Napster Was Gambling All the Way

If Napster Inc. goes out of business, it will leave two legacies: a dazzling invention that allowed millions to swap music over the Internet and one of the biggest botched financial opportunities of the Digital Age.

In the wake of this month’s federal court ruling that Napster helped consumers violate music copyrights, the company faces potentially bankrupting financial penalties and an injunction that could cripple its service.

Last week, the music industry rejected a last-minute settlement offer from Napster to pay record labels pennies per song out of a proposed membership fee charged to users.

But an examination of financial and court records, along with interviews of more than a dozen current and former Napster executives and investors, shows that the company’s legal showdown might have been avoided. And they reveal a history of missed opportunities, mismanagement and internal feuding that prevented Napster from capitalizing on a teenager’s brilliant invention.

Napster’s first investors gambled that the company would either win in court or its music service would become so popular that the $40-billion-a-year record industry would settle in order to tap Napster’s surging fan base, the executives and investors said. Napster also failed to pursue a plan to transform its service into a legal marketing tool because of intense disagreements within the company, they said.

“There were horrible conflicts at the board level that effectively derailed most of our strategies,” said Liz Brooks, former Napster marketing vice president. And Yosi Amram, a former Napster board member, said the company “blew a number of opportunities by zigzagging. It didn’t have strong, clear leadership.”

Napster’s real boss was not Shawn Fanning, the Boston teenager who dreamed up the revolutionary technology and became an instant celebrity, gracing the cover last year of Time magazine. It was his little-known uncle from Hull, Mass., a small-time entrepreneur with lingering debts and some business litigation in his past, who guided Napster in the critical first year.

As Napster’s biggest shareholder, John Fanning, 37, was the architect behind the company’s aggressive legal strategy.

John Fanning also hoped to become rich. A year ago, he startled potential investors by proclaiming that Napster was worth half a billion dollars--making his stake worth more than $150 million. And he believed that Napster would help lure additional funding for his struggling online chess and games business, according to venture capitalists.

“John Fanning was Napster’s biggest problem,” said Jordan Ritter, who designed Napster’s computer server system. Ritter is now a vice president at Round1 Private Capital Marketplace.

No one is more frustrated about Napster’s rise and fall than Shawn Fanning. Now 20, he is barely speaking to his uncle, friends say. Last year, Shawn Fanning became so upset that he almost quit to start a new firm called Napster.com, according to former colleagues.

Shawn Fanning declined repeated requests for interviews, although John Fanning answered some questions through his attorney.

Shawn Fanning grew up near Boston. His family was on welfare, Shawn’s father was absent, and for a time the youth lived in a foster home. John Fanning was a paternal figure and encouraged the boy’s interest in computers.

Not long after Shawn Fanning entered Northeastern University in Boston in 1998, a roommate complained about the difficulty of finding free music on the Web. In a few sleep-deprived weeks, Fanning banged out the first version of Napster. This brilliant invention allowed users to search for and copy songs stored on one another’s computers.

He gave the program to friends for testing, asking them to keep it quiet. But it was such a great idea that more students contributed their digital music collections, adding to Napster’s library, and soon hundreds of fans began logging in. In time, the system would allow music fans around the world to make free copies from a live inventory of millions of songs, ranging from the Beatles to Eminem, that are listed on Napster’s Web site. John Fanning was stunned by how quickly his nephew’s project was taking off.

In Napster, John Fanning also saw an opportunity that was far greater than his previous struggling enterprises, some of which had landed him in court. A decade ago, a friend, Ed Walter, sold him a struggling computer systems firm on credit. Cambridge Automation limped on as John Fanning sought new deals with lenders. But computer giant Unisys sued the firm over computer equipment bills and won a still-unpaid $700,000 judgment in 1994, according to Massachusetts Superior Court Records. Cambridge Automation never paid off the purchase loan, Walter said.

In the mid-1990s, John Fanning hooked up with some Carnegie-Mellon University students to start Chess.net. They lined up $500,000 from investors and began selling software to play games online.

In 1999 Multimedia Engineering, Chess.net’s parent, was sued in San Francisco federal court by a larger Internet games company, Eplay Inc., for using the Eplay name and Eplay.net Internet address without permission. The case was settled in December 1999, and Fanning’s companies no longer refer to Eplay.

Last August, a lumber company won a $1,934 default award against John Fanning after his firm “MM Engineering” failed to pay its bills, according to court records. The judgment has not been paid, the lumber firm said.

John Fanning, through an attorney, said he has not been served with court papers in the lumber case.

Shawn Fanning was working as a programmer at his uncle’s Chess.net, but he was more excited about Napster. In May 1999, John Fanning surprised his nephew by incorporating Napster, and he kept 70% of the business. Shawn Fanning “was upset and continues to be upset [by the split],” Ritter said. But John Fanning argued that he was entitled to such a large cut because of his know-how and business connections, associates said.

One such connection was Yosi Amram, a venture capitalist turned software executive. The two had met playing chess in Harvard Square years earlier, and Amram had invested $100,000 in John Fanning’s Internet games business.

