Throughout the current Web 2.0 boom, Microsoft and Yahoo! – joined by Google, TimeWarner’s AOL and News Corp - have driven the Internet M&A market and provided exits for numerous VCs and entrepreneurs. This weekend, however, Microsoft withdrew its largest-ever acquisition bid - for Yahoo! itself.

The saga may not yet be finished, since Microsoft could renew its bid after Yahoo!’s share price deteriorates and after disgruntled investors pressure the company’s management (Yahoo!’s top two institutional shareholders are already publicly fuming about the botched deal). Whether the Microsoft/Yahoo! merger is realised or not, one thing is clear: the discussion has sidelined two major acquirers of Internet startups.

Microsoft has been an extremely active acquirer on both sides of the Atlantic, purchasing European Internet startups such as Israel’s Kidaro, Norwegian enterprise search company FAST, The UK’s Multimap, and French mobile search company MotionBridge. Yahoo! has played an insignificant role in European Internet M&A to date, but is a key player in the US.

A platform business at heart

There is now press and analyst speculation that the nearly $50 billion (€32.2 billion) which Microsoft was prepared to pay for Yahoo! will go instead towards other acquisitions. The most commonly cited target is AOL, which TimeWarner appears willing to offload and which would provide the nearest approximation of the scale in the online advertising business that a merger with Yahoo! would have achieved. Yet smaller businesses have also seen their names thrown into the discussion: PaidContent suggests that online services like Facebook, Twitter or Digg are now possible acquisition targets for Microsoft.

These latter options are unlikely, because at its heart Microsoft is a platform business, not a content business. Like other technology platform businesses, from Oracle to Qualcomm, Microsoft’s business model is to ensure the dominance of its own software by making that software an essential part of other developers’ business models. This holds true not only for Microsoft’s Windows and Xbox platforms, but also for the company’s online advertising network, which is only as successful as the money publishers make using it.

Microsoft has clear ambitions to challenge Google as an online advertising network, and though Yahoo! would also have given Microsoft the US’s most popular web portal - Yahoo! web properties are more visited than Google’s in that country - the main driver for the proposed acquisition was for Microsoft to quickly build substantial scale in the online advertising business. Microsoft’s largest acquisition to date, the $6 billion (€3.9 billion) purchase of online advertising firm aQuantive in May 2007, provided Microsoft with a foothold but left the company with nowhere near the market share of Google, Yahoo! or AOL in either search or display advertising.

Furthermore, Microsoft has already tried smaller acquisitions in the space. Besides aQuantive, Microsoft acquired a slate of advertising companies over the past two years, including Israel’s YaData; the US’s AdECN, Massive and DeepMetrix; and France’s ScreenTonic. Yet what Microsoft needs now is scale, and Yahoo! and AOL are the only two players who can provide it.

Yahoo! preoccupied

As for Yahoo!, the potential merger has imperiled the company’s status as a major Internet acquirer. Firstly, Yahoo!’s engineering culture, reinvigorated 3 years ago through a series of critical acquisitions including del.icio.us and Flickr, has been crucial to the success of its more recent acquisitions. That culture is now at risk; as Om Malik points out, morale is undoubtedly low at Yahoo!, which will make retention of key employees a problem. Despite holding $2.61 billion (€1.68 billion) in the bank, Yahoo! will face inevitable challenges and potentially lawsuits from investors over the handling of the Microsoft offer, making immediate acquisitions difficult.

The silver lining is that neither a combined Microsoft/Yahoo!, a combined Microsoft/AOL or an independent Yahoo! are truly a match for Google’s online advertising business, particularly in search advertising. Any of those combinations would still necessitate the roll-up of additional online advertising networks, such as Germany’s Adconion Media Group, as well as the acquisition of innovative providers of advertising technology, such as Israel’s Kontera Technologies or Luxembourg’s wunderLOOP. Though neither Microsoft nor Yahoo! are likely to pursue smaller acquisitions in the short term, given time either could re-emerge as a buyer for European Internet startups.

The web is awash with news stories about Microsoft's acquisition of a 1.6% stake in Facebook. I was intrigued by Don Dodge's post on the subject which noted that this is "setting a tone for the company, and sending a strong message to advertisers, publishers, employees, and investors, that Microsoft is serious about being a leader in on line media." Given that my last post highlighted Microsoft's acquisitions in fiscal 2006 I was curious to sift back through these deals to see what sort of tone a company's acquisitions set? The chart below shows acquisitions by Microsoft, Google, and Yahoo from July 2006 to June 2007. To add some context I've colour coded these based on a rough sector classification.



One clear theme from this list is the importance of advertising. aQuantive and Rightmedia were two headline deals but ScreenTonic, Adscape, and AdInterax reinforce the notion that advertising is critical to all three.

Google's acquisitions were arguably the most diverse, although this reflects their scattered product offerings. Also, these companies were operating in common consumer spaces such as photos (Neven Vision and Panoramio), mapping (Endoxon), collaboration (Jotspot), video (Youtube and possibly Marratech for video conferencing), peer to peer file sharing (Xunlei), and presentation software (Tonic Systems and Zenter). Yahoo had half as many acquisitions and they seemed to be more focused on content than technology. Companies like rivals.com (sport site), wretch (a Xanga equivalent from Taiwan), and Bix.com (American Idol on the web) appear to be aimed at purchasing audiences. This seems reasonable in a world where advertising is incredibly valuable.

