Network Effects

How do Web companies get so big so fast? By embracing the most important strategic mind flip of the 21st century. A world governed by networks is rewriting the rules for how you build companies, market products, and create value.

The startup opened its virtual doors to customers on July 4, 1996. The date was a great choice in terms of corporate symbolism, but a terrible one for creating buzz. Most media outlets operate with skeleton crews over Independence Day, so the launch generated almost no press coverage. And there was no ad campaign to pick up the slack. Of the $300,000 in seed capital that the company had received, less than $50,000 was targeted for promotion. “There wasn’t even a marketing budget,” remembers Steve Jurvetson, a managing director of Draper Fisher Jurvetson (DFJ), the venture-capital firm that provided the seed money.


So much for a virtual “shot heard ’round the world.” The launch of the world’s first free Web-based email service had more the effect of a wet firecracker. Then a funny thing happened: Customers began signing up. John Fisher, another DFJ managing director, was at a trade show with one of the startup’s founders the week of the launch. “His beeper would go off every 30 minutes,” Fisher says, “and there would be reports of several thousand more sign-ups. It became immediately clear to us that we had a tiger by the tail.”

The first markets to light up were universities — places with “.edu” domains. A user would sign up at, say, Cornell. A day later there’d be a half-dozen users at Cornell. The next day, there’d be 100. By the end of the first week, there’d be 1,000. The service would spread to another university, and the process would repeat itself. Then word of the service began spreading around the world. Within three weeks of the first user from India signing up, 100,000 additional users from that country came on board. “It was like a miracle was unfolding before our eyes,” says Jurvetson, a boyish 32-year-old whose voice still conveys the excitement of those early days. “At one board meeting, we’d see, maybe, Sweden show up for the first time. At the next month’s meeting, there’d be a huge number of users from that country.”

By Christmas 1996, less than six months after the launch, the new company had 1 million registered users. In the entire history of subscriber-based media, nothing had grown so large, so fast. The company’s performance was unprecedented. That it happened with a marketing budget of less than $50,000 was simply unbelievable.


The startup, of course, was Hotmail, a company that has become a legend among Silicon Valley entrepreneurs for its fast-forward approach to attracting customers and creating value. By Christmas 1997 (less than 18 months after its launch), Hotmail had signed up 12 million subscribers. A few days later, on December 29, founders Sabeer Bhatia and Jack Smith sold the company to Microsoft for $400 million in Microsoft stock. Today, with 50 million registered users, Hotmail is the largest Web-based email service on the planet.

Not surprisingly, the investment in Hotmail touched off an inferno at DFJ, which has done 57 Internet deals — more than any other independent VC outfit. “We want to invest in companies where we can light a match and start a fire,” says Jurvetson. And apparently word did spread like wildfire. When DFJ recently set out to raise a new pool of money, investors offered to provide three times as much as it was looking for. It decided to limit the size of the new fund to $180 million. (Its third fund, a $50 million pool established in 1995, is now reportedly worth $760 million.)

It’s easy to grow weary of Web hype. Pick an industry, and you’re almost guaranteed to encounter a pack of twentysomethings with a few Macs and an Internet connection who are vowing to start a revolution. You’ll also encounter more buzzwords than the mind can process. Still, there’s no denying that the Internet economy works by a different set of rules than the old economy. When, in business history, have so many companies generated so much value so quickly? Hotmail is one eye-opening case among many. Yahoo!, a company that’s still barely five years old, has 65 million registered users and a market value of $35 billion. EBay, which went public in September 1998, now has 3.8 million registered users — and a market value of $17 billion. And don’t forget RealNetworks,, and E*Trade — three young Web companies with a combined market value of $31 billion.


The stories behind these companies involve different missions, different markets, different business models. But they all illustrate the power of network effects. In a sea of new-economy buzzwords, network effects is the one new idea by which more and more companies will chart their course. Part economics, part strategy, part ideology, network effects may be the defining business mind flip of the 21st century.

