Where does Google go next?

Yes, it's making gobs of money. Yes, it's full of smart people. Yes, it's a wonderful place to work. So why are so many people leaving?
By Adam Lashinsky, senior writer
(Fortune) -- Sean Knapp had it made. As a young computer scientist, he couldn't have had a better gig: working at Google, the engineer's paradise. He had all the usual perks - a massage every other week, onsite laundry, free all-you-can-eat haute cuisine. Even better, he got to work on some of Google's highest-profile products, including the search technology that is the heart and soul of the company. And he made full use of his "20% time," that famous one day a week that Google gives its engineers to work on whatever project they want. A little over a year ago he and a couple of colleagues, brothers Bismarck and Belsasar Lepe, ages 28 and 21, respectively, did what many of the young geniuses do at Google: They came up with a cool idea, in this case a new way to handle Web video.
Then Knapp, who's 27, and the Lepes did something truly remarkable. They expelled themselves from paradise to start their own company.
That sort of thing just doesn't happen at Google - or it didn't used to anyway. In April 2007, when the trio informed Google they were leaving, they didn't give any specifics, just that they were going to do their own thing. Without even knowing what their idea was, Google wanted them - and their project - to stay. "They told us, 'Here's a blank check,'" recalls Knapp, a baby-faced former track star at Stanford. "I said, 'You're asking me to be a surrogate parent.'" Knapp and his pals would do the hard work, in other words, but Google would own the product. Instead, off they went, leaving behind the perks, the 20% time, and a combined seven-figure pile of unvested options. (Google declined to comment on Knapp's account.)
A year later the company the three founded, Ooyala, is precisely the kind of budding success Google wants to be creating inside its walls. Ooyala's 28 employees are building a system that runs videos for independent Web sites, and eventually they plan to sell video ads in the same way Google (GOOG, Fortune 500) hawks text ads for other web publishers. The startup has raised $10 million in venture capital, which doesn't even come close to matching Google's resources. But the Ooyala founders say what they lack in institutional backing they make up for in speed and the ability to communicate with one another by turning around in their chairs and talking. Google was like that too, about eight years and 18,000 employees ago.
It would be easy to dismiss the exodus of some of Google's best people if it were an isolated occurrence. It isn't. Paul Buchheit, an early Google engineer who coined the "Don't be evil!" battle cry, is a founder, with three ex-Google colleagues, of a social-networking company called FriendFeed. Yanda Erlich, once a popular Google product manager, started an instant-messaging company called Mogad. Nathan Stoll, who managed Google News, is hard at work on his new company, Mechanical Zoo. (It's in "stealth mode"- no details.) Former business-development guys Salman Ullah and Sean Dempsey have a new venture capital firm, Merus Capital, that aims in part to fund startups founded by ex-Googlers. (That's employees, in Googlespeak.) The departures have grown so numerous that the exiles have formed an informal alumni club of ex-Googlers turned entrepreneurs. David Friedberg, another former biz-dev executive, who started a company called WeatherBill, which sells insurance pegged to climate risks, recently attended the club's first meeting at a conference center in Palo Alto. "I was surprised by the number of things that were being done that could have been done at Google," he says.
There's been an exodus of executive talent too: Its chief information officer, Douglas Merrill, just left. Several top people have gone to Facebook, most notably Sheryl Sandberg, who ran Google's automated ad sales, and Elliot Schrage, who ran PR. George Reyes, Google's CFO, announced his retirement last summer and has yet to be replaced.
Employee turnover is the norm in Silicon Valley, especially at companies where early hires get rich enough to do whatever they want (and post-jackpot hires don't). For his part, Google CEO Eric Schmidt - who left Sun Microsystems for Novell and then Novell for Google - brushes off the effects of all those departures. "We've been hiring on the order of 100 people a week," he says. "So in one week we hire more people than the people you just named."
But fleeing executives and star engineers aren't the only challenges Google faces these days. You may be thinking: Challenges? Google? The company that nets $1 billion - plus a quarter and is so powerful it even scares Microsoft (MSFT, Fortune 500)? Yes, the very same. Fact is, Google's torrid growth is finally slowing, as the company's sheer size dictates it must. And size necessitates changes. Gone are the days when Google could take full advantage of its quirkiness. It's the market leader now, which presents a classic conundrum: Which is more important, process or innovation? For all Google's success, it still has just one meaningful way of making money: its powerful search-advertising system. It's a gusher, but it's the only one. All the other projects it has in the works are just that, projects.
The mere hint that Google may have issues to deal with clearly hits a nerve. As I was researching this article, Marc Benioff, the CEO of Salesforce.com (CRM) and a Google business partner, phoned to discuss an alliance his company had inked with Google. I'm always happy to hear from the voluble Benioff - except I hadn't called him in the first place. Someone "at the top" at Google had asked him to reach out to me. "What they need to do is build a full portfolio of revenue, as Microsoft has," says Benioff. "They have a fantastic cash cow. They need a goat and a chicken."
