D



D. E. Shaw & Co.

The Manhattan skyline was hazier than normal on this late June 1994 day as David Shaw looked from his 39th floor office, with its book-lined wall and buffed aluminum table shaped on an ancient mathematical ratio, towards the Hudson River. Today, he was trying to predict what his very popular and accomplished senior vice president would tell him. Two days earlier, Jeff Bezos had announced his interest in leaving D. E. Shaw & Co. to launch an online bookstore. At that time, the two talked for several hours and David told Jeff that he could have a bright future at the firm, and reminded him that he would be giving up a seven-figure income and deferred compensation for uncertainty. David convinced Jeff to reflect on his decision for 48 hours, during which time David did his own reflecting. The idea for launching an online bookstore was developed under David’s initiative, with David’s direct assistance, and with D. E. Shaw & Co.’s money. Should he lay claim to the idea? Should he give Jeff additional incentive to stay with the firm? Basically, he questioned whether D. E. Shaw & Co. should be in the online retail bookselling business.

David E. Shaw

David E. Shaw was born in 1951, and spent most of his early adult life in Los Angeles. After graduating from the University of California at San Diego, he earned a Ph.D. in computer science at Stanford University. While at Stanford, David distinguished himself both academically and by his extra-curricular activities. While still a student, he founded a successful computer software company called Stanford Systems Corporation. (See Exhibit 1 for a photograph of David Shaw.)

In the early 1980s David accepted a teaching position with the faculty of computer science at Columbia University, and eventually took over as head of Columbia University’s project on Non-Von computers used in artificial intelligence. Growing tired with academia, he left Columbia University in 1986 for Morgan Stanley’s proprietary trading unit. The unit invested some of Morgan Stanley’s money using trading models based on algorithms. David was hired on to develop the unit’s technology and introduced distributed-network computing, but his curiosity refused to limit him. Here he learned about finance, became interested in computational trading and developed a few ideas himself. In 1988, two years after he joined Morgan Stanley, he left to start the firm that bears his name: D. E. Shaw & Co.

The Company

David founded D. E. Shaw & Co. in 1988 with roughly $28 million in capital. The initial investment capital came from less than ten investors and was arranged by Donald Sussman, of Paloma Partners, a successful trader himself. By mid 1995, the firm’s capital had grown to over $350 million, and average annual returns were slightly better than 25 percent, with no losing years.

The firm’s success was attributable to several factors. David was extraordinarily selective in his hiring practices. Only one percent of applicants were hired. David believed in hiring raw intelligence. Employees, including secretaries, were vetted based on SAT scores, academic transcripts, and personal recommendations. The firm did not hire for a specific position or people, for that matter, with any knowledge of finance. Rather, D. E. Shaw & Co. hired people with degrees primarily in computer science, mathematics, statistics, and physics from the very best schools and taught them finance. The assumption was that the person would someday make money for the firm.

The culture of the firm was decidedly academic and quantitative. Employees dressed in blue jeans – David was an exception, preferring to wear a suit and tie -- and worked flexible hours. There was no formal vacation policy. Employees took vacations when they needed them. The firm’s quantitative culture was physically represented by its company logo, a microprocessor switch (see Exhibit 2), and by the rectangles cut into the walls that one architectural magazine said evoked images of computer chips (see Exhibit 3). And there were a large number of computers, including over 50 Sun Microsystem workstations.

The collegiality of the firm did not extend, however, to one area. The firm was exceptionally secretive, and in this way it more resembled the National Security Agency, than an academic department or Wall Street firm. Employees were required to sign a rigid non-disclosure agreement.

The firm’s management style also reflected some ambiguity. On the one hand, employees were encouraged to do things differently, if they thought it was better. On the other hand, most important decisions emanated from the center and were made by David himself. In fact, David closely scrutinized many minor details. This ambiguity and general lack of organization led to a high turnover rate. In 1992, the firm hired Mark Lipton, a finance professor from the New School of Social Research, to address this problem. Lipton discovered communication problems and recommended that David write a mission statement, which David never did.

Proprietary Trading

The firm describes itself as “the intersection between technology and finance.” The firm makes trades based on algorithms that scour worldwide markets in stocks, bonds, currency futures and, particularly, options for tiny price anomalies. Most of the trading is done by computers, which execute millions of trades of one-eight to a quarter of a point that other investors never see. (See Exhibit 4 for a view of D. E. Shaw & Co.’s trading floor.) Trading volume can reach 10 million shares in a single day, an amount equivalent to ten percent of the entire daily volume on the New York Stock Exchange.

