Doug DeMuro)
Nobody knew that the Beetle was going to become the international hit that it would. But also the German government did know that this was a lot of value. And they also may or may not have known that on the Austrian Porsche side for the dealership distribution side, that was also a lot of value.
Acquired
Porsche (with Doug DeMuro)
So we're not going to talk as much about the Austrian operations of Porsche for the rest of the episode, but it becomes a huge business. So by the time in the early 2000s, when it all gets consolidated back into one company, For most of the two separate histories, that was the larger company by revenue.
Acquired
Porsche (with Doug DeMuro)
So the Austrian Porsche company becomes the largest car dealer network in Europe, not just for Volkswagens, but for all types of automotive brands. They're doing billions of annual revenue within a few years here.
Acquired
Porsche (with Doug DeMuro)
Exclusive distribution rights to Volkswagens. And they're in countries not just in Austria. They're all over the place. Yeah, they're all over the place in Europe. And even more incredibly, so what the family decides is that Ferdinand and Ferry, the original Ferdinand and his son Ferry, they're going to move back to Stuttgart and retake over the kind of German operations of Porsche.
Acquired
Porsche (with Doug DeMuro)
Louise and Anton, the son-in-law, they're going to stay in Austria and run this dealership business. Anton dies in 1952. And Louise is the one who builds this business. Like Louise and her children turn that into this huge, you know, the largest car dealer network in Europe. Wow.
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Porsche (with Doug DeMuro)
So it is very likely that the first gas-powered transportation vehicle—this looked more like a predecessor of a car, was created by a German inventor in 1864 named Siegfried Marcus. And I say probably because nobody really knows because Marcus was Jewish and the Nazis destroyed all records related to him during the war. We're going to talk a lot about the Nazis here in in a minute.
Acquired
Porsche (with Doug DeMuro)
I think there also might have been a technical reason, which is even though this new Volkswagen was reconstituted as a company, It's only shareholders at this point in time were the German government. So both the national West German state and the state of Lower Saxony within West Germany, which still to this day holds 20% of Volkswagen, which is crazy.
Acquired
Porsche (with Doug DeMuro)
Yeah, they would IPO Volkswagen, I believe, in 1960 or 1961. So it was even though it was a company. it was a German national company. So to operate in other states, other countries in Europe, they probably needed third parties. Yeah. Wow. Yeah, wild, right? All right, listeners, this is a great time to talk about one of our big partners, ServiceNow.
Acquired
Porsche (with Doug DeMuro)
ServiceNow is the AI platform for business transformation, helping automate processes, improve service delivery, and increase efficiency. Over 85% of the Fortune 500 runs on them, and over the past few years, they've joined companies like Microsoft as one of the most important enterprise technology vendors in the world.
Acquired
Porsche (with Doug DeMuro)
Yeah, it's telling for the magnitude of this partnership to see Satya Nadella appearing in the keynote at ServiceNow's big annual event, Knowledge, last month.
Acquired
Porsche (with Doug DeMuro)
It's pretty awesome for both companies and especially awesome for enterprise users. So if you want to learn more about the ServiceNow platform and how it can work with your company's Microsoft services, go over to servicenow.com slash acquired. And when you get in touch, just tell them that Ben and David sent you. Okay, so Ben, you hit on this a minute ago. What the hell?
Acquired
Porsche (with Doug DeMuro)
Why is the new Western-controlled, West German, post-Nazi government giving this deal of a lifetime to these former Nazis?
Acquired
Porsche (with Doug DeMuro)
Yes, yes. to the German company. And then the Austrian company has exclusive rights to distribute it. It's a crazy deal. So here's what's going on. It actually, as crazy as it sounds, makes sense. So we talked about a minute ago the Iron Curtain and the Soviets. Like, It's so hard for us to remember now, but Germany post-war was ground zero for the Cold War.
Acquired
Porsche (with Doug DeMuro)
The battle against the Soviet Union was happening right there, right next door. And so for the West, reconstituting the West German industrial base was of paramount importance. So like the Marshall Plan that people probably know about, like this is why the Marshall Plan happened.
Acquired
Porsche (with Doug DeMuro)
And this is essentially part of this philosophy of like, we don't care that these people used to be Nazis, but for Porsche, for Mercedes-Benz, for lots and lots of German industrialist companies, the reason that they get restarted and re-injected with steroids, so to speak, is like, hey, we got an existential threat next door. We got to rebuild.
Acquired
Porsche (with Doug DeMuro)
The industrial base. Now, the deal that they give them does come with an implicit string attached, which is they basically say to Porsche and other companies, we're not really going to give you a license to print money. Instead, we will give you a license to essentially create enterprise value. So what West Germany does is they create one of the oddest tax incentive systems I've ever seen.
Acquired
Porsche (with Doug DeMuro)
So for ordinary people in West Germany post-war, the tax rate was very low the maximum amount of taxes that any normal person would pay would be like 15 20 of your income but for these new old industrialists above a certain income germany sets the marginal tax rate at 95 percent
Acquired
Porsche (with Doug DeMuro)
Either way, though, Germany definitely did create the first successful production consumer automobile. It was a vehicle called the Benz Patent Motorwagen, and that was made in 1885 by Carl Benz. I recognize that name, Benz. Indeed, you probably do, as do most listeners. Now, around the same time, another German inventor named Gottlieb Daimler sets up his own motor company.
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Porsche (with Doug DeMuro)
Yeah. Like people are complaining, oh, you live in California. Oh my gosh, you're paying 13% state income tax on top of federal. Like imagine if the marginal tax rate were 95%.
Acquired
Porsche (with Doug DeMuro)
You would just have no incentive to earn any additional dollars.
Acquired
Porsche (with Doug DeMuro)
and that's on the personal side, it's equally bad on the corporate side. Any profits are taxed. So what are they trying to do here? They're trying to incentivize capital reinvestment in the industrial base. So they're basically saying to Portia and others,
Acquired
Porsche (with Doug DeMuro)
set all this up and we are going to create all the incentives such that you will plow all of the money, all these royalties we're giving you from the Beatles, et cetera, into building up your production capabilities and investing in R&D and new models and et cetera, et cetera. And I mean, it sounds crazy on paper, but like, my God, it actually works. Like, it works really freaking well.
Acquired
Porsche (with Doug DeMuro)
Maybe. And I think they did. But as we'll see, Porsche becomes like it becomes pretty institutionalized there of like, don't take profits, instead reinvest them in new models and R&D racing to the great benefit of the brand. Yeah. So I mentioned one of the things that Porsche invests in over the years is race cars and racing. And this is super interesting. None of us are racing historians.
Acquired
Porsche (with Doug DeMuro)
That's a whole nother branch of the automotive industry. So here we're in the late 40s, early 50s. Racing in this era doesn't look at all like it looks today. It hadn't professionalized yet. So the line between consumer enthusiast car market and professional racing market was very blurry, very, very blurry. Right.
Acquired
Porsche (with Doug DeMuro)
And it turns out that even though manufacturers, including Porsche, would make special versions of cars for racing for Le Mans being the most famous race at the time, you know, and others around the world. It wasn't like you look at an F1 car today or you look at a Le Mans car like there is no connection between that and something you can buy.
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Porsche (with Doug DeMuro)
So a super obvious point to illustrate this is folks are probably, you know, known names like James Dean or Steve McQueen, these famous Hollywood actors that were known as like, you know, they did all these race car films. They were also professional race car drivers.
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Porsche (with Doug DeMuro)
Yeah. They competed in like real races in addition to being actors. Imagine Brad Pitt jumping into Le Mans.
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Porsche (with Doug DeMuro)
Yeah. They'd, uh... Well, I was about to joke they'd kill themselves. James Dean did kill himself in a Porsche 550 Spyder, which Porsche would make a kind of dedicated racing-type vehicle, although it was also a consumer production vehicle, the 550. That car... That never would have happened if Porsche wasn't incentivized to invest all their profits. Like, I mean, maybe you can say, like...
Acquired
Porsche (with Doug DeMuro)
the legendariness of that car. I mean, they sell for, what, $5 million plus today?
Acquired
Porsche (with Doug DeMuro)
Yeah. So back to racing, we were talking about the Spyder a minute ago. I got so excited about James Dean. But Doug, to your point, 356s in 1951 and 1952 win their class at Le Mans. They don't win it outright like other bigger, powerful cars win it outright, but they win their engine classes at Le Mans. And these are, you know, yeah, they're modified a little bit, but like...
Acquired
Porsche (with Doug DeMuro)
And then in the early 1900s, they have a model that they're producing, goes on to be quite popular. is named after the daughter of one of their biggest dealers in their dealer network. Of course, we are talking about Mercedes. I had no idea that's where the Mercedes name came from. Yeah. Yeah. Crazy. So Benz and Daimler end up merging in 1924, and thus Mercedes Benz is born.
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Porsche (with Doug DeMuro)
And I think this was pretty unique to Porsches at the time. Certainly, you could go buy Ferraris, and Ferraris competed and whatnot. But again, like we were talking about, Ferraris were a different thing. Yeah, it was a different one. These weren't 356s. And I think they were probably also a lot more expensive than $3,700 at the time.
Acquired
Porsche (with Doug DeMuro)
There's this great, great, great ferry Porsche quote about this, which he would say later about the 911. But I think this also applies in early form to the 356. The quote is, we have the only car that can go from an East African safari to Le Mans, then to the theater, and then to the streets of New York. And, like, that's such a unique thing, especially in this era.
Acquired
Porsche (with Doug DeMuro)
Yeah. I was trying to think of, like, what the right kind of other luxury brand analogy is. Porsche. Yeah. definitely is a luxury brand. It's not like we're, uh, making, uh, apples and oranges here. Um, it's kind of like a Rolex to me. Is that really good?
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Porsche (with Doug DeMuro)
There's also this like, you know, Porsche would, I think, probably advance this argument that
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Porsche (with Doug DeMuro)
But OK, you might be asking, what does this have to do with Porsche? Well, turns out quite a lot because in 1906, Daimler scores a pretty big win in this fledgling German auto industry when they recruit the current potting prize winner.
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Porsche (with Doug DeMuro)
So on the back of all this success and like James Dean and Steve McQueen and all this, as you would imagine, Porsches start to become quite popular in America. So in 1954, Porsche, which I don't think Ferdinand and Ferry like envisioned, like we're going to sell cars in America. This wasn't part of the business plan. But in 1954, Porsche sells 588 cars in the U.S.,
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Porsche (with Doug DeMuro)
which was 40% of their entire production for the year. And that 40% basically stays constant, goes way up for a while in the 70s and 80s, but kind of never dips below that. Like America is a huge market for Porsches.
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Porsche (with Doug DeMuro)
Well, part of it was the incredible success of the cars. A big part of it, too, was the royalty on the Beetles. That's a nice, steady source of cash flow that you can invest in your operation.
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Porsche (with Doug DeMuro)
So speaking of reinvesting, As we get to the 1960s, like the 356 is great. This is an amazing car. But it's kind of, I don't know, Doug, where you would put it. In my mind, it's kind of, it's not quite a modern car. It's like, it's like close, you know, it's not a Model T, but it's not a 911.
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Porsche (with Doug DeMuro)
So we're now in the 60s. Ford announces the Mustang. Jaguar's got the E-Type. Chevy comes out with the second generation Corvette, the Stingray.
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Porsche (with Doug DeMuro)
Yep. So, OK, in 1962, Ferry Porsche makes the decision like 356 is amazing, you know, rebirth of the company. We got to invest profits and replace it with a new model. So for a couple of years, Porsche had actually been working on a design for a sedan for a larger model. Seems heretical now. Right. People look at the Panamera. Right.
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Porsche (with Doug DeMuro)
The potting prize was for Austria's automotive engineer of the year to come be their new chief engineer at Daimler, one Dr. Engineer Honoris Causa Ferdinand Porsche. Now, the whole doctor, engineer, honoris causa thing, it's a bit of a red herring, although Portia, the person and the company would make quite a big deal about it. The dude never even finished college, let alone got a PhD.
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Porsche (with Doug DeMuro)
You know, it was actually going to be the second model of Porsche.
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Porsche (with Doug DeMuro)
China is why they make that car, but we'll get to that later. So the next generation of Porsches, Ferry's son Ferdinand, known as Bootsy, named Ferdinand, named after his grandfather, founder of Porsche, I was working in the company and he had been leading the body design for this larger sedan that Porsche was going to make. Ferry decides for a bunch of reasons that to cancel the sedan project.
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Porsche (with Doug DeMuro)
Um, probably the most important reason was, um, kind of, I don't know how much of this was government motivated and how much of it was just sort of like a cabal of like Mercedes and BMW. Like they were the sedan makers and, um, Porsche maybe could have challenged them, but it was like, hey, you know, they've got their turf. We'll keep our turf in sports cars and everybody will be happy here.
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Porsche (with Doug DeMuro)
Anyway, they decide to cancel the project and double down on sports cars. At the same time, Ferdinand Porsche Bootsy, the grandson, His cousin from the Austrian side of the family, Louis and Anton's son, also named Ferdinand, Ferdinand Piesch. He's also joined the company. These two young Turks, the grandsons Ferdinand are here in the company and Piesch is working in the engine department.
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Porsche (with Doug DeMuro)
So it turns out that he's a pretty brilliant engine designer. He comes up with, and I believe even as a young kid, Doug, you may know more about this history. I think he really was the one that led the development of the six-cylinder boxer engine for Porsche.
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Porsche (with Doug DeMuro)
Now, he didn't invent the six-cylinder boxer engine, but the engine that ends up in the 911 that is still to this day the model for the 911 engine comes from him, I think. He's working on it for a racing car project that ends up not coming together. Ferry says, okay, let's take these two kind of failed projects that, you know, the next generation's working on. Let's weave them together.
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Porsche (with Doug DeMuro)
Take the styling that Bootsy's done for the sedan. Take this amazing engine that Ferdinand has built for the racing operations. And let's see what happens when we put them together. And this is the birth of the Porsche 901. The 901.
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Porsche (with Doug DeMuro)
Well, this is why, Doug, I'm sure you do this. Oh, this is a famous story. I had no idea. I think most people have no idea. The 911 is only called the 911 because Peugeot, of all companies, had a trademark in France for any car with a model name of Peugeot. Any number, any Roman number with a zero in the middle and then any other number.
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Porsche (with Doug DeMuro)
Unbelievable. So, I mean, it makes sense. Porsche is like, well, what do we do? We can't really not sell in France. I mean, France wasn't like the biggest market, but it wasn't a small market for us.
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Porsche (with Doug DeMuro)
So a couple of details that I got on this from Excellence Was Expected. I believe, could be wrong on this, but I believe 901 was the name of the engine project that Ferdinand Pietsch was working on. And I think that's the origin of it. Two, yes, in Porsche lore, it's that like the reason these model numbers are like, these are the engineering projects that they start.
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Porsche (with Doug DeMuro)
But that's totally apocryphal. Like they jump around all the time.
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Porsche (with Doug DeMuro)
Yes. Going back to the very, very beginning of the consulting company, they started with type seven or project number seven because they didn't want to look like they were a brand new company. So like, oh yeah, we've already done six projects. This is project number seven. I forget who they were working for.
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Porsche (with Doug DeMuro)
It's exactly. So like, yes, the lure is that, you know, all of our projects have model numbers and like, yeah. BS.
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Porsche (with Doug DeMuro)
Well, I think it's really brilliant. I don't know how much this is intentional versus it's evolved this way with the brand. But to me, it's just so brilliant because... There is this tribe language to Porsches. If you see a 911, you know instantly that it's a 911. It is iconic. It's one of the most iconic designs in the world.
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Porsche (with Doug DeMuro)
Um, 1962 is when they start working on it. They first start selling it in 1964. They sunset the three 56 in 1965. And so 66 is the first year that's fully nine 11 for Porsche production. They sell almost 13,000 cars in 66, uh, which that's what w what did we say? 10, 12 years ago, they only sold. Yeah, 40% of their production.
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Porsche (with Doug DeMuro)
And that number of almost 13,000 911s they sell was 15% more than their best year with only the 356s. Doug, how would you characterize? What makes the 911 so...
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Porsche (with Doug DeMuro)
Yes. Nonetheless, he definitely was a badass engineer. And we're going to talk about all of the things, the amazing things that this guy creates. But we also got to state this up front, and this is as good a place as any. Ferdinand Porsche and many other folks in the family and in the early Porsche and Volkswagen, as we will see days, were also huge Nazis.
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Porsche (with Doug DeMuro)
Yeah. To my thinking, the flat six boxer engine, which was a great engine that Ferdinand Pietsch designed to go in this first 911. There's something like cool and unique to that, like we've been talking about the difference between Porsches and other cars here. This is a performance engine, but it's A six. Right.
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Porsche (with Doug DeMuro)
An average person can walk off the street, buy one, operate it. That's right. Drive to work, have a great time.
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Porsche (with Doug DeMuro)
Now, the 356, the old 356... It had four cylinders. And so now the 911 have six cylinders. And like you said, it's not a world-class, powerful, fast car, but it elevates the 356 into a much more, like, you can really achieve a lot more with this than you could with the 356s.
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Porsche (with Doug DeMuro)
This becomes super important from a business side for Porsche because they priced the 911 about 50% higher than they had the 356. Now, what they do at first, they realize this is going to create like a major price gap in our lineup here. We're going to lose a lot of customers by elevating. So they do a stopgap at the same time that they introduced the 911. They also introduced the 912.
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Porsche (with Doug DeMuro)
And the 912 is a 911 with the old 356 four-cylinder engine in it. So they essentially kneecap the – they downgrade the 911 to be the entry-level model. Only as a stopgap. They don't want to do this permanently. They sell about three quarters of the units are the 912s, the cheaper four-cylinder ones, and one quarter of their sales are the more expensive 911s.
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Porsche (with Doug DeMuro)
The profit margins, though, on the 911s are so much higher. So, Ferry starts thinking like, okay, and this was part of the plan all along, I think, let's create a whole new model. The old 356, we're going to bifurcate it. Our performance, real enthusiast customers who are willing to spend and that we're going to make great margins on those models, that's going to be the 911.
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Porsche (with Doug DeMuro)
Let's create a new car that can replace, can be the entry level Porsche. We'll eventually introduce the Boxster. 20 plus years later, it takes Porsche a while to really get to the perfect end state of this strategy here. But for this new car, Ferry says, hey, we're not really equipped yet to, to be running multiple lines as just us, Porsche, the company, we need a partner for this new car.
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Porsche (with Doug DeMuro)
And Ferdinand himself not just was a Nazi, but was a very close personal associate of Adolf Hitler. He was a member of the SS. And, you know, we're going to glorify him and many of these other folks here of their business and engineering contributions. But, like, that doesn't mean that these are good people. So keep that in mind.
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Porsche (with Doug DeMuro)
Let's turn to our good old friends at Volkswagen and jointly engineer and produce this new car with them. So in 1967, Porsche kicks off a joint project with Volkswagen to produce a new mid-engined roadster, which is a smaller, more compact car and mid-engined, not rear-engined, called the 914. And the idea is that they're going to make both a four-cylinder and a six-cylinder version of this.
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Porsche (with Doug DeMuro)
The four-cylinder version is going to be a Volkswagen. The six-cylinder version is going to be a Porsche. And Ferry puts his nephew, Ferdinand Pietsch, in charge of this joint project with Volkswagen, a very fateful decision, as we shall see. Now, what ultimately happens with the 914, there's a change in CEO at Volkswagen and the new CEO
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Porsche (with Doug DeMuro)
definitely sees the value in deepening the relationship with Porsche and specifically the relationship with young Ferdinand. So he wants to continue the project, but he's like, I actually don't think that a sports car makes sense in the VW lineup. Why don't we just have all of these?
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Porsche (with Doug DeMuro)
Yeah. The new VW CEO, he actually gets a pretty good deal out of this. So he deepens the relationship with Ferdinand. He gives the car fully to Porsche. But in exchange, VW takes over all of Porsche's distribution in America. Huge decision. Huge deal. Huge deal for VW.
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Porsche (with Doug DeMuro)
Well, if history were a straight line, what you were saying would come to pass. Unfortunately, it's not a straight line, or fortunately for drama on our show. So you're absolutely right. The 914 goes on to be a huge success, sells way more units than the 911, which was the whole strategy. Porsche's cool with this. They're like, great, we're making our profits on the more expensive 911.
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Porsche (with Doug DeMuro)
We've segmented out our market. The 914 is the entry-level Porsche, sells 100,000 units in the eight years that it's on the market. And I think it really shows, Doug, you can comment on this. There is... Also, a market for mid-engine roadsters, including the one sitting behind us, regardless of price. These are pretty amazing sports cars.
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Porsche (with Doug DeMuro)
Yeah. I think you have a video where you say the Cayman GT4 RS, which is the Cayman and the Boxster, it's the same lineage we're talking about here, is the best modern Porsche.
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Porsche (with Doug DeMuro)
There you go. One of the differences between YouTube and podcast world is titles and SEO is really important in the YouTube world.
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Porsche (with Doug DeMuro)
Wow. And so while we're on this topic here of engines, I got to imagine this is one of just the huge sea changes that is coming with electrification.
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Porsche (with Doug DeMuro)
Yeah, he was definitely a Nazi. So when Ferdinand takes this new post as the head of engineering at Daimler, he moves his family from Austria, where he was the potting prize winner, to Stuttgart in Germany. And Doug, you probably have some more context on this, but Stuttgart is basically like the Detroit of the German auto
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Porsche (with Doug DeMuro)
Okay, so a minute ago, Ben, you said like, oh, this naturally would lead to a merging of, you know, VW and Porsche. And I was like, well... So this is in the late 60s when the 914 launches. As we head into the 70s, the oil crisis happens in the 70s and sports cars become less of a thing. People are really worried about this. This is like a challenge to Porsche.
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Porsche (with Doug DeMuro)
It's particularly a real challenge to the 914. Interestingly, 911 sales stay relatively robust throughout the 70s.
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Porsche (with Doug DeMuro)
because it's a luxury good right like just like in any recession and and even like sector targeted ones like the oil crisis and the auto industry for true luxury goods like those people like the market for that is very resilient the 914 though very different story so as we head into the mid 70s uh even though it was a very successful car and project for porsche as a whole it starts becoming a real money loser
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Porsche (with Doug DeMuro)
So this creates a lot of tension in the company. This is kind of a backdrop of stress to another family dynamic that's emerging, which is you've got these two Ferdinand grandsons that are kind of vying, starting to vie for control of the company. You know, they're now, gosh, I don't know, probably in their 30s, maybe entering their 40s. Ferry's getting older here.
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Porsche (with Doug DeMuro)
Like, who's going to take over the company? We've got succession vibes here. On the one side, you've got Bootsy Ferdinand Porsche. He's got the name. He's Ferry's son. And he's a great designer. I mean, he designed the 911, maybe the most iconic car design ever.
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Porsche (with Doug DeMuro)
Yes, he hopped over. So yeah, he's hopped over. And he's, you know, on the one hand, kind of like this dark horse kid, right? He's the Austrian side of the family. You know, you've got the car dealership business, blah, blah, blah.
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Porsche (with Doug DeMuro)
But he's also proved himself as like an incredible engineer, executive. He was in charge of this 914 project. He managed it with Volkswagen. That was an incredibly successful car until the oil crisis, et cetera, et cetera. So he's like, yo, this should be my company. Yeah. Tensions, of course, start to rise. And something pretty incredible happens.
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Porsche (with Doug DeMuro)
You know, we've come across on the show, there are lots of stories out there of family businesses in succession and how all this happens. I don't think there's another case of anything going down like this that I've ever heard of. So in the fall of 1970...
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Porsche (with Doug DeMuro)
fairy and louise together call a joint family summit they're like we're gonna settle things and i don't know i'm speculating here but i i suspect ferry and louise were didn't have a lot of acrimony over i mean they're brother and sister and they had louise had her company ferry had his company they're both making a lot of money they're both making a lot of money everybody's happy this is between the children here
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Porsche (with Doug DeMuro)
So they call a family summit. At the end of it, they come to a very, very surprising decision. They don't decide that one Ferdinand or the other is going to take over. Instead, they make the call that the families are going to completely and jointly exit operating the business. Everybody out of the pool. Not the two Ferdinands. What? Ferry. Ferry himself. Who's running the company?
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Porsche (with Doug DeMuro)
Ferdinand's long dead at this point. The original Ferdinand. They're going to continue owning the company, but they will no longer manage the company. They will no longer operate the company. They will no longer design cars. They will no longer make product decisions. And frankly, this is just insane.
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Porsche (with Doug DeMuro)
I mean, because it's not like be one thing if they were like, oh, you know, we're really not that good at this. Like we should hire a professional man. These are led the generational talents in the car industry. And the best solution they can come up with is, you know what? We're all done here.
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Porsche (with Doug DeMuro)
there's some direct quotes from a lot of them and excellence was expected. And like, as you can imagine, it's a very delicate topic. Uh, and they're also German. So like, they're very, you know, prim and proper. But, um, I think very, he basically admits he's like, yeah, there probably was a better solution to this, but like, it did mean that we could kind of reunite as a family.
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Porsche (with Doug DeMuro)
And like, I think he said something like there were still tensions, but we could go to each other's birthdays again, you know, something like that. So, I mean, I guess if you value family above all else, maybe this is irrational.
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Porsche (with Doug DeMuro)
Yeah. And I think it's not even, much like Detroit, it's not even just the car companies, but all the suppliers and the subcontractors.
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Porsche (with Doug DeMuro)
I mean, he definitely was so pissed. So let's talk about what happens here. Bootsy, he goes off and he founds Porsche Design. So there exists these weird, there's like Porsche sunglasses out there. You can buy Porsche designed laptops, like all this stuff. That's him. That's a totally new company that he started. It has now been reabsorbed into the broader Porsche conglomerate.
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Porsche (with Doug DeMuro)
But that was started, right? He was like, all right, great. I want to be a designer. That's the path. He goes down.
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Porsche (with Doug DeMuro)
I think he also was very talented. I mean, he designed the 911 for God's sake. He's talented. But yes, trading on the name here. The other Ferdinand, Piesch. This guy, oh my God, he's a G. So at first, he's like, I imagine inspired by his grandfather, he's like, I'm going to go start my own engineering consulting company and consult for other car companies. He does do that for a little bit.
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Porsche (with Doug DeMuro)
But pretty quickly thereafter, remember, VW and the new CEO really wanted to build this relationship with Porsche, with Pietsch. He gets recruited to come in and take over Audi for VW. I don't think he originally, I think he enters working within Audi, but then very quickly becomes the head of the Audi brand for Volkswagen.
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Porsche (with Doug DeMuro)
It is like the industry town. Yeah. So, Porsche Ferdinand is... It's not a short period of time. It's two decades that he is running the engineering and the car design for Mercedes-Benz. While he's there, towards the end of his time, kind of as we're getting into the lead up to World War II, he comes up with a concept.
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Porsche (with Doug DeMuro)
Would it be like today? Infiniti. I know you owned a Kia, right? Kia and Hyundai are trying to enter the luxury market. Yeah, it was on that level of like, I'm going to stick with Mercedes.
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Porsche (with Doug DeMuro)
So Pies comes in and like, I mean, this dude is good. This was such a mistake to force him out of Porsche. So he turns around Audi and builds Audi into, Doug, like you said, the Audi we know today. And he's so successful that in 1993, he gets promoted and becomes CEO of Porsche.
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Porsche (with Doug DeMuro)
volkswagen so you get the situation where they kicked him out of running the company and then he goes and ends up running wild wild i mean he oversaw and launched the new beetle uh like literally his grandfather's legacy the beetle he turned over the beetle model to the the new beetle how long was ferdinand piesch running volkswagen A long time.
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Porsche (with Doug DeMuro)
1993, I believe he was chairman until 2015, 2016, maybe. Whoa. A long time.
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Porsche (with Doug DeMuro)
And the family's Porsche is just like, yeah, now you got to get out of here. Unbelievable. Maybe he wouldn't have had the motivation to do it. Who knows? Who knows? Just wild.
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Porsche (with Doug DeMuro)
Yeah. Yeah. Yeah. Yeah. Wow. So back to the Porsche side. Yeah. This decision was just really not good. Really not good. So the first CEO who comes in, the first professional manager CEO, actually is somebody who has been with the company for a long time. Ernst Furman becomes the first non-family member CEO of Porsche.
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Porsche (with Doug DeMuro)
He was actually part of the original elite engineering crew back in the sawmill in Gamoon. So he has a long history with the company. Unfortunately, he was probably a better engineer than a manager, though. His first move is to scrap the 914 and instead introduce the 924. The 924 was another joint project between VW and Porsche. The problem with the 924, I think it actually was a decent car.
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Porsche (with Doug DeMuro)
He thinks that he can produce a small, affordable car that can really become the first German and European mass market car. Now, back in the U.S., there was the Model T and Henry Ford that existed. But Ferdinand's vision is a small car. The Model T was a large car, like like a modern, small automobile that Germans everywhere can can buy.
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Porsche (with Doug DeMuro)
Doug, you actually reviewed a 944 recently, which is the kind of next iteration of it. I think you can say, I think it was a good car, but it's not a Porsche car. It's a front-engined, water-cooled.
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Porsche (with Doug DeMuro)
So, Furman had a quote on it when asked about, like, what is this? He says... The 924 is aimed at new clients who either can't afford a 911 or are not necessarily looking for the performance of a 911. Oof. I mean, I guess that's true, right? And that's also true of the 914, but like... That's not the right way you want to position your brand.
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Porsche (with Doug DeMuro)
This is for the poor customers. Right, right, right. And again, but also it's just like in the whole philosophy of it, it's not a Porsche. Even more concerning is the 928. So Furman makes a decision as the new CEO of the company that it's time to replace the 911. And, again, you know, maybe, like, let's give him some credit. This is the 70s. The oil crisis is going on.
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Porsche (with Doug DeMuro)
Like, there's safety regulations. This is post-Ralph Nader and unsafe at any speeds. Like, it's maybe reasonable to think that a rear-engine sports car isn't, like, a great strategy to be pursuing here.
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Porsche (with Doug DeMuro)
Hmm. Totally. So in 1978, Furman introduces the Porsche 928 with the stated intention that this is going to eventually replace the 911. They keep selling the 911. He says, we'll keep selling the 911 as long as we get demand for, I think it was at least like 10,000 units a year or something like that. But, you know, once the 928 is on the market and demand dips for the 911, we'll stop making them.
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Porsche (with Doug DeMuro)
So the 9-28 comes out in 1978. And as we reach the end of the 70s and into the 80s, as we also have talked about a lot on this show, everything that the 70s was in terms of austerity, oil crisis, 17% interest rates and massive inflation, The 80s was not that, shall we say. Not that. It was a rising tide that lifts all boats.
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Porsche (with Doug DeMuro)
Seems like a good time for fast cars. And indeed, it was, including for the 928 and the 924, succeeded by the 944. And still, the 911 people still wanted them. I think largely because of that, although I'm sure there were other reasons too. So the Portia and Piesha families, when they exit operationally from the business, they still own the business. So they're still like the supervisory board.
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Porsche (with Doug DeMuro)
They get fed up with Furman. They oust him and they bring on a new CEO. an American as CEO of Porsche, one Peter Schutz. Famously, he comes in and he redraws the 911 production line. And Doug, I know you have some firsthand experience of the legendariness.
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Porsche (with Doug DeMuro)
So this really was a challenge to build a car that could be affordable enough for the average German person to buy it. And indeed, it was a challenge because the board of Daimler-Benz rejects it. They're like, no, we can't do this. We make expensive cars for wealthy people. They get into a huge fight over this. And Ferdinand ends up leaving the company pretty acrimoniously in 1929.
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Porsche (with Doug DeMuro)
This would be a good story to invent if you needed a morale boosting.
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Porsche (with Doug DeMuro)
It's a great story. Yeah. I mean, literally, he extended the line of the production line onto the wall. Right.
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Porsche (with Doug DeMuro)
Yeah. So they kept making, I think they made the 928 until 1995. It was Vita King who comes in in a minute who finally kills the damn thing.
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Porsche (with Doug DeMuro)
So in the go-go years of the early through mid-80s, no problem. Right. More. We'll do an ICO. We'll issue some NFTs.
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Porsche (with Doug DeMuro)
Yes, I think he was. Yes. Oh, my gosh. And on the back of these go-go years and success, they're selling the 911, they're selling the 928, they're selling a lot of 944s. They sold a ton of those things. The families take the company public. So just like a lot of these, like we talked about on the LVMH episode, a lot of these European luxury brands, craftsman brands, they did an IPO.
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Porsche (with Doug DeMuro)
They thought they were being smart. They sold, I think, a 30% stake in the company, but all non-voting shares. No corporate raiders here. Nobody will have any voting control except the families. It is impossible that somebody could attack us because the families all alone. It would have to be somebody inside the families who would attack us. Why would that ever happen? Well, everything goes great.
Acquired
Porsche (with Doug DeMuro)
The stock doubles within the first year that it's on the market. But then 1987, long-term capital management blows up. The end of the go-go years of the 80s. Not good. Not good for Porsche. And not good in a lot of senses. Like, A, just period, economic climate, not good for anybody. B, you're making luxury sports cars.
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Porsche (with Doug DeMuro)
Now, as we talked about in the 70s, the oil crisis in the 70s was really bad for Porsche. It was really bad for the 914. The 911 was pretty robust. Like, it was very resilient. I think the same is again true here at the end of the 80s. But they've still got the 920 and the 944 on the market. And like those things started sucking wind big time.
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Porsche (with Doug DeMuro)
So, Schutz, though, he continues production of all three lines. And not only does he continue production, he reinvests, especially in the 924, 944 line. They even refreshed it a third time to the 968. I mean, same basic car. Yeah. Like, they're investing resources in this car. And at the...
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Porsche (with Doug DeMuro)
you probably have a better sense than me, but like another aspect of the kind of recession at the end of the eighties was the exchange rates with European currencies got hit really hard. Right. And so relative to the Asian currencies in the U S so it became, I don't know, call it 10, $20,000 cheaper to buy an equivalent entry-level sports car from a Japanese manufacturer.
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Porsche (with Doug DeMuro)
I mean, I feel like I'm sort of, in my history, probably all of us, starting to enter consciousness here. This is pre-Fast and the Furious, but not that pre-Fast and the Furious. All those Japanese cars that got tuned up, the Supras especially.
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Porsche (with Doug DeMuro)
Yeah. And again, the 911 isn't threatened by this. Right. But the 944, 968, hell yeah, is threatened by these. Right.
Acquired
Porsche (with Doug DeMuro)
So once he leaves, Ferdinand bumps around for a little while. And then in 1931, he starts a consulting firm to kind of advise other car companies, not Daimler-Benz, but other car companies in Germany and Europe, and I think in America too, on their designs and like do some work for them and maybe even design cars for them.
Acquired
Porsche (with Doug DeMuro)
Huh. so as all this happens porsche is now a public company the stock price starts to decline precipitously and they floated 30 of it they floated 30 now no voting control but the company They're really like cresting the treetops here as they're beginning their descent. At one point, Porsche's market cap was less than 400 million euros.
Acquired
Porsche (with Doug DeMuro)
Like almost zero. And I believe also at that time, they didn't have any debt. So, like, truly, like, the markets believed that Porsche was worth nothing. It wasn't like, oh, there's value here, but there's a big debt burden on the company.
Acquired
Porsche (with Doug DeMuro)
So even though the public doesn't have any voting control, everybody starts to think the only thing that can happen here is this company is going to get bought out.
Acquired
Porsche (with Doug DeMuro)
One equity research analyst actually in a research note said that he thought there was a 98% chance that the families would have to sell and that they would accept, you know, some amount of value for their stake rather than just have it go to zero. So Schutz gets fired, but it's not like that fixes anything. I think it was 1987 when he gets fired.
Acquired
Porsche (with Doug DeMuro)
Over the next six years, they cycle through, I think, five years.
Acquired
Porsche (with Doug DeMuro)
four three or four more ceos brutal none of which really figure it out there is one bright spot though however which if this were a normal acquired episode we would just skip but we've got doug um the 959 yeah it's actually the 959 and another interesting component offshooting that but the 959 comes out at that time which is like their first supercar so sort of the predecessor to this car
Acquired
Porsche (with Doug DeMuro)
And he names it the Dr. Ingenieur Honoris Causa Ferdinand Porsche Construction und Bötingen Vermotoren und Fersenbau. I apologize to any German speakers out there. Wow, you are.
Acquired
Porsche (with Doug DeMuro)
Instead of losing money on having to pay the, well, yeah. Right.
Acquired
Porsche (with Doug DeMuro)
Yep, Vanta is the perfect example of the quote that we talk about all the time here on Acquired. Jeff Bezos, his idea that a company should only focus on what actually makes your beer taste better, i.e. spend your time and resources only on what's actually going to move the needle for your product and your customers and outsource everything else that doesn't.
Acquired
Porsche (with Doug DeMuro)
Every company needs compliance and trust with their vendors and customers. It plays a major role in enabling revenue because customers and partners demand it, but yet it adds zero flavor to your actual product.
Acquired
Porsche (with Doug DeMuro)
It's a mouthful. I studied French in college. And that translates as the Dr. Engineer Honoris Causa Ferdinand Porsche Consulting and Design Services for Motor Vehicles Company. And this is the beginning of Porsche the company. And up until 2008 and 2009, which we will get to much later in the episode, that is the company that makes Porsches.
Acquired
Porsche (with Doug DeMuro)
And perhaps most importantly, your security reviews are now real-time instead of static, so you can monitor and share with your customers and partners to give them added confidence.
Acquired
Porsche (with Doug DeMuro)
It's so funny. I feel like the sales cycle for a 911 has got to be 40 or 50 years, right? Like kids fall in love and then you can't really buy one until you're in your 40s or 50s.
Acquired
Porsche (with Doug DeMuro)
Also, like you said, I haven't quite thought about, but I was planning to tell this story of like, oh my God, Furman wanted to kill the 9-11. What a dumb idea. It was like natural. They killed the 356. The natural thing would have been to kill the 901.
Acquired
Porsche (with Doug DeMuro)
Okay, so Porsche's in this tailspin. The two eras that happened next are both equally amazing. So in 1993, a guy named Wendelin Wiedeking gets appointed as the CEO. Now, he had actually started his career with Porsche in the 80s. As all this crazy stuff is happening, he was like a loud voice of protest against all the, you know, shoots and Furman era decisions. He resigned and left the company.
Acquired
Porsche (with Doug DeMuro)
They recruit him back in the early 90s to take over as head of production. And he implements the Toyota production system at Porsche, which they must have been like the last auto manufacturer in the world. I don't know if Ferrari uses the Toyota production system, but like this wasn't new technology at this point in time. Right. Remember, Porsche is bleeding cash.
Acquired
Porsche (with Doug DeMuro)
Being more efficient and more profitable in your operations for whatever cars you can sell is pretty important. He's like the Tim Cook of Porsche here. He gets promoted to CEO. And when he does, speaking of Apple... He kind of pulls a Steve Jobs return like moment. He cuts the product lines down to just the 911. So this is the right thing that needed to be done. But it's also kind of crazy.
Acquired
Porsche (with Doug DeMuro)
He kills the 944, 968. He kills the 928. he takes everything back down to just the 911. And analysts, people, car magazines ask him, what's your strategy for an entry-level Porsche? And he says, Porsche's strategy for an entry-level Porsche is a used Porsche. Such a good line. Such a good line. Such a good line.
Acquired
Porsche (with Doug DeMuro)
So by the 95, 96 production year, the 911 is the only Porsche model left on the market, which hasn't been the case since the 356. Like this is kind of crazy.
Acquired
Porsche (with Doug DeMuro)
No, it's not like Weeda King was like, I am a cost-cutter, and I will cost everything down. He is much. He has big ambitions. Big, big, big ambitions. This is a transitionary moment.
Acquired
Porsche (with Doug DeMuro)
he does want to expand the porsche model line as we shall see he greatly expands it so i think this is pretty brilliant and certainly for the financial performance of the company was brilliant and its survival i think 911 enthusiasts are less enthusiastic about this but he decides that rather than the old strategy for the entry-level model of sharing a platform with volkswagen
Acquired
Porsche (with Doug DeMuro)
So when he's starting this new company, he enlists the financial support of two people. One is his son-in-law, his daughter Louise's husband, one Anton Piesch. Remember that last name because it is also going to be very important as we go along here. And the other person is Adolf Rosenberger. Now, if you are a Porsche history nut, you probably know about Anton Piesch.
Acquired
Porsche (with Doug DeMuro)
what if we have the new entry-level model instead share a platform with the 911? And so what he does is he says, let's take the front end of the 911, of the next generation 911, the 996,
Acquired
Porsche (with Doug DeMuro)
and used that exact same front end, same headlights, same hood, same everything, and then made it with a new entry-level back end, the rest of the chassis of the car, revived the old 914 concept that was so successful, mid-engine Roadster model with a, how would you describe the, it's not a convertible per se.
Acquired
Porsche (with Doug DeMuro)
Ah, interesting. So, Doug, what you're alluding to, this is the Porsche Boxster, which becomes a huge success. And I think the reason for it is that it genuinely is, to anybody looking at it, like, this is a Porsche. Not that stupid quote that Furman had of like, this is for people who don't want a 911 and don't care about performance. This is like, no, no, this is a freaking Porsche.
Acquired
Porsche (with Doug DeMuro)
And also from a production and profitability and operation standpoint, this is so great. You're now sharing so many components, not with another auto manufacturer, but with yourself.
Acquired
Porsche (with Doug DeMuro)
Is it fair to say that then, and I think maybe even especially now with the Boxster and the Cayman, the Cayman is the hardtop model of the Boxster, it's also a different kind of experience philosophy.
Acquired
Porsche (with Doug DeMuro)
Yes, it's the entry-level Porsche for sure. But it's also, it's not like you feel like crappy if you're buying one. You're like, oh, you know, I'm buying the best version on the market of this particular product. Right.
Acquired
Porsche (with Doug DeMuro)
So Vita King has this awesome quote about the strategy for this. We didn't want to flee from the competition into higher prices, meaning like not be in the entry-level market at all. He says, we don't want to be Germany's Ferrari. We don't want to be a big fish in a pond that's shrinking, but rather a growing fish with more room to move in a larger lake.
Acquired
Porsche (with Doug DeMuro)
I feel like Vita King and Don Valentine of Sequoia Capital would be like brothers in arms here. Like they're targeting big markets. That is the strategy. But they're targeting them in a Porsche way. So Vita King, like, I don't know how much this was his thinking all along or that he was just emboldened by the success of the Boxster. He really means it. He gets into SUVs.
Acquired
Porsche (with Doug DeMuro)
You probably don't know about Adolf Rosenberger because shortly after they start the company, Rosenberger was Jewish and he gets arrested by the Gestapo. He gets imprisoned. He eventually bribes his way out and escapes to America. But during the war, Porsche and the Nazis totally appropriate his stake in Porsche and he's written out of history. Wow.
Acquired
Porsche (with Doug DeMuro)
And this, I mean, I even as like a teenager at the time, Not being that much of a car guy, but I just remember people like, Porsche is making an SUV. Have these people lost their freaking minds?
Acquired
Porsche (with Doug DeMuro)
But I think part of this was a cultural, you know, German thing for sure, but, like, not understanding America. But I don't think anybody understood. Like, I don't think there were any super expensive SUVs on the market.
Acquired
Porsche (with Doug DeMuro)
Yeah. I think a few things to say about it. There wasn't anything else that was like, I can spend $100,000 on an SUV.
Acquired
Porsche (with Doug DeMuro)
And SUVs were becoming so important in America. I think there were just like a lot of wealthy people out there and a lot of status-focused people that were like, yeah, there's an SUV I can spend a hundred grand on. Like, hell yeah, take my money.
Acquired
Porsche (with Doug DeMuro)
Okay, so this new Ferdinand company, in 1934, they land one very, very, very large contract that would go down in history both for the company and the world. That contract would be to design Ferdinand's vision, the small, affordable car for the people, a Volkswagen, you might say in German, that car would go on to become the Volkswagen Beetle.
Acquired
Porsche (with Doug DeMuro)
I think because at the same time and just before, they had given a huge shot in the arm back to the performance with the Boxster and the 993 911. And then also done the SUV, which they partner with Volkswagen with Ferdinand Pietsch. It kind of makes peace between the two companies.
Acquired
Porsche (with Doug DeMuro)
Porsche starts a whole new production facility in a new part of Germany in Leipzig to make it. And then ultimately, shortly thereafter... makes this car. The Carrera GT. At the same production facility.
Acquired
Porsche (with Doug DeMuro)
For people who are just listening to the audio, this is the Carrera GT sitting behind us. The Carrera GT. Okay, we've alluded to this amazing machine behind us.
Acquired
Porsche (with Doug DeMuro)
My sense is this car, too, has a reputation, partly because Paul Walker died in it, of like, unlike a lot of Porsches and the 911, like, this is something that you need to be, really know what you're doing to operate this thing. You can't, like, if you let it get away from you, it'll kill you.
Acquired
Porsche (with Doug DeMuro)
But I guess, like, today, cars, like, there's so much... technology in cars that is designed to keep you from doing stupid stuff.
Acquired
Porsche (with Doug DeMuro)
Because production was, and this is the value of the car now, like production was initially intended to be higher than it ended up being. They stopped it early.
Acquired
Porsche (with Doug DeMuro)
about Apple stock or Carrera GT. Carrera GT would be a lot more fun to own.
Acquired
Porsche (with Doug DeMuro)
It's funny. I thought that this, you know, was going to be a fun little digression about the Carrera GT. But I realize now, actually... This is a super important point to the business history. While they were drawing on the brand equity to make the SUV, this was a big part of putting cash back in the bank of the brand equity and to do it on the same production line as the SUV.
Acquired
Porsche (with Doug DeMuro)
And the company that contracted Porsche to build and design it was Volkswagen, which was established to do so by Adolf Hitler. I had heard rumors over the years, like, oh, yeah, there's like a Nazi connection here. Like, Adolf Hitler founded Volkswagen. Yeah, that's bigger than a connection. Yeah, there's not a connection because it's the same person.
Acquired
Porsche (with Doug DeMuro)
So on the back of this, like, incredibly bold plan and turnaround and success by Wittekig, I mean, he becomes a legend. And Porsche goes from death's door, less than 400 million euro market cap when he takes over, to by 2007, Porsche's market cap is 32 billion euros. Yeah. A better investment than a Carrera GT, in fact.
Acquired
Porsche (with Doug DeMuro)
Portia is saved. It will be independent forever. Families will never have to sell. That equity research analyst can eat his words. No, not quite.
Acquired
Porsche (with Doug DeMuro)
Even if you had told a person in 1993, hey, this guy's coming in. He's going to kill the entry level stuff. Go back to doing entry-level stuff and then do an SUV. You'd be like, how do I get out of this stock? Like, where do I sell?
Acquired
Porsche (with Doug DeMuro)
Yeah. And the 32 billion euro market cap, it's not crazy because by this time, Porsche is doing almost 2 billion euros a year in operating profit.
Acquired
Porsche (with Doug DeMuro)
And China was starting to take off at this time too. So the final sort of chapter to the Vita King era on the product production side was the Panamera, the sedan. Porsche makes a sedan. Now, Doug, I'm curious to hear your thoughts on the Panamera. I'd always also been like Porsche made a sedan. It's kind of weird. It looks kind of weird.
Acquired
Porsche (with Doug DeMuro)
I think from doing the research now, I think a large part of the intention of it was to really target the China market. And it became successful globally too. But I think the Panamera and the Cayenne too really helped Porsche enter China.
Acquired
Porsche (with Doug DeMuro)
And honestly, it would have worked and did work. It was not what brought down the company. Not at all. Like you think like if you were naively following along, you might think, and then they got too big for their britches. And, you know, they expanded the product strategy too much and the brand came crashing. Like, no, no, no. Like this worked.
Acquired
Porsche (with Doug DeMuro)
And it worked beautifully, just ultimately under different ownership. So let's talk about what we've been alluding to all episode here. The German tax regime still is not very favorable to distributing profits. Just the corporate tax rate alone disincentivizes spinning off cash flow and incentivizes reinvesting.
Acquired
Porsche (with Doug DeMuro)
Yeah, yeah, there's some link between Mark Zuckerberg and Facebook.
Acquired
Porsche (with Doug DeMuro)
At this point under Vita King, Porsche is doing everything they possibly can to reinvest in new models, new lines. Like they're building a new production facility. What more could they do internally with all the money they're making? They can't do anything. So they start looking around for other places to put the cash. Now at the time,
Acquired
Porsche (with Doug DeMuro)
There were rumors circulating in the auto industry that Volkswagen had their eye on Vita King. And they were looking to recruit him to be the successor to Ferdinand Piëch.
Acquired
Porsche (with Doug DeMuro)
So I think Ferdinand Pietsch took over as CEO of the whole VW group, I believe, in the same year that Vita King became CEO of Porsche in 1993. Ferdinand's obviously much older. Coming towards the sort of twilight years of his career, you can see how this would make sense if it were true. Whether it's true or not, I'm sure Vita King gets rumors of it.
Acquired
Porsche (with Doug DeMuro)
Vita King's really, you know, kind of feeling himself here at Porsche, right? Like he's hard to imagine a better run. He gets the idea. He kind of has like a sort of Justin Timberlake social network moment of, you know, million dollars isn't cool. You know what's cool? A billion dollars. Being the CEO of Volkswagen isn't cool. You know what would be cool? If we at Porsche bought Volkswagen.
Acquired
Porsche (with Doug DeMuro)
I'll become the CEO of VW Group when I buy you. Remember, though... Ferdinand Piëch is chairman and CEO of Volkswagen Group. He's also a Piëch. He's also on the supervisory board of Porsche because he's also a key member of the family that owns Porsche.
Acquired
Porsche (with Doug DeMuro)
Yes. And he's on the board, the supervisory board of Porsche. So they thought they were done with the family drama here. It turns out there's another chapter.
Acquired
Porsche (with Doug DeMuro)
Porsche, and thus the families, needed something to do with the cash. And at the time when they start this, VW shares are a pretty good investment. They're not trading super highly. It's pretty clear to them that it's undervalued. And VW is a critical partner to Porsche.
Acquired
Porsche (with Doug DeMuro)
So I believe, certainly to the public and probably also to the families, Vita King positions this as like, hey, we're deepening the partnership. They don't announce like, hey, I'm trying to take over VW out of my seat at Porsche. September 2005, Porsche spends $4 billion to acquire 20% of the VW group on the open market.
Acquired
Porsche (with Doug DeMuro)
It's kind of a little creeping takeover vibes that you alluded to in the intro. At this point, Vita King and Porsche's CFO joins the Volkswagen board. And then they keep buying shares, but using another patented Bernard Arnault technique, they do it mostly using various derivatives and options contracts. So they're buying like the rights to buy shares in the future.
Acquired
Porsche (with Doug DeMuro)
Yes, absolutely. And in VW's case in particular, there was actually a law on the books in German law called the Volkswagen law.
Acquired
Porsche (with Doug DeMuro)
That was designed to prevent a takeover of VW because the state of Lower Saxony still owned the 20% share in Volkswagen, still does to this day. And it was considered sort of a national treasure and they didn't want it to be taken over by corporate raiders. they didn't envision that it would be another German auto company that would try to take it over.
Acquired
Porsche (with Doug DeMuro)
obviously very different people run the businesses now and so you just kind of put it out of your mind and you know what generations have gone by also less so on the porsche side of things more so on the volkswagen side of things as we'll see with the history here there is kind of a pretty incredible re-founding of volkswagen after the war um and i think if it were not for this refounding that we'll talk about in a minute
Acquired
Porsche (with Doug DeMuro)
Yes. And part of the reason this all was able to happen is there was a lot of speculation that this German Volkswagen law would be illegal under new EU regulations. In 2007, Wittgen creates a new separately publicly traded holding company. for the family's ownership of Porsche. So there's still the Porsche operating company, the old doctor, engineer, AG operating company.
Acquired
Porsche (with Doug DeMuro)
There's now a new holding company that owns 100% of the operating company and the VW shares that they've been acquiring. And this is Porsche SE. Porsche SE. Porsche SE holding. Yeah. And here's where things start to go awry. Vita King starts loading up the holding company with debt, with cheap debt in 2007 to go buy more VW shares on the market.
Acquired
Porsche (with Doug DeMuro)
Ultimately, $10 billion of debt that he puts on this holding company.
Acquired
Porsche (with Doug DeMuro)
Right? Like, why would Piesch go along with this? I think the best as I could figure out is that P.S. was not happy with the then current CEO of Volkswagen and was looking for a way to get his first successor out. So he clearly he was trying to recruit Vita King, too. So like he was benefiting from this, too. Right. Yeah. He was going to have his cake and eat it, too. Right.
Acquired
Porsche (with Doug DeMuro)
Yep. So as Porsche is buying all these VW shares on the market with the debt that they're loading up on the holding company, the float of VW shares that are actually available on the market starts shrinking precipitously. Because remember, the German state of Lower Saxony still holds 20%. Porsche now owns more than 50%.
Acquired
Porsche (with Doug DeMuro)
So that only leaves 30% left. Then you've got all the insiders like, you know, P.S. and everybody else, like who knows how much equity they hold, plus maybe some long-term holders or funds that aren't going to sell. The amount of VW shares trading hands on the open market shrinks to...
Acquired
Porsche (with Doug DeMuro)
pretty close to zero um we know that you know markets are supply and demand uh just like this car sitting behind us if there's not a lot of supply available prices are gonna go up didn't they go up so much that volkswagen like briefly became the most valuable company by market cap in the world yes they did so as all of this is happening lehman brothers collapses
Acquired
Porsche (with Doug DeMuro)
Which this is, you know, this is the black swan event that Vita King couldn't have predicted. Like, he's not dumb. He knew he was taking risks here, but like... So Lehman Brothers collapses, and it's crazy what happens. So during the week after the collapse in October 2008, that's when Volkswagen Group becomes the most valuable company in the world. Hedge funds have been shorting Volkswagen.
Acquired
Porsche (with Doug DeMuro)
You get a short squeeze that happens, and the stock just goes...
Acquired
Porsche (with Doug DeMuro)
So you would think that this is like the best thing that's ever happened to Porsche and Vita King. They now own more than 50% of the most valuable company in the world. They're invincible. I believe the threshold that they needed to get to was 75% in order to consolidate VW's financials into Porsche. And so they had announced that their intention was to buy up to that threshold and to get there.
Acquired
Porsche (with Doug DeMuro)
So you think this is great, but this is... terrible this is the undoing of porsche and vita king because they've got this debt lehman's just happened so like clearly they're not going to be able to refinance any of that And yes, VW's share price is in the stratosphere, but it's not sustainable.
Acquired
Porsche (with Doug DeMuro)
Because if Porsche were to start to sell any of their shares, which they're going to have to to service the debt really soon, the share price is going to completely crater. Because this is like an artificial price. It's just because of the short squeeze that it's that high. So Portia now is like completely trapped. They can't sell to service the debt because then the share price will crater.
Acquired
Porsche (with Doug DeMuro)
They can't buy because they can't take out any more debt. So they're just kind of like stuck in stasis at this point in time.
Acquired
Porsche (with Doug DeMuro)
They're not going to be able to sell that many shares at this price before the price craters.
Acquired
Porsche (with Doug DeMuro)
Lehman just happened. Right. Wow. Fascinating. So at this point... Piesch. Ferdinand. Good old Ferdinand.
Acquired
Porsche (with Doug DeMuro)
He's on the Porsche board, and he is still chairman of the VW board. He's no longer CEO, but he's still chairman of VW. This is when he turns on VitaKing. So he and Volkswagen announce publicly to the market that they no longer believe that Porsche is a financially viable entity.
Acquired
Porsche (with Doug DeMuro)
And they say that they have to say this because Porsche is a greater than 50% owner of VW. And so they have to disclose this to the market. And that as a result of this extraordinary circumstance, VW, led by Ferdinand, is willing...
Acquired
Porsche (with Doug DeMuro)
to bail out their partner, Porsche, and save them by purchasing the Porsche operating company for the neighborhood of three to four billion euros to get them out of this predicament.
Acquired
Porsche (with Doug DeMuro)
Yes. It is very hard to get actual production and sales data, especially for old cars.
Acquired
Porsche (with Doug DeMuro)
They floated a price of three to four billion euros, which remember, like a couple months ago, this company was trading at 10x that.
Acquired
Porsche (with Doug DeMuro)
This is exactly what is going on. Yeah. Whoa, indeed. So there's a whole flurry of negotiations. You know, this is all against the backdrop of it being October 2008. Within a few months, by January 2009, Vita King is gone as CEO of Porsche. Supposedly, when he exits the building, he exits to a standing ovation from Porsche employees, which...
Acquired
Porsche (with Doug DeMuro)
I mean, he kind of deserves, even though like all of this craziness, he did go a bridge too far. Like he did save the company. VW does end up buying Porsche, the operating company, in two tranches over three years. They buy 50% up front. Three years later in 2011, they complete the purchase. It ends up being about eight and a half billion euros total.
Acquired
Porsche (with Doug DeMuro)
So between that opening value of three to four and the 32, 32, it lands at eight and a half. What's even crazier about this, the undisputed hands down, you know, home run winner in everything is, of course, the Porsche and Fiesch families and Ferdinand. They emerge as the largest shareholders, the families personally, in VW Group.
Acquired
Porsche (with Doug DeMuro)
Already owned 50% of VW. And then VW paid $8.5 billion to buy Porsche. So the families own 50% of VW. And they just got $8.5 billion for Porsche. So they already were pretty high up there in the rankings. But after this transaction, they are now in the top, call it 15 wealthiest families in the world.
Acquired
Porsche (with Doug DeMuro)
32% of the VW group, which remember now also owns Porsche, but they have over 50% of the voting power. So they control VW group.
Acquired
Porsche (with Doug DeMuro)
Owns it all. And they just got an eight and a half billion dollar cash out. Wow. Yeah. Crazy. So here's the thing now. We're now in 2011 when the second tranche of the buyout happens. We're deep in the great financial crisis and the recession. Porsche, the business, it's fine. The drama is all around Porsche. Porsche the hedge fund, you know, and the financial shenanigans and the families.
Acquired
Porsche (with Doug DeMuro)
The actual operating business, the cars, sales are fine. Porsche has one down sales year, only one during the financial crisis. And then everything else is up. A big part of that is the investment in China. And China starts really, really growing through the early 2010s for Porsche. Also, this is when they come out with the 918 Spyder, their next supercar.
Acquired
Porsche (with Doug DeMuro)
At this moment in time, there's all this, oh, Porsche is now owned by VW and Consternation. They're like... Yeah, we can still make the best cars in the world.
Acquired
Porsche (with Doug DeMuro)
And I, um... I tried to think. I could not think of any other model. I believe the Beetle, the original Beetle, is likely the single longest produced and largest, both in terms of length of time and number of units produced, of a single generation model of a car. Like the Civic, the Mustang, the F-150... Definitely household more than the Beetle, but those aren't the same cars.
Acquired
Porsche (with Doug DeMuro)
Well, Ben, I'm sure you'll talk about this in a minute, but... Porsche is the master just of like, there is a base price, but you're not going to spend the base price. You're going to spend like 40% more than the base price.
Acquired
Porsche (with Doug DeMuro)
And this isn't the first time we've partnered with them, so we are excited to bring them back to the show. We have become quite the payments nerds this year and have a much deeper appreciation of just how important the modern payments industry is to the world. Money movement fuels literally everything. everything in modern society, and modern treasury is right there at the heart of it.
Acquired
Porsche (with Doug DeMuro)
The Beetle was the same freaking car until the new Beetle in 1998.
Acquired
Porsche (with Doug DeMuro)
Yep. And that's where Modern Treasury comes in. A payment operations platform designed for this new era. Think of it as money movement supercharged. There's faster payment rails, smart workflows, and real-time visibility. Technology that modernizes your existing financial infrastructure. With Modern Treasury, your company can move money faster and more efficiently than ever.
Acquired
Porsche (with Doug DeMuro)
boosting business performance and enhancing customer experiences. Payment operations go from manual and slow to automated and continuous, from isolated to fully connected, all in real time, tracking every cent.
Acquired
Porsche (with Doug DeMuro)
Yeah. Okay. Well, great. So this is perfect to wrap up on the history of Porsche here. As part of the VW group, they come out with the Macan, which is a huge success, both in America and China.
Acquired
Porsche (with Doug DeMuro)
This is a little bit echoes of our Lockheed Martin episode that we just did. The heritage of the great airplanes, the great Porsches, is this independent, engineering, small team culture. But to operate today within the content, you have to be part of this. So the Macan's a big hit. And then we just alluded to it with the Taycan, the Mission E is the concept that they introduced in 2015.
Acquired
Porsche (with Doug DeMuro)
We got to talk about that another day on Acquired. Like, how did that happen? I mean, they were the forefront of hybrids.
Acquired
Porsche (with Doug DeMuro)
Why do you think they came out with a sedan? It was a mistake, for sure.
Acquired
Porsche (with Doug DeMuro)
This original Volkswagen, the Hitler Volkswagen, one of the things you can do when you start a company as a fascist dictator, you can create a new city to house this company in, which he did. So Hitler creates a new city in Germany known as the then called the city of the strength through joy car. That was the, what they wanted to call the beetle. Originally the strength through joy, the strength.
Acquired
Porsche (with Doug DeMuro)
Yeah. Yeah. But relative to the other traditional auto manufacturers, I get the sense, Porsche, you've got to be in the top tier of best positioned for an electric future.
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Porsche (with Doug DeMuro)
What do you, what are the performance characteristics of the next generation of supercars going to look like? Like, what do you... Humans can't go 0 to 60 in like a second.
Acquired
Porsche (with Doug DeMuro)
Well, so that brings us to today when, or I guess more accurately last fall, September 2022, when VW Group re-IPOed Porsche. The Porsche re-IPO is the largest European IPO of all time. The initial market cap of Porsche at trading was about $75 billion. Today, that's up to about $115 billion, call it nine months later.
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Porsche (with Doug DeMuro)
It's fine. It's interesting though. Like Doug, to your point, Operationally, though, you can no longer extricate these companies. So you can financially extricate them.
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Porsche (with Doug DeMuro)
So it's interesting, Ludwigson, Carl Ludwigson, who wrote Excellence Was Expected, he published a new edition of it last year. And in the foreword to it, he said, the reason I did it now is that the old independent Porsche is done. Like this is a completely different company now and I can fully put a bow on that original Porsche.
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Porsche (with Doug DeMuro)
This is Wolfsburg. Like this is the city that Volkswagen is still located in today.
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Porsche (with Doug DeMuro)
So even though there was a re-IPO of Porsche, it's never going to be the same old independent Porsche. Yeah.
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Porsche (with Doug DeMuro)
I guess Vita King was right. He was right in everything that he was doing. He just he didn't win the Game of Thrones.
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Porsche (with Doug DeMuro)
All out of Wolfsburg. So Hitler creates Volkswagen. He creates Wolfsburg. They do start production of the Beetle before World War II starts. They only make about 200 units. These are super rare today. You find a pre-war Beetle. Then World War II begins on September 1st, 1939. As you would expect, Volkswagen, all the Volkswagen and Porsche operations get repurposed to making military vehicles.
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Porsche (with Doug DeMuro)
Yeah, it's interesting. I compared the brand to Rolex earlier. I think from a brand perception, that's true. But from the operations of the company, it really is. It's Louis Vuitton. Like they make a Louis makes a lot of stuff.
Acquired
Nike
Yes. And that's the dark side for Michael. One more really critical thing I want to say about all this and Jordan and the building of the dream and the changing of culture before we move on to all the rest of Nike history, which we will cover here. You can't ignore, too, again, the timing in this. All of this coincided with the rise of ESPN and SportsCenter. And that was so important.
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Nike
In the early days, like when Steve Prefontaine was on the cover of Sports Illustrated or some of the tennis players, it was like there was a Nike line of, oh, we could spend X million dollars in advertising, but if we get our shoes on the cover of Sports Illustrated, that's worth $20 million. With ESPN and SportsCenter,
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Nike
those athletes and Michael Jordan being all over that 24-7 every night, that was $20 million a night of free advertising.
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Nike
Second real big one. The first was the Revolution ad with the Beatles that they did for the Air Max.
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Nike
Anyway, crazy, Rudy goes across town and starts a competing company after the war named Puma. Craziest thing. Adidas, Adidas, and Puma are the two brothers. They're both the Dassler brothers. Crazy.
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Nike
Rapper. Rapper first. But yeah, those early 2000s were not a great time for Nike. But then, interestingly, Kobe was so unhappy at Adidas and wanted what Nike could give him that he bought Adidas out of his deal to move over to Nike.
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Nike
Yep. I'm sure part of that was the shoes and, yeah, by all accounts, the Kobe 2s sucked. I do think there is, and this will get to analysis in a little bit, Nike can do something for athletes, for the big superstars, that the other companies can't.
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Nike
I mean, the thing is, both of those numbers are bonkers. $700 million is bonkers. And $6 billion is bonkers.
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Nike
Phil has this idea in this class in business school, this good idea but small idea to sell Japanese track shoes in the U.S. and undercut Adidas. In 1963, after he graduates, Phil decides that he's going to go off before he really starts life. He's going to go take a trip around the world, and he convinces one of his buddies from GSB to go with him.
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Nike
This is the moment that has led to the terribleness of the sea of digital corporate products today. We all have this to thank. Plus this, plus that, plus blah, blah, blah. I'm surprised there's not a Jordan Plus out there. No, there's not because Jordan is too well-managed a brand. I actually did not know that. It's funny. That was the origin of plus.
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Nike
They go first to Hawaii famously, and the buddy meets a girl in Hawaii. It's like, why would I leave Hawaii? Yeah, I mean, smart guy. Phil, though, goes on to Japan and he's still thinking about this idea. When he's in Japan, he starts going to tracks in Tokyo and watching what people are wearing, running around the tracks.
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Nike
For context, today, Nike is, what, more than twice the size of Adidas, who is more than three times, I think, the size of the number three player. Yeah. Which is Skechers, maybe? Yep, it's super Power Law distributed. The other aspect of that is personalization.
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Nike
Nike, I actually think, is really at the forefront of apparel personalization with what started as Nike ID and now is, I think, called Nike By Me. But anybody can make their own Nike shoes.
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Nike
in their own colors with their own designs on them to be able to do that at scale with their customer base and produce the standard lines that requires a level of scale economies that nobody else can really match.
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Nike
Well, until recently, Any mainstream person would have said, of course, to that statement.
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Nike
Right. I mean, this is companies like GOAT and StockX, and we'll talk about this more in analysis, but Nike has made the, I think, very conscious decision not to capture any of that value.
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Nike
And he observes and he decides that the Tiger brand shoes that he's seeing are the best. So he looks up the company that makes Tigers. Turns out they're made by a company called Onitsuka, which is based in Kobe in the south of Japan near Osaka. And Phil, for a desperate introvert, kind of crazily, this is how passionate he is about this idea.
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Nike
The other way that Nike potentially could capture this value would be to massively increase their prices. And this is really interesting. I think this is where Nike is different from the luxury brands that we've covered, the LVMHs, the Porsches. Porsche makes tens of thousands of dollars of incremental gross margin with their library wine colors that you can buy.
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Nike
Nike sells these incredibly limited edition retro and otherwise sneakers, but they sell them for $150, $200, maybe $300, like not a lot of money. The instant that they get purchased, you can turn around and sell them on the secondary market for $5,000, some of these shoes, $10,000, maybe more. That is a very intentional decision by Nike not to capture that value.
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Nike
And I think the reason they do it is to make all of this work, to make the dream work in a way that is applicable to everybody on the planet and not just Louis Vuitton's market. is they have to keep it attainable. And so they're willing to let that $2, $6 billion or whatever go to secondary players, go to StockX in order to keep the dream alive.
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Nike
Right. The one product that I know of was the Mags, the Back to the Future shoes that they actually produced. But those were for Michael J. Fox's charity. I think they made 50 of them and sold them for $17,000, if I have that right. But A, that was for charity. B, that was, like, obviously a stunt. That's not Louis Vuitton.
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Nike
Yes. I really can't think of anything else off the top of my head where a company is making such an obvious and clear choice to give value to other players in the ecosystem.
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Nike
He gets it in his head that he's going to hop on a train from Tokyo and just go knock on their door and say hi to the Onitsuka Corporation and maybe ask them if he could import some of their shoes. So the story goes that he shows up on the door and I can only imagine what 23-year-old Phil Knight is feeling as he's going through this.
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Nike
Yeah. This was two years before Black Lives Matter became a really big thing with George Floyd. This actually was like a big risk. If this had been done two years later, it would have played out very differently. It would have been way less of a risk.
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Nike
This is, to my mind, the pinnacle of the brand halo element of this. Yeah. Kaepernick played football. Not an important sport for Nike in terms of shoe sales. Hadn't played in several years. That's right.
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Nike
Yeah. This is like the ultimate example for me of the ad, the sponsorship, the campaign. It's not about the shoes. It's about the halo. Yeah. Yeah.
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Nike
Oh, this is great. I have so much to say. Let's officially transition to analysis and do Power, and then you can update us on the business today as we go. Great. So, okay, Power, for new listeners, as part of the analysis on every episode, we do a segment called Power, which is based on Hamilton Helmer's incredible business strategy book, Seven Powers.
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Nike
So, obviously, we're going to talk about brand here in a minute. But. But. Scale economies. Yes. Yes. are written all over this company in this episode for me. And this is the clearest thing in my mind that makes this industry and Nike's position and strategy within it so different from say an LVMH or a Porsche or any of the others. I'm gonna guess Porsche has scale economies.
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Nike
But if you look at the sneaker industry, we talked about this a minute ago, it's such a power law. There's Nike, there's Adidas that's half their size, and then the third place player is well less than half of Adidas' size.
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Nike
Okay. Now compare that to the rest of the apparel industry. It's wild how different it is, right? Think about fashion. Think about clothes. Think about shirts. Think about pants. Think about jackets. Think about whatever. No other corner of the apparel industry looks like this in that there are two, three, four companies that make a huge share of all of the sneakers that the world wears.
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Nike
It's not just that Nike is paying LeBron a check every year for a lot of money like Converse was back in the day. It's not like, oh, here's your $100,000 check, right? There's alignment and an incentive to be part of the biggest machine. So like the Kobe situation is so illustrative of this, right? Kobe was with Adidas. Yeah, maybe the Kobe 2 sucked. Like, I don't know and he didn't like the shoe.
