Vonage Pays Homage To Online Trading

Vonage, the pioneering Voice-Over-IP (VOIP) service provider, announced today that it had raised a whopping $105M in new venture financing, bringing its total funding to a cool $208M. Many in Silicon Valley are scratching their heads wondering what in the world Vonage is going to do with another $105M.

At a high level it appears that Vonage is simply taking a page from the online brokerage play-book, a play-book that the CEO of Vonage, Jeff Citron, knows incredibly well as he built one of the most successful companies in the online brokerage industry, Datek Online, from scratch. In that industry, Ameritrade, Datek and E*Trade were able to pull away from the competition by dramatically ramping their customer acquisition spending and that appears to be exactly what Vonage plans to do in the VOIP space. In fact, the financial language that Vonage is currently using to talk about their business where they claim to be “cash flow positive before customer acquisition costs” is a carbon copy of how many online brokers talked about their own financials back in their heydays of online trading.

Why would Vonage dramatically ramp customer acquisition spending? It all comes down to a simple calculation: if the lifetime Net Present Value (NPV) of a newly acquired customer is in excess of the cost to acquire them, then it makes financial sense to spend as much money as you can, as fast as you can (even, say, $105M). The problem for Vonage is that, according to some analyses , they are currently spending about $450 to acquire each customer which means that at a $25/month subscription price it would take 18 months just to pay off the customer acquisition costs, let alone pay for any operating expenses.

Normally it would be crazy to scale up a business with that long a “pay back” period, but Vonage is once again likely looking back at the history of the online brokerage industry and making a calculated bet. Online trading entered a period of explosive growth in early 1998 thanks to a huge marketing bet by Ameritrade. In late 1997, Ameritrade cut its commission prices to the shockingly low price of $8/trade and then launched a massive $25M mass-market marketing campaign in Q1 1998 (up from $1.9M in Q4). In Q1 of 1998, Ameritrade’s cost to acquire a customer soared to $508, up from $271 the quarter before, however by Q2 of 1998 Ameritrade’s cost to acquire a new customer was down to $137 and they added 21,000 more customers than they did in Q1 thanks to lingering benefits of their huge national advertising campaign. The bet had paid off handsomely. Thus by going first and going “large”, Ameritrade was able to legitimize online trading in the eyes of the mass market and firmly and establish its own brand as a leader. As a result of this effort, it enjoyed faster growth than many of its competitors for several quarters to come and guaranteed itself a spot as a long term survivor.

It would appear that Vonage is betting that VOIP is at a similar “mass adoption” inflexion point, and that all it will take is a massive, mass market advertising campaign to push lots of followers over the edge to adoption. Thus, I would expect them to launch a bunch of flashy, irreverent TV commercials (probably making fun of traditional phone companies) shortly and to fire up a massive direct mail push as well. It’s a very risky bet, but Vonage is clearly hoping that they’ve been to this movie before and they know it has a Hollywood ending.

Some believe even if Vonage can benefit from a large marketing campaign that rampant price cutting in the VOIP space will undermine its growth prospects, but once again the online trading industry provides some evidence to the contrary. The average commission charged by online trading companies fell from $52.89 in Q1 1996 to $15.53 in Q1 1998 yet companies like Datek and Ameritrade were still able grow and build sustainable businesses despite this price competition. In the case of Vonage, lower prices won’t necessarily increase revenues (as they often did in online trading), but they will increase the number of “crossed” calls on Vonage’s own network (which cost them almost nothing to complete) which means that their operating cost per customer will fall as they grow their customer base.

So what should Vonage be concerned about? Using Online Trading as a guide, Vonage and the other VOIP start-ups will not find either marketing costs or pricing to be insurmountable obstacles. As long as Vonage can get out in front of its competitors in building a national brand, they should be able “ride the wave” of VOIP adoption long enough to build a large sustainable business. However, unlike the online trading space, Vonage faces two factors that online trading firms did not. The first factor is government regulation and the second is competition from access providers. In terms of government regulation, while online brokers were subjected to standard industry regulations, the overall “regulatory risk” they faced was quite manageable. Not so for Vonage and the other VOIP start-ups. The telecommunications industry is heavily regulated at both the state and federal levels and established interests (mostly the RBOCs) are mobilizing their formidable political resources in an effort to severely hobble new entrants like Vonage. Winning this fight will be very tough. The other factor that Vonage has to deal with is that while internet access providers (primarily the RBOCs and the MSOs) welcomed online trading because it created demand for their access services, most see VOIP as either directly competitive to their existing business or as a highly logical area for them to expand into. This means that Vonage will have to compete with the very companies that it relies on to provide it with access to its customers. A very awkward situation at best and, as many independent DSL providers found out, a very difficult battle to win.

So while Vonage still faces some pretty significant hurdles to becoming a long-term winner in the VOIP space, the $105M they just raised guarantees that they will be able to take a legitimate shot at the crown. Given the regulatory and competitive complexities it’s really to early to tell if Vonage will succeed, but one thing is for sure: we will see a bunch of amusing VOIP commercials on national TV shortly, so if anything the $105M will be good for a few laughs.