AOL.

COM
How Steve Case Beat Bill Gates, Nailed the
Netheads and Made Millions in the War for the Web
KARA SWISHER

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1. ‘‘A lot of companies are born from disaster, and since this is a
first-class fiasco, maybe it’ll work out.’’
In 1975, Bill Von Meister, a Washington based -- Citicorp’s George Middlemas’ comment to Jim Kimsey
telecommunications entrepreneur and Alan Peyser started a In February 1994, CBS, Sears Roebuck and IBM announced a
company which they called TDX Systems Inc. TDX was in the joint-venture to develop an online service for the users of
process of developing a new technology for low cost routing of personal computers. With this as a background, CVC
long distance telephone calls. Von Meister later lost control of approached Bell South and secured a $5 million line of credit to
the company, which, after being renamed Cable & Wireless PLC, test market an at home subscription service for Apple II and
rose to have annual revenues of more than $1 billion. Commodore computers, using some of the technology
Being at somewhat of a loose end, Von Meister noticed that developed for the GameLine console to provide a specialized
Compu-Serve and a number of other new companies were modem. The test was unsuccessful and Bell South asked for
focusing on delivering information to business customers, and their money back, but it had already been spent keeping CVC
thought that a ‘‘home information utility’’ using the low-cost afloat. Bell South joined the long list of CVC creditors.
telephone routing technology he’d helped develop at TDX would While all of this was occurring in the background, the CVC team
be a good idea. He called the new company The Source and organized themselves along functional lines: Jim Kimsey would
formed a partnership with Jack Taub, a Washington investor. focus on finance, Steve Case would figure out what could sell
That deal also went badly, and after burning through all their and Marc Seriff would build it. In early 1985, they heard that
start-up capital, Taub ousted Von Meister and sued him for Commodore Computers wanted to develop an online service for
mismanagement. its computer users. In the end, Kimsey, Case and Seriff were
Bill Von Meister next worked on a project called The Home Music able to convince Commodore to put up $1 million in start-up
Store, which proposed beaming studio-quality music via satellite funding for the new service -- as long as none of CVC’s previous
and cable line to homes. One of the staff members he hired on business arrangements created any liabilities for Commodore.
this project was a programmer called Marc Seriff, who had To structure this, a new company, Quantum Computer Services
worked on the government funded APRANET which was the Inc. was formed in May, 1985 and CVC’s stockholders were
precursor to the Internet. The Home Music Store concept failed offered warrants to purchase Quantum stock. Other new
when the major record companies refused to support the idea. stockholders were also found, and Quantum ultimately had
Von Meister then thought he could adapt the concept to deliver around $6 million in start-up funding available to it - a loan of $1
video games to homes rather than music. Bill Von Meister was million from Commodore and $5 million in equity funding.
ultimately able to interest a venture capitalist, a bank’s At the inception of the new company, the staff presented a
investment company, an investment banker and the founder of cartoon of a cockroach wearing boxing gloves to Jim Kimsey.
a computer games company to put up $100,000 each and in late This alluded to an earlier news article which had described CVC
1982, Control Video Corporation (CVC) was formed to develop as a bug that couldn’t be killed no matter how hard you tried. It
a video game delivery system for Atari computers. was an apt description of the near death experience the
By the 1983 Consumer Electronics Show in Las Vegas, CVC company had gone through, and its metamorphis from CVC to
had developed the prototype of a new device called a ‘‘GameLine Quantum.
Master Module’’ by which video games could be delivered to By November 1985, Quantum was ready to launch its first
consumers. This generated loads of interest at the show - both product -- the ‘‘Q-Link’’ service. At a cost of $9.95 per month plus
from potential customers and from venture capitalists. CVC 6 cents per minute for connect time, Commodore computer
looked to have a bright future as funding for the consumer users could log on for news, soap opera updates, a number of
release of the GameLine service was arranged. The only games and a chat service which enabled anyone to send
problem was timing -- unbeknown to CVC, the video game messages to anyone else on the service. Q-Link was available
industry was just about to go cold, with Atari announcing huge from 6:00 pm to 10:00 am each day, with the other hours being
losses and dozens of video game developers going out of used by Quantum to do service programming.
business.
The first night Q-Link was available, 24 users logged on. A few
As a result, after burning through all of the available funding of nights later, the system crashed when 60 users were logged on.
$9 million, Bill Von Meister again lost control over a company he Soon, though, Q-Link managed to go two weeks in a row without
had founded as the major shareholders installed James Kimsey a system collapse, an impressive achievement for the size and
(one of CVC’s minority stockholders) as a replacement CEO and scale of equipment Quantum had available.
fired all but 12 employees. Fortunately, however, one of the CVC
Although the joint marketing program with Commodore did not
employees who kept his job at that time was Stephen Case, who
go as well as had been originally projected (mainly due to internal
was the brother of the investment banker who had provided
problems at Commodore), Q-Link had 10,000 subscribers by
$100,000 of the original seed capital. Stephen Case was initially
January 1987, giving Quantum annual revenues of $8.6 million
employed in the marketing department of CVC.
and net income of $238,000. It was a good start, but the main
Prospects looked rather bleak at that time, however, for all of the problem was obvious:
employees. It turned out that in addition to using up $9 million in
equity funding, CVC also had outstanding bills for another $7 ‘‘Our fate is inextricably linked with Commodore. We have to take
million. For all that, the company had sold only 2,400 GameLine control of our own destiny. If we stay on this course, we’ll have
modules. to eventually shoot the company’’.