Scott Reamer thinks so. An athletic 28-year-old analyst with SG Cowen, Reamer (whose official title is director of Internet research) is a new breed of Wall Street power player — a financial wizard whose job is not just to evaluate stocks, but also to explain the logic of value creation itself. What Reamer calls his “Internet first principles.” There are four of them, and they are at work in every company he tracks.

To Reamer, what matters most is the presence of network effects. That’s why he loves America Online, a company that he’s followed since 1996 — and that’s now worth a stunning $125 billion. “The real beauty of AOL’s service is that, like any network, its value grows to the nth power of the number of people who use it. A telephone network is meaningless with 1 phone on it. With 2 phones, it begins to be useful. With 1,000 phones it’s important. With 100 million, it’s incredibly important. AOL works the same way. The value of its service increases with every single person that joins.”


If you understand how the partners at DFJ decide on which companies to fund, and you understand how Scott Reamer determines the value of the companies that make it to Wall Street, then you’ll begin to understand the mind-bending logic of network effects.

You’ve Got Hotmail

In Web circles, the Hotmail story is almost as well-known as the service itself. But, like so many Internet takeoffs, Hotmail almost didn’t get off the ground. Founders Bhatia and Smith had been turned down by something like 21 VC companies before they met Steve Jurvetson. Even he wasn’t all that impressed by the startup team’s big idea for a company called JavaSoft. But one feature of their plan — free Web-based email — did catch his eye. The talks heated up, and JavaSoft became Hotmail.

Then came a meeting with Tim Draper, 41, DFJ’s founding partner. It was the first time that Draper had met with Bhatia and Smith. Draper was enthusiastic about the company, but he was adamant about one small detail: He wanted to put a hot link at the bottom of every email with a message, “P.S. I love you. Get your free Web-based email at Hotmail.” Clicking on the link would bring the message recipient to Hotmail’s site, and let that person sign up for the service immediately. That idea almost blew the deal apart. “The founders thought that it was like Spam,” recalls Jurvetson. “And it’s true: Until Hotmail tried it, the contents of email were always considered completely private.”


Which is why Bhatia and Smith not only hated Draper’s idea but felt it was contrary to the spirit of the Internet. “They fought me for quite a while,” Draper says, remembering that initial meeting. “Then, finally, they came back and said, ‘Okay, we’ll do it. But no ‘P.S. I love you.’ ” Draper’s bemused smile turns into an oversized grin. “Then Hotmail just started to spread.”

And it spread unlike anything DFJ had ever seen. “We had to keep asking ourselves, ‘Is this a fluke, or is it something important to think about?’ ” Jurvetson recalls. “After the Microsoft buyout, the magnitude of the value Hotmail had created hit us in the face. We actually thought that the founders should have held out and not sold. But in the end, they really wanted to sell.”

Around the time of the Hotmail sale, Netscape, another pretty successful Web startup, asked Jurvetson to contribute to its internal newsletter, “The M-Files.” The assignment was twofold: First, to write about new companies in the DFJ portfolio that were using Netscape technology. Second, to examine what those companies were doing that was unique and to draw out some lessons. “That was the first time that I thought to myself, ‘How can I describe why Hotmail is special?’ ” Jurvetson wrote something and passed it to his partners for comments. In a meeting with Draper, the two financiers began trying to coin a phrase that would describe the phenomenon that they had helped create. They tried terms like “pyramid marketing,” “geometric marketing,” and “tornado marketing.”


Then they came up with a term that stuck — “viral marketing.” The email service had spread around the world with the ferocity of an epidemic. By passing along emails with a clear (but inoffensive) marketing message, current users were infecting potential users. And the rate of infection increased rather than decreased as time went on. Forget diminishing returns; Hotmail was enjoying increasing returns.

Jurvetson went home to his wife, Karla, a psychiatrist, and began poring over her medical books. “I read that a sneeze releases 2 million particles,” he says, “and I really started thinking about the idea of infection for the first time. A sneeze is only dangerous when there’s a crowd around. A sneeze on the Internet, however, can infect millions of people scattered across the planet. It’s as if Zeus sneezed: How many people would catch a cold?”

