Napster - the inside story and lessons for entrepreneurs

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.

Comments

[Steve Krause]

Good writeup. A quick question on this: "We had over 50 million users who were willing to pay $5 per month or $1 per download for digital music."

Is this something you could credibly assert at the time, or is it an extrapolation backward from the success of iTunes?

[DonDodge]

Five years ago while at Napster we did extensive user surveys to determine how many people were willing to pay for a subscription and how much they were willing to pay.

It was unscientific, we didn't publish the results, and obviously couldn't act on it. But, we learned that a very large percentage of users were willing to pay to be part of the Napster community. At the time the sweet spot seemed to be $5 per month or $.99 per song.

Today we know that subscriptions are sold for $8 to $15 per month depending on catalog size and usage rights.

[cliffreeves]

Great story, Don. I guess it's true that you write best when you write about what you know best.

I really enjoyed this!

[SR009]

Don Dodge, (On The Next Big Thing) who is now with my former employer (Microsoft) - formerly with "bad-boy" Napster, offers this detailed description of what Napster did right - and wrong.

[Jawahar Mundlapati]

Good analysis.
We should go for "win-win" in an established market.

[Adam Bornstein]

I showed your comments to the team I'm working with in Shanghai who are building a loyalty reward network program/venture in China (e.g. Nectar, MyPoints, Netcentives). All four of your lessons are things we've talked about at length; and while we are still trying to figure out the answers your posting gave us some comfort that we are at least asking the right questions. Thanks for your insights...

[Juvenn]

Thanks for ur lessons, Mr.Dodge!

[Vic Berggren]

I'm surprised that the artists didn't attempt to deal directly with Napster.

If the studios didn't have contractual rights to digital distribution wouldn't that have been a blessing in disguise for the artists that were at the mercy of the creative accounting?

[DonDodge]

Vic Berggren commented "I'm surprised that the artists didn't attempt to deal directly with Napster."

In fact some very prominent music artists did secretly work with, and invest, in Napster. But, they were still under contract to the major labels. They had to wait until their contract expired to take advantage of Napster's ability to go direct to consumers. They could have made a fortune.

This was another business angle for Napster...taking artists directly to the consumers. We figured it would only take one or two top name artists to pave the way and many others would follow.

Unfortunately, Napster was shut down before these particular artists contracts expired so we never got a chance to do it. And, don't ask. I can not tell you who these artists were...but they were huge!

[Brett Nordquist]

Very informative post. I didn't think I could dislike the RIAA anymore than I do but I was wrong. Thanks to Napster I was introduced to many groups I would not have otherwise listened to. I did download a few older singles for free but many of them lead to a CD purchase so I could listen to the entire album and rip it for my own use. Napster really was ahead of its time.

[Richard Ruekema]

I hear ya Don - been there, done that, paid the bill, lost the company.....and I've learned the lesson...just too bad I didn't realize it sooner

[Tara 'Miss Rogue' Hunt]

Don,

There is something to be said for pioneering. We need the Napsters of the world to blow open the doors on change. Instead of warning against it, we should put aside an insurance fund for people who innovated ahead of their time and were punished for doing it.

This way, brilliant teams like yours wouldn't have to worry about rocking boats. They could just effect change and the rest of us could benefit.

But then again, I'm a Utopian. ;)

Tara

[pwb]

I think the biggest mistake was thinking that Napster offered value to the music distribution industry.

[Hank Williams]

At the time you guys were doing napster, I was ceo of a company called clickradio. We were feverishly working on (and ultimately got) the first interactive licenses from the record companies.

I think the biggest problem you guys had was being in silicon valley. We were in new york and had regular contact with the music execs. And I can tell you there was never even one second, one iota, one shadow of a doubt in our minds that the record companies were *not* going to give you licenses. We negotiated for a year with universal, before we got our first license (which was before we launched) and we knew all the major players very well. At the time the silicon valley attitude was obnoxious and arrogant. You acted like you had a right to dictate how their content was used and they didnt like it. It is true that there were contract and other issues, but even if there werent, they *hated* you.

The amazing thing is to read this posting which seems to me (tho I wasnt at napster) to be an apologist, rewriting history. For you guys to really suggest that you were poised to make so much money, and you really believed you were going to get licenses is really... well I'll be polite and say, amusing.

Even if they didnt hate you, you had no encryption, no control, and more importantly, the record companies first didnt want any download services, and then wanted to do it themselves. And if they did do something, they were going to do it with friendly faces.

finally, you guys know there was no timely way to convert napster into a royalty tracking secure service. This was tried, and it took years, and tens of millions of dollars of bertelsmann's foolish money to get even close. And now, the pay services, aside from apple, each have maybe a few hundred thousand users. So I think the current truth belies your rosy scenarios, unless you are claiming that napster would have been apple. Heck, why not go ahead and be foolishly arrogant on that point too.

The truth is, even five years later, the tech world still knows nothing about the dynamics of the entertainment industry, but continues to ponificate about it. I am a programmer by training, but I spent enough years along side the entertainment guys to understand how they operate. It is funny to hear you, and your readers continue to talk about this stuff with a *totally* inacurate present day as well as historical perspective.

[Adam]

> Don’t try to convince [customers] that you have a
> solution to a problem they don’t know they
> have.
[... plus additional blatherings about how it's bad to be innovative, a first-mover... basically, a leader]

Shame, shame, shame! What a horrid and mistaken takeaway from the Napster experience!

All throughout history (and not just computing history), brave and insightful people and companies have opted to LEAD the way, rather than simply be followers. Some, nay, many have failed. Others have been great successes. Just like followers, in fact. Viewing Napster's (business) failure as a lesson in and of itself of anything other than a warning about mismanagement (internally and externally) is, IMHO, both foolhardy and shortsighted.

