Liquid Audio's future remains fluid

Liquid Audio, a well-regarded music technology company whose recent troubles are more befitting of an episode of "Behind the Music," will meet with its shareholders for the most important vote in the company's six-year lifespan. At stake is a planned merger, control over the board of directors, and the future of the company over demands by some shareholders who want to liquidate it to save its still-substantial cash reserves.

If shareholders decide to shutter Liquid Audio, it would mark the third silencing of a Net music company in the past few weeks. On Sept. 4, an Illinois federal judge said he would order the Madster file-trading system, formerly known as Aimster, to halt song swapping. One day earlier, a federal judge blocked the $9 million sale of Napster to German media giant Bertelsmann, a decision likely to force the onetime powerhouse out of business.

While Napster and Madster ran into a legal buzz saw with their file-swapping services, Liquid Audio attempted to play by the rules by working with record companies and copyright holders. But in the end it could meet the same fate.

"It's a finite universe," said P.J. McNealy, research director at GartnerG2. "Usually there's one dominant company and two or three others as alternatives. (Liquid) seems to have missed that latter category."

That squeaky-clean path has contributed to this week's shareholder meeting, where dissident shareholders are attempting to oust the current board of directors and liquidate the company's cash reserves, which totaled more than $80 million last June.

Liquid Audio executives declined to talk about the meeting, as did the key dissident shareholders opposing them.

From beginnings to the bizarre
Formed in early 1996, Liquid Audio emerged well before the surge in online music companies that marked the Internet bubble's peak. Unlike many of those companies, its founders actually had deep roots in the music industry. Founder and CEO Gerald Kearby got his start in the business running sound for bands including the Grateful Dead and Jefferson Starship.

The company had close ties to Dolby Labs, and hoped to trade on that credibility to establish itself as the audio standard. In those early years, it got good reviews. At conferences around the country, the high-quality audio and copyright-protection features were touted as the future of digital music.

Liquid's core business involved a music distribution network and software player that would allow songs to be distributed without being copied. It supported a variety of music formats, such as MP3 and Microsoft's Windows media, but consumers had to have the Liquid Audio player to listen to the music.

Their customers were record companies that wanted to sell the music, as well as other distribution channels such as CDNow or Amazon.com that wanted to sell digital versions of songs.

But like every other digital music start-up that tried to play by the rules, Liquid was forced to sell music only on the terms that the record labels allowed. That meant expensive singles, often as much as $3.99 each, and poor selection. Even as the company struck strategic alliances across the industry for distribution, actual revenue turned out to be slim.

When Napster came along in late 1999, the writing was already on the wall. MP3.com and other free music sites had already undermined Liquid's offerings. Napster's free, unlimited swap meet pushed the company further out of the limelight, even as it continued to strike deals and offer new versions of its technology and music.

Its story took a turn for the bizarre as its star fell, however. Japanese news media have reported that a former Liquid Audio Japan executive had been arrested on charges that he kidnapped a former associate.

The incident allegedly happened in mid-1999, although charges weren't brought until late 2000, well after both men had left the company. Liquid Audio severed its relationship with the Japanese operating company not long afterwards for financial reasons.

Those financial reasons, if not the noirish Japanese drama, are heavily responsible for where the company is today. In 2001, Liquid Audio's Asian affiliates accounted for 61 percent of its total revenue. All of those relationships are now gone, leaving the company with thin prospects.

Indeed, the company's most recent financial report says, "Numerous record companies and recording artists have used our distribution system to sell music...although such services have not, to date, resulted in significant revenues."

Fighting over scraps
Still, the company has well-regarded technology for delivering digital music and protecting it against piracy. It still counts several big record companies as customers, although they're not paying much.

But it's the $81 million in cash that's catalyzed two separate sets of shareholders into a bitter power struggle. The shareholders don't much care about the technology's potential, but they see profits in the cash.

The latest struggle over power was precipitated by New York-based BCG Strategic Investors, which played a similar role with the now all-but-defunct Musicmaker.com last year.

Musicmaker was in much the same position as Liquid. By late 2000, the future was bleak for the maker of custom CDs, but it had money in the bank. BCG bought a 38 percent stake in the company in December of that year and launched a hostile proxy battle aiming to distribute the remaining cash to shareholders.

That scenario is now playing itself again at Liquid Audio. BCG co-founder James Mitarotonda and his associates purchased close to 7 percent of Liquid Audio a year ago through Musicmaker's corporate shell.

Mitarotonda is now urging the company be shut down and the cash be distributed to shareholders. This time around he has an ally in another investment company, Steel Partners. Steel has made its own bids to buy Liquid Audio outright, but in recent months has also supported Mitarotonda's proposals.

Liquid Audio has fought all the way. It canceled its annual May shareholder meeting, prompting a lawsuit from Mitarotonda's group. In June, it announced it had found a buyer, Alliance Entertainment, a privately held retail music fulfillment company.

The Musicmaker group, in particular, bitterly opposes this deal. It's now trying to put its own slate of directors on Liquid's board in order to derail the proposal. In letters to shareholders coming at a frequency resembling a political campaign, Mitarotonda's group notes that Kearby and another Liquid director each will gain $750,000 retention payments if the merger goes through and they stay on board, and that the board as a whole "lacks the objectivity" needed to respect shareholders' interests.

"I am sure you realize the anger Liquid Audio's shareholders have toward management and the Board of Directors, as they have lost hundreds of millions of dollars in market value," wrote Musicmaker chairman and longtime Mitarotonda associate Seymour Holtzman in a recent letter to Liquid Audio board member Ann Winblad. "We have received numerous calls from large and small shareholders who are outraged and disgusted with the shabby treatment they have received from the management of the company." The letter was included in reams of documents filed with federal securities regulators.

Other shareholders have also begun opposing Liquid's merger with Alliance Entertainment.

"We believe that it is past time for the company to stop squandering shareholder assets and let the shareholders decide the company's direction and leadership at the upcoming meetings," wrote Dolphin Limited Partnership in a letter announcing its opposition to the merger on Monday.

Meanwhile, Liquid Audio has sued the dissident shareholders. It's already settled with Steel Partners, and that group has remained silent. Mitarotonda's group, however, has continued to release shareholder solicitations. Liquid has responded by attacking that group, charging that its takeover of Musicmaker.com wasn't good for other shareholders.

"Don't give Musicmaker control of the company," reads one of Liquid's most recent pleas. "Musicmaker wants to take away your opportunity to participate in the (benefits of the merger)."

As a result, Thursday's meeting promises to have all the drama of a political convention. But for all the drama, the debate is now about money and the company's survival. The real future of online music, as Gartner's McNealy noted, appears to have moved elsewhere.