Suddenly, the principle behind viral marketing seemed so easy to understand. In this new world, companies don’t sell to their customers. Current customers sell to future customers. In exchange for a free service, customers agree to proselytize the service. Because recipients of Hotmail messages are almost always friends, relatives, or business acquaintances of the sender, the marketing message is that much more powerful. Each email carries an implied endorsement by someone who the recipient knows. (See “Four Laws of Viral Marketing,” page 216.)


Hotmail’s performance was a revelation to the partners at DFJ. And if there were any doubts that its success could be replicated, they were laid to rest with the success of Four11. Six months before taking a 15% stake in Hotmail, DFJ had invested $800,000 in Four11 — a provider of free Internet directory services. Though Four11’s growth was not as explosive as Hotmail’s, it did exhibit all the symptoms of a viral-marketing success story. In the end, Yahoo! acquired Four11 for $93 million of Yahoo! stock. In less than two years, with a total of less than $5 million invested in Hotmail and in Four11, DFJ walked away with $200 million. “We were on the lookout for viruses from that point on,” says John Fisher. “In Tim’s case, it almost became a sine qua non for investing in a company.” Adds Jurvetson: “I can’t think of any consumer Internet company that we’d consider that doesn’t come with a viral-marketing element.”

DFJ has considered — and funded — a portfolio of companies that do fit the viral criteria. NetZero, for example, offers a lifetime of free Internet access in exchange for allowing a one-by-four-inch window to be displayed that broadcasts targeted ads. NetMind, a service that automatically notifies subscribers of changes to their favorite Web pages, has ramped up to 7 million customers in three years. Homestead, another startup, lets users create private Web sites for free. When users send their password that allows family and friends to access the site, it comes with a link encouraging them to set up their own page.

But perhaps the investment with the highest visibility (and certainly the most controversy) that DFJ has made is in Third Voice, an online service that allows users to place the digital equivalent of Post-it notes on any Web page in the world. The way Third Voice works is simple: A user downloads free software that installs itself onto a browser. Once the application is up and running, unobtrusive markers appear on a Web page indicating that other Third Voice users have left comments there. Click on the marker and the comments pop up in a small box. If the user has registered his or her name and email address with Third Voice, they’re free to add comments of their own. What’s unique is that nothing happens on the Web site itself. The entire transaction is between Third Voice’s servers and its clients’ browsers, so Web masters have no control over what’s being posted on their sites.


That’s what makes many Web-site administrators so nervous. Visitors can go to a site that’s hawking a product and leave a note that says, “This product sucks.” Any Third Voice customer who goes to that site can view the note. Third Voice users can create private lists that allow their postings to be read only by people they choose. So even if Web masters have a Third Voice – enabled browser, they can never be sure they’re seeing all the postings on and about their site.

“When you strip down all of the hype, the Web really hasn’t changed for the user since the first Mosaic browser was used,” says Eng-Siong Tan, Third Voice’s ebullient CEO and cofounder. “As a user, what can you really do? You can type in a URL and choose which link to click on, but that’s it. It’s all a one-way flow. So we thought, ‘Why not add a level of interactivity so that users can talk back?’ “

When an entrepreneur from another DFJ-funded company showed Jurvetson a mock-up of what Third Voice might look like, he was blown away. “It was just two scraggly screen shots,” Jurvetson recalls, “but it caught me. The concept was so simple: You could build a community and add comments on Web pages without involving that Web server. If Yahoo! doesn’t want to partner with you, it doesn’t matter. If doesn’t want to partner with you, it doesn’t matter. You can launch your business and get going.”


Jurvetson set up a meeting with Eng-Siong later that afternoon. He was amazed by what he saw in the shoddy warehouse-cum-dormitory that was Third Voice’s original headquarters in Foster City, California: “The big, high-ceilinged room contained rows of picnic tables on top of which were computers set up closer together than I’d ever seen. And there were 26 people at that time who, I’m sure, were breaking every fire code ever written. Almost all of them seemed to be living there, sleeping on beanbag chairs in the loft upstairs and sharing the only bathroom in the whole place. But despite the Spartan conditions, they exuded an incredible energy.”

