Is every song downloaded from iTunes really worth 99 cents? Indianapolis-based Digonex Technologies doesn't think so, and it has developed a computer program using some complicated algorithms to prove it.
The company's software compiles sales data and re-prices items for online sales, allowing merchants to maximize profits by adjusting prices up or down based on demand. Consumers don't notice a difference.
"What we're doing is a big idea," said Digonex CEO Jan Eglen, 65. "Most of the [pricing systems] you see on the Internet are retail systems that have migrated online. In the scheme of things, I think this might be the only economic system that's been developed specifically for the post-Internet world."
Investors have staked millions on Digonex, which hasn't generated revenue in its nearly nine-year existence. But there are signs that the company may be on the cusp of actually making it to market and into the black.
Three music labels have signed on to test the software, and one of them-Vancouver-based Nettwerk Music Group, home to big-name artists including Avril Lavigne, Barenaked Ladies and Sarah McLachlan-said revenue from the sale of singles increased an average of 122 percent during its four-month trial.
Digonex's software crunches sales data on demand for a particular product and then automatically resets prices. Prices can be tweaked anytime, but Eglen said research has shown that weekly adjustments often are enough for online music sales.
The company has developed different formulas for different products, ranging from those with an unlimited supply like music downloads to old-school consumer merchandise with a limited inventory.
Digonex charges a percentage of any sales it processes.
"If we don't sell anything for [a client], we don't make any money from them," said company spokesman Chris Pohl.
Hitting the right note
Eglen became interested in online music sales when he was in graduate school at Indiana State University, where he ultimately earned master's degrees in psychology and life sciences and a Ph.D. in counseling psychology.
During his academic career, he wrote about illegal downloading, arguing that consumers want to do the right thing and pay for music, but only if the music is priced correctly.
To back up his studies, Eglen worked with others to develop a computer program that tested this theory, automatically resetting prices based on a song's life cycle:
When a hit song is new and everyone's humming it, the price might rise because demand is high. The price would drop when interest wanes, then climb again as downloads pick up. Retailers who use the system can set minimum and maximum prices.
His idea grew into a business in 2000, after Eglen hosted a pool game for a group of doctors he played with regularly. When he lost, he sat down to tweak his computer program. A friend saw him working and urged Eglen to start a company so he and others could invest in the technology.
In 2003, Digonex moved to Indianapolis as the economists, math experts and programmers on staff continued working on the software. The company has landed two patents and another 12 are pending. And about 150 shareholders have kept paying the bills.
Once the program was functional, the first hurdle for Digonex was getting its foot in the door with record labels. Though the music industry is hurting-U.S. music sales fell by nearly $2 billion from 2004 to 2007-change can be a tough sell.
"It's pretty hard to walk through the front door of a big company and say, 'Hey, you aren't doing this right,'" Eglen said.
But Digonex got a big break last year, when Nettwerk Music joined forces with Tennessee-based online music retailer PassAlong Networks to test the software. They offered an elastic pricing scheme where individual tracks cost 33 cents, 66 cents or 99 cents. It also tested variable pricing for entire albums.
During the four-month trial, which began in late August, revenue skyrocketed even though prices for most songs fell-more people were downloading songs at the lower price points. Revenue from singles increased an average of 122 percent, with some individual songs' revenue jumping 500 percent.
"We see a large upside to variable pricing models," said Kevin Gorman, PassAlong senior vice president of sales and operations. "This trend is in the early stages of market adoption, but it is one we are committed to as the industry and the market needs it."
Gorman said the company talked with one other software provider before trying Digonex's system.
"They were extremely capable," he said. "Digonex was the clear winner."
Those results helped convince New York-based giant Warner Music Group to give the company a shot; it signed up for a pilot run pricing albums with the software. The three-month test is scheduled to wrap up in September.
Warner is a big catch because its artists make up about 20 percent of the U.S. market. Warner and Digonex are not disclosing which online sales platform is running the test, to avoid skewing the data.
Digonex also is set to launch another test program soon with Tennessee-based Naxos of America Inc., the world's largest classical-music label.
The company's strategy is to first make believers of the record labels, who will allow their catalog of songs to be sold with the software. Then Digonex will target the online retailers with its pitch.
Eglen said the company hopes to launch more pilot programs over the holiday season and begin to sell its software services next year. He said the service's charge could run between 1 and 10 percent of sales, depending on how much customization an online retailer needs. Online music sales made up 23 percent of the industry's $10.4 billion total in 2007, according to the Recording Industry Association of America.
Despite the promise, Eglen isn't taking anything for granted.
"You're talking to a 65-year-old Ph.D. who had a heart attack in January," he said. "I am not hitching my star to a cloud."
Eglen concedes that he's learning as he goes about the best way to make the transition from development to sales and support.
"I've never had a company in this position before," Eglen said. "We'll try to prepare as well as we can."
One expert said it can be a tricky path to navigate. The skills and personalities needed to create and develop a project are typically opposite of those needed to grow a sales effort, said David Millard, a partner at Barnes & Thornburg LLP and former president of the Venture Club of Indiana.
"Often, the mistake I see companies make is they try to morph to that next phase with the same people on the team," he said. What they really need is to attract someone with sales and business development experience, but that can be a challenge because they don't come cheap.
"Many companies don't really get an A player in that arena until they've been on the market for a year to 18 months," he said.
Variable pricing isn't a new concept-think of the pricing programs airlines run that sell tickets cheaply until a plane starts to fill up. But selling the program to online vendors will take some work, said Richard Feinberg, a professor and retailing expert at Purdue University.
That will be particularly difficult because consumers have so many options for downloading music and if a pricing system is out of line, they can click away to "five other places to download music," Feinberg said.
"Any retailer is afraid of going from what they know to what they don't know," he added. "It's hard enough to make money at retail. Retailers should be skeptical of any system that promises to make them more money. But variable pricing has proven itself" in other industries.