* * *

Oh, Mr. ClickRadio...

"At the time the silicon valley attitude was obnoxious and arrogant."

And the Entertainment Industry is/was... a bunch of friendly, welcoming, thoughtful souls?!?!?!? HA HA HA HA HA HA!

And ClickRadio... where is that today? Gee, clickradio.com, clickradio.net, nothing is coming up. How odd, given that -- with your vast amount of wisdom and brilliant business acumen that enabled you to do a deal with the benevolent recording industry -- surely your venture must have been a raging success? ;)

[Michael Ridley]

A response to Mr. Clickradio-

As a matter of fact, I worked for Napster for a while - very early on, before Don was there actually - and your characterization of the situation is not accurate.

You stated:

"At the time the silicon valley attitude was obnoxious and arrogant. You acted like you had a right to dictate how their content was used and they didnt like it. It is true that there were contract and other issues, but even if there werent, they *hated* you."

Despite what the public perception of Napster's attitude was or came to be (much of which was fueled more by the record industry's shaping than by any active marketing or statements fron Napster), that was not at all the nature or tone of the conversations we had with the RIAA. I was in the room the first time our original CEO called the RIAA. I heard the voicemails from Hilary Rosen's assistants. I don't recall if I heard any from Hilary or not, I know that for the longest time they would never acknowledge us or call us back.

We were too small and they didn't care.

There are no doubt many legitimate issues with the Napster strategy, many of which Don has highlighted. However, back in October of 1999 when I started there we were in no sense naive about the uphill battle we faced. We knew early on that there were if not necessarily legal violations implicit in the service, there were certainly some grey areas of potential risk (which turned out in the end to bankrupt the company of course). From day one we wanted to transform the service into something that the record industry could work with.

And far from arrogant, we probably would have made any reasonable deal that came by at that point. While we were relatively small at that point, we could see the direction the juggernaut was heading and it was clear that any sort of revenue split with the record industry would really be fine. Even if we had some small percentage of the revenues, it wouldn't matter. In this case even 20% - even 5% - hell probably even 1% of what the subscription fees could have been projected to be would still be "fuck you money".

I dunno, I'm rambling, maybe I should write my own post on "inside napster" - but I think I won't. Enough has been said about Napster already I think. But I did want to clarify our initial approach with the industry. The problems we had in dealing with them had nothing to do with arrogance - or at least not arrogance on our part - it had to do with the record industry executive management having no concept of technology or the reality of what the Internet was or could be. They didn't see what was going to happen because they didn't know what the Internet was. To them P2P file sharing was no different from a rogue CD-stamping plant in Southern California or China producing pirated CDs. Take them to court, get an injunction, and it goes away. That was naive on their part, not ours.

-m

[thomas]

this is really a great article

[Martin]

Hello Don, my name is Martin, i live in cologne, Germany. I read a lot of in web about you - now i found your blog. You are a "idol" for me... I hope you can answer my question: i read (2 month ago...) that microsoft will sell an "zunephone". So i designed a small website: http://www.zunephoneinfo.de - you think Microsoft bring the zunephone on the market? Please leave feedback. Greetings from Germany, Martin

[DonDodge]

Martin,

Microsoft has not announced any plans for a Zune phone. The Zune music player just launched a few months ago and they are already working on the next version.

Microsoft works with Motorola and several other cell phone manufacturers now by supplying the operating system, Windows Mobile.

Sorry, I can not confirm or deny any unannounced product plans.

[ben leefield]

Awesome article. What a great experience, to be on one of the first and greatest commercial websites.

The record companies are still just stupid and greedy. They think they can still charge too much money for something that can be downloaded digitally for no practically no distribution and marketing cost. They are greedy because they don't get the fact that if music drops to a few pence / cents per track that more people will spend more on music, building bigger collections. Until they get it, the pirates will florish. They find it hard to get digital download to work in their business model, but they hadn't worked out that it was the model that was outdated and that needed to change(and probably still does) - not that the new technology should just go away. And thats why they are stupid... and lazy.

Ps. I'm a property developer who believes in the rule of law, property rights, blah, blah, blah - but you can't stand in the way of new technology - it will swamp you.

[David]

My name is David, and I'm currently doing research for a paper on the whole issue with "illegal downloading," focusing particularly in the music industry (as I presume the majority of the issue lies in the music medium). Other than simply being fascinated with this topic, my father was the VP (either customer service or marketing) for Napster a few years back.

From Mr. Dodge's article and my father's information, I do recognize the fault and miscalculations on the part of Napster during the period in which Mr. Dodge was with company. However, it can't be denied that the RIAA was just too greedy (and moreover stupid) when their injunction killed Napster. I say that they are stupid because from my dad's explanation, there was ample room for Napster's launch to be mutually beneficial to both Napster and the record industry, and thinking that killing Napster would change the flow of technology was OBVIOUSLY wrong.

Considering I'm writing this in mid-2007, I don't see anything around me that has shown that "illegal downloading" has changed at all.

[Beba84]

I just wanted to say that this is one of my favorite business related posts of all time. The entrepreneurial wisdom will stay with me for a long time as I make my own journey through the startup world. Thanks!

[Yan Gunawan]

Wow. that's a great story. I just found this blog and so funtastic. I'm from Indonesia (Jakarta). I think many of great enterpreuners over here. May i have your suggestion, what' s the good startup internet business in Indonesia? Thank you so much.

[take surveys]

how did you handle 50 million users in 7 month. this is such great work. I just loved your article.