-- Jim Kimsey
‘‘My job was to make chicken salad out of chicken shit.’’
-- Jim Kimsey on his new job at CVC In addition, Sears and IBM (CBS had by then dropped out) were
now getting close to launching their very well funded online
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service which had changed its name from Trintex to Prodigy. rather spotty track record. Going public, in addition to allowing
Fortunately for Quantum, Prodigy’s publicity was creating private investors to cash out, would generate publicity for AOL
awareness on the online service industry. The challenge was to and provide additional capital. AOL prepared to raise $10 million
keep Quantum afloat long enough to be able to take advantage for the company and $11 million for selling shareholders in its
of the anticipated future market. initial public offering.
The only other computer which had a sizable user base at that AOL shares debuted on the Nasdaq Stock Market on March 19,
time was the Apple II. Therefore, Kimsey and Case decided 1992. The 2.0 million shares, offered at $11.50 each, were fully
Quantum should create a private online service for Apple. To sell subscribed. Steve Case’s shares were worth $2 million, while
Apple Computer on the deal, Case even moved to California for Jim Kimsey held shares worth $3.4 million. The company had
three months in late 1986 as an ‘‘internal evangelist’’ for the new 116 employees, most of whom would subsequently become very
service, to be called ‘‘Apple Link’’. In early 1987, this effort bore rich on the basis of their AOL shares.
fruit when Apple gave the go ahead, agreeing to help with Despite having gone public, AOL still wasn’t all that well known
marketing in exchange for a 10-percent royalty from Quantum. outside the investment community. That changed, however, in
Around the same time, Quantum also agreed with Tandy to October 1992 when Wall Street Journal columnist Walt
create an online service (called ‘‘PC-Link’’) for its DeskMate Mossberg wrote in a column about the consumer online industry:
computers. Based on the strength of the Apple and Tandy ‘‘At present, I regard Prodigy as seriously flawed. In contrast, I
arrangements, Kimsey sold a further $5 million in Quantum stock see America Online as the sophisticated wave of the future
at $10 per share to Berkeley Development Capital Ltd. among such services.’’
Apple Link ultimately turned out to be an expensive drain on ‘‘Though it had only 200,000 members compared to the 1.75
Quantum, as Apple was fiercely protective of anything which had million claimed by Prodigy, AOL was in the first stages of creating
their logo on it, and insisted that Quantum do things their way. just what Mossberg had been preaching about: a simple and
By June 1989, Apple and Quantum had agreed to go their own lively service with an easy-to-use point-and-click interface
way. It had been an expensive project -- for the fiscal year ended anyone’s grandmother could install on personal computers. With
June 30, 1989, Quantum showed a net loss of $5.7 million and an unfussy clarity in price and design, snazzy graphics, a focus
had less than $1 million in operating capital. Kimsey and Case on community and communication, a nimble entrepreneurial
were forced to layoff staff and cut back on operations. Quantum company culture that could change quickly and executives who
main asset now was its 75,000 subscribers for Q-Link, Apple ate, slept and breathed the online business, Mossberg thought
Link and PC-Link. Case could possibly be on the right path.’’
-- Kara Swisher
2.
In addition to creating public awareness, that kind of publicity
also attracted the attention of some of the wealthiest people in
With the split from Apple, a new name had to be developed for the United States. Paul Allen, the co-founder of Microsoft, had
the Apple Link service, and Steve Case decided on ‘‘America acquired a block of 50,000 shares when AOL went public. In late
Online’’ as the name to go with. The service, now costing$10 an 1992 and early 1993, he began buying more AOL stock on the
hour on weekdays and $5 an hour on weekends and evenings, open market. By April, he had bought 25-percent of AOL’s issued
boasted games, e-mail, chat, news, forums, travel and other shares. Alarmed that he might move to take over the company,
information. The new service was abbreviated as AOL rather the AOL Board formally instituted a shareholder rights plan which
than AO because ‘‘AO sounds too much like BO, as in body would make it prohibitively expensive for anyone to try and
odor.’’ acquire the company. Ultimately, Paul Allen’s share holding
Quantum next agreed to create a new online service for the new remained at 24.9 percent of AOL.
IBM PS/1 computer. The new service would be called At the same time, Bill Gates, the other co-founder of Microsoft
Promenade, with IBM paying $1.7 million in development costs, and currently the richest man in America, requested a meeting
committing to spending $1 million on advertising and to shipping with Steve Case and the AOL management team. The meeting
AOL with its computers. was held at Microsoft’s offices in a board room, and Mr. Gates
Around this time, CompuServe (owned by H&R Block) began began the meeting with the statement:
discussions with Jim Kimsey to explore the possibility of
acquiring Quantum. This would provide a viable exit strategy for ‘‘I can buy 20 percent of you or I can buy all of you. Or I can go
the early stage investors and provide funding for an expansion into this business myself and bury you.’’
of AOL marketing activities. Steve Case opposed the sale option, Although this sounded like a threat, it actually wasn’t meant that
but many of AOL’s investors were in favor. CompuServe way. It was more a case of Bill Gates thinking out loud, and he
ultimately offered $50 million for Quantum, but since at that price was slightly taken aback when Steve Case quickly responded
the AOL investors would have seen little return on their the company wasn’t for sale.
investment, the offer was turned down.
