On Monday, Google CEO Larry Page announced a major reorganization: The search giant is getting a new parent company, called Alphabet. In addition to owning Google, Alphabet will own other business ventures launched by Page and Google co-founder Sergey Brin.
It used to be more common for big companies to plow their profits into ambitious research and development projects. But in recent years, companies have been increasingly returning their profits to shareholders through dividends and share buybacks instead. Page is bucking that trend, betting that he and Brin can invest Google's vast profits more effectively than the broader market can.
He could be right. Google is structured in a way that gives Page and Brin total control over Google, which means that the founders can make long-term bets that would be hard for most CEOs — who serve at the pleasure of their boards — to make.
The way we innovate has changed a lot since the mid-20th century
To see why Alphabet could be a big deal, it helps to look back to the mid-20th century. In many ways, this was a golden age for American innovation generally, and computer technology in particular. A lot of these innovations were driven by a handful of huge conglomerates. The transistor was invented by the national telephone monopoly, AT&T. The early computer industry was dominated by an office equipment manufacturer, IBM. The graphical user interface was invented by a Xerox research lab.
But in the 1970s, things began to shift. When we think of the major innovations of the past 40 years, we don't think of industrial giants like AT&T or IBM. Rather we think about Bill Gates, Steve Jobs, and Mark Zuckerberg creating new companies and new product categories from scratch.
In the modern invention story, big companies are less likely to be a source of inventions than an obstacle to progress — or simply irrelevant. One generation's disruptors become the next generation's disruptees.
Big companies face pressure to return cash to shareholders
Over the same period, we've seen a big shift in what CEOs do with their companies' profits. Instead of plowing their profits back into new investments, as they might have done a generation earlier, companies are increasingly returning the profits to investors through dividends and share buybacks.
And that's not a coincidence. If you believe that innovation mostly comes from venture-backed startups that disrupt established companies, and that established companies mostly squander resources in a futile effort to ward off obsolescence, then this is precisely what you should want big companies to do.
Also, capital markets are larger and more sophisticated than they were a few decades ago. In the early days of Silicon Valley, even the most promising startups struggled to find anyone willing to fund them, so working at a big company was often the only way to get the funding needed to get a cutting-edge idea off the ground.
Now Silicon Valley is awash in capital. There are dozens of venture capital firms eager to fund every promising technology idea. So, the theory goes, technology visionaries no longer need the backing of big companies to fund their great idea.
Alphabet is uniquely positioned for long-term investments
So most companies face pressure to stick to making products in their core area of competence — in this case, online services — and return extra profits to shareholders. But Page has no intention of doing that. Indeed, last year he reorganized Google in a way that allows him and co-founder Sergey Brin to raise more capital without losing control of the company. Page thinks he and Brin will be able to put Google's profits to use more effectively than Google's shareholders could.
There are obviously many examples of the conventional venture capital approach working well and producing major innovations. But there may be some innovations that a huge, well-funded organization like Alphabet might be better positioned to accomplish than a conventional venture-backed startup can. There are now a ton of venture capital firms looking to fund innovative startups. But there are very few technology companies that are controlled by their founders and have significant cash to invest. Google is one of them, which means it can do things few other companies can.
A big disadvantage of the venture capital model is that startup founders have to choose between raising large sums of money and maintaining control of their companies. Some founders, such as Mark Zuckerberg and Page and Brin themselves, have managed to build huge companies while maintaining control. But that was only possible because they were able to get a product to market with a small initial investment. That meant that as Google and Facebook grew, its founders could run their companies in ways they thought made sense without worrying much about what investors wanted.
But there are many types of innovation where this just isn't possible: It costs so much to get the company off the ground that founders wind up as minority shareholders in their own companies. And once founders lose control of their companies, they face more pressure to worry about short-term profitability. Venture capitalists are willing to lose money for several years in hopes of a significant payoff down the road, but they still want to have a clear plan to reach profitability. Hardly any are willing to invest in wide-ranging research for a decade or more in hopes that it will eventually produce a marketable product.
And most Fortune 500 CEOs face a similar constraint. They might have plenty of cash, but they face pressure from Wall Street to deliver solid financial results on a quarterly basis. In practice, that creates pressures not that different from those exerted by venture capital firms: CEOs can invest, but only in projects that have the prospect to produce returns within a few years.
But Google is structured in a way that guarantees Page and Brin will control the company as long as they're both alive and working for the company. They're relatively young men, and could easily run Google for another three or four decades. That allows them to make long-term bets in technologies — like self-driving cars or life-extension technology — that might not pay off for a decade or more. These are investments that few venture capital firms — or most large, established companies — would be willing to make.
Obviously, it's impossible to predict how successful this strategy will be. Page and Brin might wind up wasting their shareholders' money on boondoggles that never produce significant benefits.
But it's also possible they'll find big opportunities that investors with shorter time horizons have missed. Perhaps the pendulum has swung too far toward a world where companies are a little too accountable for delivering short-term financial results. Maybe the American economy needs some companies engaged in the kind of ambitious, long-term research that companies like AT&T and Xerox engaged in a half-century ago. Larry Page is determined to find out.