That energy proved to be infectious. The more Eng-Siong explained the product, the more Jurvetson loved it. After all, Eng-Siong was speaking his language: “The way we put it to Steve was, ‘You look for viral marketing in the companies you fund: Well, we’ve got something that contains not one, but two viral-marketing mechanisms. There’s Hotmail and there’s ICQ [an instant-messaging service, used by 32 million subscribers, that was acquired by AOL last year]. Would you like to see those two elements combined in one service?’ “

Would he ever! Jurvetson and his partners understood that Third Voice was unlike anything they had ever seen. If Hotmail was like Internet flu, and ICQ, with its omnipresence on a browser, was like chicken pox, then Third Voice resembled an Ebola virus — a species-threatening event that could change the entire nature of the Web experience. And Third Voice had the potential to spread faster than anything they had ever imagined. How? When a user wants to direct a friend to a comment on a Web page, Third Voice’s software generates an email that includes a link to the page. If the recipient doesn’t have the software, a click on another link (à la Hotmail) takes that person to the Third Voice site, where the 300-kb program is downloaded in less than two minutes. Now that’s viral marketing.


Then, after the software installs itself, it asks permission to import the user’s address book from Microsoft’s Outlook Express, Eudora, Netscape Navigator, or a number of other email clients, and like ICQ’s buddy lists, the software immediately creates a new network of potential users. And the more people who use the service, the more valuable it becomes, because more user-generated postings are available to read and more communities are created around different Web sites. Which, in turn, means that more people tell their friends about Third Voice, and it gets bigger and bigger. Now that’s network effects.

And that’s why it took DFJ only a week to agree to come in as an investor, along with Mayfield Fund, which Eng-Siong had already brought on board. That’s also why the very idea of Third Voice strikes fear into the virtual hearts of so many Web companies.

But the controversy is of no concern to Eng-Siong this morning. Two weeks after the company was launched, all he can think about is the rate at which his service is spreading. The numbers from the United States are looking good. Internationally, Singapore was already lit up, thanks to the personal networks of most of Eng-Siong’s staff. Australia seems to be coming along nicely. But the country where Third Voice is growing the fastest is Germany — which its founders find strange, because the entire site is in English, and, needless to say, English is not the first language of most Germans. But they do speak the language of network effects, and in the new economy, that’s the language that matters most.


“It’s been unbelievable,” says Jurvetson. “Of the consumer-oriented Internet business plans that we see, perhaps 70% of them explicitly talk about their viral-marketing strategy. You could argue that they’re using that term because they’re just trying to suck up to us. But I’m pretty convinced, based on how deeply embedded this idea is, that they’re sending these plans to every venture firm — which means that they’re really thinking about it. It’s bizarre. The idea itself is spreading like a virus.”

Net Future Value

Eight o’clock, Monday morning, on Wall Street: Scott Reamer has just returned to his cluttered office over-looking the East River, after SG Cowen’s morning call. During that phone meeting, Reamer announced that he’s initiating coverage of Inc., the financial Web site founded by the flamboyant hedge-fund manager James Cramer and by New Republic owner Martin Peretz.

It’s now June 7, 1999: 27 days after the Street’s bottle-rocket IPO — a period that has seen the stock go public on May 11 at $19 per share, soar to as high as 71 in its first day of trading, and tank to 29 at the market’s close on May 28. On page C-1 of this morning’s Wall Street Journal, the company has the dubious honor of being featured in a story titled: “IPOs Fizzle, but That Could Actually Be Good.” Reamer’s not spooked by the volatility. He’s opened his coverage with a “buy” rating and put a $45 target price on the stock.


Reamer has been in his office for only a few minutes when the phone calls start pouring in from SG Cowen’s sales force — the people who sell stocks to institutional investors, such as Alliance, Fidelity, and Janus. The reps want to know what’s going to move the stock over the next few weeks. Reamer runs through a list of positives: media partnerships with the New York Times and Fox, a demographic where 40% of the subscribers have incomes of more than $200,000, and a hybrid business model that combines subscriptions with advertising and sponsorship revenues, commerce fees, syndication fees, and corporate intranet deals.

“Yeah, sure, when they started out, I thought it was all about Cramer’s ego, too,” he tells one caller. “But this is a real business, and they’re being very smart about it. They are in for the long haul.”

