Every country has the “one” monetary system that constitutes explicit use of the Euro and implicit use of Germany and France as collateral. But each country also has about half of another monetary system: the implicit one they develop when investors analyze their debts with a Euro dissolution in mind. It doesn’t have to be this way, and it doesn’t have to end with a split: why not create a system where the Euro works by the Euro’s rules, and everyone brings back their home currencies to finance their financial misdeads?

Here’s how it would work: as long as a country is running deficits within EU deficit limits, it can issue debt denominated in Euros. That’s supposed to be the status quo now. The problem is not just that there isn’t an enforcement mechanism (nobody ever got kicked out of a monetary union for being over one limit by .1%). The real problem is that there’s no close alternative: you borrow, or you lose an election to someone who will.

So, instead of letting people borrow in Euros past the point where their borrowing destabilizes the Euro, reintroduce their home currency *mostly* as a vehicle for extra borrowing. France can borrow up to 3% of their GDP per year in Euros, but anything beyond that must be borrowed in Francs.

What does it mean to borrow something in Francs? Whatever France says it means (just like any other fiat currency). Just to keep things simple, and to provide a way to extinguish the currency in case they stop running such egregious deficits, each country could agree to let large taxpayers pay their taxes in either Euros or the native currency. This lets each country pick an exchange rate, and build their own monetary policy, without giving up on the Euro. If you’re confident that Italy will turn itself around, lend to them in Lira—you’ll get a healthy interest rate, and you can cash in some bonds each year to pay your taxes. Worried they’re printing too many Lira? Buy their Eurobonds instead; by turning EU dissolution into a stroll down a hillside rather than a jump off a cliff, this system reduces sovereign credit risk, too.

Would countries have an incentive to screw over their Euro-lenders to help native borrowers? Maybe, but it’ll take at least a generation to have as much non-Euro debt as Euro-debt outstanding. And since local buyers already buy plenty of Euro debt, that means it’ll be years before it’s possible to help out local bondholders without hurting them, too.

And this lays some very interesting infrastructure. Once these currencies start circulating among large, institutional investors, it’s only a matter of time before they start trickling down into traditional businesses. Lots of German companies will be relieved that they can pile up Deutchmarks instead of Euros again. And that will lead to a very interesting situation, indeed: a currency with a readily ascertainable value, a fairly liquid market—and no physical currency. One can imagine German banks offering customers the option to use their debit cards for Deutchmark-denominated savings accounts (instantly convert to Euros and spend! And, after a while, don’t bother converting to Euros, because merchants will be happy to take Deutschmarks, too).

Through steady adverse selection, you’d see the Euro turn into a specialized currency: something you use to pay your taxes, or to settle deals struck before the new currency became available.

At that point, Europe’s financial leaders will be at a cross roads: there will be a clearer path to dissolving the Euro, which also means it’s a more realistic threat; they won’t be able to assume that nobody would break the rules. At that point, you can imagine two selection effects: either the most responsible countries leave the Euro one by one, or the most tenuously Euro-y countries cut their deficits one by one. Either way, this will lead to the kind of fiscal harmonization the Euro relies on.

Or it won’t, and we’ll be back to the old monetary paradigm. Which, in retrospect, wasn’t as bad as we thought.

At Digital DD, we puzzled through the strategies behind some of the biggest SEO companies out there. But Yahoo is an order of magnitude bigger. They have over a hundred million monthly uniques; if I improve things by 1%, I’ve affected the lives of a million people. It’s hard to get that elsewhere.

And I’ve been impressed by the team Yahoo has (and keeps building!) in order to take on the news business.

So what happens to Digital DD? In the short term, not much:

• Doug will continue working on actual due diligence projects as they come in. We’ll both be wrapping up consulting projects.
• I will keep writing the newsletter, but I’ll switch back to a weekly format. (Plus maybe something extra if there’s a big story worth writing about.)
• I’ll add some disclosure, and there are some topics that will be off limits.
• I will take a one-week break from the newsletter during my first week at Yahoo. I’m starting today, the 6th, and will resume the newsletter on Monday the 12th.

In August, I wrote about 33,000 words for the newsletter. That’s not sustainable. But it’s also a good sign that I like writing about this stuff. (And our reader feedback indicates that you’re enjoying it too—send your feedback!)

I’m pleased—amazed is a better word—with what we’ve accomplished at Digital Due Diligence. In four months of work, we’ve built up a franchise, made friends, made enemies, and worked on some great projects with amazing clients. I, personally, have learned a whole lot from the process. Nearly everyone I’d want to thank is already a subscriber to this newsletter, so a quick and general thanks is in order.

And rest assured, I intend to keep the Digital Due Diligence newsletter as peppy and pugnacious as ever, even on a tighter schedule. So please continue to email me your tips, critiques, and suggestions. If I had to sum up Digital Due Diligence (the newsletter, the service, and the company), I’d say: We like to figure things out. And that’s never going to stop.

Please email me at byrne@byrnehobart.com with any questions.

