Convergence of business models.

Rogers, John W., Jr.

ABSTRACT

This article analyzes e-commerce business models and the costs they incur to build brand awareness and customer loyalty. In the new competitive environment of the Internet with lower availability of capital, these costs represent an important area of weakness for new e-commerce ventures. Some firms have been successful in addressing the issue with the technique of "viral marketing." This approach uses personal relationships and referrals to build affinity groups that support and promote new brands without the costly expenditure of traditional media advertising. The approach capitalizes on many of the same dynamics as direct selling and network marketing -- the leveraging of personal relationships and word of mouth recommendations to build customer awareness and loyalty. The article analyzes the parallels between the widely accepted business model of direct selling, particularly as it has been updated during the 1990s into network marketing, and the new model of e-commerce. It suggests opportunities for e-commerce to learn from and incorporate key features of this well-tested approach to building a brand through personal circles of influence.

Introduction

The collapse of the Nasdaq, beginning in the first quarter of 2000, and the subsequent failure of many dot com enterprises, has called into question the validity and substance of the business model that many of these firms used to launch what they trumpeted as the e-commerce revolution. It also raises the larger question of how businesses will realistically exploit the undeniable potential of Internet technology. Traditional retailers can profitably use the Internet as a new channel to build incremental volume.

Mass merchandisers like Walmart and Sears who operate across a broad product range, as well as focused marketers like the Pottery Barn, L. L. Bean and the Gap have all built powerful "click and mortar" business models that supplement and complement sales in stores and mail order. The Internet has also proven to be a powerful tool in supply chain management for firms selling to the corporate B2B market. But the heart of the e-commerce Revolution -- using on line sales to replace traditional marketing channels at a lower cost, with more customization and higher levels of customer convenience -- has not produced a business model that allows firms to translate Internet productivity into profits. Technology empowers consumers with a much broader range of information and gives firms access to more consumers at dramatically lower cost and higher frequency. But, until it generates profits as well as page views, the Internet will not realize its potential to improve lives. No profits, no progress. The quest for a viable e-commerce business model is in full swing.

This paper analyzes the current, first generation business models used in e-commerce, considering them from a micro-economic viewpoint. Why has the rapid growth of on line marketing -- approaching one trillion dollars in the United States and projected to double by 2004 -- generated little or no profit, even for the market leaders? It is necessary to look at the cost of attracting customers and, more importantly, of securing repeat business. The structure of the market, the experience of the first generation firms competing in this market, and the basic cost dynamics are key to uncovering the weakness of this dot com business model. By comparing the dot com experience with other industries where technology has taken off rapidly, and with other marketing plans, the paper seeks to shed light on other approaches to entrepreneurship and business building that may have relevance to e-commerce.

The market structure of the Internet economy approaches the economic model of perfect competition, characterized by low barriers to entry (and exit) with a consequent proliferation of firms and products, rapid diffusion of knowledge to both consumers and competitors, low product or service differentiation and brand loyalty. In this market structure, intense competition tends to strip profitability from even the most successful firms, and eventually to undermine their commitment to innovation as they struggle to make ends meet in the short run with fewer resources left over to plan for the long run.

A classic case in point is Amazon.com. Despite its market position and undisputed reputation for excellent customer service, Amazon has failed to achieve profitability and faces pressure to reassess its entire approach to business. A major challenge for all E-commerce firms is building brand recognition and translating this recognition into a stable and loyal customer base. So far, the expense of attracting and retaining customers has eaten away at more profit than most firms have been able to generate with rapid sales growth.

