by Duncan Clark
Becoming increasingly desperate for a fix for its China business, in November 2003, Yahoo announced a deal it hoped would transform its fortunes, buying a company called 3721 Network Software.
Founded five years earlier by a feisty entrepreneur called Zhou Hongyi, 3721 had spotted a niche in the market. Domain names in the Internet were available only in alphanumeric characters (one reason it had chosen numbers rather than a name in the Roman alphabet, for its own website, since “3721” was a saying for something easy, as “easy as 3 times 7 equals 21”).
The company 3721 allowed the millions of new users coming online in China to search using Chinese characters thanks to a special toolbar that would then link the Chinese characters input to the corresponding website. The software was downloaded, although not always with the user’s knowledge, and was hard to remove. Competitors criticized 3721’s technology, arguing it supplanted existing browsers. In 2002, Baidu took 3721 to court, one of many Internet companies to tussle with Zhou Hongyi; 3721 raised several rounds of venture capital and by 2001 had broken even. By assembling a large sales force to market the most valuable Chinese names in the tool bar, 3721 started to make a lot of money, generating $17 million in revenues in 2002.
Born in 1970 in southern China’s Hubei Province, Zhou Hongyi grew up in the agricultural province of Henan before attending Xi’an Jiaotong University. He tried his hand as an entrepreneur twice, but both ventures failed before Zhou signed on as an employee of Founder, China’s largest university-run enterprise. Three years later, he launched 3721 in partnership with his wife, Helen Hu (Hu Huan), and four others.
Zhou felt his earlier failures cost him his rightful place as a true pioneer of the Internet industry, and he was constantly spoiling for a fight with his rivals. He relished the publicity of the lawsuits or public spats he engaged in with Jack, Robin Li, Pony Ma, William Ding, and Lei Jun (Kingsoft and Xiaomi), among others.
Jerry Yang was known for his affable and approachable manner, but Zhou was the polar opposite: a self-styled bad boy of the Internet in China. He had a passion for guns. After 3721 was acquired by Yahoo, Zhou’s new colleagues in Sunnyvale, California, were aghast when they saw his photo in the Yahoo internal directory, in which he toted an AK-47. The team immediately adopted it as his nickname. Zhou even liked to adorn the walls of his office with bullet-hole ridden sheets from target practice. His main investor, Wang Gongquan from IDG, described Zhou as a “frenzied idealist,” an “aggressive and wild child.”
Whatever their differences in personality, Jerry Yang saw in Zhou Hongyi’s firm the opportunity to boost Yahoo China’s revenues. In 2003, Yahoo China made only a few million dollars in revenue, but 3721 raked in an estimated $25 million from its clients. It was the fourth-most-visited Chinese website after Sina, Sohu, and NetEase.
In November 2003, Yahoo acquired 3721 for $120 million (with $50 million paid up front, and $70 million to follow based on performance in the following two years). The deal boosted Yahoo’s China team, from 100 to nearly 300. But just as eBay botched its acquisition of local partner EachNet, Yahoo’s efforts to integrate 3721 rapidly fell apart.
The culture clash was immediate. Former Yahoo CFO Sue Decker recalls, “Zhou reportedly felt that the original Yahoos were overpaid and lazy, whereas the Yahoo team felt bullied and believed Zhou wasn’t focused on the Yahoo operations.” Yahoo had carefully courted relations with the Chinese government. But just a couple of months after Yahoo acquired his company 3721, Zhou Hongyi was sued by none other than the Chinese government, whose Internet domain name agency, the China Internet Network Information Center (CNNIC) accused 3721 of damaging its reputation.12
Next, Zhou dumped Baidu, which he was in the process of suing, as Yahoo’s search partner in China, and launched a new search offering instead.13 But Zhou hadn’t consulted first with Yahoo executives in Sunnyvale. Zhou recalled, “I believed that with an annual investment of only several millions of dollars, it would be entirely possible for us to overtake Baidu.” Zhou became frustrated by the managers at Yahoo headquarters: “They were unwilling to invest in the company’s future. It is like farming. If you only care about harvesting, but not fertilizing or cultivating, eventually the land will lose its vitality.”
