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Nowhere Men

The anatomy of a start-up built around creating a cyberstore on the World Wide Web to sell CD recordings.
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No store. No catalog. No sales staff. Is this the future of retailing?

A beige box sits on the floor, under a Formica-topped table. Wires connect the box, a $60,000 Sparc 20 workstation, to various disk drives and to two battery backups. Every flash of a tiny red light on one of the disk drives indicates that somebody is in the store and shopping.

Store? What store?

CDnow, a Generation X-launched start-up that sells music CDs, cassettes, and a few additional products, doesn't have a traditional retail store with walls, aisles, fixtures, and products that customers purchase at cash registers. CDnow exists only in cyberspace, where commercial sites are popping up like mushrooms after a rain. But CDnow is unlike most of the tens of thousands of .com sites on the World Wide Web, the majority of which are foot-in-the-door, me-too enterprises struggling to connect existing businesses to the Internet. CDnow was conceived from day one as a low-overhead, virtual business, and it is already making money. An Internet vet approaching the second anniversary of its maiden on-line sale, this rapidly growing basement start-up has sprinted to an early lead in a wild and lucrative race -- grabbing market share in the brave new world of Internet commerce, which, according to a report from International Data Corp., should grow to $150 billion to $200 billion by 2000.

Piloting CDnow into that turbulent, uncharted future are company founders Jason and Matthew Olim, fraternal twins who were not yet two months old when the Woodstock rock festival immortalized Max Yasgur's farm. Both tie their long brown hair in ponytails, prefer socks to shoes in the office, wear worn jeans, and look like a couple of primo slackers.

Some slackers. Both recall the last two years as a blur of 16- and 20-hour days. Jason, who conceived the notion of an Internet music store, is the entrepreneurial twin, an outgoing deal maker, the corporate visionary. Brother Matt is the back-shop programming wizard. Happiest when he's writing elegant computer code, he prefers to labor in the wee morning hours.

As recently as February, the brothers were adding an employee a week to their company and had just built the head count to two dozen. Of the staff they hired, only their controller has ever blown out 30 candles on a birthday cake. Music posters adorn the walls of the company's new offices in Penllyn, Pa., near Philadelphia. Salaries are low, and the energy level is high -- as one would expect at a small, cutting-edge company that is doubling its sales every couple of months, in an industry in which entry barriers are few and new entrants plentiful.

And no one is more surprised at all of that than Jason Olim. While he was still a programmer for a software company in February 1994, he was sitting in a bar with friends when the idea of setting up shop on the Internet struck him as a perfect way to create a new kind of music store that could address the glaring gaps he saw in most music retailers' customer service. Too often he found their salesclerks unhelpful and unknowledgeable and their selection limited -- problems an on-line store could easily avoid while simultaneously achieving another advantage: convenience. Shoppers could enter Jason Olim's cyberstore in seconds from their home or work computers without fighting through bad weather, snarled traffic, or crowded shopping malls. Instead of flipping through finite racks of ill-sorted CDs, they could click immediately on virtually any title, because Jason's store would never stock or warehouse a single compact disc. He'd fulfill orders by tapping the combined inventories of other companies in the distribution chain. Equally important, he'd add value by improving the shopping experience. Browsers would find themselves only a mouse click away from performer profiles and album reviews, concert information, and more. A limited sampling of selected CDs would also be available.

The younger (by 40 minutes) Olim's draft business model was almost na√—ve in its simplicity, which is unsurprising, as his entrepreneurial r√ąsum√ą began and ended with the house-painting service he ran for two summers while at Brown University. "I'll get my CDs wholesale, ordering them from the warehouse when the customer orders them from me. All I've got to do," he remembers thinking, "is charge more than I'm paying, and that difference times the volume has to be enough to pay for my computers and my salaries." Another thought crossed his mind, too. A successful on-line CD store would be his demo. If it made sweet music, he could leverage its reputation to get him into the business of showing others how to create and operate their own cyberstores.