(Note: A previous version of this post had a rather significant typo. I’m now working at Digital Due Diligence. Not “I’m not” working there.)

If you’re not famous, there’s a tradeoff: at some point, it’s better to piss off most of your audience and impress a few people, rather than having no audience at all.

The Black-Scholes model provides a helpful way to look at this. The Black-Scholes formula allows you to price a stock option knowing only a few data points—the current price of the stock, the strike price and maturity of the option, the risk-free interest rate, and the stock’s volatility.

The great thing about this is that you can use it to model other decisions. Black-Scholes tells you the tradeoff between price and volatility, which can tell you when it’s okay to accept a worse average outcome in exchange for a better chance at the best possible outcome.

It’s great for modeling situations in which the default case is failure. For example, look at startups: the default outcome is complete failure, but there’s a huge variation in how rewarding it can be to not-fail. A startup thus behaves like an out-of-the-money call option. The startup can accept a worse average outcome in exchange for more volatility. That might include hiring non-traditional employees, scrapping an old business model, or holding a risky press stunt.

To quantify this, look at the tradeoff between value and volatility in two cases.¹ In each case, we’re considering something that reduces the immediate price of the asset by 25%, but doubles its volatility. Situation #1 is an asset trading at 50% above its strike price. In situation #2, it’s 50% below the strike price.

Situation #1: the low-volatility outcome has a present value of $60.28, and the high-volatility outcome has a value of $51.30.

Situation #2: $16.50 value for the low-volatility outcome, and a $19.26 value for the high-volatility outcome.

The same choice is value-creating for a startup (the higher odds of a great outcome mitigate the fact that it’s slightly more worthless upfront), whereas it’s value-destroying for a big company.

This is another way to explain why big companies accumulate rules and small companies don’t: at a small company, if your customer service rep curses out a customer, you’ve lost that customer, but nobody will care. If Amazon hires a customer service rep who curses out a customer, they could lose tens of millions of dollars in brand value. So Amazon is naturally more likely to hire based on minimizing downside, while a new startup can only afford to hire based on potential upside.

A few other cases where this Black-Scholes model makes sense:

• Diplomacy: The status quo is the worst-case scenario for a country like North Korea or Libya. They can be completely insensitive to risk.

• Hiring: There’s probably a 90% chance that your resume will get a five-second rejection. If you raise that to 95% in exchange for raising the “This person might be crazy, but they might be brilliant!” rate from 0% to 1%, you’re still ahead.

• Dating: Unattractive people are disproportionately likely to tell inappropriate jokes to near-strangers. That’s pure Black-Scholes thinking.

• Building a professional reputation: I got a few dozen pieces of hate mail after my over-the-top attack on index funds. But I’ve also gotten a few notes from people who enjoyed the piece—who wouldn’t have heard about it if it hadn’t riled up so many other folks. (I’d like to give a special thank-you to the critics who blogged about this piece, or wrote about it on forums. What I lack in Public Relations I can now make up for in PageRank.)

This attitude is underused. In the face of long odds, most people are needlessly cautious—they’ll take incremental increases in expected value over big increases in variance. But in winner-take-all fields like finance, marketing, and startups, that’s completely irrational. High-variance strategies aren’t just optimal; they’re undervalued.

(For more on this, see Scott Locklin’s excellent applications of financial ideas to everyday life.)

[1]I’m holding maturity constant at five years, and using a 3% risk-free rate. I used this Black-Scholes calculator.(return)

Meanwhile, $SPY investors alone saw a 28% gain for the year, with average assets of about $93 billion. They made roughly $27 billion in profits. All that, thanks to a decision they could make with about fifteen seconds of research, zero reputational risk, no major sacrifices, and no change in behavior.

Basically, professional money managers are driving themselves crazy—sometimes literally—in order to create a market efficient enough for lazy people to profit. And the lazy people make more.

Indexing Fuels Bubbles

One key ingredient in bubbles is that they genericize something specific. You can’t have a “housing” bubble until you decide that apartments in Tribeca are fundamentally the same as new subdivisions outside of Vegas, or that a company revolutionizing the auction business is the same as a company revolutionizing the pet food business. (This is is part of why the college bubble is still going strong—it wouldn’t be a bubble if it were the Harvard Bubble, and it wouldn’t have gotten this far if we’d called it the University of Phoenix Criminal Justice Degree Bubble.)

Index investing lets someone blindly allocate a chunk of their assets to some fairly generic collection of companies—some worthwhile, many not. Who determines the exchange rate between the worthies and the worthless? Who decides how many Pets.coms you need to match the potential of one Amazon? Once again, it’s the active investors.

Combine this with information assymmetry, and you’ll get massive capital allocation problems. The generic, bubble-ized companies’ managements know their stock is overvalued. Their instinct is to issue shares (or use them as currency) as long as that persists. That, of course means that more and more of the indexified sector is taken up by the lowest-quality companies. Not just the lowest-quality companies, either: the ones that combine low quality with cynical management willing to exploit the market’s misperceptions.