One promising response to this challenge lies in a business model established more than a generation ago in a similarly competitive business environment. This model of direct selling -- more recently known as network marketing -- is seldom taken seriously by professional marketers, but continues to deliver results and has shown remarkable ability to reinvent itself, to satisfy the needs of a new generation of consumers, and to accommodate new technologies and product concepts. From the door-to-door and home party approaches of the 1940s and 1950s to the sophisticated network marketing models of the early twenty-first century, the direct selling industry has evolved and prospered in the United States and has pioneered entry to international markets. Most importantly, this model offers some prospect of securing customer loyalty and defending profit margins against the ravages of competition in a market that is otherwise characterized by little differentiation and rapid migration of customers. The convergence of business models -- between e-commerce ease of use and access on the one hand, and customer loyalty in rapidly multiplying relationship driven networks on the other -- may prove a useful approach to the specific problems of selling over the Internet, while generating the level of profits needed for sustained growth and innovation.

The E-commerce Revolution and Its Business Models

The rush of entrepreneurs and established enterprises to exploit the potential of the Internet "gold rush" has given rise to a profusion of innovative business models and radically different approaches to competitive strategy and market positioning. It is also causing companies whose present businesses are threatened in one way or another by e-commerce approaches to adapt their business models and strategies to the new environment (Ghosh, 1998). In the most revolutionary business model, retailers sell products at cost and make money by advertising on their Web site. Others operate a Web site only for marketing and selling, and disaggregate their supply chain, including outsourcing distribution and warehousing service (Timmers, 1998). Because shelf space on the Internet is unlimited, a broad, "one-stop shopping" strategy like that pursued by Amazon.com has the appealing economies of helping spread many one-time costs over a wide number of items and a large customer base. In contrast, many e-tailers have adopted classic focus strategies by building a Web site aimed at a sharply defined target audience shopping for a particular product or category -- from toys, to medicines, to sporting goods, or baby apparel.

Whichever business model and strategy the e-commerce firm chooses, it must confront the exciting yet brutal economies of this new market. Entry barriers to e-commerce are relatively low, and the recent dot com shake-out has shown that barriers to exit are similarly limited. Many of the activities compromising the value chains of e-commerce businesses can be outsourced and the software necessary for establishing a Web site is readily available, and the costs of using a Web hosting company are relatively modest. Finally, financial markets, most notably Venture Capital, have made it easier to fund promising new ventures in a climate of investor excitement about the potential of the Internet. In fact, more capital was raised through initial public offerings of stock in the 1990s than in all previous decades combined. (Tapscott, Ticoll & Lowry, 2000). These low entry barriers and ready availability of capital explain why in a short period during the late 1990s hundreds of thousands of e-commerce firms were formed with perhaps millions more to spring up around the world in the years to come (Hamel, 1998).

In this fluid and intensely competitive market, the challenge facing any company seeking to establish its position is the significant outlay required to create brand awareness and draw traffic to its Web site. While many companies pursue traditional advertising strategies -- print, radio and television -- as well as banner ads directed at regular Internet users, the high expense and relatively unpredictable returns call into question the validity of this approach for all but the financially hardiest firms. Another approach that shows promise has so far been used on a largely opportunistic basis. Viral Marketing -- building a network of personal referrals and affinity groups -- is a low cost and potentially high return method for building site and brand awareness, traffic, and repeat business.

It is driven by many of the same dynamics as network marketing or direct selling -- a business model that has been used successfully for a century and developed to high levels of sophistication in the past twenty years. The potential for transferring this approach of personal relationship marketing to the Internet is a fruitful topic of exploration and experiment.

The Direct Selling Model

The use of personal relationships to sell products has been around since time immemorial. However, this approach to marketing only gained formal status in the early years of the twentieth century. By the beginning of World War II, the pioneering companies in this nascent sector of the retail trade had built national sales forces, and perfected a business model that used personal relationships to demonstrate and sell products while compensating their sales people through variable commissions on retail sales and override commissions on the production of personal networks of directly or indirectly sponsored sales representatives. The pioneering firms -- Avon Products, Fuller Brush, Stanley Home Products, Tupperware -- defined the differences between in-store retailing and direct selling, a definition that has been refined since World War II with the growth of many new direct selling organizations. According to John Rochon of Richmont Corporation, a leading spokesperson for this market sector during the 1990s:

 "In a retailing organization, resources are organized primarily to support
 the selling of products in a store where people come to buy them. The key
 to success is being able to attract -- or `pull' -- customers into the
 retail establishment to buy the product. Advertising and promotion `pull'
 the customer to a specific product once he or she is in the store. Once the
 customer is inside a retail establishment, the retailer can begin to `push'
 additional product to the customer." Direct selling, by contrast,
 "by-passes the `pull' phase and goes straight to the `push' phase. Unlike a
 department store that `pulls' customers into the store, a direct selling
 company has sales representatives who, in effect, act as mobile mini-
 stores who initiate the selling occasion by taking the product to the
 consumer." (quoted in Bartlett, 1994, p. 32)

During the period after World War II, the direct selling industry expanded rapidly in the United States and made significant incursions to international markets. A 1989 research study reported on a nationwide consumer survey show that 57% of respondents had purchased a product or service from a direct sales company in the year preceding the survey. Purchasers tended to be younger, more educated, and more affluent than non-purchasers. Convenience was perceived to be the major advantage in purchasing through this channel, while pressure from `pushy' sales people was considered the major disadvantage (Peterson, Albaum & Ridgway, 1989). Since the late 1980s major changes have transformed the industry, moving direct selling to a new model of network marketing. Network marketing retains the same overall approach of non-store `push' retailing, but streamlines the model by eliminating fixed sales territories and creating a deeper and broader `downline' that allows for override commission payments on a much larger volume of retail sales. The result is a more financially dynamic compensation opportunity. At the same time, the model substitutes reliance on selling skills of individual representatives with a simpler and more straight-forward network relationship based on the strength of personal referrals, while reorder takes place through convenient and semi-automatic resupply agreements. High pressure tactics of door-to-door selling and home party demonstration are replaced with personal referrals through a natural circle of influence, using technology to streamline the delivery and reorder process (Laggos, 1998). Thanks to these innovations, the direct selling industry (independent of mail order and on-line selling) has grown steadily since the mid-1980s, reaching $30 billion in US sales and $90 billion in worldwide sales by the year 2000 (DSA, 2001).

An Epidemic of "Viral Marketing"

On the new frontier of e-commerce, start-up companies face the challenge of getting the word out regarding their products and service. Before the technology-laden Nasdaq stock index plummeted, it seemed that the supply of advertising money was unlimited. But spending power has fallen along with dot-com share prices and the mounting doubt among investors in the validity and sustainability of e-commerce business models. Companies and their investors realize the need to exploit other routes to building a brand and a loyal customer base. Some are turning to the rather awkwardly named concept of "viral marketing" to accomplish these objectives.

By offering special deals and discounts to its shoppers and encouraging them to forward the deals to their family and friends, they have seen an increase in traffic much higher than that prompted by magazine or television advertising (Jurvetson, 2000).

Viral marketing "started out as a business-to-consumer tool for mass marketing products such as music, books, and software," according to Kim Brooks, Internet marketing consultant at Bardo-Brooks Marketing, based in Kirkland, Washington. Then its use spread into other fields. About 80% of the companies polled in the 1999 Jupiter Executive Survey reported using viral marketing as their prime tool for reaching out to consumers. This strategy is reported to be the most effective way of drawing Web users to sites. According to Jupiter, more than 90% of consumers said they told at least one other person about a Web site when the original recommendation came from a friend. Experts cite Hotmail as the most successful viral marketing campaign ever. The free e-mail service spent just $50,000 on traditional marketing and still became the world's leading e-mail provider with 75 million users. In fact, Hotmail's founders came up with the term. "It struck us that it was like a virus, said Steve Jurvetson, whose wife, a physician, explained that a normal sneeze releases 2 million particles (Businessweek.com, 2000).