"I was imagining three people. We were going to manage a computer and eat pizza," he says. "I never expected to sell $2 million worth of CDs in my first year." But back in February 1994, the Web barely existed. In 1995, CDnow's first full year of business, the number of Web users jumped eightfold, from one million to 8 million, according to International Data. That number has probably shot past 13 million by now.

Though Olim didn't anticipate the salutary effects of so many new Net surfers, he did count on the low overhead costs of founding and running a virtual business. CDnow's start-up costs, as he figured, proved minimal. He spent $1,500, which he'd saved for a bass guitar, on a new computer, and another $500 for a software license. He soon tapped his savings for an additional $12,000. But except for that and a $70,000 loan from an outside investor that he has begun to pay back, he has financed the growth out of revenues.

Working in the basement of his parents' house after work and on weekends, Jason began building the "store" -- a possibility only because it required no real estate, no bricks and mortar, and no inventory. He did need thousands of lines of computer code, the writing of which he soon relinquished to brother Matthew. The older twin quickly grew adept at building the intricate software necessary to construct and manage an interactive Web site. He also became obsessed with harnessing the commercial capabilities of an exciting new medium. Month after month, seven days a week, he worked nearly round the clock, often brushing his teeth in front of the computer. Meanwhile, Jason forged links with so-called one-stops, music-industry wholesalers that stock discs from most distributors. It didn't hurt that the father of one of Jason's college fraternity brothers headed one such company, Valley Records Distributors Inc.

In August 1994, six months after Jason's vision at the bar, CDnow sold its first album. First-month sales totaled $392. During the same month a year later, sales of CDs, cassettes, and T-shirts brought in $189,000. In 1995 sales for the company's first full year reached $2 million, more than double Jason's projections. So far, the on-line music store has continued to hit mostly high notes. By February of this year, CDnow was attracting well over 300,000 shoppers a month and ringing up 300 orders a day. The average order: $40. "We're now the size of a chain of 10 retail stores," says Jason. "And I expect to triple in size by the end of the year." CDnow regularly appears on various top 10 lists of hot Web sites. A review in the May 1995 issue of NetGuide gushed, "CDWOW! might be a better name."

Inevitably, as other entrepreneurs have also spotted a product well suited to on-line commerce (one that comes essentially presold and doesn't need to be tasted, touched, or tried on), CDnow has been joined by a chorus of competitors -- easily more than 100 that sell some kind of music and at least 10 with the kind of product range and backlist that CDnow has. Many of those sites will likely shake out, but serious threats loom at such on-line addresses as Music Boulevard, which recently merged with N2K, a multimedia-development company, and 1-800 MUSIC NOW, MCI's phone-order CD business, which recently added a Web site.

"CDnow is by far the biggest and the best, the one we like the most," says Barney Cohen, chairman and chief executive of Valley Records, which currently fulfills orders for CDnow and some two dozen other cyberstores. Valley's shipments provide a window on rising music sales over the Internet. In its fiscal year 1996, which ended this past March 31, Valley wholesaled $5 million in Internet orders. Over the next year, says Cohen, "we hope to do $15 million to $20 million, and that's a conservative projection."

Even $20 million is still small change in the multibillion-dollar recording industry. But no one doubts that on-line commerce will get a slice of that juicy pie. The question is, How big a slice? Jason figures that Web sites should be able to capture most current mail-order and record-club sales, pegged by the Recording Industry Association of America at nearly 20% of the $12.3-billion nationwide recorded-music market. "In five years, minimum, I think you'll see $1 billion of CD transactions on-line, and it could be $5 billion, depending on how the Internet takes off," Jason predicts, boosting his estimates by factoring in worldwide sales.

A key determinant of the growth of Internet commerce is the growing willingness of consumers to provide their credit-card numbers for on-line transactions, although they are still somewhat cautious. Consumer hesitancy on that issue, Jason believes, will soon disappear.

