|BUSINESSWEEK ONLINE : AUGUST 14, 2000 ISSUE|
How the music-sharing phenom began, where it went wrong, and what happens next
"Go Napster! Woo-hoo!," screams a 25-year-old woman who goes by the name Netmixia. She is standing outside the office of Napster Inc. in Redwood City, Calif., holding up Napster placards while wearing pink sequin shorts, a skimpy black tank top, and a translucent white cape with a mask. Netmixia is here with her friend Jacob Lawrence, 27, who is in a T-shirt, shorts, and sunglasses. The two drove 35 miles from Berkeley, Calif., to show their support for the embattled music-sharing site. Two vans from local TV networks are parked outside the company's headquarters, their anchors preparing to shoot live stand-up for the evening news. ''I've got 3,000 songs on my hard drive,'' says Lawrence. ''I'm the biggest fan around.''
There aren't many businesses in the world that are fortunate enough to inspire this level of devotion. Less than an hour earlier, in a shock decision, two federal appeals judges in Northern California delivered a last-minute reprieve for Napster, staying the preliminary injunction issued on July 26 that could have closed the popular Web service. For now, Netmixia, Lawrence, and more than 20 million other people can trade copyrighted music--free. The news sent Napster's Web traffic skyrocketing to an all-time high of 849,000 visitors on July 28. The record industry had hoped to turn off the music. Instead, the volume just cranked up.
"WE'RE GONNA WIN." Inside Napster, it's pandemonium as the company's 46 employees celebrate the temporary legal victory. Napster's management was on a conference call with its legal team trying to figure out how to obey the injunction when they got the news of the stay. John Hummer, the 6-foot, 6-inch venture capitalist who sits on Napster's board, stomps around the office beating his chest and playing with a Napster-branded yo-yo. ''This is like the playoffs,'' says Hummer, a first-round draft pick in the National Basketball Assn. who played professionally for six years with the Seattle Supersonics and Buffalo Braves. ''They won the first game. And we won the second game. It's going to seven, and we're gonna win it.''
Or will they? You wouldn't know it from the expression on Shawn Fanning, the 19-year-old college dropout who created Napster. He's wandering the halls looking dazed after three days of zig-zagging fortunes. ''I feel numb,'' says Fanning, tugging the bill of his trademark University of Michigan baseball cap. And well he should--it's far too early to break out cigars.
Indeed, this ragtag bunch of Internet rebels may never get the chance to enjoy their victory smoke. A three-judge appeals-court panel will hear arguments on whether the injunction should be lifted after taking written arguments between now and Sept. 12. Many legal experts predict that the judges will reinstate the injunction, in which case Napster will be forced to stop everything except its chat rooms and new-artist program. Why the apparent turnabout? Because the standards for injunctions are quite high. Even though the appeals court was not comfortable letting Patel pull the plug on Napster before a trial finishes, they may decide she was right after they have time to review the matter. Napster argues that its users are protected by ''fair use'' rights, which let people tape a song or TV show for a friend without violating copyright laws. Still, the facts of the case remain the same, and experts say they don't look good for Napster: The upstart enables the free distribution of copyrighted music. ''If I were a betting man, I would say Napster faces an uphill battle,'' says David Post, a professor specializing in cyberlaw at Temple University Law School in Philadelphia.
LONG ODDS. Even if Napster defies the odds and wins the case, it faces the same thorny question that has dogged it from the beginning: How will it ever make money? Today, Napster generates zippo revenues. That could change, though, if the company works out a deal with the record industry. Napster executives are exploring a host of options, from charging for ads and sponsorships on its site to charging a monthly subscription fee with a cut going to the record industry. ''When you're facing these lawsuits it's very difficult to do anything,'' says Napster CEO Hank Barry. ''At some point, though, I can imagine we'll move to a model where revenues get generated.'' But the record biz may not be interested in any collaboration. ''They need to crush these upstarts so they can build their own online business model,'' says Anthony Berman, an attorney at San Francisco law firm Idell, Berman & Seitel.