A limitation of this technique is the tendency of people to become "inoculated" to the spread of these viruses. For the method to succeed, companies should benefit if their network is expanded. Therefore, services that depend on a huge network of users, such as e-mail service like Hotmail, benefit the most. However, it becomes difficult to distinguish valid references from "spam" or unrequested junk e-mail. In fact, firms using the viral marketing technique have hired antispam specialists to deal with suspected cases of user spam and fraud. Some have kicked out users for sending marketing messages about the company not just to family and friends but also to entire lists of e-mail addresses posted on community Web sites. For this reason, according to John Deighton of Harvard Business School, while "everyone involved in Internet marketing has thought about it, not everyone has decided to use it" (Ransdell, 2000).

Viral marketing taps into the element of "buzz" -- word of mouth promotion that is recognized by marketers as an increasingly potent force, capable of building rapid consumer awareness, interest and loyalty.

A McKinsey study of marketing practices estimates that at least two-thirds of the U.S. economy is potentially affected by buzz. This includes not only obvious sectors like entertainment and fashion, but also electronics, automobiles, and pharmaceuticals. In fact, advertising and the Internet are rapidly transforming purchasers of health care and prescription drugs from passive patients into active consumers. In deciding on a treatment, these active consumers can and do generate buzz. The Internet is a natural medium for people to share their experiences with a product or service. Viral marketing provides a structure for those who seek to stimulate and guide this natural human instinct (Dye, 2000).

Case Study-Targeting a Hard to Reach Demographic Segment

The most promising avenue for viral marketing seems to be that laid out by companies who are moving beyond mere word-of-mouth and referrals of friends and family to create a real online community. An illustrative case study is provided by the programs of YouthStream Media Networks, a marketing consultancy that seeks to penetrate the niche of selling to teens and young adults. In the United States the 88 million young people 14 - 30 years old have $350 billion in purchasing power. The younger portion of this market segment, Generation Y, is one of the fastest growing segments of the U. S. population. They represent the so-called "reverse baby boom" that is set to fill the demographic hole left by the "baby bust" Generation X. Because of Generation Y demographics, the college age population will burgeon during the next ten years. College students are wired and online to an extent that no other demographic group can match. They have evolved culturally with the Internet: 95% have some form of personal access; 88% of colleges have institutional access. Although college students represent only 7% of the total population, they generate 22% of all Web traffic, spending an average of 14 hours per week online. Moreover, 75% of college students have credit cards; 43% have purchased online, 68% in the past two years. There are a lot of pages being clicked (Turban, et. al., 2000). Clearly, this is a market of enormous immediate potential, apart from the long range, lifetime value that young customers can be expected to generate if they develop brand loyalty at an early age. But while the features of this niche are attractive, the audience is notoriously hard to reach and fickle in its tastes.

YouthStream has experimented with unconventional techniques for building brand loyalty within this challenging segment. The key to the process is the creation of a relationship between the brand and the customers. While transactions are handled online, offline approaches can bring customers to clients' web sites. YouthStream uses the concept of viral marketing to create affinity groups of young people and to develop feelings of brand ownership. Cash prizes and other incentives reward customers for bringing their own friends to the web site, while the web site itself encourages the formation of customer groups to exchange information and news about the brand. To use current marketing jargon, the process of sponsorship and "in group" discussion creates "buzz" about the brand. Sixdegrees.com is a connection engine that facilitates the process of young people bringing in their friends by creating a network of sponsorship relations. This networking system allows participants to earn bonus points on the people they have sponsored. Experience shows that 35% of invitees bring three or more people. This network of customers represents a core of brand loyalty and of commitment to the brand itself.

Examples of offline activities that feed this brand loyalty and the sense of belonging are Spring Break Events, campus social activities, exclusive deals with hotels and health clubs, contests and surveys connected to the brand. In a period of two years (Q1 '98 - Q1 '00) Sixdegrees has created a member network of 3.5 million for YouthStream brands. Within their group, members can send messages using the Web site and can benefit from a variety of supplier sponsored features such as chat rooms, discussion groups, e-mail information tailored exclusively to them. By integrating these online services with offline activities, brands can add value to the right people and the right location. They can position themselves as having a special relationship with their customers. For example, while colleges do not want banks to advertise credit cards to students, through an affinity group of sponsored customers, Citibank has been able to position itself as a trusted source of help in financial matters. By surrounding the user with multiple properties, marketers can cross-sell and can tailor their sales propositions to the specific needs of customers who have already committed to the brand and are willing to spread this commitment through their own circle of influence (IceExpo.com, 2000).