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Nike
I doubt that was the issue. I think the issue was what Nike could do for Kobe and thus what Kobe could participate in was exponentially higher than even what Adidas could do.
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Nike
Yes, in that the other companies couldn't do it because Magic and Bird would never tolerate Jordan getting a fundamentally much better deal. Correct.
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Nike
I've been thinking a lot about, I think this is David Senra saying that the CEOs and the founders of these companies that we cover, that he covers, they are the Genghis Khans of our time. And Phil doesn't present as a Genghis Khan. Yes. But he still is. Right.
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Nike
Or is it the athletes that have the brand and Nike's scale economies let them buy the athletes' brands?
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Nike
Unquestionably, that was the case in 1984 with Michael Jordan. And then again in 1987, 88, when they renegotiated the deal.
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Nike
Right. Now, maybe again, that's a intentional choice by Nike. But in this category, I do think, yeah, if the Dunks cost more than the Adidas Sheltos... I don't know, maybe Sheltos would be popular right now.
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Nike
Yeah. But I do think, despite you saying the trap, and I think there is a big trap in overestimating brand value of Nike, it does definitely have brand value and brand power.
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Nike
Yeah. My thought exercise on this, which is a little different than my usual brand power thought exercise, which is, can you kill it? Can you intentionally kill Nike? No, you can't. It can't die. It will be with us in 100 years. Ooh, that's quite a take.
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Nike
I have something way less squishy for you here, though. Okay. I think I was talking with Scott Reams about this. I have no data on this whatsoever, but I don't think it is a controversial statement to say that the Swoosh logo is tattooed on more bodies around the globe than any other company logo. I'm sure that's the case. It has to be the case.
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Nike
deep down underneath all that introvert, he has that same drive that John Rockefeller had, that an Elon Musk has, that a Mark Zuckerberg has.
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Nike
So if that's not brand power right there, I know it doesn't fit Hamilton's definition.
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Nike
This is, again, and this is purely conjecture, I do think this is an intentional decision on Nike's part. I think they absolutely could sell 500, 1,000, 5,000, $10,000 Nike items. They absolutely could. And they choose not to, I think, because if they did that... Well, one thing we didn't talk about.
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Nike
So Nike announced a few years ago that their whole marketing strategy was going to be reoriented around, I think, 12 cities in the world. And they were going to focus everything they did from a marketing standpoint on thinking about what it would mean to be interesting in those cities. So what's behind that? And the cities are like New York, Los Angeles, Tokyo, Shanghai, Rio, Paris, etc.
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Nike
And I think what's behind that is Nike needs to be accessible to the tastemakers in those cities. And that doesn't mean wealthy people. That means people on the streets. That means young people. That means people who can't afford $5,000 items but want to be participating in the pinnacle of Nike.
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Nike
I think the thing that is so confounding here is is the secondary markets. There is no question that the value of many Nike items is well above their selling price. Right. And I don't think that's the case for Adidas. Maybe for some items, but I doubt as many as Nike.
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Nike
Ooh, maybe this actually all comes back to scale economies because it's kind of the same thing with Amazon, right? Or Netflix. For a given price, Netflix can offer more value or could in the past offer more value than anyone else. Amazon with Prime can offer way more value than anybody else. This is the scale economy play.
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Nike
It's funny you say Nike there as sort of founding principles because Nike isn't going to come for quite a while here. While Phil is making this train trip down to Kobe, he suddenly has a realization. His plan is he's going to show up at the door.
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Nike
It's funny, this doesn't jibe for me with the statement on the investor relations page, Nike is a growth company. I mean, I guess 10% growth at their scale is impressive. 35% growth in the Jordan brand is very impressive.
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Nike
Yep. I mean, that's 100% what it is. Yes. Like we were saying, it's not really that different than Netflix acquiring or producing content for Netflix.
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Nike
He's going to say that he's an American businessman, you know, a distributor, and he wants to distribute their shoes in America, literally his business plan from the GSB class. He doesn't have a company, though, and he doesn't have a name for the company, so he has to think fast and come up with a name. And there are multiple conflicting stories about where the name comes from.
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Nike
The other shoe companies who are still doing big deals in the NBA, let's take Under Armour and Steph Curry here in San Francisco. Like, what are they doing? Name another Under Armour athlete. I mean, they exist, but I don't think I could, right? Like, why? And obviously it's worth it to Steph. Steph could sign with Nike tomorrow, but Under Armour is just paying him a boatload of cash.
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Nike
This is absolutely fascinating and blew my mind when I talked to a few people in the industry about this. So yes, the official jerseys, let's take the NBA for example, Nike replaced Adidas a few years back as the official jersey maker of the NBA. When most NBA jerseys are sold to buyers who pay money for them, aka fans, not the players,
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Nike
Most of those are replica jerseys, which I'd heard that term before and I never thought about what it meant. Most of those are made by Fanatics, which has run an incredibly interesting playbook in the sports marketing world over the past few years. They are replicas made and sold by Fanatics in conjunction with the teams of the jerseys that the players wear.
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Nike
Nike pays to make the jerseys that the players wear. It is a billboard. It is a sponsorship. That is what they are paying for. But that's probably not what you're going to buy. You're going to buy a replica from the team store that is made by Fanatics that has the Nike swoosh on it.
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Nike
The one that Phil tells is that the name Blue Ribbon Sports comes from him thinking back to his childhood days, becoming a track athlete in middle school and high school. He talks about he got cut from the baseball team and his mom encouraged him to go out for track. And then the blue ribbons that he won at his track meets, you know, really helped define his personality. It's a very nice story.
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Nike
but Nike is a growth company. That's the ultimate non sequitur. I hope that becomes a mean, but Nike is a growth company.
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Nike
Very nice story. That's where the name comes from. The other story that appears in the other books... is that Phil was out drinking the night before, either drinking Pabst Blue Ribbon PBR beers, or I think more likely the other one that I read is Suntory Blue Ribbon Whiskey, which is a Japanese whiskey brand.
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Nike
To the scale economy's power question, to the extent in footwear that there are limited numbers of factory operators that are the big ones that are fully audited that you want to work with, being the scale player that can dominate the capacity in those factories is a huge advantage.
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Nike
We saw a billboard or something like that, and that that's where the name Blue Ribbon came from.
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Nike
It even continued through to the Jordan story, right? Nobody else was going to do that deal.
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Nike
Yes. Either way, perhaps driven by this drive to succeed... Phil puts on the performance of a lifetime in this meeting. He claims that he is a U.S. businessman from America. He's gone to Stanford Business School. He has a company called Blue Ribbon Sports. He wants to import their shoes. By the way, he ran track for the legendary Bill Bowerman, who of course they know. He tells them,
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Nike
Yeah. Only thing I would add to that is just to reiterate what kind of has hit me through doing the research in this episode is that Athletes are Netflix shows.
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Nike
And these days especially, in the beginning it was athletes are billboards and Netflix shows on SportsCenter or whatever, like you're going to see the swoosh. Now with social media and the modern world, it literally is a Netflix show. People are following... You name it. Patrick Mahomes, Serena Williams. They have a following who are following their lives like a reality TV show.
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Nike
I see your Rob Strasser quote, and I will one-up you a Phil Knight quote. Give it to me. This is actually about Phil Knight in Just Do It. Around the time Michael Jordan became a Nike guy, Phil Knight had finally begun to apply in full measure his hunch that if the general public could be helped to imagine great athletes as he imagined them...
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Nike
as having implications of the very best that the human spirit had to offer, then those athletes would become like the heroes of old, the heroes in books, and people would come to those heroes and listen to what they had to say.
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Nike
Now, what's really interesting, since we did the NFL episode earlier this year after doing the NBA episode, I've really changed my thought on this. The NFL is a better business as a league than the NBA. No question in my mind. But... The amount of value created out of the leagues. I think more value is created out of the NBA.
Acquired
Nike
The NFL just captures way more value and thus is the more valuable league. But this Nike episode is totally solidified for me. the value coming out of the NBA. Jordan, Kobe, LeBron. It goes on and on. Zion, Wemby, Victor, Wem and Maya, the new phenom coming out of France that was the number one pick of the Spurs. He's already a Nike athlete. Fascinating.
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Nike
And basketball, again, because it directly translates to those are the shoes that people can buy. Whether they buy that model or a different model, they are buying those shoes. They're not buying football cleats. And it's the face of the person. It's not behind a helmet. It's like, they're the heroes.
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Nike
I mean, it's funny because it's the Gatorade line, not the Nike line about Michael Jordan, but like... Be like Mike. If you want to be like Mike, it's really easy. You just buy the shoes. If you want to be like Patrick Mahomes, it's a little harder.
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Nike
that he's done market research. He thinks that the U.S. track shoe, you know, running shoe market could be a $1 billion market, which he totally makes up. He has no evidence to back this up whatsoever. He's done lots of market research. Lots of market research. And it is completely wrong in both directions. The actual U.S. market for running shoes at this point in time, I mean...
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Nike
Well, this gets to your question at the start of the episode. This is the crux of the question. I think there's two answers. The Prestige models, the Jordans, the Retros, the Vaporfly, what have you, the Prestige $150-plus Nike models, I don't think those are commodities. I think those are products. Nike also sells a lot of 50, 60, $70 pairs of shoes.
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Nike
Yeah. Totally agree. And it's interesting, even like telling a little bit of the athlete story along the way here, too. Even that story of the product is what's important. That's kind of part of the myth of the marketing of the brand with the athletes, right? You know, the Jordan 2, the Jordan 3. Like, yeah, the Jordan 2 sucked. Sure. Like everything I said, probably true.
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Nike
I think MJ probably really believes that, as do many people. On the other hand, it's also a really convenient story. Or the Kobe story of, oh, Kobe's Adidas shoes sucked. Right. Sure. Makes for a really good story for the soap opera that is the athlete's life that is the Netflix show that they're selling.
Acquired
Nike
there's no way it was a billion dollars. Like maybe a hundred million, maybe? I mean, we just were talking about like running was not a thing. It was a thing that athletes did.
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Nike
When I think maybe part of this, what has happened is Nike can participate in getting their billboards in these other aspects of popular culture, music being... the biggest example of it without having to have rappers be sponsors because how much Nike placement is there in music? A ton. How many songs are there about Michael Jordan to this day or LeBron or Zion or Ja Morant or what have you?
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Nike
He designed the Pegasus, which I think is the longest single running model with no pauses in Nike's history. I ran in a Pegasus two days ago.
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Nike
Well, Nike is also so insular. People develop up through the company and stay there forever.
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Nike
Right. So he's completely wrong on what it actually is at that point in time. He's also completely wrong on what it would become in the other direction, thanks to Blue Ribbon and Nike.
Acquired
Nike
Fair enough. I totally see what you're saying. I think if you were to say that the equivalent Disney animation for Nike... was running at the beginning, I think it is unquestionably basketball today. Fair.
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Nike
I don't think this is really a bare case, but if you're viewing this through the lens of should I buy the stock, not investment advice, but versus other companies I could put my money into, as incredible as this company is, the operations, the power, the scale economies, the brand, I think the durability, it's still not a software gross margin business, nor is it ever going to be.
Acquired
Nike
I love that our complaint is always it's not a SaaS company. Well, it's a really good business model. I mean, look, if you could put all your dollars, you could put it into SaaS companies, you could put it into Nike. Right. I do think Nike has incredible durability.
Acquired
Nike
And I'm sure both hardcore basketball fans and sneakerheads would nitpick with this statement. But to me, Nike basketball and the sneakerhead culture is the core of the driving force, you know, the pinnacle of the Halo, the Jordan brand. And I just don't see, like, it feels like as strong as it's ever been to me.
Acquired
Nike
Yeah, amazing. I did find that, and that is an amazing connection, and the deep cut is great for acquired lore, but that is not what I tweeted about. My tweet was actually about something slightly different, which was people that we come across in the acquired universe, minor characters who go on to be major characters in other stories. And it was actually about Don Katz and Audible.
Acquired
Nike
Which I love these wild career changes where like you go from being a journalist and an author to starting a technology company. Yeah, it's pretty cool.
Acquired
Nike
So Knight leaves this meeting, this performance of a lifetime. He gets an agreement from Onitsuka that if he wires them $50, they will send samples of the shoes to his office back in the States, i.e. his family home in Portland, Oregon. Yeah. So first thing Knight does, he gets in touch with his dad.
Acquired
Nike
Well, it's like LeBron selling shoes. You know that he's selling shoes. But my God, he's amazing.
Acquired
Nike
Great. I've listened to the Ben Thompson interview, but not the Lex one yet. So I'll have to do that. I am breathing a huge sigh of relief over here because I was more than ever certain that we were going to have the same carve-out today. Can you guess what mine is? No. Maybe not because we've been so deep in Nike research to not pay attention to current events. Mine...
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Nike
is Speak Now, Taylor's version, which just came out. And I feel like Speak Now, at least for me, in my Taylor Swift experience, is like the forgotten album. Like, I just never think about it. And then when it came out, I was like, oh, wow. Well, A, I was surprised that she's even continuing to do the re-releases.
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Nike
Yeah, the ultimate power move would be to stop. So pleasant surprise that it came out. And also pleasant surprise to rediscover Speak Now. Like there are some bangers on there. Great album. It's so funny listening to her now. How old is Taylor now?
Acquired
Nike
And to hear her singing songs from when she was 21, it's just such a fun juxtaposition.
Acquired
Nike
Wow. You are bringing a new energy to these outros. I like it. It came to me in a fever dream. Wow. That is some Black Air Forces energy. Yep. All right. Later. All right, listeners. We'll see you next time.
Acquired
Nike
I don't know, he sends him like a telegram or something back in Portland and asks him to wire $50 to the Onitsuka Corporation of Japan for purchasing these samples. He gets home, I think it's two or three months later after this. Surely the shoes would have arrived by now. Surely the shoes would have arrived. He rushes home, says, hi, mom. Hi, dad. Did the shoes arrive? His dad's like, what shoes?
Acquired
Nike
The shoes did not arrive. The shoes would not arrive for almost another year. Wow. A little foreshadowing in what doing business with Onitsuka is going to be like for the fledgling blue ribbon sports.
Acquired
Nike
So Phil gets home. He's disappointed. He's got to start his life. He gets a job as an accountant. He's got a business school degree. He's studying to take the CPA exams and become a licensed CPA. And then finally, at the end of 1963, I think right around Christmas, Phil writes in Shoe Dog, the samples show up. And Phil gets them. You know, they're great. They're what he remembers.
Acquired
Nike
He thinks, you know, these aren't quite maybe as good as Adidas, but they're good enough. And I can sell them cheaply enough that my business plan will work. Right. They're way cheaper. So Phil gets back and writes Onitsuka, says, great, I would like to be the U.S. distributor for track and field shoes. And Onitsuka says, okay, great. You can be the distributor for the Western United States.
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Nike
We already have somebody that we're working with on the East Coast, but you can have the Western 13 states. Phil's like, great. He quits his accounting job. He He starts the company. He goes to work. He hires one of his twin younger sisters, who I think was maybe still in high school, to help him part-time with receiving the inventory and sending them out and stuff.
Acquired
Nike
Or even really to get enough inventory to sell wholesale to other retailers. So his genius business plan, I don't know how much of this was part of the Stanford paper or not, is he's going to drive around to track meets in Oregon and up and down the West Coast and sell the shoes out of his car.
Acquired
Nike
Yes. Speaking of proprietary, he also has another actually really great idea, which is that while he's driving around, he'll go down to Eugene and see his old coach, Bowerman, at the University of Oregon. And he thinks, oh, if I could get Bill to put his runners in Tigers, then that would be great marketing for me. And I know he's not always super happy with Adidas.
Acquired
Nike
We're going to have a better relationship. He'll be able to experiment with these shoes. And I'll sell them to him for cheap. Because at this point in time, even the legendary Bill Bowerman and the University of Oregon, they bought all the shoes. Nobody was giving them shoes. It was like a major line item in their budget. Crazy.
Acquired
Nike
Not exactly what GSB or any other business school would determine a recipe for success here.
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Nike
That's a super good point. And it turned out actually that Onitsuka had already studied the U.S. market, whether they agreed with Phil's plucked out of thin air market size or not. They wanted to enter the market, but they didn't think they could do it on their own. So they actually were looking for somebody like Phil.
Acquired
Nike
Oh, my God. I think Amazon owes a thank you note to Acquired LPs because I bought every Nike book out there. I mean, my six foot long desk is covered in Nike books. So fun to read all of them.
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So Phil goes down to see Bowerman. And to Phil's surprise, I mean, Bowerman is not a warm and fuzzy guy. He's never really shown Phil much encouragement when he ran for him or since. Bowerman says, this is a pretty good idea. not only do I want the shoes for cheap, I want you to cut me in on the deal. I want to be partners with you in this company. And Phil is like floored.
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So Phil's like, what's the deal you have in mind? I think originally Bowerman says 50-50 and then he sleeps on it and he comes back with his lawyer and he says, actually, let's do 51-49. I want you to have 51, me to be 49 because I don't really want to be involved here.
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Now, on the one hand, this is super exploitatory of Bowerman, of his old athlete that still obviously looks up to him like a father. It's kind of like there weren't really VCs yet in this era, but when there would be, like, VCs taking 50, 60, 70% of the company. On the other hand, this is a no-brainer yes for Phil.
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He's like, oh, only half the company? Great. Well, and if Phil doesn't do this deal, he would have 100% of Phil Knight's Blue Ribbon Sports. But he does do the deal, and he gets 51% of Bill Bowerman's Blue Ribbon Sports, which is a completely different animal.
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There are so many of them. I read thousands of pages. But there are three books that all basically tell more or less the same story that we weave together to come up with our core Acquired Nikki story here today. And I bring it up because it's actually pretty important what these three books are. The first, of course, is Shoe Dog, the goat business memoir of all time.
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Just like Onitsuka was primed to receive young Phil Knight, so was Bowerman. Ben, this is so awesome. I was going to save this for a reveal later in the episode. Scott Reams is legendary. He was, as you say, Nike's corporate historian. He worked super closely with Phil on writing Shoe Dog.
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Not only I sent him a message on LinkedIn, I talked to him. I spent hours talking to Scott.
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He spent a few days helping me put our version, Acquired's version of the Nike story together. We have a huge, huge thank you to him. But I was going to surprise you with this. This is super cool.
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Oh, I've got one in particular that I want to bring Scott's perspective in, but it's a little farther in the story. Great. All right, so Bowerman. So, okay, we've got 51 night, 49 Bowerman in Blue Ribbon Sports. They each put in $500 to finance the first big shipment of inventory of tigers from Onitsuka. And they do, they, meaning Phil, does what he intended to do.
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He drives around to track meets around the Pacific Northwest and sells them out over the back of his car. And... Even with that funny sales strategy, and in Shoe Dog, Phil talks about this while he was in Hawaii with his buddy. The way they made money was they sold encyclopedias door to door, and then Phil gets a job as a stockbroker trying to sell stocks. He doesn't make any sales.
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He's the most introverted person in the world. He can't be a salesman. But for some reason, when he's selling shoes, when he's doing his crazy idea, he can literally just go to track meets and convince kids and their parents to buy these shoes out of the back of his car. When you believe in something, sales are just natural. It's so true.
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So they sell out basically immediately, and then they plow all the profit that they're making back into the next orders of inventory from Onitsuka. So they do $8,000 in revenue in 1964. That doubles in 1965. They do $16,000 in revenue. But Ben, as I think you're about to say, there's kind of a problem here.
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This is not a solvable problem. It's a circular issue. There's no way to do it. So Phil is selling the Tigers for $6.95 a pair. It costs him and Bowerman about $3.50 to get each pair of shoes. So that leaves, what, about $3.50? Yeah. Pretty soon, Phil hires his first full-time employee, the legendary Jeff Johnson, who has a huge role in Nike, as we shall see.
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The second is a book called Just Do It that was written by the journalist Donald Katz. Ben, do you know who Donald Katz is? Ooh, I do not. So Don, after he wrote this book, and I think he wrote one or two other books, he had quite the career change. He went on to found the company Audible. Oh, really? Isn't that crazy?
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Once Jeff and other sales reps come on board, he's giving them about $1.75 in commissions. So half the gross margin ends up going into sales and marketing expenses. Exactly. So that leaves, what, $1.75, maybe $2, like you said, in profit per pair, right? How are you going to order more inventory at $3.50 a pair when you're making $2 in profit per pair? The math doesn't pencil. Wow.
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Quick aside on Jeff Johnson. Like we said, he is absolutely legendary. He also sells out of the back of his car. He's based in California. He met Knight at Stanford. Jeff was a Stanford undergrad who ran track and met Knight while he was at GSB. Johnson sells out of the back of his car. He evangelizes the brand. He designs shoes. He eventually opens Nike's first retail store in LA.
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He sets up manufacturing. He moves back and forth across the country. He is basically like everything you would ever want in a first employee at a company. To find a Jeff Johnson... is the most incredible thing that could ever happen to a startup company.
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This is one of the moments that just floored me, rereading Shoe Dog and internalizing that. running. I go for a run maybe three times a week these days. Right. It's just normalized into life. Every time I walk out in the street, basically anywhere in the world, unless I'm like truly in the middle of nowhere, you see people running.
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And the idea that motorists would throw beer and soda cans at runners is crazy. Yeah. Totally wild. So back to this financing issue. As you can imagine, the only way to grow as a company with the set of operating constraints that Blue Ribbon Sports has is through financing. And the only way to get financing in Portland, Oregon in those days was to go to Oregon regional banks.
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I think actually there were laws in the US that corporate banking could not happen across state lines.
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So there are only like two or three banks that Knight even has the option of going to.
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Yep. And the bankers who are making these loans in Portland then was a very, very small town in a very, very small state on the west coast of the U.S. They're not going to be very risk-seeking.
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Yeah, just wow. So he wrote kind of the canonical third-party journalist take on Nike. And then the third book is a book called Swoosh, which I bet most people have not read, but kind of like Taste of Luxury. I think people who are really in the know in the footwear industry have read this book. It was written by one J.B. Strasser and her sister, Laurie Beckland. J.B.
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Yeah, it's basically factoring. Right. Is what it's known as today. Right. So yeah, as you can imagine, there are quite a lot of struggles with the various banks in Oregon, and it's all very well chronicled in Shoe Dog. So since growth is literally rate limited by the banks, Knight decides that he can't justify taking a salary. He goes back to being an accountant by day.
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He joins Pricewaterhouse in the Portland office. He does that for a couple years. I mean, years, years. It takes a long time to grow this thing. Eventually, Blue Ribbon does become big enough, and he needs to devote enough time to it that he can't be a full-time accountant. So instead, he gets a job teaching accounting at Portland State. where he meets two women.
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Both of which will change his life. The first one is a student. Man, things were different in the 60s. A student in his first class that he teaches named Penny Parks, who he sees has great potential as an accountant. So he hires her as a bookkeeper part-time while she's a student, I believe, for Blue Ribbon Sports. Very shortly thereafter, she becomes Penny Knight, his wife.
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Now, I think of, gosh, like 60 years, maybe? Something like that? The other woman he meets is an art student, not an accountant. An art student named Carolyn Davidson. And Phil overhears her talking with some friends in the hallway one day, talking about art classes. And he stops her and he says... hey, I've got a company.
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We need some part-time art and design work for, like, brochures and sponsorship collateral.
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And the way I'm going to do it is I'm going to hire a part-time student from Portland State to do my advertising collateral for $2 an hour. Yes. She says, sure, put a pin in that. We are going to come back to Carolyn Davidson and the Nike art department in a minute here. Yes.
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But first, now is a great time to tell you about one of our favorite companies here at Acquired and a new sponsor this season.
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Strasser is Julie Strasser, who was the wife of Rob Strasser. Now, Rob, if you've seen the movie Air, the character played by Jason Bateman is Rob Strasser, Nike's legendary first head of marketing.
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So in the meantime, by hook or by crook, and maybe Onitsuka, as we will see, would argue by crook, Blue Ribbon Sports' sales do keep growing. They do keep getting just enough and just enough in time financing to finance their inventory and orders from Tiger and Onitsuka. In 1966, they do $44,000 in revenue. In 1967, they do $84,000 in revenue. You're noticing a doubling theme here.
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Turns out, even from a very low base, if you double every year for like 20 years, you can still become a big company. So then... In 1967, Bowerman. Remember, you know, Bowerman's been involved. His name, his association with the company has been huge throughout all this. But like you were saying a minute ago, Ben, his real motivation is he wants R&D access. He wants to be able to make shoes.
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And in 1967, ahead of the 1968 Mexico City Olympics, he comes up with a new idea for an entirely... new type of shoe, one that he probably can't really manufacture on his own. But now he has this relationship with Tiger, with Onitsuka.
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An item among many that is not discussed in the movie is that Rob, shortly after signing Jordan, had an enormous fight with Phil Knight, left the company with Peter Moore, who was the designer behind Jordan's, and ended up joining Adidas as CEO of Adidas America just a few short years later.
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And his idea is that rather than leather on the upper parts of these track shoes, what if we instead use a breathable material like nylon so that my runner's feet aren't sweating throughout the whole race? On the one hand, like, yes, nobody likes sweaty feet.
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On the other hand, if your feet sweat a lot in leather shoes over the course of several miles, well, they're going to get heavier and weighed down. And so maybe this might help the shoes stay lighter. And Bowerman is obsessed with lightweight in his shoes. So Onitsuka is very receptive to this. They think, great, we love this. We'll make the shoe. We can do that. We can source the nylon.
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We'll make the shoe. So Bowerman and Phil get together. They're like, this is amazing. We're going to have our own model, you know, that we've designed, that Bowerman's designed. Which you should already start to get a little bit nervous here because it's like, well, okay, who... Who owns this shoe?
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Yep. The relationship complicates a little bit here. It's no longer just, hey, we're the American distributor of Tigers. So Bowerman and Phil want to call the shoe, they actually want to borrow from the Adidas playbook and call the shoe the Aztec ahead of the Mexico City Olympics. Adidas has been doing this for years.
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They always come out with new shoe models ahead of whatever the Olympics is in the world every four years. Adidas, of course, has already beaten them to the punch. They have trademarked a shoe that they're coming out with called the Azteca Gold. And I don't know if it's Blue Ribbon or Aritzuka decides that the Aztec is too close to that.
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So legend has it, you know, knowing these men, I assume this is quite true. Bowerman is casting about for other ideas for names of the shoe. And he says to Knight, what was the name of that Spanish guy that kicked the you-know-what out of the Aztecs? And Knight is like, oh, that's Cortez. And thus, the blue ribbon slash tiger Cortez is born. Naming aside, the nylon uppers are a huge innovation.
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Yeah, spoiler alert, Tiger eventually became Asics. Yes. so also in 1967 bowerman has another just monumental contribution his contributions though sporadic when they happen are enormous yeah so he writes a book i feel like some marketing agency these days would advise a startup on oh yeah this is how you build a market you know write a book start and evangelize a movement
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Bowerman just does this because it's what he wants to do. He had gone on a trip to visit another international track coach in New Zealand a few years earlier. And he discovers the concept of jogging. I don't even know if the word jogging really existed in America at this point in time. The idea of running not to win, but to run for joy or for physical fitness was an entirely foreign concept.
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This is like a Judas-level betrayal. I mean, to say he was persona non grata around Nike is an understatement of the century. And here's this book that was written in real time by his wife as this was all happening. Incredible.
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This is Phil Knight, the founder of Nike. Right. I mean, even Phil Knight is like jogging. That's crazy. So Bowerman writes this book. It's called Jogging, a Physical Fitness Program for All Ages. He writes the book. It comes out in 1967. Life Magazine. Life Magazine was huge in America at the time. They come out to Oregon and they write a profile of him and his...
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jogging clubs that he started for the citizens of Eugene of all ages to get into jogging and physical fitness. And by God, I mean, as much as anything, this book and this article is what starts the fitness movement in America.
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Yes. So Knight has this great quote about this later in life. He's asked literally this question, if Nike started the fitness revolution. And his answer is so typically Phil Knight. He says, we were at least right there. And we sure rode it for one hell of a ride.
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Yes. I like that. Changing the definition. More than just people who define themselves by their occupation, whether amateur or professional, as athletes. Right. So by 1970, just a short while after this, Blue Ribbon is now doing over half a million dollars in annual sales. So they're like a real company now.
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They're selling out of the Corteses literally as fast as they can get them off the boats from Japan. Onitsuka renews Blue Ribbon's distribution agreement in 1970 for three more years to run through 1973. When this happens, Phil then goes to the bankers in Oregon and asks for, hey, you know, great. The Cortez is selling out great. Fitness is this new thing.
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We're a half a million dollar revenue company. We've got a three year ironclad deal with our manufacturer.
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So he asks for a line of credit of $1.2 million to finance inventory. He never asked for an over-million-dollar line of credit before. He trips the alarms. He trips the alarm system. $1.2 million. A kid off the street can literally walk down Sand Hill and raise $1.2 million today.
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We start, however, with the Shoe Dog story, the origin of blue ribbon sports. And actually a little bit before Shoe Dog starts, in July 1948, when one Bill Bowerman becomes the head track coach at the University of Oregon. Now, Bill was a legendary figure. In addition to being Nike's co-founder, along with Phil Knight,
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Exactly. Just say it's an AI company. So the bankers, not literally, although literally they would do this very shortly thereafter, they throw him out. They're like, no, no, no, no. We're done here. You can't be doing this.
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One, this is so sad. That's the way it was. And thank God the business world has evolved since then. I mean, you can decry the ridiculousness of startups and VC and tech and all that now, but this is a way better alternative than the way things used to be. Two, though, ironically, I actually, as crazy as this sounds, think it was a critical element of Nike succeeding and becoming Nike.
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Because if it were too easy, there would have been a flood of other competitors. Or Onitsuka and others would have just done this themselves.
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And there's huge survivorship bias here. Yep. But the journey that they had to go through to survive is incredible.
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And Nike almost does. So when this happens, when he gets thrown out of the banks, Phil needs to do something to raise money. So he decides... The only thing he can think of is to do a small public offering, like a local IPO. Remember how Ben & Jerry's was the first... Direct listing?
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Yeah, I think it's something like that where they sold shares, Ben & Jerry's sold shares in Vermont to like their neighbors. This is what Phil wants to do. And this is how bad it is. So A, he changes the name of the company. This is so good. Nike isn't anywhere in the picture yet. He changes the name of the company to Sports-Tech, T-E-K, Inc.
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With the idea that, oh, this will make us sound like a technology company and then people will be interested in investing.
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I mean, kind of the only way to describe him is he was like a descendant of the survivors of the Oregon Trail. The cowards never started and the weak died along the way was one of his favorite sayings.
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Exactly. We are right in that era now. Don is about to start Sequoia. A lot of this is happening around Stanford. Of course, Phil up in Oregon is hearing about this. But once anybody, you know, any proto-venture capitalist digs into sports tech, they're going to be like, no.
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Oh, that's a great question for Scout Reams. We'll have to ask him. Yeah, yeah. So this is how bad it is, though. The offering fails. Nobody's interested. None of these proto-VCs, none of the local business people in Portland. They're all like, oh, no, no. This is a terrible company.
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Yep. So he ultimately has to raise some money from the families of some of the employees at Blue Ribbon. Most famously, Bob Waddell, who would become Nike's first president other than Phil when Phil takes a sabbatical later in the 80s. Bob has this amazing story. He was also a Bowerman runner, had a terrible accident in college and was confined to a wheelchair for the rest of his life.
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Becomes one of Nike's and Blue Ribbon's first employees and then becomes a huge leader, builds so many things at the company and becomes the first president other than Phil. But he doesn't come from wealth and his family loans, I think, $3,000 or $5,000 to Blue Ribbon, like a huge amount of money for them.
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So Bill's dad was the governor of Oregon. And... Bill fought in World War II as a major, and he actually negotiated at the end of the war the stand down of a German battalion. He's also such a character. He lived in a remote mountaintop in the Oregon mountains, and the mail delivery people who would come up to his home kept knocking over his mailbox with their trucks.
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Phil would convert that into equity before the actual IPO, and they would become millionaires and change their lives.
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1971. The anus, either Mirabelis or Haribla, depending on how you want to think about it. I just butchered both Latin and French there, but clearly this financing path isn't going to work for the next stage of growth. Eventually, Knight, I think he reads in either a magazine or a newspaper article about Japanese trading companies.
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How he had never heard of Japanese trading companies before then, given the amount of business he was doing in Japan, is crazy. Although it was in Onitsuka's strong interest for Phil and Blue Ribbon not to find out about Japanese trading companies, as we shall see.
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Yes, to do asset-based financing, exactly what Blue Ribbon needs. So the company that he ends up meeting at the local branch office of it in Portland, I think they might have been the only Japanese trading company with a branch office in Portland, is Nisho Iwai, which is one of the smaller ones. Today, the company is called Sojitz. Today, it is still a $40 billion revenue company.
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Back then in 1971, it was a $100 billion annual revenue company. And it was, I think, the sixth largest Japanese trading company. The other ones that many listeners probably will have heard of are companies like Mitsubishi or Mitsui or Sumitomo. These are enormous companies. And especially in the 70s, as Japan was really rising, we told the story on the Sony episode that
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Right, because he gets a little spooked. According to Shoe Dog... Phil walks into the office of Nisho Iwai in Portland. This is like the Portland, Oregon branch office of Nisho Iwai. Meets with one of the officers there who would go on to become an incredible personal relationship for Nike and for Phil, a guy named Tom Sumeragi.
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So he rigs the mailbox with explosives to blow up the truck the next time it happens, and he literally blew up the truck. I mean... The stuff you could get away with in the 50s.
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And he offers on the spot to finance all of Nike's inventory on the spot in a meeting in the branch office in Portland. So Phil's like, whoa, how do I deal with these guys?
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So Phil, in retrospect, makes the mistake of calling up Onitsuka and saying, hey, you know, I'm in this lurch with financing. I just met Nisho Iwai. They offered to finance all my orders with you guys today. would you be okay if I do it? And they immediately say, absolutely not.
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And the reason they say absolutely not is, Ben, just like you're saying, they know what's going to happen here is Nisho is going to say to Phil, hey, you know, this is nice that you're buying Onitsuka's inventory. Onitsuka, I think, is like a 20, 30, maybe $40 million revenue company in Kobe at this point in time. Right. This could creep into us. Nisho is a $100 billion company, right?
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Nisho is going to say, hey, we'll introduce you to manufacturers, to factories here in Japan. Right. Build your own shoes, make your own brand, screw these Tiger guys. And that is exactly what happens.
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Crusoe is honestly one of the coolest companies in the world right now. They are a cloud infrastructure provider. So just like AWS and Azure, that's purpose built for AI training and inference. So just like Phil Knight had the crazy idea of taking on Adidas with Blue Ribbon, Crusoe and its founders, Chase and Cully, had the crazy idea a few years ago that they could take on AWS and Azure.
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No, they do not. So when Bill comes home after the war, he first coaches high school, and then he becomes the head track coach at the University of Oregon. He takes this background and character that he has, and he becomes maybe arguably the most successful coach
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And incredibly, they're actually pulling it off. And for many AI workloads, you'll get significantly better cost performance trade-off from Crusoe than any traditional cloud provider.
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Yeah, so this is crazy. Crusoe has gone out to oil fields around America and the world, think like Texas, Montana, etc. And they have built their data centers right on top of oil and gas flares and renewable energy areas like wind farms. So as some of you might know, oil and gas production often has a process called flaring. where they have to burn off excess product.