The odds of any startup making it into the winner's circle are long. And in Napster's case, they may be even worse. A look at the company's brief but electric 15-month life shows that it pursued a high-risk, self-destructive path when it couldn't afford to make many mistakes. From the get-go, its founders not only considered but studied the law--and concluded that they would be free to dispense music to the masses after a knock-down, drag-out legal fight. John Fanning, the uncle of Shawn Fanning and Napster's chief business strategist, says he has personally read the entire U.S. Court of Appeals for the Ninth Circuit's rulings on copyright law and determined that the highest courts in the land will side with the company. In an e-mail obtained by Business Week, John Fanning even suggests that there is only a 10% chance that Napster could lose a court case.
That the elder Fanning, a 36-year-old entrepreneur who has worked in the computer business since 1988, had no formal legal training mattered not to this small tribe that believes the music industry must ultimately bend to the will of cutting-edge technologies like Napster. Such hubris is the common thread that weaves the Napster story together. For nine crucial months during its early stages, Napster was run by CEO Eileen Richardson, who was combative, inexperienced, and unable to develop a business model palatable to the record industry. Former employees say Richardson could be heard screaming into the phone at record-company executives on the other end.
NAPSTER LEGACY? When it came time to compromise, Napster waited too long to bring in seasoned and reasoned minds that could have salvaged a deal with the record labels. ''I think Napster is a disaster as a company,'' says Randy Komisar, the former CEO of LucasArts Entertainment Co., who was asked by several venture-capital companies to screen Napster as a possible investment. ''It left the record industry with no choice but to gain control or shut it down.''
Although Napster's future is uncertain, its legacy will surely live on. The company's bold new way of distributing music by enabling individuals to share each other's personal music collections pioneered the creation of a much bigger idea: so-called peer-to-peer computing, a way of sharing information by hooking up the contents of an individual's computer into a global information index that others can use. Today, most people request information from computer servers on the Net that are easily controlled by one company. ''Napster is truly revolutionary--and it will be a precursor of some of the most important Web applications over the next several years,'' says James W. Breyer, a managing partner at Accel Partners, a Silicon Valley venture-capital firm. ''There will be hundreds of companies that pursue a peer-to-peer model in areas such as storage, file sharing, and processing.''
Napster didn't start out with such huge ambitions. Shawn Fanning had a rough-and-tumble childhood. He grew up on welfare, without his biological father, in Brockton, Mass., a working-class town 20 miles outside Boston. But Shawn's uncle John was always there to lend a helping hand. John bought Shawn his first computer when he was a sophomore in high school and later paid for a new phone line so Shawn could surf the Web whenever he wanted. During summer breaks in high school, Shawn worked as an intern at his uncle's company, NetGames, an online-gaming site.
It was there that he began learning about computer programming. In the fall of 1998, Shawn went to Northeastern University in Boston to study computer science. Bored by college, he hung around his uncle's office instead of attending class. There, Shawn started work on the Napster software, which he conceived as a better way than search engines to find MP3 music files. ''I didn't see us turning into a business,'' says Shawn. ''I just did it because I loved the technology.''
INSTANT HIT. As the two got into the project, they realized it had commercial potential. In January, 1999, with his uncle's blessing, Shawn dropped out of college to focus on Napster. In May, about a month before Shawn finished a test version of Napster, the elder Fanning incorporated the company. John got 70%; Shawn got 30%. ''We all knew from the beginning that this would be huge,'' recalls John Fanning. While Shawn is the public face of Napster, today he owns less than 10% of the upstart and is not involved in the company's business decisions. Shawn Fanning has no senior management position and isn't on the board. Mostly, he works on developing the company's software.
Napster was an instant hit. On June 1 of last year, to test the beta version of the software, Shawn gave it to some 30 friends he met through online chat rooms--on the condition that they not spread the word. When they got their hands on it, they couldn't resist. In just a few days, Napster was downloaded by 3,000 to 4,000 people. Now, Shawn's uncle had proof to back up his hunch about Napster's power.
That summer, John Fanning began to raise Napster's first round of funding. The first person he brought in was his friend and mentor, Yosi Amram, a Harvard University MBA who had run product marketing for a small database company. John sold the first ''A'' round of Napster equity at 10 cents a share. By summer's end, he had raised enough money to fund Napster for six more months. Amram kicked in $250,000 and brought in fellow tech entrepreneur Bill Bales, who invested $100,000 and became Napster's first hire as vice-president for business development.
