FourWeekMBA

In this session, I interview Robin Wigglesworth, FT’s global finance correspondent, based in Oslo, Norway. He focuses on the biggest trends reshaping markets, investing, and finance with a particular emphasis on technological disruption and quantitative investing. Robin is the author of incredible research into the story of the Index Fund, but also the story of how passive investing evolved. That is the topic of our discussion. 

Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever

Robin Wigglesworth:

I’m a journalist at the Financial Times. That’s my day job. Between 2015 and 2019, I was the US markets editor at the FT New York. The way the FT is set up, we can’t cover everything that happens around the world all the time, so we have to be a bit more like special forces. We have to be very focused on where we spend our efforts.

For me, the rise of passive investing was just such an incredible story that was under-told because it doesn’t have many of the other personalities that we know in banking. There is no Jamie Dimon of index funds, there’s no Ken Griffin of index funds because we’re essentially just algorithms that buy all the stocks or bonds in an index.

But it was huge. Now it’s $20 trillion. $20 trillion in index funds. That’s more than the combined hedge fund, private equity, and venture capital industries. Twice that, actually. If you take all the venture capital, hedge fund, and private equity industries, double the size of them, and they still wouldn’t be as big as index funds. The more I realized the enormity of this, and saw the many ways it was changing the wiring of financial markets, I felt it deserved a book to explain how this revolution happened and what it means.

Gennaro [FourWeekMBA]:

Yeah. For a little bit of context, 20 trillion is actually larger than the US GDP. Probably the US GDP is 17, 18 trillion, or something. Something like that. It’s a huge industry.

You also found a way to tell the story, and, as you said, passive investing is about algorithms more than people. You instead manage to tell the story in your book, Trillions, in a way that makes it very, very compelling. 

Robin Wigglesworth:

Yeah. No, I wanted to write it almost as if it was a movie script. I think people are interesting, anyway. I think narratives help us understand complex developments that otherwise would be hard to grasp, and doing it through the prism of people just makes it more digestible.

I start the story with Louis Bachelier, a 19th-century French mathematician, who died in obscurity, that is arguably today the father of financial economics. The entire field of financial economics starts with Louis Bachelier. A lot of his work that wasn’t recognized until long after he passed away was a foundation stone for what became known in the ’50s and ’60s as the random walk theory of how stocks moved around, and eventually efficient markets.

Of course, there are many people that don’t think markets are efficient, and I have some sympathy with that, but that was absolutely pivotal in why the first index funds were invented. Index funds work whether you think markets are efficient or not, but some first-generation index funds were based on that idea. That’s why I think Louis Bachelier is rightly considered the godfather of passive investing.

Robin Wigglesworth:

Yeah. The whole idea of active versus passive just didn’t exist for centuries of investing. Ironically, the very first pooled investment vehicle, the first kind of mutual fund, was kind of an index fund. It was a passive fund. It was a bond in the Netherlands that basically bought lots of physical paper bonds and locked them in the chest for 20 years. That was a passive investment vehicle before anybody ever talked about the idea.

For a long time, the way you invested was either, if you were very wealthy, you invested on your own, maybe through a stockbroker, or you gave your money to a professional, so an investment trust or later a mutual fund manager. Every time markets had a big setback, such as the South Sea Bubble, the Panic of 1907, and the Great Depression, people realized that even the professionals quite often did a very bad job. Even the ones that had done well in the boom years inevitably did even worse in the bad years.

Nobody was really able to prove it quantitatively properly until the 1960s, because of the era of the computer. For the first time, computers started cropping up on Wall Street, and people started to use them to actually crunch the data. First, manually collect all the data on stock prices from newspapers, and see how well average mutual fund managers, or pension fund trustees, and so on, did against the broader market. Lo and behold, they did abysmally.

At the time, the answer was always, “You can’t buy the market average, so good luck. You can say that we don’t do that well, but there is no alternative.” That’s why the index fund was born in 1971 because people wanted to give investors an alternative.

Gennaro [FourWeekMBA]:

Yeah. There was also a technical issue … Of course, as you pointed out, there are two key points to highlight. 

First of all, before you could have computers to track the data and actually have a study that would show, looking back on decades, whether stocks were performing better compared to other markets like bonds. It’s also worth remembering that, now we give it for granted, but there’s been a time when even stocks were not the main investing or main asset class for investors.

Of course, as you said, one was the availability of data and the ability to actually analyze that data and actually put it together in the first place. Therefore, as you mentioned, computers definitely helped along the way.

The second point, I think it’s very important to stress out, which is, it was very hard to have an effective passive investing strategy because I guess it was very hard also to have diversified portfolios, so much so that it could be effective against active investing. Meaning, in order for you to also be effective in passive investing, you had to have a very large portfolio location.

That was something extremely, extremely hard, and challenging to do from a technical standpoint, so definitely we needed some technologies that we were missing back then. 

Definitely, computers helped, not just in terms of analyzing the data, but also in a set location. Are those good points to emphasize, or do you think there is more to say about how passive investing became more mainstream compared to active investing?

Robin Wigglesworth:

No, I think that’s spot on. One of the other heroes in the book is a guy called Harry Markowitz. He was an economist who actually didn’t have that much interest in finance investing, but happened to write his Ph.D. thesis on optimal portfolio allocation.

He realized, obviously, you want to measure, you need to … If you take more risk, then you should expect more return, and so forth. He used volatility as a proxy for risk, which showed that, by more diversification, by putting in a lot of different securities, as long as they move independently of each other, the overall riskiness of the portfolio fell.

That is the foundation stone for how big institutions still manage money. That’s why they have a bit of money in stocks, a bit of money in emerging markets, a bit of money in hedge funds or private equity, in venture capital. Hopefully, the idea is that, over time, some of these things might be very risky, but as long as one does well whilst the others do badly, or vice versa, then, over time, you should have a better, more balanced portfolio.

It was his protege, Bill Sharpe, and, ironically, both of them won Nobel Prizes in economics for this work, that showed the optimal trade-off for the stock market, or for the market as a whole doing risk and reward, was the entire market. That was the optimal amount of diversification. That’s obviously a foundation stone for passive investing.

Bill Sharpe never talked about an index fund, he talked about the market portfolio. The Greek letter he assigned to basically denote the market’s returns was Beta. 

That today is the lingua franca in the investment industry for the overall market return. Passive investing is what people sometimes call it to be mean. Index funds are quite often what people inside the industry like to call it, or if they’re being fancy, it’s the beta return.

Gennaro [FourWeekMBA]:

Yeah. Of course, Sharpe really enhanced the work of Markowitz. As you mentioned, he built those two key measures. On one side was the beta, and on the other side was the capital asset pricing model, where the beta is one of the key components which is plugged into the model to actually compute, pretty much, do financial modeling of the value of stocks in the first place.

In finance, the capital asset pricing model (or CAPM) is a model or framework that helps theoretically assess the rate of return required for an asset to build a diversified portfolio able to give satisfactory returns. 

I think there is an interesting aspect that you also mention in the book, that of course, those are very important inventions, especially from a philosophical standpoint, to make the shift between active and passive investing. But, also, when we finally see the first index funds to build up over time, the mechanism behind those funds actually was also way more simple. They were actually simpler than just using complex financial metrics behind them, right?

It was more like a technical challenge, as we said, to have a fund that would be large enough, and also have the right allocation to make it valuable in the marketplace in the first place. 

Robin Wigglesworth:

There were essentially three people that got to the promised land at the same time. They all have different claims for being the very first index fund. One was Dean LeBaron at Batterymarch in Boston. He’s this really crazy, zany, outgoing guy who … He was not an efficient market zealot, but he realized that a lot of clients were going into him and saying, “We essentially want a low turnover, a very diversified bunch of US blue-chip stocks.”

He realized what they were describing was the S&P 500 index. He said, “I’ll just engineer that. It’s just an engineering challenge. We’ll sell that at a low cost as separately managed accounts.” He did this, and he started doing this right at the start of 1973, but he didn’t actually get a single client until the last day of 1973 when the money arrived in early 1974.

There was another guy called Rex Sinquefield at the American National Bank of Chicago. He was an efficient market zealot. He believed deeply and still believes deeply in it. He was a protege of Gene Fama, the father of efficient markets in Chicago. He created an index fund because he believed that markets couldn’t be beaten.

He did it by converting an existing, basically, S&P 500 active fund managed by the American National Bank of Chicago into an index fund. He basically just told investors that the object hadn’t changed, they were still trying to deliver good returns to clients, but how they would do so had changed. Nobody really objected. That was in mid-1973.

Two years before that, and this is why I think this is the first index fund, John “Mac” McQuown at Wells Fargo, and some of his colleagues, launched what was the first passive investment vehicle. It was not a fund or a classic fund, it was a separately managed account that managed $6 million on behalf of the Samsonite pension plan. Samsonite, the luggage maker, played a small but pivotal role here. That tracked all the stocks on the New York Stock Exchange, and it had tried to aim for an equal dollar amount in each of them.

That fund … First of all, it wasn’t actually a fund, and, logistically, the rebalancing that they had to do all the time to try and keep the dollar exposure constant across the stocks was monumentally big. It just turned into being a massive nightmare. Eventually, it got converted into an S&P 500 index fund a few years later.

That’s why, depending on how you define it, different people can claim to have got there. But, in my eyes, the real, original index fund, a passive investment vehicle, was the Samsonite account managed by Wells Fargo that went live in July 1971.

Gennaro [FourWeekMBA]:

Yeah. Definitely a very interesting story. A couple of points that I want to emphasize from what you were saying, number one, of course, building a successful index fund turned out to be a very hard engineering problem.

Right? Really, it turned out to be a mess. It wasn’t just a theoretical problem, was just, “How do we actually build this thing from an engineering standpoint?”

Then, on the other side, also, it wasn’t yet the time where … Because we give for granted today main indexes like the S&P, the NASDAQ, or all the other main indexes that we have. For instance, today, it’s also simpler, probably, technically to just plug some index funds to the main indexes.

But, at the time, I guess we didn’t even have them. For a little bit of context, otherwise, it’s very hard to understand how difficult it was technically to build such an index fund. Also, the last point, how was that conceived to Wells Fargo, which I guess at the time was not a major bank?

Robin Wigglesworth:

To take that last point, I think it’s fascinating that … It’s a truism, but big companies don’t like disrupting themselves. We see this again, and again, and again. The mental model I’ve always used for index funds is that they’re almost like new technology, like electric cars, Netflix in the era, or Blockbuster. Other companies might have danced around the idea or realized this might be a good idea, but it’s just very hard to do that if you’re a big incumbent.

Wells Fargo of the ’60s and ’70s, when Mac was working there, was not the Wells Fargo of today. It was a tiny pissant regional bank of no significance, really. There were all sorts of rules and regulations that prevented banks from becoming some of the national behemoths that we know today.

I think the fact that because Wells Fargo was so small because the American National Bank of Chicago was so small because Batterymarch was a startup asset management firm, that allowed them. That was one of the things that made them willing to do this. It’s no coincidence that a Fidelity, or a State Street at the time, a Bankers Trust, didn’t do anything like this.

The actual logistical work needed to set up index funds was huge. Today, this is stuff that is quite literally sold for free or close to free by Fidelity, Charles Schwab, or Vanguard. It’s basically almost the simplest, dumbest form of investment algorithm you can imagine, just basically, “Buy all the stocks according to the weighting in the S&P 500 index.”

But, at the time, there was no electronic trading. Portfolio analysis, it would take hours to run through portfolio analysis on these big, hulking IBM mainframes. The data wasn’t collected. It wasn’t electronic. You had to literally collect the data from old copies of Barron’s in their archives.

I have to admit, I knew intuitively how much hard work it must have been, but actually talking to the people involved today for my book, I was taken aback. I thought, “Bloody hell, I wouldn’t have been bothered to do that if I was there.” It just sounded incredibly hard work.

The first project to really collect a comprehensive database of US security prices was funded by Merrill Lynch. It was done by the University of Chicago, something called the Center for Research in Security Pricing, or CRSP. It used, I think it was, half a million dollars, which was a huge amount of money at that time, and took four years to collect all this stuff and clean up the data. It was on a magnetic spool that stretched for something like four miles.

That database is the genesis moment for the entire quant revolution that was to come, because that was the database that became the raw fuel for not just index funds, though index funds were a huge part of that, but pretty much everything that came since. CRSP today is still a big data provider for investment groups like Vanguard. Yeah. I shudder to think about how much work there was involved in doing this in the early days before portfolio trading or anything like that.

Robin Wigglesworth:

This is why I think those three pioneers that I focus on, the motivations varied quite a lot, and they still ended up in the same place, basically. For Dean LeBaron at Batterymarch, he just thought this was something that clients wanted. He didn’t think they should charge a lot of money for it, because there was no real management involved. He thought, “The S&P 500, it’s a decent shorthand. That’s what a lot of people want.” Some people want the very growth-oriented investing that he was known for.

A young Jeremy Grantham was working at Batterymarch as well. He was Dean LeBaron’s partner. They were active managers. They just felt that a lot of people don’t really want active management, they just want something like a big, boring portfolio of diversified, big US stocks. That’s the S&P 500. “We’ll just basically replicate that.” For them, it was just pure client demand and an engineering challenge, and not much more than that.

Though, I think, Dean LeBaron, he’s quite a character. I think he quite liked the idea of tweaking the noses of other people in the industry. He actually enjoyed, got a personal rise out of that.

Rex Sinquefield, he’s the classic efficient markets guy. He calls himself the Ayatollah of efficient markets. He doesn’t think that markets can be beaten in the long run. The reason why he set up an S&P 500 index fund was purely because that it was, at those times, with those practical constraints, you couldn’t trade small-caps and micro-caps at the time. The S&P 500 was the cleanest representation, the best representation of the entire stock market as a whole. That he chose the S&P 500 as his aim, that was more than this is, again, a good shorthand. He came to it as an efficient markets guy.

I think with Wells Fargo, and Mac and some of those people there, some of them were efficient markets believers. Mac certainly hero-worshiped Gene Fama, and they’ve worked together. Still, work together in their eighties today. But I think they just wanted to research a better way of investing, and they could see the data that the average active manager did a bad job.

They just basically ran the data, and there were people like Myron Scholes and Fischer Black, who were absolute rockstar economists that both … Scholes won the Nobel Prize, and Fischer Black passed away before he could do so, for the Fischer Black-Scholes model.

They essentially researched, what is the best systematic way of investing? What they ended up with was an index fund, but they were fundamentally not efficient market zealots. They were looking at ways, “What is the best, cheapest, efficient way of investing?” An index fund just happened to also be the answer they came across.

That’s why I think that quite often people think, because of its genesis, that index funds and passive investing only work if you believe markets are efficient. No, it doesn’t. You can think markets are horrifically inefficient, or that they do dumb things all the time like humans do all the time. But, in the long run, the data is pretty irrefutable. The vast majority of investors do far better in passive vehicles in every asset class, over any time period, in any market. That’s where all these three people ended up at, though in different ways.

Gennaro [FourWeekMBA]:

As we see there, those are the points that make passive investing more interesting in some areas compared to active investing. Things that, as we know, when you start having a high frequency of investing, of course, most of the profits are eaten up by the cost of trading, which also, as you point out in the book at the time, could be pretty high.

Robin Wigglesworth:

Huge. At the time, that was one of the big things. Today it’s the management fees. It’s the cost of professional asset managers, portfolio managers, traders, back-office lawyers, and compliance staff. The trading costs are pretty low, almost zero. But, 50 years ago, the trading costs were the real headwind. The more you traded, the worse the returns were, essentially. That’s what index funds would also aim to try and tackle.

Gennaro [FourWeekMBA]:

Yeah. Of course. As we said, it is not just about going against the efficient market hypothesis, it’s also trying to create an investment strategy where you don’t have the cost structure they usually have in active investing. Especially where, in active investing, sometimes your whole compounding is eaten up by not only the cost of trading but also by management fees.

There is an old philosophy of Warren Buffet when he’s asked, “What’s the best way for average people to invest?” He would always ask for, as also you highlight in the book, that definitely index funds are the best way for average people. It’s also because, compounding, when there are management fees that are high management fees, those eat up the whole effect of compounding. Therefore they remove the most interesting part of investing, which makes investing powerful in the first place.

There is also another key point that you highlight in the book. It’s pretty interesting to me because we also go over the story Bell Labs in this podcast series. There’s been a certain time, probably throughout the ’70s, where they formed also economic incentives toward index funds. As you mention in the book, there was a time when AT&T, which was still a large monopoly in the communication industry, had used the Baby Bells, which were regional companies, part of the Bell System, to actually invest in index funds, right?

Robin Wigglesworth:

Yeah.

Gennaro [FourWeekMBA]:

There was also … Here, there were some economic incentives that also started to work in favor of passive investing. 

Robin Wigglesworth:

Yeah. The Baby Bells were hugely important. They weren’t efficient market zealots, they just were the biggest owners of stocks in the entire United States. They could see the results were bad, and, index funds, the results were better.

Yeah, after that … The Baby Bells were huge, important backers of Batterymarch, American National Bank of Chicago, and Wells Fargo initially. I think, for the first few years, this was only an institutional phenomenon. Ordinary people didn’t even know about this stuff.

This started to trickle through because of people like Charlie Ellis, who was a fairly well-known investor who wrote a paper called The Loser’s Game that pointed out some of this data that was coming out, and how bad it was. And Burton Malkiel, another economist who popularized and brought to the mainstream the idea of … The Random Walk Down Wall Street is his classic book that’s still … It’s in the 20th edition now. I think it’s still an absolute, stone-cold classic.

But the person that really helped to fire up index funds, though not immediately, crucially, which I thought was fascinating to discover, was obviously Jack Bogle. He did not invent index funds, despite him sometimes quite happily letting people give him credit for it. He only came into index funds almost by accident, because he was fired by his former partners at a company called Wellington where he led a big active management outfit.

In the divorce agreement, he was basically set up a clerical outfit that would do all the administrative work for Wellington, and he gave it the grandiose name Vanguard. He wanted to do something, but there was a lot that they couldn’t do. So they did index funds with the argument that this wasn’t investment management because an index fund was unmanaged. That was the genesis of Vanguard.

As much as he sometimes later in life would pretend that this was all part of a massive plan, it was happenstance that made Jack Bogle the Jack Bogle we now know today and Vanguard this Titanic asset management group, with, I think, well over $8 trillion worth of assets under management today.

Gennaro [FourWeekMBA]:

Yeah. Also, initially, he thought of the index fund as a dumb idea, right?

Robin Wigglesworth:

Yeah.

Robin Wigglesworth:

Yeah. Exactly. No, I think … This is something I notice a lot as a journalist, as well. When I talk to people that are immensely successful, obviously they have a lot of drive, but quite often there’s some sort of personal or professional tragedy or major setback early in their lives that have really taken that drive and has lifted it 20 notches above what most people have. I think, for Jack Bogle, there was his family background, but it was the humiliation of being sacked from Wellington.

He was a man that came initially … Was born into wealth. His family was a very wealthy Pennsylvania family, but they lost their entire fortune in the Great Depression and the Great Crash of ’29. His father became an alcoholic and essentially left the family.

It was that sense of having fallen from wealth to … They were still comfortable, but they had to work. All the Bogle boys … He had two other brothers, including a twin. They all had to work incredibly hard. They could only afford to send one of them to university, and that was Jack Bogle. Even then, he had to work his way through university at Princeton.

Imagine if you’re only one of three brothers, the pressure that puts on you, that, “We can only send one of you. Jack Bogle has the best grades, so he’s going to university.” You’re working to repay the trust of your entire family.

He did work incredibly hard, and he was brilliant. He was noticed very early on by the founder of Wellington, which was one of the biggest mutual fund companies in America at the time. He was the wonder boy of the industry. He became one of the youngest junior vice presidents, one of the youngest executive vice presidents, then, ultimately, the youngest CEOs of the investment industry at the time. Still, almost to this day, he would’ve been considered a wonder boy.

He was a guy that had this drive. Everything he touched turned to gold. Yes, he then pseudonymously wrote an article, a paper, rubbishing the idea of index funds in 1960 when somebody proposed it. The world was his oyster.

But then he basically made a fateful decision to merge Wellington with a bunch of growth managers in Boston and gave up too much stock to do so. Eventually, when the late ’60s, early ’70s bear market happened, the clashing personalities and terrible business, because Wellington did badly in that bear market, meant that basically they ganged up and sacked him.

I think that just fired him up to just unimaginable levels, and gave him the drive that made him this force of nature. And helped turn Vanguard, which could have just been a cushy retirement job, too… He decided to turn it into the instrument of his revenge against anybody who doubted him, and to prove them wrong, that he was brilliant, that he was incredible. He succeeded beyond even his imagination, I think.

Gennaro [FourWeekMBA]:

Yeah. A few key points based on what you said. Bogle, it’s very interesting because, of course, as you said, he grew up in a very tough situation, and actually his character very came about also as a contrast with his father, where he saw his father as a weak person. He was way stronger. As we see, he also had many health issues over the years.

Then, on the other side, the turning point would be when finally there will be this contrast with his partners, where Vanguard becomes a way for him to actually say, “I told you so. I showed you how I could do something extremely valuable in the world without you,” or even, “do something better than you’re doing.”

Also, another interesting point that you mention in the book is that … At least I’m not sure if you find this to be real, but it seems like he didn’t know who Markowitz was. He started Vanguard from a position of, really, “I’m going to do it because I want to give,” let’s say, “a kick in the butt to my former partners,” was the story of the early years.

Robin Wigglesworth:

No, I think I remember talking to one of his closes, close friends, and former assistants about this, who, this was in the later years of Jack Bogle’s life, said, “Look, why are you trying to erase other people from history? Your role is so huge and what you’ve done is so monumental, you don’t need to do that.”

I don’t think Jack Bogle did it because he was mean-hearted at all, but we all have certain stories that we tell about ourselves and how we became the person we became. The reality is always a lot more complicated than even we admit to ourselves. I think we all do this, and Jack Bogle obviously had this incredible canvas on which he could write his life story.

But, yes, he later on, in his later years, would say that “I didn’t know anything about efficient markets. I didn’t hear about Markowitz or Fama. I was this yokel,” like this poor boy who worked through Princeton, and … He would downplay his own intellect and pretend that he was just this simpleton.

Jack Bogle was brilliant, and he was incredibly well-read. He was a voracious reader of any investment industry news. I know for a fact because I talked to people that met him at the University of Chicago semi-annual seminars on things like efficient markets, and all this jazz. He would try to pretend that he came into index funds almost by accident because he read Paul Samuelson, a famous economist that helped popularize the idea of index funds, but he didn’t know anything about everything else.

It’s, I don’t want to say … I think that stretches credulity. I just don’t think that’s very likely.

Gennaro [FourWeekMBA]:

Yeah. Of course, it’s also true that this story, told in this way, it’s also easier to sell to the news, to the media, because is the story of the American dream. “Also you can make it. If I could make it as a simpleton,” as you said, “also you could make it.” Definitely telling the story in this way would help him actually shape his own legend, right?

Robin Wigglesworth:

Yeah. He was a world-class storyteller. That’s a skill that sometimes gets dismissed, in the same way, “He’s just a salesman. He’s not a brilliant innovator.” Jack Bogle was a brilliant innovator in many respects, but he was, I think, one of the greatest storytellers the investment world has ever seen, up there with Warren Buffet.

That is actually important because he was able to convince people in very simple messages why this is good. I dream to be one basis point as good a storyteller as Jack Bogle was. He’s just phenomenal at this. That was one of the reasons why indexing really helped take off eventually. A lot of the stuff that he wrote and said about how he came into it had more to do with, I think, burnishing the legend of St. Jack, as he became known, rather than the reality of Jack Bogle.

Robin Wigglesworth:

Yeah. No, you’ve stumbled across one of my absolutely favorite geeky, nerdy subjects, but yes. Obviously, the first index funds, including Vanguard’s, use the S&P 500 as the shorthand because it was a pretty good reflection of the entire stock market if you weigh it by size. Today Apple is more important for the direction of the US stock market than American Airways or Alaska Airways. The S&P 500, because it captures the 500 biggest-ish companies in America, it is a pretty good shorthand for the entire US stock market.

But, it’s not perfect. Especially in an economy as dynamic as the US, there have always been a lot of smaller companies that grow quite quickly. For a purist of financial economics, like somebody who believes in the theory that underpins this, the S&P 500 is at best an imperfect shorthand, and at worst a very ugly one.

Gus Sauter was one of the people that went into … He was the head of the equity indexing arm at Vanguard. This was in the early ’90s. He was always keen. He had studied at the University of Chicago, and he felt that a true index fund should be the entire market portfolio. That should be all stocks.

He got Jack Bogle’s buy-in to finally do this, where they also included small-caps and mid-caps into one giant index fund that basic invested in all the liquid mainstream stocks in America. That fund now is $1.2, $1.3 trillion. Just this one fund would alone be one of the biggest asset management firms on the planet. It’s a huge success.

One thing I love about this subject is that, if you’re a real purist about the market portfolio the way that Sharpe envisaged it, the market portfolio does not just stock. It’s also bonding. It’s also real estate. It’s also commodities. It’s everything. I think that’s probably one of the next iterations of the index fund revolution, is that we start getting truly multi-asset-class, passive portfolios that are cheap, simple, and commoditized, and you can buy off the rack, as it were.

Robin Wigglesworth:

I think today there isn’t. Fundamentally, my idea, I think the Vanguard total stock market index fund is a great example of a one-stop index fund. It was super cheap. I think it costs four basis points a year. Because US companies are so global, it’s obviously just US stocks, but you’re getting a lot of international economic exposure as well.

If you’re a half-decent financial advisor or standalone investor, you can combine that fund with maybe a Vanguard or a BlackRock bond fund index fund, and other things. You can cobble together what is essentially a good approximation for the market portfolio as a whole.

Just maybe as an engineering challenge, I quite like the idea that I know people are working on this, but something that combines both public markets, so there are mainstream stocks and bonds, and real estate, and private debt, private equity, the whole works, so that you get … Basically you could go in and, basically, with a click, buy a fund that does all the asset allocation for you as well.

In reality, there’ll have to be some flavors around that, because, obviously, if you’re 18 years old, you shouldn’t be buying the same portfolios if you’re 80. But I think that’s where we’re heading, that the passive investing revolution is going to come to the asset allocation side as well eventually. It’s starting to, arguably, today.

Gennaro [FourWeekMBA]:

Yeah. What are some of the key facts of the early years of Vanguard? Especially taking into account the personal story of Bogle, and how he had some health … It really was going through a transition where the company at a certain time was supposed to go to the person that he chose to be the successor, which was Brennan, and then, all of a sudden, things changed. 

Robin Wigglesworth:

Yeah. It’s fascinating. It was one of the things that … I talked to a lot of people involved in the clash between Jack Bogle and his hand-picked successor, his chosen protege, Jack Brennan. Nobody knows. People know the contours of it, but nobody really knows what was said between those two, because both of them have never said a word publicly about it, and even to their friends. Which I admire as a person, but as a researcher researching my book was a little bit frustrating, at least.

Essentially, yeah. Jack Bogle was a brilliant strategist, a visionary, and also a great salesman and storyteller. Jack Brennan was the yin to his yang. Jack Brennan was the consummate efficiency guy. He was the operation guy. He was the guy that made sure that Vanguard, as it started growing enormously in the ’90s, that the trains arrived on time, that it functioned as an organization.

I talked to friends of both of them who said Jack Brennan could not have done what Bogle did. Jack Brennan would never be the founder of an organization like Vanguard, but Vanguard would not be today what it is if it hadn’t been for Jack Brennan, because he made sure that somebody would implement all of Jack Bogle’s ideas. They worked incredibly well together. They were both incredibly hardworking people.

What happened was that Jack Bogle had a very bad heart. He’d suffered many, many heart attacks. He had a congenital heart defect. Eventually, he was in such bad shape that he was still coming in to work, but he couldn’t walk upstairs. He was in bad shape.

Jack Bogle transitioned the leadership formally. Jack Brennan started running the place anyway, and he was formally named Jack Bogle’s successor as Jack Bogle went to get a heart transplant. There he languished for over a hundred days at the hospital before he finally got a heart. People assumed, “Okay. Then maybe he’ll come back to be chairman if he feels okay,” but nothing more than that.

As it turns out, Jack Bogle was invigorated by this heart. He was fitter than ever, had more energy than ever. He came back as chairman, but kind of acted like he still was obviously the founder who ran the place. By then, Jack Brennan had been running it for many years. They ended up clashing more and more.

Eventually, the board sided with Jack Brennan, and Jack Bogle was … They tried to quietly eject him to be chairman emeritus. Essentially those two men fell out, which, first of all, is tragic for both of them, because they used to be so tight, but also for everybody, frankly, around them. It’s a divorce that still shaped Vanguard a little bit in the culture, the Brennanites and the Bogle true believers, the Bogleheads. Yeah. Maybe the competition drove them to great heights, but I think it’s quite sad that they never made up even before Jack Bogle passed away in 2019.

Gennaro [FourWeekMBA]:

They never really managed to make up at the end, like the last days of Bogle.

Robin Wigglesworth:

Yeah. Many friends tried to engineer a rapprochement, but they never did.

Gennaro [FourWeekMBA]:

Wow. All right. If we move forward with the story, of course, there has been an evolution to index funds, which is the exchange-traded fund, the ETF. 

Robin Wigglesworth:

That was a guy called Nate Most that lots of people in the ETF world know about but is kind of unknown outside it. I think it’s quite sad because he was a brilliant guy as well.

He was the head of new products at the American Stock Exchange, which today doesn’t exist anymore. When he was working there in the ’80s and ’90s, was struggling in competition, getting squeezed by the Big Board, is what people call the New York Stock Exchange, the big brother, and the upstart electronic exchange, NASDAQ. The AMEX desperately needed something new to save it, essentially, and Nate Most came up with the idea of tradable index funds.

He actually ironically took the idea to Jack Bogle first, and Jack Bogle hated the idea. He thought the idea of people trading index funds was horrific. Although he really got on well with Nate Most, he basically sent him packing.

But then Nate Most took the idea to State Street, and State Street thought it was a cool, interesting idea. They had by then a pretty vibrant index fund business, mostly for pension plans, insurance companies, and so on. They came up with this new tradable index fund.

Basically, you trade shares in a vehicle. There’s lots of nifty stuff that happens under the hood. It didn’t do incredibly well, to begin with, but now, obviously, this is the ascendant form of investing. It’s grown beyond index funds and passive investing. That’s where most of the money is today. The most actively traded equity security on the planet is the S&P 500 ETF, SPDR.

If you look at the entire world, that’s now, I think, as big as the entire classic, plain vanilla mutual fund industry, and it’s growing far quicker. People are packaging active strategies up in ETFs as well. It all sprung from Nate Most. He’s the father of the ETF.

Gennaro [FourWeekMBA]:

Of course, Bogle didn’t see the potential in ETF, actually not because he didn’t realize that there could be something huge, just because he thought that, philosophically, they went against what he believed was an investing strategy which was supposed to be … Passive investing is about also holding something potentially forever, not trading it every day, which is what an ETF did.

I’m curious to hear from you, because, of course, when you make the transition between index funds and ETF, the cost structure is very similar to that of index funds, but what makes them successful? Of course, those are flexible instruments, but without the same kind of commission structure, they also get, for instance, for mutual funds, where salespeople can be rewarded widely for the work that they’re doing in selling this stuff.

Robin Wigglesworth:

You’re right that most people weren’t incentivized to sell them, commissions, or load fees. They had disappeared for a lot of index funds. Vanguard went no load, or no sales commission, in the ’80s. But then you’re very much dependent on having your own retail salesforce, or word of mouth.

ETFs didn’t really have that, because the AMEX was a stock exchange. They just wanted something that would trade on the floor. The market makers that worked on the floor quite liked this, having it to trade, and there was lots of cool stuff you could do with it. But they’re not going to go around selling it to people in the Midwest.

State Street thought it was a cool project, but they didn’t quite, I think, realize the potential of what they’d helped to invent. Yeah. They didn’t have, really, the buy-in.

I think the reason why … That was why it didn’t really take off immediately. I think the reason why it gradually did is, first of all, a lot of professional investors could see the use of this. Imagine if you’re a hedge fund, and you just want to make a … You think, let’s say, the stock market’s going up next week. You don’t want to buy 20 stocks that reflect the entire stock market and pay commissions on those 20 stocks. Maybe something happens to one of the big ones, and then, actually, you might have gotten the trade right, but still lose money.

You just want to buy the entire exposure. You can do that through index futures, for example, or options, or through an ETF. An ETF was a pretty clean way of making a trade, expressing a trade very quickly, because you just bought it like a stock.

In the same way, if you’re a mutual fund manager, maybe if I work at Wigglesworth Capital, and Gennaro Institutional Investors gives me a big check of money, say, $100 million. I want to invest that pretty quickly, because, for every day I’m sitting on $100 million worth of cash, my performance relative to the market that’s generally going upstarts getting a little bit worse. The cash is a drag on returns most of the time.

Obviously to deploy $100 million in stocks takes quite a lot of time. You want to research. You don’t know where you want to do it. Why not buy the entire equity market exposure whilst you wait? Keep some of your money in an ETF, like SPDR. Institutions were the ones that really embraced it first.

Then the retail side picked up very quickly afterward, especially among financial advisors, because it’s so easy for them. Buying a mutual fund with a load quite often was a little bit tedious, but an ETF could just be bought like a stock. Especially in the era when online trading started, and by the late ’90s started taking off, it was just easy to buy that. I think, today, that’s the revolutionary side. It’s the distribution is so easy.

In the US, ETFs have tax advantages that don’t exist in Europe. I think it’s the distribution. It’s just, you can go onto an app like Charles Schwab, or [PD 00:54:00], or some of the new European ones, and you can just buy an index fund or ETF for zero commission. Whilst if you want to invest in a mutual fund, you quite often have to go through a couple of more steps. I think that’s what’s really changed that, and has really helped ETFs take off in a really big way.

Robin Wigglesworth:

Like an index fund 3.0, as it were? I mentioned the idea of asset allocation, that people are getting better at packaging up different things into index funds. I think that’s kind of cool. It appeals to the geek in me, though I don’t know how big it’s going to be.

I think also direct investing or direct indexing gets often talked about as index funds 3.0. This is the idea that, rather than buying … The technology’s now so good, the computers are so good, the trading costs are so low that you can customize the index. Rather than buying an index fund of the 500 biggest stocks in the US, you might want to buy, basically, an index fund minus Facebook, because you hate Facebook. Or minus British Airways or American Airways, if they dumped you from a flight. Or maybe minus JP Morgan, because you work at JP Morgan and you don’t want to double your economic risk. You can do indices with a tweak. You can customize them.

That is growing incredibly quickly, and I think is going to continue to grow. I’m just skeptical that it’s ever going to grow to a scale that is even close to what we see in traditional, plain-vanilla index funds and ETFs. Mostly because most people want an easy life, and they don’t want to sit there and fiddle around with an index.

I think the real big thing is actually how ETFs have gone far beyond their genesis, their birth as passive index trackers, and now become a fund structure that is being used for everything, whether it’s commodities or active strategies. Even the hedge fund strategies can be packaged up into an ETF now. I think that’s going to be really interesting to watch over the next, let’s say, 10 years or so.

Robin Wigglesworth:

That’s a good question. I’m definitely not going to write a book for the next 12 months, I think. This took a fair bit of me over the pandemic, and I think the family would be very unhappy if I start a new big project. Hopefully, I have another book in me.

There are so many interesting, fascinating people and interesting, fascinating subjects in the world of finance that I don’t really feel are that well told. All industries have their jargon, and we talk to each other almost to keep outsiders at bay. But I actually think finance is incredibly important and interesting. I think a lot of the stuff that people hate about finance they’d maybe hate a little bit more, or maybe they’d hate different things if they understood it better.

I do think there’s a lot of stuff I’d like to write. I just need to be cognizant of my kids occasionally wanting to see me, and there only being so many hours in the day.

Gennaro [FourWeekMBA]:

Yeah. Of course, this might turn hopefully into a movie or series soon. One of my favorite series was definitely Billions. Now we’re missing one about Trillions, so who knows?

Robin Wigglesworth:

Yeah. Exactly. Hopefully. Somebody will hopefully option the book for a movie. Whether it ever becomes one I think is going to be very difficult. But if you have any good ideas for who should play the different characters, then let me know.

Gennaro [FourWeekMBA]:

Yeah. Again, Billions one was one of my favorite series. There are some characters there that I think would be … Probably use those for Trillions.

Robin Wigglesworth:

Yes. Exactly. No, index fund people, there are a lot of geeks, but there were some pretty big characters in the history of index funds as well that I hopefully was able to show.

Gennaro [FourWeekMBA]:

Absolutely. Thanks, Robin, for joining this conversation. It was my pleasure.

Robin Wigglesworth:

No, thanks, Gennaro. I loved being on it.

Gennaro [FourWeekMBA]:

Thank you.