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It's an enormous waste of energy. And as you can imagine, it's also a huge greenhouse gas problem. It depletes the ozone. It increases carbon footprint. You get it. Crusoe helps to reduce this by instead converting those flaring emissions into powering your AI workloads.
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Yeah, it's crazy. And the key insight that really made this possible was that Amazon and Microsoft and Google's data centers have to be physically located close to where the quote-unquote internet happens, i.e. where internet usage is. But for 99% of AI workloads, latency doesn't matter. So Crusoe can put these data centers out where energy happens in these oil fields and wind farms instead.
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And as an aside, while we're here talking about Nike's asset-backed financing strategy, what Crusoe is doing also requires billions in capital funding. They finance the build-out of these data centers, not through venture capital, but through similar structures as Nike, just from large endowments and foundations instead of Japanese trading companies.
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Although, if Nisho EY is interested, I'm sure they would be happy to work with them too. So if you or your company or your portfolio companies have AI workloads that you could use lower cost and more performant infrastructure for... And I'm pretty sure that's everybody listening to this podcast right now. Go to crusocloud.com.
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track coach in american history so i believe bill coaches the first american sub four minute milers he ends up coaching several olympic teams he definitely turns the university of oregon into the most prestigious track program in america you know he's a national celebrity, which is pretty crazy for Oregon in the 1940s, 1950s. Right.
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So this basically sets off a whole chain of events that would later get prosecuted in court. So Onitsuka, as we said, they are super nervous. They know what this Nishio relationship is going to mean for Blue Ribbon, and it's not good for them. So they start looking around at working with other potential distributors in the U.S.
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They assume that Blue Ribbon, one way or another, is going to end their relationship with them here. they also, as kind of a last-ditch effort, make an offer to buy Phil out, to buy Blue Ribbon. And Phil thinks he's being smart here. He stalls. He doesn't say yes, he doesn't say no. He's like, oh, let me talk to Bowerman.
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But they probably turned that inventory several times. So at any given point in time, the inventory is less than that.
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He knows at this point that he's done with Onitsuka. They're going to go with Nisho, and they're going to set up their own factory relationships and make their own shoes. But he can't just shut off Tiger. It's going to take time to spin this stuff up. He needs the Tiger shoes in the interim, so he stalls.
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So there's a whole bunch of stuff. Phil hires a spy. There's a thing where the Onitsuka management team comes over to visit Blue Ribbon headquarters. Phil steals some documents out of the guy's briefcase.
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Yeah, it's pretty bad. Even worse, Phil's accommodation, as we keep saying, of Genghis Khan and like extremely introverted and really naive. He writes a memo to the whole company saying that he's hired a spy at Onitsuka. This is not the kind of stuff that you want coming up in legal discovery later. A whole bunch of this stuff happens.
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They end up in this literal Mexican standoff here where like there's no way out without firing shots. and somebody has to fire a shot first, and it's Phil. Phil shoots first. He's like, Han, he shoots first. And I say Mexican standoff too, because A, that is the situation they're in. B, the first shot gets fired in Mexico.
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So a few years into Bowerman's tenure as head coach, he recruits a pretty talented middle-distance runner, freshman, from Portland nearby, one Phil Knight, Now, Phil also has some interesting Oregon roots. He's the son of Bill Knight, who is another well-known University of Oregon alum. He was a former lawyer in Portland, and he's the publisher of the Oregon Journal newspaper.
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So while Phil is waiting on spinning up the Japanese factory relationships with Nisho Iwai, he remembers from back in the Mexico City Olympics in 1968, I think, that there was a factory, I believe in Guadalajara, that Adidas had used to make soccer cleats for the Olympics. And he says, you know, those soccer cleats that Adidas made were pretty good.
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Let me go down to that factory and see if I can get some of those cleats. And we'll sell them here in America as blue ribbon American football cleats. Now, technically, he thinks this won't violate his exclusivity agreement with Onitsuka because Onitsuka doesn't make football cleats. Now, that's debatable.
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So he goes down to the factory in Mexico. He's like, can I get the shoes? And they're like, yeah, sure. what do you want to put on them? When we made them for Adidas, you know, we had the three stripes on them, the Adidas stripes. What design do you want on your version of these shoes? And oh yeah, by the way, what do you want to call them?
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And Phil's like, um, let me get back to you on both of those. So he goes home to Portland and calls up who else? Carolyn Davidson, the part-time art department at Blue Ribbon Sports for $2 an hour. And he asks her to design something like Adidas' stripes that can go on the sides of these soccer slash football cleats.
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And huge thank you here to Scott Reams for helping us sort out exactly what the timeline is and what the details are, because it's not well understood how this all went down.
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Also, super importantly, this is not the name that we're talking about here. So point one, we're just talking about a logo to go on the shoes. So all the thought of like, oh, the swoosh is like the wing of the goddess of victory. No, not the case. This is before the name.
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Okay, so as you say, she goes through two rounds of sketches. When the second round comes back... They're out of time. The factory is calling and they're like, hey, shoes are just about ready. We just got to put the sides on them. What do you want? So finally, Phil and Jeff Johnson and Bob Waddell, they're sitting around and a couple other folks and they're like, well, we got to pick one.
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And they're like, well, maybe, I don't know, this one that kind of looks like a check mark. It maybe is the best of the bunch. And Phil very famously says the line, I don't love it, but maybe it'll grow on me. Yeah. And that becomes the swoosh. Now, ultimately, they do give Carolyn stock in the company before the IPO. So she makes more than $2 an hour. But for this project, she was paid $35.
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Phil follows in his dad's footsteps. He majors in journalism at Oregon, and he runs for Bowerman. And I would say Phil is okay as a runner.
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And I heard Phil say somewhere, I think it might have been in the GSB graduation speech, I believe he said that she held the shares. Yes.
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Yeah. Wow. Incredible. Pretty cool. So they send the logo off. So a short while later, Factory in Mexico calls them up and is like, all right, shoes are done. We're ready to box them and ship them. what should the model name of these shoes be? Like the Cortez or the Azteca Gold or, you know, whatever they had called them. What's the model name of the shoes?
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And so back at Nike headquarters, they're all sitting around brainstorming. And this is where all the famous ideas that get thrown out, Phil Knight loves Dimension 6. The other people are throwing out the Bengal, the Falcon, you know, all the naming ideas. The idea is they want to name the model of the shoes, like these cleats. What are the cleats called?
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And as best as we can tell, this is actually true. In typical Phil Knight style... He can't make a decision. They're waiting towards the end. It's the same story as happened with the logo all over again. They're batting it around, and then the night before they need to finally drop dead, give the name of the shoes to the factory, Jeff Johnson comes in and is like, I had a dream last night.
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Nike
Johnson. And in the dream, the name came to me. Nike. And everybody's like, What are you talking about? What are you talking about? And he's like, the winged Greek goddess of victory. These are going to be the Nike football cleats. And everybody's like, all right, well, we like that better than the other stuff. Ship it. But it wasn't that big a deal.
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Nike
Like, it was a big deal, but it wasn't that big a deal. This wasn't intended to be Nike. This was intended to be the name of the model of the football cleat.
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Nike
Well, no, I don't think that was the problem. I think the factory was fine. I mean, they made shoes for Adidas for the Olympics. The problem was it was in Guadalajara. It doesn't get very cold in Guadalajara. So the shoes were great, but in freezing temperatures, they would crack. They'd never been tested in the cold. And...
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You know, as Americans at least know, many American football games are played in cold temperatures. So they ordered 3,000 pairs. They sold them. Apparently, the Notre Dame football team wore them that year, or at least the quarterback did. Then they would crack in cold weather. So it was a very inauspicious start to Nike and the swoosh here.
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Nike
But again, whether it violated the letter of the agreement with Onitsuka or not, ultimately the courts would decide it didn't. But it's game over here. Like, the relationship is done. They have burned the bridge. It's over.
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Nike
And for most of these situations, this one very much included, yeah, like this ends up in lawsuits and yeah, it's probably a toe over the line. On the other hand, it's also a little bit like Uber in the early days with toe stepping, like the alternative was the taxi industry. It's good for the world that they stepped a toe over the line. Like, they didn't do this. There's no Nike. Yep.
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Nike
So, with that, Onitsuka pulls out of the relationship. They don't send any more tigers to Blue Ribbon. Phil signs a deal, finally, with Nisho Iwai. And the core part of the deal is... Nisho will, A, finance all of Blue Ribbon's financing needs, henceforth, pretty much at a scale that goes all the way up to the moon.
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I mean, they're a $100 billion revenue company, certainly way more than any of the Oregon banks could do. And they'll do that at market interest rates. Two, Nisho will help Blue Ribbon set up direct manufacturing relationships in Japan, which they do.
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And then three, in exchange for all that, Nisho gets a 4% royalty on every shoe that Blue Ribbon sells, which ultimately ends up being a great relationship.
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Nike
Does that still exist? I don't know. I doubt if it does in the same way. I know that the relationship with Nisho Iwai continued for like 30, 40 years, like a very long time. If it still does exist today, I'm sure it is not the same terms. But this goes on for a very long period of time.
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Nike
This is exactly what I was going to say. I think at any other school, Phil would have been a star. This isn't really in Shoe Dog, but I know Phil's personality from reading so much about him over the past couple weeks. I think he probably went to Oregon in part because he wasn't going to be a star there. I mean, he is, I think, the most introverted CEO that we have ever covered on Acquired.
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Nike
Yeah. Shoe Dog has a lot of great, like, Phil Knight's personal experience going through this, which is... I mean, it's worth the read no matter what, but read it for that.
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Nike
Yep. So once this is all in place, Phil goes over to Japan and works with Nisho, goes, visits lots of factories, ends up meeting the Nippon Rubber Factory. He's touring with lots of folks and his sort of test of these factories of whether they can be a good partner is he pulls out a Cortez and he asks the factory how long it would take them to make a version of this shoe.
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Nike
So he meets with Nipon River in the morning. They say, let's go out to lunch. Let us borrow the shoe, inspect it a little bit. We'll come back after lunch and we'll have an answer for you. They come back after lunch and there is an almost perfect duplicate of the Cortez sitting there on the conference room table. And Phil's like, hell yeah. This is what I'm talking about.
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Amazing. So he is jazzed. He orders all sorts of models. He's like, can you do all the running shoes that we slash Tiger were doing before? At least the ones that we and Bowerman designed. They're like, yep, no problem. He's like, can you do tennis shoes, basketball shoes, cleats? He's like, yep, yep, yep. Whatever you want.
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So in a kind of very unfilled night-like peak of confidence here, he says, great, well, I'll just start writing out model names. So he writes out the Wimbledon tennis shoe, the Forest Hill tennis shoe, the Blazer basketball shoe, the Bruin basketball shoe, the Marathon, of course, the Cortez. He's like, great, let's do all of them.
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Nike
The blazer for sure. Yep, of course, the Cortez. And they're like, okay, great. And then Phil's like, one more thing. The boxes. Can you make them bright orange? I want them to stand out. And Nippon Rubber's like, you got it, man. Whatever you want. It's awesome. So great. And to this day, they're orange.
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And by the end of this trip, Phil and Blue Ribbon Sports has a whole new line of athletic shoe models coming out of Japan with a much better relationship, solid financing, and a brand new brand to show it all off. The winged goddess of victory, Nike.
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Nike
So Phil gets home and he tells Bowerman about this. And this is where yet another sporadic but incredible Bowerman stroke of genius comes to play for Blue Ribbon slash Nike. Bowerman's jazzed. He's like, great, I never liked the Onitsuka guys that much anyway. Hey, But he doesn't really care about that. What he cares about is he's like, wait, so there are factories now?
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I mean, Rockefeller was pretty introverted, but he looks like Elon Musk compared to Phil Knight.
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Nike
We can tell them exactly what to do? You mean, I'm the new chief R&D officer of Blue Ribbon Sports? Let's get to work. So that weekend, supposedly it was the weekend right after Knight told Bowerman about what was happening. He goes home and over breakfast on Sunday... Bill is sitting there. His wife, Barbara, is making waffles for breakfast.
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Nike
And honest to God, I think, you know, I mean, according to Scott, according to everybody, this really happened. Bill is struck with inspiration. And he's like, hey, honey, can I borrow that waffle iron? Borrow. That waffle iron was not coming back. He goes out in the back in his mountain home. And he had a vat of polyurethane sitting there. And he had it because
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The University of Oregon had just redone their track and made it into a polyurethane track instead of a cinder track. And Bowerman at the time was like, well, this is great. This is the future. The Olympics are going to do this and whatnot. But the shoes that I have, that I have my runners in, they're not gripping the track that well. And so he sees the waffle iron and he's like,
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Now, according to Scott, in a really like you cannot make this stuff up design, Everybody thought that that original waffle iron was lost to history and like, was this even true or apocryphal anyway? Years and years later, after Bill had died, his, I think it was his kids, are going through the estate. No. And Outback is up in the mountains. Like, they didn't have real trash service.
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Nike
So they threw the trash... in like a garbage pile in the back. And they're doing some renovations to the house or something. Somehow, they discover out in the trash heap the glued shut waffle iron. And it is in Nike's possession to this day.
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Nike
Isn't that awesome? So where, of course, this is leading is the waffle trainer, which is another one of Bowerman's genius inventions and becomes the first big hit shoe for the new Nike brand. He would... Eventually, after gluing the first waffle iron shut, then create a mold out of plaster in the waffle iron, pour polyurethane into that, and then make the waffle soles for the shoes.
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They work incredibly well on artificial surfaces, not just tracks, but also astroturf, which is becoming a thing at this point in time. So the University of Oregon football team wears them that year on their new astroturf field. It's like a huge thing. They beat Oregon State wearing their waffle trainers. This is incredible publicity for Nike.
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Nike
I forget what the first colorway that they do it in is. Look at you, sneakerhead over there. Colorway. Colorway. Eventually, I think it's Phil who's like, oh, we should do this in a blue that'll go well with blue jeans. Ah. Yeah. The canonical old school waffle trainer is blue with a yellow swoosh. And I think a lot of those were sold to be lifestyle shoes going with blue jeans.
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I mean, I was super lucky. I owed a huge thank you in my life to Phil Knight. I went to Stanford Business School. I was one of the first classes to graduate at the night management center that he endowed there. Didn't he give your graduation speech? Exactly. It was amazing. It was kind of the first draft of Shoe Dog that he had been working on. The book came out a couple years later. So great.
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which turns into Nike's real business eventually. But that, the success on the field, on AstroTurf fields, the success in track, that year, so this is 1972, Blue Ribbon's first full year doing sales as Nike purely on their own, They do $3.2 million in revenue. Remember, just a couple of years before their last kind of full year with Tiger, they were doing half a million dollars in revenue.
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Nike
So to go from all the crazy drama, ending the Tiger relationship, starting up their own factory production, making the Waffle Trainer to be at $3.2 million, fully financed by Nisho, what a great spot to be in.
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Nike
Yes. And it turned out that it was the former. People were willing, definitely willing, to buy Blue Ribbon shoes and to buy Bill Bowerman shoes. regardless of Tiger and Onitsuka.
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Nike
Well, this is how important Bowerman was. He started jogging. Not only was he Bill Bowerman, you know, legendary track coach, he also started jogging.
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Nike
So the convergence of things, all the butterfly wing flapping that had to happen for Nike to become Nike, right at this time, right as Nike is being born and Blue Ribbon is going out on their own, Bowerman gets a generational runner at Oregon, Steve Prefontaine. Tragedy.
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Nike
Like, weirdly, so many people we've covered recently on Acquired dies in a car crash way too young, you know, James Dean style, which ironically, of course, just cements his legacy. But Pree was the American runner. He was on the cover of Sports Illustrated while he was a runner at Oregon for Bowerman. He simultaneously held every American record for every distance between 2,000 and 10,000 meters.
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Nike
Yes. Incredible. And he did this at Oregon and then later as a professional, but still for Bowerman and his Olympic teams in Nikes right as Nike was starting.
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But I remember thinking, this does not seem like the founder and CEO of Nike. You know, even here talking at Stanford, the most warmly receptive audience possible, like, he was very nervous. Yeah. Huh. So Knight runs at Oregon. And it's important to say, we should note about Bowerman. He was definitely a person, a man like they don't make anymore.
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And this is one of those things that the AAU and the amateur rules and all that, like Nike was a thousand percent on the side of right here.
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Nike
Yes, exactly. So what was happening was amateur athletic rules and the Olympic organizing committee's rules were that you had to be an amateur. You couldn't be a professional athlete. You couldn't take endorsements or take money to race. Pree was this poor kid from Oregon.
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Nike
So after he graduated and wasn't at the university anymore, he literally had to bartend to make money while he's simultaneously holding the American records in every major distance event. This is criminal. So what Phil does is he decides to employ Pri as a corporate employee of Nike, as the national director of public affairs for $5,000 a year. With no responsibility. Yes.
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Nike
And there's this amazing quote in Shoe Dog. Phil says, people asked me what that meant. I said, it means he can run fast. So great. So great. This is the perfect encapsulation. I'm going to foreshadow just a little bit here of the later number three in the later Nike document of the 10 principles of Nike that we will talk about in a bit. Number three is so great.
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Perfect results count, not a perfect process. Break the rules, fight the law. That's exactly what Phil and Nike are doing here.
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Nike
So that's on the sort of proto-marketing front that this early Nike playbook is getting going. You know, $5,000 for the best publicity you could possibly ever get.
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Nike
Yes, that's part one of just the brilliant kind of re-startup of the Nike startup playbook that Phil puts together here. Part two, equally brilliant and innovative. He comes up with an idea for what he calls the Futures Program. So the way retailing worked back then, and Nike had their own stores always, but they also sold through retailers, of course.
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Nike
The retailers would place orders with Nike to buy the shoes and then they would resell them at retail. And then they would pay after they got the inventory. This is how retail works. This is like the law of the land, not the official law, but the way it all works. Yep.
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Nike
Phil comes up with the idea, because remember, he's got the Nisha UI partnership, but financing is still, like, he's scarred by this. So he goes to the retailers and says, if you commit and pay for your orders six months in advance, Blue Ribbon will give you a 7% discount, and we're going to call this the Nike Futures Program. Wow.
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Nike
So he's essentially moving his financing from banks and Nisho Iwai over to his retail partners, to his customers. And the retailers, of course, tell him to take a hike at first. But then the waffle trainer comes out, and they can't make enough of them, and retailers can't get enough of them.
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Nike
And the only way that they can get the waffle trainer, sweet, sweet inventory, those delicious waffles that they want, is to sign up for the Futures program.
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But despite what you might think, he wasn't militaristic. He really was pretty innovative. He was the first track coach, maybe college coach of any sport, who really put a focus on rest for his runners. And... Part of this famously for the Nike story too was technology and was shoes.
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Nike
The third piece then is sort of obvious and has happened all along, but now as Nike is making their own shoes, is outsourcing and global outsourcing of manufacturing. So again, Nike isn't making the shoes in their own factories. Now, they did actually buy a factory in New Hampshire along the way, which is a little bit of a detour. Phil sent Jeff Johnson out to buy it and run it.
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I like that. Break the rules, fight the law sounds much more inspiring than toe-stepping. So global outsourcing, though. At first, this, of course, is in Japan with Nippon rubber. But as we were saying, Japan is coming up in the global economy. And right around this time, Nixon cuts the dollar peg to the yen loose, and the yen starts floating against the dollar.
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Nike
So up until this point, from after World War II until the mid-'70s, the yen was pegged to the dollar. Once the currency floats, and the Japanese economy, of course, has come up hugely over these decades, now currency issues become a big problem for Nike in terms of importing from Japan. And the cost of labor is going up. So basically, the writing's on the wall.
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Nike
There's no way that they're getting shoes for $3 a pair anymore anytime soon. This means that they got to go find other countries to make the shoes in.
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Nike
So Phil and a bunch of the management team starts flying around Asia. They go to Taiwan. They go to South Korea. Ultimately, they go to China. They go to Indonesia. They go to Vietnam. And this is where the Nike global production machine is born. And at first, it's primarily Taiwan and then South Korea that they go to. then the big move is into China, both in terms of production and for selling.
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I think there's a scene in Shoe Dog, even when he's on the trip around the world in 1963, that he like peers into China from Hong Kong and is dreaming about 2 billion feet in China. Nike would be one of the very first companies, and I think the first footwear company that would be allowed to sell in China. To sell and open factories. They sort of opened the country for the industry. Yeah.
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Nike
So, this we would certainly be remiss in doing a Nike episode if we didn't talk about the downside of this. The upside, of course, is cheap shoes. And the upside, I think you can make a strong argument in the case with many of those countries that this is part of the... coming-up process in the global economy.
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Nike
If you look at what happened to the Japanese economy, to the South Korean economy, to the Taiwanese economy, they went from making shoes to making chips to making technology to being global economic powers. It's part of the process. At the same time, people are making like 70 cents a day working in these factories.
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So Bowerman actually taught himself how to be a cobbler and would take athletic shoes, usually Adidas athletic shoes, and modify them or even build his own and then use his athletes as guinea pigs to any advantage that they could have, he would be looking for and shoes were part of it.
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Nike
One of the things that Nike folks were really surprised by at the time when the controversy came up is they were like, all the other shoe companies do it this way. All the clothing companies do it this way. Why are we being picked on?
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Nike
But I think it's even more than that. People had come to love Nike so much and the brand represented so much that it was like a huge betrayal. It was a disappointment. It was like, oh, I thought you were better than that. You are about inspiring greatness and this is not greatness.
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Nike
And I think that's really interesting that like, yeah, this was part of Nike from the beginning, but because of everything else that made Nike successful... it's super ironic that they didn't hold themselves to the high standard that the whole company was all about. And then their customers were like, yo, this doesn't compute.
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Nike
So, okay, back to the mid-1970s. In 1974, these pieces of the Nike startup playbook, the inventing sports marketing, basically, sponsoring quote-unquote pre for $5,000, the outsourcing your financing to your retail partners, and then the global outsourcing of manufacturing, all of this combines in 1974 for just an explosive year.
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Nike
I can't remember exactly the phrase, but in Shoe Dog, Phil says something like, the limiters were off. The governors were off. We could run. They do $8 million in revenue in 1974. Which is up almost 100%. They nearly doubled again in 1973 to 1974. 1974 is also a momentous year for Blue Ribbon because they finally settle the legal battles with Onitsuka and they win in court. Amazingly.
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Nike
Ultimately, they settle for Onitsuka paying Blue Ribbon $400,000, which by this point in time is a pittance to Blue Ribbon. But the actual butterfly flaps its wings, hugely important outcome of this for the Nike journey, is that the court case with Onitsuka leads to one Rob Strasser coming into Phil Knight and the Nike orbit. He was their lawyer on this case, right? Yes.
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Nike
Strasser was the junior attorney at the Portland law firm that was working on the Nike case. And Strasser is just a force. I mean, this guy was not cut out to be a corporate lawyer. He actually comes in after the case is settled to Blue Ribbon as in-house counsel, but then Phil quickly realizes, like, oh, this guy is... Way more valuable to me than as my lawyer.
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Nike
You know, everybody else at Nike at the time, they're all former runners. Most of them ran for Bowerman. Strasser is, I think, about 6'2", and weighs over 300 pounds. And he has an equally outsized personality as his actual size. He gets the nickname within Nike of Rolling Thunder. And boy, does he roll like thunder.
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Nike
And while he and Phil, of course, did ultimately clash, and there was the terrible betrayal that happened.
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Nike
So the first thing that Phil puts Rob in charge of is taking this really early sports marketing concept of doing sponsorship deals with athletes and And blowing it out. So they had already, before Rob joined, done the first official sponsorship of an athlete with Ili Nastassi, the tennis player. They paid him $10,000 to wear Nike tennis shoes. Oh boy, how quaint.
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Nike
When Strasser comes in, he starts doing sponsorships in a systematic manner. So he goes out and negotiates with athletes and agents. He signs up like half the NBA for peanuts. Now, not the big stars, but the journeymen, the role players in the NBA. He just obliterates them and their agents in negotiations. I mean, they're getting like, I don't even know the dollar amounts, but not a lot.
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Nike
They're getting free shoes, basically. And then Nike is showing up on nationally televised broadcasts every single night. Yep. This leads then to a bigger initiative that Strasser puts together. And if you've watched the recent movie, Air, about Air Jordan... This totally gets played as like a Sonny Vaccaro thing.
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Nike
Strasser hires Sonny Vaccaro to come in and build the college basketball program for Nike. And this is another just equally brilliant move. So Strasser gets Sonny to go around the country and sign up coaches of the big basketball schools. to become Nike coaches. Now, there's nothing preventing the coaches at schools from being consultants, advisors, running Nike clinics.
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Nike
Exactly. This is where it all comes together. So after Phil graduates, he goes to business school right after undergrad to Stanford, to Stanford GSB, hence the connection. He graduates from GSB in 1962. It's also crazy. Nike feels like such a modern company. This was a long time ago.
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Nike
Yeah, exactly. So within a month of working on this, Strasser and Vaccaro have got UNLV, Georgetown, Texas, Arkansas. They get legendary coach Jimmy V at Iona to sign up to be committed to being Nike coaches and their teams wearing Nike. And this is hilarious. So all this is happening. The Washington Post gets word of this. They run a real pearl-clutchy article saying that this is shameful.
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Nike
Nike is commercializing the purity of college athletics. Like, oh, my God, give me a break. Like, these kids are being exploited. Like, at least they're getting free shoes here now in the article. The Post mistakenly says that Iowa is one of the colleges that Nike has signed up, not Iona. So Lute Olsen, the coach at Iowa, who's legendary, he goes on and coaches at Arizona.
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Nike
Lots of listeners probably know who Lute Olsen is. He's in the Hall of Fame now. Instead of being pissed off that he was included in this shameful article with the Post, he calls up Nike and he's like, yo, can I get in on this? Yeah. So then they sign up, looted Iowa and then Arizona, and he becomes a big Nike coach. It's incredible. Strasser then takes the same playbook to college football.
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Nike
Signs all the big coaches in schools, all the big powerhouses for peanuts. This is incredible. Now, selling football cleats is never a big business for Nike, but college football is huge. I mean, still huge.
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Nike
So one thing that's worth mentioning, this is sort of obvious, but didn't click for me until really getting pretty deep in the research here for Nike. There are actually only three sports that matter. So Nike, Adidas, you know, Reebok, they sponsor lots of sports, but running, basketball, and tennis are the only sports that matter because those are the only shoes that normal people can wear.
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Nike
Normal people don't wear baseball cleats or football cleats or soccer cleats, no matter how popular those sports are. Yep. Even to this day, all the marketing, all the athletes, everything you see on TV of Nike and the other athletics companies, it's not about getting you to buy the shoes that that athlete is wearing. It's about getting you to buy Nike.
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Nike
So in Phil's final term there at Stanford, he takes what is then the only quote-unquote entrepreneurship course at GSB. I mean, today there's like 100 different entrepreneurship courses taught by the famous Professor Frank Schallenberger, who Knight gives tons of credit to for Blue Ribbon Sports and ultimately Nike. And in the course for Knight's final paper,
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Nike
Yes. Now, I don't want to say that Strasser alone architected this grand strategy, or even I'm not really sure that Phil or anybody at Nike understood this at this time, but certainly Strasser executes this in just an incredible way. Nobody else was doing this. The college coaches, they ran the table, and it was just an incredible run in the late 70s. All the while...
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Nike
Yeah. The core sales, what they are marketing is go buy a waffle trainer and wear them with your blue jeans. Yep.
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Nike
Yes. It was 1976 when they officially changed the actual name of the company to Nike. Then 1977 was a huge year, as you say they do. $70 million in revenue that year. They signed John McEnroe.
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Nike
Two other things. They bring one former NASA engineer and true mad scientist, Frank Rudy, into the fold. The inventor of air soul technology.
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Nike
Well, he thinks it's a crazy idea at first. Phil's meeting with Rudy. He's like, I don't even know how Rudy got into my office. Who is this crazy dude? Yeah. He's about to kick him out and then Rudy's like, yeah, Adidas didn't want it either. And Phil's like, oh, you said the A word. All right, let me try it.
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Nike
So supposedly, Phil goes for a run in the prototypes of the Air soles, and he's like, yeah, actually, these are pretty great.
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Nike
Yeah, I mean, Rudy really was a genius. So Phil's like, all right, let's do it. He tasks, who else? Rob Strasser, with going and doing a deal with Rudy. They do a deal. Rudy gets between 10 to 20 cent royalty for each pair of Air sole technology shoes that Nike sells. Eventually, Nike would just buy Rudy's company and Rudy would become an employee of Nike.
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Nike
So still here in 1977, Strasser is just on fire. I don't know the full context around this. Scott Reams has a great LinkedIn post. But as best as we can tell, Ben, as you said, the company was growing hugely. There are all these new employees there who are just kind of taken for granted that Nike is winning.
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Nike
Strasser gets kind of pissed off one day and he goes to his typewriter and he fires off a memo saying, He Xeroxes, he copies this memo and pastes it up on the walls all around the office of Nike. 10 principles. And this document is just amazing. We've tweeted it before. It's going around the internet.
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Nike
He writes the business plan for Blue Ribbon Sports, pretty much word for word. His thesis is that he knows from growing up with his dad, and I think he actually maybe spent some summers at college and then at GSB working in the newsroom at the Oregon Journal, and he knows from the photography department that high-end professional cameras had traditionally been the domain of the Germans.
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Nike
Yeah, it's been so fun to watch Statsig's growth, even just over the last couple months. The market was clearly hungry. Most companies today are working with expensive, clunky, and disjointed point solutions or under-resourced with internal product experimentation tools. Statsig works with large enterprises. They have a startup program.
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Nike
They're powering some of the hottest and fastest growing brands in AI as well. One quote I particularly love, this is from a data scientist at one of their customer's
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Nike
We're operating like a large experimentation organization at an enterprise tech company, organizing, tracking, and analyzing multiple experiments, providing intuitive visualizations that even enable non-technical users to make informed business decisions.
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Nike
What's really cool is that the company that this data scientist is from, Black Crow, which is an AI startup, is running StatSig natively in their Snowflake data warehouse. We talked on our ACQ2 episode with Kamakshi from Samuha about... bringing compute into data warehouses like Snowflake. And this is a great example of that happening here with Statsig.
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Nike
Leica was the most famous camera brand. And then at this point in time in the 50s and 60s, the Japanese are starting to enter the market. So Nikon was the big Japanese entrant. Fuji, Ricoh. Exactly. They made great cameras and they undercut Leica on prices by a huge amount.
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Nike
All right. Nike principles, according to Rob Strasser in 1977. One, our business is change. Two, oh, this is so good. We are on offense all the time. Three, we already alluded to, perfect results count, not a perfect process, break the rules, fight the law. Number four, this is as much about battle as about business. Five, assume nothing. Make sure people keep their promises. Push yourselves.
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Nike
Push others. Stretch the possible. Number six, live off the land. Number seven, your job isn't done until the job is done. Eight, dangers. with a underline as a heading, bureaucracy, personal ambition, energy takers versus energy givers, knowing our weaknesses, don't get too many things on the platter. Number nine, it won't be pretty.
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Nike
And then number 10, if we do the right things, we'll make money damn near automatic. It's so good. It's so good. That last one is so spot on for any business through to this day. It's so easy to get wrapped up on all the other crap. You do the right things. You make product that customers love. You market it right. You build a brand. You will make money damn near automatic.
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Nike
So Nike IPOs, the second week of December in 1980, the same week as Apple. Unbelievable. It's amazing.
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Nike
And he also knows about the sporting goods market from his time at Oregon and particularly being a test pilot, as they would say, for Bill's Shoes. And actually, the dynamics are pretty much exactly the same in the athletic goods market. There are two companies, both German, that dominate sports equipment. One, of course, is Adidas. Or Adidas, as the Germans would say.
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Nike
Yep. It was about $400 million, the market cap at IPO. Apple, for comparison's sake, was $1.8 billion. Now, interestingly, before they went public, Bowerman sold most of his stake back to Phil Knight. Actually, this was related to some of the financings earlier, but as Nike got bigger, he just didn't want to be a major listed shareholder in a highly visible public company.
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Nike
Certainly, he was in retirement age towards the end of his life. He was like... I'm going to sell my stake back to Phil. So when they went public after the IPO, Phil owned 46% of the company and was overnight one of the richest people in America.
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Nike
Now, he was far from the top richest person in America, but still this made national headlines.
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Nike
So this is where Shoe Dog ends, which is kind of crazy. I had forgotten this before I went back and reread it. There's no Jordan. There's no huge fall from grace that is about to happen for Nike, basically right after they go public. Phil picked an interesting time to end the story.
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Nike
Early Nike did so many things right, but they made one critical mistake. They mistook the running and the jogging boom for the broader fitness boom. The broader fitness boom was a massive secular trend that continues through to this day. The running boom was a cyclical trend that was part of the fad-driven fitness cycle.
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Nike
And by the early 80s, as we're heading into everything that the 80s was and that the 70s were not... Running and jogging is out, and aerobics are in. And Nike absolutely refused to see that and refused to do aerobics, like, on principle.
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Nike
So Reebok, funny, originally a British company, started as Foster & Sons. They were the company that made the track shoes for the 1924 British Olympic team that was the basis for the movie Chariots of Fire. The Reebok we all know, well, not today, but back then, is a completely different animal. It's a marketing-driven company started by a guy named Paul Fireman, who is American.
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Nike
And pretty quickly, they developed a business plan to cash in on the aerobics fad, and they made a shoe that, in Nike's principled opinion, sucked. But it went really great with leg warmers. You know, it was all white. It had soft leather that wrinkled. It looked good. Women loved it. It was everything that Nike was not. And their rise, like you said, Ben, was even steeper and faster than Nike's.
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Nike
Ironically, Reebok would end up much later getting acquired by Adidas and then spun back out to private equity recently. Wow.
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Nike
Yes, as we will get into in just a sec here. And the other one, to a lesser extent, was Puma. Now, there was an American athletic apparel footwear maker in Converse and others. But Converse at the time was stuck in the canvas shoe era, which was already like ancient history. So if you know Chuck Taylor, All-Stars, you know the famous seminal Converse shoes.
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Nike
And meanwhile, in our core consumer actual reason people buy truckloads of shoes, the fitness market, the swooshing sound you hear, is that going to Reebok? Yes. So, interestingly, financially... There only are a couple quarters where Nike's revenue declines. I think that's because of the futures program. Kind of saves their skin again.
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Nike
Retailers had to commit six plus months in advance to their orders. And yeah, Nike was able to at least maintain revenue through a lot of this. But the actual underlying dynamics of the business are ugly at this point in time. The market, like I said, is swooshing away. So that brings us to 1984. Phil Knight actually wrote in the letter to shareholders that year.
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Nike
1984, like George Orwell predicted, was not a good year for Nike. Everything that we talked about is happening. But 1984 was also the seed of something pretty incredible that would make everything that happened before in Nike look like child's play. And that would be a young kid from North Carolina, Michael Jordan, who walks in the door and
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Nike
This is such a fun time to do the Nike episode because the movie Air just came out, which really is like a fun kind of summer blockbuster movie. Also very, very inaccurate in how it portrays everything.
