(FORTUNE Magazine) – Day after day, e-commerce salespeople called Heritage Environmental Services, a hazardous-waste management firm in Indianapolis, to tout the potential of Internet-based business exchanges. These online bazaars, the pitchmen said, would introduce the company's services to hundreds of new customers and help Heritage boost sales almost effortlessly. Finally last year, Heritage president Ken Price agreed to enter two Web auctions, hosted by FreeMarkets, to bid on contracts. But Heritage didn't end up winning. Not only that, the online-auction process emphasized price, meaning Heritage had to lower its fee to compete.

Heritage managers quickly concluded that this flavor of Net commerce wasn't for them. Instead, they decided on a different strategy: building their own online portal to link Heritage with existing customers. Heritage's Web-based exchange lets customers order services and keep tabs on their accounts. It also speeds up the billing process because it accepts payment for services online. "What we've got is a nice central focal point where everyone in the process can see what's going on," says Price, who expects his company to book up to 15% of its business this year through the private portal.

Heritage is at the forefront of a new development in business-to-business commerce on the Net: so-called private exchanges. This form of online link appeals to a growing number of large and small companies disappointed by public Internet markets intended to facilitate auctions and group purchasing. Like Heritage, many suppliers have been unhappy with the downward price pressures they encounter in public Internet markets, which include Covisint, an auto-parts marketplace, and e2open, an exchange linking buyers and sellers in the high-tech industry.

Businesses concerned that participation in public exchanges would put sales information and other critical data in the hands of customers and competitors are also turning to private exchanges. Smaller companies such as Heritage as well as giants like Dell Computer, Intel, and Wal-Mart have set up private online exchanges to link to suppliers and customers, help streamline the business, and boost sales. Private exchanges offer more control, say executives at these companies, and permit easier customization--allowing automation of processes such as sending purchase orders or checking delivery schedules. And the exchange owner can set its hub to swap data instantly with key suppliers and customers.

In light of September's terrorist attacks, private electronic links have become more important. As businesses rethink the need for corporate travel and explore alternatives to face-to-face meetings, they will also seek better information about business partners. Online exchanges--both public and private--let workers from different companies collaborate in real time: Businesses can meet, design products together, and buy and sell commodities without leaving the security of company headquarters. Naturally enough, private exchanges offer more peace of mind than public ones because they are open only to business partners already vetted for creditworthiness and legitimacy. That would put to rest post-Sept. 11 fears that terrorist-backed shell companies could use online exchanges to buy materials with potentially dangerous applications--from chemicals to fertilizer to metals. Public exchanges still face that risk. Expect to see greater scrutiny of their operations.

The embrace of private exchanges marks a decided shift in thinking about how business-to-business (B2B) links will work. Just a few years ago, entrepreneurs were touting the idea that corporations would use the Web primarily to drum up new suppliers and customers, and that online public marketplaces would be the place to do it. Venture capitalists, at the time handing out millions of dollars to online retailers such as EToys.com, More.com, and Pets.com, also became enchanted with B2B commerce. And why not? Although analysts projected that business-to-consumer markets would generate millions of dollars in revenues, B2B marketplaces were expected to handle transactions worth billions or perhaps trillions of dollars annually. By the end of 2000, venture capitalists had invested $5 billion in 363 companies undertaking business-to-business efforts, according to VentureOne, a venture-capital market-research firm in San Francisco.

One of the highest of the high-flying investors enthralled with B2B commerce was Internet Capital Group of Wayne, Pa. ICG's plan was to invest in B2B startups, then cash in by taking them public. At its peak, ICG had stakes in a host of public marketplaces, including Onvia.com for office supplies, PaperExchange for paper goods, Autovia for automotive parts, FuelSpot for fuel products, and VerticalNet for exchanges in various industries. In January 2000, ICG shares topped out at $200, giving the firm--not profitable at the time--a larger market capitalization than General Motors, the world's largest automaker, which recorded profits of $4.4 billion last year.

Those heady valuations came because the Internet was seen as a revolutionary tool that would upend established business relationships. But the revolution never came. Many public Net exchange sites failed or languished. Nearly 120 have been shut down or acquired, according to the research arm of Deloitte Consulting. Among the casualties: small exchanges such as Foodusa.com, which tried to link slaughterhouses, distributors, and brokers of beef and poultry, as well as big ones like PetroCosm, an online buying site for the petroleum industry; it closed little more than a year after Chevron and Texaco founded it. Investors took a pounding, too. ICG shares lost more than 95% of their value in the past year.

