Former Yahoo executives Jerry Yang and Sue Decker at the D6 Conference in 2008

Asa Mathat for AllThingsD

Former Yahoo executives Jerry Yang and Sue Decker at the D6 Conference in 2008

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In May of 2005, Yahoo CEO Terry Semel, co-founder Jerry Yang, business development executive Toby Coppel and I went on what would turn out to be a fateful trip to China.

Fateful for Yahoo, for certain.

Less than a decade later, the ownership stake that resulted from that trip has been the saving grace for the company that had once dominated the early Internet. The value of the shares bought then, in fact, now make up a big chunk of the value of Yahoo today, and the windfall of cash from that purchase is what many hope will allow it to remake its uncertain future.


And then we found Alibaba — and it found us, too — and that meeting ultimately led to the partnership that ultimately proved to be remarkably successful in a market that many others have found elusive.


At the time, though, we were just in search of a new approach to building a sustainable business in that oftentimes difficult but critical market. Things hadn’t gone well up until that point. In fact, you could say (and many did) that our previous attempts had failed, in the sense of amassing a sustained and meaningful market position.

The roots of this success were built on learnings from our prior attempts in China and a resolve to take some new risks to make this one successful. In some ways, these powerful lessons ring with greater clarity nearly a decade on and might shorten a comparative pathway to success for other business leaders seeking growth in that dynamic market.

Build, buy, partner

The first Yahoo forays into China started with a build strategy, later moved to a buy strategy and ultimately settled on a partnership strategy. In each incarnation, we spent a lot of time thinking about what might leverage our existing product. In hindsight, this thinking turned out to be far less important than the lessons we learned about leadership, control and trust, which ultimately were reflected in how each of the businesses were created, capitalized and staffed.

Yahoo China logo

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Yahoo’s first attempt to build a business in China began in 1999, a basic effort to extend the brand and products, except for the extraordinary complexity of doing even that in China. To begin with, coding was entirely different in the so-called “double-byte” countries, since Web traffic has to handle the more data-rich characters associated with Chinese characters as compared to Latin ones. Even so, from 1996 to 1998, Yahoo had already launched businesses in Japan, Korea and Taiwan. At that time, China was seen as just another step forward into a fast-growing market.

As such, Yahoo China was launched in 1999 as a translation of U.S. content into two Chinese languages, including directory access to 20,000 websites with a heavy portal orientation, including news, finance, weather, email and instant messaging. We had done it elsewhere, and it was working.

When Yahoo China was established that year, roughly five million people were accessing the Internet in China. That figure would prove to more than double in each of the coming years, until China became the single largest country of Internet users, surpassing the U.S. by the end of 2005 with roughly 200 million users across PCs and mobile phones.

But by 2002, just two years into our operation, it was clear that Yahoo was not getting the traction that other local Chinese Internet companies were seeing. Revenue was only a few million dollars and we were drawing only five million to 10 million users to the site each month.


Our homegrown strategy had failed, so we clearly needed to do more than just extend our existing operations into China to be successful there.


In contrast, our local competition were collectively generating close to $100 million in revenue at the time, with much higher user bases. The ad market in China was only approaching $70 million by 2002, so many of these companies were already experimenting with new types of revenue and business models that were beyond our reach. As a result, they were drawing increasingly more of the now 40 million people who were accessing the Internet in China by this time.

Having seen great success with local Chinese entrepreneurs, we decided that the solution was to acquire a local company that had already gained traction in the market, one that could give us proven local management.

We had also made search a priority in our core business after buying Inktomi in 2002, and we wanted an acquisition that could help us extend there, as well.

In November of 2003, following careful consideration of multiple alternatives and six months of due diligence, we announced our agreement to purchase 3721. The company met all the requirements: It was clearly of the Chinese market; they had five years of growth experience and close to 200 employees; and, perhaps most of all, it was run by an aggressive Internet entrepreneur, Zhou Hongyi.

