BUSINESSWEEK ONLINE : NOVEMBER 15, 1999 ISSUE
ENTERTAINMENT

Digital Entertainment Network: Startup or Non-Starter?
A sex scandal clouds Webcaster DEN's IPO

It has all the makings of a great turn-of-the-millennium Hollywood saga: flamboyant characters, big dollars, giant corporations, and a sizzling Internet concept. With its plans to create the online equivalent of a TV network targeting the mercurial tastes of 18- to 24-year-olds, Digital Entertainment Network Inc. has already raised close to $50 million from the likes of Microsoft, Dell Computer, two Chase Manhattan venture-capital units, and several top executives at Lazard Freres. No less than Ford Motor (F), Microsoft(MSFT), and PepsiCo (PEP) have signed on as charter sponsors. And since filing in September to raise $75 million more through an initial public offering led by Credit Suisse First Boston, the stage has been set for DEN to burst out of the pack of Web wannabes.

But don't bookmark this one just yet. DEN is looking more and more like a cautionary tale of what problems can erupt when Hollywood excess meets Internet euphoria and blue-chip backers pile on board. Although it has yet to book a dollar in revenues, DEN has raised eyebrows for paying salaries to its executives that are steep even by standards of the TV networks it hopes to displace. And on Oct. 25, its three founders, including 39-year-old chairman and controlling shareholder Marc Collins-Rector, abruptly resigned. That came soon after Collins-Rector settled a lawsuit alleging that he had a sexual relationship with a minor from 1993 to 1996, BUSINESS WEEK reported in its online edition on Nov. 1. Collins-Rector's lawyer, Ronald J. Palmieri, says his client denies all the allegations in the complaint but confirms the case was settled and dismissed. The company says it was Collins-Rector's decision to move up the founders' previously planned departure from DEN. ''His idea was to immediately protect the company,'' says Palmieri. ''It would be a travesty for the millions of dollars invested [in DEN] to be affected by these unverified allegations.''

SIX-MINUTE SHOWS. Although they weren't named in the suit, DEN co-founders Chad M. Shackley, 24, and Brock Pierce, 18, also resigned. Company officials say they left with Collins-Rector because the trio is closely aligned and plans to start a new data-storage business. Meanwhile, Palmieri says Collins-Rector's 34% stake in DEN has been placed in a trust and can be voted only with the approval of two outside board directors. But are the departures enough to keep DEN on its trajectory as a hot Web startup? ''You can paint an ugly picture here,'' says a DEN investor who asked not to be identified. But ''this is a real business, with a real strategy.''

Certainly DEN is at the center of the latest Web craze, creating four- to six-minute streaming-video vignettes catering to the fastest-growing segment of the U.S. population. Its more than 200 employees have already created 13 online ''series,'' including everything from sports to drama shows (table)--but with a heavy dollop of sex and music. So hot is the concept of streaming-video mini-films that on Oct. 26, DreamWorks SKG and Ron Howard's Imagine Entertainment teamed up to start a new venture, Pop.com, to develop similar programming backed with $50 million from mega-investor Paul G. Allen. Indeed, the threat of existing Hollywood biggies and powerful brands like MTV entering the arena may be one reason traditional media investors have shied away from DEN. ''There are just too many companies like them out there,'' says one media executive who heard the pitch but declined.

NO REVENUES. But few startups have invested so heavily in their payrolls. To get former Walt Disney Co. TV production head David A. Neuman as president, the company paid a $1 million signing bonus, promised a $1.5 million salary, and threw in a large grant of warrants and options to purchase DEN stock. Not counting the founders, DEN's top eight executives are paid $5.2 million in annual salary. The megabuck salaries for a company with no revenues has helped DEN lose $27.1 million in the past 18 months. ''Someone isn't being prudent,'' says Judy Havas, managing director for headhunter Spencer Stuart's entertainment and digital media unit. ''No one in Internet startups is getting million-dollar salaries that I know about.''

DEN officials counter that they need the expertise of top-flight professionals such as former Capitol Records Inc. President Gary M. Gersh and manager John P. Silva, who has guided the careers of such acts as Beastie Boys, Beck, and Foo Fighters. Their take to run a new DEN music label: $600,000 apiece, plus a bonus of up to $1 million annually. ''We did our due diligence and saw the costs,'' says board member Mitchell J. Blutt, an executive partner in Chase Capital Partners, which has an 8% stake in DEN. ''But we like the management, which we think is the best of any Internet startup at this stage of development.''

With the founders' departure, management is now led by H. James Ritts III, the former commissioner of the Ladies Professional Golf Assn. and a founder of the Channel One closed-circuit TV network for high schools. Ritts joined DEN as its chief executive in March and has now assumed the role of chairman. Although the prospectus filed in September makes no mention of it, ''it was planned all along that Marc would leave,'' says CEO Ritts. ''But it was accelerated in light of the court case.''

DEN was not Collins-Rector's and Shackley's first startup. In 1991 the pair, then aged 31 and 16, founded Concentric Network Corp., an Internet service provider in Bay City, Mich. It was while running Concentric, the case against Collins-Rector alleges, that he had the affair with a minor. The suit, filed in U.S. District Court for the District of New Jersey on May 26, 1999, says that Collins-Rector met a 13-year-old boy living in Lambertville, N.J., in 1993 through a Concentric bulletin board.

Chatting with the plaintiff online using the moniker ''Cyberpoet,'' the suit alleges, Collins-Rector offered the boy a job. According to the suit, the boy accepted, and the then-CEO flew him to his home in Bay City where he ''used his age, his corporate position, his home, his wealth, and his maturity to commit acts of sexual abuse.'' The suit says the relationship and abuse continued through 1996, with the boy visiting Collins-Rector after he and Shackley moved to Beverly Hills to start DEN. Calls to the boy's lawyer were not returned.

Even before the lawsuit, there was much gossip about what one investor calls the former chairman's ''extravagant'' lifestyle. Collins-Rector and Shackley both live in an Encino, Calif., compound company insiders called M&C Estates (for Mark and Chad) that had once been owned by notorious Death Row Records founder Marion ''Suge'' Knight Jr. They drive matching Ferrari Testarossas. Pierce, a former actor, is listed in company documents as an executive vice-president in the office of the chairman. The 18-year-old was paid $250,000 a year and was granted shares amounting to nearly 1% of the company. ''He was the guy who could tell us what Gen Yers were likely to think,'' says one DEN board member. ''Would this board have hired him if he wasn't a friend of the chairman's? No.''

Still, it was Collins-Rector who was the main draw for many of the investors. ''People can say what they want, but he's very creative,'' says the investor who asked not to be identified. Indeed, the founding of DEN in 1996 stemmed from Collins-Rector's early vision of the potential of streaming pictures on the nascent Web. ''To me, this was the cable industry 25 years ago,'' says Falcon Cable TV chairman Marc B. Nathanson, a DEN investor and director. ''And Marc was like Ted Turner--the lawsuit notwithstanding.''

With Collins-Rector and his associates no longer at the company, DEN executives are turning their attention to a Nov. 8 relaunch of the site, which is expected to make the 6-minute shows easier to see on slower computers. And plans continue for the IPO. It promises to be a doozy of a road show.

By Ronald Grover in Los Angeles and Richard Siklos in New York

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