Microsoft's acquisitions look very different in comparison. With the exception of health-focused Azzyxi and Medstory, their other purchases generally aim to improve enterprise software experiences. Given the investment of their existing corporate customer base, it's no surprise that they're spending money to alleviate that pain.

Returning to the original question though, it certainly doesn't look like Microsoft is gunning to become an industry leader in online media. While the above analysis does stop at June 07 and they subsequently acquired AdEcn (advertising platform), Parlano (collaboration), Jellyfish (shopping comparison) and Facebook, I'm very curious to see what will be next in their shopping cart.

What company sold 71m software licenses for a single product in fiscal year 2007 while delivering over 27 per cent growth in two separate billion dollar product lines and also expanded revenues by over 25% in 46 countries? Naturally, it's software behemoth Microsoft. These are just a few of the staggering statistics pulled from the 2007 Microsoft Annual Report. While most of the stats quickly grow mind numbing, it's an interesting set of data for putting venture capital investments in perspective.

Consider that Microsoft spent $7.12bn on research and development in fiscal 2007. Over that same period, the total value of disclosed investments in all European venture backed companies was about $8.79bn. It's a bit hard to fathom that the total investment in all the 412 information technology companies (~$2.5bn) during that same time was only a third of the R&D budget of a single software company. The graph below highlights total European Venture Backed investment compared to the Microsoft R&D budget over the last three Microsoft fiscal years (July through June).

 

Thankfully though, money isn't everything. Innovation at a small start-up is much more productive and rapid than at a large company. Microsoft sometimes decides that its legions of researchers and developers can't build what their billions in cash can buy. In 2007 alone it shelled out $1.34bn to purchase 13 companies: TellMe Networks Inc, Softricity, Winternals, Azzyxi, Gteko, DesktopStandard Corporation, Colloquis Inc, Secured Dimensions, Medstory, devBiz Business Solutions, ScreenTonic SA, Engyro, and Stratature (plus $6bn for aQuantive). The TellMe acquisition was estimated at $800m indicating the average acquisition price for the other twelve companies was around $45m.  While the stats on Microsoft's research budgets may be a bit depressing, investors on this side of the pond should be happy to know that Microsoft plucked 30 per cent of this year's acquisitions from Israel, France, and Turkey.

The explosion of technology companies focused on the financial sector seems to show no sign of calming down. I'm no expert on this sector but it does seem amazingly buoyant. I guess that's not surprising given the incredible increase in financial services and trading activity since the last recession in 1990-1. As a result, there seems to be a "solution" for every conceivable area of financial activity within banks, insurers, asset managers and hedge funds, to name a few. But as an investor, how could you possibly decide whether to take a stake in, say, a firm providing performance management software for fixed income segregated mandates? Or whether a particular hedge fund risk management technology provider is any different from a whole host of similar firms already pushing their wares. For later-stage firms, I guess the answer lies in their track record and management. For this reason, Sopra Group was prepared to spend an unspecified amount today to buy Belgium-based Business Architects International. BAI has been going for 10 years and offers banks and investment management companies process models, components and software for credit processing and wealth management. Sopra operates in the same field of expertise so would have a strong information advantage over anyone else contemplating buying BAI. Business angels often have informational advantage too, but many other VCs cover broad industrial areas and often have good, but not always expert, knowledge of any particular business activity. Could they be missing out on potentially performance-enhancing deals? Or is it just the nature of the beast that some opportunities will always just slip past?

Facebook's massive popularity has spurred the company to seek ever broader audiences.  After starting with just Harvard students it expanded to all students and a year ago it opened the site to everyone.  This week Facebook announced it is opening up to search engines such as Google so that people who are not even members will be able to see profiles.   

While Facebook is expanding its remit, the legions of me-too social networks are actually becoming more specific.  The focus on niche markets makes perfect sense.  These specific audiences share demographic profiles that command higher advertising revenue.  A quick skim of Wikipedia's article on demographics could easily be mistaken as the list of the latest target for social networking.  Consider these groups listed under the frequently used demographics: age, race/ethnicity, location of residence, socio-economic status, religion, and life cycle (fertility, mortality, migration).  Below are examples of social networks in each of these sectors that have seen attention from investors and acquirers over the past few months:

• Age: TeeBeeDee Inc, a social network aimed at the 40-plus crowd, raised $4.8M from Shasta Ventures and Monitor Ventures.


• Ethnicity: Hi5 raised a $20m series A round to support their network originally aimed at the Indian diaspora.   


• Location: Rumours surfaced in mid-August that Google's investment in Tianya Club was the start of an attempt to create a Chinese social network. 


• Socio-economic Status: ASmallWorld.net is a network aimed at those seeking exclusivity.  Movie movie mogul Harvey Weinstein's production company is reported to have purchased a minority share in this network last year.


• Religion: CircleBuilder raised $800K in an angel round to support its platform for church oriented networks. 


• Life Cycle: Maya's Mom, focused on new mothers, was acquired last month by Johnson & Johnson-owned Baby Center.

I would expect entrepreneurs to keep moving through the list of common demographics and create more social networks.  There are plenty of opportunities around language and race.  However, I suspect new companies will focus on opportunities with more lucrative advertising opportunities.  Location, socio-economic status, and ownership are three that seem particularly appealing.  Networks targeted at hyperlocal communities, multi-millionaires, or car owners would address these nicely although there's a risk that the advertising value outweighs the benefits to those who join.  However, if there's money available I wonder if people in lucrative demographics might start getting paid to participate in targeted social networks?  It's surely possible?