Listen Also:

• History of Bell Labs
• History of AOL
• History of PayPal
• History of SpaceX
• History of WeWork
• History of Ethereum
• History of Trader Joe’s

Read Also: Financial Options, CAPM.

For this episode, I interviewed Jon Gertner,  journalist, historian, and feature writer for The New York Times Magazine and author of:  

The Idea Factory: Bell Labs and the Great Age of American Innovation 

Jon Gertner:

The reason I wrote the book is I was writing stories on technology and innovation and science. The question often occurred to me the historical question of how do these technologies come about? I had the good fortune of actually growing up near Bell Laboratories.

I'll explain exactly for your listeners what was Bell Labs in a moment. I had a personal connection, although my family didn't work there, but I understood that this laboratory was really this kind of the epicenter of innovation during a very important period in American history, but also global history for this origin of communication technologies, which really goes from the post World War II period.

Maybe we would say 1945 up until the late 1970s, early 1980s when digital technologies really took over in Silicon Valley, and some of these other companies really sprung into existence. The origins of this, of this laboratory for that, you really have to go back in American history to the invention of the telephone, which the patent of the telephone went to Alexander Graham Bell.

Some technology historians will correctly note that there was a patent battle over who actually earned or deserves the patent, but the patent went to Bell. The company that sprang up around his invention here in the United States was American Telephone and Telegraph. It's different than the AT&T of today here.

It really had a monopoly almost like it was the national phone company for many years. By the 1920s and 1930s, American Telephone and Telegraph was really the largest company in the world. The largest company by a number of employees, by stock valuation. The largest company, I think by revenues as well.

In the mid-1920s, this huge enormous telephone company decided to create a standalone research and development laboratory R&D lab. They moved all their engineers and scientists basically into this lab, which they called Bell Telephone Laboratories or Bell Labs. The first building, the instance of Bell Labs was a very large laboratory in Greenwich Village in Manhattan.

I'll let you cut in and guide me in a moment, but I should say the notion of an R&D lab in the mid-1920s, wasn't a brand new idea. German pharmaceutical companies had been doing for the late 1800s. General Electric had started one about a dozen years before.

Bell Labs was an R&D lab on a larger scale and with larger ambitions and with more scientists, not just engineers than had really ever existed before. At the start, it had about 3,000 scientists and engineers.

Gennaro [FourWeekMBA]:

I think a few key points to highlight to help understand the context and how things evolve. The Bell Labs as we see a spinoff of one of the first, probably modern monopolists that we had. Of course, as you said this story is so interesting because it spans across the end of 1800 up to let's say the '60s and '70s when we had really the birth of Silicon Valley.

It's interesting to notice that as you also pointed out the first development, the first R&D location was actually not the Silicon Valley was actually in New York. There was also a geographical move of where innovation was based back in the days, and where then it would end up being based as we go through the birth of the Silicon Valley.

There is an interesting point, which would be nice to emphasize, which is of course AT&T which gave birth to the Bell Labs was, of course, a monopoly, but there was also a different perception of the company back in the early 1900s going forward. What were some of the steps that the company took at the time?

How did the strategy change? 

Also, the perception of AT&T changed so that the company could start putting a lot of resources into Bell Labs, therefore, enabling the innovation that we had in those years.

Jon Gertner:

It's a wonderful question because, in retrospect, we might look fondly at this, at this company that changed the world, but at the time it was fairly controversial. There were plenty of detractors that saw AT&T as this almost like they might see, say Amazon or Google of today as a very large, almost rapacious monopolistic force that wasn't necessarily a force for good.

Not to answer whether it was a force for good or bad, it was a complex large company that was very aggressive in securing its monopoly and oftentimes beating its young competitors because it did have some early competitors. However, they were also experts at public relations. I think what's probably crucial to say is this company became very, very good at what it did.

Its purpose, its goal was to literally connect the country and then eventually help connect the world through communications technologies. In many ways, Bell Labs and the innovations that came out of there did serve this larger public relations purpose of making this great company admirable.

It legitimized these expenses on technology and research, but at the same time, there was a real not just an innovative force, but a real world-changing and quality to the work that was done there. One thing that I think just as a related point, and there's a question here, which I think that I wrestled with and different people who've studied Bell Labs.

Why did so many things come out of this laboratory at this one era in time? There's the transistor. There's the theory of the laser, there are many early lasers. There are the early ideas for digital technologies, there are communication satellites, there are the plans for cellular phones, really on and on, and all sorts of other theoretical mathematical work.

The Bell Telephone Laboratory scientists didn't have to do this. The managers, I think at Bell Labs deserve a fair amount of credit for being incredibly ambitious and incredibly visionary. Looking for new and disruptive technologies that would eventually replace these old ones.

I think that's a really important point that this laboratory could have just been a good engineering laboratory, but it became something very, very different. Much greater I think because of the people who ran it.

Gennaro [FourWeekMBA]:

I think it's extremely important also to highlight that, of course, in the beginning, what made AT&T monopoly and also what enabled the research at Bell Labs was a very practical issue, which was at the time they were trying to connect through a phone line between New York and San Francisco, which today seems to be something like that we give for granted.

At the time it was a huge challenge. I think this opens up an interesting point, which is as also discussed in the book, you mentioned the phone business, not sure if I phrase it correctly, but as a natural monopoly. 

Jon Gertner:

It's an interesting question. That was AT&T's contention. They would argue that phone service was a natural monopoly. I think this idea goes back to what you pointed out earlier that solving these practical problems took enormous amounts of work and insight.

This was really a brand new technology that was suddenly had the intention of spanning the country and the world. It was very different than telegraph cables and transmitting telegraph pulses. To create this rich work of instantaneous communication meant that there was really no end in sight to the problems that needed to be solved.

One, there were arguments on both sides, but a very compelling argument, I would say, that AT&T made both to regulators and the government, as well as to the public was that this technology and phone signals, in general, the system like the one the Bell system was created worked best when it had national compatibility.

The parts, the systems were all compatible were all run by one entity. That is not only created consistency in technology, but it allowed for certain economic benefits because you could, for instance, make more profit out of urban centers where you could have a tremendous number of phone subscribers as opposed to rural subscribers where people might be far apart.

In essence, a national company, a phone monopoly could use those urban dollars to subsidize phone coverage in rural areas that were less profitable. There were a variety of different arguments, but to sum up, they would make the argument that it was both a natural monopoly for technological reasons, as well as for economic reasons.

At least if we were looking at the benefit to society. As you and I probably get to eventually, that argument ceased to be compelling to government regulators. As the phone industry matured, as the technology matured, as competitors sprang up, it became less and less important. In that early crucial period, it was very important to make that argument.

I think to connect it just to Bell Labs and their innovative capabilities being connected to the largest company in the world that also had this monopoly that was blessed by the United States government meant that you had not only a tremendous amount of money to work with and to hire people, and to hire the best people, but that you could engage in projects and research that was really long-term.

That you could do things for instance, where you didn't have to necessarily worry about quarterly profits. It allowed for a long-range technological vision that I think was quite rare at the time, and it's certainly rare today, too.

Gennaro [FourWeekMBA]:

I think it's very important to recap a little bit of what we said. We started from a position where, of course, we had this first monopoly that was AT&T. Where also the perception changed because at the beginning, as we saw AT&T was looked at especially at the end of 1800, it was looked at as a huge monopoly that control the market.

Similarly, to probably how we see today companies like Amazon or Google as we already appointed out. Then of course this perception changed as you mentioned there also at least the main argument from AT&T was that the phone business, the way it was structured, borrowed itself as a natural monopoly.

This also made sense, because if you think about it, of course, there are features of the phone business initially that actually looked like a central technology, where for instance, you needed to route calls to a central place and you needed to reroute them. For instance, you could not have multiple calls running on the same line.

It had definitely a different let's say features that we then have found with the more decentralized technologies by nature, more like the internet. Even though over time, as we saw even there we had quite a little bit of centralization. We can say that there are some arguments that made sense when it comes to the phone business.

It's interesting because just to mention some of the key moments, we get to the early 1900 and pretty much precisely in 1921 when we have the Willis Graham Act where the U.S. Congress formally exempted the telephone business from antitrust laws.

This was a key moment because, of course, it finally justified AT&T to actually say, "I'm finding a monopoly as long as I'm actually throwing all my resources in developing of course from the business." As you said, also developing it and subsidizing more rural areas where it didn't make much sense to develop the telephone business.

Then on the other side, there was also another key moment because, in 1924, there was the span of Bell Labs from AT&T. I think this is a key moment because of course, it's also the moment where scientific research becomes extremely important. It's important also to highlight that before that moment, it was way more important, especially from the U.S. perspective, a form of tinkering rather than research.

Even if we think about the first let's say inventors like Edison, those were really tinkerers rather than researchers. There has been a huge transition also in the way innovation has been perceived. 

Jon Gertner:

I think you hit it on a point that I'll expand on a little bit that I think leads to an answer to that question. That idea of tinkering versus that idea of creating world-changing or disruptive technologies is something I talk a lot about in the book. By hiring scientists, by creating a laboratory, an R&D lab that was not just engineers solving problems would say, "Let's try this new material for copper cable or this new alloy."

Hiring scientists who understand, "We have a problem. Why do we have a problem?" They were seeking fundamental knowledge really to solve their problems in a way that was different than saying, "Let's just find an engineering solution and fix it and move on."

That core animating principle for Bell Labs of, "Let's not just create new technologies with new engineering combinations and the like, but let's listen to the scientists who have a new fundamental understanding for an instance, the movement of electrons and semiconducting crystals." Which I'll talk about in a second.

That was really this essential leap for the laboratory itself and the industrial laboratory itself in the 20th century. To understand, to find fundamental knowledge, and then use it to create new inventions and innovations. Going from there, I think it's important that the structure of Bell Labs as it evolved over the late '20s and through the 1930s moved in that direction.

Where the laboratory itself was hiring scientists as well as engineers to solve millions of problems. In a way, you could break down the fundamental problems of Bell Labs and the phone company came down to one, transmission. How do you get a call from one place to another? Two, switching. How do you connect everybody to everybody else?

The technology is to do those things are really complex especially, in this pre-digital world. In many respects, I think a lot of the fundamental knowledge and the research at Bell Labs, especially coming out of the war was geared towards that, and the transistor was too. Just to take a step back by the early 1940s, Bell Labs had expanded into a research and development operation of about 5,000 to 6,000 engineers and scientists.

The research group was probably 15% of Bell Labs. These were scientists, physicists, chemists, and the like with PhDs and then the development people were more engineering-oriented who were really trying to use some of these ideas coming out of research to solve the phone company's problems. Of course, it's crucial to note that World War II occurred earlier in Europe.

Here most of the emphasis at Bell Labs during the early 1940s was on working to serve military needs. Out of that work and a lot of that work was on radar systems at Bell Labs and on communication systems, out of that work came certain insights, the main mover I think at Bell Labs, the main leader that came out of the wartime era was a guy named Mervin Kelly, who I write about in the book a lot.

Kelly, by the end of the war, had risen to the head of research and was vice president of Bell Labs. He would later become the president of Bell Labs and he saw a couple of important things come out of the war effort. One was that you could achieve things with the smartest scientists and engineers together, working on a problem in timeframes that once would've been thought unthinkable.

He's seen this with the radar effort at Bell Labs. He also saw this with the Los Alamos effort in New Mexico for the atomic bomb. The second thing he also saw was that what you really wanted to do was to solve problems not with like-minded people, but that new ideas and good solutions actually came out of the interface of different disciplines.

Now, this probably sounds an obvious idea to your listeners and to people of today, but at the time it was radical. You didn't want a team of physicists all working together. You wanted physicists, chemists, and engineers all working together, and sometimes arguing with each other about solutions. I think why this was particularly crucial because that became a model for Bell Labs, a model of how problems were solved.

A model of how research leaps were undertaken. Right after the war, I think most crucially, and just to use one example of a really important leap that occurred to Bell Labs was that this fellow member and Kelly set up a team of scientists that eventually became known as the solid-state team.

He handpicked a group of engineers and chemists and physicists and metallurgists and asked them to look deeper into the nature of semiconducting materials. He believed there was a solution that would come out of that for some of the challenges in switching in the transmission that the phone company was dealing with.

The phone company had technologies for transmission that relied on vacuum tubes that were hard to make, expensive, used a lot of power, were bulky for switching. They used these vast banks of switches that were electromagnetic, and they are millions of them in the phone system. They had great expense.

There were questions at the phone company, whether the increase in traffic in the future, the phone company could even be accommodated by the technology that existed at the time, the 1940s. They needed a new technological solution. Out of that, the solid-state team arose.

To ruin the story, the solid-state team eventually after working for a couple of years on Silicon and on Germanium came up with the first transistor, which really changed the world. The book I call it really one of the most important innovations of the 20th century.

Gennaro [FourWeekMBA]:

A few key points as I was listening to what you said, a few things came to mind. Of course, when there was this transition from tinkering to research, it's extremely important to understand that it's just a different approach, both work extremely well, but when you actually put an emphasis on research, you're looking way forward.

You're not just looking at things that work. Also, as you said, listen to scientists that have a different and philosophical understanding of a discipline. Therefore, they actually do look ahead of, let's say, 20, 30, 40 years from where they are. As we'll see, actually some of the ideas that were developed also Bell Labs took many to actually realize in full.

As you know, as we see also information theory was [inaudible 00:24:32] information theory actually up at the Bell Labs. It is also another interesting point that came to mind, which is the fact that anyhow, the approach that Bell Labs had was quite eccentric. Eccentricity was extremely important, especially in the development, of conceiving a new idea.

Of course, as you needed to actually execute this idea at scale, then people like Kelly completely understood that you needed many, many people where we needed to be way more practical to actually execute those eccentric ideas. On the one side, you had those very eccentric individuals, and many of those ideas were born, as you said, also as a result of arguments between those people.

Of course, once those ideas had developed and there was a technology that needed to be manufactured at scale, then things changed. This connects back to the innovation loop that also Bell Labs followed where we had basic research. Then, we had applied the research development and manufacturing. Of course, in the basic research phase, you have a lot of people who are very, very eccentric.

They look at the future and they're interested and curious about those fields, not necessarily because as we see interested in the applications. One of those people probably we can touch a little bit about that, but definitely was Claude Shannon. Of course, applied research where it requires a different mindset, probably a hybrid mindset between research and development of a product.

Of course, there is the development and manufacturing that, where again, we need a different approach and different kinds of people. This was at Bell Labs at the time.

Jon Gertner:

I think it's interesting to point out that this was a postwar model that in some ways has been challenged effectively and has evolved into different models of innovation since that time. I think it's often the case where people will say, "Well, Bell Labs had this old idea of the idea would come up in the research department. It would be developed in the development department and then it would go to manufacturing."

Sometimes that's true. That is true, for instance, with the transistor. It was created by a research team and hand it over to develop development team. Eventually, it was brought to scale by the manufacturing team and achieved this scale and impact I think that innovations have. Bell Labs also did some interesting things where these were very bright people.

They were operating in an era where they were trying to understand how to manufacture basically revolutionary technologies at scale. They certainly didn't have all the answers, but they were trying to learn them. Even set up small laboratories at the manufacturing plants sometimes. Try to capture some of the ideas that would come when you are actually putting a new product into production that you could learn from it.

Sometimes you would actually make a leap from manufacturing something. When you're actually manufacturing something, you're always trying to make it better. I think sometimes ideas didn't always flow one way from research to development to manufacturing. Sometimes there was a circularity to them or feedback loops that were also very helpful.

Today, I think the innovation patterns are much more diverse, but in the era of the large industrial lab, they were still being worked out.

Gennaro [FourWeekMBA]:

There is also a very important effect of serendipity on innovation, wherein the book, we also mention it in reference to the call, the zone refining, which for a bit of context, was a way to actually manufacture semiconductors in a more pure form. In that specific context, Bell Labs was working on a form of semiconductor, which was the germanium.

This idea of germanium refining came from a metallurgist called Pfan who was actually taking a nap on the job. 

Jon Gertner:

Kelly's a very interesting person as the leader of Bell Labs. He was a hard-charging person who would run up and down staircases and was always in a hurry, and wouldn't necessarily have as we'd say, here in the U.S., a warm and fuzzy type, not at all. Yet, he had a deep understanding, I think of how scientists worked and engineers.

How sometimes engineers as well and how sometimes solutions were very difficult and failure was part of the process. Giving people room to work was crucial. In all my research, I never came across any criticism where he would want something done faster and faster from a scientist who was literally working on the cutting edge or bleeding edge of new ideas.

He understood that it was extremely difficult to find new breakthroughs and new knowledge. For instance, this guy, a metallurgist called Pfan, who was working on this problem of how do you purify large of silicone at the time, which was a pretty challenging problem. How do you do it effectively so that you can scale it to manufacturing?

Literally, was trying to come up with something and took his usual nap after lunch, and then woke up and said, "I know how to do that." There were these moments of insight that I know that Kelly was sympathetic to the fact that a lot of these scientists were quirky. They were working on difficult problems. They sometimes came at them from angles that were unconventional.

You'd mentioned Claude Shannon a little bit before Claude Shannon was a mathematician, a very eccentric individual who made his own rules. Would go down the hallways of Bell Labs, riding a unicycle and juggling, and really building robots in ways that would make a lot of people scratch their heads.

There was this eccentricity that was tolerated and sometimes appreciated, I'd say at Bell Labs because it was part of this group that we're working to do, I guess you could say, challenging things that had never been done before.

Gennaro [FourWeekMBA]:

I think it's very important to emphasize that actual eccentricity was appreciated, but you also needed to earn it. If you were Claude Shannon, you could do those things because you actually were really revolutionizing a field and you were way, way ahead of your time.

Jon Gertner:

Very true. Here in the U.S., we call it a star system. If you're a star, you get a little more room to either be eccentric or even to misbehave sometimes. I think that there's some truth to that too at Bell Labs.

Gennaro [FourWeekMBA]:

Before we get to the full intro of semiconductors, which definitely opened up one of the most important industries of our time, it would be nice also to look a bit at the character of Claude Shannon and how he came up with this idea was so ahead of his time. How did he even actually conceive that?

Jon Gertner:

Shannon was a mathematician who studied at MIT. I think probably it's fair to say, he was somebody who was fascinated by puzzles. He worked in cryptography during World War II. I think that was an essential aspect of his thinking at the time coming out of World War II, his studies in cryptography eventually lent themselves.

Once he started working at Bell Labs to how do you send a message from one place to another, in a way, for instance, where there wouldn't be any errors. He started to think in terms of messages, not in terms of how engineers at Bell Labs were thinking of them, which was sine waves moving through copper cables and systems and being switched.

He began to think of them as discreet units of information. Eventually, this took shape in a thesis that was published. At the time it was called Communications Theory, which was an overarching theory of literally how do you send a message from one place to another most efficiently and effectively. Eventually, it became more commonly known as Information Theory.

This idea is the root of both standards for how you would send messages digitally. It's also a guide or yardstick as we call about here or measure for how much information can be sent at any given time. It's led to error-correcting codes that allow for accuracy with messages sent over longer distances.

Shannon was fairly humble about this, but at the time it was a breakthrough that a lot of his colleagues said, "I don't even know how he could come up with such a thing." It was thought of as 10 or 20 years ahead of its time. In fact, it's served as the basis, really, this set of guiding intellectual principles that have laid the foundation for that information age and the digital exchange of communications.

Gennaro [FourWeekMBA]:

Going forward, as we go to the mid-'50s, there was a contrast between AT&T as a company that needed to actually implement things at a very slow pace. Then on the other side, Bell Labs was actually innovating at such a pace that they were looking years ahead.

Just in the case of Claude Shannon who had developed the idea of Information Theory way ahead of his time. Going forward, there is I think a key moment to look at, which is the antitrust case of 1956, which actually was good for AT&T, let's say it didn't break the company up.

On the other side, it posed a condition that later down the road would turn out to be just probably the end of the whole thing, which was the fact that AT&T could not enter the computer or consumer electronics market. 

Jon Gertner:

It's a really important moment I think in Bell Labs’ history were in the early '50s, they saw this coming, that the federal government had a certain level of discomfort with how the company did business and how the company kept competitors out. It was clear that there were going to be certain limits set upon the company.

What came out of that essentially, which occurred really just at about the moment in the 1950s, when the transistor was just about entering mass production. You had this new component of electronic systems, the transistor that replaced the vacuum tube. It suddenly allowed for this miniaturization on a scale that had never existed before.

It was seen at that point already as a radical technology, but what Bell Labs had to do based on this consent decree was it could use transistors and it could use any of its technologies and research for any kind of phone communications business. Bell Labs and AT&T were still monopolies in the United States.

However, they were prohibited from going outside of that kind of core business. At the same time, they had to make their innovations like the transistor available to outside customers. They either had to give away previous patents or license them, or they could license for instance transistor technologies for a fee, which is what they ended up doing.

If you go back to that era, Bell Labs would have these conventions really where they would hire buses and bring representatives from companies all around the world who would come to Bell Labs for these three-day seminars in the 1950s. How do you manufacture transistors? What kind of transistors are there?

What are quality control issues? How do you create consistency in manufacturing? It was a recipe book that they would offer to companies that wanted to spend whatever it was, I think $25,000, a not-insignificant amount at the time on the technology. Your point is well-taken that at this moment in time, they were sharing their technology in a way that planted seeds I think that.

Eventually, became the end of Bell Labs and the end of AT&T. It allowed for one thing for the computer industry, eventually, in the electronics industry in general, to become much more dominant. It also allowed for competitors and competition to use some of this new technology in a way that eventually threatened the monopoly of the phone company as well.

Jon Gertner:

Well, for sure. William Shockley was handpicked, Bill Shockley by this fellow Mervin Kelly to help lead the transistor or the solid-state team. Together with Shockley, Walter Brattain, and John Bardeen, two physicists came up with the invention in December 1947. That was the first transistor.

Eventually, I think it's important to note the first transistor wasn't actually that useful. It was very hard to make, and it had certain limitations as a technology. Bill Shockley came up with other ideas for transistors junction transistors as they were called. Eventually, they became much more crucial to the electronics industry as well.

What I think changed things as much or more is that eventually Bill Shockley left Bell Labs and went out to the west coast to California. He was really one of the first-ever to say, "I'm going to become an entrepreneur." You can look at Hewlett-Packard and HP before him, but it was a little different.

Shockley left the east coast, which in the U.S., is almost like a symbolic transition. Leaving the east coast to go to the west as an entrepreneur, as this world-renowned physicist who had won the Nobel Prize to start a company, the first transistor company. He started it on some land at Stanford University that was developing as an incubator.

He created something called Shockley Semiconductor. For those who don't know this history, it's the very history of technology and entrepreneurship. Shockley was a very difficult man with all sorts of strange ideas about race and intelligence. Objectionable ideas really, but he was actually really good at hiring people.

His first company really hired people who became the entrepreneurs of the transistor age or the integrated circuit age. These were people he hired for instance, like Moore, who created Moore's law that created the companies like Intel, that created venture capital firms, like Kleiner Perkins.

That really seeded the companies that created the information age. Now, there was another company, Texas Instruments that grew out of the transistor work down with Kilby. There were other companies, but all of it, I think if you were drawing a family tree, for instance of how the transistor and how the information age began, it really begin at Bell Labs.

It would branch off from there into Shockley Semiconductor and Texas Instruments, and eventually Fairchild Semiconductor, which grew out of Shockley's company, and then Intel. Then, of course, the modern-day. Does that answer your question a little bit?

Gennaro [FourWeekMBA]:

Absolutely. You touched on all the key points. Also, I want to emphasize as I was listening deeply to what you were saying. From the ashes of, let's say Shockley's attempt to become an entrepreneur, how all industry was born. As we said Shockley was this character was a very smart person. He actually built our whole industry.

As you said, he was very, very good at picking the right people as would turn out later on. Another point is also that for the first time, there is this transition from being a physicist to becoming an entrepreneur because let's remember that before if you were a scientist, a physicist, you just wouldn't go out and try to become an entrepreneur.

Also, this transition that Shockley did I think was very important also to open the way to many others going forward to actually know that it was possible to get out from research and just become an entrepreneur. I think it's a very important point. He did that in what would, later on, become Silicon Valley.

As you said, just to emphasize a little bit more the transition because it's so important. Shockley of course opened up his own shop in California as you said building up Shockley Semiconductors, which would eventually pick up the right people, but completely fail also probably for lack of leadership on the side of Shockley or the fact that as your account in the book, it was very focused on the technology that he created.

Probably, he didn't actually focus on how this technology could evolve behind what he had envisioned. Also, as we said, from Shockley from the ashes of the company that Shockley created, other companies like Fairchild Semiconductor came up. Then from Fairchild, we had those people like Moore, Noyce, Henry that then, later on, created the Intel.

As we know, from Intel, of course, there was the first family of chips, which was the 4004 family that opened up the whole industry. We have all of a sudden people like Paul Allen, co-founder of Microsoft, acknowledging how that family of chips that Intel created was a huge deal because all of a sudden you could develop an operating system on top of a semiconductor of a chip, which before was not possible with the previous technology.

There were a few jumps after that and a few technologies that we actually developed that exponentially increased the ability to make those semiconductors. Also, as a side note in the show, I'm going to have also Federico Faggin as a guest, he was one of the leading team members of Intel who made the family of chips that later on would become extremely important for the old development of the industry.

I wanted to emphasize a little bit more because what you said was so important that it just created the whole Silicon Valley as we know it today.

Jon Gertner:

It's a really important point because in some ways the book is about technology, but it's also about how innovation leads to these economic upheavals and how these innovations, I should point out that they're not just inventions, they're what I call in the book platform of innovations. They revolutionize entire industries.

When you think about the implications of them and the wealth it creates the number of jobs, it's quite staggering. To write about Bell Labs or to read about Bell Labs, it's more than just saying, "This is how the transistor is made." It's also, I think or I hope at least to understand how economic revolutions begin in some ways.

Gennaro [FourWeekMBA]:

Also, another key point, which one thing is actually invention another is innovation and where you can actually probably patent as it happened inventions, it's very hard to actually patent innovations because innovations are the result of many things combined together many inventions.

Also, processes that go behind the technical aspect, which are about also the ability to scale, distribute. Innovation, it's something completely different from invention, which is something primarily technical. I think this is also a very important point, which you made me think about right now.

Moving forward, it's interesting also to look at one invention that Bell Labs came up with, which was the picturephone. 

Jon Gertner:

Bell Labs, I mentioned a bit of the successes, this lab that changed the world. I think a big part of Bell Labs too was that sometimes it failed and sometimes it made mistakes. Sometimes the people at Bell Labs whose job or at least as they saw it was to try and figure out what the future would be figured it out incorrectly.

Going back to the '50s and 1960s, there was this belief at Bell Labs that eventually telephone conversations would evolve into video conversations. The technology really wasn't ready, but they would debut these early prototype video phones, for instance, the world's fair in the early 1960s. By the early 1970s, they were ready to turn this idea into a business. It was called the picturephone.

The idea was really that they would sell these fairly high-priced subscriptions to businesses. They perceived a really large demand for this. That companies in the future everybody would want to look at the person they were talking to. Companies would pay high prices. Everybody would have a picturephone in their office, maybe at their home as well.

They started marketing this. They put in really hundreds of millions of dollars, which would probably be somewhere in the billions today into developing this technology. What they found was that it was a complete terrible failure of a business. The technology was actually pretty good at the time. I mean, there wasn't really the bandwidth by any means that we had today.

There were limitations on the picture and the quality of the image, for instance, but it was a colossal failure. I think we can learn a few lessons from it. One, that if we look at it today where we're having Google chats and Zoom meetings and everything, the general idea was, was correct that eventually, video chats would play a very large part in culture and business.

One, if you're too early, you're wrong and you have to hit a moment that the culture is ready for it. Two that this, I guess you could say pushing of technology without understanding demand can be very dangerous sometimes. That sitting in a room and deciding that the future of technology is going to go to this place that I envision is a very risky pursuit.

The engineers and the marketers of Bell Labs were completely shocked. They just didn't understand, eventually, they did understand bitterly what a failure it was, but going into it, they didn't understand how little demand there was for people to see each other on the phone.

Gennaro [FourWeekMBA]:

Also, as we said, this is a matter of invention versus innovation. Innovation is also based on economic incentives. Those oftentimes also come as a top-down approach where, for instance, if let's say there was also a push from the government to actually go toward mobile communication or this sort of communication, then it would've been possible to achieve, develop this market let's say in probably 10, 20 years, who knows.

It's important also to highlight that instead at the time, also the government was more focused on broadening the TV, broadcasting rather than focusing on mobile. I think it's very interesting because, in the '50s, there was also this decision of the FCC to actually award the block frequencies to broadcasting TV, rather than giving those frequencies to mobile communication.

Which probably would've helped definitely to launch more successfully the picturephone, which as we can tell from today's standard is actually pretty, pretty successful. We have video calls as one of the main applications of mobile communication, but at the time there were no economic incentives developed that would help them to develop these markets quickly.

Innovation is also a lot about market development, it's something that you can control or you can't. You need to understand whether you can move forward. Just to get to the end of it as the time is almost due. 

Jon Gertner:

I see it on a smaller scale to some extent, maybe companies like Google that have labs like Google X, for instance. I think Bell Labs was a particular moment in time. It was the right industry at the right moment. I don't really see an R&D lab with that same ambition, the same amount of money, same long-term focus.

That's not necessarily a criticism, it's just that Bell Labs was not really operating as a private sector technology company would. We have something different today, at least in the private sector. You could say, for instance, in the United States, we have these national laboratories that are looking at long-term research and projects, but then again, they don't have the manufacturing capacity that Bell Labs had, so those are different too.

In a nutshell, I don't think there will be another Bell Labs, but I think if there's some kind of future where we see a great concentration of scientists and engineers working on some difficult problems, I think it might resemble more maybe like a Los Alamos model where there's a crucial intensive period of work that happens.

It might be to solve the next pandemic. It might be some terrible problem I don't want to think about, but I think, for the most part, we don't see Bell Labs at that scale or that kind of level of funding. We might see for the moment are these smaller labs working in the private sector.

Gennaro [FourWeekMBA]:

I definitely agree that some of the similar environments, of course, are Google X, which is also called the Moonshot Factory as Google has a huge amount of resources. They also look at exponential technologies. On the other end also one, bet on my side is also companies like SpaceX as well. As a fun fact, the company also is experimenting with a lot of new technologies. 

Also, as the last fun fact, as you mentioned in the book, the Bell Labs developmental rather up on a small island Atoll, which was called Kwajalein. This is also the same place where SpaceX built its first rockets. There is some coincidence there.

Jon Gertner:

I think your point about SpaceX is a good one. They aren't really operating purely in the private sector. They have NASA investing in them as well and it's been very helpful for them to achieve a long-term vision.

Gennaro [FourWeekMBA]:

Thanks, Jon, for joining this conversation. 

Jon Gertner:

That's a great question. I'm actually writing. Just starting the third book on long-term thinking, but I'm focusing actually on a NASA mission from the 1970s called Voyager, which is the longest space mission ever undertaken. It's still going. It's going to reach its 50th anniversary in a couple of years. I hope my book comes out right before that.

Gennaro [FourWeekMBA]:

Nice. It would be nice to have you, of course, when this is ready. I'll be extremely to read the book because I enjoyed it so much the Idea Factory. Thanks for taking the time.

Jon Gertner:

Thank you, Gennaro. It was a pleasure, great questions. I really appreciate it.

Gennaro [FourWeekMBA]:

Thank you. Appreciate it.

For this episode, I interviewed Patty Civalleri, an author at 1-TAKE Publishing LLC. She authored many incredible travel guides. And she made sure the memoir of Joe Coulombe could come to life!

Becoming Trader Joe: How I Did Business My Way and Still Beat the Big Guys



Patty Civalleri:

Yes. I got involved in the stories socially and Joe had written a journal about the founding of Trader Joe's and he held onto it and made changes over the years, and one day he found it in a box and didn't know what to do with it, so he gave it to his first employee Mr. Leroy Watson, who is a very close friend of my husband. And because we've been friends with Mr. Watson for many, many years, I have met Joe socially, gosh, many times over the last couple decades. So when Joe asked Leroy to do something with this book, Leroy came to me and he said, "Patty, you have published many books, can you help us do something with this book?" And I had written many books about Italy for travelers being a historian and Italy has the coolest history in the world.

I took a look at the manuscript and I fell in love with Joe's story, what a great story. So I looked at it it was very raw, it needed a lot of work, so I spent many months bringing the manuscript, cleaning it up and making it work and rearranging everything. And I sat down with my agent and said, "Paul, can we sell this manuscript?" And we got several bids for the manuscript, but the winning bid was from HarperCollins, one of the largest American publishers in the world and that's how we got the story published.

And as soon as we signed the contract with HarperCollins, the following week Joe passed away, which was a very sad event, and left me wondering how on earth I was going to promote this book without Joe, because he is clearly the center pin of all of this. But I realized that since Joe's passing it's much more important now to get his story out and get his history out, so that his story is not lost to history and doesn't get lost. So the book was published late last summer and it's gone global, we're so extremely happy with it and it looks like a book that's going to be around for a long time, so we're quite happy.

Gennaro:

Yeah. As I was telling you I'm very glad that the book came to life because it's an evergreen, the story it's very compelling, it's contemporary, the way it is written it's very practical. For a digital entrepreneur as well, looking at the story behind how you create such a valuable brand, it's incredible, so thanks for putting this together. How were the first and early years before we get to Trader Joe's because the story before Trader Joe's would come to life there is an evolution to that? 

Patty Civalleri:

Joe was born in Southern California on an avocado farm, avocados grow very well here in Southern California, but Joe went to Stanford University and got an MBA at Stanford. And right out of school Joe got his first job with Rexall Drugs, which was a large pharmaceutical retail company here in the United States at the time. And Joe was very bright and had quite a compelling personality, and he got the attention of the executives at Rexall very early when he was working there, and they adopted Joe and took him under their wing and groomed him for executive management, which is incredible because you learn a lot more in real life than you could ever learn in school, in a classroom, and every entrepreneur knows that. Joe was called into the executive offices one day and they said, "Listen, Joe, we have funding for six stores and we don't know what to do with these six stores, so we want to send you around the United States to go find a model that doesn't exist here in California, but that could work here in California."

So Joe set off for a couple of months on a road trip and visited many different types of retail stores. When he finally got to Texas he found a chain of variety stores that were all over Texas and doing very well. For those that don't know the American definition for a variety store is sort of a small footprint store, that you can just run in real quick and run back out, that you could buy anything from paper towels and toilet paper, to cereal, to olives, to beer, dog food, everything all in one small store, they're convenience stores basically. And California didn't have that kind of convenience variety store, so he brought that idea back to Rexall and Rexall said, "Okay, Joe, we can open six stores. We're going to give you 49%, we're going to retain 51%, and you open and run and manage and grow those stores."

So it took Joe a couple of years, but he managed to open all of them and he opened another one, a seventh store, which was 100%, his own store. Those stores were called Pronto markets, pronto meaning fast. And it's a place you could just run in and get something that you need very quickly and run back out again, so Joe started and ran those, and by 1958, they were open, they were doing well, and Joe had a good plan for them. So Joe went back to Rexall and said, "Hey guys, if you let me buy out your 51% at market cost, I would like to be the owner of 100% of Pronto Markets." And Pronto responded, "You pay us 10% over the market and they're yours." Well, now Joe really didn't have any money, he didn't have two nickels to rub together at the time.

And so he went to his employees, he used very creative financing, he got some loans for part of it, bank loans, part of it, he got from his employees where Joe had created tremendous loyalty with his employees. So when Joe went back to his employees and said, "Hey guys, we have the ability to maybe own this company, all of these stores, would you guys like to buy in as my partners?" And he got a lot of partners to step up and put up the money and it was wonderful, because creative financing and employee loyalty is huge. He also got money from a company, a dairy called Adohr Farms. Adohr Farms was a dairy company. Back then the dairy companies had milk trucks and the milk trucks would come to your home and deliver all the dairy products, milk, eggs, cheeses, those kinds of things, and they would deliver them to your home once a week or however often you wanted them to deliver.

And one of the major brands back then was called Adohr Farms, which was run by a guy named Merritt Adamson Jr. And Merritt had been trying to get Joe's business for several years, he wanted the Pronto Market business, he wanted Joe to carry Adohr Farms on the shelves in Pronto Markets. So when Joe needed this money to buy out Rexall for the Pronto Markets, he went to Merritt and said, "Hey, I need some extra money. I'll tell you what, let's make a deal. If you give me a loan I will carry all of your dairy products, so that we can grow together. As my company grows, I'll be paying back the loans and I'll be buying your milk products from you."

And they shook on it, they shook hands and made a deal. And so Joe was able through these various ways to bring the money in to buy out Rexall, which was really great. So now Joe has seven stores. He has seven Pronto Markets, they're healthy and they're young and he has a plan. So over the next few years he grows them and grows them more, and in the 1960s he now has 16 stores, this is the late 1960s. He's up to 16 stores and he's got a lot of his own blood, sweat, and tears invested in the growth of the company. One day he and Merritt were sitting down having a cocktail and Merritt told Joe that he had bad news for Joe, that the company in Texas that had all of those variety stores found a way to change their policy to be able to open stores in California.