Index investing, and the instincts behind it, exacerbate the natural tendency towards bubbles. We’d still have localized excessive optimism even if we didn’t have index funds. We just wouldn’t be able to act on it so decisively.

Even Worse: Active Investors Don’t Win

The strongest defense of index fund investing is that active investors don’t win. And that’s largely true: analyst projections don’t have strong predictive value, mutual funds underperform their benchmarks, and even hedge funds’ excess profits are largely absorbed by management fees.

That’s a strong defense of individual investors’ decisions to invest in index funds. But that excess performance is only possible if active managers are trading stocks. At some point, someone has to decide that one company is a buy and another company is a sell—if we all invested solely in index funds, share prices would move in lockstep (disregarding liquidity).

It’s like finding out that avid movie theater attendees have lower disposable incomes than people who use Bittorrent.

Passive investors are free-riding on active investors. Granted, many other investors free-ride on one another—we all get liquidity from the quants, the quants avoid buying overpriced stocks because value investors arbitrage away big value discrepancies, and value investors avoid getting blindsided by macro shifts because macro investors make the appropriate bets.

But index investors don’t contribute to any of that. They’re just the world’s worst trend-chasers, combined with the world’s most counterproductive underwriters. If you’ve invested in index funds, please, please take a flyer on something specific—but only if you’ve thought about it first.

Here’s the Google search results page for “Current Gold Prices”:

Notice anything odd? There’s an ad from Marketwatch.com, the financial news site. While they do talk about gold, they make their money through ads. They’re not the kind of company that can easily monetize Adwords traffic, especially for a term like “Current Gold Prices,” which costs $1.89 per click. It’s rare for media companies to advertise their stories like this. (The only other case I’ve seen was Vanity Fair promoting a profile of Sean Parker on Facebook.)

Click through the ad, and you land on this page on Marketwatch (Edit:: MarketWatch took down the page. Here’s a backup). While it’s technically on MarketWatch.com, it’s not their content—it’s a press release, put out by the company paying for these ads.

This is one of the smartest advertorials I’ve seen in a long time. To a less savvy Internet user, it’s just a Marketwatch article endorsing a particular gold-selling company. To PR Newswire, it’s just another self-aggrandizing press release. But to GoldFellow.com, the advertiser, it’s, well, an ad.

(It’s a fairly misleading ad, too. The ad claims that “[GoldFellow.com's founders'] company grew to become the largest karat gold jewelry manufacturer in America, culminating with a sale to Warren Buffett’s Berkshire-Hathaway in 2007.” That’s true—GoldFellow appears to be run by Michael Gusky, who sold his previous company to Berkshire Hathaway in 2007. No word on when he left— or why. The ad also violates some of Google’s technical guidelines, by redirecting visitors through GoldFellow.com even though the display URL is “marketwatch.com”.)

This is not especially expensive. PRNewswire is cagey about their prices, but it looks like it might cost less than $1,000 to get a press release out. Compare that to the cost of hiring a PR firm to get your company mentioned in Marketwatch—and mentioned so positively—and it’s obvious why GoldFellow made this move.

But it’s probably not a smart move in the long term. Who’s going to trust a company that pulls this kind of stunt? The sad part is that they may very well be a good company. Their ad copy works great—as ad copy, not as an advertorial. And it’s incongruous for a company to play up their “higher level of trust,” and “transparent business practices,” when they’re running deceptive ads.

Some day, the education bubble will burst. How can you trade this?

(If you happen to think that degrees are undervalued, either as an investment or as collateral, feel free to use this as a cheat sheet for making that bet, too. It takes two to make a market.)

Short For-Profit Schools and Student Loan Companies

If you had to sum up the education bubble in one misconception, it might be: “The average 22-year-old is a good credit risk for $150,000 in debt, collateralized by something completely intangible.”

Tragically, there aren’t very many companies built on this premise. The money-good nature of student borrowers was enforced by government insurance, and few companies made it a specialty to lend to students without these inducements. The “College Cost Reduction and Access Act” and the “Health Care and Education Reconciliation Act” got rid of these subsidies, and the credit crisis led to a general shakeout, so it’s tough to find a company with lots of non-insured loans on the books. Nelnet, for example, lists uninsured loans as <1% of assets.

About 20% of SLM’s assets are in private loans. That’s better, especially since that’s where they expect most of their growth to come from. It would take a serious wave of defaults to actually cause SLM distress, and those defaults won’t come all at once even if college degrees do become worse collateral.

A more direct short is the for-profit education industry. They’ve already been shorted heavily, and some of these schools could benefit from the bubble popping if more people chose vocational schools. Regardless of which one you short, you’re getting in behind lots of savvy investors who will want to cover at some point.

Invest in Countries With Saner Higher Ed Systems

Australia has the low-hanging fruit we had 200 years ago: land and natural resources. So their economy looks a lot more like that of a country on the way up, rather than a status-seeking/rent-seeking culture like ours.

This LessWrong piece talks up the benefits of working in Australia, including low taxes, a growing economy, some guest worker-friendly retirement policies, and a laid-back attitude towards college degrees and other such credentials. They also pay truck drivers $145K/year.

