Today’s New York Times ran an article titled “Studios Try to Save the DVD” which mirrors an earlier post we filed titled “Why Warner Bros. did Toshiba a massive favor by going with Blu-ray (Rock Lobster)” after Toshiba bowed out of the HD format race in early Jan ’08. The Times article reads:

But the victory of Sony’s new Blu-ray high-definition disc over a rival format, Toshiba’s HD DVD, masks a problem facing the studios: the overall decline of the DVD market. [US] Domestic DVD sales fell 3.2 percent last year to $15.9 billion, according to Adams Media Research, the first annual drop in the medium’s history. Adams projects another decline in 2008, to $15.4 billion, and a similar dip for 2009.

We suspect the decline in DVD sales will accelerate in 2008 falling more than 11% to about US$14.3 billion in the US (need we even talk about China?) on the back of the proliferation and growing acceptance of the Internet based ad supported digital content model (free stuff), lower bandwidth costs and fatter pipes. Indeed, five years from now DVD sales will be 50% lower (conservatively) then where they are now.

Why the doom and gloom?! I mean, won’t the Studios come up with cool new interactive features that will pull consumers into their DVD web?! Not going to happen.

Okay, so what about all those ad supported models, you know those ones that give streams away for free yet charge for digital download or physical DVDs? This must be the answer the industry is looking for…right?! Hey, we’ve got all those social networks to monetize. Those dudes totally want our stuff. Hoorah! Hoorah! Hoorah! We’re saved…

Well, boys…you might want to sit down with Google and ask them about their ability to make money off social networking. Better yet…let’s chat with Google’s CFO George Reyes about 4Q 07 revenues. Hey Reyes, what’s up with Google’s US$900 million deal to supply ads to Myspace? According to a recent BusinessWeek article Reyes states:

“…[in 2007] social networking inventory is not monetizing as well as expected…”

Anyway you look at it…this whole selling content (both online and offline) is a genuine mess. Mark our words: 99% of all ad supported content models are doomed for failure. Why? For so many reasons, such as: (1) Because once a content provider does a deal with Google why would you go anywhere else to consume the same content? and (2) Ad revenues are going to polarize around “non-trendy, Web1.0 sites”, such as CNN.com where consumers are accustom to seeing advertising; and as a result of this polarization we’re going to get a lot of very unhappy dissatisfied studios, labels and artists hoodwinked by flashy sites promising sacks of cash. Whatever!

Moving forward, we think on-line ad supported content models will be the main catalyst (second only to online piracy) behind the continuing eyeball popping deflationary pressure on content for the foreseeable future. And no one will make any money (sans one or two sites) to boot. Talk about a pissed off world looking for CHANGE!

There is light at the end of the tunnel (cue soapbox) but a lot still needs to be done: The answer is blanket licensing at the ISP level…full stop. This is the only way to to properly compensate content providers and ensure some amount of recurring income those companies aggregating and distributing content on-line.

I received Morgan Stanley’s Year-end 2007 Capital Markets Review from my friend Mark Pols the other day. Below are some of the more interesting factoids from the report.

In 2007, U.S. IPO issuance volume of Chinese companies increased dramatically:

• 29 Chinese companies were listed in U.S., raising US$6.8bn in total;
• 2007 saw a much more diversified set of companies choosing to list in U.S.;
• Of the 29 issuers, only 34% were from traditional technology sector compared to 63% in 2004 and 100% in 2000;
• Other industries include healthcare, telecom, consumer retail, real estate, professional services, and financials;
• More companies chose for NYSE listing versus NASDAQ listing, 18 in 2007 compared 3 out of 8 in 2006.

