AOL and Time Warner: how the smaller company bought the giant

Full transcript

Narration of the video, cleaned from the captions. Narrated by an AI voice; script, research and analysis by Erhan Civelek.

0:00 A deal with no cash

In January 2000, a company with about five billion dollars in yearly sales agreed to buy a company with almost twenty-eight billion. And it didn't pay a single dollar in cash. The buyer was America Online, the dial-up internet company that greeted millions of people with "You've got mail." The target was Time Warner: Warner Bros. movies, HBO, CNN, Time magazine. It was the biggest merger in history, valued at around one hundred and sixty-five billion dollars.

Three years later, the combined company reported a loss of ninety-eight point seven billion dollars, for a single year. At the time, the biggest annual loss in American corporate history. So how does the smaller company buy the giant? Why would the giant say yes? And where did almost a hundred billion dollars go? The answer starts with a simple idea most people never think about. When a company buys another company with its own shares, it's paying with a currency it prints itself.

And in January 2000, AOL's currency was worth more than almost anyone's. This is How Deals Work.

1:06 Two companies, two worlds

Let's rewind to the late nineties. For millions of Americans, AOL was the front door to the internet. A free CD arrived in the mail, you plugged in your modem, listened to that screech, and you were online. By the time of the deal, AOL had more than twenty million paying members, each paying up to about twenty-two dollars a month. Time Warner was the opposite kind of company. Old, enormous, and full of things you could actually touch:

film and TV studios, magazines, cable TV channels, and the country's second-largest cable system, with about thirteen million customers. On paper, Time Warner was the heavyweight: nearly twenty-eight billion dollars in sales, against AOL's four point eight. But on the stock market, the order flipped. On the Friday before the announcement, investors valued AOL at about one hundred and seventy-three billion dollars, and Time Warner at about one hundred and one.

So the smaller business was the bigger company. How is that even possible?

2:07 Paying with a currency you print

A company's stock-market value is just the price of all its shares added up. And that price isn't really about this year's sales. It's about what investors believe the company will earn in the future. In 1999, investors believed the internet would change everything. So AOL's shares carried a huge price tag. Here's the trick. If your shares are expensive, you can use them like money. Think of a coffee shop that prints its own tokens.

If everyone in town believes those tokens are worth a lot, the coffee shop can buy the bakery next door with tokens alone. No cash changes hands. But here's the catch: the bakery is real. The tokens are only worth what people believe. That's what happened here. AOL shareholders got one share of the new company for each AOL share. Time Warner shareholders got one and a half. When the dust settled, AOL's side owned fifty-five percent of the new company, and Time Warner's side forty-five.

AOL's chairman, Steve Case, put it in one line: "We figured it's better to own fifty-five percent of the new company than a hundred percent of AOL." Read that again. There's a second meaning hiding in it, and we'll come back to it in a minute.

3:23 Why the giant said yes

So why would Time Warner agree to be bought by a company with about a sixth of its sales? First, the price. The offer was worth about seventy-one percent more than Time Warner's share price on the Friday before. Boards find a premium that big very hard to turn down. Second, fear. Time Warner had tried to build its own internet business, with a website called Pathfinder and an interactive TV experiment in Orlando.

Neither took off. The internet looked like a train that was leaving without them. And third, a story. Old media plus new media: movies, news and music delivered straight to millions of online homes. AOL's president, Bob Pittman, said each company was "the missing piece of the other's puzzle." But AOL had a fear of its own. And it was the bigger one.

4:13 AOL's hidden worry

AOL's business ran on dial-up: phone lines and modems. The future was broadband, the fast, always-on connection. And in much of America, broadband came through cable TV wires that AOL didn't own. Time Warner owned a lot of those wires. On the day of the deal, Case told analysts that if you were an AOL shareholder, you went to bed the night before a little worried about broadband. Now, he said, you no longer have that worry.

So now we can read his famous line properly. AOL used its shares while they were still expensive, and swapped them for a big slice of a company full of real assets: studios, channels, cables. In a way, it was selling high, and paying with paper. And then the paper started to lose its value.

5:01 The crash, and where $98.7 billion went

On the tenth of March 2000, just two months after the announcement, the tech-heavy Nasdaq index hit its peak. Over the next two and a half years it fell by about seventy-eight percent. The deal still went through. Regulators took a year, and the merger closed on the eleventh of January 2001. But the world it was priced for was already disappearing. Online advertising slumped, and AOL's growth stalled. Here's where that ninety-eight point seven billion went, and it takes one simple idea:

goodwill. When you buy a company for more than the value of the things you can point at, the extra is recorded as goodwill. Think of it as the price you paid for hopes: future growth, savings from combining, the power of the brand. When those hopes fade, accounting rules make you write that goodwill down. New rules in 2002 required the company to test it. The first write-down was fifty-four point two billion dollars, in a single quarter.

At the end of the year came another forty-five and a half billion, mostly for the AOL business. The total loss for 2002: ninety-eight point seven billion dollars. Most of that wasn't cash leaving a bank account. It was the company admitting, in public, that what it had bought was worth far less than what it had paid. But here's the uncomfortable question. Even without the crash, would this deal have worked?

6:29 The merger that never merged

The plan was to run old media at internet speed. But Time Warner's divisions, the studio, the magazines, the TV networks, had long run like separate kingdoms. Bonuses were tied more to the combined company's shares, and some division heads resented being dragged down by AOL's weaker results. Within about two years, many of the people who built the deal were gone or going. Chief executive Gerald Levin announced in December 2001 that he would step down.

Time Warner veterans took over the key jobs. In January 2003, Steve Case said he would leave the chairman's seat. And in 2003, the company dropped AOL from its name. It was Time Warner again.

7:14 The slow divorce

What followed was a slow divorce. In 2009, Time Warner spun off its cable business. In December that same year, it spun off AOL as a separate company again, giving shareholders one AOL share for every eleven Time Warner shares they held. In 2010, Time Warner's chief executive, Jeff Bewkes, called the merger "the biggest mistake in corporate history." And in 2015, Verizon bought AOL for about four point four billion dollars.

The company whose shares once bought an empire was sold for less than three percent of what the market said it was worth in January 2000.

7:53 From the deal table: 3 lessons

I've spent years around deal tables, and this story keeps coming back for three reasons. One: when a deal is paid in shares, the price is only as real as those shares. The headline number was set by what AOL's stock traded at on one Friday, and it moved the moment the market changed its mind. Two: look at why each side wants the deal. Time Warner wanted the future. AOL wanted protection from it.

Both stories were true, but they weren't the same story. And three: savings and growth from combining don't happen on their own. A slide that says one plus one equals three needs people, incentives and a plan behind it. Otherwise, one plus one can turn out to be a lot less than two.

8:39 Next episode

AOL and Time Warner shows what happens when a deal is priced on belief. Next time: Netflix signed a deal to buy Warner Bros. Twelve weeks later, it walked away with two point eight billion dollars for losing. How does a signed deal get beaten? Subscribe so you don't miss it. And tell me in the comments: which deal should we break down next? This is How Deals Work.