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Sunday, March 19, 2006

The Google Economy


Everybody seems to like Google! If we need some information, about anything, the first place that we look up now is on Google. We do not ask anyone, we do not go looking for a book, we just go to www.google.com. It's become so natural, that we do not think twice before searching for something on Google. And almost always, we find what we are looking for. That's why we have come to trust Google as much as we do. And Google has achieved this in just a few years without any advertising spend. Googling has become a pastime, it's also become a word in the common lexicon now.

Google as a concept and as a company fascinates me. The story of how Google began and how it evolved is very interesting, but I'll leave it for another day. This post is about the most interesting aspect of Google. How does Google make so much money? What is its business model? And how did that model evolve?

Before that, here's some background on Search engines. A search engine connects words we enter (search queries) to a database of web pages it has created (index) and produces a list of URLs (Uniform Resource Locators) and summaries on content it believes are most relevant. Although there may be other approaches to search, this text-based approach is the paradigm that every major search engine is driven by.

A typical search engine consists of three major parts - the crawler, the index, and the runtime query processor. The crawler is a specialized software program that hops from link to link on the World Wide Web, scarfing up the pages it finds and sending them to be indexed. It sits on its own server and sends out many requests to pages on the Internet, just like your browser does. Those requests bring back web pages, which are sent to the indexer. It also takes any links it finds on these pages, and queues them for more requests, which find more links...and so on, ad infinitum. The more sites the crawler crawls and the more frequently it crawls them, the more complete the index is and the more relevant the search results will be. The index organizes the information such that given a set of words, the search engine can come back with the most relevant URLs. The indexes also have tags or metadata. Pages might be tagged as written in a certain language or as belonging to a certain group.

Once the crawl data is analyzed, indexed and tagged, its dumped into a runtime index which is a database ready to serve results to the front end which includes the Query server and the User Interface (UI). The Query server transports the search query from the UI to the runtime index and brings back the results. The query server also combines some intelligence by removing query incoherence and noise words.

Let's come back to Google and its business model now. Google has two key advertising programs. AdSense for Web publishers and AdWords for advertisers. AdWords allows advertisers to list ads targeted to users who are looking for their products or services. On the Google search results page, ads can appear on the right hand side of the page and sometimes also above the search results, and these are clearly labeled as advertising links. AdWords puts these ads there and they are triggered by the search query. This is called as Keyword advertising. Keywords are terms that advertisers choose to trigger their ads on Google. When a user searches for something by entering a search query, AdWords delivers ads relevant to that query. The advertisers hope that the users will click their ads and go to their websites to do some business. Keyword advertising has its distinct advantages. It allows the advertisers to target their ads specifically to users who are looking for similar products or services. This translates into a better Return on Investment (ROI) for the advertising budget, and the risk is minimal. Another benefit for advertisers is the ability to target specific potential customers based on location and language. Targeted ads also helps Google ensure the users keep coming back for more searches, which means more potential customers for its advertisers.

With the AdWords program, Google charges for impressions or clicks, based on the type of campaign. For keyword advertising, AdWords uses the cost-per-click (CPC) pricing approach. A click is defined as any action the user takes to select the ad and be taken to the advertiser's website. Under the CPC model, the advertiser is charged only when a user clicks on the ad and not when the ad appears on Google but is not clicked on. For site-targeted campaigns, the advertisers are charged on a cost-per-impression (CPM) basis. An impression is defined as the appearance of the ad on the Google network. We will soon see what the Google network is. Under the CPM model, the advertiser is charged for each impression irrespective of whether the ad is clicked on or not. CPM bids are made per thousand impressions, hence the name.

Another industry term to be understood is Clickthrough Rate (CTR). It's a measure of the number of clicks the ad receives against the number of impressions. This metric shows how well the ads and the campaign itself are doing. The more relevant the ads are, the more the number of clicks they accrue, and the higher is the CTR. A point to note is that the CTR cannot be compared across the board, it varies from industry to industry and from keyword to keyword. The CTR helps determine the Quality score. The Quality score is the basis for measuring the quality of the keyword and determining the minimum bid amount for the keyword. The Quality score is determined based on three main factors - CTR, Ad text relevance and historical keyword performance.

The Ad Ranking is determined by the maximum CPC, the maximum CPM and the Quality score. Ad Ranking decides which ad appears first, which appears second, and so on. The advertiser has to pay only the CPC necessary to have a rank higher than that of the next lower ad, so he never pays more than he has to. The minimum bid is the amount assigned to a keyword based on its Quality score. Its the least amount the advertiser can pay in order for the keyword to show ads. Separate bid amounts can be set for search and content clicks, if the advertiser wishes to do so. The higher the Quality score, the lower is the minimum bid amount, the lower the price the advertiser will pay per click and the farther the daily budget fixed by the advertiser will go. This is how Google rewards its advertisers for good quality keywords and campaigns.