Zhou Hongyi

Zhou Hongyi

The core product at 3721 was a browser download that helped users in China go directly to destination websites, which was essentially an early form of a search. The company generated revenue from selling hundreds of thousands of Chinese-language keywords for Latin alphabet domain names targeting small- and medium-sized businesses. It had also begun to sell wireless offerings from SMS and ringtones, as mobile phones had already surpassed PC internet users in China by this time.

The idea was simple: Combine the best of both companies into one blended operation to create the new Yahoo China. The tagline of the press release said as much: “Cooperation Will Help Asia’s Small- and Medium-Sized Businesses Reach Increasing Number of Consumers and Build a Bridge to Global Markets.” The combined companies were projected to generate more than $25 million in revenue in 2004. We had 300 people — mostly local talent — and, together, we were reaching more than 50 million users each month.

Careful attention had gone into structuring the deal to moderate the risks of operating in China, while also empowering the local talent. As we closed the deal, China had become the No. 2 Internet market in the world measured by users, yet our penetration was still only five percent. We felt confident that with a stronger presence and a more local team, opportunities to expand would follow, as more and more people came online. We were optimistic about Yahoo’s future in China as the deal closed in January 2004.

By mid-2004, however, the operation was mired in internal conflict, largely due to friction over control issues and management style differences. Most of the Yahoo China people had been forced out or elected to leave, because of the new management style. And our finance, legal and HR functions were in a complete state of upheaval.

Jack Ma

The Guardian Jack Ma

Hongyi reportedly felt that the original Yahoos were overpaid and lazy, whereas the Yahoo team felt Hongyi wasn’t focused on the Yahoo operations, and felt bullied. So, we spent much of 2004 clarifying and trying to implement internal processes. As the business was wholly owned and consolidated into our financial statements, we insisted that the local team had to follow Yahoo systems and governance requirements. Not surprisingly, this didn’t sit well with the local team.

Ultimately the earn-out, which was a feature in the structuring of the original deal, was used as leverage to incent Hongyi to gain compliance with these issues, while building organization for a smooth transition for his eventual departure in 2005. He later went on to found and lead Qihoo 360 Technology, a $12 billion company that now trades on Nasdaq, in which he didn’t face the same sort of control issues that were placed upon him in the Yahoo ownership structure.

Although Hongyi was able to outperform the financial plan, the gap between 3721’s market position and the local competition was rising. Yahoo was in a stronger market position than before acquiring 3721, but there were big gaps, and both Google and Baidu were gaining share. Other local portals also continued to extend their lead versus our product offerings.

During the first half of 2005, as Semel and our executive team studied the landscape carefully, we were looking at companies we might acquire or with whom we might strike a partnership. And so began that auspicious trip in May of 2005, in which Semel, Yang, Coppel and I set out to meet dozens of companies and government officials over the course of a whirlwind week.


Most of all, we were impressed with how visionary and principled Ma was about his management philosophy, and liked how our two companies might fit together.


Most of the companies we met with were publicly held, but Alibaba was still privately held. The company was owned by management, venture capitalists and SoftBank. We met with founder Jack Ma and his chief financial officer Joe Tsai, with whom we immediately felt a strong cultural alignment.

Alibaba was based in the south, and had about 2,400 employees. The previous year, it had generated more than $4 billion in gross merchandise sales through its platform, yielding about $50 million in revenue.

The company also had two startup business lines, Alipay, a new payment system designed to work like PayPal, and Taobao, a startup auctions site. Both were offered free to consumers and merchants.

We had seen the power in Yahoo Japan of a similar partnership, and we thought that maybe Alibaba could help us bolster our market position in the things we brought to the table. We also had the financial resources to help them weather the days of offering auctions for free, as it attempted to compete against eBay. This was important, given Alibaba’s ambition to launch new businesses and a privately held capitalization structure.

We thought there might be a window of opportunity to build a leadership position in search and commerce in China, to complement our portal offerings with the right strategic partners. We returned in late May to Sunnyvale, and began an intense two-month period of negotiation and crafting of what became the joint venture with Alibaba.