‘‘Gates wasn’t obnoxious or combative. He didn’t mean, "I’m
‘‘We had a high degree of confidence, but no proof that it would gonna crush you". He meant that he was interested in this area
actually work.’’ and wanted to find the right way to leverage the technology for
-- Steve Case Microsoft and figure out the best direction to go in.’’
-- Russel Siegelman, Microsoft executive
Since AOL was not going to be acquired by anyone, it was
decided the optimum strategy for raising development funding Case responded by suggesting AOL could create and manage
was to go public. Quantum, now renamed America OnLine Inc. a private label online service for Microsoft -- in other words, to
now had 150,000 users, $20 million in annual revenues and a find a way to work with Microsoft without being eaten by them.
 AOL.COM - Page 3

In a follow-up call after the meeting, Siegelman told Case Soon, every home in America seemed to be receiving AOL disks
Microsoft was interested in acquiring the company, probably at from numerous directions, and immediately people began
around $40 a share which would value AOL at $268 million. signing up. In January 1994 alone, 70,000 new users joined, and
Against this expression of interest, the AOL Board of Directors by August 1994, AOL had reached the 1 million subscriber mark
met in June 1993 to consider their options. On the one hand, it -- a tripling of size within 12 months. This explosive growth
was flattering that Microsoft and Paul Allen were interested in severely strained the company’s computer architecture, and
AOL. On the other hand, Steve Case strongly felt AOL should AOL became widely known as ‘‘America On Hold’’.
retain total control over its own future. In the end, however, the Interestingly, Paul Allen (who still held an 18-percent share
Board voted (by a margin of one director) against negotiating holding in AOL) decided to liquidate his investment in mid-1994.
and for the company to go its own way. He ultimately sold his shares to institutional investors, making a
profit in excess of $130 million. While AOL had managed to out
‘‘I just thought that if these really rich guys wanted to buy us, then perform CompuServe and Prodigy, the battle against Microsoft
we must be worth something.’’ was just about to heat up dramatically, and Paul Allen appeared
-- Jim Andress, Board member to be getting out of Microsoft’s way. On November 14 1994, Bill
Gates unveiled the Microsoft Network which would be bundled
3. in with the millions of copies of Windows 95 that would soon be
sold.

Having made the decision to stay independent, and realizing that ‘‘There is really an opportunity to come in and bring some
Microsoft would soon launch a new service to compete against innovation that will help this market grow. We don’t think this is
it, AOL knew it could not win just by doing a good job. It had to anti-competitive at all.’’
bet the entire company’s future by making some massive -- Bill Gates
investments in marketing in an industry that would only show its
true value far in the future. To compete against Microsoft, AOL first added more personnel.
Next, the company bulked up its financial resources, making a
‘‘It is a land grab and it’s never going to be cheaper or easier to secondary offering of 4.0 million shares netting AOL $62.7
own that territory.’’ million in additional stockholder funds. And critically, AOL
-- Steve Case revamped itself to make its service more attractive and to take
into account the emergence of the Internet.
Fortunately, CompuServe -- the largest online service provider
-- was pursuing a slow growth strategy, being content with 30- ‘‘The reality of it was the Internet took off faster than any of us
to 40-percent annual revenue growth. Prodigy -- the second thought it would. And we were also skeptical of it at first, because
largest service provider -- was focusing on shopping it was not a consumer product like ours.’’
transactional fees and advertising revenues more than anything -- Marc Seriff
else. Neither CompuServe nor Prodigy felt threatened by the
smaller AOL. AOL also took advantage of the fact its stock price was so high
to make several acquisitions of small companies which had
In mid-1993, AOL had several hundred employees, 300,000 developed innovative technologies. Instead of paying cash,
subscribers and $40 million in revenues. Case now focused AOL these transactions were mostly funded by the issue of additional
on three specific areas: AOL stock. In rapid succession, AOL acquired Redgate
1. Communications - combining chat and e-mail to create tools Communications Corp., BookLink Technologies Inc., Medior
people could use to keep in touch with each other. Inc., Wide Area Information Services Inc., Navisoft Inc. and
2. Community - creating an online environment people were Advanced Network & Services Inc. AOL also tried
comfortable with and enjoyed visiting. unsuccessfully to invest in Netscape Communications during an
early funding round.
3. Clarity - using graphical interfaces which were easy to install
for inexperienced users, which updated themselves AOL also realized it would have to beef up its
automatically and which were fun to use. telecommunications network rather than rely solely on Sprint.