Strong technology markets led to high private company valuations:

• Deals priced in 2H07 up to 11/8/07 achieved 2008 PE multiple of 24.3x on average;
• Valuation level dropped for deals priced between 11/8/07 and year end amid subprime concerns and broader market correction;
• Deals priced during that time period averaged 2008 PE multiple of 11.2x;
• “Superior execution” (Morgan Stanley’s words) was required to justify valuation and sustain aftermarket trading momentum;
• Mean and median performance from offer to 12/31/07 were 31.3% and 1.6%, respectively.

Morgan Stanley concludes that growth in IPO and secondary volumes expected to subside in 2008 but remains open for high quality issuers with decent visibility in the business.

(1) DISCOUNT, PLEASE! Keep the structure simple and offer your bridge investors a discount to Series A Preferred share price rather than a warrant:

A real quick way to lose investors’ interest is to price your bridge financing at the same multiple as Series A Preferred shareholders are paying. In lieu of a discount what we’re seeing from start-ups (particularly, those with American legal counsel) is a warrant granting the right to purchase shares COMMON SHARES at the same valuation as Series A

Yeah, are we like…missing something here? Bueller?…Bueller?..

Common folks, time for a quick reality check. If you’re coming to us, looking for bridge financing, offering a note that converts into Series A Preferred shares, why on earth would we have any interest in exercising a warrant for common shares at the same price as the more valuable preferred shares?

Furthermore, why would we have any interest in acquiring additional common shares when preferred were still on offer – it is like walking in an Aston Martin dealership packed to the gills with inventory, buying an Aston Martin DB9 and as a bonus being given a coupon to buy a Chery QQ for the same price as the Aston Martin.

Look, bridge rounds are highly attractive and potentially lucrative deals to roll into, yet a bridge investor undertakes a relatively higher level of risk and uncertainty than a Series A investor; thus the bridge note must absolutely positively reflect this risk. And a discount to Series A is the simplest and cleanest way to accomplish this.

(2) ODD LOTS? Avoid irrevocable super majority rights and odd lots holding the same rights and warranties as your Series A Preferred investor(s):

So, your next door neighbor, Xiao MeiMei, and her extended family want to dump the equivalent of US$32,000 into your bridge round. Word gets out that you’re looking for cash and quickly snakes through the hutong. Next thing you know you have 23 different bridge loan commitments from various “friends & family” totaling the equivalent of US$411,000. You’re rich…rich…rich! Great news, right?!

Well, not really…because in the bridge subscription documents (lovingly prepared by your brilliant lawyers for US$40,000) excluded language that makes the distinction between rights and warranties held by institutional investors and those held by Xiao MeiMei, mom, and pop.

We could go on about this but we’ve already turned this blog into the Mahabharata – so, let’s cut to the chase – we have two words for you – super majority.

In the past, we’ve advocated (fiercely) that a founder, when faced with a funding situation that will massively dilute their equity holding, should seek some protection in the form of super majority rights. But, this is definitely not the case when you’re structuring bridge financing. Doing so leaves yourself (and company) exposed to the possibility that handful of bridge investors (e.g. those investors that are two or three degrees removed from your real “friends & family”) that could block or challenge future business related decisions with a flick of their pen.

How might this be possible?! Well, one scenario would be a situation where an institutional investor (e.g. venture capitalist) subscribes to the bridge and pulls down 40% of the entire offering. The venture capitalist, cognisant of the fact that once the bridge loan converts into Series A Preferred shares (and given the significant number of mom and pop odd lot bridge co-investors and the ensuing dilution from larger Series A investors), will neither have control of the equity class (Series A Preferred) nor (in some cases) a board seat (as this seat may have to be relinquished the larger Series A investors or there is only one board seat available to all bridge investors); and thus in order to ensure rights and interests are protected may insist upon the inclusion of clauses granting super majority rights in the Series A shareholder’s agreement.

What a headache this becomes for the company when faced with business critical decisions (requiring preferred shareholder approval) because now, not only will you need to chase down with your 20 plus odd lots, bridge institutional investor, and Series A investors but also you’ve got to build consensus across an investor base that is as diversified as New York City in the summertime. (Job Posting: ISO cat herder or rodeo clown with excellent communication and taser skills).

