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Internet Business Models


This paper consists of an abstract, executive summary, a main paper, and footnotes. A plain text file of the entire document may be downloaded. Comments are requested and should be sent to the author at dyurman@world.std.com.


Main Paper

What is the business model for profiting on the net?

This briefing paper considers the business models and related success factors which favor profitability doing business on the Internet. It addresses four areas:

Mass Markets

Perhaps the best metaphor to describe Internet business is that it is like the California gold rush of 1849.[1] A wave of entrepreneurial start-ups have entered the field, but all are struggling to find the gold. The miners are going broke while the saloon and general store owners, and the brothels, are prospering. The suppliers of technological infrastructure, network access, and software are making money. For example, Spring, MCI, and some of the 'Baby Bells,' are profiting from selling Internet connectivity in bulk to local Internet Service Providers (ISPs). However, developers of WEB sites, the suppliers of online content and merchandising, are not. They are still struggling to transform costly test marketing efforts into money-making businesses.

No one is sure how many people use the Internet from home PCs. The most authoritative survey, conducted by a business unit of Dow Jones, estimated approximately 10-20 million users in 1996.[2] A.C. Nielsen, which monitors television viewing, conducted another study which estimated 11.5 million people use the Internet from home PCs. Perhaps the most important numbers are those which estimate intensity of use. Only 16% of all users self-identified themselves as heavy users, e.g., more than 20 hours per month or using the Internet at least once each 24-hour period. Another 20% consider themselves as regular users, e.g., between 5-20 hours per month or using the Internet at least once a week. This leaves a staggering 64% who use their Internet accounts less than five hours a month. Most of that use is for email.

The significance of these numbers for online merchandisers is not good. Not much shopping is going to be done by 6.4 million people who spent less than five hours a month in the medium in which advertising are spent to sell products or services. The average American spends more time watch TV than surfing the Internet.

Even successful niches, such as online travel reservations, have run into problems. There are hidden costs of directly interacting with consumers online. Airlines have discovered that eliminating the travel agent and allowing customers to use the Internet to make reservations online has quadrupled their customer service costs. These functions used to be performed by travel agents. Clearly, the lure of the Internet led at least one industry to re-calibrate its cost models.

In terms of media content or merchandising on the Internet, the current success factor in mass markets is to tap subjects of passionate interest to a group of users who are characterized by three qualities. First, they are "early adopters" or the "early majority" of new technologies. Second, they are not price sensitive about what they spend online. Many purchases are recreational rather than necessities. Third, their subject areas of interest are lifestyle choices which may approach obsessions. As it turns out, 60% of the people who fit these qualities are upper-income males. Not surprisingly, the two kinds of Internet WEB sites which are making the most money are those which sell either sports or sex as media content and merchandise. While profit figures are closely guarded, two high profile examples described below provide some insights into the sales picture.

    Sports
    Starwave, a Seattle-based Internet Service Provider (ISP), offers a service called "Sportszone" and has, since the start of 1996, signed up 40,000 subscribers who pay $5/month as a base or entry fee for professional sports box scores and related information. Other subscribers pay additional fees for more robust levels of access to sports information. The service is successful, media analysts say, because it offers big niches, e.g. baseball, football, basketball, and other sports, plus infinite salami slices of each niche to people with different sports interests. Each slice can be marketed and priced to fit its niche. The firm is reporting revenues this year of approximately $4 million. Initial investment in the firm has totaled $60 million so far, primarily from Paul Allen, the billionaire co-founder of Microsoft Corp. Other partners in the business are ESPN, a cable TV sports network, and the Walt Disney Company. Online sports appears to be on its way to being a big business.

    Sex
    Adult entertainment on the Internet is expected to generate nearly $52 million in revenues in 1996.[3] This is the third largest sector of Internet sales surpassed only by the travel services and computer hardware and software markets. It is estimated to be the second most profitable after sports. Early adoption of the Internet for access to sex-related information and merchandise follows similar trends for other technologies such as the video tape player and subscription to cable TV channels. Adult content sites on the Internet have been among the first to use technologies enabling secure transactions with credit cards via computer.