The firm’s algorithms identify undervalued securities and hedge all investments. Computers create a market neutral position by selling a long bond, for example, against a short position in hundreds of securities. This trading strategy helped disguise D. E. Shaw & Co.’s investments, and helped ensure the firm’s low risk strategy and abnormally high profits.

Explores New Business Opportunities

However, by late 1991 D. E. Shaw & Co. was beginning to see limits to its quantitative proprietary trading. Some of its trading strategies could not absorb more capital without a significant negative effect on returns. Inefficiencies in the market were being squeezed as more “smart money” entered the market. As a result, the firm found itself with excess capital. So, with the consent of his investors, David began brainstorming with staff to see if they could come up with promising new business ideas that respected the firm’s cautious investment philosophy. The result was that for every ten ideas generated, nine were dismissed almost immediately.

Beginning earnestly in 1992, the firm explored a number of business opportunities, including trade finance, investments in the former Soviet Union, and custom derivatives. In early 1992, David put Jeffrey Bezos in charge of developing off-board trading in listed securities, the “Third Market” project. By early 1993, the first off-board trade was completed. In 1994, David put Jeff in charge of exploring commercial opportunities on the Internet, a decision that eventually led to the current situation.

Online Commerce

The Internet – or ARPAnet as it was originally know -- was initially developed by the Defense Advanced Research Projects Agency (DARPA) for redundant computer-to-computer communication, designed to withstand disruption in the event of nuclear war. Its users were mostly academics. In the 1980s, the network was broken into two parts: Milnet for government and military traffic and the NSFnet (so named because it received funding from the U.S. National Science Foundation) for academic use. In 1991, the first commercial Internet connection, Commercial Internet Exchange, became available.

Prior to mid 1993, navigating around the Internet required the knowledge of basic UNIX computer commands. There were two main methods for distributing information. Telnet allows users to log into a remote computer via the Internet. FTP allows a remote computer to run the server, but requests are limited to uploading or downloading a file. (See Exhibit 5 for a brief description of several programs used for navigating the Internet.)

In 1993 an important change came when Tim Berners-Lee, a British computer specialist at the European Laboratory for Particle Physics (CERN) in Geneva, developed the World-Wide-Web. The networking protocols developed by Berners-Less enabled the user to navigate the Internet with point-and-click commands made possible by “hyperlinks.”

The second milestone came in October 1993 when a group of software developers working at the National Center for Supercomputer Application (NCSA) and students at the University of Illinois at Champaign created a program for browsing the World-Wide-Web. Before Mosaic, finding information on the World-Wide-Web required knowing commands like “Telnet 191.1000.82.900.” But the real breakthrough came, however, a few months later when this team of software developers created a version of Mosaic that ran on the Apple Macintosh as well as on Microsoft operating systems that they made available for free. Several hundred thousand users acquired Mosaic in less than a year.

The development of the World-Wide-Web, the accessibility of Mosaic, and commercial online services such as America Online and Compuserve helped grow the Internet in early 1994 by 2,300 percent per year, from roughly 2,000 users of the Internet in 1981 to about 20 million users.

NSFnet, the main U.S. high-speed backbone of the Internet, was opened to private commerce in fall 1992. Already, nearly 60 percent of all registered domain names were commercial organizations, or dot com’s. By June 1993, commercial use accounted for 29 percent of all Internet traffic. Still, several problems stood in the way of the commercial viability of the Internet.

• The Internet was so slow that people were calling it the “World Wide Wait.”

• For security reasons, buyers and sellers were reluctant to use credit cards.

• There were problems identifying customers.

• But most important, the technology that existed was not broadly enough adapted.

Jeffrey Bezos

Jeffrey Bezos was born on January 12, 1964 into a closely-knit upper middle class family. Jeff’s stepfather, a Cuban refugee, was an executive with Exxon. Jeff spent most of his childhood in Texas or Florida, and showed an early interest in science fiction and aptitude for technology. At the age of nine, Jeff was the subject of a 1977 book on the education of gifted children in the Houston area. Several years later, he graduated as Florida’s Palmetto High School class valedictorian.