China was the least of Yahoo’s worries. In the United States, the company was being eclipsed by Google, whose algorithmic search engine was outgunning Yahoo’s directory-based design. Yahoo was slow to recognize the threat posed by Google, a company like Yahoo founded by two Stanford Ph.D. candidates. Yahoo had missed an opportunity in 1997 to buy Google from Larry Page and Sergey Brin, but its biggest mistake of all was the June 2000 decision to make Google its search partner. With Google’s logo featured on its home page, millions of customers discovered a superior search product and gateway to the broader Internet that made Yahoo increasingly irrelevant.14
In July 2005, six months before the end of his two-year earn-out, Zhou announced he was quitting Yahoo China. Within two months he had set up his own company, Qihoo 360 Technology. Here he would adopt the same aggressive tactics15 that he’d used at 3721.
It wasn’t long before Zhou took to the media to criticize Yahoo, telling journalists that selling 3721 to Yahoo was his biggest regret, that Yahoo’s corporate culture stifled innovation, and that the firm was poorly managed: “Yahoo’s leaders have unshakable responsibility for its decline. Whether it is spiritual leader Jerry Yang or former CEO [Terry] Semel, they are good people, but [they] are not geniuses. They lack true leadership qualities. When facing competition from Google and Microsoft, they didn’t know what to do, and had no sense of direction.”
Yahoo had struck out twice in China: first Founder, then 3721. After years of frustration, Jerry Yang made a bold decision. He handed Jack $1 billion, and the keys to Yahoo China’s business, in exchange for a 40 percent stake in Alibaba.
Project Pebble
Although it took some time for them to realize it, the deal was transformative for Alibaba and Yahoo. Alibaba gained the ammunition to finish off eBay in China, and to build Taobao and Alipay into the behemoths that they are today. The rising value of its stake16 gave Yahoo leverage in dealing with its increasingly frustrated investors, concerned about its deteriorating market position versus Google and its subsequent controversial decision to rebuff Microsoft’s offer to buy the company.
The deal originated in a May 2005 meeting17 between Jack and Jerry at the Pebble Beach golf course in California. Before a steak-and-seafood dinner with other tech luminaries from the United States and China, the two founders, who had a common shareholder in Masayoshi Son, took a stroll18 outside. Jack recalled, “It was extremely cold that day, and after ten minutes I couldn’t bear it anymore. I ran back indoors. [But] in those ten minutes we exchanged some ideas. I told him clearly that I wanted to enter the search business, and my opinion was that search engines would play a very important role in e-commerce in the future.”
From this initial discussion, the outlines of a deal—which Yahoo called Project Pebble—started to take shape two weeks later when Jerry19 held further meetings with Jack and Joe on the sidelines of the Fortune Global Forum, hosted that year in Beijing.
Yahoo had known for some time that 3721 was not going to be the silver bullet to solve its China woes. But after a thorough screening of which company might be the answer, Alibaba had not been Yahoo’s first choice.
Sina was the most logical target. The company had started as an Internet portal and was positioning itself as the “undisputed online media leader in China.” Guided by CEO Terry Semel,20 Yahoo was increasingly trying to become a media and entertainment company. Yahoo and Sina had already signed a memorandum of understanding for Yahoo to invest in Sina, subject to Chinese government approval. Sina’s executives and investors were ready to pop the champagne corks when Sina CEO Wang Yan went to meet China’s propaganda chief, Li Changchun.21 Li rejected the deal. Sina would not be allowed to align itself with a foreign strategic investor.
Davi
d Chao, a partner at the investment firm DCM, related a conversation in 2004 with Hurst Lin, then COO of Sina: “When their stock was about three dollars Hurst called me up and said, ‘I just met Jerry and I think I can finally get rid of my stock. We have a deal.’ He was really happy. But, of course, as you know ‘the forces above’ were uncomfortable.”
Yahoo’s second choice of partner was Shanda, the Shanghai-based online games specialist.22 But Shanda’s founder and CEO, the Zhejiang-born Timothy Chen (Chen Tianqiao), wasn’t interested.23 Baidu wasn’t an option for Yahoo, either; it was already on its way to an IPO.