Japan is another possibility. As In Praise of Hard Industries argues, their industrial policy was deliberately designed to create jobs for high school-educated workers, not just smart engineers. A country with that kind of policy will have a saner labor market, even if their superficial problems still drag down current performance.

Tilt Your Portfolio Towards Natural Resources

Dylan Grice at Societe Generale says When you buy commodities, you’re shorting human ingenuity. Fair enough.

A world in which college is a good investment, on the margin, is a world in which human capital is under-exploited and natural resources are over-exploited. In that world, continuous innovation will reduce our costs in terms of physical resources, leading to lower commodity prices.

If we’re over-investing in human capital when we need resources instead, that will lead to supply shocks eventually. A resource-heavy portfolio can be a great defense.

Short Second-Tier Companies in “Prestige” Industries

Goldman Sachs, McKinsey, and Google all prize well-educated employees. But they don’t have to chase them. But their competitors do need to chase them. These are the companies that are most likely to overvalue credentials. Goldman Sachs can attract the very best Harvard grads, but a smaller bank without the budget or the brand name will still try to find people who appear prestigious. If the best people are hired by top companies, the ones who are left are worse than their credentials make them appear.

The thesis of this short sale isn’t that these companies will collapse, but that as long as society overvalues college, they will bear the brunt of that problem. Even worse, many of these companies are in the labor arbitrage business: they sell employee time by the hour. That makes them especially vulnerable to anything that causes them to persistently overpay for workers.

The easy way to construct this portfolio: take a list of software companies, consulting companies, and investment banks. Order them by revenue per employee. And short the bottom half.

Invest in Test Prep Companies

What’s the easiest replacement for a college degree? Steve Hsu has a hint:

When I was on the faculty at Yale I knew people in admissions and it’s not clear to me that they were the best able to spot potential in 18 year olds. In studies of expert performance admissions people are less good at predicting UG GPA than a simple algorithm. (The “algorithm” is simply a weighted sum of SAT and HS GPA!)

If test scores and GPA give employers most of the information that four years of college would, that means that great test scores are the best short-term substitute for a college degree. And that means lots of people prepping for their SATs.

Invest in Dropouts

The best technology companies seem to be founded by college dropouts and PhDs. By the time these companies go public, their founders’ credentials are basically meaningless. But at the earlier stages, lacking a college degree can be a serious impediment to getting a job or raising money for a business.

It’s a bad idea to blindly bet on college dropouts. Many people drop out because they simply can’t handle the work. In that case, they’re a symptom of the bubble (dropout rates have risen as it’s gotten easier to borrow money—and as degrees have gotten more common).

But dropouts with a few years of job experience are undervalued by the job market. Large companies’ HR departments will automatically reject them, but they don’t have the personal networks necessary to get their résumés in front of the right people any other way.

This isn’t an “investment” strategy per se; it’s not going to show up in a broker’s monthly statement. But it’s a way to use lifestyle decisions to hedge against risks, like buying a Prius instead of buying oil futures.

The Usual Caveats

The market can stay irrational longer than you can stay solvent.

That’s a feedback loop problem: people making bad decisions ought to lose money, but it’s entirely possible for someone to buy an overpriced house or an overpriced e-commerce play and still come out ahead in the short term.

The education bubble faces a different problem entirely: basically everybody in charge got their money’s worth from a college degree. Take a look at the board of directors at SLM or NelNet; you won’t find many University of Phoenix graduates. Most educated people have a disproportionate number of educated friends, so their personal experience will consist entirely of smart people for whom college was a good option.

So not only can the market stay rational, but that Ivy-educated market can rationalize like crazy.

The Short Higher Ed Portfolio

It’s not smart to build a portfolio around a single undiversified bet. When he wanted to short housing, John Paulson created a separate investment vehicle; Scion capital never invested more than a small percentage of its assets in CDS trades, even when Michael Burry was convinced that it was an obvious trade.

So a portfolio shorting higher education will look a lot like a typical portfolio. But it will be:

• Underweight finance, and possibly short SLM.

• Possibly short for-profit education companies, but long test prep companies.

• A bit more international than most, with a special emphasis on Australia and Japan.

• Long natural resources, especially energy.

• Long elites (Goldman, Google), short sub-elites (smaller banks, consulting companies).

It’s a slightly depressing portfolio, actually: if this works out, the rich will get richer, the poor will lose some hope for upward mobility, we’ll all pay more for gas, and the sheepskin industry will be devastated.

That’s just one more reason to short higher education. We’d all like to live in a world where human capital is worth investing in, and where we’ll have both material abundance and a smarter, happier populace. So think of this portfolio as a hedge against a sadder future.

Full Disclosure: The author currently has no position in any of the securities mentioned in this piece. That could change without notice. Consult a financial advisor before making any trades, do your due dilligence, etc. The author is a college dropout, and considers the decision prudent. The author does not speak for his employer.