    An example is Playboy magazine which adopted a two-tier pricing structure. As the 11th most visited site on the Internet, or 123,000 users per day, it offers some free areas, a base fee of $7/month for access to current information, and then higher prices for access to a vast archive of previously published material.[4] The company will not say how many visitors a day are paid subscribers. So-called "blocking software," which has generated its own market of products designed to inhibit access to "smut sites" sites, does not seem to have affected Playboy's online sales. The company says its Internet site is getting five million "hits," or visits, a year.

WEB Merchant Sites by Industry Type
The 1996 estimated revenues of $518 million for online merchandising, according to Forrester Research, breaks down as follows. Computer products and travel are expected to grow substantially in terms of total revenues while adult entertainment is expected to decline over the next four years as a percentage of total online sales.
Industry Percent
(rounded)
Computer Products 27%
Travel 24%
Adult Entertainment 10%
Apparel 9%
Gifts/Flowers 9%
Food/Drink 8%
General Entertainment 7%
Other 7%

Business to Business Markets

The most significant growth in Internet marketing and profitability will be business-to-business sales.[5] Business-to-business sales are expected to reach $7 billion by the year 2000 according to Forrester Research of Cambridge, MA. The total Internet market, including all forms of public access, may be worth as much as $30 billion, by the year 2000.[6] This implies that one-third of all businesses and one-quarter of all households will have some form of Internet access and will use it for online commerce. Additionally, approximately 60% of current privately held electronic data interchange (EDI) business services will shift over to use of Internet technologies in the next four years. However, private business use of leased lines over public data networks, such as Sprint, AT&T, MCI, etc., may still dominate the telecommunications market in terms of total revenues.

Much of this transition will occur as a result of companies already providing EDI services making the necessary investments to provide Internet services to their customers. However, it could be an additional one-to-three years before digital IDs, which will allow authentication between buyer, seller, and their financial institutions, become widespread. A successful business model involving use of Internet technologies must do four things.

  • Unequivocally identify the customer, the business, the product or service, and the financial means of exchange of money for goods and services through secure means.
  • Provide fast, robust, reliable network technologies to carry out and keep track of all aspects of the transaction.
  • Integrate the Internet-based transaction with other information used by the customer and the business, e.g., checking or credit card account on the customer side and the usual accounting system functions on the business side.
  • Link shipment of the goods to the customer with inventory and production control systems in the business.

For these reasons it is unlikely that companies providing Internet access to mass consumer markets, such as Compuserve or America Online, will be able to deeply penetrate the business-to-business markets if they continue with their current marketing strategies. An additional barrier is that "peak" events like national elections flood the Internet with casual users who are looking for information, but few of them are willing to pay extra fees for it. The flood also bogs down allocated bandwidth causing problems for those seeking to access commercial sites.

    Federal Express

    One company which has overcome these challenges is Federal Express. It uses a proprietary authentication scheme embedded in software it distributes to online customers. So far, 450,000 Federal Express customers use the system. The company is successful because it has mastered all four steps in the online transaction chain.

    1. Acquiring customers,
    2. Validating the ability of the customer to pay,
    3. Executing secure transactions,
    4. Delivering goods, services, and customer support.

    The company enables customers to complete the entire shipping function from their office or home office PC.

    • The user enters a valid FedEx account number and other required information.
    • Then the user enter the shipping information
    • The user's laser printer completes a label including bar code information for tracking the package
    • The user selects a schedule option for package pickup.
    • Billing information is uploaded at the completion of the transaction.

    This service is available for U.S. domestic addresses. Canadian and international shipment options are expected to be added next year. Federal Express would like to go to the next step in a secure online transaction processing, which is to drop the requirement to manage software at the customer's site. To do this it must imbed digital cash technologies in a WEB site which can handle industrial strength online processing, database updating, and inquiry response.


    Chemical Industry

    The chemical industry has closely watched Federal Express's success and plans to implement similar arrangements for business-to-business sales.[7] In May 1996 a number of firms announced plans to adapt electronic data interchange (EDI) transactions with key clients to reach a larger customer base more inexpensively and easily. Internet technologies, including email, WEB sites, and file transfers, will be a part of the strategy.