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Nike
the big important thing from michael jordan the air jordan one and then everything it became in the jordan brand is that it didn't just save nike it changed the world that's a super campy thing to say but it is 100 true if you walk down any street
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Nike
Pretty much anywhere in the world today, or you go into any event, building, venue, whatever, and you look at what people are wearing, they are wearing sneakers. And they are mostly wearing basketball shoes and running shoes. That was not the case before Air Jordans. Air Jordans and Michael Jordan made sneakers into culture.
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Nike
But if you had to guess, when do you think Chuck Taylor played basketball? Ooh, let's see.
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Nike
All right, so let's talk about what that deal was and why it was so different. Nike, like we just said, their back's against the wall. They need to do something to save the company. And it's actually Strasser who puts this deal together. And together with Sonny Vaccaro, as portrayed in the movie, goes after Jordan. But Strasser puts it all together.
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Nike
So the deal is a $2.5 million minimum guaranteed payout over five years. But that's not actually how the economics work. The revolutionary aspect of the deal was the payouts were calculated as a 5% royalty on gross revenue from the sales of Air Jordans. The whole line, the shoes, the merchandise, everything.
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Nike
Right, and it goes even deeper than that. This structure was completely revolutionary. So the way shoe deals were done at the time, so Magic Johnson and Larry Bird were the biggest stars in the NBA at the time. They were both signed with Converse. Their deals were roughly $100,000 a year in cash payments to wear the Converse weapons. Ben, have you ever worn the Converse weapons? No, never.
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Nike
Do you know what they are? No. No, I don't. These are not air birds. They weren't signature shoes. Nike says, we are going to make you a signature shoe. and then you were going to participate in the upside from that. They did that intentionally. It wasn't Jordan who asked for that. Nike wanted it that way. They thought, we need to incentivize Jordan to build the dream here.
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Nike
Yeah, you might think so contemporaneously with the time we're talking about right now. No, Chuck Taylor played professional basketball in the 1920s. Whoa. That's when the Chuck Taylor All-Star technology is from. It's a canvas shoe. By this point in time, the market had migrated to leather upper shoes, of which Adidas or Adidas was the leading technology manufacturer of it.
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Nike
Right. It goes even further. Also in the deal, the previous year... Nike had sold 400,000 pairs of Nike basketball shoes. They include a clause that Jordan gets a royalty on incremental sales in future years beyond the baseline of everything in the Nike basketball line. I did not realize that. This is how it works. We alluded to this earlier in the episode. It's the halo effect.
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Nike
Yes, the Jordans are important, and we'll talk all about the Air Jordan 1s in a second here, but it's not about the Jordans. It's about the swoosh, and it's about the halo effect and the lifting up of the whole company's sales. I had no idea that Jordan got a royalty of non-Jordan shoes. He did.
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Nike
And this would eventually morph into the Jordan brand and the Jordan line and Zion Williams and Jason Tatum, and they are Jordan athletes. This is part of it. So Nike also guarantees a minimum ad spend to promote the Jordan line. They're all in here. They also give Jordan stock options in the company. This is a hell of a deal, and it's smart for Nike.
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Nike
No, it's all owned by Nike because there's the minimum guaranteed payment. Right. For $2.5 million over five years. That seems like a pittance today. But that was huge. Nobody else was getting that kind of money. So here's the thing, and this was chronicled in the movie. This is absolutely true. Jordan didn't want to work with Nike. Nike was for the second-rate pro players. Jordan wanted Adidas.
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Nike
Jordan was a kid in the 80s, like a teenager. To the extent that sneakers had started to transcend into culture... It was Adidas. Hip-hop, breakdancing, track suits, shell toes. That was Adidas. That was what Jordan wanted.
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Nike
Yeah. So Jordan actually takes the deal and shops it to Adidas afterwards. And he's like, I really don't want to go with Nike. Like, I really want to be with Adidas. You don't have to match this. Can you just come anywhere in the ballpark close? And Adidas is like... we could give you $100,000 a year, you know? And so reluctantly, Jordan goes with Nike. But you're so right, and it's so important.
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Nike
In that first year, the Air Jordan 1s, this is going to be very incredible. Some of you know this. Some of you are going to listen to this. You're going to be blown away. Hang on, because there is a second part to this story that is not what you expect. In the first year, Air Jordan 1s sell $126 million. That's the shoes and the associated merchandise with it.
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Nike
So anyway, basketball shoes wasn't really the market yet. It would become much, much later, as we shall see. The market was running shoes.
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Nike
David, do you know what their goal was? $3 million over three years. So it's about 15% of Nike's entire revenue for the whole year.
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Nike
So put aside the halo royalties that Jordan is getting on the rest of Nike basketball. Let's take just the 5% of that $126 million that he made in his first year. That's $6.3 million that Jordan got from Nike in 1985. Do you know what Jordan's contract with the Bulls was? It's too perfect. $6.3 million over seven years.
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Nike
Well, trade-offs. I think there are two things. One, none of this would have happened if Jordan didn't turn out to be Jordan.
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Nike
and it was like an okay market but this was not the camera market so phil knight's thesis here it actually didn't get any sort of notice or praise famously from his classmates or even really from the faculty because they're like okay this is a good idea to apply japanese low-end disruption to the athletic apparel market and the footwear market but This is not a big market.
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Nike
Ah, interesting. Which I think he did in the first year. Yes, yeah. Yes, that's right, because the other players kept the ball away from him, and they froze him out because they were so jealous. Okay. One, Jordan had to become Jordan. Two, though, he sacrificed a huge amount. There's this great quote from Jordan when he retired for the first time.
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Nike
He said, Phil Knight and Nike have made me into a dream. And that's very sweet on the surface, but that's very dark underneath of it. Michael Jordan's life was no longer the life of a normal person or anything close to it. And now to a certain extent that happens to every star, but like today you're like, duh. But back then, this was the first time this happened. Jordan became a dream.
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Nike
And that's very hard to live with as an actual human being. So there was some downside.
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Nike
And he's a kid. Yes. So, again, like, this is all normal today. Everybody understands this. LeBron knew exactly what he was getting into when he signed with Nike out of high school and went to the NBA. But, like... This was the beginning of all of this.
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Nike
Right, because it takes a while to actually make a new shoe. So the Air Jordan 1 is still in production.
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Nike
The thing that's so great, though, Nike, right? Like, it doesn't matter. It's the story. It's the dream. Like, it doesn't matter.
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Nike
Oh, man. Okay, so I mentioned a minute ago about the other side of the Air Jordan 1 story. It's not the dark side of Michael Jordan's fame. I think this is crazy. I don't think anybody really knows this. Nike sold $126 million worth of Air Jordan 1 shoes and merchandise in the first year. Fact.
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Nike
Another fact that gets put out there is that Nike sold $150 million of Air Jordan shoes and merchandise during the first three years. Now, if you look at that, you're like, wait a minute. Huh. What happened? Something bad happened in years two and three. Yes. And indeed, something bad did happen in years two and three and in year one.
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Nike
And it's worth maybe saying one word on the Adidas or Adidas story before we move back to Phil Knight and Shoe Dog here, because it's pretty crazy. So it's called Adidas because Adidas was founded by Adolf Dassler, or... Adi, for short. Adi Das.
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Nike
Nike needed that first year of the Jordan deal to be a huge hit. So they stuffed the channel. They pushed so much product on retailers and through the Futures program and whatnot that that's how they hit the $126 million in sales. There wasn't actually $126 million of demand for Jordan products that year.
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Nike
I mean, there probably was, I'm making this up, $50, $70, $100 million of demand, like unprecedented for any shoe in history for a single year. But Nike also effectively took some steroids on this one. That turned into a huge problem because the retailers and the buying public had a huge hangover the next year in year two that was compounded by two issues.
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Nike
One, Jordan broke his foot early in the season of his second year, missed most of the season. Two, the Air Jordan 2s sucked. There's kind of no other way to put it. This was where Strasser, who again had masterminded all of this, the Jordan deal, the Jordan 1s, working with his collaborator Peter Moore, all this stuff, they kind of went rogue. The Air Jordan 2s cost $100.
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Nike
The Air Jordan 1s cost $65. The Air Jordan 2s were made in Italy out of premium Italian leather. This doesn't sound like the Nike playbook. This also doesn't sound like a good basketball shoe. Do you want to play basketball in Gucci leather? Probably not. Jordan didn't like the shoes. They were not good to play basketball in. They were super stiff. They were hard to break in.
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Nike
They didn't fit his style right. So, A, he wasn't playing. B, he wasn't incentivized to push them. I mean, he was economically incentivized, but he didn't like the shoe. It all kind of fell apart. On top of that, as this is all happening, Strasser, and more too along with him, but really Strasser is becoming increasingly rogue within Nike. He breaks away.
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Nike
I mean, literally, like the parallels here, unfortunately, comes to a tragic end. He sets up his new campus, new division, you know, away from Knight, away from the rest of the company. He mandates that all new product launches have to go through him and this new group and that they're going to take control and streamline the process. And the Jordan 2s come out of this.
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Nike
Obviously, it's not a very good shoe. this becomes a big problem. Obviously, there's only one way that this is gonna end. Either Strasser is going to become CEO of Nike or Strasser is going to leave Nike. Yep. And Strasser ain't going to become CEO of Nike because one, Phil Knight is CEO of Nike. Two, Nike has a dual class voting structure.
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Nike
Yes. So after World War I, when Germany was totally decimated, but before World War II, he becomes like a fairly well-known elite cobbler, shoe purveyor, track cleat purveyor to Olympians at the time. So actually... Ironically, I guess, Jesse Owens wins the 1936 Olympics, the big American demonstration, literally beating Hitler in Berlin, in Germany, in Adidas shoes.
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Nike
Phil Knight controls all the high vote shares and he controls the board. So really, this is the end for Strasser. They get in a huge fight in 1987. Strasser leaves the company. He goes off and takes Moore with him, Peter Moore, and they start a consulting firm in Portland called Sports Incorporated. All of which is fine.
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Nike
And you could imagine a future where one day Knight and Strasser might reconcile and they could be friends again and say, wow, Rob, you've had such, you know, incredible part of the Nike journey, contribution to everything. We can bury the hatchet. Well, Sports Incorporated takes on as one of their major clients, Adidas.
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Nike
And then eventually Adidas buys the company, moves their North American headquarters to Portland, Oregon, and makes Strasser the CEO of Adidas America. Oof. And then incredibly tragically—this is just terrible— Eight months into the job, Strasser has a massive heart attack and dies, I believe at age 46. Oh, it's just terrible.
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Nike
But. the betrayal that this engenders. It's irreversible. Ben, you talked about earlier the Nike culture. There's a quote from Jeff Johnson, Blue Ribbon employee number one, who I think had already left the company at this point. He's asked in the book, Just Do It, about Rob becoming CEO of Adidas. And he says, I know they, Adidas, aren't what they once were, but Adidas people were the Huns.
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Nike
And still, the repercussions of this exist to this day. Adidas' American headquarters are still in Portland, Oregon.
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Nike
Yep. So, okay. Back to Jordan. The plot thickens here. Jordan's not happy. Strasser was his guy there? Yeah. Yeah. Strasser was his guy. Strasser leaves, starts this new company, starts working for Adidas, becomes the CEO of Adidas. Jordan's going to go to Adidas. The writing's on the wall here. I mean, Jordan's deal is up in 90, right? Not only is his deal up in 90, he tries to renegotiate.
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Nike
So in year three, Jordan is so unhappy. The wheels are in motion at Adidas. Adidas with Strasser, not yet at the helm, but whispering in the ear, is going to be willing to do a Jordan-type deal for Jordan. Michael always wanted Adidas anyway. He's going to break the deal with Nike and go with them. Yep. So, back to Nike and Phil. This is serious wartime mode.
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Nike
They schedule a pitch meeting with Jordan. This is, I think, towards the end of year three of the deal to try and save him, to try and re-sign him. They're willing to do anything. Renegotiate the deal, give him more economics, give him another shoe, anything. Phil goes to a bright young star within the Nike design group.
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Nike
He was an architect. This is super important. Tinker was another Bowerman guy. He ran track for Bowerman in Oregon and studied architecture. And then he comes into Nike, and together with Mark Parker, who would become the CEO of Nike, they designed the Air Max, they designed the Air Trainer.
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Nike
They're part of Nike's revival on the running and training side and competing ultimately in aerobics with the Air Trainer. Now that Strasser and Moore are gone, Tinker is the star that he can give Jordan. He says... Go fly out to Chicago. Go with Howard White, Jordan's guy at Nike. Go talk to him. Come home, like, bearing your shielder on it, essentially. So Tinker goes out.
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Nike
And remember, he's trained as an architect and then became a shoe designer. What do architects do when they meet with their clients? They ask them questions. They say, what do you want? What are your specifications? Tinker sits down with Jordan and he's like, tell me what you don't like about the Jordan 2. They were too tough to break in. Okay, cool. What else is wrong with them?
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Nike
They're high tops. You know, that's too much weight. I'm Michael Jordan. I need lightness on my feet. I want to fly. I don't want the extra weight. Okay, cool. in an ideal world, Michael, what shoe would you want? What would it look like? And Michael's like, well, I want a great basketball shoe that will also look great off the court, but it needs to be both.
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Nike
It can't be like the Jordan 2 that look great off the court, maybe, but sucked as a basketball shoe. Tinker's like, okay, noted. So he goes back to Nike and Works feverishly. Jordan comes in for this last-ditch pitch meeting. He shows up four hours late. Phil starts the meeting and is like, oh boy, here we go.
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Nike
Tinker, like an architect, has the shoe under a black cloth on the table, just like Steve Jobs in the keynotes many years later. Phil hands the meeting over to Tinker. He's like, Michael, I took notes on our conversation. Here is the Jordan 3. And he pulls the shroud off and hands the shoe to Jordan. And he's like, it's the shoe you asked for. He goes right down the checklist.
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Nike
Soft leather that doesn't need to be broken in. You can wear a new pair in every single game. Mid-cut height. Not a high top. Not a low top. The support you need without the weight of a high top. elephant print leather for style off the court that won't detract from performance on the court. And then the pièce de résistance, no swoosh. There's a little swoosh on the back tab.
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Nike
The main logo is the Jordan Jumpman logo on the tongue. The Jumpman logo did exist beforehand. Peter Moore had actually designed it. But it was never in the prime position. It was always the swoosh and then the Jumpman.
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Nike
It's kind of like hearkening back to the beginning of like Phil Knight could have had 100% of Blue Ribbon Sports or he could have had 51% of Bill Bowerman's Blue Ribbon Sports. Yeah.
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Nike
Indeed. So as part of that, they renegotiate the deal. Jordan agrees to stay with Nike. The Jordan brand becomes its own sub-segment within Nike. Its own shoes, its own clothes, its own colors, its own logo, its own advertising, all managed standalone. And then ultimately, this would take several years, but it would become Nike. Zion Williamson wears Jordans. Jason Tatum wears Jordans.
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Nike
Yes. So they extend the deal for seven more years, I believe at the same 5% royalty on gross sales. But there's the new massive further commitment to making the Jordan sub-brand much more of its own brand. And they up the total guarantee to at least $18 million. So from two and a half to 18 in three years. Wow.
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Nike
Ultimately, just like the two and a half, that's meaningless because Jordan brand sales go back up in 88, 89, 90, on and on and on, 200 million, 300 million, 400 million, 500 million in sales. This is when they do the Spike and Mike ads with Spike Lee. It's got to be the shoes. And Wyden Kennedy, got to be the shoes.
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Nike
Now, interestingly, at retail, again, back to this Halo strategy, the Jordan 3s and then all Jordans subsequently, really, this is when they become the luxury brand. The Jordans are Nike's Louis Vuitton trunk. Yeah, they make a lot of revenue from them. Yeah, they sell a lot of them. But you know what? It also helps them sell a lot of wallets. Yeah.
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Nike
After World War II, though, the two brothers have a huge acrimonious split. Rudy goes off and starts a separate shoe company. It never came out what the fight was about, but one of the rumors is that Rudy went and fought in the Nazi army and Adi didn't. And maybe that might have, I don't know, but may have had something to do with it.
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Hermès
And actually, still to this day, Accel talks about this a lot. Any one of their production sites does not have more than 250 to 300 craftspeople.
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Hermès
Yep, and they are not in the business of factories. At the same time, he and the company have stated as an explicit goal that they will ramp up production capacity by 7% every year. Well, as the company gets larger and larger today, that means adding 500 artisans every year.
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Hermès
Right. Now, here's the issue, though. How on earth are you going to do this? Like you were saying, this is a dead art.
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Hermès
Right. And those people, you know, the Beatrices here in San Francisco, they're entrepreneurs. They're not going to go back to joining Hermes because they all came from Hermes in the first place. How are you going to hire 500 a year? It's not like they can go hire from their competitors. They're not doing this. Right. Their competitors have all outsourced production and embraced assembly lines.
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Hermès
So they do the only thing that you can do. They build the pipeline of training master crafts people and artisans entirely themselves. They build schools. They build training centers. They go to parts of France that are in rural areas that have high unemployment. They go to those areas and they open trade schools and they say, we're going to train you. They have 100% graduation rates.
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Hermès
They're like, we're not going to give up on you. We're going to make sure you learn this trade that you graduate. You may not come work for Hermes when you graduate, but we're going to give you this skill and then we're going to offer you a job as a master craftsman. It's crazy. It's unbelievable. So back in the, you know, even through the Jean-Louis era, the fifth generation,
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Hermès
So by the time he takes over, he's been working in the shop as a craftsman for 20 years. And by the way, this sort of family tradition and way of business continues to this day. So Axel Dumas and Pierre-Alexis Dumas, who are the two descendants of Hermes, the sixth generation that are running the company today – Axel is the CEO and Pierre-Alexis is the artistic director –
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Hermès
Beatrice was the anomaly as a woman. These were all like old men that were doing this stuff.
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Hermès
Today, the average age of the Hermes artisan workforce is 30 years old and 80% are women. It's wild. It's a wholesale transformation. And they are training them. They actually just opened in 2021 their first official French governmentally sanctioned degree granting program, the École Hermèse de Savoir-Faire.
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Hermès
This is the Savoir-Faire that pops up in the annual report, you know, a hundred and whatever times. Let's name a school after it too. Yeah, yeah, yeah. They're like getting into like government policy here. They are preserving and growing this art form in France.
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Hermès
Yep. So today there are 31 Hermes ateliers, you know, artisan manufacturing facilities all throughout the country, each with no more than, you know, 250, 300 people in it.
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Hermès
This is the point I'm getting to. Right. They're building data centers. They were Amazon and they added AWS and they are adding... Two to four of those every year. It's so funny.
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Hermès
So this is an insane idea that leather goods, which is 43% of the business, Hermes did what 11.6 billion euros in revenue last year. They're on track to probably do call it 14 billion in euros.
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Hermès
Yeah. That 6 billion of that is going to be handcrafted items where one artisan makes one item at a time and they're sold around the world. Like 6 billion euros worth of that every year growing at 15, 20% a year.
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Hermès
The Amazon comparison is so apt here. Hermes has this incredible unassailable flywheel, but it operates in the exact opposite way of an Amazon flywheel. It's not about maximizing the cycles. It's slowing. It's minimizing. It's a intentionally rate-limited flywheel, and it all works together.
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Hermès
They apprenticed in the business. When they were teenagers, for five years after school, they went to the atelier, they learned the saddle stitch, they made bags, they made items with their hands. Now, obviously, they also sort of learned the business from their parents, but they're not learning the business the way that the Arnault children are learning the business at LVMH as executives.
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Hermès
Totally. I mean, like we've told the whole episode and I'm thinking back to what Beatrice told me when I asked her why. If a master craftsperson made this thing by hand, it has a soul. And if a machine made it in an assembly line, it does not exist.
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Hermès
Totally. Let's take a step back here. We got to consider the exact opposite case study of this, which is 100% happening to great success, which in a lot of ways is the same thing that the consultants told Jean-Louis back in the day. Look at the rest of the industry. Louis Vuitton, which as we talked about, has the same caliber of heritage and history as Hermes. Yes.
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Hermès
Right. They are having the same level of success, the same margins. It's working like a charm. But it's less durable. Well, I think that's sort of the question. Is it less durable or is it just these are different markets or different strategies? Now, here's the crux of it that we've also been teasing on the episode that I think now's the time to come back to.
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Hermès
I have a lot of complicated feelings about the thing on my wrist, including primarily that I love it. Okay, here's the story. 2015, Apple launches the Apple Watch. Supposedly, the story goes that Johnny Ive, and the watch I think was really Johnny's kind of like pet project as his last hurrah before leaving Apple.
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Hermès
He had all these quotes at the time of the Swiss watch industry, better watch out, we're coming for them, you know, et cetera, et cetera. Which was true. Yeah.
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Hermès
Yes. Mark Newsom was consulting for Apple specifically on the watch, and Johnny asked Mark to introduce him to Pierre Alexia and XL and to Hermes. Apple... was looking for a luxury fashion brand. Remember there was the Apple Watch Edition in the beginning that was like the gold Apple Watch and all that?
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Hermès
Yeah, that clearly didn't work. But it's beautiful. Yeah, totally beautiful. But they needed a luxury brand. They needed a brand that was not deeply in bed with the traditional Swiss watch industry, which some of these luxury groups are.
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Hermès
They're learning with their hands as craftspeople how to make this stuff. Which is wild. Excel is the CEO of a $200 billion plus company.
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Hermès
That's one reason. The other reason is they needed a brand that was going to appeal to pretty much everybody.
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Hermès
For everything we've talked about with Louis Vuitton and how successful that's been, it's polarizing. Totally.
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Hermès
Axel and Pierre-Alexis talk about this all the time when they're asked about, oh, XYZ flashy celebrity is carrying a Birkin bag, blah, blah, blah. They say, look, we don't judge. We never judge here at Hermes. Our clients are our clients, whether it's Grace Kelly or Kim Kardashian. And that's what Apple needed. So Axel has a great quote on this. He says,
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Hermès
Right. I mean, even more than my phone, this thing is part of me. When I was looking to do research for this episode and buy... a bit of the Hermes dream. I couldn't imagine anything more appropriate to be closer to me than literally it's on my wrist 23 hours a day. At the same time, I find it absolutely terrifying from the perspective of what it means for Hermes and the Hermes future.
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Hermès
Not because I think that Apple and technology is going to take over the world, but I think there's some serious problems with this product along the lines of the issues that Bernard identified in the company when he was making his run. Let's start with the price. I bought the deployment buckle version of the strap because I thought it looked amazing.
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Hermès
It is the most expensive version of the band that Hermes sells as such, and it cost $540.
Acquired
Hermès
This is among the cheapest leather products that Hermes sells. As a comparison, if you want to go buy a Hermes luggage tag, $640. Let's move out of leather goods for a second. If you want to go buy an Hermes sweatshirt, over $2,000. If you want to buy an Hermes piece of furniture, and they make incredibly beautiful furniture, $40,000 minimum. $540 for this thing...
Acquired
Hermès
Yes. And maybe that's because it's also sold in Apple stores, et cetera, et cetera. But related to that, you start to think about that, like, wait, why is the price so low? Nowhere on the exquisite orange packaging and box that this thing came in, nowhere on it, nor on the product page on the website, does it say that it was handmade. Right.
Acquired
Hermès
And this to me is like, wow. You know, would I have spent $2,000 on a handmade Apple Watch Hermes band? Maybe, maybe not. Like, I don't know. Whether I would have is irrelevant. Hermes should be selling $2,000 handmade Apple Watch band.
Acquired
Hermès
Right, yeah. So, I don't know. On the one hand, I love it. I don't want any other Apple watch strap. It is an Hermes product. It's beautiful. On the other hand, yeah, it feels like a profanity.
Acquired
Hermès
Well, I think that is certainly part of it. The thing that is really just kind of head-scratching to me about it is why do they not sell these things for four times as much and make them by hand?
Acquired
Hermès
Right. The business and the craft are intimately intertwined. They cannot be separated. And this is a playbook theme I want to pull all the way forward, but it's so critical to understand about Hermes and what really, in my mind, differentiates it from LVMH.
Acquired
Hermès
I don't want to spoil Jenny's birthday Valentine's surprise. I'm actually getting two things, but we'll talk about this on a future episode.
Acquired
Hermès
Cliffhanger. So just to put some numbers and finish out the story, by 2018, revenue has grown from call it 3.5, 4 billion euros when Accel took over in 2013. By 2018, that's 6 billion euros. 2019, it's 7 billion. It dips a bit during 2020 with the pandemic, but then 9 billion in 2021. Last year, 11.6. And like we said, on track for, call it, 14 billion euros in 2023.
Acquired
Hermès
This is an absolutely resounding success. as we've said, what Axel and Pierre Alexi and this generation of the family has done, like all the generations before them, has been nothing short of amazing.
Acquired
Hermès
Starting with the defense against Bernard. Incredible. I don't want to fully judge or leave a negative mark on the company solely because of the Apple Watch thing. But I just got to say, you know, we've seen with a few times here in these generations that the seeds of the next challenge are sown in the current generation. And I wonder if this is it here.
Acquired
Hermès
LVMH, as we talked about on that episode, has world class, best in the world business executives who partner with world class, best in the world creatives. At Hermes, these are not different people. Now, obviously, there is a different CEO and artistic director that are both members of the same family and who are cousins.
Acquired
Hermès
That's such a good point. And that's the counterpoint to my impassioned concern a minute ago. Okay, great. David, everything you were just saying, that translates to Hermes is a museum and Hermes is not a museum.
Acquired
Hermès
And it has to meet its clients where they are. And like I said, I wear this thing 23 hours a day. I couldn't imagine buying any other product from them.
Acquired
Hermès
Now, certainly there is an element, too, to the dividend that is part of making the family shareholding lock up an easier pill to swallow.
Acquired
Hermès
There's one more elephant in the room to me that we haven't addressed via the story, which is that the business is a global business for sure. But really today, this business is an Asia business.
Acquired
Hermès
But in spirit, they're cut from the same cloth and they apprentice as creative craftspeople. And they collectively and the family is in charge as much of the creative side of the house as they are of the business side. Yeah, makes sense. So back to Charles Emile and the second generation. he finally adds saddlery to the business. That's his big expansion. He adds saddles. Ba-da-da! Ba-da-da!
Acquired
Hermès
Ben, do you know what company was also founded in 1837 that we have discussed quite a bit on Acquired? No, I do not, David. That would be the other iconic color luxury company, Tiffany.
Acquired
Hermès
Interesting. The Japan story actually, I think, is still significant. Japan today is what, like 10% of revenue?
Acquired
Hermès
Right. So I actually looked into that. I was like, huh. Yeah. The rest of Asia, you know, again, AKA China is 48% of the business, but on a per capita basis, Japan buys twice as much Hermes as China. That's interesting. Still, Japan is, I believe, around a 10th of the size of China and is 10% of Hermes sales versus 48% for rest of Asia. Huh.
Acquired
Hermès
For a small country, kind of like France, it's still very, very significant for the business.
Acquired
Hermès
And, you know, again, this is a huge, unique success for Hermes. China has been big for the whole luxury industry over the last decade plus, but the past few years, particularly the last two years... China has been real tough for the luxury industry, and yet Hermès is still growing there.
Acquired
Hermès
Yep. And I think a lot of those, like there's a silversmith and a tableware manufacturer that they own large stakes into. So it's like a related party.
Acquired
Hermès
Which, you know, again, as Paris is modernizing, as you can now buy your way into status, for the first time in Paris, you can be seen riding in addition to carriages. And... the ideal of what it is to be a noble person or a noble person of status has changed. It's no longer just, oh, I'm a leisurely courtier. It's like, no, I'm Baron Osmond. I am doing things for the state, for the country.
Acquired
Hermès
Yeah, I'm glad you reminded me to bring this up. When we were talking earlier about the question of the secondary market and why are they leaving pricing power on the table... Or essentially there's consumer surplus in economic terms. Right. And I said, I think they increase prices across the product range by about 7% per year. So where I got that from is if you look at the...
Acquired
Hermès
compounded annual revenue growth rate of Hermes for the last 10 years, you know, the sixth generation era, it's 15%. Revenue's grown 15% compounded annually since Excel took over in 2013. they've increased production 7% per year. That's their stated goal.
Acquired
Hermès
So if you say like, okay, of the 15% revenue growth, take out the 7% production growth that leaves seven to 8% of that's got to be attributable to price increases. Huh? Which I think this is the answer. Now, Right. Right.
Acquired
Hermès
There probably is an element of like, I want to say almost defense that they can fall back upon of, well, yes, we sell these things for $12,000, $20,000, whatever. But the moment you take possession, you can turn around and sell it for more.
Acquired
Hermès
This concept landed for me during our Porsche episode, working with Doug DeMuro. There's a class of almost every car that you would ever buy. The old adage is true that the day you drive it off the lot, it's worth 20% less than it was the day when you bought it. For, I don't know what the right word is, luxury cars, collector's cars, rare cars, etc. The opposite is true.
Acquired
Hermès
These are investment vehicles. If you buy a Carrera GT... You're going to spend a million dollars for it, but you can also be confident that you're not going to lose money on that purchase.
Acquired
Hermès
What it basically says is... If you have a private jet and you want it outfitted with Hermes seats... And we don't make seats. We've got the division for you.
Acquired
Hermès
There's an amazing quote from an article, probably 10, 15 years old. The person who was running this division said something like, we get a lot of clients who come in here and they want a big H on whatever it is they want us to make. And we have to have a discussion with those clients that if that's what you want, we are not the place for you. Yes. So great.
Acquired
Hermès
Maybe one day be Hermes Horizons customers. Maybe. We'll see. All right, well, let's transition officially to analysis and start with power as we always do. Hamilton Helmers, Seven Powers.
Acquired
Hermès
And you need a saddle for that. So Charles Emile, he adds saddles. And in 1880, he moves the workshop in the store to Vincat rue du Faubourg Saint-Honoré, 24 rue du Faubourg Saint-Honoré in the 8th arrondissement of Paris. The famous address. The building that is today known as Le Faubourg by everybody in the Hermès universe.
Acquired
Hermès
Now on the LVMH episode, we talked a lot about, and I think this truly was maybe the most brilliant thing that Bernard Arnault did was he realized when nobody else did that there were scale economies in luxury to a group of luxury brands. There's the opposite of scale economies to an individual luxury brand, but at the group level, there is power and specifically scale economies power there.
Acquired
Hermès
Well, and I think even the other luxury brands out there, most of them probably do have some craftsmen. Yes. Some stuff that's done by hand, some components of some products done by hand. But nobody does what Hermes does, and Hermes does all the craftsmen, so cornered resource for sure.
Acquired
Hermès
No, I like that. Actually, it's rare to have counter positioning at scale. As Hamilton would put it, counter positioning is usually a takeoff phase power. Yep. I think there's an element of that. You could dissect how much of that particular element is actually part of the Hermes brand versus counter positioning in and of itself. But I buy it. I think at the end of the day, though.
Acquired
Hermès
I mean, we spent however long this episode will be when it ships recounting the myth of the brand here. Like brand is the power.
Acquired
Hermès
And this street in this location is one of the most iconic streets in the world, buildings in the world, headquarters in the world.
Acquired
Hermès
It's amazing. You know, at least in the Palo Alto Hermes, which is what I've most recently been in, you walk in and you would think this is a homewares company.
Acquired
Hermès
And there's clothing. And there's some leather goods. There's scarves. But you would really think, wow, I'm in the most expensive Ikea ever.
Acquired
Hermès
Yes. And I think that's really the story here. Yes, there are other brands. There's Chanel. There's Gucci. There's Sicily. I don't want to say that those luxury brands and those handbag brands are not incredible. They are. But... There's Hermes and there's Louis Vuitton. And they're both connected all the way back to Empress Eugenie and France and the nobility and all of that.
Acquired
Hermès
Yeah, the Rue du Faubourg Saint-Honoré is where the French presidential residence is. It's where the British embassy is. It's where French Vogue is today, probably because Hermès is there and because all of the other luxury flagships are there. So Charles Emile runs the business for 25 years. He adds saddles. He moves the company to the Faubourg. And then in 1902, he retires.
Acquired
Hermès
And it's so interesting that they have such different strategies and they are the two pinnacles.
Acquired
Hermès
Yeah, this is really cool. I saw a very large splashy media buy from Hermes very recently, and I was shocked when I saw it because I didn't expect it. But then now doing all the research, understanding the strategy, it makes total sense to me.
Acquired
Hermès
It was at the ballet here in San Francisco at SFB at the program for Mere Mortals, which was just, as I talked about on the Novo Nordisk episode, we went to see it opening night, just incredible, incredible piece, you know, allegory for Pandora's box and AI and ballet in the modern world here in San Francisco. The back of the program was a full page Hermes ad.
Acquired
Hermès
And I was like, whoa, I think I texted you a picture. I was like, Hermes is buying full page marketing ads. But no, no, no. This is in the program at the ballet. This is not on the back of Vogue. There's a difference.
Acquired
Hermès
Also, their event spend. You might say, like, wait, how do they spend twice as much on events as they do on media? You haven't read about Hermes Events.
Acquired
Hermès
Even just the pure marketing events like a store launch or product launch, they'll spend a million dollars on a party.
Acquired
Hermès
And his two sons, Adolphe and Emile, who have apprenticed in the business just like him, just like every generation will do for many generations to come. They take over and they change the name of the company to Hermes Frere, Hermes Brothers, because the two brothers are now running the company.
Acquired
Hermès
It's part of the status is getting the ability to buy one, getting the appointment with your SA, spending the money. That's part of the status.
Acquired
Hermès
This is going to sound absurd on the surface, but I think it's true. That audience is incredibly diverse. That audience is lots of customers in the Middle East. That audience is 40 plus percent China. That audience is still French people with the preface de in their names, i.e. old nobility. That audience is the wealthiest people in America. That audience is Cardi B and Megan Thee Stallion.
Acquired
Hermès
Yep. I don't think we want to go down this rabbit hole, but there is a whole TikTok and Instagram culture of Hermes sales associate appointments and Birkin appointments and reveals and all that. And like, you know, it's huge. There are millions and millions of people that watch this. Yep.
Acquired
Hermès
I believe there's also a regulation that every store needs to carry at least one item from each métier.
Acquired
Hermès
They've been apprenticed together. They're going to be like Axel and Pierre-Alexis today. Well, of the two brothers, I think it is fair to say that Emil, who I believe is the younger brother, is the sort of much more ambitious and much more adventurous one. There's this great story that in the late 1890s, so before his father, Charles Emil, retires, the young Emil...
Acquired
Hermès
This is a really uniquely Hermes thing and is related to their airport strategy, too. Oh, yeah. And I experienced this, too. When I went to Palo Alto, I just walked into the store. I was pretty intimidated. As a first-time buyer and you don't have an SASL's associate relationship...
Acquired
Hermès
It can feel very intimidating, especially knowing what I know about the company and the brand, the weight of history, like walking into this store. It's not like walking into an Ikea. This is very intentional, the e-commerce strategy. And then the airport strategy is, hey, nobody feels intimidated in an airport.
Acquired
Hermès
Obviously, you don't have to have an appointment to walk into the airport Hermes store. It's a way to get first-time buyers into the fold, establish the relationship with them, get them more comfortable. in this buying experience, which is wholly unique to Hermes.
Acquired
Hermès
So that translates to a longer than 20-year average tenure. This is like Costco-level employment retention.