Last month, LinkedIn filed a prospectus with the SEC. It’s a great case study: LinkedIn is one of the largest social networks, and it may be the most mature of the major social networking businesses. Like Facebook, LinkedIn has turned a profit; unlike Facebook, LinkedIn’s profit is dependent on several known business models.

The filing itself was a better read than most. Among other risks, it cited the possibility that:

[O]ur initial public offering could create disparities of wealth among our employees, which could adversely impact relations among employees and our culture in general.

I guess that’s what you get when your Chairman is an avowed “free-market socialist.”

The hurdle LinkedIn’s IPO faces is that the easy comparisons are completely wrong. LinkedIn shouldn’t be valued like a job board: for a variety of reasons, it’s a much more defensible model; LinkedIn is likely to stomp all over the traditional job boards (not so much traditional recruiters). But it’s not a “social network” that can be valued like Facebook and Twitter. LinkedIn’s business model is already in place, and its potential is a matter of execution, not innovation.

LinkedIn’s Competitive Advantage

Two of the strongest monopolies online are search engines and social networks. There’s rarely a good reason to use a less popular social network, and search engines have notoriously unforgiving economies of scale.

LinkedIn has solved both problems: for many users, it’s a second social network and a second search engine.

In both cases, LinkedIn isn’t competing with the dominant companies in the industry, because it’s targeting a very narrow use case. In search terms, LinkedIn is the ideal tool for finding job candidates with a very specific set of skills—project managers who know Perl and live within commuting distance of San Diego, or Ivy-Educated distressed debt analysts with at least a year of experience, for example. There’s no good way for Google or Bing to parse that query, but LinkedIn has that information at its fingertips. For recruiters, whose main “overhead” involves looking at résumés that turn out to be irrelevant, this is key.

As a social network, LinkedIn has positioned itself as the place for things you’re willing to brag about, which are not fun. This is brilliant. Most social networking tools are designed around the human need to show off. That can easily be divided into two basic categories: being happier than other people (partying, making great jokes, having kids, being close to family members, discovering funny videos), and giving up more happiness than other people (working hard, taking business trips, publishing a complex academic paper, dealing with a job search).

That’s a great niche, since things that aren’t fun are often the most impressive to potential employers. LinkedIn has clearly pressed this advantage by adding a powerpoint presentation-sharing app, an itinerary app, and a book-tracking app to user profiles. In my experience, very few people use the book-reading app to talk about fiction—they’re usually reading Too Big To Fail. The travel app isn’t for reporting on vacations; it’s for reporting on business trips.

This gives LinkedIn a purpose as a social network. They aren’t competing head-to-head with Facebook or Twitter. Instead, they’re absorbing the content that’s too boring for either. At the same time, Facebook and Twitter provide an outlet for anything less professional. It’s a symbiotic relationship that allows each network to move more content online.

(Yes, LinkedIn has Twitter integration. And some people do use Twitter to post mostly professional information. Twitter is a medium less dependent on message than LinkedIn or Facebook, so it makes sense that it could be cloned or integrated by each.)

LinkedIn also has another advantage: they have consciously tried to own people’s names as an SEO strategy. This is probably responsible for a huge fraction of their traffic. They don’t find people whose search queries imply intent: they don’t show up for terms like “tech jobs” or “find jobs,” and their ranking for “professional networking” is due to their Q&A page. LinkedIn is trying to find people who are looking for other people in a professional context, and they’re trying to make LinkedIn the way to do this.

LinkedIn actually has a great relationship with search engines; they even have “social sitelinks”:

That’s a tough policy for Google to reverse, so LinkedIn’s SEO risk is overstated.

LinkedIn’s competitive advantages rely on network effects. There is simply no better place to find out about someone’s professional skills and reputation. And there’s no better place to upload your résumé. LinkedIn has supplanted the personal site (will a hiring manager find it?) and the job board (what about when you’re not actively looking for a job?).

That’s actually quite impressive. LinkedIn is a well-executed version of two of the big business models of the 21st century: search and social.

LinkedIn’s Financials

Anyone can look at LinkedIn’s recent performance and see the salient numbers: quarterly revenues have risen from $23mm in Q2 2009 to $61mm in Q3 2010, an incease if 17.7% per quarter. Gross margins have gradually increased (75.9% to 80.9%) and variable cost as a percentage of revenue has dropped (63.8% to 57.9%) during the same period.

But the numbers get more interesting when we look at scalability:

• LinkedIn’s quarterly “hiring solutions” revenue per user has risen from about $.17/user to $.33/user. This is a reflection of the site’s network effects: with higher and higher saturation, it’s increasingly easy for LinkedIn to offer the very best applicant for a given set of criteria.

• LinkedIn’s quarterly marketing revenue per user has grown from $.16/user to $.24/user. This is a good sign that they’ve gotten better at price discrimination, and scaled their sales force up to be appropriate for the number of pageviews they handle.

• LinkedIn offers a “Premium” account for recruiters and job-seekers, offering more access to profiles, and more chances to contact users. “Premium” revenue per user has declined in the last six quarters, from $.29/user to $.19/user.