Well, that brought a chill up Joe's spine because he knew that that company had a giant, giant bank account and a giant marketing budget. And that this company was going to come to California and roll over Joe like a truck and Joe didn't know what to do, he knew with his little 16 stores that there was no way he could stand up to those stores. So he felt he had two choices, he could either try to stand up to those stores but eventually die a slow, painful death, or he could close his business on Monday morning and call it a day.

Gennaro:

Yeah. And that would've been an easy solution also because just to remind the audience, the company that you're talking about was 7-Eleven, which at the time-

Patty Civalleri:

Yes.

Gennaro:

7-Eleven was a giant. Compared to the Pronto Markets, which was just a bunch of stores, a few stores that of course were successful, and they had grown into also successful customer clients for the company owned by Merritt, which was the first real partnership that Trader Joe... actually Joe Coulombe had in place. But what happened next? Because, okay, as you said we went from the '50s to the '60s, there was this idea of Joe Coulombe to start a set of markets based on the idea of 7-Eleven, which was in Texas and other states, but was not yet in California.

Also, it's important to remember the context we are in after a Second World War period, where there were still a lot of regulations that limited the supply of some of the goods that many retail would be able to sell. So there were a lot of barriers to entering this industry, and this definitely helped initially Joe to get started. 

Patty Civalleri:

It's funny, Joe is a very visual man, when you would sit down to have a conversation with Joe, you can see him, he would always look up and you can see that he was envisioning whatever topic you were talking about, you could see that he was watching it in his head, he was a very visual human being and so he would always see pictures and images in his head. Well, this particular weekend when he just didn't know what to do, and he felt very threatened, and should he close down or die a slow lingering death, he felt those were his two choices. He gathered his wife and children and they got in the car and drove up to a mountain in Southern California for the weekend, and he just closed the door just to think, he just wanted to think.

He was scared to death. He knew he was going to leave everything and he was going to lose his loyal employees, he was going to lose his vendors, he was going to lose everything that he worked so hard for over the last 10, 12, 15 years, and so he was very scared. And as he sat there, he started thinking about a ride that he took at Disneyland with his family. And it was a Pirates of the Caribbean ride, for anybody that's ever been to Disneyland I'm sure you might have experienced that ride. But that memory came back into his head and he started to think about a movie that he had recently seen about these old ships, these old sailing ships from the 1700s that would travel around the world with their big beautiful sales.

And they would go from port to port buying goods and selling goods and trading food and goods everywhere that they went. And he looked down at the drink that he had in his hand, his wife had made him a Mai Tai and back then Mai Tai's were very popular, they were this little tropical drink with an umbrella in it. He started thinking that these drinks, which were very popular and everybody was drinking them in the United States, but were created by a bar called Trader Vic's. But all of these images were floating through the air in his head when it hit him, it hit him like a shopping basket in a parking lot, it hit him hard. He got this idea and he went running back down the mountain and gathered all of his troops together in the stores and said, "Guys, I know we talked about two options," he said, "but I have a third option. So the two options we discussed on Friday were either to stay alive and fight it out and die a long slow, bloody death or to close down on Monday morning."

He said, "I came up with a third option. Here's what we're going to do." He said, "We're going to change everything. We're just going to change all the rules, that's what we're going to do, we're going to change the playing field, and we're going to change our name to Trader Joe's. All of our employees, we're going to act like those old trading ships, that go around the world and buy and sell foods and groceries and items from all the different countries in the world. We're going to dress like Hawaiian shirts, and we're going to adopt a Tiki Polynesian theme in all of our stores."

And he said, "We're going to change our name to Trader Joe's, and we're going to completely go away from the variety store model and we're going to go into a Trader Joe model, and we're going to create our own model as we go." And that's what they did, they did it. So with the 17th store, which was going to become the 17th Pronto Market, that became the first Trader Joe's. And then one by one, he converted the old 16 stores, one by one, the old Pronto stores into Trader Joe's and that's how that part of the story happened.

Gennaro:

Yeah. And he managed eventually to buy out his first partner, which as you would account in the book actually inherited such an incredible piece of land in California that would eventually be Malibu in Los Angeles, so the whole story seems like a movie. Trader Joe went through a few phases that made the company evolve, this was not... The whole period for a little bit of context, we're in a time where there are not really private brands in the retail space, and we are in a time in which both radio and TV are actually gaining traction, and therefore they're becoming a sort of mass media, which for the first time enables companies to communicate at scale and produce a single message for many people, and gives the ability to whoever can leverage this message to build a brand which before was something that didn't exist. 

Patty Civalleri:

Oh, okay. Trader Joe's went through several phases, but as you said, radio and television in the '50s and '60s were really coming online strong. And most of the major brands owned a lot of the advertising space, which allowed them to grow to phenomenal, phenomenal brand sizes, just huge. Well, that was again a huge obstacle for Joe because he didn't have that kind of budget. So he had to come up with a philosophy of how can he compete with these giant grocery brands and product brands? How could he compete against them with no advertising budget? How could he be the little guy and how can he attract people and gain trust, to get people to come in his door rather than going into the large trusted brands on the corners, the large supermarkets that were popping up everywhere at the time and that was a huge question.

And what he realized very early on in the process was that he needed to come up with a strategy of differentiation. In other words, he thought, "People are not going to come into my store because I'm going to carry all the same products that the large supermarkets carry. People are going to come into my store because I'm different, but how can I take that concept and make it truly different?" And he came up with what he called his pillars of differentiation. And so this is the underlying philosophy that happened behind the three phases that you were talking about, so if you don't mind for one second, I'd like to go into those pillars of differentiation-

... that sort of underlies all the phases. He says, "Okay, how can you differentiate your products from somebody else? If I have to carry milk, how can my milk be different? Or if I have to carry eggs or cheese or bread, how can I make my products different to make people come into my store rather than go to the supermarket, the major brand supermarkets." So he came up with these pillars of differentiation, he decided that you can differentiate your products, assuming you're carrying similar lines of products, you can differentiate based on price, that's the most obvious one, you can just lower your price.

Well, that's all fine and good, but Joe didn't become known as the cheap store brand, the discount cheap store brand, he wanted to still be able to... He wanted customers, consumers to perceive a quality about him, so how could he lower his prices and still have quality? So his next area of differentiation is about packaging, you can change the packaging. And by changing packaging, it's not just about changing the labels which he did, but also by changing quantity. See back then most of the stores carried 50-pound bags of flour. Well, a lot of people at this point were moving into apartments, post World War II college graduates were moving into apartments, they weren't buying homes. So they didn't have room for things like 50-pound bag of potatoes and a 50-pound bag of flour and a 50-pound bag of rice, they needed to buy things in smaller quantities. So Joe got the idea of taking a lot of the staples that the grocery stores carried and creating small packages for them so that people would come back to his store often, but they were able to buy smaller more manageable quantities.

Another area is ingredients, so what if he was able to slightly change the ingredients of some of the products, maybe make them a little bit more wholesome, a little bit more natural. He had an advantage in that back in the '70s, '60s, and '70s, the big brands were touting science as being the reason why people should buy their products. And there were large companies like Monsanto and huge giant brands like Swanson frozen TV dinners, which were just horrible, my mother would never buy them, but these were the big brands. The Big Swanson frozen food brands, the Del Monte canned vegetable brands with hormones and preservatives, all of these big brands were scientifically created, and those in America at the time were considered the trusted brand.

And Joe was thinking, "No, what if I came up with a way to can corn without hormones and preservatives. And what if I came up with a way to flash freeze products so that they didn't have a lot of preservatives and would be just really disgusting foods in the freezer." And so over time, he came up with these, so again, his pillars of differentiation were pricing, packaging, ingredients, and of course uniqueness. And that's where he would send his buyers around the world to find you unique products that Americans had not seen yet, so those were Joe's pillars of differentiation, pricing, packaging, ingredients, uniqueness. Now talking about the three phases, the growth phases that he went through, he first went through something that he called his Good Time Charlie phase, which was the original phase of Trader Joe's.

And originally coming out of Pronto, he was thinking in terms of he'd like this to be where every man could go to the grocery store, where back then grocery stores were really for women, so he wanted to carry things that would attract men into the store. Things like girly magazines or bullets for guns, or cigarettes, whatever, things that guys would buy, in addition to all the groceries. And then the phase in the United States came in the late '60s and early '70s, we sort of call it the hippy-dippy period, where everybody went back... they started to realize they didn't want to eat these preserved foods, they didn't want to have hormones and chemicals in their foods, they felt it was important to go back to the earth.

And so going from the first phase, which Joe called his Good Time Charlie phase, that was the story that he wanted to attract men, it sort of evolved into the second phase, which he called his Whole earth Harry phase, and this was Joe's hippie-dippy phase. So Joe started growing squash and pumpkins in his backyard, and he started creating relationships with farmers around California. Now California is a very similar ecosystem to Italy, so California and Italy have a fresh farmed environments in common.

And California was bursting with freshness and fresh fruits and vegetables and meat and produce and dairy products that Americans weren't used to eating, they were used to buying the convenient frozen preserved foods from the big major "trusted brands." So Joe felt that no, no, no, no, he wanted to create what he called his Whole Earth Harry phase, which would introduce the public to much more natural brands and more fresh farm to table philosophy and products. At the time it didn't go well, most of America looked at this philosophy as being the hippy sandal-wearing store down on the corner, this Trader Joe's that never carried the big trust in brands. But Joe stuck to it, he was on the right track, slowly over time people started getting educated about what they were eating on the scientific side and started wanting to feed their family more natural foods, and that really did help Joe grow his Whole Earth Harry phase.

As he grew through the '70s, Joe sort of got older and sort of outgrew his own Whole Earth Harry phase and grew more into his business phase. Now, this is the phase that Joe really started taking a close look at the bottom line where every product on the shelf had to earn its own profit, each product on the shelf had to be profitable. He refused to carry products because the vendors were telling him that they were the big brands and they could dictate to him what to carry like grocery stores did. If he said, "Hey, I only want one product. I'm going to carry only one product. I'm not going to carry 30 products or 40 products that aren't profitable to me. I want every square inch on my shelves to be profitable."

And that's where he sharpened his pencil, and that's the phase of his store that he called Mac the Knife, it was a very aggressive business approach to groceries, now that he had defined his market, defined his customer base. Now his pencil was sharp, this was called Mac the Knife and that was his real sharp business phase of Trader Joe's.

Gennaro:

Wow. And this is so contemporary also because a few like a couple of key points based on what you said so far. First of all, of course, there was this evolution where Trader Joe's started to invest a lot on creating a new category of retail, which was completely opposite with what existed at the time where you had those huge brands, which were completely let's say artificial and they leveraged primarily mass media extremely well, and they had a huge budget and they can reach a lot of people. And then there was the Trader Joe side where Joe said, "Okay, I want to create something which is based on quality, where I'm going to be able to create my own also brands within my offering." And he actually started from a niche that eventually would end up becoming quite a huge market, which was what he called over educated and underpaid.

Patty Civalleri:

Yes. Going back again to the early days, we were coming out of World War II, the United States had a veteran's plan where if you were a veteran, a military veteran in the United States, one of your benefits would be that you were able to get a college education, very, very inexpensively. And for the first time, the education level in the United States, if you look back to the 1930s during the Great Depression, the education, the number of people that were getting college degrees was very low, it was under 10%. And because of this what was called the GI Bill, the veterans were able and their families were able to get a much higher education and get college degrees. What this meant was now in the '60s, you now had 70%, 80% of Americans with the ability to get college degrees, which was it changed everything.

And it created a whole new brand of consumers as a direct result and these consumers because they were educated, they were getting better jobs, they were getting better pay, they were traveling now, it created the first line of travelers. During this period, Boeing, the airplane manufacturer, Boeing was releasing it's 747, and with that, they were severely dropping the price of international travel. Well, guess who was the first crowd to be able to step aboard the 747s to travel the world, it was these educated people. And Joe had a term for these people, he called them the over-educated and underpaid because all these people were getting an education, but the United States wasn't set up yet to accept... they didn't have a lot of high-paying jobs for educated people yet.

So you had all these people that could be orchestra conductors or college professors or teachers or executives, but they weren't getting paid a lot of money, but they had great taste, they were experimenters, they wanted to know more, they read about what people were eating and doing and how they were living in other parts of the world, they didn't want these preservatives that Americans were eating and all of this today we call junk food, they wanted getter foods, they had a better appetite.

Joe saw this group as a growing group that he identified as his overeducated and underpaid, and these were the people that Joe decided he wanted to create Trader Joe's for. He didn't care much about families that had kids, he didn't care much about pets, he didn't care much about anything. What he cared about is he wanted this educated group of people to be the ones that walk into his store, because they were dissatisfied with what they were getting in the major grocery brand stores on the corner and that was his market. And what a great choice, because what he was identifying was what we now call the middle class. Well, back then there was very little middle class, and as you know it was that burgeoning middle class that grew into a giant that was America in the 20th century, so he was right on when he saw that.

Gennaro:

Wow, so for a bit of context, as we said, the evolution of Trader Joe's was quite interesting because he eventually managed to actually target a market that initially was niche, which was the market of the overeducated and the underpaid, which as you explained, that this would become the U.S. middle class. But going forward what happened next? I think there is an interesting aspect actually, which is an evergreen aspect that I found in the book also as a digital entrepreneur. There's one thing that Trader Joe's used over the years to grow its own brand, which was the Fearless Flyer, which was sort of a publication or a newsletter if you wish that Trader Joe's was sending out to its audience. 

Patty Civalleri:

Oh gosh, those are some great stories. I'll tell you some of my favorites, how to differentiate, these are great examples when you have to carry something that somebody else is carrying, how to make it different. So eggs, we're going to take eggs because eggs are one of those items that are impossible to differentiate because an egg is an egg. But Joe being Joe, see Joe see the world differently, he had to still find a way to make an egg different. And of course, he did consider square eggs, but he couldn't get the chickens to cooperate. Hi there. And so he did consider square eggs. But what he did is he realized that at the time eggs were regulated by the government, by the dairy consortiums. And so being regulated meant that all stores had to sell eggs of a certain size, they had to be packaged in cartons a certain way, and they were priced at a certain price and that's what regulation is.

Well, Joe is thinking, how can I get out of that because my customers need me to carry eggs. So he found a farmer that had different eggs of all things, not square eggs, but eggs that were a different size of eggs. And because they were a different size, they were not regulated, they didn't have to be regulated. And there was not enough volume of these eggs to supply the entire grocery industry, but there was certainly plenty enough to provide for Trader Joe's. Well, guess what that allowed Joe to carry eggs differently. And the eggs, what was different is they were not what's called medium size eggs that the rest of the grocery industry was carrying, these were extra-large eggs. And Joe was able to negotiate such a price that he could sell extra-large eggs for the same price that the rest of the grocery industry was selling regular-sized eggs, or medium-sized eggs.

And that was enough to get moms to step foot in his door, but again, that was Joe thinking a little bit differently. Another area was cheese, his customers wanted cheese, everybody wants cheese, but again, the dairy industry had regulated cheese. So you would carry a cheddar cheese and maybe a Jack cheese, a Swiss cheese, but how do you make those different, when the dairy industry is telling you what cheese you can carry, how to package them, how to price them, where to get them from, et cetera. So again, Joe had to think of this differently, so he sent his buyer, Mr. Leroy Watson to Europe to go find cheese and Leroy found Brie in France and brought it back to the United States. And what they did is they negotiated Brie at such a wonderful price and it came by the trainloads out to California.

And Joe was able to sell Brie at the same price that the grocery stores were selling, well, it wasn't even cheese, it was called Velveeta and it was a processed cheese food, they couldn't actually call it cheese. Today Brie is such a loved brand and Trader Joe's became the biggest seller of Brie cheese. Another one of those stories, again, in the cheese category is Swiss cheese. Again, he was told how to carry it, how to package it, whatever, and he didn't want to have anything to do with that, so he sends Mr. Watson back to a Swiss cheese factory. And as the guy was cooking in this big vat of cheese, the heat is coming up from the middle of the bottom of the vet, so the middle cheese in the vet was bubbling, but around the edge it wasn't bubbling. And the man would take this bubbly cheese and he would pour it into a cold mold that would set the cheese quickly while the bubbles were still in the cheese, and that's why Swiss cheese has holes in it.

But Leroy says, "Gee, what about the cheese that's around the edge, what do you do with that?" And he says, "Well, we call it grade B cheese and we sell it to schools and anybody else that wants it." And Leroy said, "Is there anything wrong with the cheese?" And the man said, "No, it's perfectly good cheese, it just doesn't have air bubbles in it and Americans want bubbles in there's Swiss cheese." So Leroy said, "Would you mind if we bought it?" And so they sent this cheese back by the tray loads to California and Trader Joe's packaged it in small packages and they renamed it, they called it Trader Joe's Closed Eye Baby Swiss and it sold like crazy.

But these are ways that Joe could carry the same products as everybody else, but still, be different. And if your business is a product-driven business or a service-driven business, it doesn't matter, if you can think of ways to make each of your individual products or services slightly different than your competition, you will very quickly, if you can stick to that, that philosophy all by itself is what created Trader Joe's because of that differentiation. And then of course he private labeled, he private-labeled because as Joe used to say, you could hide a myriad of secrets behind a private label.

His competitors couldn't tell what the ingredients were, what the recipe was, his competitors couldn't tell where he bought the product from, who the vendors were. So therefore they couldn't tell him what price to put on his products, so he would have products that were equivalent, if not healthier than the grocery stores selling for less expensive and a much better variety. So he really liked the idea of private labeling because you can hide all of your company secrets behind that label.

Gennaro:

Yeah. That's the incredible aspect of that, he managed to actually build a different kind of business, and the way it was done at the time it was completely different. And there was a way to differentiate which was much easier, which was about distribution and lowering the price, but this is not what Trader Joe's did, he did quite the opposite. So they found ways to bring high-quality products on the U.S. market and make them very, very affordable, so there was a perspective that was not easy to build over the years, but Trader Joe's managed to do it. So those are some of the things and the stories that you told us that are very, very interesting. And there was also another aspect of Trader Joe's, which was intensive buying coupled with what he calls virtual distribution.

Patty Civalleri:

Yes. Intensive buying was a philosophy that Joe created and it housed several aspects, the first one is what he called honor thy vendor. And by that, instead of treating vendors badly, many stores really do treat their vendors badly and they dictate everything to the poor vendor, who's trying to figure out how to get products and how to pay their own bills and pay their own employees. Joe felt the opposite, he felt that taking good care of your vendors, visiting them often was really a big deal. Visiting their plants, understanding their products really well. He felt that his buyers in the house should be extremely well paid, that his buyers shouldn't be there shopping on a computer for their products, they should be out in the field testing the product, discovering the products, traveling, finding, exploring, trying things new ways was very important to Joe, that his buyers were out in the field and he paid them well to travel around the world, to find new products, new foods and build new relationships with new vendors and build small companies.

Joe never liked doing business with large vendors and large companies, he felt that they were cold and impersonal, and if he couldn't look you in the eye and shake your hand, he wasn't interested in doing business with you. Joe loved finding small businesses, entrepreneurs, farmers that he could build new relationships with, but he cherished watching them grow because he felt they allowed him to experiment with his business and find new avenues of differentiation, and his gratitude was expressed by helping them grow. So he felt that level of intensive buying also intensive intervention, by intervention he wanted his chefs and his buyers let's say the product was, oh, I don't know, cereal, come up with some product. He wanted to know every ingredient that was in it, he wanted his chefs to make sure that every product was clean, every product was pure, clean, organic, no preservatives, no processing, but be able to shift things according to maybe how Californians like things or because everybody around the world has a different palette, Joe realized this, he wanted to be able to make sure that they can shift their ingredients just a little bit.

So he called that intensive participation in the manufacturing of the products and this created really great relationships because he was also providing new products for a lot of his vendors to sell to other stores and markets as well. In terms of this virtual distribution, the classic way that products came from manufacturers back then is that manufacturers would ship products via truck or train to individual stores, Joe did not find that to be a very practical way of distributing products, because there was a lot of trucks going into a lot of different directions. He also didn't want his store personnel to have to work with the vendors all day long, he wanted his store personnel to be dealing with the customers all day long, not the vendors.

So Joe changed things out, which made things a lot easier for the vendors and it gave Joe a lot of control over product distribution, and that was to create a centralized distribution, where he had one warehouse, where all of the goods came into one central warehouse and then Joe's own trucks, his own truckers would then go out on established routes to each of the stores bringing the trucks and this freed up his store personnel. But that also meant that the truck drivers they were also because they were part of Trader Joe's, they could go into the stores, they knew where to put things, they knew exactly where to put the pallets, where to put the cartons and the crates, that would make it easy for the store personnel to grab them and load them onto the shelves. So that was sort of a very fluid, very practical way to handle things within the store, and it freed up the store personnel to work directly with the customers, and that was kind of a really big deal to Joe.

Gennaro:

It's impressive because still today, one of the given-for-granted principles of business is that over time as you go through the process of vertical integration, you sort of create a monopoly in the market and this is towards in technology or digital business. And what happens is that you squeeze out your suppliers and this was not how Joe conducted business, this is impressive because it's so contemporary. And he was not looking to actually build a monopoly, he just wanted to build something extremely valuable for people, but he was also balancing out the value that he was creating for employees on the one side and for suppliers on the other side, which is something that today in a customer-obsessed digital business world is not very common, because as you scale you tend to focus too much on customers but then you squeeze out everyone else.

So it's very important to highlight that Joe was against management, at least for the sake of management he was pro-management if it could help to actually improve the product, but otherwise, he was not a fan of having too many layers of management between him and the main people and all the other stores. And also he didn't appreciate vertical integration also for the sake of it, because as you explain he added this concept of visual distribution that was one of the key elements of Trader Joe. So to get to the end of the story and thanks for taking the time you were very, very kind. Eventually, he sold the company. 

Patty Civalleri:

Yes. Joe saw a couple of things coming at the time he saw a... and he was very good, he was very forward-thinking, it's almost like he could see the future at least for a couple of years, so he was always on trend and on the mark. But one of the things he saw was inflation coming and it was something that he felt was going to be almost catastrophic financially in size and he felt he needed help, that he couldn't do it alone, that he would not be able to handle alone. And that he had had Trader Joe's for 20 years, and he had had Pronto Markets for 10 beyond that, he was getting tired and he felt like it was time maybe he should move on a little bit and slow down and spend more time with his family.

So he found Aldi, Aldi Markets, he didn't sell to Aldi, he sold of the Albrecht family, which owned Aldi Markets, but he sold to the Albrecht family. And Joe ended up staying with Trader Joe's 10 years after the Albrechts purchased Trader Joe's. And he stayed on for another 10 years as president and general manager of the company and saw it through many more changes in evolution all the way through the '80s before he actually finally retired from Trader Joe's. He didn't write these memoirs until the 2000s, his journal. And as he looked back, he asked himself, he said people ask him all the time does he ever regret selling the store?

And he says, yes, looking back, he did regret it very much, but he didn't know how to see past that big financial hill that he saw in front of him at the time. Wow. He ended up on the board of directors for many large American national retailers and influenced the way they buy, the way they sell, the way they pay their employees, the way they handle distribution. And a lot of these companies to this day, still, when you walk through the stores you could see Joe's touches in their stores. Really neat.

Gennaro:

Nice. And I was looking at an article from last year just to see at which stage is Trader Joe's, and of course, it's very interesting that in 2020 most probably the company passed 16.5 billion in revenue by 2020.

Patty Civalleri:

Yes.

Gennaro:

Which is an incredible number. The scale of the company is incredible and is part of the Aldi Group, as we said, which in Europe is a giant that probably makes more than 100 billion per year or something-

Patty Civalleri:

Sure.

Gennaro:

... like that. But it was such a great story. Thanks again, for making sure that the book came to life and this is inspiring and so contemporary, so thanks for taking the time, Patty.

Patty Civalleri:

Oh, Gennaro, it's been my pleasure, and thank you so much for inviting me, this has-

Gennaro:

Absolutely.

In this episode of the FourWeekMBA podcast, I interview Eric Berger, Senior Space Editor at Ars Technica since 2015, Founder And Editor of Space City Weather, and author of:

Liftoff: Elon Musk and the Desperate Early Days That Launched SpaceX

Gennaro [FourWeekMBA]:

Eric, thanks for joining this conversation. It’s a pleasure to have you in this session.

Eric Berger:

Oh, it’s my pleasure. Thank you.

Eric Berger:

Yeah, I mean, I’ve been covering space for a long time. I’m based in Houston, Texas, where Johnson Space Center is located. And so space is a big part of the fabric of community here. It became clear to me about a decade ago that the real future of space flight, at least in the United States, was in the private sector. It was at that point that SpaceX was just starting to take off. And then they’ve had really tremendous success over about the last five years with all the rockets they’ve launched, putting humans into orbit, and demonstrating reuse.

And so it was back in about 2018 that I realized that SpaceX basics was not just sort of a really interesting company. They were really transforming the industry and continue to do so. And I wanted to understand why they had been successful. And so I was wondering, is this because of Elon Musk or did he just get lucky? Is he really as involved as he says he is? And so it was sort of with the goal of answering those questions that I embarked upon the project of really understanding the beginnings of SpaceX.

Gennaro [FourWeekMBA]:

Yeah. Interesting. And for a little bit of context to the audience, because in this series, I also had an interview with the author of The Founders, which is a book about PayPal. And it’s a very interesting connection because actually when Elon Musk used the funding for SpaceX, it was actually the money that Elon Musk managed to get from an exit from PayPal. It was like around 2002 when PayPal was acquired by eBay, and that was what gave him actually the money to get started with SpaceX.

And the interesting notice also that just one or a couple years before Musk had been ousted from the company, because he had been like the CEO of the company, and then there was a sort of interesting story behind it because Max Levchin and David Sachs organized, let’s say, ousting of Musk from PayPal. And there is a whole story behind it, which is very interesting and we cover in the other episode. 

Eric Berger:

Yeah, I mean, it’s really interesting that he went from software into space flight, and then not too long after that, into electric vehicles. And I think the answer really begins with his unique personality. He is very much an engineer, and so he looks at the world, sees problems, and wants to solve them. And so I think after he’d sort of made it with PayPal in the sense that he was now sort of well off and could do the things that he wanted to do, he started to look around. And one of the things that had bothered him was the fact that we were a species that lived on a single planet. And so if something really went bad here with the plague, some kind of environmental catastrophe or an asteroid, we were pretty screwed. And so he thought that we ought to have a backup plan. We ought to become a space-fairing species. And I think part of it too was he reads a lot of science fiction and is inspired by the idea of civilizations that span multiple worlds, multiple stars. Right? And so he saw that NASA really wasn’t working to bring about that future. They were very much doing what they had done for decades, and that was not involving getting more people into space, going more places, and really sort of becoming a space-fairing species.

I was just going to say I think it was that big idea that got him thinking about how he might affect some change in that area.

Gennaro [FourWeekMBA]:

And of course, there’s an interesting fact that you recount in the book that actually, at the beginning, Musk thought that probably with more budget for NASA, this would develop them to actually speed up the process of going again in space, but actually figured that this was not the case. It was not a matter of actual budget. It was something else. I mean, what were some of the discoveries in the early days for Musk that actually led him to say, “Okay, now it’s not just me getting involved in understanding whether the industry can get more budget. It’s me getting involved personally with my mind, with my money, to actually get these off the ground.”

Eric Berger:

Yeah, that’s a great point. You know, from the outset, he thought that if NASA could get more money, then they could accomplish more things in space, like sending people to Mars. And as he did a little more research, he realized that wasn’t the case. First of all, NASA didn’t have a humans-to-Mars program anywhere on its books. And second of all, he looked at the launch technology that this country was using and NASA was using at the time, and these were basically rockets based on decades-old technology. It cost an enormous amount of money, and it just… As he told me in the book, these horses in the barn were lame that NASA was trying to use to do these programs.

And so he just saw an industry, a launch industry in particular, that was sort of stuck in place. The world around him was changing, right? This was the early 2000s. The internet revolution was at hand. With PayPal, he had helped to bring about change, moving the banking industry online, medical records. I mean, all of these things were happening with the internet, but the space industry was basically not changing at all. And he looked at this and said, “Okay, what is the biggest constraint to getting a civilization on Mars?” And what he realized pretty quickly is that it costs way too much to launch people and payloads and things into space. And so that became his first goal, was to develop some kind of reusable space transportation system.

Gennaro [FourWeekMBA]:

Yeah. And of course, coming out from the PayPal acquisition and realizing that in order for actually being able to change the space exploration industry, Musk needed to get involved personally. He actually started with a hundred million investment, which might seem a lot in some cases in the software industry, but it was not that much in the space industry. How did he manage… 

Eric Berger:

Right. So he looked at the existing launch industry and thought that it was really pretty inefficient. And so he came in with the idea of, “How can we do this for the least amount of money possible?” That was kind of the questions he asked his earliest employees. He asked Tom Mueller, “If you could build a powerful rocket engine, what’s the least amount of money you could do it for?” And he asked Hans Koenigsmann who was going to do his avionics and software, “Could you build a flight computer from off-the-shelf hardware with 10 or 20 people instead of a hundred or a thousand people?” And sort of these were the challenges that he set about. It’s like, “Let’s cut the bone and let’s cut this back to the bone, and sort of see… Let’s do things as efficiently and as ruthlessly as possible in terms of cost.”

And the other big thing that he did is he tried to build as much of the rocket in house. Like they tried to build the engines and the structures and all this stuff in their own factory. And this may seem, “What’s the big deal about that?” But it really was a big deal. 20 years ago, if you were going to build a new rocket in the United States, you would go buy your engines from Aerojet. You would buy your structures from someone else. And you would buy your payload faring from RUAG. And you would sort of just assemble the rocket. And so his idea was, “No, no, no, no. We’re going to see if we can eliminate as many suppliers as possible and do this in house.”

Gennaro [FourWeekMBA]:

And so it was definitely this sort of, as you explain, a vertical integration that helped SpaceX make this objective possible. And initially, as you also explain, it was more a matter of… Like it wasn’t just innovating the product. It was more lowering down the cost in an industry that instead hadn’t been able to do it in the last decade. So it was a little bit step also in bureaucracy and politics, of course, because we can imagine that if a program that was financed by NASA in the public space was failing, then of course, failure was a big deal. Instead, when SpaceX came along, it brought a different kind of approach. 

Eric Berger:

So, a couple of things on that I would say. First of all, one advantage that SpaceX had was that it was building the rocket it wanted to build. So, typically, the way things had been done before was NASA or the Department of Defense would decide it needed X amount of capability, and then it would tell the industry what design it wanted, what specifications. Then it would work very closely with industry, engineer to engineer, to sort of get that rocket built. And it was a costly, time-consuming process because you have to go back and forth. There’d be changes, blah, blah, blah, and all this government oversight.

What SpaceX said is, “Okay, no one is going to pay us to build this rocket. We’re not getting a government contract to develop Falcon 1. But that means we get to do it our own way. We get to develop the rocket we want. If we’re going along and we find something doesn’t work, we can scrap it immediately and move to a new design or change this part or that part.” And that allowed them to go much more quickly, much more leanly, and sort of without the bureaucracy that goes along with working with the government. So, that was one important thing. Now, that meant they were taking a financial risk. If they couldn’t find customers to fly on the Falcon 1 rocket, then they were going to lose a lot of money, because the development cost was more than a hundred million dollars.

The other thing they did is they had a few senior managers, like people who had experience. And so Musk was about 30 years old when he started SpaceX, and he hired a few people in their thirties who had experience in the industry. And then the majority of employees were people who were in graduate school or had just graduated, undergraduate engineers, basically, who were, 20, 21, 22, 23, 24, who could work long hours, were willing to work long hours. And so he went out to try to find the best and brightest students he could to build his rocket.

Gennaro [FourWeekMBA]:

Yeah, and those are extremely important points. As you said, first of all, SpaceX changed the whole industry by saying, “Okay, we are not going to develop those rockets according to your specifics. We’re actually selling you, let’s say, an outcome, which is the launches that you’re going to need in the future. But we are going to do it the way we want to do it.” So this gave them a lot of freedom in terms of development, design, and everything else. So they could really figure out how to make this possible at a much lower cost.

And another key point, as you said, as you mentioned, is that, yeah, SpaceX at that point really figured out how to make sure that it could lower the cost by also adding talent, talented people. But some of them were young people, of course, but some of them were also experienced, people. So Elon Musk actually managed to attract people that actually were coming from the industry but from other established companies.

Eric Berger:

Yeah. That’s a great question because there was a guy, Elon Musk, who had no experience in rockets and was coming into this industry talking a big game of lowering the cost of putting stuff into space, and blah, blah, blah. And this had happened before. Like people with money had come into California and tried this very same thing, and they all had failed. And so how did he manage to attract some really talented people, like Tom Mueller to do engines, and Tim Buzza to do his launch sites, and Chris Thompson for structures and Gwen Stockwell to do sales. And the answer to that is Musk is really a pretty charismatic person. And so, when you talk to him, you can see that he’s very committed to an idea.

And so he had this mix of money, right? He was willing to put a hundred million dollars on the table, and some of the early employees got a lot of stock and a lot of… You know, they got some guaranteed money up front. But he also had a pretty compelling vision and was able to sell them on it, and was there working just as hard as they were. So they could see pretty quickly that he was in the game too, right? He was not just sort of coming in, giving an inspirational speech, and then jetting off to Tahiti for three weeks. He was there with them in the trenches.

Gennaro [FourWeekMBA]:

Yeah. And there is an important thing to emphasize a little bit, which is, as you explained, SpaceX changed the whole approach of developing rockets by using a sort of iterative approach, what of course in the startup world is known as also a lean methodology, whatever we want to call it. But the main point is they manage to use a different approach from the linear approach that is used in the industry. 

But also this is not intuitive because, in an industry where hardware is extremely important, failing is not cheap, actually quite the opposite. It was pretty expensive. And indeed, as you explain also in the book, as they went through the process of figuring out how to make a successful launch, a few things also this iterative approach made them fail in a pretty miserable way. So it was not like all this beautiful thing where we apply the iterative approach and things work out. 

Eric Berger:

Right. So, the way that rockets and spacecraft are typically designed is some engineers will sit around and come up with a perfect design of the rocket, and then other engineers will review it. And they’ll sort of go through this big, long, preliminary design review. And then they’ll go through other designs. And then they’ll start building the rocket, right? And they may build a test version first, or they may not. But then they spend years sort of crafting this perfect vehicle.

The archetypal example of this is this space launch system, which NASA started awarding contracts on back in 2011. And they’ve been building this single, first, SLS rocket since about 2014. And now it may launch later this year, finally, for the first time. 

And they’ve had to go really slow with it because if they drop it or something and break it, there’s not like a second SLS rocket right behind it. Right? This is the final design, and it’s got to work first because there’s only one, and it’s going to take two or three more years to build a second one.

Okay, that is quintessential linear design. SpaceX has taken a much more iterative design approach. And that basically means that you build things pretty quickly early on in the design process because you want to test them out. And if they fail, then that’s okay because then you just come up with a better design, test it out, and try it again. 

And so you have to be willing to accept failure. That means components blowing up, rockets not succeeding on the first time out, to get to the final product. But then you typically get there faster, and you get there with a better design because it’s sort of been failure tested in a lot of different ways. And that’s iterative design.

And that’s something that SpaceX can do with a privately funded project because it’s their money. They can get away with it. 

And if it fails, as long as Elon doesn’t get too upset, it’s okay. Right? Whereas if the space launch system fails on its first launch later this year, then the world is going to be watching, and Congress is going to be saying, rightly I think, “We spent $25 billion on this rocket. Why did it blow up?” You know? And so that’s really the key difference.

And you see that. You see that, frankly, with the Starship project. Just like Elon Musk now has all of the money he could hope to have, we’re seeing his optimal design for building a rocket, which is building like 20 Starship protocol types. You know, there’s half a dozen rocket booster prototypes in south Texas. 

And some of them are going to fly, some of them aren’t, but they’ve learned a lot building these. And so it’s like the iterative design process gone mad to the point where SpaceX could build a rocket in a matter of weeks. Whereas NASA’s taking five to six years to build this first rocket.

Gennaro [FourWeekMBA]:

It’s a huge difference. And there is an interesting statement attributed to a recent venture capitalist in 2011, that software is eating the world. And now it seems to me that SpaceX is bringing this to space. 

So, really software is going to be eating space as well because pretty much it’s very important to stress out that this iterative approach is also translating in software that controls hardware at distance. 

So, which is the same approach that, interestingly enough, also Tesla uses. Because when you have a car like Tesla, a lot of it is hardware, but when you have a software update, you can actually control various parts of the car. So you can make the car different, like not a whole new different vehicle, but you can improve the product a lot just with the software update. And the same applies back to, I guess, rockets. And this is extremely important.

