Secretive Guelph firm raised $160 million thanks to arbitrage expertise. Apparently, investors believed that Geosign had discovered the magic formula eluding so many traditional publishers – how to make pots of money while giving away free content online
Last winter, just after the unknown Guelph company Geosign caused a stir by announcing it had received $160 million in investment from an American private equity firm, its chairman and founder Tim Nye and his wife went out for a celebratory birthday dinner at Toronto’s pricey Harbour Sixty Steak House. Later, Nye reviewed the meal on the website Restaurantica.com, one of several internet businesses Geosign owns. Although he didn’t much like his Greek salad and found his Kobe beef porterhouse fatty and salty, he gave the restaurant a 10 out of 10 for service. Nye was clearly impressed by the sommelier who “was great and recommended a bottle that was $600 less expensive” than the French Bordeaux he had been about to order.
Scanning other Restaurantica.com reviews written by Nye — under both his own name and TGN, his initials — reveals that, though in appearance he resembles an aging hippie, when it comes to food, he likes to spend his new found millions on establishment fare such as Kobe beef, oysters, Chateau Margaux, Stoli martinis, Norwegian Voss water and the occasional Chilean sea bass. While writing all this up on the net might seem like a strange habit for a guy who describes himself on another of his web sites as a “reclusive inventor,” the past few months have shown both Nye and his mysterious company, Geosign to be nothing if not contradictory.
Geosign first caught the public’s eye in March when American Capital Strategies of Bethesda, Md. announced it was paying $160 million to acquire a minority stake in the Guelph-based internet publishing company. Although it was one of the largest private equity financings for an internet company since the crazy dot-com days and almost certainly will be the biggest VC investment in Canada this year, the story faded quickly from the news. It wasn’t until late May that Geosign made it back into the headlines as it laid off almost 100 of the 200-odd employees at its Guelph operations and proved less than forthcoming with the local media about the extent of the layoffs.
This strange chain of events at a company that had promised plenty of new hiring only a few months earlier prompted Mark McQueen, president of Wellington Financial, a Toronto financing and venture debt fund, to suggest on his popular Bay Street blog that American Capital might not have known exactly it was getting into with Geosign: “Has the deal of the year had become a nightmare?” he asked
Certainly, in some quarters there had been puzzlement over the Geosign deal from the moment it was first announced. While both Geosign and American Capital emphasized that Geosign’s portfolio of some 200 specialized consumer websites attracted 35 million visits a month and that the company was a leader in targeted search, many observers, who checked out Geosign sites like www.wealthygeek.com, www.dietnation.com and www.nomadik.com upon hearing the news of the private equity placement, were stunned to find that the content being touted as the future of media was downright terrible.
On the popular web site TechCrunch one commenter asked, “Geez, who would fund this?????” Another wrote: “I just can’t believe how someone gave them $160 million.” And yet another mused: “Maybe they need one more 101 site: FoolingVCs101.com.”
Although some posters alluded to the secret of Geosign’s success, their comments were nothing that would make sense to someone who wasn’t intimately acquainted with the details of the internet advertising business. In fact, it was only when Geosign turned around and laid off almost half its staff, and former employees began posting information about the private company’s operations on online chat boards and Facebook, that the story started to become clear. The bottom line, so to speak, was that while Geosign preferred to describe itself as an “internet media company shaping the online landscape (and) leading the publishing revolution,” it made its real money — and there was indeed a lot of money – mostly, and possibly entirely, from a speculation scheme involving spam websites and internet advertising.
Along with its portfolio of marquee websites that it publicized, Geosign had tens of thousands of other websites (and possibly far more) that it kept quiet – sites like thefart.com and canadianrockiestour.info – which are variously described as spam, splogs, made for advertising and scraper sites. Almost the only way these spam sites and even the marquee Geosign properties generated significant traffic was through buying Google AdWords ads to attract visitors. Once visitors lured by ads arrived, be it at a marquee site like thewealthygeek.com or an embarrassing site like thefart.com, they were confronted with a web page designed specially to be user unfriendly. The theory, explained former insiders, was that the more confusing it was for a readers to figure out the site, the more likely they were to click on one of the many pay per click ads displayed on all Geosign websites.
While Geosign bought ads from Google to display on search pages and to deliver traffic to its own sites, the ads displayed on Geosign websites were from Google’s competitor, Yahoo. Every time a user clicked on one of them, the advertiser was charged and the profits were split between Geosign and Yahoo.
The profits from this arbitrage operation — buying cheaper Google ads and displaying more expensive Yahoo ads — were by all accounts enormous given the sheer volume of sites Geosign owned. “It was a mathematical formula,” said one former employee who marveled at the fact that Google and Yahoo didn’t close the arbitrage loophole given the number of individuals and companies openly exploiting it and the hundreds of millions pouring into online advertising.
Geosign’s president Ted Hastings, who took over that part of the job from Tim Nye in January, has said in interviews that the company had some $100 million in annual revenues. Although no one but Geosign executives and potential investors who had access to the company’s books know for sure, former employees estimate the annual profits, which they believe all went to Nye, to have been in the tens of millions.
Nye, who is in early 40s, had earlier founded the apparently successful home design software firm CADSOFT and then sold it in 1998. Ex- CADSOFT employees don’t recall whether his training and background was in business or technology or why he sold the company. Whatever the reason, Nye started Geosign, which was originally a company dedicated to local or geographic search, not long after. He had a few early investors including Jim Estill, the president of SYNNEX Canada, a billion dollar wholesaler of computer equipment, and currently a member of RIM’s board of directors, but Geosign didn’t get very far until about three years ago when it turned to arbitrage on a large scale and started to generate spectacular profits from a business that only needed a very minimal infrastructure. Although Nye continued to drive a Prius, he started flying in private jets and hosting lavish hospitality suites at industry events in Vegas. Prospective investors began taking note.
