Free for All : Eager to Boost Traffic, More Internet Firms Give Away Services No-Charge Policy Has Users Flocking to Egreetings; Will Revenue Follow? `Spoiling' Another Industry

07/28/1999

SAN FRANCISCO -- A year ago, Egreetings Network Inc. was hawking e-mail birthday cards for 50 cents to $2.50 apiece and struggling to find customers. Then, the company took an ax to its pricing strategy.

Plenty of other fast-growing companies are committing similar forms of pricing suicide in cyberspace -- and then declaring they have cleared their path to success. Want to receive a fax? Open an Internet account? Collect your voice mail, make a long-distance call, listen to music or read commentary by prominent writers? Nocost versions of all these services are popping up on the Internet, to the consternation of established rivals that believe in charging for their services.

"Time and again, do-it-for-free companies are coming in and spoiling an industry for everyone else," says David Cowan, a partner at Bessemer Venture Capital, Menlo Park, Calif. "But it's a fact on the Internet: People expect a lot of things for free. And if you don't give it away, some other start-up will."

Like many venture capitalists, Mr. Cowan scoffed a year ago when entrepreneurs wanted him to finance start-ups that involved giving away the store. Now, he has two such companies in his portfolio. No-charge business models may make sense on the Internet, he says, if companies can do two things right. They need to build huge pools of users without spending much. Then, they must turn those audiences into paying propositions by raking in advertising dollars or nudging users into online commerce.

A handful of Internet pioneers have shown that this strategy isn't quite as crazy as it sounds. Yahoo! Inc. doesn't charge for its Internet directory service, yet the company, which had second-quarter revenue of $115.2 million, has attracted enough users and ad dollars to command a $29.7 billion stock-market valuation. Netscape Communications Corp. decided a few years ago to give away its Internet browser, and despite some bumpy moments, was acquired by America Online Inc. earlier this year for $10 billion. And Hotmail Inc., which provides free e-mail, was bought by Microsoft Corp. last year for $400 million.

Such companies were able to woo millions of users in a matter of months, without spending serious money on factories, showrooms or sales forces. That's the charm of the Internet, says George Zachary, a venture capitalist at Mohr Davidow Ventures, Menlo Park, Calif. The marginal cost of adding another user is practically zero. The catch, Mr. Zachary says, is that the companies must scramble for revenue to cover the fixed costs of building Web services in the first place.

In the current free - for - all , it's far from certain that many competitors will succeed. Of the $1.9 billion spent on Internet advertising last year, 10 companies garnered nearly 70%, and their share has been steadily increasing. That leaves thousands of smaller businesses to fight for the crumbs, amid signs that more Web surfers are tuning out ads or installing ad-blocking software. Furthermore, while Internet commerce is growing fast, it isn't clear whether users of a free Web service will stay there to do their shopping.

Nonetheless, many entrepreneurs can't resist the temptation to abolish prices, gambling that rapid user growth will pay off down the road. NetZero Inc. of Pasadena, Calif., is less than a year old, but 1.2 million people already have signed up for its no-cost Internet-connection service. That's in line with the subscriber totals at Mindspring Enterprises Inc. and Earthlink Network Inc., two long-established companies that charge about $20 a month for Internet connections.

NetZero isn't remotely profitable now. But it recently filed plans for an initial public offering, and it is betting that advertising dollars will fill the revenue void created by its no-charge policy. NetZero's Internet browser comes with a special advertising window that is engineered to prevent users from disabling it. That permits the company to bombard its Web surfers with paid messages no matter where they go on the Internet. Already, eBay Inc. and others are buying those ever-present ads. The company's prospectus doesn't disclose its rates, but Internet banner ads typically cost $10 to $40 for each 1,000 times the ad is viewed.

Rivals are watching NetZero warily. "I don't believe they can offer the level of customer support that we do," says Erika Jolly, a vice president at Atlanta-based MindSpring. "As a user, I'd rather pay someone $19.95 a month to take care of my problems." But she says the competitive pressure, which remains intense, already has forced Internet service providers to cut their prices.

In other markets, companies that once charged for their services now say they do better with a give-it-away approach. Take Slate, an online magazine owned by Microsoft. For close to a year, it offered only a tiny slice of its content at no cost, trying to coax its nearly 400,000 monthly visitors to paying $19.95 a year to see the whole magazine. As of February, only 28,000 people had subscribed.

"It wasn't working," recalls Michael Kinsley, the magazine's editor. "We were spending 90% of our time on content that hardly anyone saw." Even worse, visitor traffic was too sparse to attract many advertisers. So, on Feb. 12, Slate slashed its online price to zero. Traffic doubled within six weeks and kept climbing, reaching nearly one million visitors a month in June. Meanwhile, advertisers such as First USA and Intuit Inc. stepped up their spending, lured by the higher readership.

Abandoning subscription revenue defies a deeply held belief of print publishers: that advertisers chiefly want to reach paying readers. In fact, Dow Jones & Co., publisher of The Wall Street Journal, charges for most of its online content, partly because it believes that such audiences are more valuable to advertisers. Among other financially oriented Web sites, MarketWatch.com Inc. is free of charge, while the Street.com Inc. charges users $10 a month.