Earlier this year, Institutional Investor ranked SG Cowen’s sales force as one of the best in the business. Reamer calls them his “bull horns to the Street.” When he makes a move, his troops spread the word. And word travels fast. Reamer covers only 7 companies. So when he adds a new name to his portfolio, it’s news in and of itself. “I don’t cover 45 companies because it doesn’t make sense,” he explains. “You don’t want to diversify on Internet investments; you want to pick the best companies and stay with them. The goal of my research list is to reflect those companies always.”

America Online is a cornerstone of Reamer’s list. And it too is generating big news this morning. On Friday, a federal judge in Portland, Oregon ruled that cable-TV operators cannot block AOL and other Internet-service providers from getting access to their infrastructure. This is bad news for AT&T, which has been buying up cable properties in the hope of locking up Internet access, but it’s great news for AOL — and for Reamer. Last October, when the young analyst launched his biweekly newsletter, “The Internet Capitalist,” investors had been hammering AOL’s stock, concerned that it would fail to be a player in the Internet’s broadband future. Reamer took a hard line in the opposite direction. “AOL most certainly will not be left out of the broadband game,” he wrote with characteristic directness. “Indeed, it is our firm belief that it will be driving it.”

The game’s far from over. But on Friday, after the Portland ruling, AOL jumped 12 points. When Reamer checks his monitor this morning, the stock has already dropped 5 points to 115. At that valuation, AOL is still a $125 billion company. But just two months ago, when the stock hit its 52-week high of 175, it was a $190 billion company. From a market-capitalization standpoint, AOL has lost $65 billion. Or put another way, in 8 weeks, AOL’s value has decreased by the GNP of Ireland.

That kind of volatility is what makes Reamer’s job one of the toughest in the entire Internet space. “Clients pay me to separate the wheat from the chaff,” he says. “In a world that changes every day, I try to distill things to their essence: What are the enduring qualities of Yahoo!,, and AOL — the two or three factors that really matter to investors? And what other companies have those things?”

AOL, with 19 million paying customers and 1998 revenues of $3.8 billion, is undeniably a real business in a virtual world. But even with a market cap of $125 billion, Wall Street is saying that AOL is worth more than General Motors, Sears Roebuck, and Boeing combined. Does the new math of the Internet economy really compute?

For Reamer, the way to answer that question is to ask a related one: How much is a customer really worth? “The ultimate value of network effects comes down to the lifetime value of a customer,” he explains. “Obviously, it takes a certain amount of money to acquire a customer. Then you spend a certain amount of money to service the customer. And, of course, you derive a certain amount of revenue from that customer. You hope that the revenue you get from ‘monetizing’ customers — whether it’s from subscription fees, or e-commerce, or advertising — exceeds the cost of acquiring and servicing them.” It sounds pretty simple. But the miracle of network effects — what separates a company like AOL from companies like gm and Boeing — is that all three elements of this value equation can improve at the same time. Forget the law of diminishing returns. AOL and other fast-growing Internet companies can operate under the principles of increasing returns.

Take customer acquisition. In the first quarter of fiscal 1998, when AOL had 9.8 million subscribers, the company was spending $3.91 per customer on marketing costs — to retain its current members and attract new ones. By the first quarter of fiscal 1999, with 13.5 million members, the cost had dropped to $3 per person. By the third quarter, when the service had grown to 16.9 million members, AOL’s marketing costs per member had fallen to $2.51. In other words, as AOL got bigger, it became cheaper, rather than more expensive, to get bigger still. Old-economy companies just don’t work that way.

So why does AOL work that way? Reamer tells a simple story: “I have an institutional salesperson here on the New York sales desk who got off AOL because he basically outgrew it. In effect, he became a more advanced and sophisticated Internet user, so a year ago he dropped his account. But this Christmas, he told me he was back on AOL. Why? Because his daughter came home and said, ‘All of my friends at school are on AOL. I want to get an AOL account and chat with them.’ AOL didn’t spend one dime to market to this nine-year-old girl. All the other nine-year-old girls who were in her class spent their precious time and energy convincing his daughter that she should be on AOL. That’s network effects.”