Eric Berger:

Yeah, just to sort of finish up the point you were making about software, first of all, I think that this kind of focus on iterative design, actually we can trace it to Musk’s roots in writing software. Because the basic idea is you write a program, you run it, you find the errors, you debug the program, and you run it again. And basically, you keep doing that until the program works. And that’s, I think, the same kind of mindset he brought to building rockets, and that really was a pretty innovative approach in the private sector, in the aerospace industry.

Eric Berger:

Anyway, going back and saying, “What were some of the signs that they were on the right track?” I think really one of their biggest successes was the first time they static fired the Falcon 1 rocket. So this means that the rocket was held down on the test stand, but they sort of lit the engine for about 20 seconds to simulate a launch. And this was in May of 2005, so just three years after the company was founded.

 And they sort of were on the test side in Vandenberg Air Force base in California. And they ignited the rocket, and lo and behold, they were ready to launch or get there. And that was really a successful moment. And up until that point, I’m not sure that the Air Force officials in California realized how close SpaceX was to be ready, because SpaceX had a green light to launch from there, and then basically after that static fire, the Air Force officials said, “Oh, you can launch, but you’ve got to wait for this other rocket over here on the next pad over to launch, and that may not be for six or eight months.” 

And so that was one of the reasons why SpaceX ended up not launching in California, had to go to Kwajalein in the Pacific Ocean. So that was like a success and then a setback right after that.

Gennaro [FourWeekMBA]:

Another important point, probably to emphasize a little bit as we move forward: It’s not like SpaceX was the first to try this out, to try to commercialize the space industry. 

Actually, there were other companies throughout the eighties and the nineties that tried to figure this out, but they actually were not successful. So, even when we look at the perspective on the other side, so let’s say from the Air Force or the NASA side, they were skeptical. 

They were right in being skeptical because they had seen this play before. There is also, I think, a change on the other side, so let’s say on the NASA side, toward SpaceX, by going from, “We don’t trust…” Not, “We don’t trust,” but, “We don’t trust that a commercial player can make it through, that commercial prayers can actually make it through.”

Eric Berger:

Right. So, one of the reasons I think why you have to look at SpaceX’s success is because of Elon himself. I think Tom Mueller, who was the vice president of Propulsion, he basically developed the Merlin rocket engine, which was the foundation of success for the Falcon 1, Falcon I, and Falcon Heavy rockets. 

He said he had seen a lot of entrepreneurs come along with good ideas about launch companies, and he’d seen entrepreneurs come along with lots of money and wanted to start rocket companies. But he felt Elon was the first one to come along who had both the right combination of money and good ideas.

And what do I mean by good ideas? Good idea being basically like, “What is a realistic first attempt for a rocket? If you were going to build a product that’s a launch company, where’s a good place to start, and what’s a good design for it?” 

And I think Tom felt that Elon’s idea of building a rocket that could lift about half a metric ton to lower-Earth orbit, pretty simple design in that it’s liquid-fueled engine first stage, one smaller engine upper stage, and sort of demonstrating that you could get to orbit with that was a pretty good concept. And so Elon started with a pretty basic idea and told his team to go execute on that. And so I think that they weren’t trying to get too crazy right off the bat.

Gennaro [FourWeekMBA]:

I think this is a very important point because when we hear stories from Elon Musk, we tend to look at those stories and the fact that he has such a grandiose vision as something that cannot be achieved. 

But it’s very important to highlight that the vision that, yes, it’s very practical. So it’s not like a vision that cannot be, let’s say. It’s a vision with an objective. So, as you explain as well, he wakes up every day trying to understand how you can lower the cost even more so that in the long term you can reach the target of going to Mars. 

So it’s a grandiose vision, but in the short term, there is a lot of practical-based objectives, which is extremely important. That’s what makes really SpaceX, I think, successful as well. 

Eric Berger:

Yeah, that’s a great point. And I think what I’d want to say here is that, from the outside, it may look like madness, but there is a method to the madness. Right? So the first step, as we talked about, was, “Okay, you want to be a rocket company? Put a rocket in orbit.” And so that’s what they did with the Falcon 1. And then, “Okay, you want to be a real rocket company? Build a medium-lift rocket that can lift, can carry stuff to the International Space Station.” And that’s what the Falcon 9 is.

And then you sort of get into Elon’s vision, which is, “Okay, to really go to Mars, we need to make space flight a lot cheaper.” And that’s where the reusability part comes in. 

And that’s where their success with the Falcon 9 rocket flying at 10, 11 times now, at the first stage, really is impressive because that is actually delivering on that vision. That was like the next step, right? “Okay, Falcon 1, Falcon nine. Okay, now demonstrate reusability with the Falcon 9.” Wow. 

They’ve demonstrated that. So now the next step is to build a much larger launch system and take all of those lessons you learned from the Falcon 9, put them into Starship, and then that is your actual Mars transportation vehicle.

Gennaro [FourWeekMBA]:

And it’s very important because again, he has a grandiose vision, but as an entrepreneur, he is very practical. And the same approach has been used also for Tesla in the early years. So he had to explain the vision of transitioning the whole world to electric cars, but then when it started, actually Tesla was targeting a very small niche, a subset of the sports car industry, where Tesla was going to show off how an electric vehicle could actually have great performance. 

And that’s how it started, with a few models, to show out the Roadster. So this sports car could actually be used as a way to showcase the technology and move from there. So it’s interesting also to notice that, again, grandiose vision covered with a lot of entrepreneurship and practical approach on a day-to-day basis.

And you mentioned also a very important point, which is the fact that making rockets reusable changed the whole industry and the whole business model of the space industry. 

How did reusable rockets change the whole business model of the space industry? 

Eric Berger:

Yeah. I mean, even the idea of landing a rocket on the ground or on a ship, bringing it back to the factory, refurbishing it, and launching it again, even in 2015, 2016, that seemed like a really out-there idea. It seemed something like you would talk about from a science fiction standpoint, but that you probably wouldn’t see a private company doing. 

And I distinctly remember, in like 2017, Elon having a press conference or a press call where he started talking about a flight-proven rocket and basically saying that if you’re a person or a customer, you really want to fly on the second, third, or fourth flight of a rocket. You don’t really want to be on the first flight. 

You want to be on a flight-proven version. And man, I have to say, at the time, that just sounded like a marketing gimmick, and everyone just kind of laughed at that like, “No way. Whatever, right? He’s just trying to make these rockets seem safer than they are.” 

But now, in the last year or two, you’ve seen the most valuable missions that this country has. Like the NASA astronauts are now flying on the second and the third, and probably the fourth flights of the Falcon 9 first stage. And the Department of Defense is putting GPS satellites. You have commercial customers flying on the seventh or eighth flight of a Falcon 9 rocket.

And so he’s really turned it on its head and shown that, yeah, actually flight-proven is a thing. And so the industry has really had to grapple with this. Like there’s a very rapidly changing mindset in just the last two or three years that basically if the rocket you’re designing now is not reusable, you might as well not be building it because that is so very clearly the future. The companies and the space agencies that aren’t building reusable rockets are basically almost being mocked. Right? Because it looks anachronistic.

 And it’s continued even with Starship because, with Starship, he’s trying to do something that’s never been done before, which is build a fully reusable rocket, which means not just the first stage comes back, but the second stage comes back and it all gets reused and flown quickly. And you’ve seen Relativity is looking to build a fully reusable Terran R vehicle. Blue Origin is going to be trying to make the entirety of its New Glenn rocket reusable. And so this is not just a trend. It’s the future now.

Gennaro [FourWeekMBA]:

These are key points because from being mocked, actually, SpaceX, a few years back, most people didn’t think also in the industry that making a reusable rocket was possible, probably made sense. And now this has become a standard. So, if you’re not doing it, then you are actually being mocked. So these are very interesting.

And of course, there is also another point where SpaceX spent a lot of resources in developing the Falcon 1, but then it added actually people to the Falcon line. 

Eric Berger:

Right. So, Elon Musk is not a particularly sentimental individual. And so the company had put blood, sweat, and tears into making the Falcon 1 rocket a success. And really, the focus of my book is on all of those early failures. They failed the first three launches of the Falcon 1. And really with everything on the line with the fourth launch, they ultimately did succeed. And that set the company up, basically, on the glide path that it’s been since then.

But yeah, I mean, the Falcon 9 was just a much more capable rocket. Like with the Falcon 1, the half-ton, you’re kind of limited. And Musk realized that if he built a larger rocket, he could launch all of those other things he had contracts for with the Falcon 1, but he could also serve many other customers with the Falcon 9, and most importantly, NASA, which was bidding out contracts to deliver cargo and astronauts to the International Space Station. You just couldn’t do that with the Falcon 1. And so he basically decided, “Okay, great job demonstrating that the Falcon 1 works, but we’re going to be all-in on the Falcon 9.”

Gennaro [FourWeekMBA]:

And as of now, most probably SpaceX has grabbed most of the commercial satellite launch business. And this is another very interesting point because there is another part, another project, which is Starlink that has become also a very important revenue generator for the company. 

So I admire this strategy where you use something like Starlink to generate money on top of an existing industry that exists here on earth, which is the communication industry, where actually you’re going to be using that same technology, I guess, to power up also a connection in space. And so this, to me, it’s a very smart approach that also explains how SpaceX has been able, compared to others, to compete in this industry. 

Eric Berger:

Yeah, absolutely. SpaceX from the time when the Falcon 1 was basically David, and now in the aerospace industry, it’s Goliath in terms of the way it delivers.

I want to come back a little bit to the comment you made about Starlink being a smart play. We’re going to see if that’s the case over the next couple of years because building a low-earth orbit broadband network is extraordinarily expensive. 

And so they’re putting a lot of money into that, and time is going to tell whether or not they’re ultimately successful with that. They’ve got a long way to go, and they’re putting a lot of capital into that. 

And so it’s a big gamble, but really, Musk’s goal legitimately is developing a program to settle Mars, and the US government isn’t going to pay for that. NASA’s not going to pay for that. And people aren’t going to pay for that. And so really it’s going to have to come off the revenues from Starlink.

Gennaro [FourWeekMBA]:

Absolutely. Alrighty, so let’s close this up. Our time is almost here, so let’s close this up. 

Eric Berger:

Yeah, that’s a great question. So I’m 48 years old, and if SpaceX denies this, I have almost no faith in NASA or any of the other international space agencies to bring about a humans-to-Mars program in my lifetime. It’s just too expensive. It’s too much risk in terms of human life. And there’s just no real geopolitical reason for the government to make that kind of investment. It’s just, for lots of reasons, it’s difficult to see that happening. But now SpaceX comes along and that’s like the raison d’etre. The reason why SpaceX exists is to put humans on Mars. And again, it seemed preposterous when Elon was talking about it at the beginning of SpaceX. But as we talked about, he’s taken this methodical, step-by-step approach to making it happen. So it is possible this happens in my lifetime.

I think it’ll be some kind of cooperation between NASA and SpaceX. SpaceX clearly is building the transportation system to take humans to Mars possible. Starship is large. It’s rapid. It’s a good design to be rapidly reusable and is the kind of rocket you would need to start setting up a settlement on the surface of Mars. And that was the key first step. Like NASA had done studies of humans to Mars for decades. 

But until you actually have the transportation system, the rocket, and the spacecraft, it’s just an academic exercise. Well, SpaceX is taking that first step. And so once they demonstrate Starship, I think then you could see a program with them working with NASA, sort of for the first couple of missions, to be like professional astronauts to Mars; and then SpaceX getting going with its private missions where actually they start developing a settlement on the surface of Mars.

And you ask for a timeline. I just can’t see that happening this decade. I think if it happens anytime before 2035, that would be an amazing achievement. So I’d love to see something happen in the 2030s with humans to Mars.

Eric Berger:

SpaceX definitely has competition, but it has really, in terms of the traditional launch industry, blowing past the competition. Now, what I mean by that is, for a long time, United Launch Alliance, which is co-owned by Boeing and Lockheed Martin, the two largest defense contractors in the United States, United Launch Alliance was the competition. They were America’s dominant launch company.

But last year, SpaceX launched five rockets in the month of December. And in all of the year 2021, United Launch Alliance launched five rockets. So, that tells you about all you need to know about where that competition is today. And frankly, SpaceX is pulling away from United Launch Alliance, especially if and when it gets the Starship vehicle up and running.

And so then the question becomes: Are there other new space companies that could challenge SpaceX? And you brought up Blue Origin. And I still think, despite sort of some of their stumbles, that Blue Origin does offer the best competition because Bezos, Jeff Bezos, has billions of dollars to invest in space and is investing that money and does have a big vision. And they see the new Glen vehicle, the large rocket they’re building, as a viable competitor to Starship. And I’ve seen enough plans for that rocket. 

If it does become fully reusable, then it could become a viable competitor in some sense to Starship. But SpaceX is really about a decade ahead of every other rocket company in the United States right now or in the world.

So, in terms of launch, there’s a big gap. And it would be one thing if SpaceX was resting on it laurels or just sort of standing pat. But they’re sort of charging boldly into the future. And you look at the European Space Agency, and they’re now talking about a rocket that looks something like the Falcon 9 and may be developed in five or seven years from now. Well, by that time, the Falcon 9 will be two decades old. 

And there are lots of startups in China that are looking at developing rockets that look a lot like the Falcon 9, like a lot with grid fins, landing legs, all this stuff. But again, if they get flying in seven years old, they’re going to be five, seven years, they’ll be 15 to 20 years behind the Falcon 9. And so again, SpaceX just has a really large lead right now.

Gennaro [FourWeekMBA]:

Yeah. Interesting. And Eric, let’s close this up. I know that our time is almost… The book, it’s incredible. I hope that it might turn hopefully in a movie because of the story of the first failures, going forward, now they manage to succeed and still manage to become one of the main players in this industry and bring the commercial space industry forward. It’s so incredible. So thanks for taking the time to join this conversation.

Eric Berger:

Oh, it’s my pleasure. I hope I’ve been helpful.

Gennaro [FourWeekMBA]:

Yeah, absolutely. Thank you.

After PayPal’s exit, Elon Musk had the financial resources to devote to his lifelong passion for space. As he had been ousted from PayPal in the year 2000, Musk started to think about something very ambitious, and space exploration was one of these things.

Yet, the real move came when finally PayPal sold to eBay in 2002, thus giving Musk over $100 million in personal wealth to devote to an ambitious project.

As the idea of enabling space exploration developed, Musk initially thought that a simple involvement where he could help NASA get more budget would have helped make improvements.

Yet get figured that was not the case. The whole industry had been stuck for decades, and personal involvement was the only way to go. Musk devoted $100 million to his own wealth. While this seems a large sum of money in reality in space prototyping this isn’t much. Thus, since day one Musk had to think of ways to cut costs to develop rockets.

In the early days, he also explored the option to buy from Russians, yet he finally figured he needed to do it all in-house.

Musk’s first attempts were unsuccessful, and SpaceX had the runway to get going for three launches max. In the early days, the company was close to bankruptcy on several occasions.

After years of trial and error, and near-death experiences, on September 28, 2008, the Falcon 1 experienced its first successful launch (flight 4)

In order to redefine the industry development model, SpaceX understood it needed to sell also to commercial players, not just governments. In addition, even for government contracts, SpaceX didn’t get contracts, then developed rockets according to the agency specs. instead, it secured launches contracts, thus having complete freedom in terms of development, design, and launch.

While this would be extremely expensive, and risky on the part of SpaceX, it also enabled a lot of innovation.

SpaceX changed the whole space travel industry by bringing an iterative approach to rocket development. From a linear approach that has stalled the industry in the last decades, where failure was not an option.

SpaceX led an iterative approach where failure was possible and making quick changes on the fly was the rule of thumb, even in a hardware-heavy industry. In addition, the software has become a key element of SpaceX’s success as it can control the hardware as it travels to space.

Similar to how Tesla updates its software to upgrade its cars, or like the iPhone upgrades its software to enable more features to its hardware device, SpaceX has brought this approach to space!

Another key revolution that SpaceX brought was the reusability of its rockets. From an industry that has thrown away billions of rockets, to an industry where reusability has become the standard.

SpaceX has led this change. In the early years of trying to figure out a reusable rocket, the company was mocked, and now this has become the standard.

Reusability is the key, as it enables to lower exponentially the cost of launching over time, thus making the commercial space travel industry viable.

After years of developing a viable Falcon 1, SpaceX eventually went all-in with the Falcon 9, as government contracts that enabled the long.-term vision of the company to be accomplished finally opened up.

This was a huge change in direction, and yet it proved successful over time.

SpaceX has become the Goliath of space, grabbing 2/3 of the commercial satellite launch business. And even as a behemoth of space, SpaceX hasn’t changed its playbook, still working as an iterative company, continuously innovating, and eating its own products, to enable further innovation.

To start surfing an existing market, like the communication market, SpaceX has also leveraged the Starlink project. Musk announced on Twitter on February 14 2022, that Over 250k Starlink user terminals making this a multi-million per month revenue stream:

Most US players are well behind SpaceX, yet China might be a potential player in the future race to space travel.

SpaceX has redefined – in a single generation – space travel, making it feasible to think about going to Mars within the next decades. As Musk will push to achieve that goal within his lifetime!

This is a recap of the WeWork story.

The full episode is here.

Or here: https://fourweekmba.com/wework-scandal/

https://fourweekmba.com/what-happened-to-wework/

In this session, I interview Eliot Brown, a reporter at Wall Street journal since 2010, and author of:

The Cult of We: WeWork, Adam Neumann, and the Great Startup Delusion

We recount one of the most incredible startup stories of the last decade. The story of WeWork, and how it went from being the most valuable startup on earth in a few years to almost risking going bankrupt, in a series of dramas, conflict of interests, and turns of events!

This story is also turning into an Apple TV+ series.

Eliot Brown:

Yeah, so it was many years ago that I first came upon them. I was at the Wall Street Journal in 2013 covering commercial real estate and the office market. I was just interested in new trends in the office market and how people were working. A lot of people were talking about co-working spaces. So I went down to lower Manhattan and met this one company that was leasing a lot of space. I heard the CEO was kind of fun and talkative, so that’s when I first came upon them when I met with Adam Neumann.

Gennaro [FourWeekMBA]:

Oh. I guess at the time, WeWork was one of the hottest companies in New York. It was very easy to end up hearing about that. But can you tell us a little bit more about the background of Neumann, who was the founder of WeWork. 

Eliot Brown:

Yeah. He had a pretty interesting life. He grew up in Israel largely. He did a brief stint in the U.S., but his parents were doctors, they were divorced. His mom was kind of unstable and always moving them around, always spending all the money she had. So they were running out of money, even though she had a decent-paying career. He spent some time on a Kibbutz, which communal socialist experiment type thing in Israel. Someone we talked to remembers that even then when he was just a teenager, he was always brash and had this real desire to make money, which is kind of a funny thing to come out of a socialist-communist little village.

Fast forward, he did some time in the Navy in Israel, as is compulsory. Then he just wanted to get to New York and become rich. So he moved there. His sister was a supermodel, lived with her. She mostly supplied the money and he tried to start a baby clothes company, or he did start a baby clothes company that tried to make clothing that had knee pads for babies when they’re crawling. It was called Krawlers. The idea was that babies, their knees must hurt so here’s a way to make it so they don’t, and didn’t go very well.

Gennaro [FourWeekMBA]:

Yeah. Also, because I mean, at the time he was a guy in his 20s, and he was selling like a product for babies. He didn’t have babies, actually, probably didn’t even understand what being a parent was at the time. But also there is another interesting paradox of this whole story, which is quite curious. As you said, when he was a kid he had the chance to actually hang out in a Kibbutz, which is a sort of closed, gated community where there is this sort of communism where you share everything. How important was this experience to Adam Neumann, on the negative side and also on the positive side?

Eliot Brown:

Yeah. I mean, well, I’ll tell you what he said. Though, it’s hard to differentiate myth from reality. He said, on the Kibbutz, that he learned the value of community and how it’s great to share everything. This is a place that had one big dining hall for everyone in the community to eat at. At first, when he first got there, I think, they actually had unlimited meals and you would just take what you wanted, but then over time, it wasn’t working. It was financially or economically broken.

So they had to start charging people or limiting how much people could take unless they wanted to pay. At one point, nobody owned cars, they just had two shared cars for the community. But at one point they allowed you to not have to pay for power, and then everyone would just run the air conditioner all day long. So it was sort of broken in that sense. To listen to Adam, he learned that you should take the communal aspects but you need a real strict capitalist layer over that. He called it, WeWork was a capitalist Kibbutz, which is of course a pretty strong contradiction, but contradiction never really stopped Adam.

Gennaro [FourWeekMBA]:

Yeah, absolutely. We see that throughout this episode. The interesting part is that, of course, this experience as a kid in the Kibbutz actually was… Let’s say to recap a little bit, he learned that actually, yes, the community was important, but then on the other side, you needed to also give it sort of a business model to actually make it work. 

Even though, as we see throughout the story, actually, we were handed up sort of like Kibbutz where the money burned was a lot, there was a lot of talk about the community and a lot of buzz words. But also a lot of money burned along the way, so also we see that the company at a certain point was not financially viable. What happened next? 

Okay, Adam Neumann, he moved from Israel to New York City. He started to have some experiences as an entrepreneur with a field, as you said, a startup called Krawlers, where he sold clothes for kids. It didn’t work. Then suddenly something happened that actually gave him the idea of WeWork. 

Eliot Brown:

Yeah, it was actually, he just was in class… He was always looking for new ideas. He was clearly just… He didn’t care what it was. It was, “I want to make money and this baby clothes thing isn’t working.” 

He met someone who ran an office space subleasing company, a little incubator-type environment called Sunshine Suites. It was the son of a classmate of his at college. That guy showed him around Sunshine Suites and showed him the business. 

Adam was really impressed by how much money he was making. So he saw that in Manhattan and he basically said, “We can…” He went back to a guy he had met who he was friendly with and said, “Hey, you’re an architect. Do you want to do this with me in Brooklyn?” 

Because they were working out of the same office, and that became his co-founder, Miguel McKelvey. So they started a predecessor to WeWork in Brooklyn when they convinced their landlord to essentially give them a floor and put up the money to do this, and all they had was the idea and sweat equity.

Gennaro [FourWeekMBA]:

Mm-hmm (affirmative). This is interesting because this will connect also to the next step. How did actually Adam Neumann convince the landlord in the first place to actually rent the property? I mean, those were, just remember, two guys in their 20s trying to enter the real estate business in New York, which is extremely competitive. Yet they managed to enter that business. 

Eliot Brown:

Yeah. I mean, I think Adam just… The main theme here is that Adam is one of the world’s great salesman. Even though he had no experience in real estate or had no idea what he was doing, he was able to just by talking, sell the landlord on this vision that didn’t exist. This is a constant theme. He did it actually decently well with baby clothes, but the problem is the product was no good and wasn’t really a market that made much sense. But he at least could like draw a crowd of people around him interested in buying these baby clothes at these baby clothes conventions. It was merely just the power of persuasion and gifted salesmanship that got the landlord to commit.

Gennaro [FourWeekMBA]:

Yeah. We’ll see that this is a recurring theme, the ability of Adam Neumann actually to convince people in his grandiose vision. Actually, this startup turned out to be successful also because, for a little bit of context, we were in the years 2010, when we went through one of the biggest recessions of our times, especially in the U.S. So it’s also true that there was some convincing by Adam Neumann, but then on the other side, it’s also true that many of those commercial buildings were also empty. 

It was hard for real estate owners to actually turn them into profitable commercial buildings, so definitely this might have helped also Adam Neumann as he was rising to become a successful entrepreneur. What happened next? I mean, this startup actually worked, but the interesting part is that as soon as it started to work out, Adam Neumann had ready a grandiose vision for the future. 

Eliot Brown:

Yeah.

Gennaro [FourWeekMBA]:

Yeah. The first attempt to make it in the real estate scene in New York, what happened next?

Eliot Brown:

Yeah. I think basically Adam was just not content with making hundreds of thousands of dollars. He wanted to make millions. Then quickly when he saw that millions might be attainable, he wanted to make billions of dollars. Basically he just, from 2011 or so onward, when he started WeWork, he was in constant fundraising mode and just was always sort of climbing to the next larger rung of the ladder, or always looking for the bigger fish that had lots of money. 

Early on in 2010, he found some small backers. Then he got introduced… WeWork opens one or two locations, and then he gets introduced to some people with more reputable names, and then gets them and then gets like a third location.

Then the thing that really took off, and that gave him huge sparkles in his eyes for what the future could be, was when he first discovered venture capital, and that they were looking exactly for the type of thing that Adam wanted, which was to make a giant business. He realized that venture capital is where the money is. So he started talking to venture capital firms and got one of the best ones out there interested in him. They gave him a series A investment in 2012.

Gennaro [FourWeekMBA]:

Yeah. As we see, this is a key point where Adam Neumann had learned how to play the fundraising game. 

Actually, we can say that he was one of the best at playing that. He will go through many rounds and manage to keep control over the company, but there is also… Before we move forward to that story, there was also a person that played a role in Adam’s life behind his main partner, which was McKelvey as you said, which was probably the opposite of Adam Neumann. 

There was also Rebekah Paltrow who would eventually become his wife. Can you tell us a little more about the story, just some of the things that you also tell in the book that are quite interesting to understand how the couple came together, and how also Rebekah shaped Adam as a person moving forward?

Eliot Brown:

Yeah. I think they were met by chance, the two of them, through a friend. She had a lot of what Adam was interested in. I mean, Adam loves status and social power, and celebrity. 

She is the first cousin of Gwyneth Paltrow. Then she also, I think, quickly saw Adam, as a friend though, she saw him as a project and is like, “Here’s this guy who has a failing business and is full of BS. Maybe I can enlighten him.” She’s very spiritual, so she had him immediately like start… She’s like, “If you’re going to date me, you have to have a spiritual side.”

She took him to the Kabbalah Centre, which is a Jewish mystical, mysticism thing, and got him really involved there. Then he really liked that because lots of rich people were there. So he got to network with rich people. I think overall, she infused WeWork and Adam with this woo-woo spiritualist side of things. 

Maybe the way to think about it is, WeWork, when they talk a lot about us and the power of community, that was the Rebekah side, I think. Adam was more focused on the rapid growth and making billions side. Together, they melded to create WeWork.

Gennaro [FourWeekMBA]:

Mm-hmm (affirmative). Yeah. It’s important that you mentioned the Kabbalah Center, which was… I don’t know how to define it, probably like a new age New York community where many famous people also hanged out, many wealthy people hanged out, which was also an important source of connection for Adam in the early years of building up WeWork. 

A couple of points, which are very important. As you said, Rebekah Paltrow, which was the cousin of Gwyneth Paltrow, eventually would turn out to be the wife and the main companion of Adam Neumann as we go through this journey, because we’ll see she would play also a role in the company, big role in the company. 

But pretty much she brought Adam Neumann toward this path of spirituality, but we’ll see also that a lot of it was empty, meaning that there were a lot of buzz words and some of this spiritual stuff was so translated in financial metrics that they would later use when WeWork would eventually try to IPO.

But yeah, just two key points. 

Rebekah Neumann also brought Adam Neumann within a circle of people that would help him especially in the first years to kick off the company, because there were many interesting connections. Then also many on the circle of his wife also were people that eventually became very close people within the company. It was like the top management within WeWork, because as we’ll see, the company was managed in a very family-oriented way. The aspect of this community and spirituality is also used as leverage to actually have employees work way behind what they were supposed to. Which as we’ll see, it’s another contradiction of the whole WeWork story, which also makes it so, so interesting.

As we move forward, there is an interesting fact. We have this company, WeWork, again there is this guy coming from Israel. He goes to New York, the city, it’s incredible. He has probably the most incredible time of his life. He’s in his 20s. After a few attempts of building up a successful startup, he face various times one of the major failures, as we said, was like Krawlers company selling baby clothes. Then after he moved to Green Desk, which was the first real success. Also, the first exit, because from Green Desk, Adam Neumann would actually cash out about half a million or something like that, which he would later use for creating another startup, actually WeWork.

But the interesting part is, WeWork was created and you said the company was growing. Again, we are in the context of the year 2010, and going forward just the end of the recession, many of the commercial spaces were empty. It was also probably easier to start the company in that sense, by leveraging the short-term lease aspect of the business. But the WeWork of the early years, we’re talking about especially 2012, it was actually a profitable company. I mean, how was this company at the beginning? Because it’s interesting to see the change or so over the years.

Eliot Brown:

Yeah. In its history, now 12-years old, WeWork has had one profitable year and that was 2012, I think. Might have been 2011. I think what happened at first is they did really hit on this geyser of demand and realized that there was this Millennial, hipster-ified, very Berlin-like or Brooklyn-like demand for casual office space, and not having something that looks like a cubicle. 

They found just a lot of people working as graphic designers who wanted to be around others. That was real. The other thing that happened, as you mentioned, was the real estate market was much different. Landlords really… Rents were very low because it was after the recession.

So WeWork is basically… I mean, the business model is just arbitrage. They lease office space at one rent and then they sublease it at a different rent. That arbitrage was working really well at first because the rents that they would rent from landlords were really low. Then the graphic designers and photographers, and whoever else was wanting to take office space was willing to pay a decent rent. That made for a great business. The flaw came when they thought they could scale it and replicate it around the world really rapidly. Thus began their many years of really large losses.

Gennaro [FourWeekMBA]:

Yeah. After this point, WeWork was, as we said, a profitable company. Adam Neumann had a grandiose vision were to bring the company going forward. He actually secured the first deal, which was with Benchmark, that I think valued the company over 100 million after a very short period of time, which was really a lot of money. Yet this was not enough for Neumann because later on, as you were accounting in the book, actually there would be another deal also with Goldman Sachs, where Adam Neumann played his cards very, very well. 

Eliot Brown:

Yeah. With Benchmark, I think that was one of the most influential investments, or it was the most influential investment in WeWork’s history, and that guided lots of things. Because Benchmark is this really well-known name in Silicon Valley, they were the first big check into Uber. They became famous by backing eBay early on and making one of the best returns in all of the venture capital ever. He basically just met one of the partners through networking, and really impressed him with his drive and his salesmanship, and then showed off the business. He was like, “Look, it’s already profitable.” These guys are used to software companies. So then he impressed another partner there and eventually convinced them that…

I think they basically thought, “We don’t really know much about this business. It does look like real estate, but he seems to like this incredibly talented entrepreneur who has all the bravado and salesmanship that make a good tech entrepreneur these days.” So they gave him the money. Then what happened is, that brought on a lot of other interest from other investors later. 

He did turn down investment from Goldman Sachs the next year because the valuation was too low. It was only $200 million and he thought they should be worth 400 million. Then he found someone to value him at 400 million, and then soon thereafter J.P. Morgan’s asset management arm valued them at a billion and a half dollars. 

It really… I think in venture capital, a lot of these investors will look to each other for signals, and if everyone is running in one direction, they all start running in one direction. That’s basically what started early on with WeWork and Benchmark.

Gennaro [FourWeekMBA]:

Yeah. As we see, hearing the story, actually the ability of Adam Neumann to turn the narrative around the company will change various times. To use a buzz word, would pivot various times throughout the years. Because for instance, as you said, Adam Neumann managed to make the company valued at almost half a billion. 

He also knew at the time that being a tech company meant being valued way more than you had on the balance sheets. So at the time, he started to think already about a business model, because right now the software-as-a-service industry is a huge industry. You have many multi-million dollar players. It’s a huge market.

WeWork runs a membership model that gets monetized via a set of packages that include ancillary value-added products and services to enable companies to scale or shrink their workspace on-demand. WeWork defined its revenue model space-as-a-service claimed to be more scalable than traditional commercial real estate.

But at the time, of course, Adam Neumann had already a mind to frame WeWork as a tech company and to frame it as a space-as-a-service business model. 

PropTech stands for property technology, is a relatively recent movement in the real estate industry. A movement is an innovative approach that uses technology to optimize how consumers and real estate professionals interact with property. PropTech, therefore, leverages digitalization to help property managers, owners, builders, and landlords to manage their assets.

This will be also one of the things mentioned in its financial prospectus as the company would try to IPO much later on in 2019, as we’ll see. There will be a very important step. Before we get to that, though, there is a very important point to highlight, which is part of the contradiction of the whole story of WeWork and Adam Neumann. 

As he was closing those deals, actually he was carrying some also personal deals out of those venture capital investments. 

Eliot Brown:

Yeah. I think one of the most… The important theme that runs through Adam and WeWork’s story are that Adam loves money, and he loves personal enrichment. Even though this is all a company that’s literally named We, and he would very frequently say things like, “You need to put we over me. This is about all of us. It’s not about an individual.” 

He was probably the most selfish person I’ve ever covered, as a reporter. He, starting in the first round of funding, took some money out for himself. I believe it was around a million, could be off by a million there. Then basically every round after that, with a couple of exceptions, every time he would negotiate to take out greater sums for himself.

Each time the board of directors or the investors thought, “Well, he just needs a little more money. Then he can have a nice lifestyle, and then he’ll be focused on the business.” But he would negotiate these rounds where these investors would come put in money. 

They’d be like, “Ah, I want to put in 200 million.” He said, “Well, I only have room for 150 million, maybe you could buy some of my shares.” It’s the type of thing that just… I think he just liked it. 

He likes money. Later on, he would borrow money and I think he also would buy properties and lease them to WeWork. These became really problematic later on in life, and later on in WeWork’s life. But at the time, he was just very focused on one thing.

Gennaro [FourWeekMBA]:

Yeah. Two key points. One, of course, there’s nothing bad in liking money, especially if you’re doing business. The problem is, he was on the one side predicting the gospel of the community, and on the other side, he was cutting deals on the back of his own company. Another also key point is that as we move forward, actually, this would become even worse. 

We’ll see that the whole structure of the company would be actually probably created on the backbone of making sure that this company could finance the personal lifestyle of Neumann and his family. Again, the interesting part is that on the one side they were sort of predicating to everyone how they ought to live, but then they also were doing the opposite of that, so probably this is something that didn’t help.

But going back to the business story, I think there was… After we go, just to recap a little bit, we have the first investment by Benchmark, which is quite a known venture capital firm. 

Of course, for the first companies that cut into deals with Adam Neumann, they saw the company was valued at the time, there was a big opportunity. That anyhow, probably by giving the money to someone with this grandiose vision, like Adam Neumann, would have created a valuable company. For them, the initial risk was relatively low.

As we move forward, of course, there would be a lot of other cases in which the context was right also for Adam Neumann to take advantage of the situation. 

There would be like a turnover event in which pretty much WeWork got valued over a billion. It entered the unicorn-verse, and actually, it entered the decacorn, meaning a company valued more than 10 billion when he cut a deal with a mutual fund, with Fidelity. 

Eliot Brown:

Yeah. I think in this year and a half stretch, I think, so it was I think very early 2014 through mid-2015, they went from being worth a billion and a half to 10 billion, and not much had changed in the business. They were just continuing at pace. Adam pivoted from marketing WeWork as the physical social network and playing off, he’s like, “The iPhone was about I, we’re about we.” 

To focus much more on the hot trend at the moment in fundraising, which was the sharing and the sharing economy. So Uber and Airbnb were the hot companies at the moment, and so he said, “Just like Uber and Airbnb use cars and apartments, we do that with offices.”

Now, that of course was a completely different business model, neither Uber nor Airbnb actually leased or owned their cars, they’re using other people’s. They’re in theory just a tech marketplace that connects people. WeWork was leasing buildings, building decks, spending money to buy glass and beer and kombucha, and paying people at the front desk. It was very what we call an asset-heavy business model. 

But regardless, he was able to still capture the moment and the vibe of FOMO, fear of missing out, that investors were feeling when they were throwing money at Uber and Airbnb, and get lumped in that. He found very willing, eager investors in mutual funds, and mutual funds that were actually competing with each other. 

They were overlooking WeWork’s negatives and just focusing on the positives because I think they needed to believe a story because they were suddenly interested in spending a lot of money on unicorns.

Gennaro [FourWeekMBA]:

Yeah. Also, a very important point to highlight, also to make the audience understand the context, here we are living in a time, 2014, 2015, where mutual funds were late in the game and they were taken aback also by the fact that index funds had become extremely successful. 

They were trying to actually show that they could be successful as well by playing the venture capital game. Also, the amount of money that was available to them was so large that also placing a large check for the venture capital firms, it was a small check for actually the mutual fund, the firm. For Fidelity also giving a few hundred million dollars check to WeWork was very small compared to the ability and the firepower that the mutual fund had.

Again, they had to show that they could actually enter the game and be innovative where retail investors would otherwise have invested just in index funds, which are just replicas of indexes that we have. 

There is no active management and they get… Let’s remember that mutual funds get a lot of management fees for the work that they do. If you don’t perform well on the market, then why do you exist in the first place? This was a little bit also the context, and Adam Neumann understood that and understood how to take advantage of that. 

What happened… a few details of the Fidelity investment, because there was also the same pattern that we see throughout the story where also there, Adam Neumann did a couple of things. One was that he also managed to get a few million for himself, I guess, out of the deal. The other key important point is that he managed to create a control structure where he had control of the company, even if he was going to sell most of the shares.

