How Napster changed the world - A look back 7 years later

It was 7 years ago today that I left a great job at AltaVista to join Napster, this tiny little startup that virtually no one had heard of. My wife thought I was crazy. No argument there. I was crazy...and still am. I am reminded of Paul Simon's song "Still crazy after all these years". Here is a look back, 7 years later.

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. 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 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 100,000 that like 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 hired David Boies, probably the best trial lawyer in the country. 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.  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.

Where are they now? 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, then went to FaceBook, and is now in the VC business with Founders Fund. Hank briefly went back to being a VC at Hummer Winblad, but is now a lawyer at Howard Rice. Eddie Kessler, the VP of engineering is now an engineering manager at Google. 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. Seven years later, the music industry is still struggling.

Subscribe - To get an automatic feed of all future posts subscribe here, or to receive them via email go here and enter your email address in the box in the right column.

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. 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 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 100,000 that like 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 hired David Boies, probably the best trial lawyer in the country. 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.  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.

Where are they now? 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, then went to FaceBook, and is now in the VC business with Founders Fund. Hank briefly went back to being a VC at Hummer Winblad, but is now a lawyer at Howard Rice. Eddie Kessler, the VP of engineering is now an engineering manager at Google. 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. Seven years later, the music industry is still struggling.

Subscribe - To get an automatic feed of all future posts subscribe here, or to receive them via email go here and enter your email address in the box in the right column.

Comments

[Danial Jameel]

Dear Don,
I cannot thank you enough for posting this invaluable blog with us. You have shared some important insights which will be helpful not only to would-be starups but novice players in the game as well.

Arrogance has led to the downfall of many institutions throughout our history.
In the end that's life i suppose...

[Paul King]

Don, I am an avid reader of your blog.

As a Nashville songwriter and as the owner of the premier blog concerning entertainment in Nashville, I wanted to let you know that I'll be posting about your post on my site. I've recently had a series of post talking about the label 'system' and how it is broken or flawed and this certainly proves the point. I will give credit of course and will be using quite a large chunk with link back.

I was a member of pho at the time of this, living in LA, and friends with Jim Griffin - - all of this was a very big topic of conversation during meetings and on post. I really appreciate you posting about this. I admit, I still hate Metallica.

Also, as someone who has been trying to attract VC's and other technologist to my Web 2.0 centered approach to create and distribute music, pictures, videos, etc. - great points on starting a business. Of the 4 VC's I've spoken to about my plan, I've not yet heard a negative word - disruptive is the one I particularly like to hear. Right now, I only need help building 'something'... as I say, I am brilliantly creative, technologically inept.

[Steve Morsa]

Don--thanks from me as well for sharing your thoughts, ideas, experiences, insights, and yes; even your opinions.

Don't know how you find the time to put out so much worthwhile content.

Anyone interested in, or involved in, the Internet or business in general who's not a regular reader is missing out on a great continuing (and free) education.

As for Napster; though it didn't end as you'd hoped for (and as it should have); one of it's little-mentioned effects on the "webospere" can be readily seen in the subsequent explosion of all these "ster" companies and websites since its birth.

[TJ Halpin]

with regards to your second to the last bullet point, would you consider the labels the customer that Napster did not talk to? I always thought of Napster as solving consumers' problems (not big company x's) by providing a service to the labels. You seem to put it the other way around.

[DonDodge]

Paul, I remember the Pho List. It was required reading for anyone in the business. Those were interesting times.

Today EMI announced DRM free music encoded at 256 kbps. I wish they had agreed to do this 7 years ago. Napster would have been the place for online music.

TJ, the problem was that Napster was trying to solve a customer problem for the record labels. Yes the consumer was the customer but the record labels owned the content and the problem. Napster tried to solve the problem for the labels and then partner with them to take it to market. The labels obviously were not interested in partnering at that time, so it failed. We were too far ahead of the curve.

[Sprewell]

Great post, summarizing what happened and what you take from it, but I must quibble with your third lesson and add to your fourth. Plenty of startups solve big companies' problems, the difference is that they don't infringe on their IP in the process. Napster built awareness by facilitating copyright infringement and hoped this would lead to a deal. The record companies chose instead to use that legal opening to put you out of business, not the result you'd hoped for from your gambit. Since most startups that intend to sell to big companies don't use similarly illegal tactics, I think your advice is colored by your unique experience and not a valid lesson.

As to your fourth lesson, I completely agree that you need to understand your customers' problems. I will add, however, that most customers are incapable of suggesting a solution, especially technical ones. Make sure that you understand their problems but don't expect any inkling of a solution from them.

[Elad Kehat]

Great post.
Regarding the lessons learned, we should all keep in mind that Napster wasn't started as a business, and Shawn Fanning must have been surprised as hell that his dorm-room creation had grown so big so fast (correct me if I'm wrong here).
It's only after the fact that all the people you mentioned in this post figured that there must be a way to make money from such a huge phenomenon and decided to jump on the bandwagon.
Maybe the lesson should really be that not every social phenomenon, huge as it may be, lends itself to making money.
Napster and the new reality that it has spawned with regards to copyrights, is a great boon to society in my opinion. I truly believe that most of us are the better for it. However, from a sheer economic perspective, it has done nothing but destroy shareholder value for the music business.

[Don Dodge]

Elad, you are right. Shawn didn't consider his Napster program to be a business when he created it. He just wanted to make it easier to find sources for downloading music. FTP sites were the normal source, but they were very unreliable, very frequently not online, and you never knew if the song would be there or not. Shawn figured out a way to make the whole process easier.

It was ultimately not possible to convert this into a real business. It was a wildly successful social phenomenon, but not a viable business.

You are also correct that many social network type services can attract lots of users but may not be able to translate that into a viable business.

[Brian Despain]

I remember writing in my thinkingmonkey.com blog about how shutting down Napster was a pyrrhic for the labels. One of the very first ecommerce sites I did was for a retail record chain in 1995. Ah the world that might have been.