Shawn Fanning created Napster in his dorm room at Northeastern. It was the fastest-growing application in the history of the Internet. We changed the world but failed to achieve business success. Here is a glimpse into the inside story of Napster, and at the end, some lessons learned for entrepreneurs.
I was VP of product development at Napster back in the wild days of 2000. We went from just a million users to over 50 million users in about 7 months time. At the time it was the fastest growing application in the history of the internet. We changed the world, but failed to achieve business success. I could write a book about all the wild and wacky times at Napster, the artists who secretly supported us, the visits from Metallica who did not, and other fun facts, but this story will focus on the key business issues.
Napster started out as a free download tool but the goal was to make it into a real business in partnership with the record labels. At first Napster was too small and unknown to get a meeting with the major labels. The record labels, and most of the rest of the world, had never heard of Napster and didn’t know what it was. That changed in a hurry…in fact too fast. Napster went from being an unknown underground technology to the biggest threat the record labels had ever seen, all in the span of less than six months. At this point the record labels wanted us dead.
The goal at Napster was to be the online distribution channel for the record labels, much like iTunes and the *new* Napster is today. There were several offers made to the labels that would have given them the vast majority of all of the revenue. The numbers were staggering. We had over 50 million users, many of whom were willing to pay $5 per month or $1 per download for digital music. That translates to about $250M a month or $3B per year. Even if Napster kept just 10% of the revenue that would be $300M per year against expenses of less than $10M. At the stock market multiples of the day that would have been a $15B IPO.
The economics of the record industry are puzzling and their accounting methods are very creative. At the time CD’s were sold for about $17 at retail. The retailer and distributor took more than half of the price as their mark-up. The manufacturing costs took another couple bucks. The promotional costs of advertising, music video, payola to radio stations, and other PR typically ate up all the rest of the revenue. Only the most successful artists made any money from recording contracts, and even then only $1 or so per CD. The vast majority of music groups never make any money for themselves, and barely cover costs for the labels. Cost is a flexible term in the music business, and the way those costs get allocated can be creative indeed. The successful artists cover some of the costs of the less successful artists. The bottom line is that the record business only drops about 10% to the bottom line in good years.
The promise of Napster was simple. Napster offered a pure profit channel with no manufacturing costs and no wholesale/retail channel costs. Napster would have provided a huge new revenue channel that would be extremely profitable. Napster could also target niche music markets. We could easily find the 400,000 people who loved a particular brand of new age techno, or Irish folk music. We could introduce new artists to their specific market quickly, precisely, and cheaply, making them profitable without needing a platinum record. More artists would make more money and the record labels could avoid much of the manufacturing, promotion, and sales channel expenses. They would make more money on more artists at lower volumes. But the labels would hear nothing of it. They wanted us dead because they felt Napster’s digital distribution business would kill the CD business.
In retrospect, the reality was that they couldn’t have made a deal with us even if they wanted to. The record labels existing contracts with the artists had no provisions for digital distribution of individual songs. The payments to artists were all based on CD sales through the normal channels. It took them several years to rewrite their contracts with artists to get to the point where today you can buy a single song via digital distribution.
Things looked promising for a while. Hummer Winblad made a significant first round investment in Napster and installed Hank Barry as interim CEO. Hank was a former entertainment lawyer at Wilson Sonsini. He knew a lot of people in the music business and was determined to get a deal done with the labels. Hank hired several music industry veterans in an effort to prepare Napster for a real business relationship with the labels. We had a plan. We just didn’t get a chance to make it work.
Later BMG (Bertelsmann Music Group) made a significant investment in Napster. The CEO of BMG at the time was Thomas Middlehoff. Mr. Middlehoff made a name for himself at BMG by doing a joint venture with AOL to create AOL Europe. That deal made hundreds of millions for BMG and established Mr. Middlehoff as an internet visionary. He thought Napster would be the next big thing and that he could broker business deals with the other record labels. Things were looking good.
Then the RIAA (Recording Industry Association of America) sued Napster on behalf of the major record labels. Napster hire David Boies, probably the best trial lawyer in the country. He is the lawyer the government hired in its case against Microsoft, and he was Al Gore’s lawyer in the Florida Presidential election case. Mr. Boies put together a very credible case and was confident we could win. Unfortunately we ran into a judge on the 9th circuit who didn’t see it that way at all. We lost the case in the first round, but won a “stay” which allowed us to continue operating until an appeal was heard by a three judge panel. We still felt that a business deal would get done, but that the labels had the upper hand in the negotiations. Well, as you know it didn’t turn out that way.
We made one last effort to convince the labels that they should do a deal with us. A little known underground product called Gnutella had just surfaced. It was a P2P file sharing program that required no central server and no company to operate it. Gnutella was an open source program and we were already seeing new variants of it emerge. We told the record labels that we (Napster) had a loyal audience of over 50M users. We had servers that could control distribution. If they didn’t do a deal with us and put us out of business then Gnutella and its derivatives would become unstoppable. There would be no company to sue and no server to shut down. If we worked together now we could convert the market to a paying subscription or per download model. If we didn’t do a deal chaos would ensue. They didn’t believe us and didn’t really understand what this Gnutella threat was.
The RIAA succeeded in shutting down Napster, but lost billions in potential revenue over the next several years to Gnutella, Grokster, Morpheus, Kazaa and others. CNET has reported that the RIAA has finally succeeded, five years later, in shutting down Grokster. See Last Waltz for Grokster for the story. There are still lots of P2P download systems out there, and new ones popping up all the time. Good luck to the RIAA is trying to shut them all down.
Roxio bought the Napster name and logo in a bankruptcy auction. They later changed their corporate name to Napster and sell music online as we had once planned to do. The founders of Napster have gone off in many different directions. Shawn Fanning and Ali Aydar started a company called Snocap, ironically to identify copyrighted music for the record labels. Jordan Ritter founded CloudMark a spam protection and security company. Sean Parker was president of Plaxo and is now president of FaceBook. Hank went back to being a VC at Hummer Winblad. Eddie Kessler, the VP of engineering is now doing consulting work in the bay area. Liz Brooks, our VP of Marketing went back to the music business. Milt Olin, our COO started a private law practice in Los Angeles. I went on to two more start-ups; Bowstreet and Groove Networks, and am now working with the Emerging Business Team at Microsoft.
What lessons can be learned from this experience?
- Never get too far ahead of the market. Creating new markets, new business models, and value propositions is very difficult and takes lots of time and money. Pioneers are usually unsuccessful, the fast followers make most of the money.
- Understand who your customer is, what problem you solve, and how much they are willing to pay for it. Sounds simple enough but you would be surprised how many start-ups get excited about their technology innovations and forget about the basic business proposition.
- Never start a business focused on solving a big company’s problem. They don’t know they have a problem…and they are probably right. That is how they got to be so big in the first place. The record labels didn’t know they had a digital distribution problem and were not interested in our solution to it.
- Test your assumptions before spending lots of money. Interview your potential customers. Understand what their top 10 problems are. Don’t try to convince them that you have a solution to a problem they don’t know they have. Take a survey of 100 potential customers. Ask them to list their top 10 problems, without prompting from you. If you don’t see your problem area listed…move on to another problem.
- Marketing and image matter. Provocative challenges make good headlines but don't make good business.
Napster changed the world. Millions of people rediscovered their love of music through Napster, and created a whole new way to enjoy it. We made mistakes, but we learned valuable business lessons. The business lesson of the Internet is that you can attract a much larger audience, and generate more revenue, with a “try it for free, and buy it if you like it” approach. Five years later, the music industry is still struggling with how to capitalize on the Internet business model.