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The Bi-Coastal Solution John Stewart Unfazed by recent failures, a pair of startups says they have the keys to unlock the massive potential in sub-$5 online content. If they’re right, there’ll be hefty profits for merchants and processors alike. If not, it’s back to credit cards—and crushing transaction fees. If you want to get an idea of the potential for micropayments these days, take a look at the market for digital music. Apple Computer Inc.’s iTunes site is on track to sell $150 million worth of 99-cent song downloads this year, having almost single-handedly created the legitimate online song market just to peddle its $299 iPod music players. Plenty of other music merchants, though less storied, are reaping like results. MusicRebellion Inc., for one, did 100,000 downloads in the first quarter of this year, at prices like 88 cents a clip. If you think that’s a modest number, consider that it’s 20 times the number of sales the site did in the first quarter of 2003. And this is just the beginning. “I believe the fourth quarter will be 10-fold anything we’ve seen [so far],” says Rex Fisher, chief operating officer for the 3-year-old merchant. Action like that has been enough to prompt heavyweights like Wal-Mart Stores Inc. to muscle in, with all that that implies for volume potential. The sour note in all this, though, is that 15 years after the invention of the World Wide Web retailers are still almost completely dependent on credit cards for online payments. That’s okay for a $200 pair of shoes but the merchant fees on credit card sales all but wipe out any margin on goods selling under $5, the accepted upper limit of micropayments. A steady parade of ventures in the past decade, with names like First Virtual and MilliCent, tried solving this problem and foundered. Even PayPal Inc. holds aloof from the micropayments market generally, though it cut its transaction fees last December for digital songs. “What’s the value in slashing our margins for this sector?” asks Todd Pearson, managing director for merchant services at the San Jose, Calif.-based unit of online auctioneer eBay Inc. “We haven’t got our heads around that.” Doing the Math Now a couple of startups argue they’ve not only gotten their heads around micropayment processing, but they can ultimately make macro-profits on the transactions. Peppercoin Inc., Waltham, Mass., and BitPass Inc., Palo Alto, Calif. (box, page 38), both introduced a commercial micropayments service late last year. Both are funded by venture capital and are now headed by experienced chief executives. Both are actively calling on online peddlers of digital content. Both say they’ve learned from recent failures. And both are eyeing the same market potential. Digital content like songs, games, ring tones, and text will account for $15.1 billion in 2008, up from $2.33 billion last year, according to industry forecasts. And not every customer for this content will want to sign up for subscriptions, they argue. “It seems crazy to force the customer to buy a $10 monthly plan,” says Michael O’Donnell, chief executive at BitPass. “Apple proved people will pay 99 cents for music.” Peppercoin is betting that people will buy 99-cent songs and a whole slew of similarly priced goods if they can simply press a buy button and get what they want. No subscriptions. No prepaid accounts. And no grandiose efforts to create a “digital currency,” as with past ventures. Just a line item on their credit card statements detailing what they bought and for how much, as with any other product. To make this work, the company relies on a highly sophisticated mathematical model invented by a pair of noted cryptographers at the Massachusetts Institute of Technology, Ronald L. Rivest and Silvio Micali. And this summer Peppercoin is set to roll out an even more sophisticated version of the proprietary model, dubbed version 2.0, on which the fledgling company is pinning a lot of hopes, believing it will open the world of digital-content sales to big companies that have been holding off because of transaction costs. “We believe large merchants are going to find this very attractive,” says Robert Kiburz, a former Lucent Technologies executive who took over as chief executive last fall. Rivest, often introduced as the “R” in RSA, as in the widely used cryptographic security protocol, took an interest in the problem of efficient micropayment processing years ago. “I like to look at problems where the constraints seem very challenging and where there’s practical application,” he says. So he and Micali hit on the idea of using probability theory to select only a random sample from the transaction flow. The selected payments could then be stepped up to larger representative values, or macropayments, against which credit card discount fees would not erode all hope of profit for the seller. Although all transactions from all buyers and to all sellers are eligible for sampling—a technique Peppercoin calls “universal aggregation”--Rivest and Micali’s model keeps track of the who’s buying what, from whom, and for what sums in such a way that customers receive line item detail on their credit card statements. Meanwhile, all the gearing of selection rate and macropayment size is transparent to buyer and seller. The whole idea of universal aggregation is to hold down costs by reducing the number of times transactions must travel across a network and be processed. Peppercoin calls it processing at the edge of the network. “With micropayments, you can’t afford to put a lot of effort into each payment,” says Rivest. He and Micali formalized their idea in an academic paper, suitably studded with equations, that they presented in March 2002. By then, however, they had already co-founded Peppercoin with seed capital from MIT and with Perry S. Solomon, a former investment banker and Inktomi Corp. executive, as the first chief executive. With Kiburz’s arrival, Solomon became vice president of strategy. Merchant pricing was established at 7% to 10% of each transaction, with no fixed fee, unlike the dimes and quarters that come attached to credit card interchange rates. And last September, the company attracted $4.25 million in funding from Pod Holding, a private-equity firm based in Boston and Sweden. Peppercoin went from beta testing to commercial product at the end of 2003. MusicRebellion was one of its first clients, coming on board for the beta test. Now, says Fisher, Peppercoin payments account for between 8% and 10% of the site’s downloads, and he’d like to see it account for more. “It’s run pretty smoothly,” he says. ’Pain Point’ PayPal, which accounts for anywhere from 7% to 10% of sales, is still too high-priced for Fisher, despite the payment company’s decision to cut its fees, just for song downloads, from 2.9% plus 30 cents or 2.2% plus 30 cents to 2.5% plus 9 cents. “That still cuts us off at the knees,” moans Fisher, who says MusicRebellion makes just 15 cents to 20 cents per song before transaction costs. The site also allows customers to pay for downloads from prepaid accounts funded by credit cards, but Fisher likes the ability to let people buy their music by the song. “This way the customer doesn’t have to tie up $10 or $20 with us,” he says. “You need a micropayments method.” Recognizing how competitive the business of pint-sized payments is becoming, Peppercoin plays several things close to its vest, including how many merchants are using its model. Publicly, it’s only willing to own up to MusicRebellion and the Smithsonian Institute’s Folkways Recordings unit. BitPass, which went commercial at almost the same time, claims 1,100 sellers using its system, mostly very small merchants of goods like photos, comics, and streaming radio. But with its universal aggregation approach, Peppercoin may come closer than BitPass to the ideal of permitting consumers to buy seamlessly online without bothering with pre-funded accounts or some sort of artificial currency. It also harbors ambitions of one day enabling micropayments in the physical world, for example payments for cups of coffee and newspapers. But for now it’s focusing on major players on the Internet that sell or would like to sell digital content priced under $5. When it comes to this market, says Kiburz, “large merchants have the greatest pain point. The concept is to identify the winners in this space.” Like BitPass’s O’Donnell, Kiburz sees subscription models as inherently limited, in that they bring in the aficionados but leave others in the cold. “Micropayments in addition to the subscription model allow the merchant to bring in more casual users,” he notes. Who are these major online players Peppercoin is targeting? Kiburz is mum on that, noting that his discussions are enveloped in non-disclosure agreements. But to lasso these merchants, he’s touting version 2.0, which is, he promises, even more seamless to use than the first rendition. Unlike the first model, the new one doesn’t require buyers to download software. It backs up Web merchants’ buy buttons, filtering out micropayments at thresholds determined by the merchants, processing them, and forwarding them to acquirers. In other words, it functions much like a traditional gateway. It also offers Web-based customer service at a site Peppercoin has set up, smalltab.com. Kiburz expects this last feature to be particularly powerful, since it allows sellers to offer service over disputes and the like without directing customers into expensive call centers. “When you’re selling something for $1, you can’t get on the phone for a long time,” he says. Still, Kiburz and crew will find skeptics. Even Peppercoin, for all its talk of cutting transaction costs, is too rich for some. “The biggest challenge with micropayments is that the processing costs are outlandish,” says Lonny Paul, director of e-commerce at TigerDirect Inc., an online and physical merchant of consumer electronics that is selling ring tones on a site co-managed with Zingy Inc., a New York-based company that relies on prepaid accounts and cellular-carrier billing. To win his business, Paul says, fees need to get down into the 2% to 4% range. If too many other merchants agree, Peppercoin may have trouble signing up enough sellers to reach its goals. These are, after all, micropayments. But Peppercoin remains optimistic, as do its inventors. Says Rivest: “We’ll see what sorts out. We really think we have the best approach.” A Doctor’s Prescription for Micropayments BitPass Inc., Palo Alto, Calif., is the brainchild of a medical doctor and his roommate, who became frustrated as sites offering favorite content lost advertising revenue in the dotcom bust and had to either close down or restrict access to those with a professional interest and the ability to pay for expensive subscriptions. “I’d be willing to pay a small amount to be entertained,” says Kurt Huang, the doctor, who, with Gyuchang Jun, co-founded BitPass in 2002 while pursuing a doctorate in artificial intelligence systems in medicine at Stanford University. Apparently, others felt likewise. Today, the company has won the backing of venture-capital groups like Garage Technologies Ventures and Cardinal Venture Capital, and has attracted some 1,100 sellers of digital content ranging from photos and comics to patent searches and streaming radio. Half of these merchants accept BitPass exclusively. It’s even testing a site, called mperia, that lets some 700 lesserknown musicians peddle their songs. “It’s an iTunes for independent music,” says Michael O’Donnell, former chief executive at Salon Media Group, who took over earlier this year as chief executive. Mperia now boasts an inventory of 1,500 songs. Buyers using BitPass fund prepaid accounts using credit cards or PayPal. Merchants on the system display a small icon next to each piece of content on their site, letting buyers know they can pay with BitPass. Each payment is then debited from the prepaid account. Huang says simplicity sells on both the user and merchant sides. “We landed on the model of a prepaid phone card, essentially,” he says. “We made the user experience extremely easy.” BitPass charges its merchants 5% plus 50 cents on transactions above $5. Under $5, the fee is a straight 15%. That may yield more revenue as time goes on. O’Donnell says the way the market is going, micropayments are becoming a little less micro. Indeed, BitPass’s average ticket is more than $1 and even ring tones are selling over that amount. “The sweet spot in this space is going to be from $1 to $10,” he says. “It’s not a business where you’re dealing with nickels and pennies.” And, while processors like PayPal have to slash their margins to accommodate online music, Huang says BitPass’s model has the advantage that micropayments pricing is already baked in. Says he: “We’ve been designed from the ground up to that.” Like Peppercoin, BitPass is pursuing a strategy of going after bigger fish among the online peddlers of digital goods. “We’re focused now on the major brands,” says O’Donnell. He says, for example, that the spread of broadband capability in U.S. homes is expanding the market for streaming radio, and hence the market for BitPass to enable payment for that content. “People aren’t giving away streaming content any more,” he says. He’s also talking to trade associations like the Online Publishers Association. It helps that word of mouth is getting around about BitPass, which holds down marketing expense. Says O’Donnell: “We’re getting great viral marketing.” Next may come a mobile service for Web-enabled cell phones, which Huang and O’Donnell say is in testing. Another part of BitPass’s strategy is to offer sellers what it calls access control, everything from site creation to the management of cookies and browser compatibility. “It’s an expensive proposition for a lot of companies,” says Huang, so BitPass sees value in allowing them to outsource it. If enough sellers respond to that pitch, BitPass may find itself sitting on a big opportunity in little transactions.