Jeff headed to Princeton University in 1982 with the intent to major in physics, but he switched his major to electrical engineering and computer science when he discovered he was not going to be the next Albert Einstein. Graduated with a 4.2 grade-point average in his major (Princeton awards a 4.3 for an A+), Jeff had offers from Anderson Consulting and several other more established firms, but chose instead to join a start-up financial telecommunications company, Fitel. Fitel was building a global telecommunications network to settle cross-border equity sales.

Jeff joined Fitel in May 1986 as manager of administration and development. In February 1987, he was promoted associate director of technology and development and put in charge of developing and promoting Equinet, a network designed for cross-border trades.

In April 1989, he left Fitel for Bankers Trust. There he developed software to manage the firm’s pension fund clients, and after 10 months on the job, at age 26, he was named the youngest vice president in the history of the firm.

Feeling stifled at Bankers Trust, Jeff was ready to leave the financial industry altogether when a headhunter convinced him to interview with D. E. Shaw & Co. Jeff was so impressed with David Shaw, that he joined the firm in December 1990.

Jeff spent most of his time at D. E. Shaw & Co. leading a unit charged with exploring and developing new business for the firm. For example, Jeff was put in charge of the Third Market trading operations, and was rewarded for his efforts with the promotion to senior vice president, at age 28, and the youngest of four at D. E. Shaw & Co.

Explores Internet Opportunities

In early 1994, David Shaw asked Jeff to begin exploring commercial opportunities on the Internet. David was quick to realize the commercial potential of the Internet. Jeff met regularly with David for a few hours each week to brainstorm ideas, and then Jeff would go off and conduct exhaustive research.

Jeff drew up a list of 20 viable products to sell on the Internet, and based on several criteria narrowed that list to five (compact discs, videos, computer hardware, computer software, and books) before ultimately settling on books.

Jeff settled on books for a number of reasons:

• The bookselling industry was large and fragmented, with no single dominant publisher or retailer. This would make it difficult for competitors to lock out an outsider (see Exhibits 6 and 7).

• U.S. book sales had been growing at a steady rate for several years. Worldwide book sales were expected to reach $82 billion in 1996. (See Exhibit 8 for information on retail sales by U.S. bookstores.)

• He wanted a low-priced product that would be acceptable to first-time purchasers on the Internet concerned about security and reliability.

• There are over 3 million books in print worldwide across all languages (compared to roughly 300,000 CDs). That large number meant he could leverage the Internet’s search capabilities that made it easy to “browse” by title, author, publisher, and keyword.

• There was no way to have a 3 million-title bookstore in the physical world. The largest physical bookstores only have roughly 175,000 titles, while the number is considerably less for the typical mall bookstore (about 25,000 titles).

• It would not be possible to compete with an online bookstore by catalog sales, because if one were to print a catalog of all books in print, it would be larger than 50 New York City telephone books.

• A list of books in print was already available on CD-ROM.

• Books could be easily obtained directly from publishers or distributors.

• Books do not require explanation. Everyone knows what a book is.

• The people currently using the Internet were frequent buyers of books.

At the time Jeff was developing his idea, the Internet Shopping Network launched. Organized like a “virtual” shopping mall, it was a one-stop source for over 10,000 software and hardware items. Several retail booksellers had also already established themselves online. (See Exhibit 9 for a list of online bookstores.) Jeff expected that Barnes & Noble, the largest U.S. retail bookseller, would sell books online eventually, but he believed a first-mover advantage built on strong customer service would allow his online bookstore to compete.

Exhibit 1: David E. Shaw

[pic]

Source: D. E. Shaw & Co. web page

Exhibit 2: D. E. Shaw & Company Logo

[pic]

Source: D. E. Shaw & Co. web page

Exhibit 3: Lobby Interior at D. E. Shaw & Co.’s New York Office

[pic]

Source: D. E. Shaw & Co. web page

Exhibit 4: D. E. Shaw & Co.’s Highly Computerized Trading Room

[pic]

Source: D. E. Shaw & Co. web page

Exhibit 5: Internet Navigation Programs Existing Prior to the World-Wide-Web

Archie: Searches public archives, telling the user all the different places on the Internet where he can find the information he seeks.

Gopher: Uses menus to browse through available information and transfer it to one’s computer.

WAIS (Wide-Area Information Servers): Similar to Archie or Veronica but smarter. WAIS responds to questions with a list of possible choices.