RAGING FIRE. In Internet lore, Napster is portrayed as a group of freewheeling kids who never considered the legal implications of their software. That just isn't the case. With word of mouth spreading about Napster, John Fanning called Andrew P. Bridges, a lawyer at Silicon Valley law firm Wilson, Sonsini, Goodrich & Rosati, to discuss the potential legal issues surrounding Napster. Fanning wanted to talk to Bridges because he knew a lot about how copyright laws apply to digital technologies after successfully defending Diamond Multimedia Systems Inc., a manufacturer of MP3 players that had been sued by the Recording Industry Association of America (RIAA). During those conversations in the spring of 1999, Fanning learned about many of the key legal precedents that would later form the basis of Napster's defense in its lawsuit with the RIAA. The talks gave the senior Fanning the confidence to push the business forward. More important, he became convinced that if Napster was sued, it would have a good shot at winning in court. ''From the very beginning, we were intent on following the law,'' says John Fanning.
Meanwhile, Napster raged across the college circuit like a forest fire. College students throughout the U.S. were discovering Napster, and they couldn't get enough of it. At Oregon State University, Napster was taking up 10% of the school's Internet bandwidth by October, 1999. At Florida State University, Napster was consuming 20% to 30% of that school's pipes. Bob Foertsch, the computer-security officer at the University of Illinois at Urbana-Champaign, says that at one point, it was hogging 75% to 80% of the university's bandwidth. By this time, Napster had passed the 1 million-download mark.
That fall, it became clear that Napster had a whale by the tail. Colleges began banning it. At Iowa's Grinnell College, the situation got so bad that networking specialist Michael Pifer was forced to send out a letter explaining why it prohibited Napster on ResNet, a high-speed computer network Grinnell set up for its dorm rooms and college-owned campus buildings. ''Quite simply,'' wrote Pifer, ''Napster is eating up ALL available bandwidth.''
To cope with this viral growth, John, Amram, and Shawn knew they needed to bring in a CEO to run the company. Bill Bales suggested Eileen Richardson, a Boston venture capitalist he knew. With the blessing of John Fanning and Amram, Richardson became Napster's first CEO in September, 1999--though only for the startup phase.
CONFRONTATIONAL MANAGEMENT. Richardson's mission was clear: to stabilize the company, raise Napster's first round of venture capital, and soon after find a CEO to replace her. From the beginning, Napster employees and outside execs say she was out of her depth. To be sure, Richardson faced a torrent of challenges. But in hindsight, Napster paid a price for hiring and sticking with a CEO who was confrontational and inexperienced for the Herculean task at hand. This was the first time Richardson had run a company, let alone a Net startup that was challenging the giants of the music business.
From late summer, 1999, up to when the RIAA sued Napster on Dec. 7, the two sides were engaged in discussions about the service. People familiar with the situation describe the talks, which involved executives from Napster and various record companies, as a clash of cultures and monster egos. In late November, one former Napster employee says he met with an executive from a major record label who gave him the impression ''that there was a deal in hand.'' The talks did not get very far, but the general idea was to sell a minority stake in Napster to the company and allow Napster to license a host of content from one label. That deal could then be used as leverage to approach another record label. Several weeks later, on Dec. 7, the RIAA sued Napster.
Many insiders, especially John Fanning, believe the record industry was never serious about negotiating a compromise with Napster. But numerous venture capitalists, tech execs, and Napster employees, say there was a chance for both sides to come together before the lawsuit was filed. Richardson, they say, hurt the chances of a possible compromise because of her abrasive style. One Napster employee, who declined to be identified, heard Richardson yelling on the phone at Frank Creighton, the head of the RIAA's antipiracy group. Richardson also had face-to-face meetings with Hilary B. Rosen, the RIAA's president, that did not go well, according to people familiar with the discussions. ''Eileen got into fights with Hilary,'' says Marc Geiger, CEO of ARTISTdirect, a digital-music company that partners with the record industry. ''Eileen was fairly arrogant and thought what they were doing was right.'' Richardson declined to comment.
By now, Napster's relationship with the RIAA had deteriorated to the point of warfare. That didn't stop the company from raising more money. In October, 1999, Napster raised a $2 million series ''B'' round of angel funding from a phalanx of wealthy Silicon Valley execs such as Angel Investors founding partner Ron Conway and Excite@Home co-founder Joe Kraus. That would help fund its growth for six more months, when Napster hoped to raise its first round of venture capital.