The numbers paint a pretty simple portrait. LinkedIn is three major businesses:

• Premium Subscriptions were an early cash cow, and still bring in $15.7mm/quarter. But they’re growing slowly. LinkedIn appealed to hyper-networkers early, but there aren’t that many of them out there. And LinkedIn needs to keep these prices high, to ensure that these networkers don’t bother other users.

• Hiring Solutions is LinkedIn’s most effective vehicle for monopolistic pricing. This is the revenue stream to look at when considering LinkedIn as a job board (versus LinkedIn as a social network or LinkedIn as a source of high-quality pageviews). LinkedIn is growing their hiring solutions revenue rapidly, in terms of revenue per user (12.4% quarterly growth), revenue per employee (10.5% quarterly growth), and revenue per “corporate user” (7.4% quarterly growth). This product makes LinkedIn most comparable to a job board in terms of monetization strategy. But LinkedIn’s competitive advantage, discussed above, put it well ahead of other job boards.

• Marketing. LinkedIn’s marketing revenue is icing on the cake. As a large site with a capitive audience and great SEO, LinkedIn generates pageviews. Lots of pageviews. And it sells them. LinkedIn’s marketing revenue per user has risen 6.1% per quarter in the most recent six quarters. Combine that with their user growth of 13.7% per quarter, and the result is a massive ad platoform.

“Marketing” and “Hiring Solutions” are both high gross margin businesses. LinkedIn has been able to continuously raise revenue per customer even as they go after more customers, which is a good sign that they haven’t nearly hit the point at which this market is mature.

Overall, LinkedIn’s marginal revenue per user is in the $.50 to $1.25 range, depending on the quarter. This is probably driven by two forces: on the downside, the quality of their users is declining over time as the extend their reach to people who a) have lower-prestige jobs, b) aren’t very active online, or c) are less likely to seek out new jobs. On the other hand, every new user raises the value of the site’s marketing and hiring solutions.

LinkedIn may end up using their “Premium” accounts as a way to reduce, but not eliminate, annoying interactions. They can gradually strengthen the site’s privacy settings (as they have already done), while loosening them for paying customers. That means LinkedIn captures lots of the economic gain from invading people’s privacy or sending them unsolicited messages. And since LinkedIn benefits in the long term if those interruptions are rare enough that users don’t flee the site, it’s an optimal arrangement.

The best-case scenario for LinkedIn is that they find a new stream of revenue to join this triumvirate, adding more high-margin profits to their existing revenue. But even if they don’t, they’re in a great position. All of their major revenue sources are growing in a way that implies that additional users won’t seriously disrupt things, and that additional sales staff will offer a useful contribution.

Thus, while LinkedIn is profitable, and has a few conventional business models, it’s still worth considering the possibility that it will have a sudden, sharp acceleration in growth.

One note regarding LinkedIn’s financials: they have some “variable” costs that vary with revenue (e.g. hosting costs, marketing expenses), and some that vary on a discretionary basis (e.g. investment in new products). LinkedIn has cut back their product development as a percentage of revenue, from 36.8% in early 2009 to 27.8% in mid 2010. This accounts for 138% of their increase in operating earnings. In other words, if they invested in R&D like they used to, they’d be losing money.

This is not, strictly speaking, a bad sign. LinkedIn doesn’t have a comparative advantage in this kind of spending—Google and Facebook will always be able to outbid them for the best technical talent. But LinkedIn is still a technology company, so it’s important to note that their profitability is a result of being less technical and more of a sales-and-marketing company.

There is a decent chance that this is an abberation, and that they’ll raise their product spending later on. This would account for their projection that they won’t be profitable their first year as a public company. This isn’t a useful long-term concern, but anyone buying on the IPO and looking at the next quarter should beware.

The LinkedIn Management Team

LinkedIn is traditionally considered an offshoot of the “Paypal Mafia.” Their founder, Reid Hoffman, certainly got some great experience—and a healthy grubstake— from Paypal’s IPO.

But LinkedIn’s management also hails from Yahoo!, not LinkedIn. Their CEO, Jeffrey Weiner, worked there, as did their SVP of operations and engineering. They’ve also recruited from TiVo (CFO Cteven Sordello) and Google, (Dipchand Nishar, SVP of product and user experience).

Oddly enough, many of LinkedIn’s senior executives were promoted to their current roles just in time for the IPO. Of their top six executives, four were promoted in January. This is probably a sign of the usual pre-IPO reshuffling (in a company of that size, it’s important to identify which VPs are worth talking about!) but it may also have something to do with LinkedIn’s options grants.

LinkedIn’s Competitors and Risks

LinkedIn is not a job board. It shouldn’t be compared to them. However, the market will probably look at job boards as the most similar companies to LinkedIn. A few of their competitors:

• Monster Worldwide trades at 2.5X sales. It’s fairly mature: the big determinant of Monster’s revenues is the market for jobs in general.

• TheLadders, like LinkedIn, targets high-income professionals. TheLadders has, by all accounts, done a great job of extracting more revenue from top-tier job applicants. But it’s a site for finding a new job, not curating a career.