Amid this fallout, many companies have begun to use the Net not to win new business on public exchanges, but to get closer to existing customers, transforming their business processes in the bargain. That is the plan at Burlington Coat Factory, which wants to automate its ordering process so that popular items such as water-resistant trench coats and twin comforter sets can reach store shelves more quickly. Most of the company's merchandise ordering is manual today, which adds time and increases the potential for errors, according to Brad Friedman, the vice president of information services. A buyer for Burlington Coat types orders into a computer, but must print them out for approval instead of transmitting them electronically. Those printouts are then faxed, mailed, or hand-delivered to suppliers. Once merchandise is received by Burlington Coat, employees compare the shipments to the purchase orders by hand.

If Friedman gets his way, most of this process will be automated online. Burlington Coat's private network, set to begin operating in November, will let the company's buyers get electronic approval for orders. Those orders can then be zapped over the Net to any of 4,000 suppliers. When products arrive, electronic bar codes will let employees scan shipments quickly and compare them to the purchase orders. "There are no two ways about it," Friedman says. "The private exchange we're going to use will improve efficiencies across the board."

In response to growing disaffection with public exchanges, some B2B marketplaces are scrambling to change their business models. Neoforma of San Jose was founded in 1996 as an online marketplace where hospitals could order everything from bandages to bedpans. Steven Wigginton, Neoforma's executive vice president of marketing, operations, and development, says the company's founders believed that if they built it, hospitals would come.

But they didn't. Hospitals already had long-term buying contracts, and didn't see how Neoforma was going to get them lower prices or offer any other benefits. So last year, Neoforma began offering private links between groups of hospitals and existing suppliers. Neoforma now helps reduce the paperwork-intensive process of ordering supplies. More than 500 hospitals have signed three-year contracts for the service.

Private Net links have their roots in a 40-year-old technology called electronic data interchange (EDI). EDI lets businesses exchange critical information on payments, products, services, or logistics over special telephone lines or leased data lines. The cost of EDI connections is high--setting up an EDI link can run $100,000 and monthly maintenance can cost $1,000--so only the largest businesses can afford this system.

The Internet offers a cheaper alternative by allowing private-exchange traffic to run over public networks--yet still letting companies restrict access to authorized partners. A Web-based private exchange with moderate traffic might cost a provider $1,500 for an additional T1 line, plus the cost of managing the private site. Authorized smaller companies could access such an exchange using a Web browser and a standard dial-up connection. Web-based private hubs are also more flexible than EDI. Private exchanges deliver information instantly, while EDI functions more like an e-mail account, storing and sending data in bulk at predetermined times.

Despite the rise of private exchanges, the public ones aren't doomed. Instead, the two variants will coexist, analysts and users say, because each offers benefits the other can't match. Public marketplaces can link buyers and sellers that may not have done business before--a great advantage for sellers of commodities or for companies seeking to expand their market. Private exchanges, however, are better for serving regular customers and for sharing up-to-date information with suppliers and customers. An AMR Research survey this year showed that 12% of major U.S. companies use private exchanges, equal to the percentage using public exchanges. By 2003, AMR projects that private and public exchanges will each be used by nearly 30% of U.S. companies, however, other studies suggest that the dollar volume for private exchanges is far higher (see chart).

Public exchanges are also likely to handle spot purchases or other transactions not central to a company's business. Covisint, the auto industry's public exchange, has managed more than $129 billion in transactions for products that range from office supplies to vehicle parts--nearly half of the $240 billion spent last year by founders DaimlerChrysler, Ford, and General Motors. "Public," in this case, means participating competitors all use the site, though they represent a select group.

While General Motors spent $96 billion on raw materials and parts through Covisint last year, it also operates a private exchange called GMSupplyPower for more than 3,000 of its parts suppliers. GM SupplyPower gives suppliers weekly updates on the quality of the parts GM receives from them. "Obviously, we're talking about proprietary information that we need to keep between us," says GM spokesman Dave Barnas. Suppliers call up Web pages corresponding to the parts they sell to GM and see their quality rating based on a color scheme: green for good, yellow for questionable, and red for trouble. Since it began using the private link in 1999, GM says it has been able to flag problem parts more quickly, cutting the number of flawed parts it receives in half.

Private links are emerging as the main conduit for a company's most important deals and most sensitive data. And though private exchanges will be used by the same percentage of companies as public exchanges, corporate spending on private links will be greater because building them requires more customization. In fact, a Juniper Media Metrix survey of more than 80 mid- to large-sized companies, released in April, says corporate spending on technology to build private trading networks will catapult from $230 million last year to more than $37 billion by 2005. This is more than three times the amount projected to go toward building public Net markets. Plenty of software makers are competing to sell the building blocks for the private exchanges. A few of the largest, including Ariba, Commerce One, and i2 Technologies, have built about half of the private exchanges in existence today, according to AMR, though smaller firms with software aimed at particular industries continue to grab business as well.

