October - 1999 - issue > Cover

The concept of viral equity is simple. A startup can offer equity to its customers as an economic incentive for doing business with the firm. The more customers transact with the firm, the more equity each customer gets in the firm. The more customers they refer to the firm, the greater the value of their holdings becomes. And the earlier the customers get in the game, the more the value of their holdings. The system of viral equity, therefore, closely aligns the incentives of customers and investors.

Two Tectonic Plates

The information revolution has turned several conventional marketing assumptions on their head. Traditional advertising models, where marketers pushed advertising to customers, are being supplemented by consumer-driven advertising models, where consumers act as advertisers, spreading marketing messages at the speed of light. In viral marketing, something of value is given away free to build a large customer base that can be leveraged for services, commerce and referral revenues.

The pioneer of online viral marketing was Hotmail, which offered free email to consumers. Hotmail grew rapidly because every email sent using a Hotmail account included a note from Hotmail advertising its free email; each customer was implicitly acting as a “virus,” spreading the gospel at light speed. By using customers as agents for their message, Hotmail was able to harness the “word of mouse.” However, despite the rewards of lifelong customer ownership through brand loyalty, a business model based on zero margins is hard to sustain without some way to generate revenues from the customer base. Hotmail eventually sold out to Microsoft.

The Net is also revolutionizing the financial services industry. Companies are providing consumers access to private equity investments and initial public offerings (IPOs) that were once the sole preserve of institutional investors. Firms like Off Road Capital allow high net worth individuals to make private equity investments in early-stage companies. And firms like W. R. Hambrecht are reinventing the role of traditional investment banks through online pricing of IPO shares. The democratization of capital markets is well underway, and consumers are getting more knowledgeable about corporate securities.

It is the coming together of these two tectonic forces that is giving rise to the phenomenon of viral equity.

Understanding Viral Equity

Referral marketing involves word-of-mouth referrals. Referrals are more credible than advertising, because they come from a user of a product or service, and often from people we know and trust. Viral marketing is like referral marketing on steroids, enabled by the Internet. When the customers of a firm voluntarily (or involuntarily, as in the case of Hotmail) act as spreaders of marketing messages to other prospects, the viral chain is activated.

Viral marketing dates back to pre-Internet days. Perhaps the most successful example was the MCI Friends and Family program, where customers of MCI were given incentives for signing on members of their social network to MCI. But the Internet greatly amplifies the magnitude and the speed of the referral phenomenon, to the point that the referrals spread like a viral disease.

The Promise of Viral Equity

The viral equity model provides early-stage companies a means to build customer loyalty without spending a lot of cash on marketing. By making customers part owners of the company, incentives of customers are aligned with the company. Customers act as champions and salespeople of the company, because they profit if the company profits. Viral equity also epitomizes capital democracy, because customers can now have voting power, and can help set the direction of the company, in proportion to their holdings in the firm. Viral equity promotes a culture “of the customers, for the customers, by the customers.”

As startup firms struggle for attention from customers, the bulk of the venture capital funding for a typical Internet startup firm goes into customer acquisition costs. Instead of giving equity to venture capitalists, who fund marketing dollars, which are in turn used to acquire customers, who are then offered incentives to be loyal to the firm, viral equity gives equity directly to customers.

Viral equity can potentially cut out the middlemen - venture capitalists! Furthermore, as we observe companies going public at very early stages, the risk is shifting from the venture community to the public markets. Viral equity efficiently allocates equity to the public market investors who take the risk.

Pitfalls

The value of equity obtained through online lotteries and giveaways, like all other equity instruments, could drop to zero. In addition, there are obvious dilution concerns as more customers come on board as investors. Pricing of shares may become an issue for members signing up at different times.

There could also be some corporate governance challenges; for an extreme example, if voting customers own enough shares, they could form a union and oust the management. Management may also be able to control decision making by giving customers those classes of shares that would provide them financial benefit but no voting rights.

Viral equity may remain “viral” only until the concept is novel. If all Internet startups start pursuing this model, then the winners will chosen in the way they are now: on the strength of the management teams. Viral equity would then become just the price of entry.

The Law

Viral equity raises a host of legal and regulatory issues related to the Securities and Exchange Commission (SEC). Recently the SEC announced that it had brought, and settled, administrative enforcement actions against four promoters and two companies who had unlawfully offered unregistered “free stock” over the Internet. The SEC was worried that consumers were being misled by claims that the shares were free. Companies that have actually filed with the SEC to give away shares and conform to this ruling include YouNetwork and takes.com.

Forward thinking management should welcome the SEC’s disclosure requirement, but it does come at an expense. More disclosure means competitors can get more information about the company and its operations. Beyond initial registration requirements and approval, continual filing with the SEC would impose considerable time and effort on a startup’s management team and restrict its flexibility. The ubiquity of the Internet may also cause problems regarding specific country and regional laws regarding securities regulation.

While this is uncharted territory for the SEC, there seems to be a time lag between evolution in securities law to keep pace with Internet business model innovation.

As sophisticated consumers start to make informed decisions, companies will incur higher costs to acquire an initial customer base. In addition to better understanding the needs of customers and providing improved products and services, companies may opt to give customers ownership of the company and a share of the economic returns from stock price appreciation.

Write to mohanbir@siliconindia.com and amol@siliconindia.com.