The decision was made to build an AOL network through
AOL did one other thing that was critical. In July 1993, it launched
acquisitions. And AOL saw it would have to do something to beef
the largest marketing program in the history of online services,
up its online content offerings -- particularly since Microsoft was
which ultimately would see more than 250 million disks with free
now approaching most of AOL’s traditional content providers
AOL software being sent out. This campaign also positioned
with better revenue sharing deals, combined with the fact the
AOL as the best known brand in the industry. Marketing was
Internet was dramatically changing the competitive environment
managed by Jan Brandt.
for content providers.
‘‘The ability to get things done quickly was very appealing. I was To boost the creation of new content, AOL began investing in
very passionate about marketing and thrive on being promising start-ups developing innovative online material. One
accountable for my decisions, so the environment was very of the most successful of these ventures was an irreverent
fertile to me. I was afraid to touch a computer, but I was financial information site, run by the Motley Fool Inc.’s founders
fascinated by the social dynamics of people in the online culture David and Tom Gardiner. (Ultimately, AOL would end up buying
and how democratic it was. I immediately saw the service as a 20-percent stake in Motley Fool for $500,000).
something that could really change the shape of our everyday AOL also took an innovative approach to the coming battle
lives -- the way people communicate with each other.’’ against the Microsoft Network (MSN). Instead of downplaying
-- Jan Brandt the threat, AOL built it up and maximized it. By making MSN
seem enormous right from the start, its actual performance
 AOL.COM - Page 4

would seem disappointing if it did not excel immediately. And, Under the surface, however, two problems were brewing. First,
significantly, by maximizing the threat, AOL hoped to attract the many Internet users were becoming used to the flat-rate
attention of the federal government’s antitrust officials. unlimited use pricing scheme offered by most Internet service
providers -- usually $19.95 per month regardless of the number
‘‘It was a fear factor, driven mostly by respect. Some felt it was of hours used. Secondly AOL, despite a massive ongoing
a bit manufactured, but the time this company was most in sync marketing program, was losing older members as quickly as it
was when Microsoft was coming at us.’’ was signing on new members.
-- Steve Case
When the company announced its third quarter results, Steve
Fortunately for AOL, however, the arrival of the Internet was to Case hinted that growth may slow a little. The market took his
have a much larger impact on the viability of the Microsoft warning to heart, and AOL’s stock price fell 10-percent that day,
Network than anything AOL could muster. In fact, by the time accompanied by an intense selling frenzy. It was to be the
MSN officially launched with the release of Windows 95 on beginning of a difficult summer in which AOL’s stock price would
August 24 1995, it was already widely known the service would fall 70-percent by October 1996.
be changing noticeably in the following few months to shift away At that stage, the problems facing AOL were:
from a proprietary service to an Internet based service. AOL had
1. The ‘‘churn’’ rate -- the rate at which members left AOL -- had
won the first round of the skirmish with MSN. By late 1995, AOL
grown from an average of 1-percent per month to 6-percent
had passed the 4 million member mark and was bringing in
per month in early 1996. That meant over a year, 72-percent
250,000 new members each month. MSN, by contrast, had
of AOL’s members would stop paying AOL any fees.
signed up a total of 375,000 users.
2. Marketing expenses to secure new members were very high
-- estimated at around $50 per new member in fact. And
4.
many people were leaving AOL as soon as their free initial
trial period was over -- without having paid AOL a cent.
The Internet’s arrival, however, was for AOL a double edged
3. The company’s cash reserves were declining.
sword. While it did change the competitive landscape in the MSN
battle, there was also a growing perception the market need for 4. More serious online competitors were once again appearing
a proprietary service such as AOL was diminishing, and that the on the horizon.
open standards of the Internet would render AOL irrelevant. 5. The forecast new revenue streams from advertising and
Reports of AOL’s demise were greatly exaggerated. AOL other sources were slower than anticipated in materializing.
passed the 5 million member mark in February 1996 - a doubling 6. Members were getting sick of a per hour pricing scheme and
in size in just 12 months. The company also carried out another demanding a monthly flat rate pricing scheme.
public share offering, raising $110.2 million through the sale of Despite all these challenges, Steve Case set a company goal to
3.5 million shares at $58.38 per share. achieve 10 million members by the end of 1996.
With regards to the Internet, Steve Case continued to work along Around the same time, a huge public debate also began on
the line the Internet was a pipe, not an online community. His AOL’s method of accounting for its marketing costs. AOL
strategy was to position AOL as an Internet service provider with followed the practice (routinely used in numerous industries) of
an additional sense of community. spreading the costs of marketing to new members over the
‘‘I think the conventional wisdom is dead wrong because we expected period of their subscription rather than in the month in
deliver what customers care about -- community and which that expenditure was incurred. If the churn rate was higher
information; and what they don’t care about is the underlying than projected, those costs would have to be written off over an
system they get it on. The problem is that there is too much accelerated period -- with the result AOL’s operations may be
insular thinking by technological elites in the industry that say we generating a trading loss rather than the operating profit
are finished, when we are just getting started.’’ previously shown. That, in turn, would impact on the company’s
-- Steve Case market valuation and investor willingness to inject additional
capital into the company.