A deal with Alibaba was attractive on a number of levels. It was a private company, and this meant a deal could be struck quickly. Yahoo and Alibaba had a common shareholder. SoftBank owned 42 percent of Yahoo and 27 percent of Alibaba.24
Another positive was good chemistry. Jerry and Jack had known each other for seven years, since their first meeting in Beijing, when Jack played tour guide. The two men hadn’t stayed in regular contact, but they had established a rapport.
For Jerry, dealing with Jack was a breath of fresh air after the cantankerous Zhou Hongyi. Jerry also got on well with Joe Tsai. Both were born in Taiwan and educated in the United States. Yahoo CFO Sue Decker recalled that the two companies “immediately felt a strong cultural alignment.”
Yet the logic of the combination was not immediately obvious. Yahoo, a consumer content company, was to hand over its China assets to a company that was essentially a B2B business information company with two newer businesses, Taobao and Alipay, tacked on. Taobao was gaining traction in consumer e-commerce, but Alibaba had recently committed not to charge fees for the next three years. How do you value free? Sue Decker recalled Yahoo’s concerns: “At the time this seemed like a big leap of faith: More than half the value of the venture—more than two billion dollars—was attributed to Taobao and Alipay, both of which were losing money.” The decision to hand over Yahoo’s China business was a gutsy move, as Decker recalled, “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 fifty percent of the local operations. It also meant we would leave all employee issues to our partner and allow our code to be used by people with no previous connection to the company. Scary.”
A decade later, Jerry Yang reflected25 on the deal, pointing out that in 2005, when Yahoo made the investment: “The balance sheet at Yahoo was around $3 billion, so it wasn’t as though there were huge amounts of cash at Yahoo.” Putting a billion dollars into Alibaba, he added “probably raised a lot of eyebrows.” Although Yahoo conducted extensive analysis on the underlying business, Jack’s charisma and vision for Alibaba also played an important role, as Jerry recalled, “It was probably in retrospect a big bet, but if you met Jack, and having got to know him and seeing what his vision was, you certainly thought it was worth it. And he really had an inside track on being a very dominant commerce platform in China, so that really gave us a lot of comfort.” Asked about which company got the better side of the deal, he answered, “If you look at that partnership over ten years, clearly Alibaba was a beneficiary of a very strong vote of confidence back in 2005, and now Yahoo as a company is a beneficiary of that investment.”
For Alibaba, the deal immediately delivered the cash it needed to support Taobao, still unprofitable, in its fights with eBay. Yahoo and SoftBank already had a profitable relationship stretching back almost a decade. The Yahoo investment in Alibaba added a new dimension, creating a “Golden Triangle” that has linked Jack, Jerry, and Masayoshi Son for a decade more. With the deal, the New York Times crowned Jack as “China’s New Internet King.” Jack couldn’t resist taking yet another shot at eBay: “Thank you, eBay. . . . You made all of this possible.”
With the sale, Alibaba was also able to reward its employees, by allowing them to cash out a quarter of their shares, and its early investors, who sold about 40 percent of their stakes in the company to Yahoo at a valuation of about $4 billion. Although they had made an impressive return, the investors then saw Alibaba sell a stake in itself to Yahoo at a valuation some four times higher.26
Jack later emphasized that the impact of the transaction went beyond the funding and market recognition provided by Yahoo. Although Alibaba had demonstrated its ability to build start-ups—Alibaba.com, Taobao, and Alipay—the deal brought much-needed experience in mergers and acquisitions, something that would become increasingly important in the future.
The final ownership of Alibaba would be Yahoo, 40 percent; SoftBank, 30 percent; and existing management, 30 percent. In 1999, Jack had sold a 50 percent stake in Alibaba to Goldman Sachs and other investors—something he had joked was the worst deal he ever made. Did he feel any seller’s remorse about parting with this 40 percent stake? A decade later he again looked back on the deal: “I asked for one billion dollars, and they gave us one billion dollars. I thought the war between Taobao and eBay would last for a long time, so we needed enough cash to fight.” In the end, $1 billion was enough to scare off eBay.27 “We asked a lot. But we did not know when we got the money eBay would run away. So the money [wasn’t used].” Jack said he would do the Yahoo deal again but “in a better, smarter way,” adding, “Nobody knows the future. You can only create the future.”