Acquired
Hermès
sets off to conquer Russia for Hermes. He literally like gets on a train with a notebook and a suitcase filled with miniature versions of the saddles and the harnesses that Hermes makes. And he just finds his way into the Tsar of Russia's court and lands him as a customer. That is wild. Unreal.
Acquired
Hermès
Especially in the context of, think about the two areas that are the bulk of Hermes' employees. It's craftspeople and sales associates.
Acquired
Hermès
I mean, they have incredible YouTube videos and documentaries. They put out like you referenced and you go see these people and like you really get to feel like factories, you know, they're not factories. These ateliers are something truly unique.
Acquired
Hermès
But by nature, given what this is in the luxury industry, you can't assemble this experience, the Hermes experience, out of separate components. Right.
Acquired
Hermès
They have to staff up a whole new atelier with like 80 craftspeople to fulfill all the orders for the Tsar in Russia.
Acquired
Hermès
Yeah. So this is Emil. He's going places. And right as he and Adolf are taking over, kind of at the end of Charles Emil's tenure, they decide to introduce a new product. Now, they're not thinking that this is going to be a big thing at the time.
Acquired
Hermès
All right, should we do value creation, value capture, and then we've got a new way to wrap up episodes here?
Acquired
Hermès
Well, it's interesting. Yes. But the secondary market is this very direct, if you're talking purely about economic value creation, value capture, very direct data point that like, no, they are leaving a lot of surplus on the table for their consumers. Yep.
Acquired
Hermès
There's actually a brief period where Jane Birkin boycotted Hermes bags and asked her to take her name off of them.
Acquired
Hermès
But some of their customers, again, now that they've added saddles, once they get off the horse, they want something to carry the saddle and maybe their riding boots on. with them while the horse is in the stables at wherever they're going. So they say, great, we can help you with this.
Acquired
Hermès
I could be wrong, but I believe this is when Hermes took the crocodile farming in-house and improved a lot of the animal welfare standards.
Acquired
Hermès
To me, that is a better argument than we farmed the crocodiles for the skins. It's funny, actually doing the Novo Nordisk episode gave me a new perspective on this with animal products. And obviously insulin doesn't come from animals anymore. It's genetically engineered, but a lot of pigs and cows went into producing insulin for many, many, many decades.
Acquired
Hermès
That's a new perspective to look at things because people would have died otherwise. Yep. Now, is that what's happening here with Hermes? Absolutely not.
Acquired
Hermès
And they introduce the haute aqua bag, which translates as the high belted bag to carry saddles and boots for their clients. Now, like I'm saying here, this was intended to be an accessory to the main business of equipage and saddles, the equestrian business. But It's not really practical for anything else. I don't know why anybody else would want a big tote bag that could carry your boots.
Acquired
Hermès
We've kind of been struggling for a while with how do we end these episodes? These like books that we write now. Right.
Acquired
Hermès
Right. That doesn't make sense. That was always kind of hokey anyway. And we've done bear case and bull case. And like, again, are we going to do that better than an equity research analyst? Like, I don't know.
Acquired
Hermès
Here's an incredible new insight that'll change your perspective on the stock. Like, no. Right. So, you know, we've been casting about for honestly a while here of like, how do we land the plane on these episodes? And so what we're trying here for the first time, and let us know what you think, if you like it.
Acquired
Hermès
in a very Hermes-like way, we dedicate really a month plus of our life to each of these episodes. Like this is all we're doing for certainly the last four weeks. Every day we've been getting up, we've been studying this company, we've been writing, you know, it's sort of insane.
Acquired
Hermès
And really, like you said, Ben, this episode started a year ago when we did the LVMH episode and it's been percolating and percolating and percolating. And the last four weeks, it's been every waking moment for us. And so I think a fun way to try to end the episode is when we wake up in the middle of the night and Hermes is on our mind, what are the aspects of Hermes and why?
Acquired
Hermès
And it ends up being personal for us. Like what resonates for us from having told this story and done this work and what resonates for Acquired, honestly. And for me, we've touched on this a little bit throughout the episode, kind of with the whimsy and the dream element of Hermes and
Acquired
Hermès
But there's something also to this company that I think is deeply interconnected with the fact that it's on the sixth generation of the family. You ask yourself, how is that possible? How, six generations later, is this company stronger than ever and the family members are more committed than ever to running it? And I think it's because they have fun.
Acquired
Hermès
And like, again, this comes through in the whimsy. This comes through in the annual reports. This comes through when you watch the interviews with XL and Pierre Alexi. And when you read the articles and hear people talk like Beatrice about Jean-Louis, they are really having fun doing what they're doing.
Acquired
Hermès
It's an amazing culture and it's kind of hard to have in a environment where you are also, I think, the 47th largest market cap company in the world. I think about other companies, like it's about winning, right?
Acquired
Hermès
You think about a professional sports team or like, I think my mind goes to like the New England Patriots, you know, or like, honestly, it goes to like Benchmark and Sequoia, like the best venture capital firms out there. These are organizations that are 100% dedicated to winning, right?
Acquired
Hermès
And it's not that Hermes isn't dedicated to winning, but they're kind of even more so dedicated to like having fun and enjoying themselves.
Acquired
Hermès
Right. So for me, that's the splinter in my mind over the last set of months with Hermes is honestly, it's what Acquired is for me and for us. Hermes could go out tomorrow and they could follow the consultants. They could borrow a page from the LVMH playbook and they could vastly increase their sales and profitability overnight. Right.
Acquired
Hermès
And if they were solely focused on winning, that might be what they do, but they are never going to do that.
Acquired
Hermès
Right. So I think it's kind of tied into this short-term, long-term perspective thing. The reason I say it's fun is the family wants to keep doing this. And so if it weren't fun, they would probably maximize value and they would hit the short-term bid and they would sell to Bernard. But they don't.
Acquired
Hermès
What's this bag look like Well, this bag looks exactly like the Birkins and the Kellys today, except a lot bigger.
Acquired
Hermès
Certainly not all, but a lot of people. I was thinking about that too a little bit in the context of oftentimes in a market, the best way to compete with your best competitor is is to do the exact opposite of them. You know, it's not to compete with them.
Acquired
Hermès
Right. This is Android and iOS. Right. Well, all right. That's our landing of the Hermes plane. Let us know what you think. I just love doing this one. This was one of the most enjoyable experiences for me. I mean, all of our episodes are, but I just really loved this one.
Acquired
Hermès
Yeah, but it has the same trapezoid shape. It has the crossover belt, the haute courroie. That means the high belted bag. It has the belt. It has the turnstile lock closure for the belt at the top of the bag. Fascinating. So this accessory that we're going to add to the business... This becomes the spiritual heritage to the business today.
Acquired
Hermès
Nice. I've got a 60-watt Anker that, you know, kind of same concept. And yeah, totally. Only thing I travel with. Is it gallium nitride? No, no, no. It's a few years old.
Acquired
Hermès
I might need to upgrade my travel setup. Maybe I need an Hermes leather case for it.
Acquired
Hermès
Okay. I haven't actually tried the app yet. Love those guys. Now I got to try the app.
Acquired
Hermès
Oh, wow. Okay. All right. We got to have perplexity on ACQ2 or something like that. More to come on this.
Acquired
Hermès
Honestly, this is why I don't use ChatGPT for acquired work. I feel like we need to be 100% all the time.
Acquired
Hermès
Oh, getting that answer. Otherwise, you're going to spend half an hour on Google trying to find it.
Acquired
Hermès
I love it. Okay. I've heard from so many people about perplexity. I got to give it a go on next episode research. It's phenomenal. I'm so disappointed in myself, but also it's just the reality of my life right now. I've become like the, you know, middle of the bell curve technology adopter. I used to be the bleeding edge, you know, early adopter. It was just, man, getting old is hard.
Acquired
Hermès
Joanna Stern had a great quote about this, the Wall Street Journal, and she was interviewed by Ben Thompson recently. She said like, man, I wish I had the access that I have now when I was younger. I would be on stop, be pulling all nighters. I'd be using it to its full degree. And I don't have the energy now. Like I got kids, like, and I'm like, man, I feel that.
Acquired
Hermès
What's the Dune quote? Life is not a problem to solve, but a reality to experience. Ooh, yeah, I think that is it. There you go. Okay, my carve out. We are recording this. By the time the episode comes out, the Super Bowl will have been played and won by somebody. But man, I am fired up. Go Niners, San Francisco 49ers, Brock Purdy. Hell yeah.
Acquired
Hermès
I'm channeling my inner JTO Sullivan and QB School YouTube channel here. I'm so excited. Brock's story is amazing. So I was trying to think, okay, I can't have like the Niners and the Super Bowl be my carve-out.
Acquired
Hermès
Right, especially if they lose, right? But what I can have as my carve-out and is perfect for Acquired Years ago, I read Bill Walsh's book. Bill Walsh was the legendary coach of the 49ers during the Joe Montana, Steve Young era. He invented the West Coast offense. And he wrote this book called The Score Takes Care of Itself. And it's so good. It's just like a great leadership book.
Acquired
Hermès
But, you know, the title says it all. It's related to Hermes. It's related to acquired. It's the splinter in the mind, everything we've been talking about. It includes some ideas like scripting. This is now so commonplace in the NFL and football everywhere, but everybody scripts out your first set of, you know, five, 10, 20 plays, et cetera. Bill Walsh invented that.
Acquired
Hermès
And like, we do the same thing on Acquired. We have scripts, like I have a script, you know, you have a script. And obviously the episode doesn't follow the script any more than an NFL game.
Acquired
Hermès
So this bag, this accessory that would become the Kelly and then the Bergen, They introduce it just at the right time. It's 1902, kind of as Charles Emile is retiring. And this idea of this bag that you would put stuff in, because you wouldn't bring a bag on a train. You know, if you're of this class, you need a trunk, a flat pack trunk that Louis Vuitton is going to make for you.
Acquired
Hermès
Right. Obviously, Bill Walsh didn't invent that idea writ large, but he invented it for the NFL. There's also some really good stuff in there about when to persist with doing something different and continue to do it versus stop doing it. And what are the right reasons to do it, especially in the early days when it's working or not working, like I'm thinking about.
Acquired
Hermès
you know, launching the Birkin and all that. Anyway, it's a great book. Bill Walsh was a legendary figure. And yeah, go Niners. Hell yeah. There you go. Wishing you the best of luck and listeners, you know what already happened. Well, either way, I'm celebrating because either the Niners won or we're going to see a lot of Taylor Swift and Travis Kelsey. So I'm thrilled.
Acquired
Hermès
Taylor is 100% thing. I'm not saying she's dating Travis because of this, but Taylor is one of the smartest CEOs in the world, writ large, period, bar none. And like, of course, she's thinking about this.
Acquired
Hermès
Jenny has negative interest in football, but she's telling me about what Taylor is wearing, whether she's going to be able to make it back from Japan from the Super Bowl. We'll see.
Acquired
Hermès
It's funny, you know, we did not talk to anyone at the company. We usually never do when we're making an episode. It's just kind of awkward. Yeah. We usually talk to them afterwards, but not during. In this case, we didn't need to.
Acquired
Hermès
Yeah. Well, speaking of April in Paris, Beatrice Amblard here in San Francisco. So fun to talk to an actual former Hermes artisan. There's personal stories of Jean-Louis and the family. They really gave me a sense of... Just how special the family is, they are, the company is, and the work that they do. And then I also have to thank Lauren Sherman.
Acquired
Hermès
Lauren is, I think, pretty much bar none, the very best business of fashion and business of luxury reporter out there. She was at the business of fashion for a long time. She's now at Puck. She's Puck's fashion correspondent. She launched the fashion vertical for Puck. Lauren is awesome. I chatted with her for a long time. She gave me a lot of great perspective on Hermes within the industry.
Acquired
Hermès
And none of these three men could have seen it at the time, but this accessory to the real business of saddles and horses and harnesses was going to become the perfect transition to move Hermes into the age of the automobile. But before we tell that story... Yes.
Acquired
Hermès
Really, there are a few journalists out there. I'm thinking of Brad Stone and Emily Chang at Bloomberg and Kara Swisher, obviously. But they're incredible journalists. And they really, really understand the business and the industry that they're covering. And Lauren is one of those. And it was super great to get to chat with her.
Acquired
Hermès
Yes, our presenting partner this season is J.P. Morgan Payments, and J.P. Morgan Chase traces its heritage back to 1799.
Acquired
Hermès
Their current payments business was officially forged a few years ago, but many of the capabilities and products came from different parts of the firm, which were already powering the whole payments industry. You can trace their merchant acquiring to the 90s, their treasury products to well before then, and even their blockchain work started earlier than most in the mid-2010s.
Acquired
Hermès
When they combined all that together under one group... It really became a one-of-a-kind, end-of-one business. A portfolio of treasury, online commerce, point-of-sale, global trade, card, cash management, fraud prevention, analytics, and more. A one-stop payment shop for businesses of all sizes.
Acquired
Hermès
So while Hermes explicitly avoids e-commerce for their most coveted products, as we will talk about later, for the other 99% of you out there, that's probably not your strategy. You want to do more business online. Large retailers are increasingly adopting a digital marketplace strategy to connect buyers and sellers directly.
Acquired
Hermès
But for the underlying platform, whether that's B2C or B2B, there's a lot of complexities that come with having a frictionless payments experience. You have to create and manage the seller bank accounts, money movement, and most importantly, who's going to take on the compliance and risk of holding and dispersing the funds, the third-party seller or the platform?
Acquired
Hermès
Oh, we've got a great discussion of that later in the episode. I used to think that and I no longer think that. But after our LVMH episode, I mean, you were so inspired by learning about Hermes, you went out and you bought your first luxury object, right? And it was not an LVMH brand.
Acquired
Hermès
So whether you're in retail, luxury, or really any industry, there's a clear growth opportunity from having an end-to-end payment solution. Head on over to jpmorgan.com slash acquired to discover more payment solutions driving growth for businesses, whether that's Fortune 500, startups, or any stage in between.
Acquired
Hermès
And also, if you're heading to the Retail Conference Shop Talk in Las Vegas in March, be sure to stop by the JPMorgan Payments booth where you can learn more directly from their team of experts. Yep.
Acquired
Hermès
So, this is wild. I suspect you probably also found this in research. But when I did, my mind melted. So, during World War I, in 1916...
Acquired
Hermès
emile becomes an officer in the french military and the military sends him to the united states to learn about kind of u.s industrial and military production you know he's sort of a leading industrialist in france at this time shall we say and one of the people that he gets sent to meet with is do you know about this ben No, I have no idea. I can't believe you didn't find this. No.
Acquired
Hermès
He meets with Henry Ford. No. He goes to Detroit. He sees the assembly lines. He sees the car. He sees the future.
Acquired
Hermès
This is what's so funny. No, he's like, this is unbelievable. And to the, you know, manufacturing efficiencies point, he actually does take some elements of the assembly lines and brings them back to Hermes. It's not like they're anti-efficiency, they're pro-efficiency, but in the context of being a craft, you know, non-mechanized human master craftsman built object.
Acquired
Hermès
Also, the Hermes annual reports are the most beautiful annual reports ever created in the history of the financialization of mankind.
Acquired
Hermès
So he actually does take some of the production ideas from Henry Ford. But more importantly... he's looking at this place and he's like, my God, there is a Model T rolling off the assembly line every three minutes. Ford at this point is producing half a million cars per year. Everybody knew about the automobile, but this is a different era.
Acquired
Hermès
This is kind of the same time as when we talked about our Novo Nordisk episode about the start of that company, where news didn't reach Europe. This wasn't a global world. And so Emil getting this window, like literally seeing the assembly lines in Detroit, he's like, whoa. Once this war is over, the world is going to change forever.
Acquired
Hermès
Yeah, he's quite the character, this guy. The other thing he finds in America is, I know you know this one.
Acquired
Hermès
I couldn't believe this. The zipper was a late 1800s, early 1900s invention in America. And it was primarily used for industrial use cases. In this case, it was zippering closed the hood of a car.
Acquired
Hermès
Yeah. Where Emil first sees it. It's not at the Ford factory. I think it actually might've been in Canada on the later leg of his journey where he sees it. on the car. It was also used for opening and closing boots. And that is how the name zipper came to be. I think it was the BF Goodrich company.
Acquired
Hermès
Yeah. I believe they made a brand of boot with this close all function and they called it the zipper and that's where the zipper came from. Regardless, enterprising young Emil, he tracks down the inventor of the zipper, like the holder of the patent in America. He obtains an exclusive license for two years in France. This literally is like the Novo Nordisk episode.
Acquired
Hermès
Brings it back to France and makes the first zippered products. He makes the first zippered jacket ever created anywhere in the world. It is a leather golf jacket for the British Duke of Windsor, the heir to the throne. Just amazing. For years in France, the zipper would be called the Hermes fastener in France.
Acquired
Hermès
Just a while. I think they made the right decision not to make zippers the business and instead to stay focused on Flutter Kids.
Acquired
Hermès
Yeah. And a golf jacket literally for use while playing golf, while playing sport. You know, what more modern activity to happen here? Yep. Regardless, though, the big thing for Hermes that he brings back is, oh, my God, the car is coming.
Acquired
Hermès
When Emil comes back and he's running around making zipper jackets, he's collaborating with car companies, leads to a rift between the two brothers. Adolf, the older brother, he's much more conservative. He wants to remain in the horse market. He's kind of depressed about the car coming. He's like, hey... I just want to remain a niche leather worker.
Acquired
Hermès
Right. Now, I don't know if it was that he had his head in the sand or more just like he didn't want to go build a big company. Right.
Acquired
Hermès
Totally. I could totally understand that. Either way, in 1919, Emil buys him out and says, I believe in my ability to lead this company making this transition into the automobile era. And legend has it that he goes to the craftsman in the atelier above the shop in the Faubourg and says, OK. What are we going to do?
Acquired
Hermès
What can we make with our hands here in this atelier that will interest our clients today? And I think this is still kind of legend around Hermès of like, what can we make with our hands that will interest our clients today? And the obvious answer at the time is... a version of the Haute Dacroix bag. You know, it's bags for these cars.
Acquired
Hermès
And if you want the most exquisite bags, the most exquisite things to show in your automobiles that you're buying, who better than Hermes? And finely handcrafted leather bags and accessories that you can outfit your car in the same way you could outfit your horse. So the business is now Emile's and the business is now handbags. Yes.
Acquired
Hermès
And once again, to timing and insight here, kind of like Thierry in the original case, what the automobile does, and it's not just automobiles, it's also improvements to trains and improvements to ships. The global rich, the global elite, they start traveling a lot more. You know, we're now in the 1920s, the roaring 20s. This is what F. Scott Fitzgerald is writing about.
Acquired
Hermès
The visible symbols of wealth. It's when you're home, it's in your car and the bags and the accessories you're using with your car. But you're also out traveling a lot more. You're rubbing shoulders with elite all around the world. The American elite are going to France. They're going to Europe, vice versa. People are starting to travel around the world. People are traveling to Asia.
Acquired
Hermès
People are traveling to the Middle East. People are traveling to South America. Emile's going right along with all these people. And your luggage, your bags, that's what you bring with you. That's what you show.
Acquired
Hermès
The product itself, yes. Yep. So in 1922, Emile's wife famously complains that the large bag they've been making, the haute corvois, the saddlebag, it's too large to fit through car doors. So she asked for a smaller version. And this launches the handbag business in 1925. And by the way, by this point, they've put the zipper on a handbag. Yes, exactly.
Acquired
Hermès
And speaking of the zipper, in 1925, they had ready-to-wear clothes, like the legacy of the golf jacket here. The legend has it that they added clothes because a longtime client came in and said, I am fed up with seeing my horse better dressed than me. Yeah. Which, you know, who knows if that's true, but it's a nice story.
Acquired
Hermès
But they really go into this in this modern world where the global wealthy, the global elite are traveling. They're seeing each other. What outward signifiers can they supply them? Clothes. 1927, they had jewelry. 1928, they had watches.
Acquired
Hermès
Right. It's not right to say that they're licensing products. It is a collaboration, but they are selling products in their stores that are not made end-to-end by Hermes-employed craftsmen.
Acquired
Hermès
Yes. And I think all this is being figured out real time. These ideas of retailers versus brands. It was a much fuzzier line then than it was today. So what does Hermes do? What does Emile do? They start opening up stores outside of Paris. And where are they going to go? They're going to go to the travel destinations where their clients are going.
Acquired
Hermès
So the first store is in the Côte d'Azur in the south of France. And then they start opening up more stores around the world. You know, again, not necessarily in like the Londons or the Romes or the New Yorks of the world. They're opening them up in the travel destinations.
Acquired
Hermès
I suspect, though, that it was strategic of like, our French clients are going to go to these places. They're going to rub shoulders with the Americans, with the British. And then we're going to have a store there so that those Americans, those British elite, they can go there.
Acquired
Hermès
Yes. Now, I think some element of this certainly still exists. You had a nice time going into the Hermes store in X, right?
Acquired
Hermès
Yeah, we really uncovered the breadth of J.P. Morgan Payments as we went deep into industry research for our Visa episode last year. And just like how we say every company has a story, every company's story is powered by payments. And J.P. Morgan Payments turns out to be a part of so many of our acquired companies journeys.
Acquired
Hermès
Yeah, I think they very brilliantly walk this line. And the products that the shops carry are very different. We'll get into that later in the episode too. But back to this era. So I think we've laid the groundwork of a few critical components of Hermes so far. First and most importantly, the craftsmanship.
Acquired
Hermès
These things are handmade by artisans with their hands, and the family and the people who own the company are the chief artisans. That goes all the way back to Thierry. We've talked about the connection to the legacy of French nobility, but not really French nobility. It's sort of like status, but accessible status for the first time in the world and the modernization of the world.
Acquired
Hermès
We've talked now here about the true modernization of the company and the transition to the automobile era. What we haven't talked about yet and what Hermes at this point certainly is not is this element of whimsy and art that is really, really critical, I think, to the company.
Acquired
Hermès
And this, I think, is really a very different thread than the original kind of leather craftsmanship. And it is a critical one in the kind of weaving of the Hermes business. And this thread comes from the next generation of the family, specifically Robert Dumas. So Emile had four children, but they were all daughters.
Acquired
Hermès
And tragically, one died young, but the other three grew up and they got married. And back in this day, women weren't going to take over the business, unfortunately. Right.
Acquired
Hermès
And in this case, when you read about the Hermes family fortune today, it's the Dumas family that are obviously the CEO and the artistic director that you hear about visibly. But really, I think all the sons-in-laws and all of their descendants become active in the business. So there's Robert Dumas, there's Jean-René Garin, and there's Francis Poitier. And these are all son-in-laws.
Acquired
Hermès
And these are all son-in-laws. And those are the three family names that you still hear about to this day of the Hermes family. But back to Robert Dumas and the fourth generation. He brings this whimsy and real art into the business.
Acquired
Hermès
Totally. And this comes from Robert. So one of the first things he does when he joins the business is he redesigns the kind of smaller Otakowa bag, the handbag line, into what he calls the Sac a Depeche in 1935.
Acquired
Hermès
Yep. A little later in the 1930s, he introduces the chaîne d'encre bracelet, which is another iconic Hermes item in there. Jewelry métier.
Acquired
Hermès
A métier is like someone's work, but in the craftsman sense. A métier is like a trade. It's like a craft profession. And this is what Hermes calls their divisions. I feel gross even just saying the word divisions. There are 16 of them today. And jewelry, of course, is one of the métiers. Oh, I feel so much better saying métier.
Acquired
Hermès
So Shandanka in French means chain of anchors, anchor chain. And these are anchors like boat anchors. And the way that this bracelet comes about is Robert is walking along the beach in Normandy one day, and he's just inspired by the scene of these boat anchors on this foggy beach. And so he makes a little sketch in his notebook, and then he plays with it.
Acquired
Hermès
I was tempted. Well, if you read The Luxury Strategy, which is a great book that we've referenced many times on Acquired, they start back 50,000 years ago. We start in 1801. Not in Paris, not even in France. You know, as we've been talking about, the land of beauty, luxury, enlightenment, where Hermes, of course, was founded and is still based today.
Acquired
Hermès
The family talks about this a lot. The words they use is, this is not a museum. There is this artistic element to what we do, but we are not a museum. We are a business and we have clients and we are here to serve our clients. There is this push-pull here. Yes.
Acquired
Hermès
So that was in kind of the mid-30s. So then in 1937, Robert introduces the other key pillar of Hermes products that is less talked about today relative to the bags and the leather goods, but for many, many decades was the bigger business.
Acquired
Hermès
So silk scarves, the Hermes classic silk scarves. And this is the embodiment of this art and whimsy that we're talking about. The silks that they use are the finest silks in the world. It takes 300 silk moth cocoons per scarf, as they will readily tell you to produce these things. But the designs on them, the artwork on them, are whimsical, like we said.
Acquired
Hermès
So the first design, the Jeux des Omnibus et Dame Blanche, where these sort of white ladies at play, I guess you could translate that, is based on a woodblock engraving that Robert does. I mean, this is like what an artist this guy is. He's about to become CEO of Hermes, but he's making woodblock engravings and then making silk scarves out of them. That's the first design that they put out there.
Acquired
Hermès
Well, it's funny you say the French woman's uniform. Yes, that is entirely true. But the woman who really popularizes them around the globe is a British woman, specifically Queen Elizabeth.
Acquired
Hermès
Yeah, this is so iconic Queen Elizabeth. She starts wearing them as headscarves in the 1940s. And I mean, Queen Elizabeth, she's Queen of England for what, like 60, 70 years.
Acquired
Hermès
And uniquely, Hermes still does 85% of their production by hand by Mastercraftspeople in France, as we will talk a lot about. But instead, we start in the land of hardness and precision, of engineering, of exactitude, the future land of the Porsches of the world. That is right, Germany. A century before the Porsches and Volkswagens of the world. Yes.
Acquired
Hermès
And she's wearing these scarves, these, you know, whimsical, playful scarves on her head as the Queen of England.
Acquired
Hermès
Yeah, there's no digital process here. It's not like you're going to customink.com and, like, ordering up some Hermes scarves.
Acquired
Hermès
all of which are like extremely hard to replicate and involve both extreme craftsmanship and extreme taste. The competitive barriers to the Hermes scarf, I think they're way higher than the bags, honestly, even though the bags are bigger business now.
Acquired
Hermès
And I think also, you know, as a client too, at least in scarves. Like if you entered the Hermes scarf universe, you're not buying any other scarves.
Acquired
Hermès
Yeah. I mean, I remember growing up, my mom is half British, I'm a quarter British. And to the Queen Elizabeth thing, Hermes scarves, my mom's Hermes scarves were and are among her most treasured items. So, you'll note all of this that's happening. Robert, the innovations, these new products, the art, the whimsy. He's doing all this in the 1930s. This is the Great Depression era.
Acquired
Hermès
The illustrations, the themes, you can tell they care. You can tell. All right, let's do it. Let's do it.
Acquired
Hermès
Where Thierry Hermes was born in the town of Creffield, which is just outside of Dusseldorf. where he's the sixth child of a family of innkeepers. So Hermes, is that a German name, a French name? Hermes is obviously not a German name. I mean, even I know that. Thierry's father was French and his mother was German.
Acquired
Hermès
This tells you about Hermes and Hermes clients. They are unaffected. They keep buying. And this carries through right to this day. I mean, I don't know that there is a more recession insulated business than Hermes.
Acquired
Hermès
So after this, there's World War II. And famously, before the war, Hermes products came in cream-colored boxes. Robert was very meticulous about the packaging that his crafted items and his art would come in. And it was cream. It had to be cream. During the war, there's a shortage of packaging materials. They can't get cream.
Acquired
Hermès
The only color that is available to them in the quantities that they need is orange. That was designed for patisseries, for bakeries.
Acquired
Hermès
That's why there was an excess of it, because it was used for bakeries, and bakeries weren't baking as many croissants and pain au chocolat during the war, etc. So there's all this orange packing material. Robert embraces it, and the Hermes orange box is born. This is crazy. I didn't know this until research. Hermes owns this color. You cannot get Hermes orange anywhere else.
Acquired
Hermès
So a few other things that Robert adds over the years. He adds the men's silks métier, a.k.a. ties. The legend behind that one is pretty great.
Acquired
Hermès
Supposedly in Cannes, a number of gentlemen were refused entry to the casino and thus went to the neighboring Hermes shop, you know, next door and said, can you take some of your beautiful silk scarves and cut and tailor them into ties for us so that we can enter the casino? Yeah. I'm sure that's apocryphal, but adds to the legend here.
Acquired
Hermès
And shortly after Thierry is born, he was born in 1801, something pretty major happens in France and then throughout continental Europe that will become very, very important to our story here. And that is that Napoleon comes to power in France. I mean, this is the era we're talking about here, like Napoleon.
Acquired
Hermès
Totally. Yeah. After World War II, Robert decides that Hermes needs a logo. So taking inspiration from the 19th century painting Le Duc Atelier Groume à la Tente, which means Hitched Carriage Waiting Groom, the famous Hermes logo is born. The logo is the callback to... The carriage. It's the nobility.
Acquired
Hermès
You know, I find it really interesting, especially at that point in time that Robert decided you could imagine like, you know, a galloping horse or something like that would be the appropriate logo.
Acquired
Hermès
and no longer exists. Horses in the equestrian world still exist. It's obviously not what it once was, but it still exists. The carriage world is gone. It's just a dream these days. And that's what Robert is so good at, this dream. The other thing we have to talk about are the window displays. You referenced this a little bit earlier.
Acquired
Hermès
So he hires first Annie Baumel, and then she's soon joined by the legendary Leila Manchari. Specifically, these two women, they come from theater set design. just to design the window displays at the Faubourg, at the flagship store on the rue Faubourg Saint-Honoré. I mean, there are whole museum exhibits just dedicated to these window displays.
Acquired
Hermès
And it's not like, you know, again, you walk by XYZ other store, even the most prestigious brands, and it's like the products are there. You know, here's the products, here's the brand you're buying, here's the LV, etc., These displays, it's a dream. There are probably some Hermes products in there, but it's like a museum exhibit. It's artwork.
Acquired
Hermès
There's this genius aspect, too, to what Hermes is doing and what Robert's doing with the arts, like these window displays. The Luxury Strategy book talks a lot about this. When you're selling luxury items, they can't just be art. They need to have some utility to them. Yep. You will never see any of these brands, Hermes included, become art galleries. They're not selling paintings. But...
Acquired
Hermès
He is critical to what is about to happen here. So in the aftermath of the French Revolution, Napoleon essentially stages a coup, declares himself emperor first of France, and then he basically begins conquering all of continental Europe, including Germany. Now, this Napoleonic conquest was at the same time both the very best thing that could happen to young Thierry.
Acquired
Hermès
It's critical for luxury brands to have a connection to the arts. I think he realized this before anybody of like the windows in our stores are these portals into this world of dream and art. And you'll come in and you'll buy a scarf that you'll wear. You'll buy a bag that you'll use. Maybe you'll buy a tie. Maybe you'll buy a wallet, right?
Acquired
Hermès
or homewares or furniture or any of the other things over time that they sell. And that will have utility, but it's connected to this dream.
Acquired
Hermès
Yeah, totally. So speaking of dreams, we're now in the 1950s, in the post-World War II era. The most amazing, unbelievable, fantastical dream of the 1950s happens to Hermes in real life. And that dream is Princess Grace Kelly.
Acquired
Hermès
So I sort of mentioned a little while back that one of the first things that Robert did when he came into the business was redesign the handbag and christen it the Sac a Depeche. Well... It becomes popular, but like we're talking about, leather goods, handbags, you know, important. But that kind of was the previous generation of the business.
Acquired
Hermès
Now under Robert, it's the scarves, it's the dream, it's all this stuff. And leather's part of it, but a smaller part. Well, in 1956, Princess Grace Kelly of Monaco, this is a girl from Philadelphia, an American girl. Yeah. Who goes on to become a movie star, who then goes on to become Princess Grace of Monaco. I can't imagine a bigger dream for any woman or any person in the 1950s.
Acquired
Hermès
So the legend is that it was on the cover of Life magazine, but I googled a lot of 1956 covers of Life magazine, and I didn't find it on the cover. Oh, interesting. So maybe that's been sort of played up over time. This might have become part of the lore. Regardless, big picture in Life magazine, she is clutching her beloved Saka Depeche to her midsection.
Acquired
Hermès
It is. It's a paparazzi photo. And her husband, Prince Rainier of Monaco, is holding the door behind her. It's like the most dreamlike thing you could imagine. And it's in black and white. And the reason that she is clutching this fairly large bag, unbeknownst to the world at the time, is she's trying to hide her pregnancy from the paparazzi. She's pregnant with her first daughter.
Acquired
Hermès
And this photo just becomes iconic. Everybody wants to be Grace Kelly. Everybody wants to have this bag. And one of the last things that Robert does right before he retires in 1977 is he officially changes the product name of the Saka Depeche to the Kelly bag. And this is the birth of, I don't even know what to call it.
Acquired
Hermès
I mean, it leads directly to Hermes, but also the very worst and truly worst. All this conquering, this glory of France that we're going to talk about becomes important to Hermes. That's the result of wars. So Thierry's entire family, his parents, his mom, his dad, all five of his siblings, they are all killed. either directly in the Napoleonic Wars or by disease and famine as a result of this.
Acquired
Hermès
The Kelly and the Birkin are ends of ones, but these leather good products that transcend everything that are like so truly end of one. There's no other way to describe them.
Acquired
Hermès
Yep. ServiceNow digitally transforms your enterprise, helping you automate processes, improve service delivery, and increase overall operational efficiency all in one platform. Over 85% of the Fortune 500 runs on them, and today they are the 76th largest company in the world by market cap. That's wild. They're coming up on Hermes here. Yeah.
Acquired
Hermès
It's just like our NVIDIA series. Moving from product to solution makes you an essential partner for your customers, which lets you build real enterprise value. And Bill is the best in the world at this.
Acquired
Hermès
As a high schooler, this is amazing. He buys the deli for $7,000 in seller financing from the owner who is retiring.
Acquired
Hermès
He literally made life-changing money from this deli. He buys his parents a beach house.
Acquired
Hermès
And the company's performance since then has been incredible. I mean, honestly, it's like Hermes over the past couple of years. Revenue has doubled. Earnings have nearly 10x since 2019. And Bill and ServiceNow have entered the conversation with the NVIDIAs, the Microsofts as the most important technology partners for enterprises around the globe.
Acquired
Hermès
Certainly this plays right into this whole dream thing that we've been talking about. and burnishes Hermes's already incredible brand and image. I mean, my God, Princess Grace Kelly of Monaco is carrying this bag, not just carrying this bag, but it's her favorite bag, the closest thing to her body. But we're still in the 50s here. So like, yes, it becomes incredibly popular.
Acquired
Hermès
I mean, absolutely terrible. And the result is that Thierry, by the time he's 20 years old, he's an orphan. He is the last Hermes left.
Acquired
Hermès
Yes, I'm pretty sure it becomes Hermes's biggest selling bag. But the market isn't quite there yet in the way that it is today with the Birkins and the Kellys. The global rich isn't that big of a population. And like, yeah, I'm sure they're all buying Kellys. But Robert probably knows all of these clients personally at this point. We're not anywhere near the scale that we're talking about today.
Acquired
Hermès
Right. The number of people who could spend the equivalent of $12,000 on a bag back then was just much, much, much smaller than it is today. Yep, exactly.
Acquired
Hermès
And in fact... Actually, sadly, kind of quite the opposite happens. So as we head through the 60s and into the 1970s and the end of Robert's tenure and his generation as the head of Hermes, the company kind of starts to fall on hard times.
Acquired
Hermès
And it's particularly not working because, like we just talked about, that market was not that big yet. And as we enter the 1970s, something really funny happens. The next generation rejects that dream. This is, you know, you and me, our parents' generation. The hippies, the 1970s, this is democratization. Little girls don't want to be Grace Kelly anymore. Hmm.
Acquired
Hermès
They want to be like Stevie Nicks or, you know, something like that. Hmm. And the dream of Hermes that was once so elegant and so desired by so many people but inaccessible is kind of now like, it's certainly still got its audience, but it's not as universal. This is when so many of the other, what we now think of as luxury brands, really start to come up.
Acquired
Hermès
And we talked about this on the LVMH episode, but they're connected to fashion. It's first Dior, and then it's Yves Saint Laurent. This is the Mondrian dress from Yves Saint Laurent. This is the revolution. It's Gucci. It's Chanel in the 80s when Karl Lagerfeld takes over. And what they're selling, is very, very, very different than what Hermes is selling.
Acquired
Hermès
Obviously not Rockefeller, which is where my mind first went because we talk a lot about his dad. Yep.
Acquired
Hermès
Yes. This was super cool. And, you know, one of the things that for me and for both of us just kind of blows our mind as Acquired grows. We got to talk with Domenico Di Sole, who was CEO of Gucci during the fight with Bernard Arnault that we chronicled. Really, I think that was the best part of our LVMH episode.
Acquired
Hermès
But it was super cool. When we talked to Domenico, he comes from that world, even, you know, with the heritage of Gucci. Yeah. He and Tom, it was fashion first. And in his perspective, and I think the perspective of many folks that are coming out of this 70s, 80s era of luxury, that's what's interesting. That's what's fresh.
Acquired
Hermès
So all this culminates towards the end of the 1970s as Robert is nearing the end of his tenure at Hermes and the end of his life. Sadly, there's a moment, this is like probably 1977 or so, Yeah. Unbelievable. Yeah. That was the accepted wisdom at the time. I don't know if it was McKinsey or, you know, who was saying that.
Acquired
Hermès
I mean, this is enshrined in the luxury strategy as anti-law of marketing number 19. Do not hire consultants.
Acquired
Hermès
Yeah. I mean, it's working for them and it's not working for Hermes. It's crazy. And this is when the next generation transition happens to Robert's son, Jean-Louis Dumas. I kind of can't believe it with this family.
Acquired
Hermès
Every time they come in at a generational transfer and the company and the brand is under existential threat, even though we think of Hermes, you know, the most unassailable thing in the world right now, but finds itself in a moment where it can be assailed and There's a generational transfer happening. You would think this is like the downward spiral. This is the dropping of the baton.
Acquired
Hermès
I really do think that there is an element, too, of the successive generations. They apprentice in the ateliers with their hands. I think there is an element of that. And they also apprentice, especially these days, on the business side, too.
Acquired
Hermès
Axel talks all the time about dinner table conversations between his uncle, Jean-Louis, who we're about to talk about now, who is the fifth generation CEO of Hermes, and and his mother, who was head of production at the dinner table growing up. You can't not absorb that. I think that's the flip side of nepotism, right? Which makes it such a challenging topic.
Acquired
Hermès
On the one hand, obviously limiting the universe of talent. On the other hand, how do you replicate those dinner table conversations?
Acquired
Hermès
Totally. Okay. Jean-Louis, the fifth generation. The brand, you know, the consultants are saying, hey, go be like Gucci.
Acquired
Hermès
Well, I do have to correct you there. That is not specifically true. It's certainly spiritually true. I believe now the only products that are made in the Faubourg are saddles.
Acquired
Hermès
Great. He, like all the generations before and after him, he's come up. He's apprenticed in the business. He knows how to do the saddle stitch. It's in his hands. It's in his soul.
Acquired
Hermès
It's also incredibly beautiful. It's got a slight diagonal valence to it as opposed to the normal straight-line stitching.
Acquired
Hermès
Yes. So in 1821, Thierry leaves Cretfield, leaves Germany. He abandons his original kind of destiny as an innkeeper, and he moves to France, not to Paris, but to Normandy in the north. And there he becomes an apprentice under a master craftsman learning the art of equipage craftsmanship. Now, equipage is the business of outfitting horse-drawn carriages. And...
Acquired
Hermès
I'm going to channel my inner Pierre Alexei here, the current artistic director of Hermes. I think it still has relevance if you want your object to be permanent. If you want an object that you own to represent something wholly different and antithetical to, let's call it the Amazonification or the Walmartification of items these days, you want it to be made like this.
Acquired
Hermès
Oh, I think it's even more than that. It's two years of training to become a Hermes artisan, period. I don't think you're allowed to touch the Birkins and the Kellys when you start day one on the job. I believe you need at least another three years, if not more, before you're allowed to touch the Birkins and the Kellys. Fascinating.
Acquired
Hermès
Ooh, hang on to this. I have a lot more to say when we get to the current generation about this.
Acquired
Hermès
Partially in their defense, savoir-faire literally translates as know-how. It's kind of like a proper term in French.
Acquired
Hermès
who were the customers of horse-drawn carriages, Ben, like you're talking about. The nobility. The nobility. You know, horses were extremely important to the world back then. The horse was the car. It was the Ford F-150. It was the Toyota Camry. It was also the Rolls-Royce that drew the carriage. And only the Rolls-Royces were the carriages.
Acquired
Hermès
Yeah. That's the true genius of the current generation is they have scaled that to 7,000 people. It's unbelievable. Unbelievable. I was going to talk about this towards the end of the Jean-Louis era, but I want to say it now because I think it's perfect. I got to talk to a woman named Beatrice Amblard who lives here in San Francisco. This is amazing. She was an artisan at Hermes in Paris.
Acquired
Hermès
She was hired right at the start of Jean-Louis' tenure. She worked in the atelier at the Faubourg when Jean-Louis' son, Pierre-Alexis, current artistic director, came to train after school as a teenager. He sat next to Beatrice. And I got to chat with her about this.
Acquired
Hermès
So she moved to San Francisco when Hermes opened the San Francisco store here. And I asked her, I was like, oh, you transitioned to the front of the house. And she was like, no, no, no. I was the person for the West Coast who repaired everything for North American West Coast clients. There was one person in New York and I was in San Francisco and we came from the Faubourg.
Acquired
Hermès
And, you know, a few of these people go around the world. And one of the things about Hermes and actually Jean-Louis, who say that it's like the true essence of luxury and the true essence of Hermes is everything they make can be repaired. And so if you buy an item from Hermes, no matter what it is, they will repair it.
Acquired
Hermès
Yeah. So I asked Beatrice when I was talking to her, what was this like? You know, what was special? And she said, look, you have to understand. When I was training as a young person and decided I wanted to go into this field, Hermes was absolutely the greatest company that anyone could hope to work for. It wasn't even close. There was no comparison. What years?
Acquired
Hermès
This was in the late 80s, early 90s. She said, look, I decided that either I was going to get a job at Hermes or I was going to leave this industry and go do something else. It is in that high of esteem. And I said, well, why? And she said, look, by the time we're at this era, nobody else was left that did this. Right.
Acquired
Hermès
Everything we talked about in the 1970s, all these other brands, they all went in this complete other direction. Right. The consultants were telling Hermes to go in that direction too. But they're the last one standing that did all of this by hand in the tradition handed down through hundreds of years. If that's important to you, there's no place else.
Acquired
Hermès
You can't ply your trade doing that anywhere else. I asked her then, I was like, okay, well, as for the products and to the clients, to the customers... Why does that make a difference? And what she said is what you'll hear the family talk about all the time. She said, look, it's about soul. This product has a soul. Somebody made that thing with their bare hands. That means something.
Acquired
Hermès
And there's nobody else, certainly at Hermes' scale. that does that. You know, she ended up leaving Hermes and starting her own boutique here in San Francisco, April in Paris. And she actually also runs her own leather school here in San Francisco, too, to train artisans. You can get custom stuff, small boutique stuff. You know, Beatrice is a worldwide master. You can get that from her.
Acquired
Hermès
So when Thierry moves to Normandy and takes up as an apprentice, he apprentices for 16 years. Wow. And it's not until 1837 that he finally moves to Paris as now a master craftsman and opens up his own shop in Paris on the Rue Basse du Rampart in the 9th arrondissement, which that whole street today no longer exists.
Acquired
Hermès
But the idea that a $200 billion company at scale would be doing this, like there's nobody else.
Acquired
Hermès
The other thing Beatrice said, to bring it back to Jean-Louis, he is a legend. He really cared. The idea that he would follow the consultants, it was just so completely anathema to him. He's the artistic director and CEO of the company. She ran into him in the elevator in the Faubourg right after she started. He looks at her and said... You're Beatrice Amblard. Welcome to Hermes.
Acquired
Hermès
You know, she knew everybody by name. And then when she ended up leaving in 1997 to open her own store, he called her and he was like genuinely shocked. Nobody ever leaves. Like, what are you going to do? And she explained that, well, she wanted to be entrepreneurial, start her own thing.
Acquired
Hermès
And then shortly after the San Francisco Chronicle did an article about her, he found the article, read it in France, cut it out, mailed it to her with a note of congratulations handwritten.
Acquired
Hermès
Yep. Okay. So Jean-Louis' story. How did he turn this thing around and save Hermes from the consultants? Well, like we said, he'd apprenticed just like every other generation. But unlike any other generation, or I guess maybe sort of like Emile back in the day going and meeting Henry Ford...
Acquired
Hermès
He comes to America, and specifically he came to America to follow his wife, Renna, who became a world-famous architect. Renna was interning with IM Pei in New York. Really? And Renna Dumas would go on to design all the stores that they opened up all around the world. and design the Atelier in Pantene when they expand production.
Acquired
Hermès
Yeah. Jean-Louis, when he's in America, he works for Bloomingdale's. Bloomingdale's! My God, of all places.
Acquired
Hermès
And there he establishes himself as really quite an exceptional harness maker for horse-drawn carriages. Now, it's kind of unclear to me at this point if he's using the famous saddle stitch, which becomes so important to Hermes. And the reason it's unclear to me is because he's not making saddles. Saddles are what other people are making. It's not that the nobility don't ride horses. They do.
Acquired
Hermès
It's hard to stump me. Yeah. But you do it sometimes. Okay, so Bloomingdale's. So from that experience, being in America, being in this much more mainstream audience, he comes to understand what these other brands are doing, what the consultants are suggesting. But he takes that back. And what he says, like, look, the way forward is we are going to figure out how to make Hermes relevant.
Acquired
Hermès
We're not going to throw away everything we've done. We're going to keep our tradition. We're going to keep our craftsmanship. We're going to keep our market position. But our clients want to be like these young people, particularly these young women. The moms don't want to be like their moms. They want to be like their daughters.
Acquired
Hermès
This is such a tight needle to thread to use a pun here. They need to run the Not Your Mother's Tiffany campaign without actually running the Not Your Mother's Tiffany campaign.
Acquired
Hermès
So, well, the first thing in 1979, the first year he takes over, he launches a new ad campaign in Paris with young Parisian women wearing the iconic Hermes scarves, which remember, like that's the main part of the business at this point in time. But it's, you know, all these old people who want to be like Queen Elizabeth wearing the scarves.
Acquired
Hermès
Young women wearing the scarves, not how you would typically wear a scarf. Different parts all over their body. It's the Hermes version of Not Your Mother's Tiffany. And most importantly, they're wearing these scarves with jeans. Grace Kelly would never wear jeans. I don't know if she ever did wear jeans, but she sure as hell wouldn't be photographed wearing jeans.
Acquired
Hermès
These ads are the scarves that Queen Elizabeth is wearing with jeans and in fun, interesting ways, playful ways to wear the scarves. But they're still the same scarves. Fascinating. And this is like a revolution. I mean, the rest of the family is really upset about it, but he pushes it through.
Acquired
Hermès
And you can still see echoes of this to this day, like a big part of Hermes fashion and probably the biggest part of, I think, the scarf fashion these days is tying the scarves on your bags, on your accessories, on various parts of your body, not wearing them. Like your mother wore them.
Acquired
Hermès
Ah, that's super cool. Yeah. But I think this is brilliant because this is allowing Hermes to exist and be relevant alongside fashion without actually getting into fashion themselves. The scarves and then ultimately the bags can be the accessories that to your jeans, to your fashion, to your, you know, we're past the era of bell bottoms, but like the spiritual equivalent of bell bottoms here.
Acquired
Hermès
And they can say something about you, but they're still the same products that they always were.
Acquired
Hermès
But they ride horses like the elite today drive a Ferrari. It's not something they do every day.
Acquired
Hermès
Yeah. So Jean-Louis has a quote about this, which is very French. He says, That's the most French way of ever saying this, but this is what we're talking about. He got their client base and often the young people's parents who wanted to be more like the young people here to see with new eyes the same things. Yep. Total genius. Yep, for sure. Okay, so that's brilliant.
Acquired
Hermès
So that's on the product side and kind of doing this jujitsu to reposition the products in Hermes. The other thing that he did, which was huge, was he had the very same realization that Henri Racamier had at Louis Vuitton. And we foreshadowed this earlier. What Racamier figured out at Louis Vuitton in the 1970s was...
Acquired
Hermès
The market now, the global wealthy, the global elite, the global rich is so much bigger now than it was in the 1950s. The number of people with wealth on the order of Grace Kelly and Prince Rainier of Monaco, or even a few rungs below them, but the number of people who can be in our client base around the world is just so, so, so much larger than it used to be.
Acquired
Hermès
Yeah. And this is super key. And I think to this day is a huge part of the defensibility of Hermes and Louis Vuitton, too. No matter where you live in the world and no matter what your cultural background is, when you attain this status, there's still something about this connection to French and European nobility that you cannot buy from a brand from any other country.
Acquired
Hermès
Yeah. So when Thierry arrives in Paris in 1837, he pretty quickly starts becoming known as really the best harness maker and carriage outfitter in Paris serving the nobility, which is pretty impressive. I mean, here he's this immigrant from Germany, apprenticed in Normandy. He shows up in Paris and all of a sudden he's making the best stuff out there.
Acquired
Hermès
Yep. So all of this stew comes together in 1984 with Jean-Louis' greatest achievement. And unlike the Kelly bag, which, you know, again, was an accident, like, yes, it was his father, Robert, and incredible genius, and then repositioning and renaming the bag, the Kelly bag. Jean-Louis, this is literally whole cloth conceived of by him on a flight from Paris to London.
Acquired
Hermès
in the early 1980s, where he's seated next to the French and British actress Jane Birkin. The it girl of the time. Now, here's what's really interesting. I bet 95 plus percent of people listening to this right now have no idea who Jane Birkin was.
Acquired
Hermès
Well, certainly if you follow the Hermes stock, you know what a Birkin bag is, even if you probably couldn't pick it out of a crowd. Yes. But anyway... this is the culmination of everything we've been talking about. Who is Jane Birkin? She was British. She was born in England, but she moved to France and became a French citizen. And she became like a French cultural icon.
Acquired
Hermès
I mean, again, the tie to France is so important here too. And we didn't talk about this with Grace Kelly either. Grace Kelly was an American from Philadelphia, but she became the princess of Monaco. These two women, these two personas that are embodied in Hermes, like Hermes doesn't do celebrity advertising, right?
Acquired
Hermès
I think it's so important that even though neither of them were French, they became so deeply European in what they represented.
Acquired
Hermès
And for Jane Birkin, she was this next generation. She was an actress both in film and theater. She was a singer. She was incredibly beautiful. She was the it girl, but in a very, very different way than Grace Kelly. She wore jeans. And in particular, she had a trademark accessory fitting with the, you know, 1970s.
Acquired
Hermès
Yep. Counterculture, you know, back to the land type ethos. She carried a wicker basket with her everywhere that she went.
Acquired
Hermès
No, it does not. So as the two of them, Jean-Louis, CEO and artistic director of Hermès, and Jane Birkin, French cultural icon, are boarding this flight to London... They're seated next to each other and Jane is struggling to get her fixed handle wicker basket up into the overhead compartment. And at this point, Jane had become a mother and had kids. And she had, you know, kid stuff in her basket.
Acquired
Hermès
Turns out he was just really good at the craft. And he had exceptionally good timing. We spoke about Napoleon a little bit earlier. When Thierry finally comes to Paris, at this point, Napoleon I has been defeated, the Battle of Waterloo, that was 1815. France has now seesawed through a whole bunch of different republics, and the monarchy comes back, and it's crazy French history stuff.
Acquired
Hermès
She had baby bottles that were like spilling out. Totally. I mean, I carry a lot of kid stuff these days. Like you need a lot of stuff with the kids.
Acquired
Hermès
Yes. And again, on the one hand, this is sort of esoteric Birkin lore. On the other hand, I think this is super important to Jean-Louis. Like, imagine the older generation Hermes embracing this.
Acquired
Hermès
So they sit down, they start talking on the flight and Jean-Louis introduces himself and it's like, I notice you're struggling with your wicker basket there, Miss Perkin.
Acquired
Hermès
Yeah. The legend, now who knows if this is true, is that she said, well, when Hermes makes a diaper bag, you know, I'll use that one.
Acquired
Hermès
Yep. And as they get to talking, they're talking about the Kelly. And she's like, look, you know, Kelly's the Kelly, right? But I can't wear it over my shoulder. So Jean-Louis starts sketching out designs on the plane and voila, the Birkin is born. Larger than the Kelly, but smaller than the old original Hermes bag. It's a tote bag, and it has two handles, unlike the Kelly, which has one handle.
Acquired
Hermès
And so with two handles, you can put it over your shoulder. You know, it's this sort of, it feels weird to say more casual version of the Kelly, given that it's, you know, the Birkin bag, but it is. It's the more casual, modern version of the Kelly.
Acquired
Hermès
So here's what's interesting. They release the product in 1984, and it is not an immediate success. I think part of this is that the Hermes kind of brand transformation, modernization was probably still underway. When you watch interviews with particular Pierre Alexi, he'll talk about this. He's like, any other company would have given up on this product.
Acquired
Hermès
But it takes about five years before the Birkin bag becomes the Birkin bag. And the time is right. We're in the 1980s, the go-go years. This is the years that are shaping Bernard Arnault here.
Acquired
Hermès
Yeah, I mean, it takes five years for it to become... any modicum of success for Hermes. And then, like a lot of these things, this just kind of slow burn starts that grows and grows and grows and grows.
Acquired
Hermès
But shortly after Thierry returns, Napoleon's nephew, Napoleon III, stages another coup and reestablishes the empire in France. And this is super important, Ben, to what you were talking about earlier about, hey, this guy's an orphan. Louis Vuitton was an orphan. How did they become so important? When Napoleon III comes to power in France, he does two things.
Acquired
Hermès
It's funny, you know, my experience was different. Of course, I had to go do some research for this episode.
Acquired
Hermès
Yes, I went to the Palo Alto store. I had to be down there anyway for some meetings. And the sales associate who ultimately helped me is equally wonderful woman, had a great experience. Her name is Susan. I'm going back to see her tomorrow as Valentine's Day and Jenny's birthday is coming up. But I walked in the store with the intention of buying what I ultimately did buy, which is...
Acquired
Hermès
An Apple Watch Band. Yep. And well, we'll get to the Apple partnership in a little bit. But I was passed around between a few different people in the store until ultimately Susan helped me out. And she was great. And I think she actually might be a higher level SA. But when I expressed that I was there to buy an Apple Watch Band.
Acquired
Hermès
Yeah. I don't know if that was just the day in the store or if that was part of the policy.
Acquired
Hermès
Well, the scene where she walks in to try and buy it is just iconic, where the sales associate is responding to her like, it's $12,000 or whatever. Like, oh, I know. There's a waiting list. Of course.
Acquired
Hermès
A way of summing up what you're saying is the hard thing about buying a Birkin is not coming up with the money.
Acquired
Hermès
Yeah. But also what you're talking about, you know, with echoes of our Nike episode here, the minute that you are in possession of a Birkin bag, you could immediately sell it for a lot more than what you paid for it.
Acquired
Hermès
Yeah, that would be the last Birkin bag that you ever buy. Every bag, I think maybe even every item that Hermes makes has what Hermes calls a blind stamp on it. And this is a series of symbols and numbers. There's one on my belt right now.
Acquired
Hermès
Yep, there's some on my watch band right now that are stamped into the leather that uniquely identify that item, the year it was made, and the craftsperson who made it.
Acquired
Hermès
One, he completely modernizes the city. So if people have heard of the Baron Haussmann, who kind of rebuilt Paris, that happens at this time. under Napoleon III. They transform Paris from a medieval city with super tight streets. Like if you go up to Montmartre, those streets around there, that is old Paris.
Acquired
Hermès
I was just laughing as you were talking about building goods there, and I whipped out my copy of the luxury strategy and flipped to anti-law of marketing number 13. Raise your prices as time goes on in order to increase demand.
Acquired
Hermès
Yes, this is the same dynamic with, I think, a very different set of motivations as we talked about on the Nike episode. I very firmly believe that Nike could sell many of their shoes for two, three, four, five times the price that they do. And they'll show up on Goat or StockX all the time regularly at higher prices than Nike releases them for.
Acquired
Hermès
I believe that the reason that they do this is to maintain goodwill with their customer base and maintain Nike's image as a brand that is accessible to everyone. Hermes is doing the opposite. They want this to happen. In order to maintain the image of Hermes, and specifically the Birkins and the Kellys, as a brand and a product that is not accessible to everyone.
Acquired
Hermès
But what you think of, the Eiffel Tower, the museums, the Grand Boulevards, the Champs-Élysées, that's happening right at this time. And the Baron Osman, he's kind of like Robert Moses was in New York in the mid-20th century, remaking New York. He is given full latitude and direction by Napoleon III to burn Paris to the ground and remake this city as a modern city. Fascinating.
Acquired
Hermès
We'll talk about this more later in the episode, but by my very back of the envelope calculations, they are raising their prices on average across the entire line 7% per year for the last 10 years.
Acquired
Hermès
Right. They're already viewed as the most expensive handbags in the world. So what harm done to go from 12 to 20? Right.
Acquired
Hermès
Right. And for somebody who's going to spend $12,000 on a handbag, are that many more of those people going to be price sensitive at that swing from 12 to 20? Like, probably not.
Acquired
Hermès
And I was just thinking about that as we were chatting here. This makes sense to me, that it wouldn't be a hit right away, because it takes time to build the lore and aura around this bag. You can't just drop a new product and have it become like this forever. immediately in this category. Correct. You're never going to have like an iPhone of luxury handbags.
Acquired
Hermès
Totally. It's also that the product was the Arras tour. The product was not Midnight's. If it were like, oh, I'm going to go to Taylor's concert and listen to her play all the songs on the new album, of course a lot of people would still go. But it was like, no, I'm going to go to Taylor's concert and hear all of Taylor.
Acquired
Hermès
Yes. The Disney plus of Taylor. All right. All right. Different episode here. Okay. Back to Jean-Louis. So this is how he does it. He does two incredible things to save the company. One, he repositions the brand. I mean, this is just like, I can't believe he pulled this off. He pulls off Not Your Mother's Tiffany without saying Not Your Mother's Tiffany. Yeah.
Acquired
Hermès
And the culmination of that is the Birkin bag and everything that that represents. And then two, the internationalization and discovering and running the same playbook that Racamier ran at Louis Vuitton. By the end of Jean-Louis' tenure in 2006, so a couple years after the famous Sex and the City episode, Hermes has gone from well less than $100 million when he took over.
Acquired
Hermès
And this is super important for Thierry and Hermes for two reasons. One, in the old medieval streets in Paris, not that many people were going up and down them. Not that many people were going to see the nobility in their carriages and all their finery. Now you've got the Champs-Élysées, the Grand Boulevard, everything about the sort of gallantry of Paris that we know today.
Acquired
Hermès
The consultants were saying, you know, outsource, shut it down. Essentially, by the end of the decade of the 80s, he was just under half a billion dollars in revenue. And then in 2006, he's taken it to $2 billion in annual revenue from, you know, nice family business to like, this is a real, real thing. So one more time on those numbers.
Acquired
Hermès
So I don't know the exact revenue figure when he took over, but let's call it $50 million in annual revenue. We know it was well less than $100 to $2 billion when he retires in 2006. So 40x in 30 years? Yeah, 40x in under 30 years. Wow. Pretty good. Pretty transformative for the family business.
Acquired
Hermès
Well, along the way, as the company clearly becomes more and more valuable, you know, remember, he is the family member who's running it. But we're now in the fifth generation of the family. We're starting to bleed into the sixth generation of the family. There are now over 80 family members out there. Eight zero. many of whom are involved in the business, but many of whom aren't.
Acquired
Hermès
And now this business that they all own is doing $2 billion a year in revenue at very, very high margins. There starts to be some demand for liquidity here.
Acquired
Hermès
Right. So in 1993, Jean-Louis lists Hermes on the Paris Stock Exchange. Collectively, when the dust settles, the family has sold 19% of Hermes to the public. They still own 81%. Now, the public float grows a little bit over the years as more family members sell, more generational transfer happens. But, you know, more or less still, you know, 70% plus family owned and controlled.
Acquired
Hermès
It would really take some sort of absolute financial genius to like come in and even consider, you know, we own over 70% of this business. We're unassailable. Who on earth could possibly make a run at our company?
Acquired
Hermès
Which brings us to, you know, this has been so fun. I've had so much fun with this episode. All this history, I just revel in the French connection and everything. This is Hermes' finest moment that we're about to talk about here. Through it all. And it's interesting, it's not their product. No, has nothing to do with the product.
Acquired
Hermès
It's all on display now. So this becomes really important for showing off, for signifying your wealth, your status. The other kind of related thing here that happens with Napoleon and Napoleon III is that status is no longer just about what you were born into. In the old system, the nobility, the royalty, it was like, look, you're born noble or you're not.
Acquired
Hermès
Yes, and the big news that they announced last week is they now have over 7,000 customers just five years after launch. Vanta is the perfect example of a quote we talk about all the time here on Acquired. Jeff Bezos' idea that a company should only focus on what makes your beer actually taste better, i.e.
Acquired
Hermès
spend your time and resources only on what's actually going to move the needle for your product and customers and outsource everything else that doesn't. Every company needs compliance and trust with their vendors and customers. It plays a major role in enabling your revenue because customers and partners demand it. But yet, it adds zero flavor to your actual beer or your product.
Acquired
Hermès
And critically, your security reviews are now real-time instead of static, which you can monitor and share with your customers and partners. Vanta's platform helps you continuously monitor compliance alongside reporting and tracking risk. Plus, you can save countless hours by completing security questionnaires with Vanta AI.
Acquired
Hermès
I know, I know. Okay, so for anybody who's listened to our LVMH episode, as we talked about earlier, the climax of the story is Bernard's fight with Gucci in that episode. And Gucci is the one that gets away. Bernard isn't able to buy it. Right after the Gucci fight ends in the early 2000s, the same story plays out with Hermes. I think really in an even more dramatic fashion. Mm-hmm.
Acquired
Hermès
So in 2001, right after he lost Gucci, Bernard quietly buys an initial stake in Hermes of 4.9%. Now, I believe that was just under the threshold that they would have to disclose it under French securities regulations. And then here's what they do that the Hermes families couldn't see coming, that only Bernard could engineer. He continues buying for the next 10 years using equity swap derivatives.
Acquired
Hermès
So it looks like other entities are buying these shares on the open markets, but LVMH have the rights to exercise options to go actually take those shares. Now, This is really hard to remember. I had to triple check these numbers. At this point in time, Hermes' market cap is below $20 billion.
Acquired
Hermès
And when Bernard first starts buying in the early 2000s, it's below $10 billion. But you could say lots of things about Bernard, and genius should be top of your list. But he is one of the best investors of all time. I mean, to identify Hermes at this point in time, and as we will see, he makes an incredible amount of money on these trades.
Acquired
Hermès
Today, Hermes is a $230 billion market cap company, and he starts buying at below $10 billion.
Acquired
Hermès
And it's kind of independent of how much money you have or what you do or what influence you have. Under Napoleon, he brought in this modern idea that you could shift your class. I mean, he was essentially a nobody and he became the emperor of Europe. That'll completely upset the mindset of people. So all this is happening. This is the best thing that could ever happen to Thierry.
Acquired
Hermès
So he starts buying Hermes shares and Axel, I think, jokes about this in an interview. He's like, look, Bernard isn't buying your shares just because he wants to make an investment or he wants to have some fun. Like, obviously he wants to own Hermes.
Acquired
Hermès
Yes. It's great. We'll link to it in the sources. You should go watch it. So why is Bernard doing this? Obviously, on the one hand, he sees the value here. I mean, for God's sake, the Sex and the City episode was just dedicated to the Birkin. There's a lot of value to be unlocked here, shall we say, in owning Hermes. But it's not just that.
Acquired
Hermès
I hope on our LVMH episode, this is some of the nuance that we painted about Bernard. He's not just a corporate raider. He actually is an operator. And he is one of, if not the best, luxury operator out there. So he sees two things in Hermes that maybe aren't as obvious to the rest of the world and that he thinks actually are going to create an opportunity for him.
Acquired
Hermès
One generational transfer is about to happen. Jean-Louis can't live forever. And it's not immediately clear who the next successor is going to be. So Jean-Louis' son, Pierre Alexi, takes over as artistic director. Pierre Alexi went to America for college. He went to Brown University. Interesting, in an interview I found this, he initially wanted to study computer science at Brown University.
Acquired
Hermès
But he switched to art history. Very fitting. And he comes in and he joins Hermes right after graduation in 1992. So he's being groomed. But Jean-Louis wants to separate out the artistic director role and the CEO role.
Acquired
Hermès
Yes. Until this generation, it was one person. There was no separation at all. So Pierre Alexi is clearly the artistic heir. There's not a clear CEO heir. And in fact, Jean-Louis Choice, Excel, who ultimately does become CEO, he's not in the business yet.
Acquired
Hermès
Yes. So the story is that Excel really wanted to go work in China. And so he goes into investment banking after undergrad. He goes to Sciences Po. Now, and remember, Jean-Louis was his uncle, but his mother, who actually was not a family member... was the managing director for production for Hermes.
Acquired
Hermès
Axel has this sort of, you know, dinner table trading in addition to the apprenticeship craftsman trading. But he goes off into the investment banking world. He works first in China and then in New York for Banpei Paribas.
Acquired
Hermès
Huh. But he doesn't join the business until 2003 when Jean-Louis taps him. And again, on the one hand, as we've talked about, this is a nepotistic business. On the other hand, they're not going to just give him the CEO title right away. He needs to come pay his dues. He starts in the finance department in 2003.
Acquired
Hermès
He's the best artisan, most exclusive crafter of carriage wear, of equipage. The city is being transformed so that this can all be displayed prominently. Social stratifications are becoming more blurry. People can spend money for the first time to buy status.
Acquired
Hermès
And then in 2006, when Jean-Louis retires, Axel takes over running the jewelry métier as CEO of Jewelry.
Acquired
Hermès
So he does that for two years. And then in 2008, he goes and takes over the leather goods and salary business. So the big one.
Acquired
Hermès
So Bernard sees, okay... We've got a generational transfer opening here. And in fact, when Jean-Louis retires in 2006, he promotes his sort of COO right-hand person, Patrick Thomas, to be the first non-family member CEO running the business side of the house alongside Pierre Alexei on the artistic side.
Acquired
Hermès
I think there's as much chance as not that that was right. But at a minimum, I think this shows the sort of ignorance. You know, I don't want to say lackadaisicalness of the family here, because it's certainly not that, but... Maybe sort of ignorance or naivete that, hey, you're now a public company, and there are people like Bernard Arnault out there.
Acquired
Hermès
You can't just be like, oh, yeah, we're going to do public company CEO transition in this way and take our time. You can, but you're opening the door for the Arnaults of the world. So that's one thing that Bernard sees. The other, and I really think this is a testament to his vision,
Acquired
Hermès
Despite all of the strength within Hermes and everything that Jean-Louis did, they actually are showing some cracks. And this we had to kind of piece together a little bit and talking to folks in the industry helped us out here. But look, there's no questioning Hermes' financial results and sort of on the surface brand value at this point in time in the 2000s, early 2010s.
Acquired
Hermès
But there are a few things that are just kind of starting to slip as they scale. And I think actually the best story that illustrates this is one that the family members themselves do not tell, but that you'll hear out there in the lore about Hermes, which is that in, I believe it was in Japan. They had a product, a bag.
Acquired
Hermès
And you never hear it from the perspective that we're about to tell it. Okay, so here's how the story goes. It's called the late 2000s, early 2010s. And Hermes is selling a canvas beach bag in Japan. And it is flying off the shelves, selling like hotcakes. It's like a equivalent of, call it $150 canvas tote bag beach bag.
Acquired
Hermès
And this obviously gets the attention of management and the company that this is happening. And they decide that they are going to, in true Hermes fashion, because it is selling so well, they are going to not only stop selling the product, they're going to take all their supply of it and destroy it. And they come into a board meeting, you know, with all the family members and management.
Acquired
Hermès
They sort of announced this and it is met with a standing ovation from the family. This is upholding what Hermes is, which is we don't sell beach bags.
Acquired
Hermès
So then you think about it a little bit and you're like, wait a minute. Why the F did this happen in the first place? Exactly. A canvas beach bag in Japan?
Acquired
Hermès
Yes. Before all this, before this era, there's no way that this evolves into Hermes or honestly that Louis Vuitton and what he's doing with luggage and with trunks, there's no way that that evolves into Louis Vuitton. So speaking of, both Hermes and Vuitton have one really important client, a key influencer, so to speak, that they both land at this time.
Acquired
Hermès
Yeah. The story here is not a heroic one of we destroyed the supply. This is a tragic one.
Acquired
Hermès
Right. And building up the Birkin, the Kelly. I mean, for God's sakes, the scarves sell for like $500. Yeah. So, okay, that I think is the most visceral illustration of this. Two other things that I saw in the research, and I think Bernard probably saw here too. Towards the end of Jean-Louis' tenure, he and Hermès started buying and investing in other companies. But why is Hermès doing this?
Acquired
Hermès
The best Hermes could ever hope for by doing this is they're going to be a subscale, like they're not even going to be Richemont or Kering.
Acquired
Hermès
Yeah, did you find the biggest disaster? This is kind of in your wheelhouse. Ooh, I don't know. I was wondering if I could stump you with this. They bought, I believe, a 30-35% stake. They were the largest shareholder in a German company that makes... what is really a piece of technology, an old piece of technology, but not something that should be a luxury brand.
Acquired
Hermès
This is very much in the performance end of the spectrum. They became the largest shareholders in Leica, the camera company. Really? Yeah. Huh. Which, you know, I mean, sort of the motivation is like, oh, you know, they're beautiful and they're like luxurious cameras and they have leather on them and we can put Hermes leather on the Leica cameras.
Acquired
Hermès
But, okay, you're talking about a very narrow target market here, and it's just... You know, it's a technology product. I mean, we'll get into this with Apple in a minute, but it didn't go well. Let's put it that way. They ended up divesting the stake.