By fall, it was time to move from the East Coast and set up shop in Silicon Valley. Shawn, Jordan Ritter, and Sean Parker, who all helped write the beta version of Napster, moved into a hotel room in San Mateo, Calif. They lived there for three months, stirring up trouble by trying to sneak into local bars while underage. ''They thought they were invincible,'' says Bales, who maxed out his credit card putting them up at the hotel. Napster moved into formal digs, stuffing 15 employees into a dingy, cramped office over the top two floors of a bank in downtown San Mateo.
SHOPPING FOR BACKING. More than money and office space, Napster needed management that could help it broker an agreement with the record industry. One way to bring in more savvy management would have been to quickly recruit an experienced venture capitalist from an A-list firm. But some Napster employees say Richardson wanted to keep control of the company and build Napster's user base before bringing in outside talent. One Napster former exec says he brought in two offers from VCs in the winter of 1999 that gave Napster a higher valuation than what they got from Hummer Winblad Venture Partners five months later. But, the executive claims, Richardson refused to accept the deals because she wanted to bring in a venture capitalist herself.
It wasn't until February, 2000, that Napster started shopping for venture-capital backing. Richardson and several Napster execs made the rounds of Sand Hill Road, the legendary strip of asphalt that is home to most of the nation's top VC firms. By then, VCs who had heard Napster's pitch say the company spent too much time crowing about its growing audience and not enough articulating how the service was going to turn a profit. And the legal issues scared many people. ''It was hard to see how it was legal,'' says Andrew L. Anker, a partner at August Capital.
Napster execs claim they received several offers to invest in the company, some of which were from such top-tier VC firms as Kleiner Perkins Caufield & Byers and Benchmark Capital. Benchmark execs say they never made an offer to Napster, and Kleiner Perkins declines to comment. The fact that Napster did not secure an investment until May, say venture capitalists, indicates that the company was having a hard time raising money. Several venture capitalists say Napster received an offer from a big-name firm, but it was contingent on the company reaching a compromise with the record industry. It didn't help that on Apr. 13, Napster was sued for copyright infringement by heavy-metal superstars Metallica.
On May 21, nine months after Richardson became CEO, Napster finally raised $15 million from Hummer Winblad and brought in Hummer partner Hank Barry as interim CEO. Hummer co-founder John Hummer also joined the Napster board. Hummer, which had invested in many ailing consumer Net companies, such as Pets.com, was looking for a home run and placed a high-risk bet on Napster. While Hummer Winblad did not make the investment with a specific blueprint for a business model, it believed that Barry could bring all the parties together to forge a compromise that would pave the path to revenues. Richardson left the company. ''I chose Hank,'' says John Fanning. ''He had all the right stuff.''
NEGOTIATIONS. Barry, a former lawyer who has worked with tech and entertainment companies, hit the ground sprinting. For the first time in Napster's short history, Barry began to mold the service into a business. On June 16, he brought in Microsoft Corp. shredder David Boies to beef up Napster's legal defense. On June 19, he hired Milton Olin, a former senior vice-president at A&M Records, to be COO. On July 12, Napster nabbed another music exec, Keith Bernstein, who was a vice-president at Universal Music Group's digital-music division.
Barry also renewed negotiations with the record industry. David Pakman, senior vice-president of MyPlay.com, a service that allows people to store MP3 and other music files online, says Barry held the first constructive conversations with the record companies, talking about how the industry could use Napster to its benefit. But Barry couldn't get past the music industry's licensing concerns. Contractual problems with artists and publishers over royalties have yet to be worked out, limiting the extent to which music can be distributed over the Napster service. ''The technology is here, entrepreneurs are here, and consumers are ready,'' says Pakman. ''The only thing missing is the licensing. That's what's holding everything back.''
Even as Napster's day in court was approaching, John Fanning was still holding to his belief that its ruling would vindicate Napster. In an internal e-mail the night before the hearing for a preliminary injunction, he boldly predicted that a stay would be granted. ''If the motion is granted, the order will be stayed pending appeal to the Ninth Circuit, where the motion will be decided...and if they rule against us, which I view as a 10% chance, we would be appealing to the Supreme Court, where the future of the world will be hanging in the balance.''