Joe Tsai

Alizila.com Joe Tsai

Yang had struck up a good relationship with Ma, which greatly facilitated the negotiations. On the finance and deal side, we also felt a strong kinship with Tsai. A complicated deal to structure, we eventually came to agreement in which Yahoo would own 40 percent, SoftBank held 30 percent, and existing management kept 30 percent. In addition, Ma and the Alibaba leadership team would retain management control.

The deal was valued at just over $4 billion, with Yahoo putting in $1 billion in cash and our Yahoo China assets, which were then valued at $700 million. It was an attractive offer and step-up in value, considering what we had contributed to 3721 and its $120 million purchase price two years earlier.

While Yahoo China was tracking toward about $40 million in revenue in 2005, Alibaba’s consumer business alone was poised to do more than double that for the year, so it was valued at close to double our operation. In addition — and at the time, this seemed like a big leap of faith — more than half the value of the venture, more than $2 billion, was attributed to Taobao and Alipay. Both were losing money, having told the market they would be free of service for the next few years.

Still, we announced the deal by early August, less than three months after the trip that gave birth to the venture.

Key lessons learned

Looking back now, it is clear that there were three primary factors that ultimately led to the Alibaba deal being set up for value creation in the Chinese market.

The goal of “failing fast,” and learning from those mistakes to pivot and change the approach, has almost become a maxim in Silicon Valley. We learned that a willingness and inclination to stay at it and keep trying new approaches was critical to our ultimate success.

I serve on two boards with noted investor Charlie Munger — Costco and Berkshire Hathaway. Munger is a legendary business leader with an abundance of wisdom. He says repeatedly to us that he has constantly seen people rise in life who are not the smartest. But he noted that “they are learning machines,” adding that “they go to bed every night a little wiser than they were when they got up.”


Probably the most important element of Yahoo’s ultimate success was to recognize mistakes early, and to be persistent about trying new and different ways to approach the market.


A second critical principle that contributed to our success in China was the realization that we had to be willing to loosen the reins of control.

The most “controlled” approach was our initial “build” strategy, in which existing Yahoo controlled the product and the team and generally centralized the compliance functions, such as finance and legal. To do that, we relied on talent hired by Yahoo employees and recruited managerial talent from within Yahoo. This facilitated communication to headquarters and know-how on the ground, and felt like a comfortable way to access a new market, considering the great distances, both geographically and culturally.

This approach, however, turned out to be problematic. The local hires in China felt that our Sunnyvale leaders did not understand the market. They viewed the “multinational” leaders we empowered to operate in China as outsiders. This fostered tension from the get-go, and nurtured a lack of trust. Lead times on approvals back to headquarters in Sunnyvale for locally generated ideas were too long, and we weren’t able to move fast enough in a fast-growing market to be competitive with local competition on the product side.

To remedy this, when we purchased 3721, we were willing to give up a lot of the product control to an aggressive and experienced Chinese leader, and allow much greater latitude for local decision-making. We thought this would speed up decision-making and product launches, tuned for the local market, a clear characteristic of all of the local competitors that were beating us.

Charlie Munger

BBC.co.uk Charlie Munger

We also empowered the 3721 management team to manage the combined operations, including the former Yahoo China operations. The functions of legal, finance and human resources were the only ones still reporting back to headquarters and outside the local business operations.

This “hybrid” approach seemed like a good way to thread the needle of local product control, while also recognizing the goals of building cultural alignment and establish compliance controls where we needed them. While 3721 was an evolution in giving up some control, it also wasn’t enough, and, in some ways, this hybrid approach was the most difficult. Too much time was spent internally on all the people issues that emerged from two different cultures and business practices. Worst of all, it slowed us down on the product side, as well.

And so, with Alibaba, we realized we needed to be willing to give up all operating control. Practically speaking, this meant forgoing our previous desire to own more than 50 percent of the local operations. It also meant that we would leave all employee issues with our partners, and to allow people with whom we had no history to have access to our code and to build on top of it.