The real power of network effects kicks in on the revenue side, when AOL monetizes its customers. “If AOL has 1 customer, huge advertisers like Procter & Gamble aren’t interested in spending money there,” he says. “But if AOL has 1 million customers, then P&G takes notice. With 10 million customers, I guarantee you that P&G wants in. And when AOL has 20 million customers, P&G can’t afford not be interested.”

But it’s not just about the total volume of customers. “Over time,” Reamer continues, “AOL has greater and greater capacity to choose among its millions of customers and pull out those who are likely to be of the most interest to a particular advertiser. AOL can identify, say, men between the ages of 24 and 34 who are interested in some topic, and sell that list of people for an enormous amount of money to relevant advertisers. The bigger and smarter AOL gets, the greater its ability to monetize its customer base.”

Crunch the numbers, and you’ll find that’s exactly how it has worked over the past few years. At the beginning of fiscal 1998, AOL managed to generate revenues of $18.99 per customer. At the beginning of fiscal 1999, that figure had risen to $21.20. By the third fiscal quarter, AOL was taking in $21.53 for each customer it had. Over the same period, its subscriber base had increased by 3.5 million members.

Put simply: Success breeds success. More revenues per customer, multiplied by more customers, equal serious growth. “Just think of what this will look like a couple years out,” Reamer says, going to a whiteboard to graph the phenomenon. “You don’t have to go too far out to say — ‘Whoa! That’s a lot of money.’ That’s the beauty of this equation. The amount that AOL — and Yahoo!, and, and eBay — can monetize from each of its customers today probably pales in comparison to how it will be able to monetize those customers two years from now.”

Then it becomes a question of the “X factor” — just how much do costs go down, profits go up, and earnings increase? Is it 2 times, or 10 times, or 100 times? “Plenty of people think that it’s going to be 2 times; plenty of people think it will be 100 times,” says Reamer. “That’s a legitimate debate, because we don’t know. What we do know is that in this environment, profitability per customer goes like this.” Reamer draws another right angle on the whiteboard. “That means that earnings and cash flow do the same exact thing.”

Scott Reamer’s path to Wall Street was not nearly as straight as the lines he had been drawing on his whiteboard. Reamer was born in upstate New York and attended Lafayette College, where he majored in chemical engineering. He’d already been accepted to graduate school, to work toward a doctorate in chemical engineering, when he decided to take a Wall Street internship with Prudential Securities. “At the time, I thought to myself, ‘I’m going to grad school where I’ll spend five or six years getting my PhD, and then I’ll probably work for Exxon. I’ll never have an opportunity to be on the floor of the New York Stock Exchange during trading hours. I’ve got to go for this.”

That one summer got him hooked. “I’d studied engineering and mathematics during my entire college career, and I didn’t know a lot about Wall Street,” he says. “But I became more and more interested, until at the end of the internship I just said, ‘I’ve got to do this. I want to do this.’ So I got an interview and worked in the investment bank at Prudential Securities.”

After 18 months in Prudential’s investment-banking program, Reamer became an analyst, covering enterprise-software companies. The companies he tracked included Microsoft, PeopleSoft, Sybase, and Informix. That was the spring of 1995. That summer, Netscape had its now-legendary IPO, and Reamer’s world changed again. “Netscape had an enormous impact on Microsoft,” Reamer says. “Jamie Kiggen [the senior analyst he was working with] and I got interested in it. We didn’t officially cover Netscape, but we watched it all the time. We had to know everything about it because it affected Microsoft. We also started covering AOL around then.”

As the Internet became a bigger and bigger deal, Reamer and Kiggen had to choose: stick with enterprise software or devote themselves full-time to the Net. They chose the latter, and eventually moved from Prudential to Cowen and Co. It was the perfect launching pad for Reamer and Kiggen. On Wall Street, Cowen (now SG Cowen) is what’s known as a “boutique investment firm.” Unlike the giants — Merrill Lynch, Goldman Sachs — it doesn’t cover all of the publicly traded economy. It focuses on just two main areas: health care and technology. The big Wall Street firms were covering the Internet on a piecemeal basis, through their software and telecommunications analysts. Cowen let Reamer and Kiggen establish a stand-alone Internet research division. As a result, in the summer of 1996, they became the first full-time Internet-only analysts on Wall Street.