Alternatively, you could face an issue where the lead investor in Series A, as part of closing conditions, insists that super majority rights get revoked. So, do you go with the big money and dook it out with those investors who’ve supported you when no one else would or do you walk away from the money (knowing full well you might encounter the same push back from other investors)?! Hopefully, you won’t be under the gun to make such a decision as the sound of the last dollar from your bridge round is hovered from your corporate account.

So, do yourself a favour – when structuring bridge financing: (1) avoid irrevocable super majority clauses; and (2) if you’re not in the position to turn away odd lots from your bridge round, either give them common shares (preferred path) or get them to sign a side letter transferring control of their preferred rights to management (messy, but effective).

In late 2005, I happily connected with Hank and Steve, two of the three co-founders behind Shanghai based education service Chinesepod. I’ll be honest, Chinesepod was such a fresh service there weren’t many comps to look at, thus it was truly difficult to determine whether or not user acceptance and demand would hold-up long enough for the company to reach critical mass and turn a profit. Basically, we had to wait and see what happened as the business matured a bit more.

In the meantime, I tucked in, did some crawling around the Web, held a dozen or so focus groups (online and offline), and became a user of the service.

As part of my research I placed adverts on Craigslist (and a couple local Chinese bulletin boards) looking for Chinese Mandarin tutors – I wanted to see if there were alternatives to the traditional offline courses or CD/web enhanced lessons. What I started noticing was a significant number of duck taped Web2.0 Chinese and English tutoring services – these tutors had cobbled together real-time virtual classroom on the back of Skype. The only problem was I had no way of determining if any of these tutors were good value or a waste of space.

This got me thinking – why not create a web based on-demand professional tutoring service for Chinese mainland students of all ages, across all subject – some possible service features could have been: (1) no required minimum session time; (2) tutors selected based on student/parent ranking, relevance, or dialect; (3) sessions held in a browser based 3D virtual meeting room; and (4) various social networking tools.

Sure, there were some challenges in hiring and qualifying tutors, monitoring the quality of sessions, and 3D environments were bulky but the platform was scalable and required few full time employees – definitely an execution play rather than a capital intensive venture. However, I got busy and this concept melted like the polar caps.

Fast forward to February 2008 – so, I’m surfing around New York Times’ website and I came across an article by journalist Michelle Slatalla titled “On Demand, on Time and for a Fee, an Army of Tutors Appears”. The article is a narrative of what happened after Slatalla unleashed her kids on a couple US online tutoring services – indeed, it is worth a read – more importantly, it jarred my memory…

Granted, it has been a couple years since (and, sure there are some people playing around in this space in China) but I still think this is a very interesting business – especially, given recent advancements in 3D environments, increased popularity of computers in the home, and the fact that Chinese students (and uniquely so) have completely blurred the line separating the real world (offline) and the virtual (online) space.

To wit, American students are drawn to a service, such as Tutor.com it’s heard to imagine a similar service not succeeding in China.

UPDATE (13/2/08): This morning, we got an email from Steve Williams (Chinesepod) that provides some additional insight into China’s tutoring industry – we don’t normally post comments/emails on our site but this one is particularly interesting. Many thanks.

I’ve seen a fair bit of interest in the space from Indian call center firms, looking to extend into English tutoring in the China market. I think they’ll have a hard time building brand awareness, given the spend of big chains like English First and Wall Street, but if they partnered with off-line schools they could have a good opportunity.

Scale is another problem, as is stopping freelance tutors poaching customers and servicing them off-platform. Another huge gap is the lack of online support materials. A key piece of offline school ‘technology’ is the textbook, but what do online tutors use? A lot of them send the student a link to an Amazon page, where the student buys a book and waits a week for delivery. Insane! I think there is an opportunity for Praxis here, with on demand syllabi.