Why the world's hottest tech company will struggle to keep its edge

The spring sun shines brightly on the so-called Googleplex, the five-building campus of the hottest Internet search engine on earth. At lunchtime, hundreds of engineers at Google Inc. chow on free fare prepared by the former chef of the Grateful Dead. Kicking back? It's more like a fuel stop. They eat, paying little heed to co-founder Larry Page as he swoops by on skates. And as evening sets in, those same brainiacs, wedged three to six per office, huddle in quiet conference or patter away at their computers in unblinking concentration. Whether in sneakers or on skates, the Google crowd emits cerebral intensity and a near-palpable sense of urgency.

You'd think they would be celebrating. All around the world, Web-surfing humanity has found its way to Google's bare-bones Web site and picked up the simple formula, pecking out a few words and hitting enter. Google has blazed a new path of learning and turned its search engine into the keys to knowledge. Its massive banks of servers process more than 3,000 searches every second of the day. Now, much of Silicon Valley waits eagerly for the miracle company to translate its soaring popularity into a mountain of cash. As soon as late April, Google could file papers for an initial public offering, the first marquee tech IPO since the collapse of the dot-com bubble three years ago. Google, which analysts believe topped $900 million in sales and $150 million in net profits last year, could raise $1 billion to $2 billion. The whole company may be valued at $20 billion by the public market -- easily a record among Internet IPOs. "Google has proved a better mousetrap matters," says Microsoft Corp. (MSFT ) CEO Steven A. Ballmer.

BATTLE FOR THE HEART. But Google's payday arrives just as the search phenom faces a withering battery of tests. The company's spectacular success has lured brawny competitors such as Microsoft and Yahoo! Inc. (YHOO ) into the arena. Those companies view search as a command center of the Internet, and they plan to wrest it from the upstart in Mountain View, Calif. The result will be a battle for the heart of the Net -- one just as momentous as the browser war between Microsoft and Netscape Communications that took place a decade ago. Says Roger McNamee, managing partner at venture capitalist Silver Lake Partners, which has no stake in Google: "Search is the key to the kingdom."

And the battle is raging at Google's ramparts. Yahoo is leading the assault. In February, the portal giant fired up a new search engine that analysts say nearly matches Google's performance. More worrisome, Yahoo CEO Terry S. Semel is driving Yahoo to the next frontier, customized search. Instead of today's one-size-fits-all searches, he wants to offer queries tailored for an individual's tastes, interests, even location. Advertisers are ready to pay royally to reach this type of targeted audience. And Yahoo is off to a big head start in gathering the personal information necessary to deliver such customization. It has amassed 141 million customer profiles; Google next to none. "They're quite vulnerable," says Michael A. Cusumano, professor of management at Massachusetts Institute of Technology.

Even if Google sidesteps that threat, it faces another, perhaps more daunting one. Microsoft is working to leverage every bit of its Windows monopoly in the effort to win the search market. Ballmer and Chairman William H. Gates III are working to embed search capabilities into nearly every aspect of future versions of the operating system. Have a question? Search the Web and the hard drive too from a Word document, an instant chat box, even an Excel spreadsheet. No need to pay a visit to a search site. If Microsoft makes good on this sweeping expansion, it could turn Googling into a quaint ramble down memory lane.

Google's trials would strain even a battle-hardened outfit geared for war. But the company still operates under freewheeling management, a vestige of its peaceful prosperity as a private company. Under a ruling triumvirate, no one exec has clear control. CEO Eric E. Schmidt, 48, was hired three years ago to provide experienced leadership. But his role, as he describes it, sounds more like a chief operating officer's than a CEO's. He says he handles "the day-to-day stuff," making sure the right people are talking and reaching out to partners. Decisions emerge from three-way negotiations between Schmidt and co-founders Page and Sergey Brin. It's the founders who chart Google's path, wielding veto power on strategy and technology moves. Engineers, meanwhile, work in the same culture of controlled chaos that built the startup. All are free to pursue pet projects. The result is an engineer's dream -- but hell for planners. Some investors find the approach unsettling. "They do not sound even remotely like a fiercely competitive world-class company, [but] rather kids playing in a sandbox," says one Google investor, who plans on selling shortly after the IPO.

