The start-up is launching the service with artists from the fourth-largest music company, Warner Music Group, which will sell songs and albums without copy protection software known as digital rights management.
To prevent illegal distribution, downloads will be possible only to an iPod.
Lala is also in talks with other major record companies to expand the service with more music, the company said.
Lala is free and does not carry advertising. The company hopes to make up for licensing costs of playing the music online with sales of songs.
"We believe over the next two years we might lose $40 million," founder Bill Nguyen said. Licensing fees could be $160 million over that time.
"We expect up to 70 percent of people will be freeloaders just listening to the music but around 30 percent will be buying music," Nguyen said.
Lala is backed by Bain Capital and Ignition, which so far have invested $14 million over two rounds. The company is still raising money.
Lala is one of the few non-Apple services to explicitly offer iPod compatibility, as it synchronizes seamlessly with the market-leading digital media player. Lala customers can also use iTunes.
"Considering they have the installed base of iPod users in the market, it's a very strong place to start from," said Susan Kevorkian, analyst at IDC.
With CD sales down nearly 20 percent in the first quarter of 2007 and digital music sales failing to make up for that short-fall, the music industry is becoming more willing to experiment with new models that encourage the legal distribution of music online or through other devices such as mobile phones.
Major music companies have also been concerned about online piracy and have insisted until recently that retail partners like iTunes use digital rights management software to protect the songs from illegal distribution.
Warner Music has effectively taken a step toward selling music without digital rights management through the deal with Lala but the digital songs, in MP3 format, will only be available for downloading directly to users' iPods--and not to their computers.
The world's No. 3 music company, EMI Group, started selling online music without digital rights management on iTunes last month.