Napster needed money for computers and programmers. But when John Fanning called to talk about Napster, Amram had reservations.

“[John Fanning] is aggressive, he’s creative. He does not accept limitations . . . [but] he can over-hype things, and he let his ego get in the way,” Amram said.

In the summer of 1999, as Napster users grew into the thousands, John Fanning finally persuaded Amram to invest $250,000. In return, Amram demanded the right to name new management and insisted that Napster move to Northern California, where he was running a software company.

Amram hired Eileen Richardson as Napster’s interim chief executive. Richardson, Amram and John Fanning formed Napster’s board of directors, with Fanning as chairman. Shawn Fanning, meanwhile, was busy heading Napster’s engineering efforts and did not have an executive post.

In September 1999, Napster moved to San Mateo, where a small team led by Shawn Fanning worked frantically to improve the program.

Richardson had little experience running a business, but she was respected by venture capital firms. Earlier, she led an investment in Firefly, an Internet service that recommends music, which Microsoft Corp. bought last year.

“The record industry spends millions [promoting] new bands, and I saw Napster as a way to . . . test-market and feed new musical artists to you for virtually nothing,” Richardson said.

Among the possibilities she pitched to investors--all dependent on peace with the music industry--were plans for Napster to charge for advertising on its Web site, to sell music-related clothing and other merchandise, along with striking a deal with record labels to take a percentage of music sales.

Meantime, word of Napster was spreading on college campuses. Traffic on university networks grew so heavy that some schools banned Napster for clogging their computer lines.

In late 1999, the Recording Industry Assn. of America called and soon after RIAA President Hilary Rosen met with Richardson. But the industry group was more interested in learning how Napster worked, and it argued that Napster should pull the plug before any talks continued.

“The position has been: Stop the infringing activity and seek a license,” Rosen said.

Napster wasn’t very serious about reaching a deal either.

In December 1999, the major record labels sued Napster for copyright infringement. The ensuing media coverage drew millions more users. As lawsuits--by A&M;, Warner Bros. and others--multiplied, some Napster executives wanted to settle. But Napster put off serious settlement talks for too long because it was focused on getting more funding, along with the credibility and negotiating power that such an infusion of cash would bring, Richardson said. And getting more money took too long, she said, because of disagreements within the company.

Several heavyweight venture capital firms were interested in Napster, and they brainstormed plans for turning it into a more traditional business. But as Napster’s board dickered, most of those opportunities were lost. John Fanning called on some of the same venture capital firms that Richardson had. But he pitched them on investing in both Napster and his own small Internet firms.

“He was super-aggressive,” said George Zachary, of venture capital firm Mohr Davidow Ventures. John Fanning’s multi-company pitch “was unusual,” Zachary added.

Other top-drawer venture capital firms, including Kleiner Perkins Caufield & Byers, offered to become minority investors in Napster in deals that would have valued the firm at $80 million or more, according to former Napster officials. Kleiner Perkins partner John Doerr, one of Silicon Valley’s most celebrated figures, helped bankroll Amazon.com, Sun Microsystems and Compaq Computer. “We had backed Yosi [Amram] before. We liked Eileen [Richardson] and we liked Shawn,” Doerr said.

But both Kleiner Perkins and Mohr Davidow insisted that, if they were to invest, John Fanning would have to resign as a Napster director.

“If we were going to invest in [Napster], I did not want a board with no one but investors [on it],” Zachary explained. “You had multiple people all thinking they were running the [company].”

Kleiner Perkins planned to combine Napster with its Internet firm Gigabeat, which recommends music to users based on their preferences. That prospect excited Richardson, who saw this as a way for Napster to establish a clear-cut legal business, add Kleiner’s reputation and grab Gigabeat’s engineering talent.

“It would have jump-started Napster,” Amram said. “It could have changed the game.” He and Richardson tried to persuade John Fanning to accept the deal, but he refused to give up control for the price offered, Amram recalled.

By last spring, Internet stocks were plunging, and only Hummer Winblad Venture Partners remained interested in Napster. In May, Hummer Winblad invested $15 million in the company and allowed John Fanning to stay on the board. The venture firm took control and installed one of its partners, lawyer Hank Barry, as Napster’s CEO. Amram and Richardson departed as the new management took over.

Under Barry, who declined to be interviewed, Napster continued its legal battle. Last October, German media giant Bertelsmann lent Napster $50 million, hoping the firm could reach a settlement with record labels and run a fee-based music service.

Even if Napster’s prospects appear grim, the work of its creators will live on. The inventive type of file-sharing they pioneered is already used for music services, film, medical research and even to design jet aircraft engines.

Today, still privately owned, Napster has about 50 employees and no revenue.

John Fanning, meantime, has already earned some money. He sold some Napster stock for more than $500,000, according to company documents. He remains busy trying to line up funding for his other Internet ventures.

Shawn Fanning, who started it all, has a small equity stake in Napster that may soon be worthless.

But according to several friends, Fanning has told them that the next time he starts a business, he’ll make sure he owns the rights.

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* ON THE WEB

The Times’ comprehensive coverage of the Napster saga is at http://netblogpro.com/musicweb.