BREAKING POINT. The kids will have to grow up fast. Their giant rivals are not only knocking off Google's search engine, they're also plugging it in to just about everything they offer, from e-mail to job boards. This is an attempt to outflank Google and turn search into a ubiquitous feature, a commodity. To defend its market, Google must come up with a better model, one that establishes its search engine as a central platform for computing. This pushes Google to extend from its slender specialized base and venture into many of the same broad services the giants offer. To keep the big powers from feasting on its specialty, Google must stretch and become a sprawling power of its own.

This is leading Google execs to weigh ideas that to some may seem dire in nature. For example, Jeffrey D. Ullman, a computer science professor at Stanford University and a member of Google's four-person technology-advisory council, says he's urged the company to acquire or team up with a Linux desktop company so Google can extend search to information stored on the computer. This means competing head-on with Microsoft's dominant Windows operating system. "If Google doesn't reach the desktop," cautions Ullman, "Microsoft will eventually take Google's business, just like it took Netscape's." Google execs say that they've discussed the possibility but aren't poised to act.

With such intense competitive pressure, Google's management could be stretched to the breaking point. Considering how rarely co-CEOs have been able to share an executive suite effectively, experts think it's only a matter of time before the power-sharing setup at Google dissolves. "If multiple people are making decisions, decisions don't get made," says David Yoffie, professor at Harvard Business School. "At Google, there are tens or hundreds of projects going on simultaneously. Ultimately one person has to make a decision."

Schmidt responds that Google's consensus-management structure, while maddening at times, is effective. It combines Page and Brin's technology expertise and his own operations experience. "We try to run as a group, because partnerships make better decisions," says Schmidt, adding, "It's very, very lonely if you're the only person with a very hard decision to make." He takes exception to the idea that he acts like a COO. Rather, he compares Google to Yahoo and auction titan eBay, where the founders shaped the strategic vision, though they didn't have the chief executive title. "I've tried very hard to have this be a founder-driven company," he says. "It's what most other high-tech companies have done."

Schmidt's supporters say that the CEO's style may send an inaccurate signal about his power in the company. "Eric likes to be self-deprecating," says Bill Campbell, chairman of Intuit (INTU ) who has served as a management adviser to Google for 2 1/2 years. "He's not the COO. He's the CEO of the company and does a good job of it."

Google execs also maintain that the company's freewheeling engineering culture is not a liability but an asset. To offset Microsoft and Yahoo's crushing advantage in size, scope, and customers, they say, the far smaller Google requires breakthrough innovations. The company, which receives about 1,000 résumés a day, has hired hundreds of engineers and scores of top-ranked PhDs in recent years. By giving them free rein to pursue new ideas, Google expects to come up with services, from e-mail to community networks, that set its larger competitors back on their heels. "What we really talk about is how we can attract and develop this creative culture," says Schmidt. "Innovation comes from invention, which you cannot schedule."

The Google team dished up a fresh serving of its trademark audacity on Mar. 31 when it announced a new e-mail service known as Gmail. The service will offer users free e-mail with one gigabyte of storage -- 250 times as much as its nearest competitor. But it comes with a catch: a bold and controversial proposal to introduce advertising into e-mail. Google's computers will sift through correspondence and place related advertisements in the margins of e-mails. Gripe in an e-mail about your busted toilet, and the note is likely to come with an ad for plumbing supplies. It's classic Google: imaginative, provocative, and capable of obliterating the status quo.

DAMAGE CONTROL. But with the launch of Gmail, the young company unwittingly put its own naivete on display. Instead of basking in the glow of the new service, Google's harried press-relations team had to shift quickly into damage control as 28 privacy and consumer groups blasted the company. They complained that plans to scan the text of letters constituted an infringement of privacy. Co-founder Brin was pressed into service, calling up media outlets to make Google's case. This kind of scrutiny is new to the company, long a darling among consumers.

The Gmail hiccup has done little to dampen the Googlemania sweeping Silicon Valley. The upcoming IPO promises to deliver the kind of bonanza the Valley has been aching for since the dot-com bust. According to researcher Venture Economics and sources familiar with Google's financing, venture firms Kleiner Perkins Caufield & Byers and Sequoia Capital stand to turn their $10 million investments from five years ago into about $2 billion each. Co-founders Brin and Page could be worth more than $3 billion each. Even execs at rival Yahoo are licking their chops. The company invested $10 million in Google four years ago for a stake that could be valued at roughly $300 million. Investors, meanwhile, are lining up to buy Google shares. "I love this company. I love this business," says Duane Roberts, head of equity strategy at Dana Investment Advisors, an asset manager in Brookfield, Wis. "This is going to be another one of the blue chips, like eBay, Yahoo, and Amazon (AMZN )."