More than diversification, though, Google has to prove that its quirks - its odd hiring practices (e.g., asking 45-year-olds their GPAs), refusal to play the guidance game with Wall Street, the free food, etc. - will stand the test of time. It has to show that its success is because of its Googleyness (more Googlespeak), not despite it. Even its friends harbor doubts. "I'm not convinced they're in the ranks of GE or P&G or even Microsoft, for that matter," says Peter Chernin, president of News Corp., whose MySpace unit is a key Google partner. "Not yet."
A basic tenet of Google's way of doing business is that it is not like other businesses. Founders Larry Page and Sergey Brin celebrated this quality in their famous letter to prospective shareholders before the company's 2004 IPO, and they promised to keep things that way. For example, Google's operations themselves are unconventional. One of the most fundamental precepts of modern management has to do with how to allocate resources: deciding which projects to pursue, where to spend money, when to take a pass. In fact, MBAs learn in their first classes at business school that resource allocation is a manager's most important task. Yet it's a concept that, while not exactly alien to Google's top dogs, isn't their highest priority. After all, why focus on allocating scarce resources when the resources aren't all that scarce? At the end of the first quarter Google had cash and other liquid assets of $12 billion; it generates almost $2 billion of cash per quarter.
Where does Google go next? (page 2)
By Adam Lashinsky, senior writer
At Google, what you often end up with instead of resource allocation is a laissez-faire mess. Take, for example, the hassles Dave Girouard had to face. Girouard is vice president in charge of Google Apps, the company's fledgling initiative to sell Web-based software applications to businesses. He wanted some alterations to Gmail to make the e-mail product more appealing to his corporate customers. To do that, he needed to lobby Gmail engineers, who don't work for him. He likens his efforts to a Peace Corps mission: all heart but little power to enforce his will. Yet while Girouard is begging for engineers, others, like the Ooyala founders, get blank-check offers. Says one ardent, if critical, Google fan: "They can't do everything, but they still think they can."
The dabbling often results in duplicated efforts - or products stuck in also-ran status. Google Page Creator, an early-stage product that nevertheless was publicly released in 2006, does about the same thing as Google Sites, a newer offering. "Even on Web search, there were multiple teams working on similar projects," says Ooyala's Knapp. Google Checkout is a payment system in which Google has invested heavily, yet it remains far behind eBay's (EBAY, Fortune 500) PayPal unit in market share. It doesn't help matters that eBay is a major Google customer, but that's another story.
Even high-profile business deals don't always reflect a clear logic. When the company outbid Microsoft to supply search ads to News Corp.'s MySpace social network, for instance, Google was aware that the deal wouldn't make it a lot of money right away. Almost two years later Google still isn't making much, if any, money on MySpace - or any other social network, for that matter.
Google also has yet to see the kinds of financial returns it had hoped for from its prodigious acquisitions. In its first significant purchase Google paid $98 million in early 2006 for dMarc, a startup that manages ad spots for radio. It was to be the foundation for Google's move into selling forms of advertising other than plain text ads. But dMarc, now Google Audio Ads, hasn't amounted to much. Indeed, it's one of seven products, as Google dryly notes in its securities filings, that have not produced any material revenue. Another of those products, surprisingly, is YouTube, which Google acquired in 2006 for $1.6 billion and which continues to experience torrid growth. According to comScore Video Matrix, YouTube's share of video on U.S. websites is now 34%, double what it was in February 2007. Yet Google has been relatively ineffective at selling ads on YouTube, collecting about $100 million in revenue in 2007, mostly from ads on YouTube's home page. Google says it's focused on growing share and improving the "user experience." Industry wags suspect that advertisers simply see little value in selling their wares next to dancing cats.
Google does have some big bets that could become meaningful businesses. Google Apps, a Microsoft Office lookalike package, is a modest success, with expected 2008 bookings of "several hundred million dollars," according to Google. That's still tiny compared with Google's main search-ad business, and it's downright microscopic next to Microsoft's $19 billion Office franchise. Another initiative with serious potential is Google's Android project, which offers a standard and open operating system for cellphones, compared with the proprietary systems in use today. Important industry players such as T-Mobile and Samsung have signed up with Google to be partners on Android.
Google's biggest bet so far is its recent $3.1 billion acquisition of DoubleClick, a specialist in online display advertising. Display ads are like what you'd find on TV or in magazines: They're focused on image and message rather than on transactions, which is the allure of text ads. Online display ads have grown more slowly than search ads, but they are a huge untapped territory. In the traditional ad world, brand advertising is far bigger than direct marketing. Same deal online. When people are on the web, most of the time they're not searching- they're reading, watching video, playing poker, whatever. There's big bucks in getting ads in front of people while they're engaged in all their nonsearch activities. Google hasn't excelled at such ads; DoubleClick has. (Disclosure: My wife is a former DoubleClick, and newly minted Google, sales executive.)