The deal left Jack and Joe in charge of Alibaba, although the agreement also included a little-noticed clause that gave Yahoo the right, in October 2010, to appoint an additional board member. If that board member aligned with SoftBank, then Yahoo could then enjoy a majority and the ability, in theory, to take control of Alibaba.
The key terms decided, Alibaba and Yahoo prepared to position the deal to the public. Jerry Yang told BusinessWeek that Alibaba was now “the only company in China that has commerce, search, communications, and a very, very strong local management team. This is going to be a very valuable franchise going forward.” The media reaction was mixed. Andreas Kluth at The Economist was unconvinced: “Yahoo can’t keep on being all things to all people. It seems to me that Yahoo has to decide what it is, which means deciding what it’s not. Does Yahoo think that it’s a search and a media and an e-commerce company now? So why not manufacturing, retailing, banking, health care? So I’m confused.”
Yahoo was keen to reassure the market, and its employees, that Alibaba was a safe pair of hands to manage its China business. Yahoo China staffers in particular were unhappy about the change in ownership. Former Yahoo China employee Liu Jie, who quit the company for Qihoo soon after, remembered the jarring change in management style under Alibaba: “At noon the sales-oriented departments at Alibaba would jog and sing. I felt a bit low at that time.”
The reception in Yahoo’s headquarters was more positive. Former executive vice president Rich Riley28 recalled, “Markets like China had proven challenging for Western companies,” adding that, “this seemed like a smart way to go.”
But other than the financial return, did Yahoo achieve its other objectives?
When the deal was announced, Jerry Yang told the media that although Alibaba was taking over Yahoo in China, this didn’t mean the end of the Yahoo brand in the country: “All of the consumer Internet products will be branded Yahoo—search, mail, and anything new they decide to come up with. They definitely feel that the Yahoo brand in China has not only global implications but a lot of resonance.”
Yet under Alibaba’s management the Yahoo brand would rapidly fade and indeed eventually disappear entirely from China. Within a year of the deal, local media started to refer to Yahoo China as the unwanted “orphaned child,” with Alibaba more focused on nurturing its own baby, Taobao. In May 2007, Alibaba changed the name of the business from Yahoo China to China Yahoo, an apt reflection of who was in charge.
Alibaba did invest heavily in the Yahoo China brand at first, pouring in 30 million yuan (over $4 million) to make TV ads to promote Yahoo Search. Jack spared no expense for the ads, partnering with the Huayi Brothers film studios, in which
he would later invest, and hiring three of China’s most famous directors, Chen Kaige, Feng Xiaogang (who directed Alibaba’s Singles’ Day TV special in 2015), and Zhang Jizhong. Zhang was known for his flamboyant, big-budget TV adaptations of Jack’s favorite author Jin Yong.
But in the core area of search, the superior algorithmic search of Google and Baidu was winning out. China Yahoo was in trouble. After the deal, Jack became exasperated at how slow Yahoo was in delivering on the search and other technology it had committed to provide. The pressure was so great that in 2006 Jack made the decision to remodel Yahoo’s home page in the uncluttered, clean style popularized by Google, which Baidu had already mimicked. But Jerry Yang was very unhappy with the move and asked Jack to change the China Yahoo site back to its original portal look and feel, which he did. Not surprisingly, Yahoo’s users were confused by the changes, and the company’s market share slid further. From a 21 percent share of search revenue in 2005, driven largely by the 3721 tool bar, Yahoo’s share fell to only 6 percent in 2009 as Baidu’s soared to take almost two-thirds of the market, leaving Google with just 29 percent.
Messy Exit
But had Yahoo soldiered on without selling its China business to Alibaba, the company would still have had to contend with two major challenges: 3721 founder Zhou Hongyi, and an ethical and public relations catastrophe involving Chinese journalist Shi Tao.
Zhou Hongyi, on learning of the Yahoo-Alibaba deal, immediately announced his resignation and became a disgruntled former employee. He began to brief journalists that he would be starting his own venture and started to hire people away from Yahoo. In the coming years Zhou and his new firm, Qihoo 360, caused a lot of headaches29 for Alibaba, China Yahoo’s new owner.