    Chemical companies are turning to the Internet's open technology as a way to cut costs by eliminating more costly proprietary electronic data interchange protocols. A key strategy is to strengthen relationships between distributors and end-users of chemical products. This strategy has four major pieces.

    • Provide Internet access for producers, suppliers, shippers, distributors and customers.
    • Establish WEB sites or other Internet software interfaces for data acquisition for each transaction type, e.g., order, shipment, payment, etc.
    • Integrate Internet transactions with other information systems within each user's company, e.g. accounts receivable, accounts payable, sales management functions, etc.
    • Establish just-in-time production scheduling to inventory requirements to sales and use.

    Barriers to the transition to Internet use by chemical companies include managers who do not have the technical expertise to understand the changes required or who are afraid of unknown risks which might be associated with new ways of doing business. Some companies, like Shell Oil, are concentrating just on intranets, that is, internal networks among business units and organizations which are focused on internal company processes. Reliability and security of Internet technologies continue to be the biggest questions chemical companies have when it comes to adopting the Internet as a basis for transacting business externally. As a result, many firms still rely on proprietary commercial networks for transfer of time-critical business information.

    Paying for Class of Service

    Some chemical companies are adopting Internet technologies within private networks to insure reliability and security of electronic data interchange. This is giving birth to new classes of service privately financed entirely by those using them rather than by a broader base of public Internet providers and users. For instance, the petroleum industry is building its own network, dubbed Aries, which will be used to exchange massive amounts of scientific and commercial information.[8] The Aries network is being defined as a "mission-specific" network. Amoco Oil Company indicates that it needs to move data at ten times the speed of normal Internet traffic and is willing to pay for that capability because of the time-based value of its information. This is a model for other industries.

    In another example of Internet technologies being adapted to proprietary electronic data interchange systems, the auto industry has developed links with its suppliers for exchange of very large graphics files used in computer-aided design of car parts. For instance, Ford plans to connect all 11,000 of its suppliers using this approach. In turn, these electronic drawings are linked to the auto companies' internal computer- aided manufacturing systems. These networks hang off the net, and are linked to it tangentially, but their main benefit is that they are very fast, dedicated, secure resources designed to meet specific needs of an industry group rather than the diffuse needs of mass consumer markets. Companies have indicated they are willing to pay for premium priced data transmission because they can measure the time-based value of their key data sets.

    The business models being adopted by the chemical and auto/truck manufacturing industries may have the potential to be successfully transferred to other industries such as food processing

    Integrating the Internet with Other Business Information Systems

    Vincent Cerf, who is widely recognized as one of the founders of the Internet, sees electronic commerce unfolding on the Internet in three phases.[9]

      1st - computers are connected to each other. That's already happened

      2nd - people get connected to information. Much of it is free. Some of it is useless. Much of it is corporate identity advertising.

      3rd - the interconnection of business processes - inside the company and between organizations - takes place. This is where the largest multipliers in terms of value are expected to be found.

    Growth in the third phase is expected to occur in a non-linear fashion. Growth in electronic commerce, Cerf says, will be exponential. Electronic publishing may be one industry which benefits early on from this growth. The arrival and use of online digital cash will be key to its success. Digital cash, which will allow electronic transactions for pennies that cost dollars when handled physically, may open new opportunities to protect and sell intellectual property on the net.

    A vast conglomeration of Internet technology and service providers are competing for what appears could eventually be a $30 billion market. This include long-distance telephone giants, regional baby-bell companies, cable TV operators, satellite firms, wireless telecommunications service providers, Internet service providers, and even power companies. The goals of all of these companies are essentially the same - to sell the customer, be it a business or household, a "bundle" of telecommunications services, to provide one-stop shopping, and to secure that customer's business for as long as possible, perhaps for life. This strategy is designed to achieve maximum profits as customers sign on for more and more services over time. By offering as attractive a "bundle" as possible to customers, firms hope customers will not go bargain hunting for individual services.[10]

    The primary target of companies offering the "bundle" is the mythical "power user," a business or individual who will likely rack up $300 or more in long distance phone calls, cable, Internet, entertainment, and other telecommunications charges per month. Profits will go to the provider who can cram the most services into the bundle and market it to the biggest users. The change in marketing strategy is from communications companies that sell individual services to all customers to one that sells a broad, interrelated group of services to a preferred set of customers. This may lead to electronic "red lining" of rural and economically depressed areas.