According to employees, who wished to remain anonymous due to their confidentiality agreements and severance packages, potential investors visited the downtown Guelph offices regularly from the fall of 2006. What they saw was a company that had expanded so fast – from some 30 employees in early 2005 to 200 in fall 2006 – that, along with the headquarters in downtown Guelph, Geosign had to rent more office space in an industrial park outside of town.
Apparently, investors believed that here, just one hour west of Toronto, Geosign had discovered the secret eluding so many traditional publishers – how to make pots of money while giving away free content online. There was, however, a hitch. Even if Geosign, Yahoo and Google were all benefiting from the situation there was one key group who was becoming more and more unhappy with it.
Fed-up advertisers, whose products were being pitched on Geosign spam sites, found that potential customers arriving from these and similar operations had lower “conversion rates” than customers coming from content-rich sites. In other words, someone reading about the Rockies on a site about Canadian bears and moose would be more likely to book a flight than someone who just clicked on the ad to get out of a carefully constructed internet maze. While advertisers, were ready and willing to increase their online budgets to buy pay per click ads, they were not keen to pay a premium for the privilege of enriching Geosign, Google and Yahoo. Not to mention the millions of information seekers who were coming to ignore Google and Yahoo ads completely thanks to operations like Geosign’s.
The pressure, which has been building for at least two years was finally enough to convince Google, which makes 99% of its revenues from advertising, to cut off a number of advertisers who had been using Google ads to promote spam sites as well as publishers using their websites purely to display and profit from ads. Although neither Geosign nor Google has ever confirmed that large number of Geosign sites are no longer allowed to buy Google ads and neither would agree to talk about this story, statistics from the web information company Alexa show that traffic at Geosign sites dropped sharply on June 1 when Google clamped down on arbitrage.
Google’s announcement also directly preceded Geosign’s layoffs of most of its editors, writers and web designers. CEO Ted Hastings explained that the company was streamlining operations by using advanced software and allowing website users to generate their own content, thus requiring fewer staff. “We are no longer aiming to build a costly content and publishing empire,” he told the Guelph Mercury.
Among the estimated 50% of employees who were informed enough to realize most of their employer’s cash came from arbitrage and that either Google or Yahoo could turn off the tap at any moment, there had been concern for quite a while about having a back-up plan. While some employees truly believed in the quality of their websites and that the company was just using arbitrage to gain the money it needed to become a “real publisher”, others doubted that there was any goal other than making money and saw the 200 legit websites as “a front” to bring in investors that had served its purpose.
There is also much ongoing speculation among former employees and observers as to whether American Capital Strategies (which, according to the 10Q filing it made with the SEC in May, American Capital invested $US48.3 million in subordinated convertible debt and $US78.4 in convertible preferred stock) really understood what it was buying into. According to the version of the story told on Mark McQueen’s Wellington Financial blog, a few days after the $160 million financing closed — with a rumoured $50 million of it going directly to Tim Nye as a so-called secondary sale — Google got wind of things and decided that it had to deal once and for all with the growing arbitrage problem. “American Capital’s lawyers pour over the reps,” wrotes McQueen, “but can find no way out and no misrepresentations by Geosign’s owners. Just a case of bad timing. Or good, depending on which chair you occupy.”
But Randall Howard, a general partner at the Toronto and Waterloo venture capital firm Verdexus, doubts that American Capital would make such a mistake, “They did a tremendous amount of due diligence. I’d be totally shocked if they didn’t know not only where the revenues came from but where they were going to be coming from,” he said.
Certainly, Geosign had been making investments in other companies even before the American Capital deal. In January it announced a strategic investment in Ontogenix, an Ontario search technology company and, more recently, it has taken over SWI Digital of Fort Lauderdale, Fla., which specializes in advertising, multimedia and search engine optimization. This fits with Geosign president Ted Hastings’ statement at the time of the layoffs, when he told the Guelph Mercury, Geosign would be “growing (its) lucrative search marketing business, which requires fewer employees.”
The problem remains however that Geosign’s local search arm, True Local, was also heavily propped up by advertising on Google and its traffic has plummeted since December 2006 when its former president boasted at an industry conference about the money it was making from arbitrage. Jim Estill, the early investor who sold out, says that the spam/arbitrage business was “not good PR and probably a mistake,” but he still has faith. “Nye is a technological visionary, “ he says. “I think Geosign will have technology that becomes an integral part of the future internet and Web. 2.0. They have the intelligence, cash and resources to implement.”
Does he regret selling his stake then? “Every good investment, I always wish I’d invested more.” And as for the negative user-generated content out in Web 2.0 land about Geosign, Estill attributes it to what he believes is a basic human need to knock down a winner.
That’s one way of looking at it. Another is that some people just call it like they see it, be it an overpriced restaurant serving up bad steak or an overvalued company dishing out dicey web content.
Note: I wrote this article for publication in a Canadian newspaper that turned out to be reluctant to publish it and sat on it for two weeks. Because I felt it was timely and wanted to get it out before I left on vacation for several weeks, I decided to publish it here on my blog.
The story was a real challenge because not just Geosign but also Google and Yahoo declined to talk to me. And almost all of those who did talk to me either didn’t want to be quoted or give their names.
If you spot any inaccuracies please let me know via the comments and I will take steps to correct them as soon as possible.
I’m also interested in hearing about new developments although won’t be able to address them until I return.
Finally, I wrote the sidebar below for people who want more details on how Internet ad arbitrage works.
Update: Why I think American Capital got suckered.
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