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Building a Net Trojan horse

When you boil it down to the basics, all an Internet company needs to be successful is a critical mass of customers and a viable business model. And of these, the one that's been considered the highest priority so far is the ability of a company to attract customers.

    When you boil it down to the basics, all an Internet company needs to be successful is a critical mass of customers and a viable business model. And of these, the one that's been considered the highest priority so far is the ability of a company to attract customers.

    Investors have been trained to push the question of business model viability into the distant future and have even rewarded companies for investing aggressively in the early years. The bet is that those who position themselves best early on, often measured by growth in the number of customers, will reap the rewards as the industry grows. It doesn't matter much if you win the 50-yard dash when you're running a marathon.

    As competition intensifies, companies are finding it increasingly expensive to attract and retain customers at their sites. Consequently, a growing number of companies whose success depends on consumers coming to them are pursuing what we call a Trojan horse strategy.

    According to Greek legend, Greek soldiers hid inside a giant wooden horse, enabling them to gain entrance to Troy and achieve their objective of conquering the city. With more benign consequences, we see more companies pursuing a similar strategy, using attractive and viral applications or services designed to quickly attract a critical mass of consumers.

    Free access, free PCs, event planning and million-dollar sweepstakes can rapidly bring critical mass to a site, but at best they are break-even propositions. The margin in the business typically lies in ancillary products or services that are introduced later or are by-products of the Trojan horse.

    One of the most intriguing companies pursuing this strategy is PeoplePC. The company is working with world-class partners to offer a PC, unlimited access, a portal, shopping sites and a buying club, all for $25 per month--not a bad deal considering that AOL members only get access and aggregated content for $23 per month. With this compelling offer, the company has signed an impressive number of customers in the short period of time since its launch. The real margin in the business, however, will come from bounties and revenue sharing on transactions that the company hopes to generate from its members.

    Reaching critical mass quickly offers another important advantage: a barrier to entry. Buyers attract sellers and vice versa.

    As the successes of Yahoo and eBay testify, companies that establish an early lead are in a position to capture a disproportionate share of the growth going forward, preventing their competition from getting a firm foothold. In addition, they enjoy higher margins, lower customer acquisition costs, and the benefits of a network model. The more buyers there are in the network, the more sellers will be attracted, and vice versa.

    In the current Internet environment, the proliferation of well-funded and aggressively marketed sites has made it difficult for any site to rise above the noise level and attract the number of people necessary to make the company successful. To revisit the track analogy, if you can't even get to the 50-yard line, you certainly aren't going to win the race.

    With hundreds of public companies and another hundred in the deal pipeline, companies do not benefit from the immense media coverage that the early pioneers enjoyed. This fact in conjunction with the speed with which good concepts are copied and supported by venture capitalists has made it critical that companies find alternative, low-cost ways to reach critical mass.

    A good business delivered via a Trojan horse will permit the early proponents of this strategy to rise above the noise level. Over time, this strategy will become less effective as too many companies adopt it, and a new model will emerge. Darwin would have marveled at the adaptive capabilities of Internet companies.

    The preceding comments should not be considered a recommendation concerning the purchase or sale of any securities mentioned therein.