Acquired
Hermès
Yeah. Unless that is the core strategy of what you are doing, like LVMH. Yes. Yeah. The third thing that they do, they incubate and create a new luxury brand and company in China called Shangxia. I believe I'm pronouncing that right. In 2009 is when they launch it. It literally means up, down, or like... past, present.
Acquired
Hermès
And the idea is that the Chinese market is so big and so important to Hermes, they're going to lend the Hermes brand to this new brand that is going to have Hermes principles, but take traditional Chinese craftsmanship, of which there's a long multi-thousand year history.
Acquired
Hermès
Well, yeah, I mean, it sounds good on paper, right? But here's the problem, like we were talking about earlier. Nothing compares to French culture as an export and when you're buying luxury. And this is a great experiment to run, sure.
Acquired
Hermès
But the reality is that for probably most countries in the world, when you're talking about spending $20,000 on a piece of leather, you know, you want that to be from Hermes and you want that to be from France.
Acquired
Hermès
Yes, the same client. So Napoleon III's wife, the Empress Eugenie. becomes a client of both of these men for her carriages, in the case of Hermes, and for her luggage and for her trunks. And actually, I think also for her packing. I think Louis Vuitton was the royal laitier, I believe, and he packed the trunks. He was the luggage guy. Hermes was the carriage guy.
Acquired
Hermès
Right. Now, easy for us to armchair quarterback here. Like, obviously, it didn't work. They end up selling it off actually pretty recently to the Agnelli family from Italy, which is the family behind Fiat. Now, look, certainly that one, the Leica thing, it's the combination of all these and the beach bag incident. Bernard sees all this. Here's what he says in the press at the time.
Acquired
Hermès
I would never diminish the quality of Hermes. Hermes can be an even rarer and greater quality business if they ever wanted to work with us. And I think he's genuine about that. The family obviously circles the wagons and mounts their rebel alliance here, mounting their defense against the empire.
Acquired
Hermès
We'll tell the story here and it's amazing. But I think this is like a really important point that I want to land is I don't think Arnaud was wrong. I think he had a point and I think the company at the time didn't get it. They certainly do now. Yeah. So, okay, what's the story? What happens? Finally, in October of 2010, Arnaud, he's patient. He spent nine years?
Acquired
Hermès
Nine plus years, yeah, that he's just building this stake, being patient. In October 2010, LVMH exercises its options on the equity swaps that it owns and announces that it now controls 14.2% of Hermes shares. And Bernard, at the time, he says, I had to do it because... Other luxury groups were also talking about making a run at Hermès.
Acquired
Hermès
And I didn't want this crown jewel of France to be owned, heaven forbid, maybe by a non-French organization. A quote here, I could not sit by and allow a competitor or another investor to take a stake in Hermès. He's good. He's so good. I love it.
Acquired
Hermès
In response to this is the famous or infamous, if you will, quote from Patrick Thomas, the then CEO of Hermes, which we're not going to say the full thing here on air. You can go Google it. But the response, and this is an official press conference with investor relations people.
Acquired
Hermès
He says, if you want to seduce a beautiful woman, obviously Hermes being the beautiful woman here, you don't start in the fashion that Bernard is. And he doesn't use those words. This is hilarious. This is amazing. That makes, of course, a huge splash in the French and international press. The drama here is delicious. Karl Lagerfeld has asked his thoughts on what's going on here.
Acquired
Hermès
And Lagerfeld, of course, he's a legend. He's the longtime creative director of Chanel. He comments publicly, well, if you don't want to be taken over, don't put your business on the public market.
Acquired
Hermès
Now, of course, Lagerfeld, yes, famously is the creative director of Chanel, but he wasn't exclusively the creative director of Chanel. Who is he also working for at this point in time? He is also, I believe, the menswear creative director for Fendi, which is owned by?
Acquired
Hermès
LVMH. He's on payroll. He's on payroll. This continues on for months in the public markets and in the press. By December of 2011, the LVMH stake has grown to 22.6%. Now, the family owns 73% of the company at this point. So Bernard now owns almost the entire public float of Hermes.
Acquired
Hermès
Yeah. Hermes is in danger of being delisted from the stock exchange. Crazy. Now, this is what's so brilliant. You might ask, why does this matter? The family owns 73%. Bernard can't do anything. Price is a function of supply and demand. So as Bernard is shrinking the float of this company, the shares that are available for trade on the public markets, well, what happens to the stock price?
Acquired
Hermès
Skyrocket. It goes through the roof. So now you've got 80 family members and they already thought they were really wealthy and they already wanted liquidity. And now Bernard's coming to them. And this is a strategy.
Acquired
Hermès
They just go pick off individual family members one by one, keep increasing his stake and saying like, yeah, I'll pay you the market price, which is now incredibly inflated for this company. Great. Happy to pay you many hundreds of millions of dollars. Crazy. So what happens? This is why I think this really was the family and the company's finest moment.
Acquired
Hermès
Yes, absolutely. Eugenie and everything going on at this time makes Louis Vuitton and makes Thierry Hermes. But it's interesting, right? Vuitton and luggage, that is inherently of the world that's coming, the modern world. The train, that exists at this point in time. Steam engines are a thing. And then the car is about to come.
Acquired
Hermès
That temptation, I mean, must have been extreme. And that's just the externally identifiable motivations. I'm sure Bernard and other people at LVMH and everybody else in the industry is doing everything they can to convince family members to sell.
Acquired
Hermès
I think also just from a psychological perspective, a couple dominoes fall here. And then as a family member, you start looking around and being like, do I want to be the last one? It's kind of like a crowded theater, you know, running for the exits.
Acquired
Hermès
I may never see another opportunity to get liquid at this price ever. And the minute that other family members start selling. It goes down. Supply and demand. The price goes down.
Acquired
Hermès
So in 2011, the family comes together and over 50 of the 80 family members collectively contribute 50.2% of the equity in the company into a new cooperative vehicle that's called H51. As in 51% of Hermes. As in this vehicle will have majority control of the company.
Acquired
Hermès
When they contribute their equity into this vehicle, they contractually agree that that equity will be locked up and cannot be sold for at least 20 years. So they're basically saying to Bernard, no matter what you do, you could pick off anybody else after this.
Acquired
Hermès
For a minimum of 20 years, with potential to extend beyond that, you will never, never, never, you or anybody else, have control of Hermes. So badass.
Acquired
Hermès
I love it. I love it. Well, hey, you know, we haven't floated our business on the public markets yet. So we're taking Karl Lagerfeld's advice. We don't need to incur the legal fees around doing this. That vehicle was and is still headed by one of the family members, Julie Garan, who was an investment banker at Rothschild.
Acquired
Hermès
So she leaves and full time becomes head of the defense, I assume, alongside XL, who obviously comes from the banking world, too.
Acquired
Hermès
I don't believe these documents are public, but my understanding from comments that family members in Excel make about them, and spoiler alert, recently they've renewed the term of this for another 10 years. So it's into the mid-2040s.
Acquired
Hermès
But I believe it's pretty ironclad that these shares cannot be sold. Wow. So in addition to that, two of the Puesh brothers, Bertrand and Nicholas, Nicholas is the one that there's the Gardner drama about right now.
Acquired
Hermès
Anyway. The two Puest brothers, they do not contribute their shares to H51, but they give H51 a right of first refusal on their shares. So they could sell their shares, but at whatever price they agree to, the rest of the family has a rofer on purchasing them. Oh, interesting. So that's another probably 10 to 15% of Hermes right there.
Acquired
Hermès
Yes. Not the case with Hermes. And actually today, I think this is one of the biggest strengths of Hermes. And they still, you know, the equestrian theme, the horse is so much of their brand. They talk about it so much of their products, the saddle stitching. It's calling back people. to that other era, like that pre-modern era where the horse was primary.
Acquired
Hermès
Yeah, right? And those shares would be, I believe, subject to that rofer, assuming that that has stayed in place. Anyway, this is really just an incredible... coordination. Yes, it's a family. They're all family. But there's 80 people here.
Acquired
Hermès
Well, let's get into what happens with Bernard's stake. Because famously, as Domenico Di Sole said in the press at the end of the Gucci affair, even when he loses, he still wins. And Bernard still wins here. So this effectively ends the takeover bid when H51 is put in place.
Acquired
Hermès
But meanwhile, there are all sorts of lawsuits going on, particularly around how LVMH amassed this stake in secret with the equity swaps. It was basically illegal, right? Well, in 2014, the French court rules that this was illegal. LVMH has to pay a fine, I believe like a $10, $15 million fine for having done this. Pennies. Yeah, right. As we'll see, it's truly pennies.
Acquired
Hermès
And they also mandate that LVMH needs to distribute out that Hermes stake to its own shareholders. LVMH can no longer hold the stake. Well, who's the largest shareholder in LVMH? It's Group Arnaud, which is Bernard Arnaud's family office. So they get 8% of Hermes personally into his family office entity.
Acquired
Hermès
Which, this is the brilliance of Bernard, they take that value, which is, call it on the order of $5 billion. And remember, when they started buying, the whole company was trading at a market cap below $10 billion.
Acquired
Hermès
He has unlocked shareholder value for sure, even in the absence of a change of control transaction. So back when Bernard was engineering his takeover of LVMH, one of the financial instruments that he used to do it was he IPO'd a 25% stake in Dior. He already owned Dior that he had gotten out of bankruptcy from Busek. That's right.
Acquired
Hermès
Yes. But... He and LVMH didn't own this 25% minority stake in Dior. He takes the Hermes shares and does a share swap. So swaps that value directly with the 25% of Dior that he doesn't own to bring that first into Group Arnault, his family office, and then he trades that into into LVMH. So LVMH now finally, as a result of this, is able to take 100% control of Dior.
Acquired
Hermès
And in exchange for Group Arnault trading this asset into Dior, Bernard's ownership of LVMH goes from 36% up to 46%. So he gets an extra 10% of LVMH. And here's the most incredible aspect of this. Not a single dollar in tax is paid on all of this.
Acquired
Hermès
Because it's all share swaps. Basically, Bernard just gets 10% more of his own company as a result of this. Which would then go on to appreciate... Call it four or five hundred percent over the next five, six years.
Acquired
Hermès
Unbelievable. Now, this is a situation where everybody wins. I don't think there are any losers here. And the Hermes families absolutely are not losers. And you could even say they sort of have the last laugh here. Because yes, Bernard gets to benefit from an extra 4 to 5x appreciation in LVMH's market cap here.
Acquired
Hermès
From, let's call it the real beginning of when LVMH publicly announces their stake in Hermes. So 2010, Hermes' market cap is up 16x.
Acquired
Hermès
Tech companies go like, I don't know what Hermes color to call it, but some color with envy over this. There is one more chapter of the story that we have to tell because that wouldn't have just happened. It wasn't just the Bernard affair in and of itself that led to this 16x market cap increase. He was right, like I was saying earlier. There were, I think, some real problems in the business.
Acquired
Hermès
And that is the story of the sixth generation of Pierre Alexi and Excel, who I think have certainly fixed those problems, but have really led Hermes, the business and the company into a whole new era.
Acquired
Hermès
But it would all be irrelevant if the brand didn't translate out of the horse era and into the car era. Right. which was not Thierry Hermès' doing, nor was it his son's doing. So Thierry dies in 1878, and his son, Charles Émile, takes over. Now, he apprenticed coming up in the shop in exactly the same way that Thierry apprenticed. He just apprenticed for his dad.
Acquired
Hermès
And... What they've done over the last 10 years since the Bernard fight is that they have figured out how to scale handcrafted artisanal production. Yes. On the surface, those are completely like oxymoronic terms. Those are completely diametrically opposed.
Acquired
Hermès
Totally. What was the stat that you said a little while ago that there are 120,000 Perkins and Kellys produced every year?
Acquired
Hermès
Yeah. If they were still making these things on the third floor at the Faubourg, no way, no way. And this was kind of the problem and what the consultants were saying at the start of Jean-Louis' tenure of like, hey, you need to outsource production. You need to scale production. You need to make this more accessible. Yeah.
Acquired
Hermès
Yep. So the Patrick Thomas quote that I want to start with is so great. The luxury industry is built on a paradox. The more desirable a brand becomes, the more it sells. But the more it sells, the less desirable it becomes. We've been talking about this whole episode, but then he continues. I believe Hermes's vision provides a solution to this dilemma.
Acquired
Hermès
And this is what the current generation has found, the solution. So today, I think we referenced this earlier in the episode, Hermes employs 7,000 Mastercraftspeople, artisans.
Acquired
Hermès
Most of the story that we've been telling thus far, you know, until 1992, all of the craftspeople in the company, more or less, were working in the Faubourg, in this one relatively small building on the Rue Faubourg du Saint-Honoré in Paris. In 1992, they moved production to Pantin in the suburbs of Paris. That building is amazing, but only houses about 250, 300 craftspeople.
Acquired
Uber CEO Dara Khosrowshahi
So I came up here. We scheduled this time to record. What are we talking about today? We haven't talked about Uber in a while. That's right. A lot has happened since we did the IPO episode.
Acquired
Uber CEO Dara Khosrowshahi
Over 85% of the Fortune 500 runs on them, and over the past few years, they've joined companies like Microsoft as one of the most important enterprise technology vendors in the world.
Acquired
Uber CEO Dara Khosrowshahi
Yeah, it's telling for the magnitude of this partnership to see Satya Nadella appearing in the keynote at ServiceNow's big annual event, Knowledge, last month.
Acquired
Uber CEO Dara Khosrowshahi
It's pretty awesome for both companies and especially awesome for enterprise users. So if you want to learn more about the ServiceNow platform and how it can work with your company's Microsoft services, go over to servicenow.com slash acquired. And when you get in touch, just tell them that Ben and David sent you.
Acquired
Uber CEO Dara Khosrowshahi
Yeah, I think it was the most capital burned before an IPO by any company in history up to that point.
Acquired
Uber CEO Dara Khosrowshahi
With booking, you can build a market of, say, geography for hotels and then use that to build a vertical. You can do the same thing at Uber in a way that your competitors on both sides of the business can't, right? Because you can cross-market rides and eats.
Acquired
Uber CEO Dara Khosrowshahi
So everything you just said, that's always been like the story. It seems like in the past few years, though, especially relative to your competitors, it's actually become more of a reality. And I'm curious, maybe you talked about booking being execution machines. Like what is the Uber execution machine looked like? since the pandemic to maybe make that more of a reality?
Acquired
Uber CEO Dara Khosrowshahi
Is it still that, um, supply acquisition cost is bigger than demand acquisition cost for you guys? Yes. Yeah.
Acquired
Uber CEO Dara Khosrowshahi
Yeah, not to mention the Uber CEO recruitment process, which I don't think Dara's talked about anywhere else before.
Acquired
Uber CEO Dara Khosrowshahi
You said in the episode that it was the most that a company had ever lost before going public in history.
Acquired
Uber CEO Dara Khosrowshahi
I don't know if that's true, but attributed to Ben Gilbert at the time. Order of magnitude, that's true.
Acquired
Uber CEO Dara Khosrowshahi
The airport in San Francisco this morning was the cheapest it's been in months. So, thank you.
Acquired
Uber CEO Dara Khosrowshahi
Thank you, Mr. Market. Yes, exactly. How has the complexity of Uber relative to Expedia matched up with your expectations coming in?
Acquired
Uber CEO Dara Khosrowshahi
And also, Expedia, you weren't providing the service. Yes. You were a marketplace layer. You're not operating the airplanes.
Acquired
Uber CEO Dara Khosrowshahi
Does Uber HQ plan for Taylor concerts ahead of time as they're happening?
Acquired
Uber CEO Dara Khosrowshahi
I want to get a little bit of what Will's covered there. When did you first get contacted about it? How did you enter the Uber orbit?
Acquired
Uber CEO Dara Khosrowshahi
You weren't going to get fired because what was Barry going to do, like step in and be CEO himself?
Acquired
Uber CEO Dara Khosrowshahi
Yep, Vanta is the perfect example of the quote that we talk about all the time here on Acquired. Jeff Bezos, his idea that a company should only focus on what actually makes your beer taste better, i.e. spend your time and resources only on what's actually going to move the needle for your product and your customers and outsource everything else that doesn't.
Acquired
Uber CEO Dara Khosrowshahi
Every company needs compliance and trust with their vendors and customers. It plays a major role in enabling revenue because customers and partners demand it, but yet it adds zero flavor to your actual product.
Acquired
Uber CEO Dara Khosrowshahi
And perhaps most importantly, your security reviews are now real-time instead of static, so you can monitor and share with your customers and partners to give them added confidence.
Acquired
Uber CEO Dara Khosrowshahi
I imagine you had to have been feeling like, God, if we can make this work, the opportunity here is just like, you know.
Acquired
Uber CEO Dara Khosrowshahi
Lyft is such a great example of a story we see over and over again on Acquired. It's never over until it's over. Never over until it's over. It was over for Lyft. Yeah.
Acquired
Uber CEO Dara Khosrowshahi
Is there something in particular that you think they've done? I mean, when I think about them, I think about what you were saying about Booking just being an execution machine. I'm curious from your perspective.
Acquired
Uber CEO Dara Khosrowshahi
I would imagine the suburbs, there are so much more weighted to food delivery than rideshare.
Acquired
Uber CEO Dara Khosrowshahi
It's so funny how much of this goes back to the original 10 years ago, 15 years ago vision for Uber. It just takes so long to realize these things.
Acquired
Uber CEO Dara Khosrowshahi
Which really, to your point about time value, he just wants you to make a decision. And so he's like, oh, we'll be fine.
Acquired
Uber CEO Dara Khosrowshahi
It was a lot. There are moments when you remember that stock prices are a function of supply and demand. And when 15% of a company's outstanding shares hit the market all at once.
Acquired
Uber CEO Dara Khosrowshahi
one of the things that we heard from many people as we were researching that time period was just the immense uh degree of the stakes involved for the whole ecosystem like this went beyond just the drama in the press that's one level right but like the number of university endowments who through the venture funds that were invested in uber
Acquired
Uber CEO Dara Khosrowshahi
had large portions of their whole university endowment that were dependent on the private mark of Uber.
Acquired
Uber CEO Dara Khosrowshahi
And sovereign nations that were, you know, not dependent, but like paid attention to this. Were you aware of that? Did you feel that?
Acquired
Uber CEO Dara Khosrowshahi
But then you had to deal with the shareholder-based turnover, which was like the unwinding of that expectation.
Acquired
Uber CEO Dara Khosrowshahi
Wow. This is like a little bit of echoes of Sumner Redstone and your early... It was good training. Good training, right.
Acquired
Uber CEO Dara Khosrowshahi
And this isn't the first time we've partnered with them, so we are excited to bring them back to the show. We have become quite the payments nerds this year and have a much deeper appreciation of just how important the modern payments industry is to the world. Money movement fuels literally everything in modern society, and modern treasury is right there at the heart of it.
Acquired
Uber CEO Dara Khosrowshahi
Yep, and that's where Modern Treasury comes in, a payment operations platform designed for this new era. Think of it as money movement supercharged. There's faster payment rails, smart workflows, and real-time visibility, technology that modernizes your existing financial infrastructure. With Modern Treasury, your company can move money faster and more efficiently than ever,
Acquired
Uber CEO Dara Khosrowshahi
boosting business performance and enhancing customer experiences. Payment operations go from manual and slow to automated and continuous, from isolated to fully connected, all in real time, tracking every cent.
Acquired
Uber CEO Dara Khosrowshahi
Did you ever think you would then live through another moment like that over the last couple of years?
Acquired
Uber CEO Dara Khosrowshahi
Well, I'm curious how much this was an explicit boardroom conversation. The Times also made a very explicit bet on scale of quality content. You could argue maybe Wall Street Journal, but other than maybe them, maybe, maybe the Post, maybe Nobody else has aggregated quality content at scale.
Acquired
Uber CEO Dara Khosrowshahi
Globally, people might think of the political stuff or the news stuff, but the New York Times company covers every vertical, every geography, has at least twice as many reporters employed as any other news organization in the world, I think. How much was that a discussion in the boardroom?
Acquired
Uber CEO Dara Khosrowshahi
Yeah, and it's interesting, right? The company's called The New York Times, and yet it's a global... It really was, in a way, in video and with Netflix, I think it was an easier leap to make. For news, I think it was a really unique leap that The Times made.
Acquired
Uber CEO Dara Khosrowshahi
But that's a guess. I'm curious, too. Also, I want to ask, given both your job and you and I both live in San Francisco, something crazy has happened in the past six, eight months that like it's now happening in San Francisco. Like we went from for 15 years, everybody's been like, yeah, self-driving cars, it's happening tomorrow. And like, yeah, yeah, yeah, yeah. But like.
Acquired
Uber CEO Dara Khosrowshahi
Have you ever taken a ride in one? I haven't yet. But like every day you walk down the street, you're like there's cars going by with no driver in the seat. It's pretty extraordinary. And it's become just so commonplace that like I don't even think about it anymore. But then friends come visit and they're like, well, what's going on here? Yeah.
Acquired
Uber CEO Dara Khosrowshahi
It's the, do you want a business with... Bill Gurley wrote that blog post years ago about a rake too far.
Acquired
Uber CEO Dara Khosrowshahi
Or maybe more accurately, you make yourself too vulnerable if you...
Acquired
Uber CEO Dara Khosrowshahi
Well, have you written her a thank you note? Because you'd be running a paint factory otherwise. I have not. That's a very good point. I owe it all to her.
Acquired
Uber CEO Dara Khosrowshahi
All right, listeners, this is a great time to talk about one of our big partners, ServiceNow. ServiceNow is the AI platform for business transformation, helping automate processes, improve service delivery, and increase efficiency.
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Starbucks (with Howard Schultz)
I think the other piece that you didn't just list off there that we've covered in depth is the Costco-like investment in your employees and the people and the reduction of turnover. In Costco's case, I think it's... Probably much more so the reduction of turnover. In Starbucks' case, it really is like that's the key element to building the humanity, right?
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Starbucks (with Howard Schultz)
This is amazing. Howard Schultz got a three. I got a three. He's an inspiration for all entrepreneurs out there.
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Starbucks (with Howard Schultz)
Do you think having that background at Xerox, did that give you a piece of perspective that helped build Starbucks to what it is today?
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Starbucks (with Howard Schultz)
I'm so glad you're bringing this up. It really resonates to us hearing you say that. It's the way we feel about Acquired and our show. And to imagine, that's easy for us. We have no stakeholders. We never would expect that this would scale to 500,000 people. If it did, I can't even imagine the complexity of that.
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Starbucks (with Howard Schultz)
Yeah, given this moment that Starbucks is in right now, here in summer of 2024, this felt like the right way to address that.
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Starbucks (with Howard Schultz)
It really is incredible. One of the very, very small number of food and beverage establishments that has scaled to the entire world.
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Starbucks (with Howard Schultz)
And needing the money to expand, just to pause on that for a minute, business-wise, Obviously, coffee bars are a much better business long term than coffee beans, but probably more capital intensive, right? Eating more staff.
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Starbucks (with Howard Schultz)
Putting ourselves in your father-in-law's shoes, how could you not feel that way for your daughter and her impending family?
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Starbucks (with Howard Schultz)
I mean, I guess that's another dimension here too. This was not 2024. It's not like being an entrepreneur was a glorified profession here.
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Starbucks (with Howard Schultz)
The other titan. We foreshadowed this on the Microsoft episode.
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Starbucks (with Howard Schultz)
Yes. Save the date. If you love Acquired, you are going to want to be physically in the city of San Francisco on Tuesday, September 10th, 2024.
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Starbucks (with Howard Schultz)
Looking back now... What do you think happened? Did he have any legitimate criticisms of you as running the company?
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Starbucks (with Howard Schultz)
Speaking of JP Morgan Payments, just like how we say every company has a story, every company's story is powered by payments. And JP Morgan Payments is a part of so many companies' journeys from seed to IPO and beyond.
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Starbucks (with Howard Schultz)
All in the Northwest. Yeah. Meanwhile, the original Starbucks folks, they've now gone down to California. They went to California. When did Pete's open coffee bars?
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Starbucks (with Howard Schultz)
This is probably a good point in time to talk about the business model a little bit. You've alluded to kind of a stigma, at least among potential investors and the original Starbucks founders of like the restaurant business. What did the economics of the coffee bar business look like when you bought the Starbucks stores?
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Starbucks (with Howard Schultz)
Yeah, that is not the quote unquote restaurant business that people are imagining.
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Starbucks (with Howard Schultz)
Even the best, most successful restaurant you could possibly imagine, how many times are their most loyal customers going to come there in a week? Yeah. Well, there was a time...
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Starbucks (with Howard Schultz)
The retail world had never seen a model like this before. There was no physical storefront that had this business model before this. Yeah.
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Starbucks (with Howard Schultz)
Okay, so- Did people think you were a hippie? Like when you were telling these, like are you on LSD or something?
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Starbucks (with Howard Schultz)
Yeah, this is America. So my one more question on this, writing the customer's name on the cup.
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Starbucks (with Howard Schultz)
And this is all like, to my mind, just starting to create this incredible flywheel, right? You've got this 80% gross margin business where the key lever is repeat loyal customer visits. You've got customization that is making customers more loyal and increasing your margin at the same time because you can charge more for it. You've got the interpersonal relationship with customers
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Starbucks (with Howard Schultz)
The baristas, sure, but also even as you scale, I mean, the name on the cup, that's something that scales even as thousands and thousands of people come into the store.
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Starbucks (with Howard Schultz)
So on the consumer side, technology has completely changed expectations for shopping and commerce. Whether it's a sneaker drop or a coffee order, customers expect functionality like ordering in an app but picking up in-store, getting real-time updates, and having our preferences and past orders synced and remembered.
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Starbucks (with Howard Schultz)
Yep. No matter how big or small your company is, you have to manage a complex technology ecosystem that now includes online payments, in-app payments, social payments, in-store payments, digital wallets, and much more in the future.
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Starbucks (with Howard Schultz)
Yep. And just like Howard pioneered many firsts in his industry, JP Morgan is doing the same with biometric payments. It's essentially a pay-by-face solution that allows you to complete transactions seamlessly and securely, removing the need for carrying a wallet or digging into your bag to pull out your phone.
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Starbucks (with Howard Schultz)
Crazy. And for businesses, speed of payments is obviously great to shorten lines. To quantify that, biometric payment solutions have shown to decrease checkout times by up to 35 seconds per transaction and increase purchase value by 4%, driving incremental revenue and maximizing profitability.
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Starbucks (with Howard Schultz)
Yep. So whether you want a full-stack omni-channel service with biometric payments or streamlined online payments with the latest APIs, JP Morgan's Commerce Solutions work to drive your business forward with the foundation and security of a leading global bank and the innovation of a fintech.
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Starbucks (with Howard Schultz)
So in this era, I mean, you must just be getting more and more excited every day. Oh, I was out of my mind.
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Starbucks (with Howard Schultz)
Speaking of system, what did your technology look like at this point?
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Starbucks (with Howard Schultz)
I'm foreshadowing here the future of the company. Yeah, yeah.
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Starbucks (with Howard Schultz)
Can you tell us about the people? This is such a huge pillar to our minds of building Starbucks.
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Starbucks (with Howard Schultz)
So we've studied lots of amazing companies on this show who have lots and lots of different business models. But one thing that just kept... Striking us as we were preparing for Starbucks are the similarities to your neighbor here in the Northwest in Costco. Costco, right. And how you treat your people, specifically. That's not by accident.
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Starbucks (with Howard Schultz)
We have a fun piece of trivia that you may know related to Costco. Do you know where Jeff Bezos and Jim Senegal met for the first time? Sounds like in a Costco. Not in a Costco, in the Starbucks, in the Barnes & Noble, in Bellevue. Did not know that. And that led to so many things, Amazon Prime among them.
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Starbucks (with Howard Schultz)
Was Starbucks buying it for use in their- They were selling it in their store. Now, but here's the thing- Because this was a consumer device.
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Starbucks (with Howard Schultz)
Putting myself in your shoes back then. Now, Starbucks and Frappuccino are like, it's like a synonym. It's like you can't disentangle them.
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Starbucks (with Howard Schultz)
We usually have pump-up music. I feel pumped up. We can do that. We've got a turntable. I saw your turntable. That's beautiful. What do you want to hear?
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Starbucks (with Howard Schultz)
How did you find yourself at Coke and Pepsi pitching a bottled beverage?
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Starbucks (with Howard Schultz)
Did you know that it was like the good old days where you're like, this is just like.
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Starbucks (with Howard Schultz)
This would be like an American luxury leather goods company coming in and competing with Hermes.
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Starbucks (with Howard Schultz)
The parallels to the Microsoft story are just so apt. Japan was Microsoft's first international market.
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Starbucks (with Howard Schultz)
It was half their business, and it started in the same way. Bill and Paul got a cold call from Kei Nishi, who was a guy in Japan who had somehow gotten a hold of the basic interpreter, loved it, and said, I'm so passionate about this, I want to bring it to Japan. 50% of Microsoft's revenue for the first at least five years.
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Starbucks (with Howard Schultz)
And that's what took them from Albuquerque to like, hey, we're international. All right, listeners. This is a great time to talk about one of our big partners here in Season 14, ServiceNow.
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Starbucks (with Howard Schultz)
Today, we want to do a little case study on how ServiceNow works with another very well-known consumer brand, NASCAR. Little known fact, NASCAR is a family-owned business. Even at today's scale in their 75th year, they're continuing to innovate with events like their race through the streets of Chicago and growing with over 1,000 NASCAR-sanctioned events per year.
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Starbucks (with Howard Schultz)
So how do you do that? Well, NASCAR has turned to ServiceNow to help it become one of the most innovative and technologically advanced organizations in the sports entertainment industry. With ServiceNow, they've been able to automate manual and outdated business processes and unify fragmented technology into a single platform.
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Starbucks (with Howard Schultz)
They've also been able to enable their employees to build low-code applications that can be speedily deployed to all employees without having big IT projects associated with it.
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Starbucks (with Howard Schultz)
So if you want to learn more about the ServiceNow platform and how it can turbocharge your business transformation and the time to deploy applications, including AI, for your business, go over to servicenow.com slash acquired. And when you get in touch, just tell them Ben and David sent you.
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Starbucks (with Howard Schultz)
So when you and Sherry arrived here, what was the coffee landscape? I mean, there were these three soon-to-be-four Starbucks beans stores here in Seattle. Alfred Peet was down in the Bay Area. But what was coffee culture? I mean, it was like Folgers and Maxwell House, right?
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Starbucks (with Howard Schultz)
But that does seem like a, reflects a misunderstanding of the fundamental business, that this is a business about a store with high gross margins based on customer loyalty.
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Starbucks (with Howard Schultz)
As the financial climate deteriorated, spending that $6 on the latte daily habit gets harder to justify.
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Starbucks (with Howard Schultz)
Yeah. You had been on pen and paper. Then you moved to DOS. And now you have the most sophisticated technology platform of probably any retailer in the world. At the time.
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Starbucks (with Howard Schultz)
It also created an even better business model for you, right? It was more efficient and you get the float with customer funds.
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Starbucks (with Howard Schultz)
But this couldn't have been like a great business. You're shipping small amounts. No, it wasn't. The logistics costs, the scale.
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Starbucks (with Howard Schultz)
Looking back now, when you were in the moment and you and others in the management team, things happened. But knowing what you know now, are there a couple key design decisions or things that you would re-architect differently about the mobile app experience?
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Starbucks (with Howard Schultz)
Well, I went to the Presidio store yesterday in San Francisco, and I would go there no matter what.
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Starbucks (with Howard Schultz)
Oh, but I've had plenty of times where I'm looking at stores in the radius. I'm traveling. I'm in a new city, and it's like, well, I'm only going to go to the one that's open for mobile order and pay. I'm not even going to try.
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Starbucks (with Howard Schultz)
We talk all the time on Acquired about Jeff Bezos' AWS-inspired axiom that startups should focus on what makes your beer taste better. In other words, only spend your limited time and resources only on what's actually going to move the needle for your product and customers and outsource everything else that you need to do as a company but doesn't fit that bill.
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Starbucks (with Howard Schultz)
Aha, I love that. For startups and growth stage companies, accounting is example number one of this idea. Every company needs it, it needs to be done by a professional, and you don't want to take any risk of something going wrong. But at the same time, it has zero impact on your actual product or customers.
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Starbucks (with Howard Schultz)
Yep. And when you say thousands of companies Pilot does this for, these are now companies like OpenAI, Airtable, and Scale, as well as large e-commerce and other companies. So it's not just that they have experience across startups. They can also keep working with you as you scale to the growth phase and beyond.
Acquired
Starbucks (with Howard Schultz)
So if your company or a company you start in the future wants to go back to focusing on what makes your beer or coffee taste better, go on over to pilot.com slash acquired and tell them that Ben and David sent you. Thanks, Pilot. Moving on from technology and mobile order and pay, there's one more, to my mind, key pillar of the Starbucks tapestry, and that's real estate.
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Starbucks (with Howard Schultz)
And maybe this is a good time because I feel like around this era is when people started looking at Starbucks and scratching their heads and being like, there's two Starbucks across the corner from one another. These guys must be insane. Talk to us about real estate. Yeah.
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Starbucks (with Howard Schultz)
Well, as you've been saying, from the beginning, it was about elevating. McDonald's, great company, but nobody would ever accuse them of elevating, I don't think.
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Starbucks (with Howard Schultz)
And my understanding from our research is that the Robusta market really developed, as you say, with the instant coffee market. And that was kind of a product of World War II, right? It was like, hey, we got to get the troops, this product to survive. And so we just need a lot of beans and we need to ground them up and create this instant product. I believe Maxwell House was involved in inventing.
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Starbucks (with Howard Schultz)
John Gray, of course, being the number two person at Blackstone.
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Starbucks (with Howard Schultz)
Did they already exist before the roastery opened? No, Milan opened first. First the roastery.
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Starbucks (with Howard Schultz)
I'm wondering another backdrop to the roastery and really throughout all the 2010s must have been third wave coffee. And I'm sure it was on your radar screen. Yes. At the same time, it doesn't seem like it's ever made a dent in Starbucks.
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Starbucks (with Howard Schultz)
Interesting. So you think... Third Wave Coffee brought consumers into the coffee culture market that have then also become Starbucks consumers, and maybe they wouldn't have been coffee culture consumers at all.
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Starbucks (with Howard Schultz)
No screen. It's like a typewriter with a little bit of cash, right? Yes, yes, exactly. So you could fix mistakes for one line, right?
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Starbucks (with Howard Schultz)
This is something that I think has translated incredibly well to the mobile app.
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Starbucks (with Howard Schultz)
And that no other food company has, really, the level of customization.
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Starbucks (with Howard Schultz)
This is actually a really interesting way to lead into Playbook because on the surface, it's like an obvious question, right? Like, yes, it's an addictive substance, caffeine, of course. On the other hand, you're in a highly competitive market.
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Starbucks (with Howard Schultz)
Selling a commodity. And the market actually is not just coffee. It's, let's stick with this theme, it's caffeine broadly. There's Coca-Cola, there's Pepsi, there's, you know.
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Starbucks (with Howard Schultz)
And I think the real question is, for us here, nobody has built Starbucks despite decades in a highly competitive market with whether it's Third Wave or competitors in other geographies or domestic competitors or McDonald's getting into the business or Folgers and Maxwell House.
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Starbucks (with Howard Schultz)
There is a unique tapestry that we've been weaving throughout this episode that, you know, in Hamilton Elmer's terms, has power here. Mm-hmm.