• Dice Holdings is a more interesting case. They have vertical-specific job boards (Dice.com for technology, eFinancialCareers for finance, ClearanceJobs.com for government jobs, etc.). Their operating margins approach 25%, and they’ve shown some recent growth. Dice trades at 8X sales.

Most of the publicly traded companies in the employment space are recruiters, not job boards. Recruiters have been early adopters of LinkedIn (hence that high but declining “premium” revenue). LinkedIn may gradually erod the economics of that business, but in the short term recruiters are happy to embrace it.

There are a few companies that are actively eroding LinkedIn’s competitive strengths:

Hashable is trying to own the “introduction” part fo the LinkedIn relationship. While that’s critical in the short term, LinkedIn monetizes the metadata—where someone worked, who recommendeded them, and who they know—not just information on who met whom. Hashable is a good acquisition target for LinkedIn, and might be a long-term threat, but even if they own the personal introduction market, LinkedIn still has a lock on the long-term employment data market.

Branchout is a new Facebook app that offers career information, hosted on Facebook. This could be a threat, since there are more Facebook profiles than LinkedIn profiles. But connecting Facebook activity is a bad move (the big career risks: for people under 30: pictures of parties! For people over 30: pictures of kids!). The new Facebook profile has a similar risk/reward profile: yes, it offers some of what LinkedIn offers, and does a better job. But it’s easier to create a LinkedIn account than to massage privacy settings to the point that Facebook is a useable tool for interacting with friends and bosses.

Quora is destroying LinkedIn answers. It is what LinkedIn answers should be: a site where the right expert answers the right question. Quora launched with a good audience; LinkedIn’s good audience had gotten less active by the time they launched Answers.

Applicant Tracking Systems are a broad competitor to LinkedIn. Once the hiring process gets started, these content management systems get used a lot. The problem with them is that they vary in quality: from being awful but useable to being awful, unuseable, and ubiquitous.

LinkedIn could easily squash Taleo, one of the largest applicant tracking systems, by creating a one-click application system, that ordered applicants based on an algorithm that looked at their experience and their degree of connection to the company. This wouldn’t just give LinkedIn a new revenue source: it would help LinkedIn replace company “Careers” pages the way it’s so thoroughly replaced personal résumé pages.

Ten Questions for LinkedIn’s Management

• Why did discretionary expenses drop so much ahead of the IPO?

• What will you do to address Hashable?

• What will you do about M&A replacing HR? What if hiring is obsolete and the best employees get found because they start compelling companies? This doesn’t post big short-term risks to the LinkedIn model. But anecdotally, programmers are overrepresented among LinkedIn user (or at least LinkedIn ads). If LinkedIn is the place to hire not-the-best programmers, how does that affect the site’s pricing power?

LinkedIn can use price discrimination to deal with part of this problem. Instead of charging full price for all companies, LinkedIn can offer discounts to funded startups with a small number of employees. If LinkedIn is a great tool for hiring the first ten people, it may be a cost-effective too for hiring the next hundred.

• Field sales are growing faster than online sales. These are higher-margin deals, with bigger lead times and more generous payment terms. What will the next big hiring slowdown look like, from a balance sheet perspective?

• Are you going to remain active in the Q&A space?

• How wil you deal with out-of-date profiles? As LinkedIn matures, the average age of profiles will go up. This will reduce the utility of profiles, which is the main driver of non-ad revenue. (And since ad revenue is driven by pageviews, it’s indirectly affected by how often people log in). LinkedIn could partially mitigate this problem by sending more emails. Whenever an employer lays people off (as announced in the news or as noticed by LinkedIn), LinkedIn could email that compay’s employees and suggest that they update their profile and ask friends for a recommendation.

• How will you deal with Facebook? Facebook is the elephant in the room. If they perfect their privacy settings, LinkedIn’s only reason for existing is its relationships with recruiters, and its database of recommendations. Facebook could clone both within a year or two, if necessary. What is LinkedIn doing now to make sure that’s not an economically viable decision for Facebook?

• Do you have another business model in the works? Marketing, hiring solutions, and premium accounts are great. But are they everything?

• Will you ever partner with other job boards? LinkedIn invades the job board niche, but many job boards still have valuabe résumés in their databases.

• Will you partner with a recruiting agency? Recruiters with niche dominance could use LinkedIn especially well. They may be able to find recruiters who dominate a particular market, and are willing to pay up for special rights.

A Few Post-IPO Predictions

(In the spirit of Byron Wien’s “Ten Surprises,” these are not things with high odds of happening, but events whose odds are higher than one would normally think.)

• LinkedIn has a few soft quarters early on, but shows solid growth in FY2012.

• LinkedIn buys an Applicant Tracking System.

• LinkedIn buys Quora for $500mm. This is widely derided, but immediately raises their revenue from every business segment, and gets them some great technical and design talent. Facebook will have trouble buying Quora for personal reasons; Google because it already owns Aardvark; Twitter because it doesn’t buy other product. Yahoo, Microsoft, and AOL are the only other suitors. I doubt that either company is willing to pay so much for a pre-revenue company.