Eliot Brown:

Yeah, precisely. I think that is one of the most important points in the whole WeWork story that enabled it to be so fiery and crazy. Somewhere around 2014, ’15, ’15 I guess, he gave himself 10 times the votes of everyone else essentially, or most everyone else. Normally in business, or in corporate America, you have share is one vote. 

So if you happen to own 51% of the shares of the company, you control the company. Adam ultimately only held 25, 30% of WeWork, but could have stayed the majority shareholder by selling off a lot of his shares, because he had 10 shares per vote. 

This was essentially meant so he could rule it as his own company, and not be responsible to shareholders. That was, I guess, something that was really taking off in Silicon Valley, and has continued to. All because of this myth of the founder, or mystique of the founder, depending on how you see it.

Silicon Valley venture capital firms were just enamored with founders because these were the people who would take their money. So they would lavish them with praise and say, “You guys are amazing. You’re a special person, please take our money. 

You’re so special that if you take our money, we’ll let you keep control of the company, even if you own less than 50%.” That’s what was happening with Adam. He saw that happening at companies like Snap and Uber, and he wanted it himself, and WeWork was a hot company so he got it.

Gennaro [FourWeekMBA]:

Yeah. We’ll see later also as WeWork would approach the IPO in 2019, after a series of twists, how this thing out the whole… the corporate structure and corporate governance structure will get even crazier than that. We’ll see that. But at some point in 2015, there was a person, don’t know if the name is pronounced right, it was like a Shorenstein which understood that WeWork was a bubble. 

Eliot Brown:

Yeah, you’re referencing this landlord that we’ve made into a little character, Brandon Shorenstein.

Gennaro [FourWeekMBA]:

Shorenstein, yeah.

Eliot Brown:

He was this really young heir to this fortune in San Francisco, the smart guy. I think for people who… For myself as a journalist at the time, and for people who would sit down to think about it and didn’t have money at stake, it was pretty clear but not 100% clear that nothing about WeWork made sense in terms of its valuation. 

It was just, at heart, a real estate company. Because the people who were going there were renting space, not because they wanted community but because they wanted office space, and they were paying office rents, and WeWork had office space-related costs. If there was something like value to the energy in the space, it wasn’t showing up in… Which is what Adam said. It wasn’t showing up in their finances.

Brandon Shorenstein, I think he basically just had dealt with Adam a few times and realized that there was this sketchy side to him, because Adam tried to give himself a stake in a building that they were talking about buying, and then leasing. 

Brandon thought that was pretty sketchy. It ended up not happening. Then he just looked at the business model more and was like, “This makes no sense.” I think that was… If you weren’t part of the herd, you could step back and be like, “What is going on here?” But what happened with WeWork is, Silicon Valley operates as a herd, and so all these investors were just looking at the other investors and looking at Adam and believing in the future that was a myth.

Gennaro [FourWeekMBA]:

Yeah. As we move forward, I think there is an important point to highlight. Adam Neumann understood that if you were WeWork and you were actually running a commercial building as a tenant, you were also contributing to improving the whole building, the whole neighborhood. 

He wanted to have a piece of cake of that. So there was this structure of the company where at a certain point he started to also invest in the stakes of the buildings where he was going to lease with WeWork. 

Also here, we have a rising conflict of interest where we have Adam Neumann on one side with a company that invests in the property, and then on the other side as a tenant with WeWork. As we know, the landlord and WeWork as a company have two different objectives.

The landlord wants to increase the lease, and then WeWork wants actually to decrease the operational expenses going forward. This will be very important. Yet going forward, important institutions like also J.P. Morgan gave him a credit line of $500 million, we have seen in 2015. 

This is a very interesting point. As we move forward, there was a turning point for Adam Neumann to finally, let’s say, amplify as much as possible his vision, which was the encounter with Masa Son. 

Eliot Brown:

Yeah. Well, there are a couple of times in that… a couple of first encounters. He first came across Masa in India at the start of 2016, and he had had this raucous trip where he was really drunk and overslept, and missed important meetings. 

But eventually, he goes to this big startup event and meets Masa Son there. This very time that Masa is trying to be… He’s a very active investor in the dot-com boom, and then shirked back and lost a lot of money and focused on telecom. Now he was eager to get investing in startups again. He makes a brief impression on Masa.

Then the next time was much more important. He meets him… WeWork is looking to raise a lot more money and Masa has just gotten the commitment to raise the world’s largest investment fund, principally from Saudi Arabia. Masa is in New York and on his way to Trump Tower to meet the president-elect. 

He swings by WeWork where a mutual acquaintance had organized the meeting, and he has 12 minutes. Adam whisks him around and shows him the tech section of WeWork. Then on the car ride up to Trump Tower, Masa sketches out a $4 billion investment in WeWork, which became the second largest investment in a startup ever.

Gennaro [FourWeekMBA]:

Yeah. For some recap of the story, we go from 2015, where again, WeWork had reached the valuation… It was a decacorn, so it was a company worth more than 10 billion. 

Of course, the question for Adam Neumann was, “Now, what do I do next in terms of fundraising to still increase the value of my company to bring it to be like 15, 20, or $50 billion company?” 

This might seem crazy because how do you actually can even do that? But for Adam Neumann, there was something that he could do. He started to think about other potential investors to enter the company. He started to do fundraising campaigns, especially in China.

Eventually, as you said, he had this encounter with Masa Son, who was the founder of SoftBank that was at the time the largest investment fund that had secured over $45 billion from Prince Salman. 

This gave SoftBank a lot of liquidity. For a little bit of context, Masa Son, the founder of SoftBank was also let’s say respected as an investor because he had done one of the most successful investments in the tech world, which was the investment in Alibaba where, I don’t remember exactly, but I think he put something like 10, $20 million and he-

Eliot Brown:

20, yeah.

Gennaro [FourWeekMBA]:

Yeah. Probably $20 million and he made like billions out of that investment. 

That gave him the aura of success, even though as you said, he failed to actually consolidate in the communication industry when he tried to merge Sprint and T-Mobile. 

It was stopped by regulators. I mean, there were many things that happened in the middle. 

Eliot Brown:

Yeah. I think Masa just has this absolutely insatiable appetite for risk and is willing to keep betting the whole farm again and again on things that he feels strongly. 

He has a very strong trust in his gut. He’ll even say it at investor calls telling investors, “Numbers are fine to look at, but really the way to invest is by using your gut.” He’s like, “It’s like Yoda, use the force.” This became, as he likes to say, briefly the world’s richest man in 2000 for a few days before the stock market, or the tech bubble popped. Then he proceeded to lose more than anyone had ever lost in history. He was trying to come back on the ascent when he met Adam and was doing a decent job making his way there. He was a billionaire again.

Then comes across Adam, and then he just had… His way of approaching startups was to always… It was almost comical how similar it was. Without even knowing much about a company, he’d basically frequently tell companies, 

“You’re not spending enough on growth. You need to increase your marketing spend. You need to grow faster.” People around him would coach these companies who met with Masa to say, basically knowing that Masa would tell them that they would say, “Well, I’m doing this.” Then they’d just be ready to be like, “Okay. Well, if I had twice as much money, I’ll grow three times as fast.” That was his way of being, and he also told Adam once famously, “You aren’t crazy enough. You need to be crazier.”

Gennaro [FourWeekMBA]:

Yeah. That definitely helped Neumann to push in a direction that would lead to the WeWork story. But what happened next? Like 2016, 2018 WeWork secures this huge amount of money from SoftBank, and now it has to expand as much as possible. I know from the book that there are many crazy that happens, especially Neumann that starts to do acquisitions that don’t make any sense you recount also one acquisition of a company called Wave Garden, which actually made artificial waves for surfing. 

Eliot Brown:

Yeah. Basically, as WeWork’s valuation grows, Adam’s head and ego grow, and his ambitions grow. It’s not just to make a big office space company, he wants to… I think at a certain point, he really saw himself as a world leader and on par with heads of state. 

We have a couple of anecdotes where he went to the capital in the U.S. and met with Chuck Schumer, U.S. Senator. After he meets with him, he likes it so much he turns to his staff and he says, “No more mayors from now on. From now on, only senators.” 

He meets with Justin Trudeau of Canada once, and then they wanted to have another meeting and Adam reschedules it at the last minute and is like, “Justin Trudeau can meet my schedule,” which is not how you usually deal with the head of state. And he almost didn’t go to a meeting with the British prime minister, Theresa May.

He had a very big opinion of himself. He would tell people, “If I were to run for anything, it would be president of the world.” Obviously, an office that doesn’t exist. 

This is just what came with seeing WeWork grow and seeing his wealth swell on paper and seeing all the money being thrown at him. With Masa, they contemplate this much, much, much bigger investment where Adam asks SoftBank for $70 billion. 

For context, no company had ever raised more than a total of like 15 billion out in the private markets. They sketch out a vision for WeWork and Masa and he writes on paper that they expect WeWork to be worth 10 trillion… Am I going to get this right? $10 trillion in a few years, by 2028.

At the time, no company had ever been… Apple wasn’t even worth a trillion dollars. Excuse me, he really just has this incredibly inflated sense of what WeWork is capable of and so starts to do crazy things like thinking he should… He tells [inaudible 00:48:39] he wants to buy Lyft. He wants to buy Sweetgreen. 

He wants to buy all the commercial real estate firms, Cushman and Wakefield, CBRE, Regus/IWG. So he just tries to buy… In the end, he only ends up buying relatively small companies at very high prices, like meetup.com, and they buy a coding academy, and they start an elementary school. But WeWork just shoots in lots of different directions and Adam is increasingly unhinged.

Gennaro [FourWeekMBA]:

Okay. Pretty much he was crazy. They had this thinking that the company would be valued at 10 trillion, and this was a shared thought between Son and Neumann. 

The duo together was unleashed to something that we had probably never seen. But then in 2018, going forward, there is market turbulence. The liquidity starts to be much less available than before. 

SoftBank is the main fund, the vision fund, SoftBank actually burns out billions of dollars. At this point, actually, Son had promised Neumann to buy out WeWork, make it a private company, and bring it to become, as you said, a $10 trillion company by 2028. 

But things changed. Masa Son also had to change direction because the fund was not going in the right direction and he was getting different pushbacks from the main investors in the fund. 

Eliot Brown:

On Christmas Eve in 2018, they’re literally done with this deal. It’s ready to close, and it’s going to be the largest ever buyout of a startup, and then Masa backs out. He calls Adam while Adam’s in Hawaii and says, “This isn’t going to happen.” 

Then Adam is shaken and realizes WeWork is burning an enormous amount of cash because, since 2013, the company’s been basically spending $2 for every $1 it takes in. They’re basically, at the current rate, if they kept accelerating, they would be out of cash by the end of the year, 2019.

He realizes they need to IPO, which is, he’s basically found all the private money there is to find in the private markets and you have to turn to the public markets. 

WeWork quickly starts to pivot to try to go public and reveal its finances. It’s going to be judged in the market, as opposed to just one or two industries that determine a price. 

That sets it down on the path for its ultimate demise because private markets were acting as a herd and he was able to manipulate that herd. The public markets are, I guess, maybe a much bigger herd and the magic was going to wear off.

Gennaro [FourWeekMBA]:

Yeah. As we said, different turns of events where he was supposed to go private, getting bought by SoftBank for 20 billion, be just a private company, and realized his multi-trillion-dollar valuation dream. 

Then finally the market turned on its back and therefore SoftBank had to change direction. It couldn’t finance anymore the acquisition of the WeWork in the private market. 

Then on the other side, actually WeWork turned out to be one of the largest failures that SoftBank had taken. Therefore, also for Masa, there were huge drawbacks. Because for bit context at the time, Masa was trying to raise a second mission fund that was supposed to be even larger than the first one, and they would’ve taken over the whole tech world. 

But as the WeWork story unraveled actually, he wasn’t able to secure additional funds because there was no other investor, even in the Arabic countries, that were available to give money to Masa as the situation had evolved in this way.

Then we go to the IPO. WeWork figures, “Okay. Let’s go to the IPO. We go public and we get the money from the public.” But things also happen very faster, where they listed… 

Actually, they submitted the S-1 form. Which for a bit of context is a form that you had to send over to the SEC, the Security, and the Change Commission, in order for you to list on the public market. 

This S-1 form was actually, remember seeing it in 2019 as soon as it came out, it was more like a marketing plan. There were different things that made the public go crazy about the IPO, WeWork. 

Eliot Brown:

Yeah. I think there were three things that were kind of crazy about the S-1 when it… When it dropped, I was hiking with some friends and it was a multi-day trip and there wasn’t cell service for some of the days. 

Then I turn on my phone and I just get flooded with these text messages before I’m able to check the internet. It was all just like, “Oh my God, did you just see this?” I knew what it was. I knew WeWork… 

Because I knew they were preparing this. I knew people just found their financials crazy. There were three things, I think. It was worded in this kind of crazy way, very Rebekah Neumann, where they dedicated it to the Energy of We. Then talked about how the company’s mission was to elevate the world’s consciousness.

Then there were the basic financials of the business, which were pretty abysmal. Then the third was probably the most concerning, which is, it was just filled with conflicts of interest. 

These things that had been written about, some by me beforehand, were some of them where he was leasing properties to the company, and the place was filled with relatives of him and his wife in the upper management. What then happens is, people also see how he had profited off of literally the name We. 

It wasn’t much money, but he’d sold the trademark to the company. I think the internet went crazy. I’ve never seen such a one-sided take on a company before an IPO. Everyone was like, “What is the deal of this company?” No one was defending it as a good investment. That’s a really bad place to be in when you’re trying to IPO because a lot of that is about momentum. So basically the bankers who are working on the deal just watch and quickly realize the evaluation is going to be much lower than Adam had hoped.

Gennaro [FourWeekMBA]:

Yeah. Fast forward, they submit this S-1, the internet goes crazy, Twitter goes crazy, as you said, many articles. 

You also contributed to that, I guess, with one of your articles shaking the situation even further. But the thing goes out of control and pretty much what happens next is that Adam Neumann… 

As you said, the evaluation was supposed to be over 40 billion, but then he would end up being way less also than 8 billion. So it was from a company worth almost 50 billion to less than 10 billion was like a huge drop. Actually, the company was risking going to zero because the money was running out. So it was risky going bankrupt. 

Pretty much there was pressure on Adam Neumann to leave the company. 

Eliot Brown:

Yeah. They’re basically about to start the roadshow to go IPO, and then I’m working on a story kind of about how crazy he is, or people around him think he is, and all the crazy stuff he does, and how he tells people he wants to be president of the world, and how he’s a total party animal. 

After we send them fact-checking questions on that, they postpone the IPO realizing that you can’t have this article come out in the middle of a roadshow, which is the two-week period before an IPO. Then the article comes out and the board at that point realizes that Adam just can’t be CEO. 

The company can’t go public with him at the helm. Then they say, “Either we’re going to quit or you have to quit because even though you control the board, we aren’t going to support you as CEO.”

He realizes the financially rational thing to do and doesn’t want the company to go to zero. So he steps aside, and the dream is done. Then soon thereafter the company is about out to go insolvent. 

They had even less cash than they thought they did. They raced to put together a rescue plan and cut thousands upon thousands of jobs, and raised multiple more billions of dollars, and it ends up being from SoftBank at this $8 billion valuation. 

Then I think the most poetic part of the end of this saga is that, right as Adam’s negotiating with SoftBank because he still controls all his shares, he gets them to give him one of the most generous, if not the most generous, severance packages of all time. He leaves with, depending on how you want to count it, a $185 million fees, another billion that he can sell of his own stock that he already owned. 

Then they refinance a $500 million loan at a favorable rate. So basically has access to $1.7 billion, just to stop being the CEO of the company that he… Stop being on the board and controlling the company that he founded.

Eliot Brown:

Yeah. That’s what they agreed to, then there was a legal battle. He ended up getting… He actually ended up renegotiating again in his favor. He ended up doing quite well. 

He ended up getting over $200 million of cash, and if WeWork stock hits a certain threshold he gets much more money, another 200 million-plus. 

He tended to be a really awful negotiator when it came to buying property… buying things with WeWork’s money, but for his own compensation, he was an excellent negotiator.

Gennaro [FourWeekMBA]:

Yeah. The end of this story is that eventually, I think in 2020, as Adam Neumann got out, he cashed the money also. But WeWork eventually would manage to get listed through SPAC, the special purpose acquisition vehicle where he managed to, I think, to get listed eventually. 

The company now, if I’m not mistaken, is worth about $5 billion. There is a movie coming out as well, I think, from Apple Plus. Is the sorry based also on your book, I mean…

Eliot Brown:

That one, a eight-part TV show, is actually based on a podcast that, if you grumbly ask me, I would say is largely based on Wall Journal stories. But that’s probably not how they would refer to it. I’ve seen the first few episodes, Jared Leto stars as Adam and he is very good at emulate… From the accent to just the mannerisms, he really gets Adam. Yeah, it’s a fun tale.

Gennaro [FourWeekMBA]:

Yeah, absolutely. This is the perfect story to make it into a movie or like a series, absolutely. To close this up, I think the story of Neumann is incredible, is not like a tyrannous thing, but very close to it for, in some ways, even though the underlying business was good, was a good business just extremely, extremely overvalued. 

Eliot Brown:

I think that the biggest thing that I took away is that smart people can really lose grip of… Even smart investors can really lose grip of reality or gravity. When you go in a herd, you can just forget your bearings. 

With WeWork, it was just so obviously, in hindsight, and to summarize at the time, a real estate company. But just because of the power of persuasion and these incentives that were baked into venture capital, everyone saw it as a software company or a tech company, even though it really exhibited almost no similarities other than fast growth, which was really just fueled by more venture capital.

You had literally some of the top minds in finance, I mean Jamie Dimon and David Solomon from Goldman Sachs, and down to some of the best venture capitalists and mutual funds, and thousands of people at WeWork all just believing this thing, that was completely hollow. I think you need to have the critical thinking, and in bubbles, in manias, we forget to do that. That, I think is for me the biggest takeaway.

Gennaro [FourWeekMBA]:

Yeah. Yeah. Also, the contracts between private and public markets. Especially when there’s a lot of liquidity, it’s very easy to fall into those traps where if you’re able to control the narrative, you can actually get a much larger valuation, as Adam Neumann did. For the audience that is going to be listening, of course, they can read the whole story in The Cult of We, which is a great book, a lot of fun reading it. Thanks, Elliot, for joining the conversation. It was a pleasure.

Eliot Brown:

Sure thing. Really enjoyed it.

In this episode, we interview Matthew Leising, formerly reporter of Bloomberg news between 2004-2021.

Now the co-founder of DeCential Media, and author of a great book:

Out of the Ether: The Amazing Story of Ethereum and the $55 Million Heist that Almost Destroyed It All

Matt made his book available as a special edition, as an NFT collection at outoftheether.net.

We cover the story of Ethereum of the early years, up to the DAO hack which would define the Ethereum governance for years to come, and it would be one of the most important events that defined the Ethereum ecosystem.

Gennaro:

Thanks Matt for joining this conversation, it’s a pleasure to have you here.

Thank you for putting together such a book that is Out of The Ether. Which is the story of the DAO, the Decentralized Autonomous Organization hack, but it’s way more than that. It’s the story of Ethereum in the early days, in the early years, it’s an incredible story. 

So the effort that went into the book for the people that will be reading it, it’s incredible. So thanks for taking the time. But so, let’s start from there. 

Matt Leising:

Yeah, of course. So I’ve been a reporter my whole life, a lot of that was spent at Bloomberg News and I was covering Wall Street and finance went through the financial crisis and all of that as a reporter. And my beat was market structure, which is like, how do markets work? What’s the kind of regulation that people are facing? Legislation is there, does this market need to be updated? So I was covering that for the derivatives market and the bond market for Bloomberg for many years.

So once I finally understood what blockchain technology was, I realized it could really change the things that I was writing about. And this was around the same time that Wall Street was starting to wake up to that Bitcoin wasn’t just a cryptocurrency, it had this blockchain technology that for the first time allowed you to engage in trustless transactions with anyone around the world, which was transformative.

So that was in 2015, I started covering blockchain as part of my beat, like I said, Wall Street was getting involved, so it was a really good time to write about it because there was a lot of interest, and to be honest not a lot of people knew much about it. So it was fun to just learn and write as I went along. So, it started just with blockchain in general, and then Ethereum had just been released in 2015, I didn’t start paying attention to it until early 2016 because there was this project that everyone was getting excited about called the DAO, it’s the Decentralized Autonomous Organization.

And I’ve written it, that’s a terrible name come up by coders that is meant to scare children in the night. But basically what this was, was, in traditional finance you have venture capital firms that have money and they want to find startups to invest in, to help them grow their business and get off the ground, and then also have an investment stake in these companies that they can then sell for lots of profit later. It’s a classic Silicon Valley model. And so the DAO was that sort of model, but just in a blockchain form.

So what it was, was a smart contract where you could send your ether, the cryptocurrency that’s used in Ethereum is called ether. You send your ether into this contract and you get tokens back. These tokens would then allow you to vote on projects that would make presentations to the members of the DAO. So it’s a big pot of money that was meant to help develop startups that would were building for the Ethereum ecosystem.

So, pretty good idea, it’s not like it’s a new idea, but it was a new format. And what happened was, they raised way more money than they ever thought they would. The people who created it were in Germany and they thought maybe five, 10 million would come in. By the time the fundraising stopped, it was at 150 million. And of course that’s ether, that’s in a contract so it goes up and down as ether goes up and down in value. So a few months later, by June of 2016, the amount of ether in the DAO had risen to about $250 million.

Matt Leising:

So a quarter of a billion dollars was sitting in this smart contract and it got hacked. There was a lot of security bugs and issues that had been already pointed out by a lot of people in the industry, but this hack was new and nobody had exactly exploited it until the hackers did. They got away with $55 million and it started this whole big process that I’m sure we’ll get into. But, that really just grabbed my attention and I ended up writing a magazine story about it and talking to the people involved, and the hackers that were good guy hackers and bad guy had.

Matt

:

And the good guy hackers all came together and made sure that the rest of the money in the DAO was safe, and it was just a fascinating story, I really just loved digging into it. So, that kind of sent me on my way, and I used that magazine story to write a book proposal, and that’s how I figured the story of the DAO hack and what happened in the aftermath is so dramatic that it would make a great way to spread that throughout the book and then have other chapters about where did Ethereum come from? Who are the people who invented it? What is it all about? And so that turned into my book out of the ether, and here we are today.

Gennaro:

Yeah, interesting. And you emphasize an important point which is, the DAO it’s, let’s say the story as you tell it, and then it’s sort of the end of the story of probably, hey, Ethereum in the first phase. So Ethereum of the early days, because after that, as we’ll see, as a consequence of actually the DAO hack, the most important decision that Ethereum meant to make going forward was whether to split the blockchain protocol with the soft or hard fork, and there was an extremely important decision, which changed the way the community would be handled forever.

And of course the final decision as we see was an hard fork, which means that now there was a different protocol which went in a different direction which was Ethereum Classic. But before we get to that, what’s the context back then, how did the main character of the story, of course, which is Vitalik Buterin.

Matt Leising:

Yeah. So Vitalik is a fast person, he’s obviously off the charts smart. And one thing that I learned that was really interesting in doing the reporting for the book is I went to his high school in Toronto where he grew up, and I talked to his teachers and I talked to the principal of the high school and, they still had nothing but glowing things to say about him. And you would imagine he’d be really good in math and maybe science, and probably say he’s a great programmer. But he also excelled in Greek and in Chemistry, and in basically every class he had.

And he was going to an elite high school in Toronto for kids who were super smart to begin with because, the public school system just was boring to him, it wasn’t challenging. So he’s a bit of a Renaissance man. He’s also a really good writer, he excelled in English. And so he has a very broad educational background and after his dad introduced him to Bitcoin, and I think it was, I’m not going to say the year because I’m going to get it wrong.

But his dad introduced him to Bitcoin and Vitalik became fascinated with it. Because it combined his love of programming and economics and math through the cryptography. And so, the problem was he was a broke teenager in high school and didn’t have any money to buy Bitcoin, so he looked around and figured out that he could write about it and get paid in Bitcoin. So he started doing that through a blog called Bitcoin Weekly. And then later after some of his articles got published, a guy named Mihai Alisie reached out to him and said, “Hey, let’s start a magazine.”

And so they started a Bitcoin Magazine and the articles are still up by Vitalik in Bitcoin Magazine and they’re really good. And so he was getting paid in Bitcoin and was getting to dig into this thing that he loved. But what happened was, soon he realized that Bitcoin was great, but he felt that it was limited. Because what Bitcoin does really well is it allows you to move value from one point to another. So, you and I could be you trading Bitcoin between our wallets anywhere in the world. It’s not really built for much more than that, the code is limited.

And so after a while that frustrated Vitalik, and he saw the potential of this underlying global network of computers that forms a consensus layer and allows decisions to be made. And he thought, I want to do something more with that. So he came up with the idea of Ethereum, which is basically a blockchain network that employs something called a smart contract, which is just a bunch of code, it’s just a program. But it now allows you to do whatever you want. So and of course you can move currency around, you can move ether around but, you can also create a contract to sell a coin to people to raise money like we were talking about, called an initial coin offering.

So if you’ve got a startup and you want to try to raise money, you can do that through Ethereum by saying, hey, here’s my idea, buy my coin and that money will help develop the idea and then I’ll deploy it to the network. It allowed for NFTs to be created, non-fungible tokens, which have been going crazy lately where it’s a piece of digital art, or maybe it’s a piece of music, or whatever it is, it’s a digitized thing that is authenticated and validated by the blockchain, which makes it have scarcity.

And so it could now be traded and collected, and have a value like anything in the real world. So what he did was give the world a canvas with Ethereum and then said, here paint what you want on this canvas. And so it was groundbreaking and Ethereum has become the most used blockchain in the world. And it’s been a huge success and really, I think, at its core goes back to Vitalik’s innate mastery of all these different subjects that he’s so good in, and it was something that, I think somebody with that temperament had to create.

Gennaro:

Yeah, interesting. And for a bit of a timeline here, I found the white article of course, and also referenced, I think in your book where most probably Vitalik Buterin was introduced to Bitcoin for sure in 2011. And the same year he started, as you said, just to give a little bit of context how things evolved to the audience. There he started to publish on a weekly magazine or to earn some money, but to earn actually some cryptocurrency because he wanted to get involved as much as possible into the project.

From there, I think the magazine, this weekly magazine a certain point it went … actually it closed. And so he also later on founded his own magazine. And also it’s interesting because I believe the first version of the Ethereum white paper would come along around like 2015 and there was really this grandiose idea, as you said, to build a different kind of blockchain protocol where it was more like the most, bad word to use, its work computer. But really it was more like, let’s develop a language instead of applications.

So instead of having a thinking process where you develop APIs, with those APIs you can just do limited things, Vitalik Buterin thought, let’s develop the whole language. And with this all sort of language, we can enable anyone to do anything on top of this application. And it’s very interesting this point because, later on in the story and in Valley Source interviews of vital Buterin, he himself was very actually surprised about some of the applications. Because there are some applications that he was very interested about, and one of those is definitely the DAO, the Decentralized Autonomous Organization, and another one it’s ENS, so the Ethereum Name System.

But he was also very surprised by new applications like NFTs. I mean, probably he also thought those were things that were very weird, had things that were created on top of the blockchain. But there was the whole approach, I guess, of the Ethereum, so enabling application. So the platform approach rather than just saying, this is what the protocol is about. And that’s what makes it very interesting, and what also drew me to look into it a few years ago. So I wanted to emphasize this point.

And another element it’s of course about, again, the evolution of Ethereum and the people that really helped shape it in the early days. Can you tell us a little bit more about the team more. So especially the initial co-founders, what happened there, because the study is so interesting that it would be nice to dig a little bit deeper into that.

Matt Leising:

Yeah, sure. So, Vitalik wrote his white paper at the end of 2012 and sent it out to people. At first he was nervous, he didn’t know how it would be received, he was expecting to get a lot of criticism. But actually the opposite occurred. He got a lot of people saying, this is amazing, and how can I help? So, he started gathering people around him who would become the co-founders of Ethereum, obviously Vitalik was there. He knew that he needed coders to help him write the actual code.

And what he wanted to do from the beginning was, write it in different languages, so different programming languages. So there was going to be the Go clients, there was going to be Python, and I believe it was C was the other one. So, Gavin Wood reached out to him and Jeff Wilke reached out to him. They’re both brilliant programmers. And so they joined the group and started writing the language, the Ethereum code in the different languages. Of course you need money for a startup so, there were a couple people who reached out to Vitalik that were able to support the project early with their own funding.

The first was Anthony Di Iorio, who was a Canadian entrepreneur and real estate owner, and he had done a lot of things in his life, but he had also found Bitcoin quite early and made a lot of money through it. So, he got introduced to Vitalik through the white paper and wanted to join and said, “Hey, I can help fund this development.” The other person with some money was named Joe Lubin. He had been a software engineer at Goldman Sachs and had run a hedge fund, and was a bit older than most of the other people in this group.

So, he had money as well, and had already discovered Bitcoin, and thought that the decentralized nature of the network that it enabled was going to change the world. So, he was very excited about the Ethereum project. There was Mihai Alisie, who was also a co-founder who Vitalik knew, of course through Bitcoin Magazine. They were friends, I would say the only friend that Vitalik had in the group was Mihai. There was Charles Hoskinson who was introduced … Anthony Di Iorio brought Charles in. Because Anthony wasn’t too technical, but he knew Charles through some work they had done together and he passed the white paper on to Charles and said, “Hey, what do you think of this?”

And Charles has a good background in programming and thought that it definitely had a lot of potential. Charles of course, went on to form Cardano, which we can get onto later. And then the last one was a man named Amir Chetrit, who had met Vitalik when Vitalik was traveling through Europe and Israel on his journey to understand whether Bitcoin could be changed into something that was more flexible or whether he had to create something new like Ethereum.

So, I don’t think I’ve forgotten anybody, those are the co-founders that Vitalik gathered around him, and they all met for the first time in Miami in January about, let’s see in 2013, so nine, is that nine years ago? They were there for the North American Bitcoin conference where Vitalik presented the Ethereum white paper.

Gennaro:

Interesting. And those are all, as you’re also recounting the book, those are all interesting characters. And just to mention a few of them of course, for instance as the example of Charles Hoskinson, he would later on develop, actually co-found Cardano, and Gavin Wood which was the main developer actually initially, probably was one of the few developers around, the few technical people around as he was the one who actually developed from scratch, the main language behind the Ethereum protocol.

Still today if you want to build on top of it, of course, I guess you have to really program in the language that Gavin Wood developed, and they later on will still go on and co-found, build up another protocol, which is Polkadot. Anyhow, the way things evolved were quite interesting, and it was initially also a debate which was about whether to set up the project as a corporation versus a foundation, which I think it’s also important because it tells us a little bit the different views between the various people within the project.

Matt Leising:

Yeah. That was one of the first sticking points among the group, they all got together in January for the first time, and then the conference was a big success and they went their separate ways but agreed to meet up again in a few months when Anthony Di Iorio was going to be hosting a convention in Toronto for blockchain. And so, the group came back to Toronto in a few months and the big question was, as you said, do they want to form a corporation, what they refer to as crypto Google? Or do they want to form a nonprofit, which they call crypto Mozilla?

Mozilla is the nonprofit, of course, behind the Firefox browser. And so, there was a definite split amongst the group. People like Anthony and Charles Hoskinson and Amir Chetrit , were definitely interested in the profit potential here, and wanted the profit to be maximized. Vitalik and Mihai I think were definitely more of the foundation, nonprofit mindset, and wanted it to be open source. And so that split the group. But the decision basically was made that they would go forward as a nonprofit.

And so, very early into the project there was already riffs that were appearing and people were maybe, I think Anthony has said, he always thought that he was in this to create a company, create a corporation. And he had seen what Bitcoin could do and realized that with Ethereum, he was in on the ground floor of something that he considered to be a $1 billion enterprise, which of course it is that many times over. But I think Vitalik held a lot of sway, and the idea of having a foundation and a nonprofit won the day, and that’s how Ethereum has been ever since.

Gennaro:

Yeah, this is a very important step, and of course among the interesting people I forgot to mention also the key role that Joe Lubin played because Joe Lubin had the main role actually was, not only was probably the oldest of the group but, he was also the most of them, between them, the one grounded in enterprise. So he was also the one who actually started the right on to enable the usage of Ethereum at enterprise level, something that probably Vitalik Buterin didn’t pay attention initially, because of course he had this vision that Ethereum to democratize and go as wide as possible.

But Joe Lubin vision, especially in the short term, was extremely important as with consensus he started to partner up with the enterprise to actually enable the adoption at enterprise level of blockchain. And this is a very smart move. Because as we know, in many cases when new technologies come to market, it’s very hard for them to prove successful at consumer level right on, you want to work first on solidly the enterprise level projects and when this proves to be successful, then you can move on and go down the supply chain, the market, so you can scale up. So definitely also he played a key role.

And as you said, the final choice was the foundation. Because the foundation, it was more like we are Mozilla rather than we are a corporation like Google, and this was an extremely important point. And the divergence of views between especially Buterin and Hoskinson, which wanted right on, I think, to look for VC, investment from venture capitalists, was a wide divergence which later on would also end up in a bad way for Hoskinson, which as we’ll see, would be, let’s say, kicked out from the project.

What happened in the days going to the crowd sale? And also, can you remind us really how Ethereum managed to, because, I think that is where also the DAO enters into the picture. Because Ethereum had to actually go through the crowd sale. So it had to figure out how to sell to the public without being also classified as a security. 

Matt Leising:

Well, yeah, the timing on this is funny because, they thought they might be able to do a crowd sale very soon after the Miami Bitcoin conference, so that would have been January of 2013. They quickly learned that there were a lot of security laws to pay attention to, as you mentioned, they didn’t want to run a foul of the securities and exchange commission in the United States, or regulators in Europe. They were also looking for a place to have their headquarters to a jurisdiction. And they looked around a few places in Europe and in Asia, but decided on Zug in Switzerland, because it’s got very favorable tax laws, and they felt that it was, regulatory wise, it was a good move.

So that’s going on at the same time as their consulting lawyers about what they want to do, this is a role where Joe Lubin was very important because he had experience in the business world, anthony Di Iorio was involved in this as well. So basically what they thought would take couple of weeks, ended up taking more than a year because they really just wanted to get everything in place on a legal front, and then also technically they were, this was very early in the blockchain space so you have to remember, they were going to sell ether coins for a Bitcoin, and the ether would be distributed at a later date.

So what you had to do was basically ensure that the wallet that you’re offering people to send their Bitcoin to is secure. So they had to build a lot of systems from scratch that didn’t exist at that point. And that took time as well. And they wanted to do that right because the last thing they wanted was to raise a bunch of Bitcoin to fund Ethereum development and then have it get hacked, or to lose it in some manner. So, all of that took time and it was in the summer, I believe, that they had a window in 2014, in mid 2014 where you could buy ether for a Bitcoin, and the price started at one point and then went up slowly until the crowd sale ended.

They ended up brazing, I think around 22 or $24 million in the crowd sale. And then it wasn’t another year then the next year was spent really diving into the coding and making sure that Ethereum could launch in 2015, which it did.

Gennaro:

There was definitely an intense period, and as you said, it’s funny to think they thought already they would do it at the time of the Miami Bitcoin Conference, instead it took them quite some time to figure out how to really make sure they could do the crowd sale without incurring into legal issues. And I guess, of course one thing that also helped was the fact that Ethereum was considered a utility token. 

Matt Leising:

Well, yeah, I should say, it’s funny the SEC did come out later and say that they thought Ethereum was a security, but they chose not to do anything about it. One reason they’ve said that they’ve given for that is they think that it became sufficiently decentralized over time. Another funny thing about the crowd sale is, they had all this Bitcoin and they didn’t hedge the money they raised, they kept it in Bitcoin and Bitcoin was actually falling at that time, at the end of 2014 it dropped quite a bit by almost by half, I think.

So they lost quite a bit of the money that they raised by not selling their Bitcoin. There’s definitely … Joe Lubin was involved here and he’s a staunch believer in Bitcoin and in crypto, and wanted to keep it in Bitcoin. When Vitalik found out about that he’s like, no, we got to stop these losses. So he got involved and they started selling so that they eventually ended up with somewhere, I think 12 to 14 million was what they were left with to fund the project after having raised somewhere around 22 to 24 million.

Matt Leising:

So after the decision to go nonprofit, like I said, rifts had formed there. Because none of these people knew each other, the only people who knew each other, well, I shouldn’t say that, the group didn’t know each other. Charles and Anthony knew each other, and of course Vitalik knew Mihai. But the group dynamic was starting to develop where Gavin Wood in particular was upset that there were people who were non-technical in leadership roles. He thought that the project should be run by the people writing the code.