The Google network includes Google's partner websites which show ads delivered by Google. This is called Ad Distribution. Google has thousands of such partner sites and the only thing the advertiser has to do is choose if the ads have to appear on these sites. You would notice the Google search box on many sites and all those sites are part of the Google network for keyword advertising, also called as the search network. The network is important for advertisers because search result pages make up only about 5% of the pages on the Internet and they are an even smaller portion of where users spend their time considering purchases.

Apart from search distribution, AdWords also delivers ads based on content distribution. Google delivers site-targeted ads to its partner sites on the content network and the advertisers may choose on which sites they want their ads to show. Content distribution also includes Google's own GMail, where the ads appear based on the content of the email. This has infact led to privacy concerns and Google obviously defends its system and denies there is any threat to the privacy of GMail users.

The major benefits that AdWords offers to advertisers are Reach, Cost, Timing and Flexibility. AdWords offers the advertiser access to as much as 80% of the Internet users in the United States and millions worldwide. There are thousands of partner websites worldwide on which the ads can appear. Thus the number of interested visitors coming to your site can dramatically increase. There is no minimum spending limit for AdWords. This allows smaller companies with tight advertising budgets to get the best out of their budgets. The advertiser can choose a daily spending limit, beyond which no more ads will appear on that day. This way the advertising spend is always limited. The advertiser can choose the maximum amount he wishes to pay for each click. Google's automated auction system will pick the ad only if the ads wins the auction for the keyword. Thus the advertiser will never pay more than the bid amount, infact he may pay less than that amount, just enough to win the auction. And ofcourse the advertiser pays only when a user clicks on the ad. AdWords helps advertisers have their ads at the right place and at the right time. Ads appear based on the search query and they appear when the users are actively reading and searching for information related to the product or service. Therefore the users who see these ads are more likely to convert into customers. The advertiser can create an ad and it can show up on Google in a few minutes. The ads can be changed or edited at any time and the system is always available. Thus AdWords empowers the advertisers like no other system does.

AdSense is Google's program for Web publishers. AdSense delivers relevant text and image ads precisely targeted to any site and its content. And if the Web publisher chooses to have a Google search box on the page, AdSense will deliver search results and text ads relevant to the search query. The Web publisher does not have to maintain any advertiser relationships. AdSense, fed by AdWords, represents advertisers ranging from large global brands to small local businesses. Web publishers can use AdSense to monetize the search results on their sites and it requires no money and little time to participate. And it keeps the users on their site longer. AdSense has filters to show only appropriate ads; competitor ads, inappropriate ads, adult ads are filtered out. The advertiser can choose to show the ads in a way that suits the look and feel of the site. (Here's an interesting factiod. In '03 Google acquired Blogger, the site on which you are reading this post! And it probably used Blogger as a test ground for AdSense and since then it has not interfered with Blogger much.)

All this means a lot of money coming in as revenues for Google. Be it a dime at a time or a few dollars per single transaction. But there are a few things that can throw the proverbial spanner in the works and the most important of them is click fraud. Click fraud is perpetrated by generating invalid clicks on the ads. Invalid clicks may be generated by repeated manual clicking, a click robot or deceptive software like an auomated clicking agent. The purpose of such fraud could be either to inflate a Web publisher's earnings with AdSense or to drive up the AdWords advertising costs for a competitor. For example, a competitor may employ spam clicks to exhaust the advertiser's budget too early, thus eliminating competition in ads delivered by Google. Google claims to have sophisticated tools and techniques to detect such fraud and the advertisers do not have to pay for such clicks. Although Google does a lot of self-policing and often provides credit to advertisers when it detects such fraud, the general perception is that it's not as receptive to complaints from advertisers as some of its competitors like Yahoo. This is probably because although Google has the data to act on click fraud, there is no incentive to do so. Obviously Google rejects such claims and sticks by its "do no evil" credo.

Another issue that causes problems for Google is their refusal to disclose their search technology and tools they use to detect click fraud. Google does this on the grounds that this knowledge may be used by people with malicious intent or even by its competitors. Infact, just yesterday a US court has ruled in favor of Google saying that it need not reveal search terms because of privacy considerations but has to only reveal some websites it has indexed, in response to a subpoena from the government.

So how much money do these advertising programs bring in for Google? Lots... and more. Here are some numbers that bear this out. Google Inc. was incorporated in Sep. '98 by Lawrence Page and Sergey Brin and as of '99 its sales stood at $220,000 and its losses were to the tune of $6.1m. By the year 2000, sales had jumped to $19m, but the losses had grown to $14.7m at the same time. Google saw its first profit in '01 and it ended the year with sales of $86.4m (up 352% yoy) and $7m in profits. It ended '02 with sales of $439.5m (up 409% yoy) and profit of 155.3m (up 2119% yoy). In '03, Google sales were at $1.5b (up 241% yoy) and profits were at $395.4m (up 155% yoy). In Aug. '04, Google went public at a price of $85 per share. Trading under the ticker symbol GOOG, the shares more than tripled in its first year, and were trading as high as $475 earlier this year. Google ended the IPO year of '04 with sales of $3.2b (up 113% yoy)
and profits of $977m (up 147% yoy). By mid '05 Google had doubled its sales and profits had shot up 500% from the same period in the previous year. The company had $3b in cash and no borrowings. As of today (Mar.17 '06) GOOG was trading at $340.