It was during that same period that Reamer’s thinking on the principles of Internet valuation began to evolve. He’d stumbled across the writings of Brian Arthur, the former Stanford University professor who popularized the field of increasing-returns economics. “I was a huge Microsoft bull,” Reamer says. “Covering Microsoft gave me a natural curiosity about how to replicate Microsoft. What was the real driving force of the business? What was the underlying economic principle behind its incredible valuation? In my view, it turned out to be increasing returns. It just crystallized the reasons behind Microsoft’s inexorable rise. It’s not rocket science, but it does call for a change in thinking — a certain leap of faith.”

What helped Reamer make the leap was that he came to Arthur’s ideas not with the know-it-all mind-set of an MBA, but with the open-minded perspective of an engineer. “Engineers are problem solvers,” he explains. “They look at an outcome and say, ‘How did that happen?’ It’s free association. You’re not locked into any one rule. That’s why I try to hire as many engineers as I can. I absolutely think the source of the success I’ve had in analyzing Internet companies comes from my engineering background.”

From the perspective of creating shareholder value, a handful of companies — Microsoft, AOL,, eBay, Yahoo! — are clear-cut cases of increasing returns. “It’s still too early to say whether this thesis is proven or not,” says Reamer. “But that’s the bet I’m making. These ideas inform my research — the presence of increasing returns in these companies and their business models.”

Last summer Kiggen left Cowen to join another Wall Street outfit. After years of second billing, Reamer became SG Cowen’s star player in the Internet space. One of his first moves after settling in was to found “The Internet Capitalist,” a biweekly roundup of analysis, research, and commentary. And, in the spirit of the new Internet economy, he decided to give it away free of charge. “I’m just trying to apply the same Internet principles to my own little franchise that the companies I follow use,” he says with a grin.

Today, Reamer’s readership is in the thousands. And in the stodgy world of Wall Street analysis, the “Capitalist” remains in a league of its own. The reason has less to do with its free online availability than with its iconoclastic style. In one of his first issues, Reamer included a section called “Froth Watch,” the purpose of which is to highlight what he believes are excellent indicators of the indiscriminate nature of shareholder-value allocation the market has been practicing. “A bunch of Web companies, including Onsale, Cyberian Outpost, and Bluefly, ended up on the receiving end of Reamer’s scorn. He even criticizes his own research. A piece back in March, entitled “Why We Were Wrong on Sterling Commerce Inc.” (the one stock he tracks that has underperformed), began with a quote from Samuel Johnson: “Studious to please, yet not ashamed to fail.”

It’s not just Reamer’s entertaining opinions (or his one-paragraph movie and book reviews) that keep readers coming back. In commentaries such as “Why Increasing Returns Matter to Valuations,” “Disintermediation 201,” and “The Art of (Broadband) War,” he tackles big themes that underlie Internet investing. “You could never get away with publishing ‘The Restaurant Capitalist’ or ‘The Oil-Field Capitalist,’ ” he quips. “Those are mature industries; people understand what drives them. But the Internet is a nascent phenomenon, ‘The Internet Capitalist’ can find a home in people’s brains and on their desktops.”

Back at the office, it’s the end of the day. Reamer has a dinner meeting with a client from Singapore. Then he’s taking his research team to see Austin Powers: The Spy Who Shagged Me. (They need a movie to review for the upcoming issue of “The Internet Capitalist.”) When he returns to his apartment in the West Village around 11:30 pm, he may take his new racing bike for a spin through Central Park. “Even then,” he says with a grim laugh, “I’ll still be thinking about these companies.” No kidding. On his whiteboard, there’s a note reminding him to eat and exercise. “There’s definitely a downside to being in the middle of this universe,” he says, “and that’s the time demands; they’re unbelievable. Everything else in my life takes a second role.”