In truth, he can ill afford the added costs of handling checks and manually entering orders from incoming faxes. CDnow's gross profit margin -- reached by buying from the one-stops and selling, on average, about 10% below typical retail store prices -- stalls at about 12%. On a new release -- say, Jackson Browne's Looking East, which CDnow recently offered for $13.96 -- a 12% gross margin yields about $1.70. (The additional $2.49 for shipping and handling covers just that.) Although its overhead is low, the Olims' virtual store still incurs expenses. CDnow must purchase the electronic rights to publish material from The All Music Guide, a database and publication that provides reviews and artist biographies. It must buy digitized jewel-box artwork so shoppers can call up album covers on demand. To add more value to its store, CDnow produces topical and promotional attractions. For instance, before Grammy Awards night, shoppers might have a chance to learn about the Top 30 Artists Never to Win a Grammy; or they might win a trip to meet Clint Eastwood by locating Eastwood's favorite hat and gun during a cybertour of his new CD-ROM. Furthermore, the company has opened a three-person satellite office in Los Angeles to help develop those on-line features. Total all the expenses, and that 12% margin shrinks down mighty thin.

"They can't get rich on the store," notes Valley's Barney Cohen. Don MacKinnon, president of Hear Music, a chain of nine retail music stores founded on the concept of adding information and service to the buying experience, is more blunt about the Olims' prospects: "If he's only able to eke out 12%, it's going to be very challenging."

Jason Olim has a more hopeful view, for at least a couple of reasons. The first: growing volume. "The rule I've kept applying is, If it adds value, you can do it," he says, admitting that he has sacrificed margin to continually improve his Web site. He believes increased volume will boost profits, thanks to economies of scale. "To double your business, you only have to add another memory chip." Second, other revenue streams will help even if margins on CD sales stay low.

A trickle of money has already begun to flow in in the form of advertising dollars -- something Jason Olim didn't factor into his original concept. CDnow was one of only a few dozen Web sites chosen earlier this year for tests of on-line ads for the Microsoft Network. The Olims charged 4¬Ę an impression (someone's clicking on a page carrying the ad); they guaranteed and delivered 100,000 impressions, thus bringing in $4,000. Though the success and eventual rates of on-line advertising remain anyone's guess, it's reasonable to assume that more traffic in the store will boost the amount that advertisers are willing to spend.

Moreover, it may be possible for CDnow to perform and be paid for playing multiple roles -- as ad agency, production house, and publisher, and, of course, as retailer of the product being promoted. Such was the case with a uniquely targeted campaign for Geffen Records. Appearing only on computer screens linked to CDnow via .edu domains was this message: "Hey, you! The college kid in front of the screen. Get 10% off all Geffen titles." Those who failed to click on that banner to learn more about the offer were blasted a few Web pages later with an in-your-face follow-up, inappropriate for classical- music lovers but suitable for university-linked Internet surfers. "Hey!" the message read. "We asked you nicely the first time, now get your ass in here."

"Advertising is going to be very critical to us," says Jason, who estimates that ad and promotional revenues should reach $1 million this year and $3 million next year.

He's counting on similar revenues from licensing CDnow's technology to other cyberstores -- even direct competitors. "I think it's the most advanced system on the Internet," he says, confident others will see the merits in paying him, say, $300,000 for a license to use his technology, as well as ongoing fees to manage their stores and fulfill orders.

In March the Olims began building both a music store and a movie store for an unspecified client. Jason realizes that big players like Tower Records, whose cyberstore is currently located on America Online, will cast big competitive shadows. "We all recognize this thing as a huge, huge, huge potential pie," he says. "We're not really jockeying for our slice as much as we're looking to be part of this thing when it builds. As Homer Simpson says, 'When the saints come marchin' in, I want to be part of that rhumba." Accordingly, CDnow appears to be mapping out an "If you can't beat 'em, join 'em" strategy, envisioning the kinds of strategic alliances -- America Online with Netscape and Microsoft, for instance -- that are already molding Internet commerce.