• LinkedIn subsumes the company “Careers” page the way they’ve subsumed the personal “résumés” page. They do this through a combination of SEO and purchasing an applicant tracking system.

• LinkedIn does not buy or get bought by a job board.

• LinkedIn’s stock, at IPO, is a good deal. At some point, it will probably close 20-30% below the first day’s closing price, but it will be considered a good investment five years down the line.

Full Disclosure: don’t consider this financial advice. Consult with a broker before making financial decisions, even poor ones. Assume the worst, and act on it.

In addition: I am an avid LinkedIn user. I will not be buying at the IPO, but may trade LinkedIn stock or related derivatives in the future. I will not necessarily trade in the direction implied by the above.

In the next few years, something strange happened: blogs became ubiquitous. But “the blogger” lost influence; the personalities that originally defined blogging never became as influential as most people expected.

I suspect that three forces sapped the blogging trend of most of its strength:

•Social media sites replaced low-traffic blogs.

•The right economic unit for high-traffic blogs is the blog network or the content farm, not the blogger.

•The only use for a blog qua blog is as an extended résumé or biz-dev pitch.

Social Media: Is Tumblr Killing Blogs?

The original promise of blogging was something like this: anyone can start a blog, and—based purely on the quality of their writing—they can become famous and respected. And that used to be true. Elizabeth Spiers wrote Capital Influx and got picked to write Gawker; when she struck out on her own a few years later, she tapped the bar blogger Manhattan Transfer as editor in chief of her new finance blog.

That might still happen, but it’s a lot rarer than it used to be. Back in the first half of the oughts, people started blogs for their friends to read, and those blogs eventually caught on, leading to bigger blogging gigs. Now, people who want their friends to read something will choose a more social platform; they’ll write something on Tumblr, or as a Facebook note. That’s a context in which it’s much more likely that ten people will read something, but far less likely that a hundred will.

(That phenomenon predates Facebook and Tumblr. Livejournal.com hasn’t produced as many popular individual bloggers as other platforms, but LJ users do give one another lots of comments.)

Blogging, in the early years, produced at least a few personalities who ended up making a splash in traditional media. (Spiers is the new editor at The Observer; Manhattan Transfer now runs a popular blog on CNBC.com.) Social media sites haven’t fulfilled this promise. Who are the famous new personalities? Everyone in the top 100 Twitter accounts is famous for something other than Twitter—except for the Shit My Dad Says guy, who is famous for being funny enough to get his own TV show (in other words, famous enough on Twitter to become famous in real life. The author of Shit My Dad Says, incidentally, was a screenwriter and web editor for Maxim before his Internet Fame.)

Social media relies on our natural social interactions, most of which have been hard-wired for a couple thousand generations. So any business based on authority or fame will be very hard to revolutionize. Technology might shake things up in the short term, but the long-term outcome is likely to be more of the same.

Blog Networks and Content Farms Beat Bloggers

As it turns out, the blogging industry has some serious economies of scale. Who knew?

The original thesis of blogging economics was that between Adsense and Amazon Affiliates payments, a good blogger could probably build up enough of an audience to be self-supporting. And it’s true that there are people who make a living from blogging—but they almost always work for multi-author blogs or blog networks, not individual sites.

Even iconoclastic bloggers like Choire and Balk do better glopping their content together than writing it on their own. Other successful blogs like Business Insider and the Huffington Post rely on an army of contributors.

In the context of optimistic predictions about blogging, this is a big surprise. What happened to the army of pajamas-clad entrepreneurs earning decent wages doing what they loved?

But in another context, it makes perfect sense: blogging is a mass medium, and the shifts in technology that prompted blogging (ubiquitous Internet access, cheap or free software for posting new content to the web) didn’t alter one of the fundamental constants of the textual content business: it doesn’t make sense to have a periodical written by one person, and it really doesn’t make sense to have a periodical written by one person who also handles the money.

The old assumption was that blogs are a new medium. But whether you’re looking at Gawker’s numbers or their new redesign, it’s clear that as a business, blogs are just magazines that happen to be online.

At least for high-quality content. For lower-quality content, blogs can be a great source of cheap ad clicks. Gawker won’t touch that strategy, but the Huffington Post loves it. And other clever sites like SeekingAlpha have caught on to how profitable this pageview arbitrage can be.

The Last Ditch: Blogs as Résumés

You’re not reading this on a content farm, a blog network, or Facebook. You are reading it on a site directly descended from the site that got me my first full-time job and helped me land my current job.

Sites like mine aren’t directly designed to make money. I’m not expecting ByrneHobart.com to turn into a full-time gig, ever. But I do suspect that a site like this is a great way to improve my career. I’ve met some very smart people through this blog, and done business with a few of them. And I’ve learned a lot in the process of articulating my thoughts on this site.

That’s not the kind of revolution people hoped for in 2003. But it’s something.

And then it was cited in a follow-up story in today’s New York Times.