Anthony Di Iorio was upset with the decision to go in a, in a nonprofit direction. Amir Chetrit, people didn’t really know what he was doing, he was involved with the project in Israel, and he seemed more dedicated to that. And at one point, at least one point he said to people directly, “I’m in this for the money.” Which didn’t sit well with the other co-founders. Charles Hoskinson was one of the younger members of the co-founding team and he has a way of rubbing people the wrong way a lot of times.

He was telling people that he was Satoshi Nakamoto, the inventor of Bitcoin. He was trying to convince people of that. He would tell stories that he had ties to the CIA, that he had a limp in his leg from jumping out of a Black Hawk helicopter in Afghanistan. Obviously none of this was true. And so the group and the people around the group just were feeling uneasy about that and so, everything kind of came to a head in the summer of 2013. They had their headquarters in Zug and they had a big house that they were renting. It was a very luxurious house, had an elevator in it and it was large and modern. And that was another point of contention.

Anthony Di Iorio was in Toronto and felt like there was a developing rift between the people in Toronto on the Ethereum team and the people in Switzerland. So, basically Vitalik called a meeting of everyone and they all gathered in the Zug house. And had a long meeting where everybody gathered around the table, and everybody aired their grievances and they didn’t mince words, as I was told by the people who were around that table. And basically the only person that everyone trusted was Vitalik at that point.

So he had a decision to make, and he went out on the balcony and paced around for quite a while, before coming in and announcing that he was firing Charles Hoskinson and Amir Chetrit. So they would no longer be co-founders. They got very nice exit packages, I guess you could call them, it was several hundred thousand ether were promised to them for their efforts for six months of work. So, wouldn’t feel too bad for them, but it was the first personnel shakeup in the Ethereum group, and there would be many more to come.

And so only six months into the project, there was already a lot of personal politics involved and maneuvering, and this was all something that was very new to Vitalik and to quite a few of the other members who didn’t have a lot of experience in the business world at that point in their careers.

Gennaro:

Yeah. And also it’s worth pointing out, they were all very young. They were all very young people also, Vitalik by the time at probably 19, 20 years old. And, so it was not an easy decision to make for Vitalik at the time. And on the other side, this paranoia which developed for some of the team members like Hoskinson as well was also the result, I guess, of many young dudes living altogether for many months in a very intense period where, yes, there were very few technical people doing the actual work, getting good, and then there were also many other who were doing other stuff, which was way less technical.

And these points are also very important point that we are going to probably look at, see later, especially when it comes to Gavin Wood and the role that he played later on. But how did we go to the hack? What happened next? So Ethereum goes to the crowd sale, it is very successful, one of the most successful ones, I guess, since Bitcoin actually, even more successful, I guess, of Dutch Coin. It’s interesting the point in order that they lost money by having the money locked into Bitcoin for a while.

Matt Leising:

So, the crowd sale all happened in the summer of 2014. By late August, I think it was late August, 2015, Ethereum was ready to go live. They were done with the coding, they had done a lot of work. Gavin, Jeff and Vitalik all had been in Berlin together testing and making sure that the clients … the thing is when you write in different computer languages you need them to talk to each other and one client has to understand that this message is exactly the same from another client, and they have to agree on everything.

So it takes a lot of testing and working out bugs and things like that to get them all on the same page. So August, 2015 they launch it and so now it’s live. And so what do you do next? Well, there wasn’t a whole lot of projects in the early days and so Ethereum just cruised along for the rest of that year, towards the end of 2015. But there was a developer who worked on Ethereum was named Christoph Jentzsch. And he was the guy that would … he was basically testing the code that Gavin and Jeff and Vitalik was writing, and he’d try to break it.

So he was a very, very smart developer and smart coder and was helping to make sure that the code that these guys were writing was good and solid. And so, he had an idea to use Ethereum to create a smart lock, is what they called it. So it would be a lock, like let’s say on a bike, that would be connected to the Ethereum blockchain. And if you’re, say you’re in Amsterdam and you want to get a bike, you come up to the bike and it’s on the street, and you scan a QR code, and that takes you to the Ethereum blockchain and you deposit a little bit of ether into that contract, it gets processed, and then the lock on the bike now opens, you can take the bike and right around Amsterdam for say an hour or two hours, whatever you paid for.

So, he had this idea, he started developing it and went around to people. Everyone was very interested, seemed like a great kind of application to use Ethereum for. So of course like any startup he needed money to develop the project. And so he was thinking about like, how do I develop, or how do I raise money? And, as he was thinking it through, he realized that everybody that he knew in Ethereum who was trying to build these new applications was in the same boat, they all needed money.

So rather than every one of those different startups raising money on its own he thought, why don’t we make this one thing that can raise a whole bunch of money for everybody, and then projects will get chosen for funding by a voting mechanism. And that was his early idea for the DAO. So he was at Slockit, it was the name of the company that was developing the smart lock and they, basically put the idea for the DAO together, released that to the community, and it was widely popular because everybody saw the utility in having one common fundraising tool.

And so, again, like I said at the beginning, they started raising money, they got way more money than they ever thought they would, and Christoph was terrified of this because, it was his code, it was his project, and he was just really worried that something was going to go wrong. So, what happened was, while there were many bugs that were pointed out in the DAO code prior to it going live, there were fixes that were made, but the project had too much momentum, I think is the way people characterize it now for anyone to try to say, hey, let’s take a break, let fix this code and make sure that it’s perfect before we go live with it.

That didn’t happen and there was a bug in the code that Christoph wrote, incredibly enough it comes at line 666 in the code for the DAO contract, which was a detail that I could not believe was true when I found that out. And what it allowed, if you knew how to exploit it, it basically allowed an attacker to come in and take money out of the big pot of money and then recycle it so that you could then do that attack again and come back over and over again, to drain money out of the DAO.

It’s a very elegant attack and I go into quite a bit of detail in the book about it. It’s a two stage attack. And what was fascinating is that, the way the DAO code was written by Christoph was, if you wanted to leave, let’s say you had bought DAO tokens and wanted to participate but then for whatever reason you wanted to get your money back and you were like, just for whatever reason you wanted to leave the DAO, you could but there was a process you had to go through where there was a number of days you had to wait to get your money out of the DAO.

And so the attacker, the hacker who exploited the bug had to go through this same process. So basically had somewhere right around 30 days where the money was sitting in a contract still within the DAO but the attacker couldn’t get that out until 30 some days later. So it’s one of those little quirks that I found so fascinating in this story was like, you basically robbed the bank, but you’re sitting there in the bank for like a month before you can go and get it in your getaway car, and drive off.

So this quirk of the code gave the Ethereum community time to decide what to do about the fork, or excuse me, about the hack, and it allowed … the money wasn’t actually gone yet so, other kind of famous, or fascinating details to me makes this like no other heist that I’ve ever come across.

Gennaro:

Yeah. And there was nothing also they could do actually to stop it at that point, once the money was ready to go out, even if the hacker was supposed to wait, still there was nothing that they could do to stop it!

Matt Leising:

That’s right. Yeah that’s one that made Christoph so nervous was he knew, once he put the code out into the world for the DAO contract, it’s very hard to change that code. You basically have to get the community and everyone who’s running the code on their computers to do an upgrade or an update, and change the code and that’s very difficult. It takes a lot of time. And, so if there’s a hack, you can exploit that hack within hours. Whereas to change the bug and the software would take days or weeks, or maybe even months.

So, they had their hands tied behind their back about fixing the bug and what they actually did, the good guy hackers who came in to secure the money that hadn’t been stolen, that was remaining in the DAO contract, they used the same flaw in the code to get the money out. So, they basically went on Twitter and said, “Hey, we are draining the DAO, don’t panic, we’re good guys.” And so-

Yeah, they called themselves the Robinhood group. Because that was the name they gave themselves in the chat group that formed on the day of the hack to coordinate this. Because you had people in Germany, you had people in the UK, you had people in Brazil, you had people all over the world and so they had to coordinate through a chat. And yeah, so they came to me known as the Robinhood group.

What was the main language behind Ethereum and why was it so important?

Matt Leising:

That’s right. So solidity is the code that smart contracts are written in? So the DAO contract is written in solidity. Of course then underlying the Ethereum network is written in the different languages that I’ve mentioned like, today it’s like GATH is a big one, it’s the Go client. There’s other languages that actually are the infrastructure layer of the blockchain. So the problem with the DAO was not in Ethereum itself, it was in the smart contract. So the bug was in the code of the smart contract that Christoph created to run the Dow.

Gennaro:

So it was not like the underlying infrastructure was compromised, it was more like the layer on top of it, which was the DAO, was actually compromised.

Matt Leising:

Yeah. And we’ve seen that in many other smart contracts over the years, there have been many bugs that have been exploited by people for various means. I can’t think of an example when Ethereum itself was the problem, it’s always the smart contract that runs on top of Ethereum.

Gennaro:

Yeah. And that’s of course, still today, one of the key issues of the developing blockchain protocols. Because, there is this trilemma where you try to balance out, of course, security and privacy with scalability, and blockchain products like Bitcoin or Ethereum, you might like them or not, but especially Ethereum, it’s a lot focused on two sides for now, which are security and decentralization. And now it’s starting like scalability with Ethereum 2.0. But this is very important what you said because, when we start building out things which are outside the main blockchain protocol, security becomes … speed becomes possible, but then it also a little bit compromises security.

Gennaro:

So that’s why also the main data usually it sits on top of the main blockchain protocol, and then on the additional outside layers, usually we bring things that are not critical for the, I guess, for the functioning of the applications that we’re building. And also there is another important point here. You said it was a two stage attack. So it means that, of course, one reason probably was because they needed to wait before they could launch another attack and drain more money from the DAO. 

Matt Leising:

Well, yeah, so that’s a good question. The one thing that I didn’t know before I really dug into this for the book was that, there were several different hacks of the DAO. The first one is the one that everyone knows about and that I’ve been describing. And that was on a Friday in June of 2016; that’s where 55 million was stolen through this two, and what I mean by a two stage attack is, everything has to be funded in a blockchain transaction on Ethereum.

So, what the attack did was it took money out of the DAO, the big pot of that’s DAO held, it took money out, but then used a little bit of it to fund the next hack, or the next time that the money would be taken out. So in the book I write about it, it’s kind of like you go to the bank and you go to the first teller and you say, “I’d like $100.” And before they give you the $100 you go to the next and you say, “I want 100.” And you do that again all the way down for 10 tellers.

And then at the end, you get your money, you get your $1,000 but in your bank account you actually only had 100. So that’s sort of the analogy that I’ve used to describe how that hack worked. And then I’m sorry, remind me of the question after that.

Gennaro:

Yeah. So was it … interesting analogy.

Matt Leising:

Oh right, right the people.

Gennaro:

Yeah.

Matt Leising:

So I think, and I got a lot of help in the book on this from blockchain forensics people because I’m not an expert at this at all, but I had a lot of experts who were really good at this helping me and looking at the code. And what I found was, the original hack was very elegant and was done by somebody or a group of people who really knew the ins and outs of solidity, and how to orchestrate this hack. Once that attack contract is launched, however, it’s public and you can, if you know what you’re doing, you can go and click on the contract and you can see where the money is going into, out of the DAO into this attack contract, and you can see the code of the attack contract.

So, now if somebody wanted to come along and basically just copy and paste that code into a new smart contract to attack the DAO they could. So that’s what the Robinhood group knew. They knew that this was now a publicly known exploit in the DAO, and that they knew that either the original attacker or a copycat could come back at any time and start draining more money out of the DAO. So that’s why they were worried. And so what I think is, I think the first attack was done by one group, and it was … one thing that I found really interesting was, when I showed the code to people, they just thought it was very elegant and it was really nicely put together, and it looked nice.

And then there was a second hack that started on the Tuesday after that original Friday attack. And this one, if you look at the code used on this one, it’s not pretty, it’s got a bunch of returns in it and it looks sloppy. And I had never thought of code like that. But, these folks who look at smart contracts all the time they do think in this way.

Gennaro:

It’s like for you looking at an article, you know, as a writer, you know which article is going to be written extremely well and which not.

Matt Leising:

Yeah. Yeah, exactly. If the formatting’s all off and the font is changing, and whatever. 

Gennaro:

The style, the grammar, many things that as an author you’re pretty intuitive about…

Matt Leising:

Yeah. So that one to me and to other people who are much smarter about this than I am, it all seemed like this was a copycat attack. And that’s one area that I was able to follow in the book, and I think I was able to find somebody who was involved in that copycat attack on the Tuesday. And because another thing, the attackers on the Friday attack were … they covered their tracks really well. It’s basically impossible to, without law enforcement or a subpoena power to trace how they got the money into the contract and all sorts of things.

They were very good at covering their track. The person who did the copycat attack, I was able to follow the steps they took with some help from some people who I spoke to, and kind of figure out, okay, this seems to be where the money came from to fund the second attack. Because as I’ve said, you always have to pay for transactions on Ethereum. And so you can look at, where does the funding for this contractor originally come from? And that’s one of the cool things about blockchain is, it’s publicly available and you can see, here’s the first transaction, now I can backtrack and go, where did that come from? And I can backtrack it from there.

And so you can look like hop, skips and jumps, and you can follow the trail, so to speak. So I was able to do that during the book, which was a lot of fun.

Gennaro:

And also, eventually did you manage because you went through, as you explained in the book, you went through such an investigation. 

Matt Leising:

Yeah. So again, nobody that I know of knows who did the original attack on Friday. The one that I think was very elegant and very smart, whoever did that. I think I found some links to somebody who was involved in the second attack on Tuesday, and I write about it in the book. And I met that person in Tokyo and interviewed him, and I’ll let readers check it out because it was a very interesting conversation. And, I’m only a reporter so I could only ask questions.

And I left that meeting with the person, I’m not sure, his answer was very interesting to me but definitely not definitive. I’m not sure that I expected anyone to confess to me but, again, I’ll leave it up to people to read in the book because I think it’s one of the more interesting parts and I don’t want to spoil it.

Gennaro:

Yeah. Also because if, let’s say, if this person was acknowledging it, in any case was acknowledging probably a second copycat attack. So anyhow, it’s still a very bad thing to do but not the original attacker which probably was the most worrying one because we can imagine that the first attack was done by very smart people, they knew what they were doing. It’s possible to speculate also that if they knew from the inside out also the main language, they have been very close to the project or in the community and all. So there are many speculations.

Matt Leising:

Yeah, that’s a really interesting point. At that point in time, the people who understood solidity at this level to do that attack, it was a small group of people. There was maybe a couple dozen around the world, tops. So I find that really just fascinating and I’d love to know who actually did it. I don’t still, and it still kind of bothers me, but yeah. 

Gennaro:

This may be actually the right angle for the sequel. So start with, who was the attacker and move forward on how Ethereum evolved after that.

Matt Leising:

Yeah. If the attacker is listening to this and they want to reach out to me, I can protect your identity, don’t worry.

Gennaro:

You’re going to say this is just for the sake of starting the other book. So, that would be a great thing actually. So to go close and to go forward, and close this up as our time is due. I don’t know how long you can stay. 

Matt Leising:

Right. So now we’re at the point where the hack has happened and there’s that 55 million that’s sitting still in the DAO, the attacker can’t get the money out for something like 32 days. And this group of white hat hackers, the Robinhood group gets together. They are nervous about using the same exploit as the attacker because they don’t know if that’s going to be seen as breaking the law. They don’t know the legal ramifications of it. They also know on the other hand, like I said, the attack contract is public and somebody could come along and try it again, and steal more of the money, which they definitely did not want.

So, they were ready to push the button on their own method of draining the DAO but they waited until the second hack began on Tuesday. And it wasn’t until then that they went into action and launched their own attack. And it’s kind of technical, but they had an ability to drain the money out of the DAO way faster than anybody else. They had amassed a whole bunch of DAO tokens and it just made it easier for them to get the money. So, they were able to safely drain the remaining funds within hours of the second attack beginning.

So now that’s also in a contract in the DAO, and so … but the money is safe for now. And then broader Ethereum community, so that was all happening kind of behind the scenes a little bit. Or if you were paying attention during this time on Twitter and on Reddit, you could have been a part of this conversation. But the broader community also had to make a decision about, what do we do about this hack? They had a few different choices. And the first one that you mentioned was a soft fork, which is basically you would blacklist the address that the attacker used and try to censor any transactions and basically freeze that stolen ether in place so it could never be moved.

This was quickly realized that that would have ramifications throughout the whole network and it would not be a good solution. So, the other option is called a hard fork, which is more serious and it’s basically where you change the underlying blockchain. Here what it would do, what was proposed was, the hard fork would … you would update the Ethereum software that you run on your computer, and this is how the network works. People are running the Ethereum code on their computers all over the world, and those computers make up the blockchain network.

So, every so often of course you have to update your code, right? So the hard fork idea was, okay, we’re going to write an update and in this update the only thing that we’re going to change is we’re going to change the DAO contract, the block that that holds the DAO contract to get rid of the DAO and basically change the program, the smart contract there. So, the only thing it does is that if you have DAO tokens, you can now send your DAO tokens to this contract and get the ether back that you originally sent in to receive the DAO tokens.

So, I think a lot of people misunderstand this and they think that Ethereum changed the whole history of the blockchain with the hard fork and that’s not true. That would have been impossible first of all, and second of all, all that they wanted to do was to fix the DAO bug, there wasn’t really anything else that that was needed fixing. So, what you do then is, basically you have to kind of get everybody on board to do that because everyone has to update their software at the same time so that the new version now has that DAO contract where only thing you can do is go get your money back.

So, they spent weeks debating it and talking to people about it, Vitalik was in favor of it, a lot of people were in favor of it as well. And then ultimately what it came down to was a vote by the people who were running the software on their computers. And when the time came several weeks after the attack to do the hard fork, basically everybody in the network updated their software. So now the hard fork was a success and they had changed the history of the DAO but none of the other transactions in the history of the Ethereum blockchain were altered.

So it was all a big success and everybody thought that they were celebrating and everybody was happy, it basically meant that the attacker had all his money taken back so, what he had stole was stolen back from him by the community, changing the blockchain, and everything seemed fine. But then people noticed something weird a day or so after the attack, or I’m sorry, after the hard fork. So the way to visualize this is like a tree branch. And a hard fork is like a new branch that splits off to the right.

And what you hope for in that case is that, there’s the old network branch, and then the new branch is the hard fork and it just keeps growing to the right. What can happen in a blockchain though is, at that point where it splits, the branch can keep growing straight. And so what has to happen for that to occur is, somebody has to keep mining transactions on the old network, and they have to keep paying to publish blocks.

And it’s oftentimes very uneconomic, it’s very costly and it’s not something that people do. But in this case it happened and this is where the story gets even weirder. So, everybody, I said, everybody upgraded their software, that’s not entirely true. There was a mining pool in China that didn’t, it was called F2Pool, I believe they’re still around today. They stayed with the network where the DAO hack was possible, where the bug was still in the DAO hack. And somebody kept mining blocks on that old chain, on the original Ethereum chain and it kept growing and growing.

And then all of a sudden there was two chains. And in a blockchain, you don’t want that to happen because it’s very confusing because a blockchain needs to have one record of transactions that everyone agrees upon on. And if you have this fork, it gets confusing. So basically this new fork that kept growing straight and had the DAO bug in it still was named Ethereum Classic. And the fork part of the network of the chain is what we call Ethereum today.

So hopefully I haven’t lost you yet. But the other thing that happens when you have this new fork, or excuse me, the original fork that keeps growing is, Ethereum Classic now is a blockchain that you have to use ether on for transactions so it has a inherent value. And this new coin was called Ethereum Classic. And suddenly if you had any ether in your account at the time of the hard fork, you now had the same number of ether classic tokens.

And so, within a couple days, I think an exchange here and an exchange there started listing Ethereum Classic for trading on their exchange helping to give a value to this new coin. And so, I know that’s a lot to digest and I’m going to stop here to see if you have questions.

Gennaro:

Yeah, yeah that sounds good.

Matt Leising:

It’s kind of beyond Sci-Fi, it’s just wild.

Gennaro:

Yeah. Incredible and let me take a bit … some steps back and we move forward. And one interesting note is, I was looking as we were talking at the market capitalization of Ethereum Classic which was the blockchain that came up as result of the hard fork where today it’s about 2.9 billion and we are in January of 2022. So interesting to notice that this has survived.

And as you said, it doesn’t always make sense because when you do the hard fork, in order for the … what remains of that to survive is actually to have also a group of people is going to maintain that. And it’s not intuitive the fact that Ethereum Classic actually survived as a result of the split. And another key point also to highlight is that, as you said, the main difference between the soft fork and the hard fork is that the soft fork only probably changes are going forward as you need to update with the new rules.

The hard fork is interesting because it removes from the past, in this case, the DAO. So it’s not like, as you said, it changed the whole history, it just changed the one aspect which was important, which was the DAO hack. So it removed from the history of that so that it could start the fresh again, that’s pretty much what they wanted to achieve. But of course to achieve that, they had to do it by achieving a community consensus, because let’s remember blockchain protocols are most similar to open source software where, there is a group of people developing it and a group of people that handle it.

And so, you need to reach consensus, and of course Vitalik Buterin was a figure around the project so people trusted him, but he was not intuitive at all to solve the issue with the hard fork, it was not a simple choice. And as you said, the other point it’s about Ethereum Classic, how it survived. And, the sort of two parallel histories. One with the Ethereum without the DAO hack, and another one which is Ethereum Classic, which is Ethereum with the DAO hack. So going to close this up, what happened next to the co-founders?

Especially because Hoskinson was out and he would later also found Cardano. 

Matt Leising:

Yeah. Gavin was instrumental in the Ethereum project because, what he did was he took Vitalik’s white paper which, Vitalik had worked out some things, some details. But, what needed to happen was, the next step was writing a technical spec basically so that anybody could come along and figure out how to work with Ethereum, and create their own node, for example. And so that’s what Gavin did and it’s called a yellow paper. So it’s basically the technical owner’s manual for Ethereum, and he wrote that.

And it’s incredibly … you definitely need to be a computer scientist and a programmer to understand it, it’s not something for laypeople to sit back and read. So he’s obviously brilliant and I do think he wanted to have more control. He always, as I’ve said, didn’t think the group should include people, the leadership group of Ethereum should include people who weren’t technical. So, he left eventually and started working on his own project which today is Polkadot.

And it’s a smart contract based blockchain. It’s got different features than Ethereum today, it’s faster, I believe it’s on proof of stake already instead of proof of work. And it’s one of the, people call them Ethereum killers, I don’t really subscribe to that, I think there’s enough room for a lot of different blockchains in the world and so I just consider Polkadot to be an alternative similar to Solana, or, take your pick.

But, yeah, so he went on to some great success and took a while to develop and perfect Polkadot. But it’s out there now and people are using it.

Gennaro:

Yep. And to recap a little bit what we said so far, so the history of Ethereum is so interesting because again, it was so intense and the way also they figure the things out on the fly was not … because now other, let’s say, layer one protocols have spared up, especially in last two, three years. But when Ethereum did actually was built up, it was the first protocol to try to do something completely different from Bitcoin. So these are the most important aspect.

Of course there was a team of people behind, very smart people, interesting people, also characters that eventually clashed also because they had a different kind of philosophy on how to handle the project as we saw with Vitalik Buterin was for adding it as a foundation, Hoskinson wanted to go more in the part of setting things up more like a corporation. And then also going forward there was also this division between the very technical people like food who were working on an object which is extremely technical.

So as you said, he needed to have technical people as the main founders of the project against the rest were not really technical people. And then we added this scenario where they figured out how to launch when they thought they could launch actually at the time of the Bitcoin conference in Miami. Around 2013 actually they couldn’t, they needed to wait for understanding now from a le

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In this episode, we're covering the story behind PayPal, based on: The Founders: The Story of Paypal and the Entrepreneurs Who Shaped Silicon Valley.

Gennaro:

Thanks for joining this conversation, Jimmy, it's a pleasure to me because you wrote an incredible book called The Founders where you actually tell the story of the PayPal founders, and also the people behind PayPal. Thanks a lot for joining this conversation.

Jimmy:

Well, thank you for having me and for the kind words, and also for taking the time to read the book. It's funny, the book is longer than I thought it would be. And I think some of my readers have said it's taken them a little while, so I appreciate you taking a look at an early copy and spending some time reading it.

Gennaro:

Yeah. Actually thank you. Because it was a pleasure, I'm really honored to have had the chance to look at the initial manuscript before the launch, it's incredible research. You've done an incredible job. The story, it's so incredible, and I want to start from here because of course I know because I already read the manuscript why you were drawn to tell the PayPal story, but let me ask you what drove you to actually cover a story of a company that yes, defined the internet business playbook but was a company that was launched more than 20 years ago. 

Jimmy:

Yeah. I came at this in a little bit of an accidental way. As my projects tend to go. I had finished up a book on a mathematician and electrical engineer named Claude Shannon and Claude Shannon had worked at Bell Laboratories in the 20th century. And Bell Labs was just the most extraordinary collection of talented people. And they had invented the transistor, they had won multiple Nobel Prizes. They invented the laser, they invented touch-tone dialing.

And I started to think about, and honestly just go down Wikipedia rabbit holes of, what are other places like this, not individual talents, but clusters, groups of talented people? And I looked at Fairchild Semiconductor, which is a famous example. I looked at Zeropark, another example, general magic stood out in history. And someone had done either great books or great documentaries on those three subjects. And so, I fast-forwarded in the history and the late 1990s in Silicon Valley, the place is on fire. There's so much happening, there's so much money, so much ambition.

And in that particular environment, you find this company created called PayPal and PayPal turns out to be the finishing school for this whole generation of entrepreneurs. Some are obviously household names, people like Elon Musk, Peter Thiel, Reid Hoffman. But there's a whole cast of characters there that maybe don't make the front pages of the headlines, but learned a lot from their time there. And I went into it just not really knowing what I was doing in the sense that I just figured, "Okay. There's probably a book on this."

And then when I discovered that there should have needed to be more work done, I just started contacting people. And before long, I discovered that there really was something that happened at PayPal in the late 1990s and early 2000s and that the story deserved to be told, but that's how I came to it.

Gennaro:

Wow. Interesting parallel with the Bell Laboratories and let's say a company where interesting people came out and as you said yes, Elon Musk, I think, it's a name that everyone recognizes today. Of course, names like Thiel and also Reid Hoffman, they're known in the business world. I'm not sure really if they're known outside that. I wouldn't say that my mom knows who like Thiel or Elon or Hoffman are, but those are people that define really the internet as we know it. Let's get to a little bit of background of the stories, of course, of some of the people that created PayPal.

And in the book, it's such an interesting account because it's not just about the stories of, as you said, the main founders, like Thiel, Levchin, and Musk on the other side, but it is also the story of many other people as we see.

Jimmy:

Yeah. What I found to be some of the most interesting parts of the story, and I think part of the reason is it's very easy to look at these people today and assume that they were destined for success. Just the very quick version of it, or the medium size version of it is on one side of the story, you have a young engineer who is fresh out of the University of Illinois, Champagn, Urbana. His name is Max Levchin and he arrives in Silicon Valley and through a series of events, he meets this young investor named Peter Thiel.

And Peter has been looking to invest in internet businesses. Max has an idea for what would be his next business, and they get together and develop a friendship and Peter makes a decision to invest in Max. And eventually, Peter becomes the CEO of that very tiny company with a few other co-founders who play pivotal roles as well. Ken Howery, Luke Nosek, Yu Pan, and Russ Simmons. That's a group of six that's on one side of this. And their initial idea is that they're going to make it possible for people to be money between PalmPilots.

And so for those listeners of a certain age, they'll know that PalmPilots are maybe the distant ancestors of your iPhones, and they were handheld devices that were very popular in the mid-1990s and they had introduced an infrared port as one update in the latest series of PalmPilots and Max Levchin's idea was we can do cryptographically secure transactions between this. So if I'm sitting at lunch with you and I want to send you $10, how cool would it be if I could do that through the infrared port on my PalmPilot?

That was one part of the origin story. The other side of the origin story, which is really never really gotten truly, I think explored is Elon Musk had successfully built and then sold a company called Zip2. And he was thinking about what would come next for him. And from his days as an intern at a bank in Canada, he had thought a lot about how the financial system was running on old technology and that there were unnecessary fees, unnecessary bloat, middlemen, bureaucracy within that financial system.

And he thought, well, look, the internet is fundamentally reducing a lot of that in other industries, it should do so in finance, so he built and found three co-founders for a site that was X.com and X.com was going to be a revolution in finance; banking, insurance mortgages. It was going to do everything. At one point I had employees tell me he would say, "We're going to be the federal reserve. We're going to be the world's financial system." It was a vast ambition, certainly different from beaming money, but those were the two predecessor companies of the company that becomes PayPal.

Gennaro:

Interesting. And as we see those two companies for a bit of context, those two companies saw one side Confinity, which was as we said, founded by Peter Thiel who had met this brilliant guy, Max Levchin who was the technical guy. They founded Confinity on the one side and then Musk on the other side who had founded X.com. As a side note in the podcast series, I also interviewed Jerry Campbell, who was in charge of product management back in days in the '90s Compaq and Compaq was the company that actually bought Zip2 for 21 million.

There was the first cash infusion that gave Musk the ability to start his next company, which would turn into PayPal and interesting enough Zip2 would play also an important role in Compaq's strategy as Compaq also bought as changing at the time called AltaVista because at Zip2 built out local directories. So it was a key tool to have in this expansion strategy of the internet at the time. You see how many interesting things are how they cross each other.

Jimmy:

Yeah. It's interesting that you mentioned that, and I'm glad you're mentioning this part of the history because one of the reasons I wrote this book is I had thought, "Okay, it's fantastic to get all this press attention for the different things that these people do today, like electric cars and rockets, but what if we went back and really asked them about the most boring or perhaps most formative and interesting period in their lives, which is their first series of startups?" And Zip2 was hugely important in Elon's life.

And I think what's underestimated and under-covered is the fact that Zip2 broke a lot of technological boundaries. When they were doing the things they were doing with Maps, these are all predecessors of things like Google Maps and Yelp. And there was a lot of technology built-in Zip2 that was really innovative for its time. It was some of the first applications of Java, which had just launched. And so I think, I don't know that Elon ever actually gets enough credit for the vision and the engineering, especially in the early days of Zip2, which he started with his brother and a co-founder named Greg Kouri.

They were really doing remarkable stuff. I'm glad you mentioned it because I think it's the easiest thing to overlook. People don't tend to... They tend to focus on what's going on in 2022, but back in the mid-1990s, when Elon was basically fresh out of college, he built Zip2 into something really remarkable, what one person labeled at the time, like a mini Microsoft. And so I'm glad that you're mentioning it because it is a part of the past so we tend to overlook it.

Jimmy:

Yeah. It's one of the central and most interesting parts of this story is let's say the period in 1999 and very early 2000 when both of these companies get going and the abbreviated version is Confinity launches its product, which is called PayPal with the idea that you and I are going to become... We're going to move all our money and all our transactions over to PalmPilots, and we're just going to be beaming each other money left and right. They build an email backup product, and it turns out that the email backup product takes off.

X.com has this other vision, which is we are going to be the place where you put all your and do everything financial, but for it too, the product that is most successful is this emailing money from person to person product. And so, it's interesting because in both cases, no one expects that the breakthrough product is this emailing money thing, because on both sides, I think there's a certain amount of... Well, that's so simple, it's so much more interesting to do a financial services superstore.

It's so much technologically interesting to do PalmPilot money beaming, but both of them end up actually having this email money product take off. And part of the reason is that it takes of in a place where that service is needed and that's eBay. And so, eBay at the time had grown into a public company. It was the world's largest digital auction house. And for all of that success, it actually hadn't rationalized how auction buyers and sellers would pay for goods and services. So if I bought something from you, I still had my choice of how I was going to pay you.

And people were still paying through checks and money orders, and these very high friction systems, enter PayPal and X.com's email money offering, and all of a sudden I've got a way to pay you that's very, very quick. They find that their user growth explodes on this platform where they hadn't really anticipated their growth. And that begins a race to see who's going to win there with this seed group of buyers and sellers on eBay who have decided to embrace these two services.

And it's a foot race the early part of 2000 is this insane battle between these two companies that leads out to obviously some moments of real humor and intensity. But it also, it also paves the way for them to become one company.

Gennaro:

And this is such an interesting point to emphasize because as you said, those companies stumbled upon a use case, which turned out to be a killer commercial use case, and also the two completely different philosophies. On the one side, you had a more technical, practical approach of Confinity with Thiel and of course, Levchin was way more technical, who looked at the PalmPilot as the main application for Confinity. And on the other side, you had the visionary approach of Musk that nonetheless, he wanted to change the whole financial system.

In reality, he figured also for X.com the email feature on top of eBay was getting used a lot. The interesting part is that both those companies eventually converged into the commercial viability which was the possibility to pay through email, but those companies had to acknowledge that actually this was the main killer commercial use case.

And it's interesting because as you also point out in the book, years after that, for instance, Levchin was still looking at the PalmPilot which was a successful device in the late '90s, but definitely didn't get the traction that it was supposed to, and Levchin was still looking at the PalmPilot as the core application. This purist view of the technological world, where you had to be on this technological platform rather than an auction website, like eBay that for how much traction it was getting, it was not as interesting as the founders thought.

And then on the other side also, Musk acknowledging that again, this was the most important application they were supposed to actually go for it. A little bit of evolution there. How did the companies then ended up from becoming successful at least, successful is probably a big word because they were struggling all along.

Jimmy:

Yeah. You made such great points and I do want to emphasize a couple of things that you said just in your meditation on their early success. There's two things. One is just the humor of at one point, Max Levchin actually tries to block eBay IP addresses and the use of the PayPal product on eBay, because he is so horrified by the idea that his technological marvel is going to be used on this auction website that he doesn't really think very much of at the time. And on the other side of it, Elon has a very big vision for what finance could be. And in some ways, he's 20 years ahead of his time.

We see a lot of the things and ideas that he was talking about coming into being today. And so, you do have this funny thing of these people are both... They're so technologically ahead of the curve, but they can't miss the clear evidence of fast user growth in this very obscure place or what they think of as an obscure place on the internet, which is auction buying and selling. And so, that's the funny part of it. I think the more interesting part or the lesson that I think people could take is, you shouldn't mess with success and you shouldn't ignore success.

Meaning like, it could have gone very differently had Levchin pursued this, like, "We're not doing this eBay thing, we're sticking with mobile encryption and security." Or if Elon had said, "Yeah, that eBay person to person payment thing is nice, but we really got to focus on these other tools and options." And it is interesting that I think one of the descriptions that I had from David Sacks was, it was the product that ate the company. It was this email money afterthought product that actually became the product that we all know and use today.

And it changed everything from what the company was focused on to the company's name. Because if you remember the names of these companies are actually Confinity and X.com and PayPal is a product that Confinity created. And 20 years later, it's the product that's left standing. You asked a question about how they came together.

There's a whole series of complicated wheeling and dealing, but the basic facts are at some point, there's a recognition on both sides that the only true competitor in town is the person that's just up the road on University Avenue. X.com's CEO at the time recognizes like, "Look, we are spending ourselves dry, trying to beat these Confinity guys on eBay, and it's not good. This isn't going to end well for anybody." 

And then the folks at Confinity say, "This X.com group has a seasoned entrepreneur, much bigger brand name, they're moving just as fast as we are, and we're going to lose because they have more money."

Both companies are also trying to raise financing rounds in early 2000 at a time when the early signals of the market decline, you're starting to see them. There's little wisps of concern that the tech bubble may be a bubble. And both of these companies' leaders, these are massive people, big personalities, lots of IQ points, but by hook and crook, they actually merge the two companies and close a joint hundred million round of financing just before the markets start to collapse. And there's not a lot of like... It happens so fast.

What I just described happens in the space of eight to 10 weeks, roughly that these two former competitors now have to become one happy family. And it's a very, very tense, very hard period, where everyone is working around the clock to continue to service the user growth, but they become one company. And as of, I think the official announcement was in late March, March 30th. As of March 30th, they are united as one fast growing payments company.

Gennaro:

Yeah. And there is one I think event that also made the company merge eventually. And it's interesting also to probably account a little bit on how the deal eventually closed between the two companies. But mainly as you said, it was critical to close it at the time because without that runaway of money most probably we wouldn't have any PayPal today because they would have finished up the liquidity to run the business. It was extremely, extremely important. 

Jimmy:

Yeah. It's a really dramatic six months in these people's lives. And whenever I would interview anyone, the year 2000 was this year, that for a lot of these people was the lo... They had to measure it in dog years. It was the longest year that they could remember. And they worked round the clock under a lot of pressure. As you can imagine, you have these two competitors, they've built two separate companies, and now they're expected to be one company, but we're not talking about a group of seasoned leaders who are really thoughtfully applying a year's worth of M&A analysis to figure out what the synergies are.

This is legitimately a merger that is done in the space of two to three months. And it's not that people weren't thoughtful about the upside. It's just that it's really hard to manage that, particularly when the company is growing by tens of thousands of users every day. The companies merge and there's a few different things that happen. There's confusion around who's going to be in charge and that leads to some things. There's confusion around what are we trying to do? What is the vision for the company? And there's some debates around that.