Private online exchanges can take myriad forms. Unlike public B2B marketplaces, which typically attempt to automate buying and selling, private exchanges may attempt to improve a company's handling of inventory, production, shipping, forecasting, and sales--collectively known as the supply chain. Some companies use private exchanges to become more effective. Cargill, a company in Minneapolis whose interests range from grain processing to meat packing, set up a private exchange last year to link its fertilizer unit with 35 regional retailers. Once they click onto Cargill's secure Web pages, retailers can check fertilizer prices and track shipments as they come via rail or truck. Soon, Cargill will add a site where the retailers can report problems in placing orders or receiving deliveries. In the future, Cargill may let retailers order online, though e-commerce is not the focus now. "The main thrust has been about improving the relationship between our customers and us," says Greg Good, e-business manager for Cargill's fertilizer unit.

Although most companies with private online exchanges are new to the medium, a few have been doing business via private links throughout the 1990s. For example, Wal-Mart, the nation's largest retailer, has linked many of its 25,000 suppliers to a trading network it set up in 1991. The result has been improved demand-forecasting and streamlined order-processing, which in turn helps Wal-Mart reduce inventories, freeing cash tied up in its warehouses.

Semiconductor giant Intel offers a private Net link to its broad customer base. Until last year, Intel's Internet ordering system was used primarily by its 20 largest computer and electronics customers, but now it serves thousands of additional customers. The change has reduced the error rate in its order-entry system by 75%. Intel books more than 95% of its orders over the Internet, or about $2 billion per month in sales.

Dell, one of the nation's top computer makers, links electronically to about 60 parts suppliers. Its system sends updated production schedules to suppliers every 15 minutes. The constant flow of information has helped Dell trim inventory in its factories to the point where parts are held on average for just six hours before assembly, down from 15 hours a year ago.

None of these companies plans to join the public marketplaces that operate in their industries. To do so, they say, would mean losing control over business processes that give them strategic advantages. Though public marketplaces can help buyers by letting them aggregate their demand for a product, representatives at Dell, Intel, and Wal-Mart all say they already get the best prices possible from suppliers. "Why would I want to aggregate my memory purchasing with Compaq's or IBM's or HP's?" says Dick Hunter, who runs Dell's manufacturing operations. Additionally, Hunter says, using a public exchange could tip Dell's hand to competitors interested in its buying patterns, which the company considers valuable information.

A private trading hub can benefit suppliers as well as the exchange owner, but selling products over private exchanges can be challenging for smaller companies. For every company like Dell that builds a private hub and dictates the rules, there are tens, hundreds, and even thousands of others faced with the need to maintain links to the exchange if they want to keep that company's business.

"Collaboration is not the term [for what is happening over private trading hubs]," says Jon Gibs, B2B analyst for Jupiter Media Metrix. "Coercion is the right term. Businesses don't work by everyone hugging each other. Whoever runs the supply chain in most cases can determine what platform other businesses work on."

Newark Electronics, a major supplier of electronic components, understands this well. Newark took many of its orders via phone and fax before some of its largest customers started using private networks in the mid-1990s. Though the networks let Newark receive orders more quickly and accurately, they also required the firm to set up internal systems that could communicate with a variety of private networks using varied technologies. "These are huge customers--Intel, Motorola," says Tony Chien, a vice president who oversees Newark's e-commerce. "You can't tell guys like that no."

The first customer Newark said yes to was Motorola. To let Motorola order online, a programmer had to go through Newark's database of hundreds of thousands of products and ensure that buyers at Motorola could read each item electronically. The job took about four months to complete. "I wish I could say that people at Newark were brilliant and saw that customers were going to implement [private] marketplaces," Chien says. "But the reality is we did this work because our customers asked us to."

Today, Newark has commercially available software that lets it synch up with private networks in less than two weeks. In a little more than two years, Newark has linked to more than 60 private networks, and it will be working on links to another 60 in coming months. Newark has even begun using specialized software that alerts customers when their databases should be updated with new product information.

Another challenge for private networks is overcoming the old, comfortable ways of cutting deals. EFS Network, a private exchange founded last year by large food-service manufacturers and distributors, expects to have a hard time persuading long-time food-industry veterans to jettison traditional ways of ordering and supplying, and migrate to the Net. "We understand this will not be a miracle or an overnight breakthrough," says Hank Lambert, EFS's chief executive officer. "It will take time to get people comfortable conducting business electronically, when it was done by phone and fax, and with personal relations, for so long."

After the collapse of the wild expectations for online exchanges, a more pragmatic attitude about these marketplaces has emerged."Everyone thought these businesses would be huge, billions of dollars. It's just not like that," says Rusty Braziel, the former chairman of online exchange Altra Energy Technologies and now head of consulting firm Netrana. "Facilitating transactions online creates incremental improvements in the business. It's not revolutionary."

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