While this was scary, at the same time we had a model that had worked spectacularly well in Japan, where Yahoo owned one-third of the company and licensed its brand and technology and local management called the shots. Sunnyvale’s role was a supporting one, with some governance rights through licensing agreements and board representation.


The idea of a CEO actively hiring leaders that may be better skilled or experienced is a popular notion in the U.S., but it is rare in China.


The third factor that was critical to our ultimate success in China was the match with the leadership team of Alibaba. To feel comfortable in giving up control, we had to find a management team with whom we could find some cultural alignment, and could work to build trust.

Although Ma didn’t have a U.S. education, he was an avid student of U.S. management and leadership practices, and was very expressive about this in our very first meetings. By contrast, we had seen, in meetings with many other management teams, the strong influence of Confucian principles respecting hierarchical, top-down leadership systems.

Ma expressed a desire to add top talent to help support him leading the company. We could see this willingness to share power and complement his strengths in Tsai, then the CFO, later COO, and now vice chairman of Alibaba. Tsai clearly understood U.S. business practices, and had strengths that complemented Jack’s strengths in strategy and setting the vision.

A 2010 Harvard Business School case by Professor Julie Wulf noted that Ma studied Jack Welch’s approach at General Electric and was inspired by decentralized decision-making. She noted Welch’s assertion that “Business unit presidents must have the freedom to do what is right for their business. I want business units to compete with each other … and focus on being the best in their businesses.” Ma wanted that same spirit for our business in China.

For us, having a leader in charge who had both the humility and confidence to hire, retain and grow talent felt like the change we needed. Thus, we were comfortable and ready to give him the keys of control on the Yahoo operations in China.

Beyond the Yahoo experience

Many other U.S. companies were either entering China or making plans to do so at around the same time that Yahoo was making its early moves. All entrants faced a similar set of circumstances and conditions, including unique business challenges and being subject to different laws and customs. Adding to this, the operation of social sites is more difficult for foreign companies, given that many local sites are not blocked to the same extent.

TaoBao logo

According to GreatFire — a Chinese Web traffic monitor — more than 2,600 websites are blocked by China’s censorship policies. This extends to any non-Chinese user-generated content sites, such as Facebook, Twitter and YouTube. Whether they are blocking because of a concern to control organized political resistance or to promote Chinese social sites, the impact is the same. Facebook does have a sales office in Hong Kong, and recently announced that it may be opening another in Beijing, but it is a long way from solving the big issues.

Within that context, most made the same mistakes that Yahoo did in those early attempts to build a presence in China. Many then left the market after those disappointments.

The most interesting attempts of a “buy” strategy was that of eBay and, in its earliest days, it looked like it might be very successful. EBay bought one-third of EachNet in 2002 for $30 million, which was the leading auction site, founded in 1999. In 2003, it paid $150 million for the remaining two-thirds, and subsequently funded another $100 million for operating expenses, in addition to funds expended in advertising with the major local Chinese portals, to drive its presence in auctions.

In 2003, EachNet had close to an 80 percent market share in the auction market, compared to Taobao’s share of less than seven percent. However, by the time we met with Ma in May 2005, eBay was already being locally outmatched. Ma told us he launched Taobao to defend Alibaba’s position in its core business-to-consumer business. He had seen eBay do the reverse in the U.S., and he felt the distinction between a small business and a consumer was small.


As of today, there are no other successful examples of value creation by U.S. Internet companies in China.


Since his main initial goal was to defend his consumer business, as opposed to build a profitable standalone auction site, Ma made a decision not to charge listing fees, whereas EachNet did. In addition, the site design and the marketing approach were distinctly oriented to the Chinese market. Taobao offered live chat features so users could make deals together and build trust. EBay feared this would allow users to avoid its listing fees and transact directly, so it didn’t offer this valued feature. Also, the eBay servers were located outside of China, making the service slow.

By 2005, Taobao had bested eBay for market share, and by the end of 2006, eBay pulled out of the market completely.