It's likely to be valued as one. Back-of-the-napkin analysis circulating in Silicon Valley puts a $20 billion valuation on Google. Assume it notched $150 million in net profits last year, as analysts estimate. Most of that comes from search marketing -- an industry projected to grow 70% in 2004. If Google maintains its share, which analysts say is likely, net profits could pass $250 million in 2004. That would give it a price-earnings ratio of 80, only a tad below Yahoo's p-e of 87. Some analysts are skeptical. "I wouldn't want to see Google come out at the same valuation as Yahoo," says Allison Thacker, a portfolio manager at RS Investments, a San Francisco-based money manager. "Yahoo has a powerful franchise that provides an array of services to consumers. Google doesn't really have that at this point."

LIGHTNING-FAST. Google execs are betting their technological expertise will help them make up the difference. Page, 31, is the son of a computer science professor and a database consultant, while the Russian-born Brin, 30, is the son of a math professor and a scientist at NASA. The duo hatched a breakthrough search algorithm at a time when virtually everyone else considered Internet search a developer's cul de sac. The next job, just as important, was to make their service lightning-fast. The Google team pulled this off by stitching together some 10,000 servers and building, in effect, their own supercomputer. This jerry-rigged approach gave Google a sizable lead on the competition in both software and hardware. The pattern was set: While well-organized foes would wring revenues from the tried-and-true, Google's unbridled engineers would blaze new trails.

Page and Brin's radical management philosophy is derived from their experiences in the labs of Stanford University's computer science program. Google's managers rarely tell engineers what projects to tackle. Instead, execs keep a "Top 100" priorities list (which today numbers more than 240 items), and engineers gravitate to issues that interest them, forming fluid working groups that can last weeks or months. Engineers are urged to spend about one day a week working on their own personal research projects, no matter how offbeat, in hopes of sparking the Next Big Thing. "We're encouraging creativity and tolerating chaos," says Wayne Rosing, Google's vice-president for engineering. "We turn that dial all the way over to loud."

Google coddles even its engineers' zaniest ideas. In one project, techies were grappling with the problem of displaying information from the Internet on cell-phone screens, recalls a former Google employee. They went as far as pondering a laser that would scan the user's retina, creating the appearance of a larger screen. Ideas such as these are often included on the Top 100 list. An "S" next to the project stands for "skunkworks" and protects it from premature reviews and criticism.

To foster a culture of creativity, the company's campus is a veritable theme park for propeller heads. Engineers unwind by playing roller hockey in the downstairs garage or racing remote-control blimps through the offices. Segway scooters, which retail at $4,000, are parked around campus, offering a novel way to navigate between buildings. Perks are lavish, from two flat-screen monitors on each computer to $800 digital toilets, equipped with remote controls to adjust seat temperature and water pressure.

Brin and Page have been searching for the right mix of freedom and discipline for years. Back in 2000, the co-founders first hunkered down with Schmidt, then CEO of corporate software maker Novell Inc. (NOVL ) Schmidt, a veteran of the software industry with the bruises to show for it, was taking a thrashing at the hands of Microsoft. Earlier, he had weathered similar ordeals as a top exec at Sun Microsystems Inc. (SUNW ). He was not considered a remarkable visionary, but that was one field where Page and Brin didn't need help. What they looked for was a grown-up manager, someone to turn Google into a real business, much the way Tim Koogle had taken over from Yahoo's young founders five years earlier.

The conversation naturally turned to technology. Almost immediately, Schmidt found himself in an argument that dragged on for most of the 90-minute meeting. Page and Brin were curt and headstrong, but Schmidt was impressed by their intelligence and passion. He left the meeting intrigued. Schmidt watched the company grow, and the next year he took over, first as chairman and four months later as CEO.