    While $300 a month is a threshold figure for the preferred set of customers, service providers hope they will find many users who will push use to much higher levels. It is important to note that the "bundle" includes a collection of services which provide "content," such as entertainment/ cable TV, etc., while other services involve simply offering a carrier to bring to user to third parties, such as Internet ISPs like Sportszone.

    Typical Annual Bundle of High Value Services
    Value Description
    $ 675 Cellular Telephone
    $ 525 Local phone service
    $ 425 Long distance service
    $ 425 Home entertainment
    $ 400 Cable TV
    $ 350 Paper news subscriptions
    $ 275 Pager service
    $ 250 Internet online service
    $3,325 Total

    The Typical Bundle

    A typical high-value residential user might spend as much as $3,000 to $3,600 a year on information services.[11] The major service providers will try to minimize the damage of hammer and tong competition by adding so many valuable services to a "bundle" that the consumer will be loath to bargain hunt for services one at a time. Current values for services supplied to households show Internet services sit at the bottom of the list in terms of annual revenue compared to other communications services, especially those with wireless components. It's clear that just selling Internet connectivity is not going to be a big business in the eyes of the major public data networks like AT&T, Sprint, and MCI. Selling products and services over the Internet offers more robust revenue opportunities, but these are still in the future.

    Wireless Networks

    Wireless networks may offer the best near-term opportunities for Internet commerce. They don't need the huge capital investments of land lines. The services are so proftable that some companies give away the end-user device, such as cellular phone or pager, in return for the committment by the customer to use the service over a year.

    Wireless networks are proliferating rapidly, going digital and harnessing "intelligent networks" technologies to locate and identify roaming customers and to tailor the services they receive to meet their needs. Wireless networks focus delivery of services on portable devices which can have deskbound links to Internet services. For instance, a digital cellular phone may tie into an outbound sales associate's fax, email, and voice mail services from the office as well as providing point-to-point communications with prospects and customers.

    The growth of the wireless market has increased pressure on regulatory bodies to allocate more spectrum and on service providers to use spectrum more efficiently by converting from analog to digital technologies. Compared with their analog counterparts, digital systems can both expand the capacity of the medium and compress the data stream it carries. Once wireless service providers switch to digital, they can further increase the number of customers served by compression techniques, which are improving steadily. Even the boost from present digital standards and compression techniques may prove insufficient to provide enough room to pass data-intensive messages among millions of customers.[12]

    Managing the User Interface

    Competition for the wireless spectrum will become intense as applications in portable, personal digital assistants (PDAs) deliver and send wireless voice, email, data files, and faxes to and from cellular devices. As the robustness of wireless services increases, a problem with user interfaces will arise. The smarter the device must be, the greater the risk its complexity will baffle the user. A solution is to place the intelligence on the network and keep the end-user devices relatively simple. Proposals for the so-called "network PC" incorporate this idea. Industries who want to use wireless technologies to communicate across value-chains, e.g., from producer to supplier to distributor to end-user will have to develop industry-wide standards for data interchange.

    Precision Agriculture

    A key business model which offers enormous market opportunities is to use a specific set of applications of information technologies as an anchor which produces benefits upstream and downstream for an industry's value chain. For instance, precision agriculture can be used to tie together suppliers of agricultural chemicals with producers allowing data analyses from the farmer's fields to drive just-in-time production and inventory control procedures for delivery of fertilizer and pest control chemicals.

    At the other end of the production cycle, for example, assuming the crop is potatoes grown for processing into fast food french fries, real-time yield monitors at harvest can be transmitted to food processing factories, using wireless technologies, to plan for purchasing of commodities such as corn oil and salt; labor force hiring, refrigerated rail car scheduling, and sales marketing systems with distributors and customers.[13]

    Market Outlook

    A problem with advanced wireless services is billing. Every company wants to be the one that bonds with the customer and collects not only the fees, but also use information that leads to new business opportunities. Because there will be multiple providers all trying to reach the single multi-function PDA carried by the customer, industry-wide standards for data interchange and data compression will be very significant. A company that chooses a proprietary standard may find itself blocked from market entry for lucrative services as a result of differences between its technology and the industry standard. Network-embedded intelligence will have to handle the billing to multiple service providers accessed by the customer from a single device. Opportunities exist to pull together industry experts, computer and telecommunications manufacturers, and end-users to develop data interchange standards.