"Everyone always asks, 'Where are your barriers to entry, where's your defensible position?" Jason says, explaining that CDnow has exciting plans for its Web site -- including live concerts. "But ultimately, I would rather be somebody providing value where I have the most value to add, which is at the technology level, than be somebody who's fighting the marketplace. I've always thought, 'Make socks.' Be in the least-glamorous business and you'll have a defensible position."

Cohen's advice to the Olims: "Run like hell." And, he adds, they should build other cyberstores as fast as they can, while they continue to enhance their existing site in order to attract the million shoppers a month Jason envisions. That way, Sony and other labels would be crazy to crush them, because CDnow would be too valuable to them as a promoter and merchandiser to kill. In their favor, the Olims have almost no debt and still own 100% of the company. In a jam they should be able to raise capital by selling a stake in CDnow. Buyers shouldn't be hard to find; the Olims have already turned aside several offers.

The unavoidable question: Can an entrepreneurially inexperienced 26-year-old, even one with vision beyond his years, go toe-to-toe with the big boys and prevail in such a high-stakes race? To date, Jason has steered the company with help from the Wharton Small Business Development Center and the Owen Graduate School of Management at Vanderbilt University, suggestions from his staff, confirmation and admonishment from Matthew, feedback from friends, and assistance from business advisers he's cultivated -- a few of them through cold calls.

One of the company's biggest problems, Jason says, is focus. "There's so much we can do." CDnow already sells magazines; a move into movies, which promise higher margins than CDs, seems likely. A deal maker even in college, when he ran charity auctions, Jason thrives on piecing together deals from which everybody benefits, especially consumers. Those who know him describe him with words like brilliant and visionary. He'll have none of that. "I'm a good listener," he says. "I think one of the things I do best is go to people and learn. I have very little ego when it comes to what I think I know. I have a lot of good advisers, and I know how far to trust them and how to challenge their assumptions."

To those who say the race to Internet riches will go to those with clout and resources, he says, Not necessarily. "The key is vision, drive, and execution." And, he might have added, quick and sure reactions to fast-changing circumstances. Having gotten in early, he's now deep in a fast-changing field in which new businesses breed like bunnies, Web pages can be changed with a few keystrokes, and nobody can see anything but the dim outline of the future. "Every week is a revolution," he says, eager to visualize and build the store of the future.


EXECUTIVE SUMMARY

Company: CDnow, an Internet retailer of music CDs, based in Penllyn, Pa.

Concept: Create a successful cyberstore and then license the pioneering Web-site and order-fulfillment software to other cybermerchants

Projections: Second-year sales in 1996 of $10 million

Competitive advantage: Boundless energy, early start

Hurdles: Luring consumers to this new shopping venue; outmaneuvering the inevitable 800-pound competitive gorillas

THE FOUNDERS
Jason Olim,
26, president. Graduated from Brown University, with computer-science degree. Favorite music: XTC, Bach

Matthew Olim, 26, vice-president. Graduated from Columbia University, with astrophysics degree. Favorite music: Nirvana, Pearl Jam

Family: Live at home with their mother, a hospital nutritionist, and their father, a dermatologist

Personal funds invested: Jason's $14,000

Equity held: 50% each

Typical hours: Jason works 10 a.m. to 11 p.m., six days a week; Matthew, noon to 3 or 4 a.m., every day

THE INTERNET'S PHANTOM ECONOMIES
An Internet store sounds great: there's no rent, no build-out costs, and no inventory, and most of the work is done by computers. But reality is something else. The chart below compares CDnow's estimated monthly expenses with those of a typical three-store retail chain doing approximately the same sales volume.

Monthly expense CDnow Retail Chain
Rent $2,500 $12,000
Fixtures and improvements $0 $3,500
Utilities $900 $3,000
Wages $50,000 [1] $32,000
Telephone $2,500 $1,000
Internet connection $2,000 $0
Inventory $0 $0 [2]
Credit-card fees $10,000 $4,000 [3]

[1]CDnow doesn't break down its payroll costs, but a significant portion of its employees' time is spent on non-CD-related software and product development.