There's confusions around what the company is going to be called and there's some debates around that, but the long and short of it is that three month or four-month period from let's say late March through the beginning of the fall, it's a really intense time for the company because the PayPal we know today really comes into being during that period. There are tools and products created that PayPal users use to this day that are born in the summer of 2000, Musk become CEO in the summer of 2000. And the company also grows to a significant scale in the summer of 2000.

Now, those are some of the positives of the big developments. There's also, the company starts to experience huge amounts of fraud and credit card chargebacks, so it loses money. There are some complicated leadership transitions and some battles at the top around things like the name, but more precisely to your question, there's a debate about technological architecture, and there's a little bit of background on this, which is, there was a long simmering internet dispute about whether Windows systems were superior or Linux based systems are superior.

And when X.com was first created, it was created on a Windows based system. And when Confinity first created PayPal, it was built to top the Linux system. And these systems have a tough time fusing together and there's a decision made to rearchitect the paypal.com Linux based site onto a Windows based system. And this causes a schism in the ranks, let's say, and it causes a lot of difficulty in conservation. You have senior people who flirt with the idea of quitting the company who think that their days are numbered. On the other side, you have people who say, "Hey, this is the only thing that makes sense because we need a stable system and paypal.com is going down once a week for hours, and we're having to stay up all night to fix it."

I want to paint the picture of, there's not one thing that the company is dealing with in the summer of 2000. It's seven very consequential things. You've built your success on a third party platform called eBay, so you have eBay attacking the company. You have credit card companies who are saying, "Wait, you're using credit cards on paypal.com and you're underwriting other people's transactions. Aren't you a master merchant? Aren’t you doing what we're supposed to do?"

You have fraudsters who say, "Hey, these guys are giving out 10 and $20 bonuses. This is a gold mine. We've got to go and use this and take advantage of this." And you have these two teams who are rapidly growing with relatively limited experience in this space, particularly at the top. You don't have decades and decades of, call it company history, let's say. These are companies that didn't even exist a year prior to that moment. And so you have all this happening all at the same time, and it leads to some tension at the top and some changes in the company vision.

Gennaro:

Extremely interesting, and in the book, of course, people are going to find a lot of other stories that I don't want to spoil, that are between the drama and the fan, because some of those stories are just incredible about the deal. Also, let's say when Musk and Thiel were going to the meeting where they were about to seal the deal between the companies.

There's one thing interesting that happens, but people can look at it in the book and also the way the negotiation eventually went through, pretty interesting because there were a few turns of events that actually were about to kill the merger between Confinity and the X.com. It was not a smooth one at all. But there was an interesting turn of event. And then also there, as you said, there are many near death experiences that happened which were about to kill the new formed company. It was not like this new formed company finally managed to give safety to the team.

Instead, they kept going through many near death experiences. And even though they had this funding ground, which saved them from the burst of dot-com bubble, yet they had to go through a lot of problems. And the main one of course, was that the main growth channel was the eBay platform. So they were working as if they were a third party application on top of the platform. And they were enabled to do that until eBay could actually decide to shut them down, which as we see it didn't happen.

But a couple of key points, 

• One it's about as you said, even though when they merged up, the two philosophies, even though they merged up eventually in good terms, the two philosophies came about because it was not just a technical problem. The underlying platform was the foundation of the old service. The difference between Musk, which went for the Microsoft enterprise tool was a much more entrepreneurial let's say, approach where he recognized the stability of the platform and importance to use simple tools so that the code base could be reduced. And then on the other side, you have the more let's say philosophical approach of Levchin which says Linux is an open source solution it's superior not just because it's open source of course there was much more to it, but the problem is by developing on top of the open source, the code base was also much more disorganized, much more complex to handle, I guess, at scale. And those two philosophies came at clash and was one of the reasons why there was eventually, as we see the host of Musk as a CEO.
• But before we get to that there is one key interesting aspect, both companies built out the business playbook of internet companies, because they managed to grow virally. 

Jimmy:

Yeah, it's what I think is one of the most interesting parts of the PayPal story is the idea that we take for granted today of viral growth. Viral growth is this commonly used term. And in many ways, as you described the rudiments or the template for this was built in 1999 and 2000 with these two startups on University Avenue. There's a few ways that they managed to take advantage of the fact that they have traction on eBay and I'll talk through some of them. One is very simple, which is they use bonus payments.

And so, for Confinity's PayPal, if I can send you $10 and if you sign up for PayPal I will get another $10. Meaning I have incented all sides of this behavior. It's not just that I can send you $10, you accept it and we call it a day. It's that I actually benefit from when you decide that you are going to finish your signing up. And again, some of this is... Yeah, it's a two sided incentive.

And there's a way in which it seems so basic to us, but this did take a certain amount of call it ingenuity and also bravado, because they are giving money out on the internet at a time of dialup modems, and limited experience with digital finance, for most customers. One person jokingly called it the largest transfer of venture capital money to college students and human history.

Because you had all these college students signing up and taking advantage of the fact that they could get all their friends to sign up and if 10 friends signed up, they were suddenly a hundred dollars richer. On eBay, the way this works is you have businesses using referral links to sign up users and every single transaction, suddenly the margins change. So if I'm buying a five-dollar touch key on eBay, and you're giving me $10, I just made five dollars for buying something, right? Exclusive of shipping costs and everything else.

They use bonuses in a really interesting way and an inventive way. And in a way that actually goes beyond just the standard bank model of giving someone a toaster. Because it's not as though, once I accept the toaster, the bank is getting another toaster. They went a step further and they were always assessing and analyzing. Sometimes they would change the bonus incentives. The Confinity guys were really nervous that X.com's bonus was twice the size of theirs. So Elon is giving away $20 instead of 10. There's this incentive piece.

The second thing they do is they get obsessed with taking advantage of the early sparks on eBay and they build tools that specifically cater to eBay power sellers, which are the core eBay community of people listing auctions. They just start building relentlessly, just building tools to scrape eBay webpages, to understand where PayPal's being used to help eBay buyers insert PayPal logos.

They developed at one point a technology called Auto link, where if a seller is interacting with a buyer and the buyer has used PayPal, even once the PayPal button will show up on that seller's page. They do all kinds of things to simply goose the growth that they're already seeing, and to make it essentially seamless for eBay sellers to use PayPal. And I will tell you, I interviewed a few people who were sellers on eBay and looked at a lot of documents and message board posts and other things from this era.

And one of the things that comes back is sellers were always impressed by how quickly the company would create a tool or solve a problem once there was a complaint and I spoke to some people who worked at PayPal's Omaha customer service headquarters, and it was actually one of the things that even impressed them. They said, "We would send something to Palo Alto and it would be changed or fixed by the next day." And you can imagine this caused obviously enormous stress long hours, but what it did was it endeared them to this power seller community.

It wasn't just that they stumbled on eBay, got lucky, called it a day. It was actually that once they noticed this first set of sparks on eBay, they started to do everything they could to increase that fire. The last thing I would say is there's a quality within the company of pushing every limit you could right up to legal limits, if that makes sense, meaning sure the credit card companies are going to be unhappy, let's push right up until we can't anymore and we'll continue to do what we can to service our user base and focus on the users and the product while treating other rules as fungible.

There's just a series of innovations that PayPal has to do to deal with fraud, for example, that might have sunk any other company, but there is a particular focus on this group of just pushing those limits as far as we can and then we will fix what we need to fix later. And so, I don't know what word might capture that quality. It's part of why the virality is not an accident. It's not an equation that someone plugged into a spreadsheet. It was the product of a lot of hard work that occurred in late 1999 and in 2000 to manage this and grow these initial sparks on eBay.

Gennaro:

Yeah. Extremely important point to emphasize, they managed to build a business playbook, which is still today, the playbook of startups on the internet when many of those disciplines didn't even exist yet. They managed to build viral marketing, built into the product what today we would call agile software development, the lean startup methodology, growth tagging, blitzscaling. Many business frameworks that today we give for granted that more or less everyone in the online business world, the digital business world knows were developed at the time of PayPal.

Again, just to emphasize a little bit more viral marketing, where you build virality into the product, the product was a freemium when freemium would become a cool term between the late 2000s, like between 2005, 2006 the agile methodology, where, as you said, when you start building up on eBay and you see that some strategies are working out is not just random success, you are doubling down on that. So it means that you're looking at the data over and over again.

You are iterating this iterative approach, which it's a typical agile development and then link startup where really there is a loop in place that is based on what's working and you keep building on that and growth tagging where you, let's say, break down the walls between product development and distribution, meaning that the product is what gives you distribution. And that was like a fixation. There was really something that the PayPal team thought about a lot, and Peter Thiel also wrote a book about that, which is Zero to One.

Zero to One is a book by Peter Thiel. But it also represents a business mindset, more typical of tech, where building something wholly new is the default mode, rather than building something incrementally better. The core premise of Zero to One then is that it's much more valuable to create a whole new market/product rather than starting from existing markets.

And then of course, blitzscaling, which is the term that was coined by Reid Hoffman founder of LinkedIn which, whether you like, or not the concept, I think there is a lot of misunderstanding around it. What he means is that in times of words and especially when you're developing a new market, you need to really prioritize on speed over everything else, because most probably in a few months, if you don't do that, you're going to be dead. So if you're put in the corner, either you go to war and you Blitz scale, or actually you are going to be dead.

Blitzscaling is a business concept and a book written by Reid Hoffman (LinkedIn Co-founder) and Chris Yeh. At its core, the concept of Blitzscaling is about growing at a rate that is so much faster than your competitors, that make you feel uncomfortable. In short, Blitzscaling is prioritizing speed over efficiency in the face of uncertainty.

Those are very critical points; I think to emphasize. And thanks for making me think about those. 

Jimmy:

No, and I couldn't have summarized it better than you just did and I think what's interesting is part of the value in coming at this story as somebody who is not in tech and doesn't have the same familiarity with that language is I was looking at these things as events, and then I would go, and I would research the origin of a phrase like freemium, right?

And I discovered, well, this is exactly the work and thinking around the freemium model was having at PayPal, but they didn't have the word freemium to call it. I would go and look at the way they organized their tech team into small units that could make changes on their own with just two or three people, and it turned out that agile software development, the first book version of that thinking came out a year or two later.

The freemium - unless the whole organization is aligned around it - is a growth strategy rather than a business model. A free service is provided to a majority of users, while a small percentage of those users convert into paying customers through the sales funnel. Free users will help spread the brand through word of mouth.

It's interesting that we came at this from both sides. PayPal does pioneer a lot of these features, but it's not like they’re sitting around thinking, "What are we going to call this methodology that we just created?" What they're doing is, "Oh my God, we're losing $12.5 million every month. We've got to figure out how to fix this. We've got to move very quickly. It's going to take X, Y, and Z." 

And then these things become principles that apply, obviously in other context, but you're absolutely right. That a lot of this style of work came into being during this period. And I would say part of the reason it came into being is because the money dried up in Silicon Valley.

One of the things that I think is so easy to forget is that in the year, 2000, once they closed that nine figure round, there's not going to be another nine figure round for a while, because you have the collapse of many dot-coms that were very high profile, and you have this, what someone who I interviewed called the killing fields, where just all of these companies dried up. 

And so, there's a part of this that is need is the mother of invention. They had to figure out solutions because they felt like if they didn't, they were the next Pets.com and they were going to go bankrupt.

And so, it's just interesting. I find that it's useful to hear someone who's more well versed in this, describe some of the broader principles because I had to reverse into them, meaning, understanding the events and then looking up and realizing like, wow, there was no book on freemium pricing model that David Sacks could have turned to to think about this.

Gennaro:

Yeah. And again, interesting also what you mentioned. There was definitely the whole playbook that still we have today was determined by the dot-com bubble. No doubt about it because many companies actually had to face near death experiences. And this was not just for PayPal for instance also huge companies, successful companies at the time, for instance Amazon were very, very close to bankruptcy.

Not many people know that, but I think in 2001, I told the story on the blog and on a few articles, which I wrote, but also Amazon was very close to bankruptcy during the birth of the dot-com bubble. And he managed to get the financing deal which gave it really the liquidity to survive those months. But once they passed through this period, they had to change the playbook altogether. For instance, in the case of Amazon, Amazon has had to transition from e-commerce to a platform business model, which is something completely different.

From a company who sold products on the internet to a company who hosted the third party sellers on the internet, and this changed the whole business, because they had to think in terms of platform, they had to think in term of how do we actually create the underlying infrastructure, which would later become AWS in 2004, 2005 to host those stores? And this is extremely important. And as you said, the lessons of many... There were a couple of huge.

There were many, many bankruptcies, but there were two huge failures that were key lessons, I think for many of the startups during that period, but also later on. One was of course Webvan which had ambition to bring grocery online, which is something that has become viable throughout the 2010 and still now throughout the pandemic where a company worth billions would be built on top of lost my delivery, like Instacart, for instance.

But one was Webvan, which had these ambitious business plan and these ambitious vision, they thrown money without validating the market, without doing a lot of iteration as instead PayPal was doing and they ended up in a very bad situation where they burned one billion of dollars very quickly, and they had to shut down. Another example, which you mentioned, which I think's very interesting, it Pets.com, which was really another key failure that made those companies change the business playbook and go toward agile and all the other methodologies that we know today.

Just as a reminder I was looking in last days just in 2001, Pets.com, spent a huge sum of money as also mentioned in a Super Bowl event, which definitely in a few months, made the company shut down. Those were key moments for PayPal. And then how was then the later transition from PayPal and Conf... Sorry, Confinity and X.com coming together, Musk getting hosted as a CEO? And also a little bit, how was the experience of Musk as a CEO?

Because I think this is an important point because in many accounts at least over the years, and thanks for putting together the book, because you also changed my mind. I had the impression that Musk as a CEO had not been a great experience for the employees or for the team around him, but from the book, that's not my understanding. 

Jimmy:

Yeah. It's interesting. I appreciate your point about, in many of these iterations of the PayPal story or versions of the retelling Musk was written out. And I think that if I can offer one important thought on this, that I really think is worth emphasizing, because it's the easiest thing to miss. There may have been disagreements at the top and there certainly were, and they were disagreements about founder vision, product strategy, technological architecture, naming.

These were serious substantive disagreements about everything from, is he company burning through too much money to make these kinds of changes? But I think the thing that people forget about Elon's tenure that I hope comes through in the book is that he was an incredible magnet for talented people who stayed with the company even after he was no longer CEO. So, if you just think of a few of the people that Elon was personally responsible for hiring, or certainly were hired under his leadership, Jeremy Stoppelman, who goes on to found Yelp.

Amy Rowe Klement, who goes on to becoming, I think one of the youngest executives at eBay when the company is acquired later. Elon hires Roelof both fresh out business school. In fact, Elon tries a few times to hire Roelof, and today obviously Roelof steers and stewards the Sequoia Capital and becomes PayPal CFO during this period. On and on. You can name person after person where they joined the company in some measure, or perhaps in great measure, because Elon really pushed and persuaded, like, "I have this vision, we're going to do this thing."

And I think that's all often gotten ignored. That you had all these talented people and sure there were some disagreements at the top, but there's no way to ignore his ability to attract talent. And I think that that's... I would say by the way, that's true of Max and Peter as well, but I think they've gotten credit for that over the years just the way these stories have been told, and I think that there's a gentleman named Sanjay Bhargava who joins X.com and interviews with Elon and Elon's the one who persuades him to join.

And Sanjay comes up with this concept for random deposits that is the way that the company authenticates bank accounts and it is critical to the company's success. And it's a story that again, rarely gets told, but part of what rarely gets mentioned is Elon is the one who meets with him, recruits him aggressively, brings him on board, actually hires Anita Bhargava, his wife as well, who plays a big role in this company and really fights for talent when he spots it and finds it.

And so I think that's actually really important as an important part of this because I think there's going to be a lot of attention paid to the Max versus Elon thing, but I would actually also emphasize that even in his departure, Elon was very gracious, but more importantly, a lot of the people that he hired go on to become some of the most consequential figures in this story. And then in contemporary Silicon Valley.

And I think, look, there's plenty of things that are going to be said and written, but I feel like it's one of the parts of the story that many do people missed, but all I had to do was look at the roster of X.com employees who were there early and say to myself, "Well, yeah. These people came because of Elon. They were inspired by him." And I had many engineers tell me that despite the disagreements around Windows and Linux, they had joined the company initially because of Elon.

I did want to emphasize that because I don't want people to think like, "This is just yet another version of this story that is the one side, but not the other." To your question about what happens, Elon is removed from the CEO position. He remains a member of the board and the company's largest shareholder, the company announces that it's going to do a CEO search and they go through this six-month period where they're interviewing CEOs.

And it's a very funny process when it's described to me by others, because basically a number of the key people in the company had decided in their minds that they wanted Peter to be CEO, but they were going to do these fictitious job interviews with other CEO candidates. Eventually, the board decides that it's going to drop, what is the interim title from Peter Thiel's title, because he was interim CEO after Elon. They dropped the interim title and he becomes the CEO of PayPal.

And he is the person who is running the company from late 2000 through to its IPO in 2002 and then through its sale to eBay in 2002. And I don't want to make it seem like once that CEO transition happened, everything was fine. It really wasn't. The company was still burning up money. They still had to fight fraud. They still had to figure out how they were going to get through everything. And I think one of the things people also overlook is right in the middle of all of that convulsion, September 11th happens. This team actually experienced the September 11th together.

And one of the things that every person I interviewed, 200 plus people, I would ask them about their memories of September 11th and as for any of us, it was a jarring searing day. And so you have all of that and you have, the markets are whip signed during this whole period. The world is down on technology. And so, in all of that, that's actually what it provides useful context for how hard these years were. One of the things that I joke about in the introduction is it's really only two years that passed from the merger of X.com and Confinity to the IPO on the Nasdaq.

And in those two years, these people feel like they've lived 10 lives. But that is how the story develops in late 2000.

Gennaro:

Yeah, I guess that the experience burned out many of them. I would like to emphasize a couple of points, which I think are extremely important. One is Musk was... Nonetheless the details which people can see in the book. He had eventually a gracious, let's say he was fine about that at the end and how much of that was shaped by the admiration that Must had for Jobs? I wonder and also, how much of it also shaped the Musk of the later years?

Because I would like to remember also for people that would be listening that also, when Musk created Tesla when it started to develop its distribution strategy, for instance to the building up the retail shops for Tesla or to sell the cars online. This was a strategy which would cut out the middleman. But when Musk was building out those two, actually he was drawing the lessons from Apple. Indeed, not only that, he also hired the main guy who played a key role in opening up the Apple Stores. And so I think over the years and still today, Tesla falls...

Its strategy is a lot similar to what Apple has done with the main difference though that a lot of processes were internalized way before by Tesla over the years. I'm talking about especially manufacturing where instead Apple managed to keep that as externalized, even though very close controlled by the company. 

Jimmy:

I have to be careful in providing an important disclaimer, which is I spent time with Elon talking about X.com and about PayPal and about the years from his collegiate years through 2002, but we didn't really speak much about what happened in his life after 2002, because I wasn't there to talk about those things. The one place that he did mention Steve Jobs was, he had a view that's elegantly expressed in the book about the value of founder CEOs, the value of the founder continuing to steer the company. And he says it's a great line, "The founder may be bizarre, they may be erratic, but this person's a creative force."

And one of the things that he talks about is that when Steve Jobs departed Apple, you lost some of that creative force and when he returned that creative force returned as well. And look, there's been whole volumes written on that whole section of Apple's life. And I am not the expert, but it's the one place where in trying to explain the value of a founder CEO, Elon had mentioned to me the thinking around, Apple's Renaissance begins when Steve Jobs returns, and there is some value in thinking about the role of a founder CEO as something critical as something set apart.

It's part of what influenced me to call the book, The Founders, because I think the founding of a company is a different period from any other. It deserves its own special attention. Things get hardened into wet cement at founding that are difficult to dislodge later. But broadly speaking, I'm not the person to comment about how, or whether Apple influenced his thinking about Tesla. What I can say is in his meditation, somewhat in the middle of the book about the value and virtue of founder CEOs, both he and David Sacks speak very eloquently about what a founder brings that others might not.

And I don't think they're saying that, best as I can tell, they're not saying this is true in every case or anything of the sort. They're simply trying to acknowledge that a founder may have a different level of creative insight of emotional investment and some indefinable quality that they bring to a company. And so, that was the context in which we talked about Apple and about Jobs. Again, I would be speaking out of turn if I took it any further than that.

Gennaro:

Just to leave up just 30 seconds of speculation, do you think, speaking with Musk many, many years after the fact. 

Jimmy:

I would say a hundred percent. Yes.

Gennaro:

Cool.

Jimmy:

Look, I think part of the reason is, and let's drill into it because it's actually interesting. His underlying vision for what X.com would've been is in part upgrading mainframes that banks and governments use that are slow, that cost customers money and that he felt and still feels to this day should be upgraded. It was actually a real pleasure to listen to how impassioned he got about COBOL code and about how he's talking about how these ancient mainframes run on this ancient code, it still is unnecessary. We should still fix it.

And so, I do think that he had this vision that someone... I think he still believes someone should do this. Someone ought to do this, but the fact is his earliest collegiate passions were electrical energy and space and all the things he's doing there. And so, he returned to those. The way I described the ending of his PayPal tenure is it gave him creative breathing room to do these other things.

And you can't ever run these experiments twice, so it's not a perfect counterfactual, but in some ways I think the world has benefited from the fact that he was not the CEO of PayPal from late 2000 on because he's applied his work ethic and his vision into other domains. That's where I netted out on it and what I gathered from all of my discussions with different people at the heart of the story, but also being able to observe it from a critical distance.

Someone had said, an engineer, Scott Alexander had said Jobs made Pixar great because he was fired from Apple and Elon was able to create SpaceX and make Tesla great because he departed X.com. That's not even my assessment. It's the assessment of somebody who thinks very highly of them and who was an X.com... He was a very early engineer at X.com and his perspective was maybe it was a good thing for the world that things played out the way they did.

Gennaro:

Interesting point. And I know our time is almost due, I'm not sure how long you can stay…

Jimmy:

Let's keep going. This is fun and you're... It's fun to engage with somebody. Again, I just really appreciate the time you took to dive into this, but then the context that you have, I found a lot of things about not just this company, but late 1990s and mid-1990s internet companies that was engaging to learn about. I spent a lot of time studying the Amazon history in order to understand some of this, but it's good to... Let's just keep rolling because this is fun.

Gennaro:

Nice. Okay. How did we eventually go? Because for a little bit of recap here, we had two companies starting on the let's say on the payment side on the internet, which was not even the main killer application yet, if we can probably say here, they were still too early because other markets would prove to be killer applications on the internet. And one of those was auction, even though those companies was out to acknowledge ethos for what would later become PayPal.

But the interesting part is that eventually they managed to really survive but how did they eventually go from a separated company working on two different use cases on the internet payment industry, they merged together after many neared that experiences, they kept growing the company while hosting various CEOs. And how did they eventually manage to actually merge with eBay? What happened? What were some of the key events that brought to this deal?

Jimmy:

Yeah. If there wasn't one crisis, there were five and for eBay, PayPal is not a welcome contribution to their platform. They are a nuisance. Imagine that you run a store and another company runs your cash registers, and does so quite well and earns the loyalty of your users. The way this begins is, obviously Confinity is PayPal, and X.com have success on eBay that success continues. eBay power sellers are excited about PayPal. They use it, it grows there, the companies obviously juice that growth through different techniques.

Over time, they develop an interdependent relationship. Meaning eBay was put in the position of, we can't just shut PayPal down because they help us close transactions and PayPal, anywhere from, at any given time, 50 to 90% of their payment volume was coming from eBay, so they have this challenge of they're both dependent on one another in some meaningful way. eBay, by the way makes several attempts to acquire PayPal. These acquisitions are always complicated. They don't quite work out as planned, the prices change, there's egos involved, there's tension, drama.

In 2002, PayPal goes public. Actually the 20th anniversary of that IPO is in about three weeks. It's February 15th. They go public and after they go public, there's a clear price set for the company. It's always hard to evaluate what the value of a private company is. But with public companies, you have a share price and you have a total number of shares. It allows for the renewal of negotiations with a clear mark. And what happens is that you have these two individuals who really, both behind the scenes and in front of the scenes help to push the negotiation forward and that is David Sacks and eBay's Jeff Jordan.

And they meet at a particularly evocative moment, which is this eBay live conference that happens in 2002, PayPal invades this conference, they give out a bunch of PayPal t-shirts, PayPal t-shirts are everywhere. It annoys and wrinkles some of the eBay folks, but they are impressed by the hustle. And Jeff and David say, "Hey, we're now competing on t-shirts, not just on payment systems. Let's figure out a way to make this work." There's negotiation that still needs to happen.

There's still tension, but in July of 2002 it's announced that eBay is going to acquire PayPal and that PayPal will become a wholly owned subsidiary of eBay. And there are a number of reasons why the board votes in favor of this deal after again, years of negotiations and different kinds of back and forth, but the principle one is risk mitigation. There's just a lot of risk with PayPal depending so heavily on eBay for its payment volume, and they don't know what's going to happen.

And so there's a way in which the competitive pressures are significant. They always feel like they're on shifting terrain. And as several employees said to me, they were like, "Look, we were tired. We had been fighting this fight for so long and it felt like we were just continuing to fight as opposed to creating value." And that level of exhaustion as one board member put it, you can't continue to expect people to work with that for years and years. And so, the announcement is made in July, the deal is formally closed in October and PayPal becomes a wholly owned subsidiary of eBay Incorporated.

Gennaro:

Interesting. The various highlights of the events that brought us here, of course, we went from two companies merging, which were Confinity and X.com becoming PayPal, then PayPal merging with the eBay. eBay who on each side actually tried to, as you said, to actually kill PayPal in various ways by out competing it. But also it owned like a payment system called Billpoint, but it didn't manage to be successful as they wanted. Also, eBay never really shut down PayPal, even though they could have done it.

Jimmy:

Yeah. There were a few different kinds of pressure that I talked through to a few of them. The first is eBay users liked PayPal. You have this situation where if you run a platform and you have this vocal group of users, and they were very vocal who were defending PayPal and saying, "Look, they're a great service. They do this, they do that. And they're better than the eBay homegrown service Billpoint. We don't want to lose PayPal, we're your users and we're telling you, we want to stick with PayPal."

The other thing is from a practical perspective as explained to me that look, even if they shut down PayPal, what eBay would've done is also shut down thousands, if not hundreds of thousands of transaction fees that were being paid to them. And so, it was actually not, the way I describe them in the book is it's not homicide, it's suicide. You actually have decided to cut off your own... You're going to have to figure out how to do payments and your users are not going to be happy, but you're going to lose a certain amount of revenue if you just turned PayPal off straight away.

I think in the early days, by the way, I think in late '99, or maybe even early 2000, eBay may have been able to flip the switch in that way, but its users had already gone rogue in some sense. And they were paying by checks and money orders and cash, and this and that. And the other thing, and PayPal fulfilled this master merchant credit card function in the middle that nobody had figured out. And so, that's a part of it.

And then I would say the final thing, it's a minor threat, but it's certainly a threat that the PayPal people tried to play up, which is there was a shadow in the air of technology, was the antitrust suit against Microsoft. And so, this idea that anything that smacked of anti-competitive behavior was not going to play well in the press and eBay by this point is a public company. That's another thing people forget is when PayPal is getting started, they're a startup. When nest within eBay's platform, eBay is a publicly traded company subject to rules and regs, and gets a lot of press attention.

The press attention that was directed toward Microsoft during this period was not a good experience for them and it was around antitrust and anti-competitive behavior. What PayPal would do is it would send signals anytime eBay flirted with the idea of shutting the service down or made aggressive motions, they would send these little notes of like, "Well, make sure this doesn't... This could be construed as anti-competitive behavior and we don't want that." And so they were a little bit of that.

Now, I would say that, in looking back at the history, that's really the thing that led eBay not to shut the service down. It was simply more practical, which is its users use the service and transactions were completed because of the service. And so, the antitrust stuff by five, 10% concern, maybe. It wasn't that significant at least as has been communicated to me by people who worked at eBay at the time.

Gennaro:

Yeah. Key point. I think as you said, if you have a product that the users love, it's very hard to shut down and then it's very important to understand the context for people that are listening. There was the time of the late '90s when there was the browser wars, where Microsoft had wakened up during 1996, as Netscape had taken over the browsers market.

And it was about to become the next internet platform, but Marc Andreessen which was one of the co-founders of Netscape also awakened Microsoft on an interesting cover, I think in 1996 on time, he said that probably something along the lines of we are going to kill Microsoft. And this definitely awakened Bill Gates who on the strategic side, he decided that the main war to win was that against browsers. And then is when actually Microsoft started to bundle in its office package, the internet Explorer and steal market shares from Netscape.

On the other side, Microsoft also closed deals with AOL just to kill quickly Netscape. There were many interesting terms of event, and it's very important to understand also the context that public companies, tech companies at the time were very scared to be into an anti-monopolistic situation. And as you said, sometimes also smart executives from PayPal used these strategy as a threatening strategy against eBay to avoid to fall into this practice. And of course, I think the strongest foundation was the fact that PayPal was so much successful on eBay as a platform.

And after that, how was that integration? Because the main story is PayPal went in... There was the merger with eBay, of course as you said, a key point to understand is that PayPal leveraged the negotiation position when it IPOed and with the IPO actually put a price on its valuation, which was unquestionable because was a price given by the market, which at the time was about 1.3, 1.4 billion. And therefore the transaction eventually closed at about 1.5 billion.

But the main story as it goes is that there was many business people say in this way, that there was really older PayPal people left eBay in a few months, but in the book you explain a different story. There were two kind of people that were yes, executives from PayPal but there were employees also, very important senior employees, which managed to stay at eBay.

Jimmy:

Yeah. It's one of the things that I was glad for the chance to somewhat correct the record. There are several high profile people at the top who leave the company shortly after the acquisition by eBay in late 2000. People like Max Levchin and David Sacks and Peter Thiel, definitely depart, there are a variety of reasons, personal and otherwise for that, they wanted to go do other things. They had other passions. Max starts to explore the academic track for a brief period.

But one of the things that gave rise too, is the false narrative that eBay lost everybody, lost all the most talented people, which is just not true. There are so many people who worked at PayPal who stayed with eBay for anywhere from one year to, there are still employees, PayPal, or&

Gerry Campbell, CEO, Entrepreneur, and Author. Former Senior Vice President and Group General Manager at AOL, between 2001-2006. And today CEO at Kryptonomic.io, helps you understand your customers and deliver the Web3 projects they love.

With Gerry, we go through the early years of the commercial Internet. The first tech giants, as walled gardens. The rise of search engines, and from there the take over of Google. A startup in the mid-90s become a tech behemoth by the early 2000s.

We revisit the history of the key events that led to the rise of Google and many interesting events in between. Gerry’s incredible experience at CompuServe, Compaq, AltaVista, and AOL is an incredible opportunity to make sense of these events.

Gennaro [FourWeekMBA]:

Gerry, thank you for joining this conversation on the Four-Week MBA podcast, and it's a pleasure for me because you have an incredible experience, especially in a period of time that was an important transition, it actually represented an important transition for the internet, for what today we call Web 1 or Web 1.0. But really, you have been actually senior vice president and group general manager for AOL during the period of 2001-2006, you also have been at AltaVista CompuServe. So, when I looked at your past experience, to me, it was such a pleasure to invite you for this conversation, so thanks for joining.

Gerry Campbell:

Oh, I'm excited to be here. There's so much really cool history that I was fortunate enough to observe, participate in a little bit of, and I love to share the stories because it's a time when nobody was really looking, there was really cool stuff going on, and it turned out to be important. And I think we had the idea at the time, but I love going through this stuff. It's fun to share, and there are some really great business principles as well.

Gennaro [FourWeekMBA]:

Yeah. And that's the whole aim of the podcast. So, we try to look and dig into very interesting business stories and history and try to reconstruct it based on the people that really lived through it.

So, to start a little bit from your perspective, 

Gerry Campbell:

Yeah, sure. So, I grew up in Columbus, Ohio, which is an unexpected place maybe by some to be involved in such early things, but I grew up just miles from CompuServe, which was one of the very first online services actually dating all the way back to the late 1960s, so there was a big history there. It was an established company. My personal interest was I'd always been a tinkerer, I got in trouble for tearing my bikes apart, and I got in trouble for taking computers apart as I got older, and so as a tinkerer, obviously, and I think I was an entrepreneur as well. Science showed very early because I started a bike shop in fourth grade or something like that. So, the internet and the technologies to me were fascinating.

So, I got a copy of WIRED Magazine number issue two, and it talked about this online world and it was happening in IRC chat. And I think I was probably in my early twenties at the time and my attention was just captured. I thought this was the coolest thing ever. I'd been up to my elbows inside my Mac at that time and taken it all apart and was just fascinated with things it could connect to, and I was goofing around places and pulling files and telnetting and all that crazy stuff. So, I worked in between undergraduate school and then went back to Ohio State. I Actually went to Ohio State twice, which is in Columbus, and I had the opportunity to get an internship at CompuServe, which was just, I don't know, 10 miles away, it was very close. And so that started my journey.

And I got involved with one of the companies that, to many people, it didn't seem as sexy as Sun Microsystems or some of the companies that were out in the Bay area, Palo Alto Research Center, I had my eyes fixed on that, but when I got involved in CompuServe... And this would've been... I started there in 1995, the Netscape browser was in beta at the time, CompuServe was about to buy SpryNet. So, the whole idea of all these really clunky tools that we were using to get around this crazy internet thing were about to be replaced by the browser, and that was really what locked me in because I ended up working on internet projects at CompuServe, which was an online service and much more focused on the core subscription service that people connected through a dedicated software client and I was working on browser-based stuff. So, that's how I got started.

Gennaro [FourWeekMBA]:

Yeah, incredible story. And just for a bit of context for the people that would be listening to this episode, at the time, really, the internet was something completely different.

 It was like more a proprietary network that users accessed through CompuServe or like AOL or Prodigy. You had the chance to access those walled gardens where you had a set of services like email or for instance boards, whatever, but you paid a subscription, as you said, it was a subscription-based service, at least initially, and then after advertising picked up, especially when search engines came along. 

Gerry Campbell:

Yes. So, there was Prodigy, there was CompuServe, there was a thing from GEnie called the GEnie Information Service, so services were popping up. CompuServe I think was the biggest of them, but just to put it in perspective, we had a couple million paying users at the time, so it was big for what it was, but then if you go to the full context, people didn't have personal computers in their home very frequently, it was not that common.

At the time, it was big, but it was still... When I was in business school right around the time I joined CompuServe, some of my friends who were going into logistics and other things and they were taking their MBAs and doing these incredible things, would tell me, "Don't waste your MBA on... Don't go to the internet. Nobody's ever going to transact over the internet. It's just a mess." And I said, "I don't know. I feel it. I think I'm going to do it." But that was the context. Computing was not a big part of people's lives, it was something you did for school projects, if you were in the government, you had access to the internet, if you were an early adopter, you might have AOL at your house... Well, not even AOL at the time, it was, you might have GEnie or Prodigy or CompuServe at the time. So, it was just a very small part of our society.

Gerry Campbell:

Yeah. I think those were really fast few years. So, CompuServe was acquired by AOL, which was a startup that was much smaller at the time. What AOL got right, and I give AOL a lot of credit for figuring out that user experience was the most important thing. So, CompuServe still had email addresses that had numbers, they were all numbers, it was very complex and not very visual.

It was just super geeky. Even though there were buttons you could click and it was a whizzing interface, it was not sexy. And AOL got a lot of credit for doing a couple of things. 

• The first thing is they figured out how to make a service that the average person could use, and I think that's pretty huge. 
• The second thing is they figured out marketing. So, those AOL CDs that you could get a certain number of hours free were everywhere. They were in the magazines, the SkyMall magazines on airplanes, they were sticking to cereal boxes, they really understood marketing.
• And then the third thing was that computing was moving along at the same time. 

So, we went from computers being super, super expensive, and inaccessible to... I ended up at Compaq. You didn't mention that. I went from CompuServe to Compaq, because the frontier at the time was Compaq was selling five million computers a year and I wanted to make sure that every single one of those people signed up to get on the internet, and so did Compaq, so it was a great fit. So, that was the group I worked on there. So, the whole context of computing moving at the same time, AOL figuring out marketing and figuring out how to deliver a technical experience to the mass market, that was really the catalyst. And then in parallel to that, the browser wars started and browsers got more and more capable, the languages behind them got more and more capable.

So, by the end of the '90s, just to fast forward a little bit, I went from CompuServe to Compaq and worked on the internet out-of-the-box experience with a team of a couple of people, and then we ended up owning AltaVista. 

So, Compaq owned AltaVista, and a big hardware company, nobody really knew what to do with it, so a small team of people was put together to spin it out. And I was one of the most junior people on the team, but we figured out, 

"Okay, let's spin AltaVista out, take the search engine and add some pieces to it." 