Veronica: Collects all the words in the Gopher menu lists. Like WAIS, it builds a database that can be searched with simple questions.

Exhibit 6: Comparative Bookstore Market Share, FY1994

| |Sales | |

| |(US$, million) | |

| | |% |

|Total All Bookstores |10,570.0 |100 |

|Four Largest Chains |3,611.5 |34.2 |

| Barnes & Noble |1,622.7 |15.4 |

| Borders Group |1,511.0 |14.3 |

| Crown Books |305.4 |2.9 |

| Books-A-Million |172.4 |1.6 |

|All Other Bookstores |6,958.5 |65.8 |

Source: American Booksellers Association

Exhibit 7: Retail Bookselling Channels, 1994

Source: Consumer Research Study on Book Purchasing

Source: Consumer Research Study On Book Purchasing

Exhibit 8: 1991-1993 Retail Sales for Bookstores (Unadjusted)

| |1991 |1992 |1993 |% Increase |% Increase |

| |(US$, millions) |(US$, millions) |(US$, millions) |1992 over 1991 |1993 over 1992 |

|Period | | | | | |

|January |750 |813 |992 |8.4 |22.0 |

|February |499 |548 |569 |9.8 |3.8 |

|March |520 |541 |604 |4.0 |11.6 |

|April |497 |526 |586 |5.8 |11.4 |

|May |523 |553 |617 |5.7 |11.6 |

|June |529 |587 |624 |11.0 |6.3 |

|July |539 |589 |615 |9.3 |4.4 |

|August |807 |889 |996 |10.2 |12.0 |

|September |778 |854 |916 |9.8 |7.3 |

|October |597 |640 |704 |7.2 |61 |

|November |655 |636 |690 |-2.9 |10.7 |

|December |1,037 |1,153 |1,297 |11.2 |12.5 |

|Total Bookstore Sales |7,731 |8,329 |9,199 |7.7 |10.4 |

|Total Retail Sales |1,855,937 |1,951,589 |2,073,839 |5.2 |6.3 |

Source: American Booksellers Association

Exhibit 9: Selected Bookstores Available Electronically As of June 1994

• Computer Literacy, Sunnyvale, California

o Registered its domain name on August 25, 1991

o Accepted book orders via e-mail

o Catered to computer engineers and scientists

• BookStacks Unlimited, Cleveland, Ohio

o Registered on October 9, 1992

o In 1993, offered a connection to the Internet with Telnet

o In 1994, launched a website on the World Wide Web, offering about 400,000 titles

o Most of its titles sell at list price

o Books searchable by author, title, subject, keyword, or ISBN

o Purchases earn credits towards free books

o Publishes an electronic newsletter

o Invites users to share their reviews

o Ten percent of profits go to a non-for-profit that helps Americans to read

• Wordworth’s, Cambridge, Massachusetts

o Registered on December 23, 1992

• The Internet Book Shop, United Kingdom

o Founded in 1993

o First appeared online in June 1994

o Lists about 780,000 titles, and expects to have more than 2 million in the near future

o Expects to add German-language titles

o Does not stock books itself; rather, it relays orders to traditional retailers and earns five percent on each sale

• The Internet Bookstore, Arlington, Virginia

o Opened for business on May 31, 1994

o Requires that a user plug in an encryption device into the computer’s printer port

o Customers download electronic books that are formatted in plain ASCII text

o Information on available books includes: a one-line catalog entry, a one-paragraph “blurb,” and an extended write-up that can run to several pages

o Revenues are divided between the publisher (60%), The Internet Bookstore (30%), and the operator of the Internet node (10%)

o Does not allow returns

o Books are priced at about 30 percent of the hardcover price

o Once an order is placed, delivery is completed in 30 seconds

• Harper San Francisco

o Set up an ordering service on CompuServe in November 1993

o As of mid-December 1993, the company sold about 400 books through its electronic bookstore

• Future Fantasy Books, Palo Alto, California

o Sells science fiction books

• Quantum Books, Massachusetts

o Inventory of 20,000 titles that is constantly changing

Bibliography

David E. Shaw and D. E. Shaw & Co.

