TELEPHONES have come a long way since the days when they were made of Bakelite, tethered to the wall and left long-distance callers with bills that would cripple an investment banker.

Take the Vonage V-Phone. It’s orange, plastic, fits on a key-ring and costs less than $40 (£20). Plug it into the back of a computer and it lets you make unlimited calls from anywhere in the world for $25 a month.

Needless to say it is the internet that has made this possible. “Voice over internet protocol” (Voip) promises a new world of telephony, cheap, sometimes free calls and a host of other new services.

Once a service used only by technical wizards, the system is almost mainstream in America where about 10m people use it. Market analyst Tele Geography estimates there will be 14.7m subscribers to Voip services by the year’s end. Nor are the revenues niche. Tele Geography reckons the total Voip market will rake in $4.4 billion this year compared with $2.7 billion in 2006.

Leading this revolution, until last week at least, has been Vonage, which has more than 2m subscribers. It has spent heavily promoting its services. The company launched in Britain in 2005 and counted British venture-capital firm 3i as one of its early investors.

But last Friday Vonage was ordered to stop recruiting customers by a Virginia court. After losing a patent dispute with American telecoms giant Verizon, Vonage had feared a ban affecting all its existing customers. But its lawyers said this compromise injunction was almost as devastating.

“It’s the difference between cutting off oxygen as opposed to the bullet in the head,” Vonage lawyer Roger Warin said. Vonage is appealing against the injunction.

The ruling was the latest in a string of setbacks that have left some analysts and rivals wondering how much longer the company will survive, let alone lead the Voip industry.

The ban on new business follows a jury trial that found Vonage had violated patents owned by Verizon that deal with how Voip calls connect to the regular public telephone networks and wi-fi (wireless) phones.

The jury awarded Verizon $58m in damages and a 5.5% royalty on future sales.

Citigroup, which helped take the company public in 2005, has issued a “sell” recommendation on Vonage. Sells are rare on Wall Street and rarer still among underwriters.

“I think Vonage faces a very challenging future,” said Clayton Moran of Stanford Financial Group. “The options for them are very limited.” Moran had earlier projected the company would end the year with more than 3m subscribers and be profitable by the end of the first quarter of 2008. Even before the ruling he cut back those forecasts. Now all bets are off.

Just over two years ago Vonage was the fastest-growing provider of internet telephone services in America and threatened to shake up incumbent telecoms players such as AT&T and Verizon.

The company was founded by Jeffrey Citron, 37, and looked set to be the making of the New Jersey entrepreneur’s third fortune. In 1995 Citron founded The Island ECN, a computerised trading system bought in 2002 by Reuters’ Instinet for $508m. In the late 1990s he founded Datek Online, among the first of the web-based stockbrokers.

Datek proved a huge success but accusations of illegal trading at the company dogged Citron and he left. In 2003 he agreed to pay a $22.5m fine in a settlement with the Securities and Exchange Commission and was banned from the securities business. He admitted no wrongdoing and sold most of his 30% stake in Datek for about $225m.

In Vonage Citron spotted another opportunity to use technology to shake up a market and cut prices for consumers. He invested $70m of his own money and Vonage started spending heavily on advertising. The “People do Stupid Things” TV ad campaign spelt out the simple message that it was silly to pay too much for phone calls. The down-side was the cost. Buckingham Research Associates analyst Qaisar Hasan estimates Vonage spends at least $300 acquiring each customer. “And we expect they will get back between $200 and $250 over the lifetime of each customer,” he said.

Wall Street agreed and the company’s float in 2005 was a dud. Opening at $17 a share, Vonage stock sagged to a close of $13 on the first day. Last week the shares were trading for $3.35. One headline on the financial website TheStreet.com last year mocked: How Do You Spell “Stupid?” VONAGE.

However, Citron has been proved right. Vonage’s problems stem not from being in the wrong business but from having the wrong patents and wrong business model.

Vonage is being squeezed from two sides. At one end cable operators such as Comcast, Time Warner and Verizon are bundling voice services similar in price and function to Vonage’s with TV and high-speed internet access. Competition is also increasing from deep-pocketed internet companies such as Google, Yahoo and eBay’s Skype. In America Comcast is soon expected to overtake Vonage as the largest provider of Voip.

According to Bernstein Research analyst Craig Moffett, cable providers now account for 71% of the Voip market. Last year Skype said it had more than 100m registered users.

In the middle ground Voip players are having to come up with different business models in order to survive.

Fusion, a New York-based firm, has stuck to providing Voip services to customers who are either either calling to or from Africa, Asia, the Middle East, Latin America or the Caribbean. Matthew Rosen, Fusion’s president, said it meant the company was not competing head to head with corporate giants such as Comcast, Time Warner and Verizon for their American customers. Fusion is now launching corporate services tailored to a business’s needs.

Fusion recently passed the 1m subscriber mark and Rosen said the cost of buying those customers was about $5 apiece.

He said a lot of his customers chose Fusion’s Efonica service because of word of mouth, but that Vonage had also helped the industry.

Rosen said the company’s marketing initiatives had helped to make Voip a mainstream product that anyone could understand.

“They have done a lot of good for the industry and saved everyone a lot of marketing dollars. That type of education has been a phenomenal advantage for us,” he said.

But not, unfortunately, for Vonage.

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