The phone rings again, and Reamer is just about to answer it when another thought strikes him. “If I had to cover oil fields or some other mature industry, I’d probably quit and do something else with my life,” he says. “But with the Internet, we’re going to look back in 10 or 15 years and realize that in 1999, we were just at step one. We were in at the inception of something huge: Something that, in 5 or 10 or 15 years, may be 20% of the GDP. This is just such an enormous event in the economic, political, and social history of the United States and the world. It’s just such an unbelievable time. I wouldn’t want to do anything else.”

He ponders that last statement for a moment and then takes the call. It’s another client wanting to know his perspective on the value of a new Internet company.0D % Eric Ransdell (, a Fast Company contributing editor, is based in San Francisco. You can visit Draper Fisher Jurvetson on the Web ( or contact Steve Jurvetson by email ( You can visit SG Cowen on the Web ( or contact Scott Reamer by email (

Sidebar: Four Laws of Viral Marketing

Back in 1997, Steve Jurvetson wrote a white paper that laid out the basics of viral marketing. Here, supplemented by interviews with Fast Company, is his primer.

1. That’s what friends are for.

Network-effects companies have to be great at signing up new customers. But truly great network-effects companies also know how to keep the customers they have. The way to do that is to create products that are so easy to understand and so compelling to use that people enlist their friends. “For products to shine, customers have to inherently want to share them with their friends,” says Jurvetson. “If people sign up their friends, a company doesn’t just grow like hell, it tends to keep its customers too.”

2. The freer it is, the faster it spreads.

Sooner or later, business comes down to money. But with network-effects companies, later is better. “If a service tries blatantly to monetize its subscriber base in every way imaginable, new users will be reluctant to spread the word,” Jurvetson argues. “That’s why, in the early days, many of these services are free — and light on revenue generation.”

3. Cafés beat subway stations.

The big difference between a café and a subway station is that people seek out reasons to spend time in the former — and try to pass through the latter as quickly as possible. One of the best indicators of an Internet site’s value is customer loyalty: How long do people stay? How often do they return? “Are you a subway station, with banner ads flying by commuters who are just trying to get to their destination?” asks Jurvetson. “Or are you a café, where customers mingle and feel like they belong?”

4. Size does matter.

In a world of network effects, the bigger you are, the harder it is for you to be dislodged. “By the time a virus spreads to the point of being an epidemic,” says Jurvetson, “its growth curve relative to a new entrant is daunting.” By the time Hotmail appeared on anyone’s radar screen, it was adding a million customers a month. Not only were its efficiencies improving, in terms of server utilization and bandwidth pricing, but it was also grabbing the lion’s share of business and financial partnerships.

Sidebar: Internet Capitalism

Scott Reamer doesn’t just follow stocks; he takes stock of the logic by which the digital economy works. He believes that four new rules define competition in the 21st century.

The first is increasing returns. Reamer looks for them in every consumer-based Internet company that he follows: “From a stock-market perspective, a company that grows its customer base at a ‘normal’ rate — 10% or 15% a year — is impressive. But a company that grows its customers by 15% or 25% a quarter — 100% a year — is clearly a more valuable entity. A company that grows its customer base by 100% a year, and then figures out how to make each of those customers more profitable — well, that’s even more valuable than the other two. That’s why these Internet valuations are tough to understand. The market has never before seen anything like this.”

Reamer’s second principle is that the Internet represents the democratization of media, commerce, and communication. “Consumers basically do three things with their leisure time,” he says. “They consume media, they engage in commerce, and they communicate with people. The Internet democratizes those activities by reducing the importance of time, place, and form.”

The third principle is that the Net reorganizes industry-value chains. is, of course, the most famous example. “ changed the whole industry-value chain,” Reamer says. “You can look across the economy and see plenty of similar opportunities. In some cases, there will be radical changes to how industries work; in other cases, there will be subtle changes, but there will be changes.”

Reamer’s final organizing principle about the Internet: Time is money. “We all know that in our professional and personal lives, time is the only commodity worth anything anymore,” he says. Consumers will pay you to save them time. The Internet saves people time. It’s a hyperconvenient medium. Companies that explicitly save people time are going to make money.”