Conclusion-Converging Business Models

What lessons can the brief experience of e-commerce with viral marketing and the much longer history of direct selling teach about the craft of building a sustainable brand? Both experiences have shown that relationship marketing can be more powerful, complex and long-lasting than the simple stimuli of media advertising. In fact, in the age of information overload, the most powerful advertising may not be advertising at all, but the nature of the relationship that people develop with a brand. The Internet allows marketers to build an online community of customers while supplementing and reinforcing this community with offline activities. But Internet marketers could learn much from the experience of direct selling. First, direct selling builds on the power of "charismatic capitalism" (Biggart, 1989). By establishing a relationship between customers and company leadership, direct sellers can articulate a clear mission for their brand that serves to position it in the mind of the customer. The mission of Avon Products and of Mary Kay Cosmetics to empower women as business people and consumers expands these brand propositions beyond simply selling quality cosmetics. The role of Nu-Skin in creating both healthy lifestyles and financial independence sends powerful messages about the meaning of the brand. Direct marketers are also able to feed their customers more information about the brand, and to tailor this information to the "audience of one" through what they know about the attitudes and buying habits of their individual customers. This is the essence of personal relationship selling. Finally, through the use of a sponsorship network, these brands create an income stream and incentive for continued loyalty among those who have brought people into the network.

Beyond these marketing precepts, the direct selling industry has developed a specific set of technical and legal competencies that e-commerce will need to incorporate if it is going to expand viral marketing into a sustained business model. Direct selling has always been suspect in the eyes of consumer regulators because of the pressure put on consumers to purchase and the perceived proximity of the compensation plan to a pyramid scheme. However, under the aegis of the Direct Selling Association, the industry has established a series of guidelines that are well accepted by government regulators in the United States and are increasingly recognized in overseas jurisdictions.

These regulations draw a clear distinction between the validity of personal relationship selling and unethical pressure tactics, and they establish clear legal and financial justifications for paying override commissions or bonuses for sponsorship within the sales network. Because the industry ethical code focuses on selling product and creating a brand and relates all payments to this objective, direct selling firms are able to avoid allegations of pyramid selling (Xardel, 1991). If e-commerce wishes to build viral marketing into a real commercial network with its own sustaining economics, it will need to incorporate these features of a legally sound direct marketing plan.

The Internet opens up a new horizon for the venerable direct marketing approach. Technology enables virtually unlimited numbers of people to connect and communicate with each other, and gives firms the ability to track the full detail of this interaction.

The viral marketing approach allows companies to surround the user with multiple messages, more complete than those of the advertising formula, and to create individual messages that are personalized and directed to specific customer needs. It also offers the promise of building a brand more economically through targeted marketing rather that the scatter shot and vastly expensive approach of mass media. The days of $2 million Super Bowl spots are over. The self promoting marketers of the e-commerce Revolution must now show that they really know how to build lasting customer loyalty and a lasting value proposition, and that they can do this without the unlimited largesse of Venture Capital and skyrocketing Nasdaq valuations. The nascent techniques of viral marketing offer an avenue for achieving this objective. Importing technique from the success of network marketing and direct selling could help to refine and focus this new business model. The key to both marketing systems is building lasting relationships. The array of techniques developed by the direct selling industry during its century of experience has many things to offer to an e-commerce marketing system still in its infancy and still in search of commercial viable applications for a dynamic and immensely powerful technology.

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John W. Rogers, Jr.
Assistant Professor of Management
School of Business Administration
American International College
Springfield, MA 01109