AOL continued to upgrade and enhance its user interface, AOL also faced class action law suits which challenged its billing
entering into strategic alliances with Netscape for client server system (which rounded connect time charges up to the nearest
software and with Microsoft for a web browser which integrated minute and added 15 seconds for sign-on and sign-off
closely with the AOL front end software. Case also strengthened requirements) and its practice of automatically charging
the AOL management team by bringing in William Razzouk, an customers at the end of their free trial period without providing
ex-Federal Express executive vice president, as the new adequate warnings to consumers. Each of these issues would
president of AOL with responsibility for operations. ultimately be sorted out, but their combined effect created
By May 1996, it appeared AOL was doing exceptionally well. Its negative momentum for the company.
stock was at $71 per share, giving the company a market In addition, Bill Razzouk, the new president bought in to instill
valuation of $6.5 billion. (Steve Case’s AOL stock and options some order in the company’s hierarchy, was having a hard time
were now worth about $224 million). AOL’s online service rivals adjusting to the casual AOL corporate style. His efforts to instill
-- CompuServe and Prodigy -- were heading downwards more discipline in the name of professionalism met with reluctant
because of AOL’s success. The company had put in place a compliance at best and open rebellion more frequently. He
series of impressive strategic alliances, including agreements ultimately left AOL after just a four month stint at the company,
with AT&T and Sun Microsystems in addition to the Netscape although he did receive a $950,000 severance payment.
and Microsoft alliances. And, AOL was just about to open a
Japanese version of its service with two Japanese joint venture Clearly, if AOL was to survive, it again had to change direction
partners. and remake itself. This was not any sort of philosophical
 AOL.COM - Page 5

challenge, for the company had always been adept at changing seem tropical. I’m intrigued by AOL’s ever-changing accounting
itself to meet different corporate challenges. The most important and by the way it manages to keep telling Wall Street whatever
question rumbling around the company’s offices in July 1996 it wants to hear.’’
was not whether to change direction again but what to change -- Allan Sloan, columnist
to.
‘‘AOL is great marketing with a good product, but they haven’t
Just when it seemed nothing worse could happen to AOL, it did. been able to price it to make a return and now they turn around
On August 7 1996, the AOL system went down completely. More and make it cheaper? It’s like inviting a busload of fat people to
worrying was the fact nobody on AOL’s technical team could an all-you-can-eat buffet.’’
figure out why. -- David Rocker
Keeping AOL’s then 6.2 million members online takes some very
impressive computer technology and technical expertise. The Despite the doubts expressed, AOL added 275,000 new
person most directly responsible was Matt Korn, AOL’s head of members in October 1996 alone. And when the new flat-pricing
operations. scheme came into effect on December 1, member on-line hours
jumped 50-percent above normal. Suddenly, the challenge
‘‘It’s similar to trying to keep a space shuttle mission going returned to being the familiar how-to-keep-up-with-the-growth
indefinitely. At least for them, when the shuttle comes down, the combination of excitement and stress. The AOL share price also
mission is over and they can relax. We never can.’’ responded, leaping more than 13-percent on December 2 alone
-- Matt Korn to more than $40 per share.
The problem had occurred during a routine maintenance period. By January 1997, the growth had become so strong (nearly
When the technical team tried to restart the system again, it failed 300% above levels just two months earlier, with 24 million pieces
to respond. The error was later traced to some incorrect routing of e-mail being sent each day) that the Attorneys General for 20
instructions and previously unknown errors in support systems States announced they intended to sue AOL for deceptive
software. The system was ultimately down for 19 hours that day, advertising because members were paying for unlimited access
earning AOL another wave of negative publicity the company but were unable to log on.
really could have done without. At the same time, CompuServe launched an aggressive
marketing drive for new members targeting AOL users who were
5. having a hard time logging on. CompuServe even used a toll free
response number called 1-888-NOTBUSY.
To address all of AOL’s most pressing concerns, Steve Case set To defuse the threatened legal action, AOL agreed to offer
about reorganizing the company in late 1996. His moves several different reimbursement options to members. The
included: company also agreed to discontinue all new marketing until such
time as planned increases in service capacity could be
1. Releasing version 3.0 of AOL’s software. implemented. And finally, Steve Case filmed a new commercial
2. Allocating $100 million for marketing expenditure to get to apologizing for the problems and explaining what AOL was doing
the 10 million member mark and to increase retention of to address the problems. (Internally, this commercial became
existing members. known as the ‘‘grovelmercial’’).
3. Carrying out a 30 city marketing tour.
4. Moving AOL’s stock from NASDAQ to the New York Stock 6.
Exchange.
5. AOL was split into three operating divisions: While AOL had been struggling with its corporate restructure and
1. ANS Communications for the access infrastructure growth problems, another important issue had been percolating
2. AOL Studios which would develop new content away in the background.
3. AOL Networks, the flagship online service In 1996, the Communications Decency Act (CDA) had been
6. AOL was changing its accounting practices to allow for signed into law by President Clinton. The CDA specified that
marketing expenditure as it was incurred rather than being anyone who provides people under 18 years of age with
spread over a two year period. pornographic material would be subject to a fine of $250,000 and
up to two years in jail.
7. AOL was to introduce a flat-rate pricing scheme of unlimited
access for $19.95 per month. The potential problems for AOL were enormous. Effectively, if
any person used AOL to send pornographic material, AOL could
AOL’s stock price had fallen from $71 per share in April 1996 to
be prosecuted, even if the company had taken every
$22.38 in October 1996 when the company restructuring was
conceivable safeguard to prevent this type of activity.
announced. When AOL wrote off all of the deferred marketing
expenses in the first quarter of its 1997 fiscal year, it showed a The CDA had been challenged in federal court as being
loss of $353.7 million -- around $3.80 per share. (Had it followed unconstitutional when it was first signed into law,. The challenge
its previous accounting practices, AOL would have instead had been upheld, and a three-judge panel in Philadelphia had
shown a profit of 17 cents per share for the quarter). declared the CDA to be unconstitutional and, as such,
unenforceable by law. The U.S. Department of Justice appealed
reaction to the profit announcement and restructuring changes
the decision to the Supreme Court.
was loud and, for the most part, negative.
Fortunately, the Supreme Court upheld the earlier decision,
‘‘‘‘By deferring those costs, AOL over the year reported profits declaring the CDA to be unconstitutional in a decision released
$385 million greater than they otherwise would have been -- in June 1997.
which would have been far enough below zero to make the Arctic
 AOL.COM - Page 6

Celebration of the Supreme Court victory, however, was messages, 136 million visits to People Connection and 62 million
postponed while AOL again struggled to cope with impressive visits to the Internet through AOL.)
growth in member numbers. Despite the fact most experienced AOL also realized the size of the annual markets it was targeting:
Internet users derided AOL as simply being ‘‘Internet with $125 billion in advertising, $75 billion in catalog sales, $120
training wheels’’, the company’s growth showed that many billion in direct mail sales and $100 billion in telemarketing.
people liked the simplified approach AOL offered.
Therefore, beginning in February 1997, AOL announced a series
When AOL released its second quarter results showing a $155 of deals including:
million loss, analysts again questioned whether the long rumored
profits would ever materialize, or whether they were, in fact, just Tel-Save Holdings Inc. paid $100 million for the right to market
an mirage. Among the expenses included in the second quarter discount long-distance services to AOL users.
results were $74 million for general business reorganization and Amazon.com paid $19 million over three years to be the
$26 million for the company’s settlement with the State attorneys featured bookseller on AOL’s web site.
general. In addition, working capital had declined by $140 million CUC International paid $50 million over three years to market
as AOL had again begun to ramp up its marketing program. its portfolio of discount retail services.
When AOL had split into three separate operating divisions, Barnes and Noble paid $40 million over three years to become
Robert Pittman (one of the original founders of MTV) had been the sole bookseller on AOL’s proprietary system.
appointed as head of AOL Services. He bought much needed
1-800-FLOWERS agreed to pay $25 million over four years
management expertise to the company, and managed to focus
to sell flowers on AOL.
on two critical issues: leveraging the good will of the AOL brand
and creating shareholder value. AOL also started charging rental fees of $250,000 per year or
more to retailers for their spots on AOL rather than simply
‘‘Long lines are endemic at Disney World. People hate them. But receiving a cut of the sales generated. AOL also entered into
offer Six Flags as an alternative, and they look at you like you agreements with companies such as CBS providing them with
are crazy. They don’t think anything is a substitute for Disney. exclusive placement as anchor partners for AOL channels.
Coke? Complain about prices. Someone can say, "Drink RC, it’s The company also started sorting out those content partners who
cheaper." Consumer reaction? No thanks. It’s the brand stupid. were charging AOL consumers for the same information they
We have to learn how to use our brand to perpetuate the lead were also posting free-of-charge on parallel Internet Web sites.
we have.’’
-- Robert Pittman ‘‘The Web is disaggregated, and that’s not what consumers
want. So with the largest concentration of consumers in
‘‘Wall Street was demanding that we develop new revenue cyberspace, it makes sense that we should only pay for
sources right away, and did not think we had demonstrated exclusive content, exchanging exclusivity for our members.
enough of an interest in shareholder value. While it was critical There are all these great sites on the Internet, but none can make
that AOL did everything it could to make itself the leader, it was any money since they can’t get enough audience there. This is
time to stop dreaming that we could do it all.’’ simply becoming a consumer play, and AOL has the consumers.
-- Robert Pittman The industry has never liked the idea of a powerful company like
‘‘I did not feel it was my job to make decisions for a lot of AOL, but in a lot of ways, having open standards was wishful
managers on every level of the corporate structure. The goal was thinking.’’
to turn Steve’s vision into an operating plan by defining and -- Barry Schuler, President of Creative Development,
developing a growth strategy with all senior managers. Then we AOL Networks
could turn that strategy into an operating plan and work on AOL also made some mis-steps during this transition. When the
building a corporate culture that perpetuates the strategy.’’ public became aware the company was proposing to sell lists of
-- Robert Pittman its member’s telephone numbers to its telemarketing partners,
With the flat-rate pricing scheme AOL had adopted, generating there was a large ensuing controversy -- which lead to AOL
revenue from advertising fees and transactional fees became of canceling those plans rapidly.
critical importance if the company was to generate significant By the time the fourth-quarter results were released in August
profits in the future. This was also quite a challenge. In 1996, 1997, AOL demonstrated it had managed to grow its revenues
only $301 million had been spent for online ads. By comparison, significantly to $476 million - a 42-percent increase. At the same
$37 billion had been spent on newspaper ads and $34 billion on time, the company was also showing signs of controlling its costs
television ads that year. AOL clearly had to get a cut of those more stringently.
revenue streams to operate profitably. Unfortunately for AOL, it also had to restate its third-quarter
Also, due to the fact computers were interactive, Pittman realized results and move a charge from the second quarter to the fourth
AOL users would not respond to ads that were paraded in front quarter, which clouded the company’s operating results.
of them like TV spots. The solution, he thought, was to leverage Eventually, however, analysts noted the huge increases in
AOL’s brand name by combining ads with commerce and usage and by the time AOL announced it had reached the 9
transactions, creating a complete end-to-end sales channel of million member mark in September 1997, its stock price was
distribution for products and services. almost $69 per share.
AOL was well positioned to use this business approach. It ‘‘If you still harbor a grudge, I have advice for you: Get over it --
already had people’s credit card numbers, and could therefore AOL is proving it has the right stuff -- particularly by comparison.
simplify the billing process. And AOL had the critical mass Consider its performance versus that of Prodigy or the Microsoft
required. (In the second quarter of 1997, AOL daily usage Network. Even its closest rival, CompuServe, continues to cast
averaged 153 million pages views in content, 131 million e-mail about for a new strategy, while its financial losses mount. AOL
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stands with Coca-Cola, Procter & Gamble and Nike as one of execute a 5-year deal making WorldCom its largest network
the premier brand-name marketers (and companies) of our time. service provider and guaranteeing AOL’s costs. It was a win-win
It’s a sales game, folks, and AOL does it well.’’ deal all round.
-- Patrick Houston, Ziff-Davis
‘‘AOL executives were gleeful: they had pulled off the
once-unthinkable coup of the digital decade. An air of jubilation
7. permeated AOL headquarters, from the cubicles right up to the
plush corner offices on the fifth floor of the Dulles headquarters
In December 1995, Steve Case had bumped into Henry Bloch, that had been dubbed "Green Acres". Just six months before,
chairman of H&R Block at a gala ball in Washington. The two AOL had been the laughingstock of the online world. Now it was
agreed to begin discussions relating to the future of the conqueror.’’
CompuServe, which had fallen on difficult times. -- Kara Swisher
CompuServe had suffered many of the same problems AOL had ‘‘ATTENTION COMPUSERVE USERS: RESISTANCE IS
navigated through, including high member turnover rates and FUTILE. YOU WILL BE ASSIMILATED -- In a complex deal that
the need to make expensive infrastructure investments. The still must be approved by antitrust regulators, America Online
company had also tried unsuccessfully to diversify into other new has acquired the consumer online business of CompuServe,
services, which had severely depleted operating capital. AOL’s chief rival. Bob Stevenson, the only remaining online
When CompuServe had gone public in April 1996, its shares service user on Earth who is not using AOL, said in a statement
were priced at $30 each. By October, they had dropped to only that he plans "to hold out for as long as possible, but I must say,
$9.25 per share, reflecting a second-quarter loss of $58 million. that Buddy List feature is quite appealing.’’
Clearly H&R Block, owners of an 80-percent shareholding in -- Bill Shein, humor columnist
CompuServe, were losing patience, and Steve Case sensed an ‘‘We view this announcement as an opportunity, as millions of
incredible opportunity to send shockwaves throughout the entire consumers re-examine their online service options. Over the
industry. years, CompuServe provided its members with a quality online
Throughout the latter part of 1996 and the early part of 1997, service. AT MSN, we’re also focused on providing our members
AOL and CompuServe managers began meeting to carry out with a valuable and secure online experience. Like
some initial due diligence. When a technology report called Wall CompuServe, we appreciate our members’ desire for privacy,
Street Strategies published a report on April 1, 1997 that AOL non intrusive third-party offers and reliable access.’’
was contemplating making a play for CompuServe, the share -- Laura Jennings, MSN Vice President
price of both companies rose.
‘‘It’s true that AOL will not die a quick and sudden death, but it
The most obvious attraction to AOL were CompuServe’s 3.0
may well fade out, lumbering in the background as the service
million members which, if combined with AOL’s 8 million
of choice of the least savvy users. It might, like Sears an,
members, would position AOL as about five times the size of the
Roebuck & Co., survive by serving a respectable portion of
Microsoft Network. In addition, CompuServe’s 80,000 modems
American consumers, but have only a waning influence over
would boost AOL’s network of 275,000 modems by another
their habits or the retail marketplace. It might, in other words,
30-percent, which would significantly improve the access
persist. But just going on is not nearly as sexy, or as profitable,
problems AOL had become well known for.
as dominating.’’
The initial proposal was for AOL to fund the acquisition by issuing -- Stefanie Syman, executive editor, Feed Magazine
H&R Block with new shares in AOL., but Steve Case didn’t feel
comfortable with the idea and ultimately the AOL Board decided ‘‘Now the view of AOL is that we are unstoppable, even though
to shelve the proposal. everyone was saying we were out of business just months ago.
I don’t like the "sky is falling" perspective, but it’s equally silly to
In the background, however, Tom Middelhof, an AOL Board
say the war has been fought and won by us.’’
member, continued to hold low key discussions with Frank
-- Steve Case
Salizzoni, President and Chief Executive of both H&R Block and
CompuServe. They also brought into the discussions John
Sidgmore of UUNet, a subsidiary of WorldCom. The three men 8.
decided to start looking at ways AOL’s network company, ANS,
UUNet and CompuServe could link up in a way that would benefit
What have been the keys to AOL’s success?
all three companies.
1. AOL has managed to survive the ups and downs of the
‘‘But there was no easy way to figure out who would run what business world because it is middle of the road rather than
and who would own what. Steve Case did not want to sell ANS cutting edge. AOL sites will never win any design awards,
outright, because I don’t think Steve has ever sold anything.’’ but they are clean and easy to navigate. Its chat groups focus
-- John Sidgmore on mundane things that actually match the lives of most
people.
In the end, the three executives came up with an innovative
proposal. WorldCom would buy CompuServe for $1.2 billion, 2. AOL has won because Steve Case has a vision for the
paid for in WorldCom stock. WorldCom would then acquire ANS business, and keeps it tracking towards that goal.
from AOL, paying $175 million in cash and CompuServe’s online 3. AOL has, at times, taken ‘‘bet the company’’ risks at critical
services division as the consideration for the sale. times. Some investors would consider AOL’s aggressive
CompuServe’s European partner Bertelsmann would pay $75 accounting and marketing policies as unnecessarily risky.
million to AOL to increase its stake in the combined Yet those same people are pleased when those bets come
AOL/CompuServe European online service. And AOL would off and the share price rises correspondingly.
 AOL.COM - Page 8

4. AOL has done whatever was required to survive. When the In the meantime, however, AOL is flourishing. In 1997:
online games company concept didn’t pan out, it went into 2.9 million new members joined AOL
private-label online services for computer manufacturers. It
offered a proprietary service when the open infrastructure AOL’s brand awareness was more than 4-times that of its
offered by the Internet was growing quickly. It moved to a flat nearest competitors
rate pricing scheme and then totally frustrated its members Commerce and advertising revenue streams have continued
with technical snafus. It has lived up to its reputation as the to rise
cockroach of the online world. And AOL will doubtless AOL’s management team is now widely considered to be the
continue to evolve and change in the future. best in the industry
5. AOL’s success was helped at various times as much by the AOL’s share price moved closer to the $100 mark (and
incompetence of their competitors than by anything brilliant actually reached $120 in March 1998)
AOL did.
In February 1998, AOL even increased its flat rate charge from
So where does AOL go from here? Most people assume one of $19.95 a month to $21.95 per month.
three potential scenarios will play out:
For the second quarter of 1998, AOL passed the 11 million
1. AOL will go bankrupt and just fade away. member mark and announced revenues of $592 million, with a
2. AOL will be bought out by a larger company, probably a profit of $20.8 million.
media company wanting to get into online commerce.
‘‘Case does not want to celebrate now, because there’s still many
3. AOL will emerge as the most important company in more innings to play -- we’re perhaps at the bottom of the second
cyberspace. or the third he says. This is a marathon, not a sprint, he noted.
While it is impossible to forecast which of these scenarios will It takes 10 to 20 years to build a mass market, he insisted it
eventually be played out, identifying the challenges currently doesn’t just happen overnight.’’
faced by AOL are much easier: -- Kara Swisher
1. Microsoft has regrouped and re-launched its Microsoft ‘‘When people ask me how or why I did it, it’s like asking a
Network to compete against AOL for online consumers. basketball player, "Why do you play basketball?" Probably
2. Microsoft and other companies are making sizable because you want to be the best. So I never did mind the focus
investments in the merger of PCs and televisions to provide on my imminent demise, because the facts are on my side. And
a broad range on interactive services. How AOL will meet the fact is that the dust settled and I am still standing, and that
such a challenge if it does eventuate is uncertain. pretty much says it all. I learn a lot from history, because no one
3. The increasing popularity of the popular Internet portal sites thought much of AOL and here we are. So I exaggerate the risks
such as Yahoo!, Excite, Start, Snap and @home are busily and diminish our advantages.’’
adding features that will compete against AOL. -- Steve Case
4. The Web is emerging as a more varied and vibrant online ‘‘And for the future? We’ll see, won’t we.’’
destination than AOL. -- Steve Case
5. Internet service providers may be well positioned to
challenge AOL at some future time.
6. Unsolicited commercial e-mail or ‘‘spam’’ (which by some
estimates accounts for up to one-third of all current e-mail)
may cause problems in the future.
7. Hackers love the challenge of breaking into AOL’s system
and stealing passwords, altering graphics and intruding into
unauthorized areas.
8. The AOL network continues to strain under the number of
users, and busy signals frequently greet members as they
try to log on to AOL.
9. Federal regulations increasing AOL’s fiscal liability for
transmitting questionable material through its system may
yet be enacted and enforced.
10. The issue of online privacy is attracting considerable
attention, and will need to be addressed in the future.

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