`IT'S JUST BRUTAL'. Google finally had its grown-up. Page, who had been CEO, stepped down to president for products. Brin, formerly chairman, shifted to president for technology. Yet Schmidt, in his three-year tenure, has left the management structure intact. And the two founders aren't shy about flexing their muscle. "We've actually had a number of initiatives -- I'd rather not go into specifics -- where somebody, usually Larry or Sergey, says, 'Look, this thing's just not good enough.' And it's just brutal," Schmidt concedes.

To their credit, Page and Brin have made a string of inspired strategic moves that would make even the boldest tycoon blush with envy. They steadfastly refused to clutter the home page with splashy ads or links to other Web sites, maintaining a zippy, minimalist design that has scarcely changed to this day. They scorned the marketing mania of the Internet boom, killing a multimillion-dollar advertising plan in 1999 and relying instead on word-of-mouth to build their hip and innovative brand. They built a business out of selling paid ads alongside search results, which turned Google into a money machine. Most important, they provided fast and reliable results, propelling Google from handling less than 1% of Web searches in 2000 to over 50% today.

Yet Google's rivals enjoy key advantages beyond search. Yahoo, for example, has proved adroit at wringing cash out of its site, particularly since the 2001 arrival of Semel. It has built a substantial retail business by catering to its regular users. It maintains profiles of shoppers, including delivery and credit-card information. Yahoo also provides a universal shopping cart, letting a shopper store, say, a new blender from one retailer while exploring elsewhere for just the right gift. The result: Shoppers can save a good 10 to 15 minutes each shopping session, compared with Google's price-comparison engine, dubbed Froogle, which can't store profiles or provide a digital cart. While 30,000 merchants pay $50 or more each month to be part of Yahoo's shopping network, Google has no comparable business.

Semel & Co. also have pushed aggressively to generate more money from search. Yahoo has embraced a practice known as "paid inclusion," in which a search engine accepts payment from a company to guarantee its site is included somewhere in relevant search results. Often, the listing is not marked as advertising. It's big business, expected to grow from $200 million last year to $600 million in 2007, according to Piper Jaffray. But not one penny of it goes to Google. Why? Google decries paid inclusion as a blemish on the integrity of search results. It separates and clearly marks as advertising all links for which it's being paid.

COURTING TRUST. This tussle over paid inclusion exposes a strategic rift. Google is sticking to its position that search is an editorial product, with a clear line between information and ads. The bet is that this stance will foster public trust in the brand and pay off with increased traffic to the site. But if the public does not focus on ad policies, Google's foes stand to mine a rich new market -- perhaps pressuring Google to follow suit. Fredrick Marckini, CEO of search-marketing firm iProspect, says: "People tend not to notice [paid inclusions]." This may lead Google execs to launch a PR campaign on the issue. "It's something we debate," says Page.

For now, Google is battling Yahoo with innovations such as Gmail. The strategy extends far beyond luring people to the site with free e-mail. It opens up vast new terrain for Google to search. It won't be long, for instance, before Gmail users toggle between searching the Web and their archived e-mails with a single click. Eventually, Google could tap data such as Zip Code and gender from these profiles to better compete head-to-head with Yahoo in customized search. "The more information we have when we do a search, the better it's going to work," says Page.

An advertising bonanza is at stake. For now, Google is the leader in paid search, a market expected to grow from $2 billion last year to $4.8 billion in 2005, says Deutsche Bank Securities Inc. But future growth hinges on customization. Already, Yahoo and AOL (AOL ) are exploring ways to customize search for willing visitors based on data they have have stored in profiles. "You don't have to plug [the Zip Code] in," says Gerry Campbell, vice-president of AOL Search. "It can be pulled right from your profile." Google offers a service that lets people enter their location and contends that having the information stored isn't much of an advantage. After all, people may be searching for a restaurant when they're away from home on a business trip. Even if they're at home, Page says, it's simple to type in the five-digit code.

In time, search engines will feast on every bit of personal information we're willing to share, and serve up links that fit our tastes and locales -- maybe even fine-tuning them according to the time of day. It's a market headed for dramatic growth and change. No wonder so many investors are grasping for a piece of the brand that has become synonymous with search. "Google represents the new era," says Michael Moe, chief executive of boutique investment bank ThinkEquity Partners. But buyers beware: Google's biggest tests are dead ahead.

By Ben Elgin

With Jay Greene in Seattle and Steve Hamm in New York

Before it's here, it's on the Bloomberg Terminal.