Just how big is Google? Here's a comparison of the market capitalizations of major US corporations as of Aug. '05. Microsoft lead the tally at $287b followed by Wal-Mart at $197b. Time Warner came in third at $85.9b and Google came in fourth at $79.6b. Google is more valuable than companies like eBay, Disney, Yahoo, McDonald's, General Motors and Amazon, the others in the top m-cap list.

But how did these advertising programs come about? There's an interesting story behind this and we have to go back a few years and look at the history of how search engines evolved as a business. Bill Gross is not a household name like Larry Page or Sergey Brin, but had history turned out a little different it could have been the other way around. Gross's IdeaLab founded many companies, but one of them survived the dot-com bust, Overture. Founded in '97 as GoTo.com, Overture remains Bill Gross's greatest success. But Gross is not ecstatic about it, rather he regrets it. Because Overture might have been Google. When GoTo launched, Google was still an obscure graduate school project. And Search was seen as being "good enough" having already had its day. Those were the days of the portals, trying ever so hard to retain eyeballs. If search was going to take the users away from the portal, then it wasn't in the portal's interest. With no one interested in search, innovation took a back seat, and spammers took control of indexes pushing irrelevant results to the top. To counter this, Gross thought up the plan of forcing the friction of pricing into the equation. He made the differentiation between good traffic, undifferentiated traffic and plain crap. Gross studied the IdeaLab companies' traffic acquisition numbers and computed the cost of the campaigns down to the single visitor. He concluded that any business would pay more for the right kind of traffic and that he could drive the price per click down to a few cents or even less as he got good at it. That rationalization became Gross's eureka moment and it spawned today's Internet advertising economy. And the Internet already had a model for an engine to create intentional traffic, called the Search engine, only nobody seemed to care!

At the heart of Gross's plan was that the search query is inherently valuable and it could be priced, and this is what drives the search economy today. When a user searches for something, say movies, he would want to see all the information and products about movies, to review and maybe to even buy. But this required that the merchants selling those products and services had to participate. And they would, because GoTo provided them with intentional traffic which was hard to come by. And Gross believed GoTo could make big money by charging in pennies for transactions. Unfortunately for Gross, not many people understood the intrinsic value of the search query; until he could prove otherwise he was just selling theory. So Gross came up with a unique idea, a performance-based model where advertisers paid only when users clicked on the ads, and he priced them as low as one cent per click. And it worked for GoTo. In six months, it had the cost of driving a search meet the earnings from it. This was way ahead of schedule. In Apr. '99, GoTo filed to go public.

But the industry and the business press as a whole was still not warming up to GoTo as much as Gross would have liked them to. Putting paid advertising as part of search results was seen as being similar to selling editorial space. As business grew, GoTo developed two lines of business, its main site (GoTo.com) and a syndication business (similar to what Google now refers to as its distribution network). By 2000, the syndication network provided 90% of the traffic for GoTo; and its biggest syndication partner, America Online (AOL), insisted that GoTo shutdown its own site as it was seen as a competitor. In Sep. '01, Gross reluctantly shutdown GoTo.com and changed the name to Overture reflecting its core business of delivering paid introductions. But soon, Gross's worst fears came true, Google was gaining ground as a pure search destination. In the middle of '99, Google did not have any business model to speak of, Page and Brin were still wondering how to make money on Google and in GoTo they saw a business model they liked. In late '01, Gross suggetsed to Page and Brin that Overture and Google merge. But they turned it down and the reason they gave was that they would never associate themselves with a company that mixed paid ads with organic results. Gross finally sold Overture (www.overture.com) to Yahoo for $1.63b in '04.

In '02, Google announced its AdWords initiative with the pay-per-click model. Overture sued for patent infringement, but the case was settled just before Google's IPO in '04. By then, the business model that GoTo pioneered, had matured and Google was getting credit for it. To add insult to injury, AOL did not renew its deal with Overture but instead went with Google. Bill Gross did not disappear after Overture though. He announced that he had the next economic paradigm in search. In '04 Gross delivered SNAP (www.snap.com), a new search engine that ranks sites by factors such as how many times they have been clicked on by prior searchers. Instead of just relying on computer algorithms to rank search results, Snap uses click-stream information from a network of Internet users. By recording and processing which websites users spend time on, and which sites they quickly leave, Snap improves the likelihood that the search results will be the results users are really looking for. But there's more to Snap than search. Snap offers a revolutionary way to advertise - Cost Per Action. This approach virtually eliminates advertisers' risk because Snap only gets paid when the user completes a purchase or any other action like giving an e-mail address or registering on the site. And Gross is open about what motivates him - Google! Gross says Google is getting spammed and he thinks Snap has done one better over Google.

Make a mention of AdWords to Bill Gross and former Overture employees and they still bristle. So not everybody likes Google!

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