[2]Assumes frequent turnover and good supplier terms.

[3]More than half of the retail stores' sales are cash.

THE FINANCIALS (in thousands)
Sales:

1995 1996* 1997*
from CDs and other products $2,000 $10,000 $30,000
from advertising and promotional fees $10 $1,000 $3,000
from licensing of technology $30 $1,000 $3,000
Expenses and overhead $2,000 $9,000 $27,000
Profits $40 $3,000 $9,000

*Jason Olim says that projections are "outrageously difficult" for him to make. A tripling of sales for 1997 "feels" about right. Expenses, and therefore profits, he says, are even harder to estimate in what is a wholly new kind of retail business.


WHAT THE EXPERTS SAY

Competitor
Don MacKinnon
President of Hear Music, a nine-store retail chain based in Boston

CDnow is extremely well positioned as the leading Internet retailer. It's capturing an audience the record companies are desperate to reach, so it should be able to improve its poor product margins by attracting substantial advertising dollars.

One of the Olims' key challenges will be competition. CDs are the first "proven" Internet merchandise, so everyone is going to jump into the game. The winner will be the company that finds the best way to use the technology to enhance the customer's experience. CDnow should focus on what Jason calls "adding value" and on what I call building a brand.

Industry observer
Michael Sullivan-Trainor,
Director of Internet commerce at International Data Corp., in Framingham, Mass.

CDnow is a sterling example of how the Web allows start-ups to come from nowhere and capture a significant share of media and consumer interest. Because it does business on the Web, CDnow can act like a national or even a global distributor, with low overhead and fast delivery. But there are no barriers preventing new start-ups or giant corporations from copying the company's success. That is the value paradox of the Web: anyone can create a storefront, but no one can create dominance.

In the future, Web storefronts such as these may turn over much higher volumes of business, thus generating greater margins for their owners. But that day will not come until consumers are comfortable with making credit-card purchases on-line, and that confidence will come as more large corporations enter this channel. CDnow and other young companies need to stay in the game long enough and remain distinctive enough to rise with the tide of on-line commerce. CDnow's experience to date suggests that it can go the distance.

Competitor
Jim Coane
President of N2K Inc., in Wayne, Pa., which operates Music Boulevard, a Web retailer

I would not underestimate the competitive advantages rooted in spirited and creative entrepreneurship, nimbleness, responsiveness, plain old hard work, and being early to market -- all characteristics of CDnow. It's going to be very tough, however, for the small, under-resourced competitor. Getting big fast is critical, and that takes access to resources -- people and money. Sustainable, long-term competitive advantages will be built around value propositions that are different from those existing today. CDnow and other companies will have to create revenue streams from sources other than the sale of CDs and advertising.

I also would not underestimate the competitive advantages derived from years of on-line experience, leadership and management from seasoned industry executives, valuable strategic alliances, innovative distribution relationships, proven technology infrastructure, and substantial financial and technical resources -- all characteristics of our company.

Industry expert
Pamela Horovitz
President of the National Association of Recording Merchandisers, in Marlton, N.J.

There are already data suggesting that computer users are often active music buyers. Also, the recent explosive growth in mail order and the direct-mail marketing of music should enhance CDnow's niche.

On the downside, price-driven search engines that allow shoppers to check the whole Web for the lowest price could quickly put pressure on CDnow's already slim margins. Second, traditional music retailers have been adding interactive kiosks that offer increasingly detailed information about records, including those the retailer may not stock, and listening stations that allow customers to sample the music. Those innovations may combine to devalue the value-added aspects of CDnow's Web site. Third, well-established brand names -- Sony Music, Tower Records -- will undoubtedly provide some well-financed competition, putting pressure on the uniqueness of the CDnow concept.

I would urge CDnow to carefully identify its future focus. For example, I'd be looking closely at offering games and other multimedia software through the on-line store. The browser software should work well for those products, and there are probably software distributors willing to play the same fulfillment role that CDnow's music suppliers do now.

Last updated: Jun 1, 1996




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