1. “Morgan Stanley to Use Sun Systems For Automated Trading; Purchase Includes Workstations, Network, Application Software,” Business Wire, March 17, 1987

2. “Computer Whiz Tops Trading Rivals By Using Math to Master Markets,” Craig Torres, The Wall Street Journal Europe, October 15, 1992

3. “D.E. Shaw Invades the Third Market With Risk Technology,” Ivy Schmerken, Wall Street & Technology, February 1, 1994

4. “’Computational Finance’ With David Shaw,” Michael Peltz, Institutional Investor, March 1, 1994

5. “Reprogramming D.E. Shaw; Why Does One of Wall Street’s Great Traders Want to Become A Banker?,” Hal Lux, Investment Dealers Digest, September 4, 1995

6. “Profiles; New Executive: David E. Shaw; Street Computer Whiz Takes A Mega-Bite Of Tech Start-Ups: Clinton Advisor Extends Reach Of Trading Shop Via Techno-Spending,” Alice Lipowicz, Crain’s New York Business, October 30, 1995

7. “Getting Real: For Years, D.E. Shaw Billed Itself As a Maverick Home to Financial Wizards, But When Trouble Came, It Looked A Whole Lot Like Any Other Street Firm,” Heike Wipperfurth, Investment Dealers Digest, April 12, 1999

8. “The Shaw Tank Redemption – Fund Manager Bounces Back With New Successes,” Robert Clow, New York Post, November 26, 2000

The Internet and Internet Commerce

1. “The Significance and Impact Of the Commercial Internet,” William Schrader and Mitchell Kapor, Telecommunications, February 1, 1992

2. “On-line Bookstores Carry Big Inventories,” Ash Nallawalla, The Age, March 9, 1993

3. “Growing Internet Connects Worldwide Web Of Users,” Frank Bajak, Austin-American Statesman, May 31, 1993

4. “Millions Of Users Plug In to Huge Computer Network,” John Eckhouse, The San Francisco Chronicle, June 1, 1993

5. “’Cyberbiz’” On the Internet: a WAIS to Go,” Larry Krumenaker, Searcher, July 1, 1993

6. “Book Stacks Unlimited Now On Internet,” Worldwide Videotex Update, Worldwide Videotex, November 1, 1993

7. “Mosaic Software Places A World of Information Just A Click Away,” John Markoff, New York Times News Service, Portland Oregonian, December 19, 1993

8. “Computer Services Seen As a Sales Tool for Books,” Sarah Lyall, The New York Times, December 20, 1993

9. “Publishing On the Internet For Fun and Profit,” Peter E. Dyson, The Seybold Report On Desktop Publishing, April 4, 1994

10. “Linking Up to A Global Network,” Wallys W. Conhaim, Link-Up, May 1, 1994

11. “Browse These Hangouts, Maybe Buy A Book or Two,” Miguel Llanos, The Seattle Times, May 22, 1994

12. “Techno-Babble Internet Changing the Face of Reading,” Yardena Arar, Los Angeles Daily News, June 27, 1994

13. “The Internet Bookstore Opens For Business,” Link-Up, July 1, 1994

14. “Business In Cyberspace: Commerce Ventures Into the Internet,” Nate Zelnick, PC Magazine, August 1, 1994

15. “Silicon Valley Big Guns Promote Business On the Internet With CommerceNet,” Jim O’Brien, Computer Shopper, August 1, 1994

16. “U.K. Internet Shops Show Slow, Steady Growth,” John Mutter, Publishers Weekly, October 9, 1995

Jeffrey Bezos

1. “ Founder Discusses How He Started the On-Line Book Store,” Catherine Crier, Fox News: The Crier Report, September 2, 1997

2. “Jeff Bezos: How He Built A Billion-Dollar Net Worth Before His Company Even Turned A Profit,” Lesley Hazelton, Success, July 1, 1998

3. “Five Questions With Jeffrey P. Bezos,” Saul Hansell, The New York Times, October 11, 1998

4. “7 Selling To Customers; ,” Eryn Brown, Fortune, May 24, 1999

5. “Playboy Interview: Jeff Bezos,” Playboy, February 1, 2000

6. “Taking On All ers,” Geoffrey Owen, Management Today, April 1, 2000

7. “Child Prodigy, Online Pioneer; Founder Bezos hires Great Minds. But Will It Matter?,” Mark Leibovich, The Washington Post, September 3, 2000

Books and Manuscripts

• 1999 Masters Thesis: Online Bookselling 1999, Anita E. Hennessey, New York University Center for Publishing, 1999

• , Get Big Fast, Robert Spector (HarperBusiness, New York: 2000)

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download