And that period of time between '95, '96 to '98, '99, those years were incredible in terms of the companies that emerged, the business models that emerged, and the people.

So, just a weird little piece of history. When we were looking to spin AltaVista out of Compaq, we wanted to put some capabilities with it. So, the idea was, let's put a shopping engine with it, so we acquired shopping.com, and we wanted to put media with it, so we built a media arm, and then we also acquired Local, because the belief was the internet should be local, and evolution of the Yellow Pages to something far greater. And there was a company called Zip2 that was founded by two brothers that we didn't know anything [at the time]: It was the Musk’s brothers! (Elon and Kimbal).

And so, at that time he was nobody, there were just all of these characters around, all of those technologies and everything moving really quickly. So, Compaq bought shopping.com and then also bought Zip2, rolled it into AltaVista. And that all happened from the time when everybody was accessing the internet by the command-line interface, which was where I started in '95, up to '98, '99, where Elon had emerged, the search had become a dominant model, and the closed Walled Garden services had started to get competition from the open internet.

Gennaro [FourWeekMBA]:

And this is a very interesting point which you're making because now we are going to look at it forward in this episode. But like anything, when a new market opens up, you expect the market to move in one direction, and instead it's going to open up in a completely different direction. As you said, the giants of the time were actually putting together all the pieces to offer a comprehensive service within their Walled Garden, also the way Compaq, I guess, was doing it by adding Zip2 because Zip2 was a service that provided local directories, I guess.

So, as you said, the two main applications that were killer applications at the time were, as you said, probably eCommerce, local directories, and probably email and boards pretty much, but I guess a few people would've expected that search would've taken over and wrecked them all apart, or at least... I mean, until a certain point, it was not clear that search would take them all over, and then after it became very clear when a company like Google probably took over so fast so quickly, and then it became clear that probably search was something that could dominate the second wave or let's say the last part of the first wave of the internet, of the web 1.0. And that's pretty interesting.

So, to remark a little bit, this transition, now let's say you went from the experience at CompuServe and then CompuServe actually was acquired by AOL to build up the largest tech player at the time, so the first tech giant of the internet era, and then after, you moved to search with Compaq and AltaVista, and then you went back to AOL. 

Gerry Campbell:

Yeah. There are a couple of things. So, I was involved very peripherally in AOL's acquisition of CompuServe, which was, I was the guy three tiers down who was told to go fetch some data, right? Because at the time, I had the personal page service and a business hosting service, so when AOL got interested in the internet stuff, that's... But I had lived in Columbus my whole life and wanted to get out. It's a great town, it's even better now, but I wanted to go see the world. So, my leaving CompuServe was not as much driven by where the technology was going, it was more to just wanting to be in the game, right? Excuse me, not where the technology was going, but where the brands were going. So, I wanted to be in the game, I intended to go to the Bay area, ended up in Houston at Compaq.

What's interesting though, is the reason I went back to AOL, so the time that I had at AltaVista was one of those crazy times where we didn't know stuff. When we did a business deal, we would have a conversation with a company, there was something... vicinity.com. We spent weeks having these fantastic partnership discussions with the team there, and then when it came all down to it, we were like, and you pay us for that, and then they said, "No, no, no, you pay for that." And so, it was so confusing because nothing had been solidified. What had started to solidify at that point was paid search.

So, I was in the shopping group at AltaVista and my job was to figure out how to turn what at the time was the world's largest search engine, from a strategic perspective, how do we get traffic into the shopping experience? How do we present purchasing opportunities? How do we do our search advertising? So, there were a lot of people working on it at the time inside of AltaVista. My particular angle was, how do we get all of these products? We had a million products in the shopping.com database and we were a shopping search engine, one of the first pay-per-click shopping search engines.

And so what I saw there was that paid search was big, and the thing that occurred to me, and I give my colleagues at AltaVista a lot of credit for this, there was high sensitivity to user experience, so as much as we were building a business and a technology, there was a great usability team there that was really focused on making sure that AltaVista delivered the results that people were searching for, and that was my first clue that paid search was going to be a big deal because when we put shopping results into the AltaVista search engine when it matched with the user's intent, we did a much job of getting people to the products that they were interested in finding. So, I developed a respect for users and for user intent.

The trip back to AOL... So, I moved to Virginia from Southern California at the time, and it was to run search. And at that time, AOL was still very much a Walled Garden. It was taboo inside the company to talk about how the internet was going to be bigger, because at that time, they were still doing what was called portal tenancy deals where a long-distance company would buy out all of the opportunity for advertising on the whole service, and it was a very small-minded model. And I learned a lot about putting content into search, I learned a lot about putting transaction opportunities, advertising, and relevance, and understanding customer intent. So, for me, it was an irresistible opportunity to run things that were going to make a big difference in search because I was a dyed-in-the-wool search guy at the time.

And then what made it just really easy was that a lot of my CompuServe friends that did stay were now people within AOL who had built credibility and had been a few years, and some of my favorite people were in positions of influence, so when they needed somebody to run search, luckily, I got the call.

Gennaro [FourWeekMBA]:

Interesting. Then afterward this period, like when there was search taking over, I guess at the time, probably around like early 2000, of course, a giant like AOL had figured out that search was becoming something that had the potential to kill them in long term. Also, for a little bit of context to the audience, during the mid-’90s, of course, the first browser was released, the most successful browser, Mosaic, and then after Mosaic, of course, there was Netscape which awakened the sleeping giant, which was Microsoft. 

The interesting part is that as Microsoft was so taken by the war against Netscape, which started to bundle in Internet Explorer and the Office package, let's say it shifted its focus from AOL dominance to Netscape. So, it was like Bill Gates started to really look at the browser war as the main war that he needed to fight in order for Microsoft to survive in long run.

But the interesting part is that this also gave, I guess, a little bit of breath to AOL and the ability to grow, because I think there was also a partnership between AOL and Microsoft during those years, again, because Microsoft was prioritizing on its browser rather than on the online services, which at the time were primarily sold as the primary application, not even on the internet, because as we said, those were really closed walled services that you could access with your membership.

But an interesting question that I would like to look at with you, how did search evolved, especially from the AltaVista standpoint going forward, there were different players. 

Gerry Campbell:

Yeah, fascinating times. So, the early search technologies like AltaVista, AltaVista was actually a lab project inside Digital Equipment and there was a computer called the DEC Alpha, which was a mini mainframe if I have that right. It was a large computer but not a room-sized computer, and it had a limited amount of disc storage, limited meaning it was huge for the time, but we didn't have cloud computing, and it had an incredibly fast multi-threaded processor, so it was a really exciting time for computing.

And so, AltaVista was actually... and somebody will correct me on my history here, but this is how I remember it. AltaVista ran on individual DEC Alpha computers, and so there was load balancing between them... and I don't want to it too geeky, but the first search engines were technically very, very limited. And the way that played through to user experience was you couldn't find everything because the web couldn't be indexed anywhere near the scale as today. 

So, we knew at the time... AltaVista had about 200 million pages in its index, and Google had come up with their cloud infrastructure and the ability to use many, many parallel smaller computers, so they had a truly elastic way to just add more and more. So, when you put a search term into the entry box and it went to Google, they could search for more information and they also had a better crawler, so they could do a better job of pulling a lot of information in.

And then the magic of Google was that they studied, and there was a lot of math and there was a lot of science and in the algorithms, especially in those days, to get the right result that you're looking for. And that technically it's called precision at 1, which means, is the result you get when you put a query in the right result, in the first position, second position, and third position. And so it was a mess.

So, early on, there weren't many pages indexed, it was a little bit slower, although AltaVista was very, very fast. Google came along and broke all of the paradigms around the size of the index, the ability to crawl it, and the ability to rank it, and they truly were breakthrough at the time, and they had a lot of both capital horsepower, but they also had just a lot of technical horsepower. They did a lot of things right. That was the beginning when search actually became more useful. 

And if you remember back to the time, the internet in terms of publishing was exploding, absolutely exploding. All of the newspapers were coming online, everybody had to have their own site, businesses had to have their own sites. There wasn't really as much of a notion of real-time information, but every company had to have a business card type site where you could just do some basic stuff, and then information like news and all of that just started to grow.

So, searching all of that was a prodigious problem that was limited technically in a lot of different ways from pre-Google to post Google.

Gennaro [FourWeekMBA]:

Yeah, absolutely, this is a key point. So, as the internet started to grow exponentially, probably there were like two, three years in between where you had a few sites that could be actually also curated. You could have like directory lists or websites until a point in which these directory lists could not be useful anymore because the number of sites had grown so exponentially that it was impossible to keep track of them. So, it was needed something that was very good at it, and so search was extremely important.

Another key point I believe to a remark about that time, going toward the late '90s is that with the explosion of websites on the internet, there were also the explosions of the first search engines, but the problem is the first search engines were also probably easy to game. I mean, if you were an SEO expert in the late '90s, probably it was much easier to game a search engine like, let's say, AltaVista compared to what would come later. 

Actually, as we know, even initially, if I'm not mistaken, also Page and Brin, the founders of Google didn't think of spam as a key issue for the search engine, instead, they thought more of indexing as a key issue to solve, but they were right at the beginning. 

But then as also Google started to index more and more pages, actually, they realized that spam was a core issue, so they had to devote an entire engineering team, a larger and larger engineering team as the web was scaling to actually solving the problem of spam, and this is still actually an unsolved problem today.

Gerry Campbell:

Yeah, it is.

Gennaro [FourWeekMBA]:

And I think a third aspect is extremely important, it's about the advertising model that Google managed to actually build up because it's important to also mark that initially when Google launched, it was an academic project out of Stanford, and initially, the Google founders actually were very skeptical about advertising. 

Indeed, there is an interesting account in various books where, if I remember well, there is also a meeting between Bill Gross, the founder of GoTo.com, which was one of the early search engines, which later on, I think, turned into Overture. 

And actually, the model of GoTo was very smart because they used a CPC model where an advertiser could actually be featured on top of the search results by simply paying more. So, it was simply a bidding auction mechanism. 

But the main drawback of goto.com is that, of course, the fact that it primarily listed paid results without mixing them up with organic results was an issue, and another issue is that also when Google started to feature paid results, the score that took into account various metrics, not just how much money the brand was pouring into the advertising machine.

So, I think those are critical points and that's how, pretty much, Brin and Page had to turn the company around because the company, of course, had a lot of servers expenses, so either they were figuring out a business model for the company, how they had to close things out because it was burning a lot of cash, and we're talking about the early years, because then the Google of the early 2000s would become really a cash machine, one of most profitable business that we still know today.

Gerry Campbell:

It's hard to imagine Google not being profitable, right?

Gennaro [FourWeekMBA]:

Yeah. Yeah, it's very hard. But sometimes you hear also the stories of some people recounting, "Google has been always profitable." 

Yes and no. I mean, in the early years when it was still evolving as a company, it was burning a lot of cash just because it was trying to figure out an advertising model that could work for its platform, how to mix paid and organic and make it still relevant for users. 

This was the main angle of Google as a company. And as they figured this out with Google AdWords first, and then by mixing this up with AdSense in 2003, and 2004, that's how the advertising machine exploded. But it's also important to look at a little bit the evolution of the search at the time.

Gerry Campbell:

Sure. Yeah, it is pretty fun. And I want to retrace a little bit of what you said because it's really important. Some of the very first ways to monetize search were simple flat-price click engines. So, shopping.com, for instance, charged a dollar a click, and so if you went into the shopping.com product search, you would search for something and you would get a list of products out of our database, and we would link you off to Best Buy or Circuit City to buy it locally or whatever else, but if you wanted to go to one of our partners, you would click and it would be a dollar, right? 

No auction, nothing. And that's where everything started. GoTo was very smart in what they did, and we competed with them for a little while and then they took a little bit of a turn and went more general than just product search, but they were doing a lot about search term relevance. And so they focused on making sure that the right ad showed up in terms of relevance to the query but they left the gaping hole open of user feedback.

And so, I left AltaVista, did a little startup for a little while, and then went into AOL and was put in charge of the entire machine for search. And it wasn't a big business at the time, it was about 20 million a year. Our partners, we had Inktomi, which was our natural organic search, and then we had Overture, which was our paid search. And the paid search model at the time was generating some money but I just had this feeling that there was user intent that was left on the table. People needed to see more things.

And simply, when you think about it, you need a massive, massive pool of advertisers if you're going to start to cover stuff in the tail. So, the notion of the tail came up at that time, and we had always known it because I'd been looking at search metrics and statistics for a long time. But when I got to AOL and we were handling tens and twenties and thirties millions of queries a day, we had a lot of topics to cover because people were searching for things that wouldn't necessarily be as simple to match to like 27 inches flat-screen TV, which was the kind of search that we would have at the time.

So, what Google did, and this is before we started working with them, what Google did was taken into account... And they did a lot of things in the algorithm, but the one that was most important to me was that they were taking user clicks into account. So, they would shuffle ads around and see which one got the most clicks. And they did a couple of things that were user-friendly that was non-obvious. 

One was the user click input for rankings. The second is they move to a second price auction. So, Overture, if you bid $5 for a term and somebody, the next guy bid two bucks, you would pay five bucks. And the problem was with that, it was very easy to game, the other problem is that if I wanted to get more and more terms as an advertiser, all of my willingness to pay to get sucked upon terms that are in the head, right? I don't have the chance to expand my queries out because I'm going to post what I'm willing to pay and that's it.

Google came out with a second-price auction. So, if I bid $5 and the next guy bid $2, I would pay $2.01 and then I could take that budget and allocate it to other terms. And so, the size of Google's index on the paid search helped, and I'll tell you about that in a second, and also their second-price auction and their ranking was absolutely superior, and I knew that.

Google had a problem at the time, which was they had some great technology, but Overture was a public company that had already won the game. Very few people that weren't inside search knew that it could be so much better. So, Google took a risk in approaching us, and there's a little bit of history here too, which is Omid Kordestani, who was one of the folks at Netscape. 

Gennaro [FourWeekMBA]:

Who later one would become Head of Business Development at Google!

Gerry Campbell:

Exactly.

Gerry Campbell:

So, Omid went to Google and had a lot of relationships at AOL. I didn't know him at the time, got to know him, and they were very patient about saying, "We're building a better engine and we want to work with you."

I was resistant, honestly. I, at the time, was like, "We've got this Overture and Inktomi thing among other things." And then here comes the story, right? So, the Overture deal came up for renegotiation, and the way deals worked at the time on search was that the company that monetized your search results page would control the page. So, Overture had control over the search results page, which means that I couldn't fully run the search engine the way that I wanted to. I had an additional objective, which was... a little bit of context as well. AOL was in the middle of the Time Warner merger and there were hundreds of brands, magazines, online sites for movies, and entertainment, and news and cooking, and everything you can imagine, and I wanted to put that stuff into the AOL search engine. I wanted to make sure that if somebody searched on AOL, I had AOL and Time Warner content there.

So, we had an unworkable situation where Overture wanted to control the search results page... and so essentially, I said, no, and that opened a window for Google to step in. So, they had the technology in place, they didn't have very many advertisers. In fact, when we talked to Amid and the team over there, they said, "We're not quite ready. Can we do this in a year?" And when I say I, there was really a we to the whole thing. 

But the answer was, "We have to do this deal now because we're about to do a three to a four-year deal and we're going to end up locked up for a while."

And the thing to note about AOL at the time is it was very clear that AOL users were going out to the web, it was also very clear that they spent a lot of money and clicked a lot of ads. So, through Overture, we had hundreds of thousands of advertisers who were benefiting from being a part of AOL. We were their largest distribution partner at the time. So, for AOL to make a change to a different paid search capability, theoretically would bring hundreds of thousands of advertisers to the new engine that we worked with. 

And so Google wanted to work with us and we were, I think, just a little bit ahead of them, and so the little bit of history there was that they stepped up and we did the deal in 2003, and I restructured or we restructured the deal. I say, I, because I did I actually did the Excel model for it instead of doing some really complicated model that had floors and collars and variable rates of rev share.

One of the things that was really important to me was to keep us aligned over time, so I personally really pressed the idea that we have a flat rev share on dollar one all the way up to a hundred million. And what that did was kept us aligned as partners, and they wanted to grow, they wanted to work with us, access our audience. And I didn't want to be having to go through an attorney or go through finance every time I wanted to make a change to see if we were going to trip a trigger in an agreement or anything, we were just aligned. And what that did was freed up business teams, product teams to truly be collaborative. So, it all happened very quickly.

We switched over to their organic search first, because that was out in the market, and Inktomi, and I had many great friends at Inktomi, it was a painful thing. And that was a rough thing for that company, but we switched over to the organic search to put Google in, then a couple of months later we launched the paid search. 

And that deal, I like to think it's a historic deal because two companies that potentially were competitors had years and years and billions of dollars of value created through a really great alignment and by being really... we were all focused on understanding customer intent, and customer intent was absolutely what drove that business. 

That we analyzed queries. We had incredible systems inside AOL to understand what was going on in our query stream, and we shared a lot of that with Google and they shared a lot of the UI stuff. And so we collaborated on what I think was one of the first really highly scalable search results pages.

Over time, we tried things, and we wanted to monetize a little bit heavier but keep customer satisfaction high, and so we put a lot of effort into doing some creative studies around that. So, that was how the switch flipped.

And there were a lot of politics, there were a lot of angry people, there were a lot of sales teams all over the place putting a lot of pressure all the way up my chain to Steve Case, who was chairman at the time. It was a very interesting time, but I knew we were doing the right thing for the user because if we could end up with a situation where the ads were more relevant and covered more of the query stream, we would do better than if we had fewer ads that weren't as well accepted by users. 

And then the benefit was I also got the chance to feed content in too. And it looked like Google OneBox now. They didn't have that capability. Since we had the organic and we had the paid search covered, we could put a lot of our effort and our profits back into building a content system that allowed us to, on a query by query basis, publish very relevant results out of our own databases into the search results.

Gennaro [FourWeekMBA]:

What a story! That's an incredible story, and incredible to have actually been there. 

But three points I think I want to emphasize from what you said so far. 

• I think at the time as search engines were still figuring out a scalable advertising machine, deal-making was extremely important. And you highlighted how, for instance, a single person, like in this case that could be a person in charge of business development at Google, like Omid Kordestani actually played a key role as he moved to Google, and as you said, he had probably good relationships with AOL. And as you said, being featured on AOL at the time made your business, because Google at the time was not yet an advertising platform where you could go and place your bids automatically, it was mostly done through, a lot of it, at least late '90s, early 2000s, still a lot of the deals were partnership deals. So, this is where Google tried to feature its search box on the main platforms. AOL was the main one. And it's interesting then... 
• Also, another point as I was listening to your story is that initially how AOL kept a little bit of a Walled Garden perspective also on search. When you said, as AOL was going through the merge with Time Warner, of course, they wanted also to prioritize a lot on controlling the search results, therefore giving a lot of results that would be based on the content they had within the proprietary network or the network of partners in AOL and Time Warner.
• And I think a third aspect, which to me it's extremely important is when there is a turning point. So, when the technology and commercial landscape is changing at scale, there is when there is the opportunity for the new player when it's way, way better than the existing alternatives to actually break up an existing industry. One example that comes to mind, in this case, is when, for instance, let's say Steve Jobs managed to break up the music industry, or when, for instance, the same Steve Jobs managed to break up the mobile carrier industry when it handed to them the iPhone, but then it said, "Okay, you subsidize this product to as many people as possible." And the reason why it was possible to do that is that it was such an interesting product that for the mobile carrier who had little to offer in terms of innovation on the market, it was a key product to have in its portfolio for its base, for its customer base to keep growing and keep being relevant. So, I think those, to me, are three extremely important points.
• And another one which I would like to just emphasize with you, what happened after the change. So, when you change... I guess, of course, on the side of Overture, this was a tragedy. Like losing the deal with AOL was a huge, huge loss. 

Gerry Campbell:

Yeah. So, on the Overture side, I found out years later that a friend that I grew up with was one layer back on the legal team when we made the decision to move away from Overture. Actually, when we made that decision, there were hundreds of millions of dollars of market cap destroyed in that company. And I feel bad about my friend, but it was the right thing for the industry.

The relationship was interesting, because looking back, deals at that time, companies when they worked together, it was always business development. It was largely business development, attorneys, and deal-making that made things happen. I started as a product manager, I started thinking about... and these were my earliest projects at CompuServe... I wanted to build things that people loved, and so finding a partner that wasn't going to send their business development team every time I had a question but somebody that would actually send their product people was critical. 

At the very beginning, it was really a simple relationship, technically. They had an API for natural search, and they had an API for paid search, and we drove the search results page and did all of our magic and included those in the two main sections on the page.

From a technical perspective, our engineers didn't have to spend much time together. We had service level agreements and all of that stuff, but what that allowed us to do was to have discussions a lot about what search should be. I don't want to overstate it, it's not like we were a buddy-buddy, because we were, in a way, competing with them, but we did have opportunities.

Marissa Mayer was running the homepage at the time, and so we got the chance to go and sit with her and talk about, "What do you think the intent is when a user comes to the Google homepage and sees the search entry box?" Because we were working on our own innovations on trying to understand intent so that we could deliver a better experience, and they could see all of our monetizations. 

When we made the decision to go three links at the top and three down the side and move pages around... We had an enormous testbed. So, we had 16 concurrent A/B tests running every day, all the time, and we were moving things around on the page all the time, and they could see all of our data. So, they couldn't see what was on the page, but they'd be like, "Wow, what did you do because this kind of queries really blew up?" And so we'd have that discussion. We were pretty open about it.

And this is a worthy point to note. There was a point... And I actually ended up in Time Warner investor meetings because investors at the corporate parent level were like, "We should have a search engine, we should own our own search engine." 

And AOL was the kind of company, it was at the core, a media company, not a hardcore technology company, although there was a lot of great technology there. In fact, I could go into all the incredible things that came out of that period of time, but what it takes to build, grow, feed, and really innovate in search requires such a constitution for investment. 

And AOL, it was a decision that I reinforced every time I got, which was, we have to find people who are very best and companies to work with that are very best at what they do so we can be best at serving AOL customers. And so, that is a big piece of it. Things moved really quickly. 

Gennaro [FourWeekMBA]:

Yeah, absolutely. I think usually, I try to take some key points from what you said, which made me think a lot as we went through the story.

• But I think you said a key point, which is about Web 1.0 when again, we moved from deals to scalable platforms, it was really the time where product development became a king. So, we went from a time when you needed the business development team. And of course today also, the business development team is very important at the enterprise level, but the key point is really the internet changed a lot from media to technology and therefore from an approach as a platform during the late '90s, early 2000. And as you said, it's very important to emphasize that as the many companies on the internet changed the playbook, they understood they needed to become scalable machines and therefore product development, so coordinating engineering team on the UX and UI and understanding how to make the user experience as good as possible became the most important aspect. Before, as we said, deal-making was very, very important.
• And it's interesting to me how also, as you highlighted one, probably in hindsight, it's always easy, but also the lack of transition from a media company to a tech company was something that slowed down AOL. And of course, there are always cycles in history, for instance, when technology becomes a commodity, then you need to become a media company. When I say this, I think about, for instance, Netflix, when Netflix launched it was primarily a platform hosting other people’s content. But starting in 2013 going forward, it needed to become a media company and invest in its own content because technology was becoming a commodity in the streaming wars!. So, there are areas in which being a media company is an advantage and other areas in which being a technology company is an advantage. At the time, I think being a technology company was a key advantage.
• And another point is that Google, from the deal, took probably one of the most important aspects which was key to keep scaling its product, but also to build up its advertising machine was probably. It was the access to the data or to experiments that AOL was doing at scale because the scale of AOL was many times over still at the time of Google of the early years. So, those are extremely important points.
• And then after that, really, let's say the war, initially, Google stole, let's say, the deal from Overture, and that was a huge deal. And then, of course, Google started to figure out the advertising machine. And in early 2000, it started to become a tech giant. But later during like 2004, 2005, there was a war then between Microsoft and Google on who was going to take over AOL. My understanding is going toward the year 2004, there was a deal that Google wanted to secure instead of Microsoft. 

Do you remember how it went in that deal (Google vs. Microsoft to secure AOL distribution)?

Gerry Campbell:

I do. I do. It was the craziest thing. So, we were in New York at the Time Warner building. So, the first time we did the deal with Google, it was a small team of a few of us and it was just our day jobs to do that stuff. By the time we launched Google's paid search in 2003 and the revenues just started to skyrocket, and we had warrants in Google as well, it got the attention, not just on a deal-making level, but it got the attention of everybody throughout the company, that AOL had a massive asset in this traffic that could be monetized through search.

So, the first time we did the deal was a few of us worked really hard. It was two product managers, me... and I say product managers... it was people like me, one guy was running Netscape and some of the other brands, and then I was running the AOL brands, and then we had an attorney and a business development person. And the four of us did the deal the first time, and not until we got towards the end of the deal did it really bubble up to the executives. If you've worked in the corporate world you know that if what you're working on bubbles up, it's a blessing and a curse.

So, the second time we did the deal, it actually went all the way up to the Time Warner level, and so that Microsoft-Google search deal ended up in a really, really funny thing. So, there were conference rooms at either end of the floor. The Microsoft guys were in one end and the Google guys were in the other end, and we were running back and forth going term by term, seeing who would give us the best deal. 

And it was like one of those things out of a sitcom on three companies where people are running all over the house, pretending they don't see each other and trying to hide, and two dates going on at the same time. It was crazy. But ultimately, the Microsoft style and their approach was very different. It wasn't Bing at the time, it was pre-Bing... I think maybe it was Bing. I think it was something else though. It doesn't matter. And on one side, there were a lot of influences, and I'll tell you about my influence on it.

I had faith in Google's ability to deliver a great experience for AOL customers, and that, to me, was the core of the business. We flipped from being a push-based advertising business to being a customer pull-based advertising business. And the things that I had to deal with in terms of running the search engine inside of AOL was that we had a company that was like, "Just go close a deal, go sell a deal, go get M&Ms in here and we'll put them all over the search results page." 

And I actually almost got fired a couple of times because I was so dedicated to making sure that we kept the user experience as the primary focus, I was willing to put my job on it because I couldn't deliver the revenues that we needed if we ended up bastardizing or changing the search results environment.

And so, at one end of the hall, we had a company that was a close partner. There were tensions, but they were a close partner and I knew that the user experience would be maintainable and manageable. And then we had Microsoft at the other end, which was a little bit more old school at the time, which was, they were just going to come in and do a deal that worked for them economically, and there were a lot of unknowns about whether that would be the best experience for users. 

So, I will not say that I had the ultimate say in it, in fact, I had a small piece of the ultimate say in which deal we did, but the piece that I had was really influencing, going for the best user experience so that we could build a sustainable business. And again, I go back to really simple deals, cuts of revenue that's a straight line, X percent for the first dollar, X percent for the last dollar. And the deal started to look far more complicated at the two ends of the hall. So, history was made. Google got the renewal.

Gennaro [FourWeekMBA]:

So, some key lesson is that it doesn't matter how much business development power you have. If you have a product like Google had at the time, then it becomes much easier to sit at the table. And then, of course, I guess also at the time, they had a lot of resources as well on the table, so it wasn't more... Like Microsoft was still much bigger, but then it was possible for Google to compete on deal-making, when instead on the previous years, when they tried to compete with Overture, it was, I guess, way more complex for Google.

And how was the feeling at the time? Because of course, if you're, let's say, cutting the deal with the company that a few years before was the same company that, thanks to your deal actually, turned things around because Google was featured on AOL, as you said, the user traffic they got was huge. 

Gerry Campbell:

Yeah. I would say if it were a single dimension and say there's a story you could tell that says AOL was a Walled Garden. We poked a whole new Walled Garden and everybody left. That's a story that could be told. It's not what happened. What happened was that users became more sophisticated and expected more and more. The nature of the partnership was always a co-opetition partnership. We knew that we were going to have to compete with everybody in the space for users.

And I want to go back to a little bit of the feeling of the time. I had friends, early days, friends at Lycos, I had friends at Microsoft and we would go to conferences and sit on stage and talk together, and it was always very respectful and there was always a lot of knowledge of what everybody else was doing. 

The ways that companies were navigating at the time, it looked in the media like a war, it looked... like up on stage, sometimes if the questions were right, that we had differing opinions, but that was one of those periods of time where really, the people who were running the experiences, we knew each other, and I will say I respected and had a lot of trust in everybody across the table and around the world.

So, when we did the co-opetition deal with Google, I had been exposed to Google when they started to poach AltaVista engineers way, way, way back, I knew their mission, I knew what they were doing, I knew their trajectory was to organize the world's information. AOL's trajectory was very different. AOL was, at the time, we were still in the Time Warner deal. 

We were a media company, a true media company. I don't want to take away from any of the technology, because, for things like instant messaging, we have an incredible number of search patents that are now held by Google, Facebook, and Microsoft. So, it wasn't as simple as a, "Oh, we're competing now and they have more horsepower," it was that we were going different directions and that that co-opetition really did work. I think that had we had complex deal structures in place, it wouldn't have lasted as long as it did. I'm very proud of the way that we kept the people who mattered aligned, because when we made money, they made money, and that was awesome.

There was an interesting day, and I'll tell you about it. The day that Google announced Gmail because AOL believed that we kept the user experience and that our mail was the mail that should be. And the day that they announced it, it caused a big buzz. There were a lot of executive questions to me, "What are they doing? Where are they going?" And I think that was the first time that they had least stepped out to challenge the partnership and had gotten strong enough that they were on their own path and could do that. 

And the answer that we had at the time was, "We don't control them." We had sold our warrants in the company so we weren't even really investors anymore, as I recall it, but that wasn't my responsibility. So, I think there was a notion of co-opetition but there were a couple of rounds that we can see now, looking backward, that hadn't played out yet.

Gennaro [FourWeekMBA]:

Wow. Yeah. And it's very hard to predict what trajectory. As you said, in some context, being a media company is an advantage. It has played out extremely well for AOL for years, and then suddenly Google scaled up very, very quickly.

And when you go from competition to competition, it's very hard. As you said, when you work on the product development side, all you care about is improving the user experience, understanding what's the next product actually can improve the user experience of a certain X amount. But on the business development side, and probably on the media side, it's more interesting to look, “okay, who's going to be the winner take all?” And eventually, as happened in this case, of course, it was Google.

Gerry Campbell:

Sure. We've identified some of the trends, right? I love the stuff we've covered. You asked great questions.

And it wasn’t about big moves, it wasn't about lots of new partnerships, it was about taking what we had and really growing it, and there was an enormous amount of value created there.

And then there are times when everything is changing, user behavior is shifting, and when user behavior shifts, it's time to break through and just pull in and go, right? And that's the time when different skill sets are required. 

The reason I bring that up is we are in that right now with Web 3. It is one of those times where there's a technology change that's making a huge impact. So, my take is, and I'm really excited... a couple of years ago when it was a time to move slowly because the innovations were much smaller, I wouldn't be having as much fun with this conversation because I'd be looking back going, "Oh, those were the days when we had incredible amounts of opportunity in front of us, and everybody was trying to talk to everybody to figure out what was happening next, and we were building this shared vision." That, to me, is one of the big takeaways.

That was a point in time when the fundamental model of how people used the internet, from browsing to searching, changed, and it was the time to just do crazy deals and have some vision about where it's going, adapt really quickly, and recognize that it's a time that... The way I talk about it is that when things change, there's a period of time where everything is fluid, and then before you know it, it's locked in cement. And I'll give you a quick example.

I was involved with a couple of the companies that Twitter acquired very early on around 2009, and at that point in time, we didn't know how everything was working. I was involved peripherally in some of the strategies around how Twitter handled the Firehose and all of that, and there were decisions made, everything changed quickly, and boom, the Firehose was shut off, and now that was locked in stone. So, decisions are made very quickly, and then those decisions, you just got to move on, and that's when you go back to optimizing. 

Gennaro [FourWeekMBA]:

You strike a key point, like cement and then fluid, absolutely agree on that. And right now you're working on Kryptonomic, so you're working on a web 3 project, so you see how the same scenario of those early days, and now you see things moving faster in the Web 3 direction, right? I mean more or less, that's how you see things now.

Gerry Campbell:

Sure. I don't want to shield for my company, so I won't talk too much about that, a little bit, but I think where we are in the context of things is that blockchain technology, you can say that there are a lot of coins out there and tokens and people are going to lose money, and you can say that, "NFTs are a little bit weird, and it will never make it to the mass market to buy a silly GIF." 

But when you look underneath all of that, what's really changed is our ability to keep records has changed. And so the ledger of a company, profit, loss, where the money comes from and goes to within a company is now being shifted from companies to projects, and that's enabling an incredible amount of innovation.

So, when you can attach software to the blockchain and you can do things, which is where Ethereum made its first step, the foundation of everything that we know about companies, technology, business, I'm not saying it's going to change absolutely every aspect of everything, but many things will be fundamentally changed through the notion of the blockchain because money can be programmed to do things, and when money can be programmed to do things, you can program virality, you can program customer usage behaviors into the money and the flows. 

And NFT, okay, great, I've got a little pixeled picture of a monkey, but what's really happening there is items can be attached to an incontrovertible record of who owns that item. That changes the art industry, which is what we're seeing, it changes the supply chain. There's just so much changing based on the core of these technologies.

It's a shame. I talk to people a lot about what's happening and it's, "Oh, Bitcoin burns too much energy," and all of these things that people talk about as being detractors are really expressions of misunderstanding. And those expressions of misunderstanding, if there's a vision that anybody can put together by looking around at all the information out there about where things are going to change, this is one of those times where people with vision can make stuff happen because, in all of my experience, I've only seen a couple of times where the underlying technology has so many ripple effects in what changes. So, that's what Kryptonomic is. We're helping companies specifically, and it'll make sense. We are trying to understand how these technologies can make user experiences better, shopping experiences better, lifetime value better for companies, and that's it.

Gennaro [FourWeekMBA]:

Interesting. An important final point, as you said, completely misses the point when you go into an argument about energy consumption. The whole blockchain-based ecosystem has evolved a lot in the last years, now we have many other layers. 

Layer One chains that do many things like Ethereum, from other chains like Solana, Avalanche, and many others. But the main point is that now we have many applications up on top of the blockchain. I also follow that with a lot of interests. 

And the NFTs are very interesting because at least if they are successful at scale, they might actually make the digital ownership similar to physical ownership, something that, for me, I'm a creator on the web, it's extremely important because it's very hard to build a business on digital products when there is no ownership of those items, there is no scarcity, so those extremely important aspects.

Gerry Campbell:

Oh, there's so much good stuff going on. I love decentralized finance. I'm not a believer that governments will be disrupted and the world will change and we won't need governments anymore. That's not what I'm talking about. 

What I do think is that our current world financial systems, and I'm talking banks on down to customers, and then the corporate thing as well, it's so limited. Although there are lots of different ways to invest money in all kinds of different weird products that people can't understand, we haven't really innovated in money in a long time.

I'll give you an example. I had a Bitcoin, and Bitcoin was trading around $50,000, and I went to a platform called Nexo and I was just curious, "What can I do this Bitcoin?" Well, I dropped it into Nexo., they let me borrow 60% of that Bitcoin at a certain percentage rate, and I connected my bank account, and the whole transaction, I transferred the Bitcoin in and had $30,000 in my bank account in, I think it was like 10 minutes. 

And when you think about the implications of access to money, you have to have the collateral, to begin with, but think about how it changes corporate finance and corporate revolvers, and the ability for a company to take its assets in crypto and invest too, and innovate, you think about the insurance products, all of the things. I am super interested in DeFi from being one of the cutting edges that are going to change things. 

I'm also very interested in how decentralized organizations change things because the notion of software being the thing that is tracked in an economy is really powerful.

Gennaro [FourWeekMBA]:

Yeah. I'm also very excited about both use cases, and DAOs, for me, it's a game-changer because you can pretty much have companies at scale without having central departments that at scale are very, very damaging. If I'm thinking about also... especially marketing, distribution, product development, if you can scale them with a decentralized approach, it would be very interesting to see what happens. Of course, we are going to see this process taking years and years before we get to that point.

Gerry Campbell:

Yep. 

Gennaro [FourWeekMBA]:

So yeah, it was an incredible discussion. I hope we can have a second discussion probably focused just on Web 3 three in the coming weeks as I ramp up the podcast series. So, thanks a lot for joining me for this conversation, Gerry. It was a huge pleasure.

Gerry Campbell:

It was a delight. Thank you very much.

Gennaro [FourWeekMBA]:

Thank you.

In the first wave of the commercial Internet (1994-1999) the first big tech players and tech giants were walled gardens. Those platforms enabled access to proprietary networks (this wasn't really the Internet, as those were not open protocols) where users could enjoy a set of online services (emails, news, forums, and later on search). These first tech giants were companies like AOL, Prodigy, CompuServe, and GEnie. Their business model was straightforward, you would pay for a monthly subscription, and enjoy a few hours of access to their proprietary networks. For each additional hour users spent

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