CLASSIC JACK: This Broadband Market Bubble Will Burst

Originally Published November 21, 2006

With billions invested in a wide variety of interactive, mobile, broadband and media start-up companies, and with billions more stashed in equity funds targeted for the acquisition of traditional media companies such as Clear Channel Radio, Tribune and virtually every other major media conglomerate, are we on the verge of a significant boost in media companies share prices and another meltdown in the Internet economy.

The answer is a clear and unequivocal "yes" to both questions and the impact will be felt in 2007 and, to a greater extent, in 2008.

A crash in the Internet economy will come when venture capital companies fail to generate the exponential growth they are projecting for their investors and are unable to deliver the minimum 15-20 times multiples promised to those who have put up the money.

Hundreds of venture capital companies in Silicon Valley, New York, Boston and scattered other cities are losing site of their purpose for existence. Not all, of course, but many. Rather than working with entrepreneurial growth companies to assist and support their expansion, too many VCs have turned themselves into hit factories, not unlike record labels and movie studios that underwrite hundreds of "productions" in order to find one or two hits.

Throughout their history, music producers, movie and television studios, and book publishers have followed a financial policy of putting hundreds of bands, scripts and transcripts into development, knowing that only a few would ever see the light of day, and that only a microscopic handful would ever actually return a profit. Those handful of "hits," however, have such huge profit potential that they support complete industries. In the television, film and publishing business, investments are all about underwriting deficits and failure while waiting for lightening to strike.

Network and studio heads admit they have little clue what will actually work and not work, justifying their speculative investment in hundreds - even thousands - of properties. The "hit-centric" business model collapses as file sharing becomes ubiquitous and new media distribution technologies make access to consumers available to everyone. Fewer and fewer hits achieve the status of blockbuster, and market fragmentation shifts the power from massive traditional moneymakers to branded niche players that can build strong emotional connections with audiences and up-sell premium products.

Too many venture capital companies, however, seem to be embracing the hit model, willing to take pot-luck that one of their investments will be the next YouTube, MySpace or Second Life. There will be hits, but even the ability to monetize them in the new media world will not be a no-brainer. Many venture capital investors are following an ignorance-based approach to the online economy, focusing their investments on companies they perceive as having the best potential to become "grand slam" hits, while acknowledging most of their investments are more likely to turn into outs.

These VCs are least likely to support solidly performing small and mid-sized companies that consistently hit singles and doubles but have little chance of hitting the ball out of the park. It's becoming more and more challenging for these mid-market slow growth companies that are the solid foundation of the new media economy to sustain themselves without access to investor support.

VCs are also reluctant to support experienced management teams that are firmly in control of their ventures' strategies and business models. VCs want and need the power to constantly tweak management, although they rarely have any clear sense of right from wrong, good from bad, success from failure. When their endless tweaking fails to produce their desired results, or if management fails to conform to the investor's whims, VCs want to have the hammer and axe. They want the ultimate recourse of replacing management.

It's as if the Internet economy is being managed by George Steinbrenner during his worst days of hiring, interfering with, and firing Billy Martin.

The hit model is extending to most segments of the media and entertainment economy. In a New York Times article Sony chief executive Howard Stringer acknowledged Sony's future depends on creating "champion products," those hits that earn high profits. It's one thing for Stringer to expect Sony to be a hit factory. It's another issue when young, newborn entrepreneurial companies are measured by those same standards and held to those same high expectations.

At the other extreme of the media economy are the huge equity investment firms that have amassed billions for equity buy-outs. As originally predicted by Jack Myers Media Business Report, KKR, Thomas H. Lee, Blackstone Partners, The Carlyle Group, Providence Equity and several others are in the market to acquire, at premiums, leading media conglomerates. Univision and VNU have already been acquired. Tribune, Clear Channel and others are on the block. Time Warner and several others are in the crosshairs. At the same time, Cablevision is privatizing itself, a move that will be copied by others.

Pulling these companies out of the public markets will relieve some of the quarterly profit demands that destroy long-term investment incentives. But these companies will still be required to effectively manage costs and define profitable business models. Their success will be determined by their ability to shift away from the traditional hit model that defines their core mass media corporate culture and develop new business models that reflect emerging media consumption patterns and valuation metrics. Whether the equity investment firms have the patience required for this transition remains to be seen.

At every level of the media business, management must struggle with the dissonance created by the changing landscape and the schizophrenic reality of managing in a mass media, hit-focused operating world as the marketplace becomes more narrowly focused and specialized. The two are rarely compatible. VCs who focus their investments in the highly specialized new media world but still depend on hits to achieve their goals are inevitably going to fail. The failures will come home to roost as today's investment culture collapses in late 2007 and early 2008.

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