But on the Web, ad sponsors can use sophisticated audience-measuring techniques to make their messages work every bit as well on free-of-charge sites, says Slate's Mr. Kinsley. What's more, he says, a free site is more likely to attract the millions of people who flit from one Web site to another.

Slate's publisher, Scott Moore, doesn't dispute industry chatter that the online magazine isn't yet profitable. Nonetheless, he says: "We're a world ahead of where we were six months ago."

In the music industry, the Internet is making it possible for digital versions of songs to whiz around the globe, free of charge. Traditional recording labels view the trend with dismay, fearing that it could undermine sales of packaged music. But a handful of Internet start-ups are championing free music downloads, hoping Web-site advertising, CD sales or marketing of consumer data will sustain their businesses.

One free-download company, MP3.com Inc., San Diego, became a stock-market darling when it went public earlier this month. MP3, whose catalog of 18,000 performers tends toward obscure names like the Adelaide Symphony and the Happy Drunks, had first-quarter revenue of just $665,000. But investors are betting that the company's brisk traffic -- 10 million downloads in June alone -- is laying the foundation for success. At MP3's current stock price of $44.50, the company is valued at nearly $3 billion.

The Internet also is shaking up the fax business. No longer is it necessary to pay toll charges to transmit faxes via long-distance voice lines owned by giant phone companies. Now, swarms of smaller companies such as e-Fax.com Inc. are offering competing fax services online. Their messages travel over the Internet as digitized packets, with delays of as little as 30 milliseconds, a time lag users seldom notice. The services, whose operating costs are next to zero, charge nothing for making or receiving a fax, or sometimes both.

It isn't clear how much of a business the upstarts can build this way. One company, Fax4Free.com Inc. of Los Angeles, tried to generate revenue by adding ad messages to the sides of users' incoming faxes. That alienated law firms and other prestigeminded users. So, Fax4Free said about two weeks ago that it would get rid of the ads.

But free Internet faxes could be a serious challenge to long-distance carriers such as AT&T Corp., says Brian Adamik, an analyst at Yankee Group Inc., Boston. He estimates that fax traffic accounts for 10% of domestic long-distance calls and as much as 30% to 40% of international volume. "That's been a fat market," he says, "but carriers need a strategy to address the Internet." An AT&T spokeswoman says her company, which has made major acquisitions in cable television and other areas, is greatly reducing its reliance on long-distance revenue.

Eventually, Internet analysts say, the no-charge trend could shake up businesses as disparate as stock-trading and photofinishing. Some online brokerage firms already charge commissions as low as $8 a trade, and there is speculation that brokers eager to get margin-account interest may some day slash their commissions on certain simple trades to zero. Meanwhile, the ability to e-mail photos and process them with image-manipulating software is making it easier for people to match photo-shop services on their computers, at little or no cost.

One innovative attempt to make a nocharge business model pay off is occurring at Visto Corp., Mountain View, Calif., which markets online planning and messaging services for businesses. Late last year, it discovered that plenty of people were interested in the bare-bones, free version of the service, but hardly anyone wanted to pay $9.95 a month for a premium version. So, it switched to a give-it-away business model -- and began negotiating revenue-sharing agreements with companies such as Nokia Corp. of Finland, which has entered a deal to make Visto available over its cell phones.

People who use Visto's service through a cell phone are likely to run up bigger monthly calling bills, explains Douglas Brackbill, Visto's chief executive officer. While that doesn't immediately benefit cell-phone makers like Nokia, it can become an important factor when wireless network operators decide which new phones to promote to their customers. As a result, Mr. Brackbill says, the more free users Visto signs up, the more valuable a partner it can be.

Much of the current free-of-charge mania stems from a belief that Internet companies don't have much time to build up a big user base, says Stewart Alsop, a venture capitalist at New Enterprise Associates, Menlo Park, and a Visto director. Giving away the product is a way to get users in a hurry, rather than slowly recruiting paying customers.

But this new approach only makes sense long-term, Mr. Alsop says, if Internet entrepreneurs can find a way to extract lasting value from their user relationships. That means either delivering a lot of paid advertising or getting a share of some commerce revenue from those users.

The online greeting-card business may be an early proving ground for the merits -- or folly -- of this new approach. The market leader is Blue Mountain Arts Inc., Boulder, Colo., which has never charged for its online cards. It attracts tens of millions of visitors a month, says Jared Schutz, the company's managing director. He declines to discuss the finances of the closely held company, except to say: "If we're losing money, we're losing a lot less than other people."

Mr. Schutz says he is proud of his company's huge public following and cites its impact on competitors. Not only did San Francisco-based Egreetings stop charging for online cards, but Hallmark Cards Inc. says it is re-examining its online pricing. Hallmark earlier this year cut its Internet prices to $1.50 a card from $2.50, and offers a limited selection of free cards.

Yet as Mr. Schutz surveys all the companies trying to make money by giving services away over the Internet, he says: "The current models aren't self-sustaining." The indirect revenue available doesn't seem sufficient to support all the new sites. "That could change if there's more advertising or more purchases online." But as long as venture capitalists and the stock market keep shoveling money at Internet businesses, he says, entrepreneurs are going to try ever-more daredevil approaches to build a business.