The new world of virtual distribution

About this time last year, AT&T introduced a charming Internet commerce-related commercial about a fictional company called "RubberEyes." The commercial tells the story of two entrepreneurial young women who come up with a new business idea after many unfortunate incidents involving standard inflexible shades and aggressive outdoor activity.

While this team has no problem designing and manufacturing their innovative rubber sunglasses, they do encounter some difficulty with traditional retail distribution: The merchants simply aren't buying. Not to be denied, the dynamic duo teams up with AT&T Internet services, opens an online store, bypasses the retailers, and becomes an instant financial success.

The AT&T commercial did highlight many of the advantages of conducting business over the Internet, but it failed to predict a subtle but critical reality of online commerce. You see, we were never shown the women of RubberEyes Incorporated entering into multimillion-dollar distribution deals with AOL, Yahoo, or Excite. It's sad but unquestionably true that the physical distribution network of yesterday has been replaced by a new virtual distribution system that is as expensive and difficult to navigate as its predecessor. Opening a commerce-enabled Web site without a portal partner is similar to opening a retail store in the desert. Sure, it's cheap, but does anybody stop there?

Many Internet retailers were profoundly shaken by the news that three online brokerage houses--DLJDirect, E*Trade Securities, and Waterhouse Securities--had agreed to pay AOL $75 million over two years to maintain "buttons" in the finance area of the online giant's service. It's not that these retailers have anything against AOL; they are just overwhelmed by how much money they may have to pay if virtual distribution becomes a requirement for success.

Currently, there is a great deal of uncertainty. How much will each retailer have to pay? How much is too much? How and when will the world "settle down" to a more stable environment? And last, but certainly not least, how should our business strategy change in light of this new reality?

The first step toward answering these questions is to get inside the heads of leading portal players such as Yahoo and AOL. They see themselves first and foremost as media companies, and consider themselves in the business of drawing traffic (aka eyeballs). To them, each of these distribution deals is really just another form of advertising or promotion that allows them to capitalize on their core asset: the eyeballs.

If a business can bring to the portal content that helps differentiate their service (and potentially attracts more eyeballs), then they typically are open to some sort of exclusive arrangement. Also, portals historically have entered into "revenue-sharing" deals, trading distribution might for a piece of the action. More recently, however, both of these leaders have grown to prefer scenarios much like the aforementioned AOL deal--multiple parties with cash up front. This way they can maximize the inbound cash while transferring the risk of commercial success to the merchants and retailers.

So how much should an online retailer be willing to pay for a high-profile distribution agreement? The easy answer, which was highlighted in an earlier column ("How to Succeed in Advertising"), is some amount below the lifetime value of a captured customer. In other words, you predict the expected cash flow from a customer over his expected customer lifetime and discount it back to determine the net present customer value. An economically rational merchant should be willing to pay less than this expected value to acquire the customer.

The problem is that this value is much easier to describe than to calculate. There are questions about average customer expenditures, customer churn, and predicted profitability levels. Moreover, if the portal expects cash up front, you must estimate how many "new" visitors it will deliver, and how many of those you will convert to customers.

To give you a sense of what boundaries you should put on customer acquisition, we can look to more stable industries that have a more established practice of paying for customers. The credit card industry has long paid for customer acquisition, with ranges between $50 and $75. Long distance telephony providers typically pay $100 for a new customer, and mortgage lenders have been known to pay between $100 and $250 to acquire a mortgage.

The AOL brokerage deal in question is based on the presumption that AOL can drive 50,000 customers a year to each of its three brokerage customers, resulting in an average acquisition cost of $250. A few online music companies have publicly stated a willingness to pay $40 for a new customer--a tough number to justify using the above metrics.

Unfortunately, the price you are willing to pay may not be the price that the market is asking. Most of these portal deals are priced "at market," and the more players in the game, the more money that is likely to be required to close the virtual shelf space.

Let's suppose the fictional RubberEyes team calculates that they are willing to pay $10 for a customer. They approach a leading portal that offers a deal for $100,000 to be the leading sunglass vendor in the hot new eyeware section. The portal assures that it can drive ten million viewers to the new section next year. RubberEyes then calculates that 1 percent of these viewers will click through to their site, and that 2 percent of those will actually purchase (these are typical industry numbers). This means that they will acquire 2,000 customers for a price of $50 each--well above the previously calculated figure.

Here is where things get difficult: