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Bootstrapping with Bits

The theory may be impeccable, and the founders’ credentials outstanding, but how does a startup transform a micropayment system into a practical, sellable product? That’s the stuff of late-night whiteboard discussions enhanced by takeout Chinese food and bad TV movies, says Joe Bergeron, Peppercoin’s vice president of technology. Bergeron, a baby-faced programming whiz, has the task of translating Rivest and Micali’s algorithms into software. Like any good engineer at a startup, he has spent many a night under his desk trying to squeeze in a few hours of sleep. “I’m dreaming in Peppercoins now,” he says.

Minting micropayments starts with hardware. A secure data center a few kilometers from company headquarters houses hundreds of thousands of dollars’ worth of computing horsepower and memory. All of Peppercoin’s money transfers flow electronically through these machines. A rack of 20 processors and backups and four levels of hardware security are set up in a special cage walled off by Plexiglas guaranteed to withstand a 90-minute riot; the rental contract even specifies that the cage will repel “small-arms fire and manual tools.”

First Out of the Gate

Andreas Gebauer remembers the pesky young guy well. Five times in 2000, Firstgate Internet founder Norbert Stangl showed up at the Berlin offices of Stiftung Warentest (Product Testing Foundation), Germany’s leading consumer reports magazine, to peddle his e-payment technology. Five times Gebauer, the magazine’s online editor, said he wasn’t interested. Finally, on the sixth trip, Gebauer agreed to give it a try if Stangl would just leave him alone.

Persistence pays off. “We’ve been very successful,” says a converted Gebauer. In the three years since Stiftung Warentest adopted Firstgate’s system, its monthly online revenues have skyrocketed from $5,000 to more than $100,000. And today, while the U.S. micropayment market is still in its early stages, Firstgate has some 2,500 merchant users and almost two million paying customers in Europe—and pulls in more than $1 million a month in revenues, making it one of the world’s leading e-payment and distribution companies. Its users in media and publishing, the fastest-growing market segment, include the Independent, Der Spiegel, Reader’s Digest, Encyclopedia Britannica, and Gruner and Jahr.

Firstgate’s software, unlike Peppercoin’s, must keep track of every transaction, and most are dollars rather than cents. But it works. Web customers can go to any Firstgate-enabled site, click on an article, and read it. They are billed via their credit card, debit card, or phone bill once they accrue a few dollars in charges. The system works by fetching digital content from Web merchants and delivering it only to paying customers. Firstgate charges a setup fee for merchants and pockets 10 to 30 percent of each transaction. (That may sound steep, but for micropayments, Firstgate can be cheaper than a credit card company.) Meticulously hand-tailored, the system has won a slew of European industry and consumer awards. “It’s finely tuned, like a BMW,” says Ian Price, CEO of British Telecommunications’ Click and Buy division, which has partnered with Firstgate to sell online games, articles, and even a voting mechanism for interactive TV shows.

Most important, Firstgate has proven that a global market exists for Internet content priced in the $1 to $10 range, says Stangl, who is now the company’s chairman. In late 2002, the company set up offices in New York. How will its success in signing up newspapers, magazines, and other media groups translate to the U.S. market? “We have experience working with so many online companies,” says George Cain, Firstgate’s CEO in North America. “What people are thinking about here, we’ve already got built into our system.”

But Peppercoin’s system must also be bulletproof to electronic problems. Take transaction speed, for instance. Peppercoin is working with one Web site that delivers 1,000 digital maps per second. For Peppercoin to handle that many purchases, and for buyers to get their content without waiting, the behind-the-scenes computations must happen in milliseconds. As Bergeron explains, sketching a flow chart on a whiteboard, the software module that identifies what the buyer is paying for, verifies that the payment is good, and sends the digital content to the buyer has been taking a few milliseconds too long in beta tests. The solution: do these steps in parallel, and manage customer queries in a flexible way by devoting more computing resources to the steps that take longer. Trimming bits of fat like this saves precious processing time per click—and ultimately keeps the system running efficiently.

Perhaps even more crucial to Peppercoin’s success, though, is its sales strategy. “The challenge isn’t getting people to buy the math. It’s enabling a new business model for the Web,” says Rob Carney. In two respects, micropayment startups are fundamentally different from online person-to-person payment companies like Mountain View, CA-based PayPal, one of the most successful of e-payment companies. First, they are enabling Web merchants to sell low-priced digital content, not physical items. Second, they don’t have anything approaching the captive market that PayPal has in the customers who use eBay, the San Jose, CA, online auction house that purchased PayPal in 2002.

So Peppercoin’s plan—similar to those of other micropayment startups (see table “The Micropayment Movement,”)—is to go after Web merchants, work with them to decide what kinds of content to sell, and build up a brand name with which to approach larger distributors. It’s a painstaking process; Solomon and Carney have attended more than 400 sales meetings in two years, trying to persuade merchants that Peppercoin’s own fees—which work out to be much lower than the flat transaction fees charged by credit cards—are a small price to pay for the extra business micropayments will generate.

But all this work is starting to pay off. “Peppercoin has been a huge benefit for us,” says Rex Fisher, chief operations officer at Music Rebellion, a Terre Haute, IN, company that last June started selling 99-cent MP3s by the download, using a beta version of Peppercoin’s system. The bottom line: micropayments allow the music site to triple its profit margin, as compared with traditional payment methods. As for the user interface—buyers sign up for a Peppercoin account and then click on music icons to charge songs—Fisher says he’s working with Peppercoin to make it “easy and hassle free.” He acknowledges that it’s still early, however, and that results in the next year will say more about the overall success of micropayments.

Other users go further in their praise for e-payments as enablers of new kinds of Web content. “The promised land is filled with micropayments,” gushes David Vogler, a digital-entertainment executive formerly in charge of online content at Disney and Nickelodeon. One of Vogler’s current ventures is a humor site called CelebrityRants.com. There, using Peppercoin’s software, you can buy animated recordings of embarrassing diatribes or confessions from celebrities caught on tape—everyone from Britney Spears to new California governor Arnold Schwarzenegger. “We explored many solutions, but Peppercoin seemed like the right horse to bet on,” says Vogler. Moreover, he adds, it was “insanely easy” to get the system up and running. That and a painless consumer experience seem to be the keys to early adoption.

So this is how it starts: not with a conglomerate of media giants adopting micropayments, but with pockets of small entertainment and Web-services sites. Plenty of sites will still be free, supported by advertising, says Carney. But micropayments, alongside ad sales and subscriptions, will become another leg of the stool that supports Web businesses. And micropayment companies are hoping that their systems will give entrepreneurs and consumers the freedom to try out new kinds of commerce on the Web, and to buy and sell an ever wider variety of digital goods. “The Web was dying,” says Kurt Huang, CEO of BitPass, a micropayment startup he cofounded while he was a graduate student at Stanford University. “We needed to do something to change its economics.”

Take Web comics. Today there are more than 3,000 online cartoonists worldwide, and that number is growing fast, says Scott McCloud, an author and Web comic artist based in Newbury Park, CA.

“Micropayments are the missing piece of the puzzle,” he says. Using a beta version of BitPass’s technology—users prepay a few dollars into an account—McCloud sold 1,500 copies of his comics for 25 cents each in eight weeks. Not huge numbers, to be sure, but the potential for steady growth is there. And it’s not supplementary income—this is how Web artists will make their money. “We’re not just slapping a price tag on what could be free,” says McCloud. “This is allowing us to do work that we couldn’t do before.”

The Coin-Op Web?

In the 1990s, e-payment startups like DigiCash, Flooz, and Beenz crashed because dot-com companies didn’t think they needed the technology to make money, and because consumers expected Web content to be free. Times have changed, but there are still plenty of skeptics who doubt micropayments will catch on broadly, considering that MP3 listeners and Web-comics fans are the technology’s main U.S. consumers so far. Even those who have made their fortunes in the online-payments world acknowledge that it’s an uphill battle. “It’s quite possible they could fail miserably in this economic climate,” says Max Levchin, cofounder and former chief technology officer of PayPal (see sidebar “The PayPal Precedent”).

But both the supply of digital content and consumers’ willingness to pay for it are increasing, and the micropayment companies’ strategy of signing up Web merchants, one at a time, has promise. “There will be small companies who figure out how to play this chicken-and-egg game,” says Andrew Whinston, director of the Center for Research in Electronic Commerce at the University of Texas at Austin. “The key is to become successful before big companies like Microsoft get into it.”

The PayPal Precedent

Max Levchin believes that micropayment companies’ two keys to success are a simple user interface and an aggressive distribution strategy. TR’s 2002 Innovator of the Year, Levchin is the cofounder and former chief technology officer of PayPal, the online-payments pioneer that was sold to eBay for $1.5 billion in October 2002.

Technology Review: Are micropayments ready to take off?

Max Levchin: The Apple music store is a good example that 99-cent payments are a reality. What is uniquely different about the market now is that personal publishing has become a lot more pervasive than it was three to five years ago. There are literally thousands of Web sites that specialize in comics, music, and art that’s only available on the Internet. [Artists] look to the Internet to actually make money. So demand is definitely increasing. The question is, are these solutions actually what the market needs?

TR: What do Peppercoin and other micropayment startups need to do to become successful?

Levchin: Most of the technical challenge is about the user interface, not the billing process. Overall, Peppercoin’s [beta version] user interface is very raw. I have to download software. I have to wait for a confirmation e-mail. What if my computer crashes? You should never force people to download software. The security is a good thing, but it adds complexity.

TR: What’s the greatest challenge, going forward?

Levchin: The biggest difficulty, by far, is distribution. How do you get all these people to start using the system? At PayPal, as soon as we “infected” a couple popular eBay merchants, very quickly we saw this massive growth, where buyers started pushing other merchants to sign up. But there isn’t a giant market online right now where you can go to look at all digital content available. Digital merchants are very disparate. And consumers aren’t going to sign up, download software, or prepay for a card, because there are not that many places to spend it yet. So marketing to digital merchants directly is one way to go. But it will take an incredible amount of human effort to get enough people to sign up.

For a glimpse into the future of micropayments, look overseas. In Japan, most mobile content and services, such as cell-phone users downloading games and ring tones, are paid. And micropayments are becoming prevalent in Europe’s publishing and news-media markets. Firstgate Internet, a digital content distributor in Cologne, Germany, has nearly two million customers and 2,500 clients, including British Telecommunications’ Click and Buy, and it is bringing in more than $1 million a month in revenues, says founder and chairman Norbert Stangl (see sidebar “First Out of the Gate”). Its most successful kinds of low-price content: news, research articles, and financial reports.

But Firstgate tallies each purchase separately and pays credit card fees, so its own fees are higher for merchants than most micropayment startups’. Peppercoin and BitPass hope to succeed in the U.S. market by being more efficient for small payments. So will micropayments take off here? “The truth is, nobody knows,” says Guy Kawasaki, CEO of Garage Technology Ventures, a venture capital firm that is funding BitPass. “But I look around and I see 50,000 unsigned bands in the world. I see thousands of bloggers, analysts, and artists who want to publish their stuff. And how many databases would you want to search for 50 cents?” Asked when he expects to see a return on his investment, the former Apple guru laughs and says, “Before I die!”

Other observers see a clear path to adoption. “The future of micropayments is very simple,” says Sun’s Papadopoulos. “You’ll get to a critical mass on the network. It will become the equivalent of pocket change, and you’ll see fierce price competition on digital content.” Falling prices, companies hope, will only increase demand. And as digital content gets cheaper, the temptation to pirate should diminish.

We’re already seeing competition: last summer, the music-download store BuyMusic.com put up billboards parodying Apple’s music ads and undercutting Apple’s 99-cent pricing by selling songs for as little as 79 cents. With America Online, MusicMatch, and Roxio (Napster 2.0) launching stores as well, the music industry will be a proving ground—or perhaps a killing field—for e-payment technologies.

As the contest begins, most micropayment startups have enough capital to see them through the rollout phase. In September, Peppercoin announced that it had raised $4.25 million in its second round of venture funding. But in the long run, how will micropayment companies stay in business? Signing up Web merchants is fine now—deals are quick and the need is there—but an eventual goal is to hook up with a distributor that will become the eBay of bits.

So as Peppercoin makes final preparations for its commercial launch, Carney and Solomon make sales calls. Engineers sit on the edges of their seats, watching the ebb and flow of processing loads and user levels on their monitors. Rivest and Micali, ever patient, stay out of the limelight. If victory arrives, it won’t come thundering out of the sky. For companies like Peppercoin, success will build up gradually, like coins clinking into a piggy bank, one by one.

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