On July 26, Shawn Fanning and Hank Barry arrived at the U.S. District Court in San Francisco at around 1:45 p.m., 15 minutes before the hearing was scheduled to begin. When they got off the elevator at the 18th floor, they were greeted by about 200 people who had been lining up since 10 a.m. to make sure they grabbed a seat for the landmark copyright case. Shawn dressed for the occasion, wearing khakis, a blue blazer, and a tie. Sweat ran down his neck as he waited to enter the courtroom. John Fanning stayed in Massachusetts, certain that the District Court case, no matter who won, was going to be appealed to the Ninth Circuit.
The hearing lasted about two hours. By the time it was over, Napster had been legally eviscerated. Judge Patel dismissed virtually every Napster argument, granting the injunction from the bench after a 15-minute recess. The sweep and strength of her ruling stunned the Napster team and most courtroom observers. Napster had to figure out a way to remove all of the infringing content from its service by midnight Friday. After the hearing ended, its legal team huddled in the back of the courtroom. Shawn, tears welling up in his eyes, pinched the bridge of his nose in disbelief. A few minutes later, the team broke the huddle. On a bench outside the courtroom, while an RIAA spokeswoman handed out a press release, Hank Barry scribbled Napster's official statement on a piece of paper. Barry was assisted by Ricki Seidman, a crisis-management media consultant who ran the war room during Bill Clinton's 1992 run for President.
"HANG IN THERE." Napster's worst nightmare had come true--and its team was completely unprepared. Napster's spokespeople told reporters that Barry was going to read the statement when he got down to the lobby. Napster's core team, including Hank, Shawn, Seidman, and John Hummer, crammed into an elevator. But the elevator wouldn't go down. It seemed the nightmare would never end. Finally, the whole team scrambled into an elevator that worked. In the lobby of the courthouse, record-industry lawyers and RIAA executives mugged for a pack of reporters, slapping each other on the back, tossing off sound bites for the evening newscast. Napster's team darted past the media horde and climbed into the back of a black Lincoln Town Car that quickly sped away. Barry never read his statement.
At 7 p.m. on July 28, Napster presented a live Webcast message from Hank and Shawn. ''We will keep fighting for Napster and for your right to share music on the Internet,'' said Shawn. Then Barry talked: ''We believe in Napster, and we believe in you. Hang in there with us.''
Back at the Napster office, the adrenaline rush from the appeal court's reprieve had begun to wear off. For the first time this week, Napster employees are leaving the office before some ungodly hour. Some employees head off to a Kiss concert, others are happy to go home and rest. Shawn is still there, playing catch with a young woman in the office. ''I think everything will work out ultimately,'' says Shawn. ''There's just too much potential.''
Most analysts say the smartest thing for Napster and the record industry is to find a way to work together. Napster is holding talks with many parties, but there was no deal by Aug. 2. The idea is to sell the record companies a minority stake in Napster and split subscription, sponsorship, and advertising revenues. If 20 million users pay $100 a year for subscriptions, that's $2 billion. Napster also is looking at ways to market its user base by charging a fee to tap into its fans or redirect them to other music sites. Fees would likely turn off some diehard Napster fans. And Napster isn't cash-starved. While the upstart is burning through about $500,000 a month, it has enough money to survive for nearly two years at present levels. But a deal makes sense because it would at least give the record industry some control over the online distribution of its product.
Whether Napster flourishes or folds, the process it started will play on. If the music biz doesn't deal with Napster, other file-sharing systems that are virtually impossible to turn off, such as Gnutella and FreeNet, will flourish. And the battle will move to other information-intensive fields such as movies and publishing. The anarchic environment of the Net is the perfect breeding ground for the free-spirited swap of information. ''The grassroots emotional response to Napster can't be stopped,'' says Accel's Breyer.
Reached late on the evening of Aug. 1, the night before he was headed off for a brief vacation, Barry was cautiously optimistic that a compromise could be reached. ''I wish I had more progress to show for my efforts,'' he admits. ''But I'm not going to stop trying.'' Otherwise, Napster may wind up among the martyrs in the Internet Revolution.
By SPENCER E. ANTE
With Steven V. Brull in Los Angeles and Dennis K. Berman and Mike France in New York
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BACK TO TOP
COVER IMAGE: Inside Napster
TABLE: Napster's High and Low Notes
TABLE: The Case for Napster
TABLE: The Case Against Napster
At Atlantic, ``My Beef Is Not Getting Paid''
Commentary: With Technology Like This, Who Needs Napster?
TABLE: The Beat Goes On
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