    Price wars are expected to cut the cost of the "bundle," including wireless services, by as much as 50% over the next decade allowing them to compete head-to-head with the wired world of the Internet. This effect will be felt primarily in business-to-business sales. Internet access for households is unlikely to be a big business for at least the next three-to-five years, or at least not a very profitable one outside of a few key niches, including advertising. There will be an endless supply of opportunities to lose money.


Online Banking

Electronic cash is the essential transaction token needed to make commerce possible over the Internet. The success factor is for banks to adopt some form of digital cash technology. So far, few banks and even fewer consumers have stepped up to the challenge. The reason appears not so much concerns over possible fraud, but rather that digital cash does not appear at this time to offer banks greater profitability than their current mode of doing business. For their part, consumers have not apparently found any great bargains, or interest rates, by banking electronically rather than with paper checks or plastic credit cards. This is reflected in the relatively low levels of market penetration by online banking in consumer markets. For instance, Security First, a major Chicago bank, has only 20,000 of its 650,000 customers using online services for routine transactions.[14] Other banks who have entered the market report similar low levels of consumer response.

Electronic cash could lead to new kinds of transactions, especially in the area of electronic publishing. For instance, the major costs of publishing a daily newspaper or weekly magazine are labor, paper, printing, distribution, and mailing. The Wall Street Journal has begun to offer an electronic version of its paper for just $49/year compared to a subscription rate of ten times that amount for hard copy delivery. Huge cost centers disappear for an electronic edition. This suggests digital cash could be used to purchase intellectual property for pennies per transaction.[15]

A dark side of digital cash is the possible abuse of the anonymous nature of the Internet. Mastercard currently experiences a fraud rate of $1.49 per $1,000 in revenue.[16] By comparison, cellular phone companies experience a fraud rate of nearly $20 per $1,000 revenue. Whether criminals would produce lower or greater losses for online banking is hard to predict, but the threat is real. A more significant potential threat related to digital cash is the prospect of unparalleled activity in the area of money laundering. Digital signatures may create as many problems as they solve. Those who seek anonymnous transactions for money exchange will always be challenging the wavefront of industry standards. The U.S. government has not yet found an acceptable method for preserving law enforcement interests while balancing the ordinary consumer's right to privacy against the threats of new forms of criminal activity.

U.S. Banks also know they have another problem. IBM and more than a dozen banks announcing the creation of a national online banking network in September 1996. These banks are positioning themselves to set their own standards for digital cash. This is to prevent software giants like Microsoft from doing it for them, or to them.[17] The service planned by IBM and its 15 banking partners will offer customers the ability to pay bills, get account status information, and conduct other financial transactions from home or office using a personal computer.

The system, code named "Integrion," is designed to insure control of payment systems remains with the banking industry. Microsoft and other software developers have not yet committed to making their online banking products compatible with IBM's network. Further Integrion is not part of the Internet, which IBM feels is not secure enough to support online banking. While major credit card companies have agreed on the designs of what they believe are secure Internet protocols for online banking, no one is sure they will work once in operation.

At stake for the banks is the prospect that traditional geographic territories for banking will be blown away by the virtual nature of online transactions. A consumer in Idaho could manage his money market account in Boston, a checking account in Pocatello, and have his mortgage written in Dallas all as a result of online shopping for the best rates. Another major stake for banks is cutting costs. A deposit handled by a bank branch teller costs $1.07. The same deposit handled by an ATM costs about $0.26, but an online transaction involving no paper, e.g. direct deposit or direct payment, costs only $0.03. Whether banks will pass some of these savings on to consumers in the form of lower fees or better rates remains to be seen. There is mounting consumer resistance to ATM-based fees because they know banks are using them as profit centers rather than passing on the cost savings to customers as new forms of competitive value.