Google's move into new kinds of advertising opens up another thorny issue: the economy. In mid-2007, Google's chief economist, former University of California professor Hal Varian, read that Schmidt had referred to Google as "recession-proof." He quickly corrected his boss: "I would say recession-resistant," says Varian. In fact, Varian ran an analysis of Google's business to determine the effect of the overall economy on its performance. His conclusions were contradictory. First, he found that Google has a "GDP beta" of one, meaning that because the company's ad base is diversified, its business should swing according to the overall economy. That would seem to be troubling. Yet Varian also determined that because Google is so successful at targeting its ads- advertisers who buy the phrase "digital camera" on Google are highly confident they'll attract digital camera shoppers - it will be less susceptible to economic trends. Furthermore, because Google caters to advertisers who buy in small increments, Varian thinks the company's offering appeals in price-sensitive times. His overall conclusion: "There is something of a contra-cyclical nature" to Google's business. What's more, the massive shift underway from traditional media to online will trump any effects Google might otherwise feel from a weak economy.
As of this spring, the balance has swung in Google's favor. Fears that a slowdown in the growth of users clicking on Google's ads would lead to worsening performance have so far proved unfounded. When Google reported first-quarter earnings of $1.3 billion, significantly beating Wall Street's estimates, the stock jumped $90 per share in a day. A slowing economy simply hasn't affected Google's performance. "We've looked at this really carefully, and we do not see an impact as of this time," Schmidt told investors on April 17. "Should the economy change, we're well positioned to continue to do well because our model is so targeted. And targeted advertising does well in pretty much most scenarios."
So far the facts bear Schmidt out. But there's that bothersome conclusion of his economist, the one where Google's performance at some point mirrors the economy's. The question is, when?
For all its challenges, Google obviously remains a phenomenon. Its people may be wasting resources chasing disparate dreams, but the engineers dedicated to tweaking and improving the search algorithm and the ad system that cashes in on it are among the best in the world. Google's share of U.S. search queries just keeps rising: It's now around 59%, up from 46% in early 2005, according to Nielsen Online. "We are in one of our most productive phases," boasts Schmidt.
Also remember just how profitable Google is - and what a cushion that provides. Net margins of 25% place Google between Microsoft's monopoly margins of 28% and Cisco's (CSCO, Fortune 500) best-in-class hardware profits of 21%. Should Google ever decide to cut costs, it will have ample opportunities. As an example, the company spends at least $14 per employee per day on all that free food. At 19,000 employees, that works out to $67 million a year, or about 20 cents per share that would drop to the bottom line if Google were to have the temerity to ask its workers - shudder - to pay for their own meals. Twenty cents is a trifle; analysts expect 2008 earnings of nearly $20 per share. But in a pinch? No-brainer.
Then there's the possibility that Google truly is inventing an entirely new way of doing business. "People are labeling them as just about search," says Bruce Jaffe, a former M&A executive at Microsoft who came to admire Google the hard way- by competing against it. "But I'm not sure that's accurate. They've introduced a new model for software. Think of it this way. If they are a household brand on products like Google Maps and Gmail, that may be more than just search." In other words, getting customers to use Google all the time would make it ubiquitous on the web, as Windows is on PCs. "It may be that they're in a whole other world from everyone else," says Jaffe. "They could be such pioneers that no one will know for years."
Even if Google does not redefine business as we know it, the company will change. Companies inevitably do as they grow and age. They lose their coolness, they bureaucratize. But expect Google to keep doing things its way for as long as possible. After all, its founders still control 58% of the company's voting shares and have vowed to invest for the long haul rather than heed criticism about short-term performance. In that regard, it's interesting to get a sense of the way Google sees itself. When Schmidt is asked how he as CEO balances the need for process with the less quantifiable demands of experimentation and innovation, he responds by relating the thoughts of Page and Brin. "Let me give you the argument that Larry and Sergey have made, which is, I think, surprising," Schmidt says. "They are concerned that the company is becoming too conservative. They say to me, 'We took huge risks when we had no cash. Now we have all of this cash and we take few risks.'"
Think about that. Google recently made headlines by bidding almost $5 billion in a government auction of wireless spectrum, even though the company had no plan for using it. Some of its more peculiar products include Google Sky, Google Mars, and Google Ride Finder. It has become a significant investor in alternative-energy projects. Yes, alternative energy. And its founders fret that its risk-taking days are over? Then again, Google's biggest risk may be recreating the magic it enjoyed as a startup- that intangible quality that makes Silicon Valley tick. Paul Buchheit, the former Google engineer who is on to his second startup now, recalls what he loved about Google's early days. "I was always so excited at Google, because I didn't know what would happen next," he says. "Then I knew what would happen next." Predictability is a virtue in the world of big business. It's just not particularly Googley.