By contrast, Google’s strategy was primarily a “build” strategy, similar to Yahoo’s first foray. Google rolled out a Chinese-translated version of Google.com in 2000, running on servers from the U.S. The site was slow, and it was often censored or shut down, causing it to lose market share over time to Baidu.

In 2006, after much reported trepidation and debate, given the massive growth in the user base in China, Google attempted to rectify the situation by launching a local .cn version of its code, using servers located in China. This came with the known cost of more limited features than in the U.S. service and filtering results in order to meet local censorship requirements. It made some competitive headway, but even at its peak, it claimed about one-third of the market to Baidu’s two-thirds.

alibaba-picks-us-for-ipo_bruneitimes-com-bn

BruneiTimes.com.bn

In 2009, Google changed its approach. It stopped self-censoring results and moved its business to Hong Kong in March of 2010. It had learned of a hacker attack aimed at surfacing information about human-rights activists. Google knew that China might ban access if it didn’t censor its results, and sure enough, the government did just that. This effectively ended Google’s attempt to compete in China. But how much of it was due to the political climate and how much to being outgunned operationally is unclear.

AOL’s approach was primarily through a variety of partnerships and investments in China, none of which appear to have borne fruit. In 2001, AOL entered China with a $100 million investment for a 49 percent stake of a joint venture with Legend (later Lenovo) to launch a Chinese-language portal. The venture was a flop within a few years. It also made a controlling investment in China Entertainment Television (CETV), which was sold in 2003.

Amazon.com purchased Chinese local Joyo for $75 million on August 19, 2004, but in its 10 years, it has not kept up with local competitors such as Taobao Mall and Jingdong Mall. The IT and logistics challenges in China are significant. It is still investing in China, but claims only about one percent of the e-commerce market in China. Amazon is still present, and it has launched a cloud service and an app store.

On the social side, sites like Facebook, Twitter — and, earlier, Myspace — have not made inroads, due to routine government blocking and censorship, and extremely strong local sites. Myspace was first in, attempting to avoid some of the early mistakes by using a local group of entrepreneurs to launch Myspace China. However, by the time they had figured out a plan, many local social and gaming sites were already very successful, including China’s dominant Tencent. By 2011, Myspace had all but left the market, with large downsides in staff, including its CEO.

Conclusion

Whether building, buying or partnering, all of the major U.S. Internet companies that did not succeed in China did not reenter with new or different strategies. Yahoo was not different from any of its peers with its early failed forays. The difference was that we kept going back, building on knowledge from the prior attempt, until the third time was the charm.

Nine years later, the venture has gone through a few many changes. For example, Alibaba was listed on the Hong Kong stock exchange in November of 2007, raising $1.5 billion, to become the world’s biggest Internet offering since Google’s initial public offering in 2004. The company subsequently went private in early 2012. There have also been changes in the framework agreement around the ownership of Alipay in both 2011 and 2012, as well as the buyback of almost half of the Yahoo stake, in May of 2012, for $7 billion.

Interestingly, these changes, as well as countless operational ones, would have been hampered by a layer of operating control from the U.S. parent. For example, Ma never really focused on the businesses of Yahoo China; in hindsight, his interest in the deal was largely to secure cash to help fund operating losses at Alipay and Taobao, and to leverage the Yahoo brand for the global business of Alibaba. But the core structure of the transaction empowered him to make the decisions to drive long-term value. Luckily, Yahoo felt it could live with this arrangement, but it would never have done on its own, and that probably would have created friction from time to time, had Yahoo corporate had a vote.

Today, the company is ranked beside Google, Facebook, Twitter and Tencent as among the titans of the Internet.

Currently, analysts estimate that the company will be valued at over $200 billion when it trades.

That works out to 40x the value of the deal we struck back in 2005. Had Yahoo held its entire stake, its share would be worth $68 billion, or $40 per Yahoo share, after tax today. Even still, the company will be reaping a huge return.

A version of this post originally appeared on HBR.org.

Sue Decker, former president of Yahoo and a former entrepreneur-in-residence at Harvard Business School, is a member of the boards of directors of Berkshire Hathaway, Intel and Costco Wholesale.



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