Industry analysts believe that the total number of customers conducting online banking will shift from the tens of thousands in 1996 to perhaps as many as one million in the next four years. As many as 500 banks or consumer market oriented financial institutions may offer some form of online banking by the year 2000. This will happen only if online banking offers new value to customers they cannot obtain offline.


Online Advertising

Is "interactive media" going to enhance or replace traditional advertising? Bran Ferren, chief scientist and a vice president at Walt Disney Company, doesn't think so. Given Disney's expertise in image management and experience with graphics, both chief elements of the Internet, his opinion may be decisive in the near-term. Ferren says most current forms of interactive media used for advertising are "terrible" in design, organization, and cost.[18]

Even if these barriers are overcome, there's another waiting in the wings. It's called "limited bandwidth," and refers to the capacity of copper wires connecting peoples' homes with the Internet to carry information. Even the fastest modems for PCs still carry data at one-300th the speed of a direct Internet connection. The effect of this limitation is that graphics take a long time to load on the home PC. Some consumers have likened the wait time for loading graphics, with regard to electronic commerce, to the wait time of standing in line at the checkout stand. This is not a positive metaphor in the eyes of online marketers.

Net-based advertising has mostly been for the computer industry itself. Nearly two-thirds of WEB advertising revenue is computer related. Yet, office equipment accounts for less that two percent of all advertising revenues nationwide. While some sites may be making a profit individually, total net-based profits from advertising may be as a little as 0.1% of the national total.

This is an industry which is still in its infancy. In some cases, spectacular failures, like the IBM/Sears venture called Prodigy, may be symptoms of premature commercialization. Prodigy was supposed to rely on advertising embedded in email and other online services as a way of buying down the cost of building a mass consumer medium through an online service.

Are there any business models which work for online advertising? There are four generally agreed upon ways people can make money.[19]

  • Sell subscriptions to online services

    Don't offer any content. Basically, this means offering a wire connection into the Internet. Many Internet Service Providers (ISPs) do just that, e.g, sell connectivity at $20/month for unlimited use. It's up to the end-user to find and use or pay for content from third parties. This is a commodity priced business.

  • Sell connectivity and content.

    This is the model used by Compuserve and America Online. The intention is to sell enough value added services to make money, e.g. travel, stock transactions, online banking, etc. So far, the model hasn't worked. Neither service is profitable. The stock market pounded both companies as a result of recent earnings reports.

  • Give away information, but sell enough ads to cover costs.

    In the first six months of 1996 total Internet advertising was estimated to be $71 million. Compare this to the national total of $87 billion for all other forms of advertising revenue for the same period. Further, nearly two-thirds of all Internet advertising revenues was soaked up by just ten WEB sites. No one has a handle on Internet demographics, a key to selling advertising space.[20] These include sites run by CNN and Ziff- Davis Computer Publications, two market leaders in Internet-based advertising. Some advertising agencies are forming networks of sites to try to get the raw numbers up, but they still lack demographics.

  • Sell products to targeted niches.

    Examples of WEB-based sales which have worked include sites selling vintage wines, books, condoms, music CDs, high-tech toys, and stock market performance data. Most of the profitable sites are plowing their earnings back into the business. Visions of cheap entry into a cottage industry of an Internet-based mail order businesses have given way to hard edged reality. A WEB site can cost as much as $50,000 just to bring up the catalog, data entry screens, and online functions necessary to take orders. That doesn't include costs for actually buying inventory, shipping it, and operating other back-office functions.[21]


Conclusion

Successful models for developing businesses on the Internet are still in early stages of development. Companies which want to succeed in the long run will not be swayed by hype or fads. Companies which want to sell profitably on the Internet must find ways to capture and use demographic data which describes the market. Consumers and companies will do business on the Internet when products and services are available there, with prices and customer service to match, which are not available anywhere else. These products and services must offer value to the customer which they cannot find offline.


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    PERMISSION TO COPY

    This paper may be copied for non-commercial purposes, classroom use, or reproduced on WEB sites so long as it is 100% intact with author credit, citations, and text. The preferred citation for this paper is:

    "Internet Commerce; Emerging Business Models," Dan Yurman, dyurman@world.std.com, P.O. Box 1569, Idaho Falls, ID 83403, December 11, 1996. Electronically published on the Internet.



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