Venture capitalists wary as Napster lawsuits loom

Napster's legal problems have riveted key Internet investment firms, leading them to take an uncharacteristically cautious approach toward the controversial music technology company.

In addition to copyright lawsuits, a volatile stock market and concern over industry backlash are creating a strong deterrent to even the most venturesome of venture capitalists, sources say. Investment firms have met with Napster, according to these sources, but no deals have emerged.

That stands in stark contrast to a year

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ago, when venture capitalists were jumping at anything that moved in the fast-growing digital music market, made popular by MP3 download technology. In theory, Napster's technology could have a far wider effect than MP3, because it could extend well beyond music.

"There are two aspects of Napster that are absolutely compelling," said Roger McNamee, general partner of Integral Capital Partners. "First, the architecture, which is brilliant, and second, the viral nature with which Napster has spread.

"What's scary about the company is that it has placed itself in conflict with the music business, including just about everyone who could help make it economically successful," he added.

A Napster spokeswoman declined to comment about financial matters, citing the company's ongoing litigation with the recording industry, which charges that Napster has failed to crack down on music piracy made possible by its software.

The latest blow: Indiana University yesterday banned students from using Napster on school computers, citing a lawsuit filed by rock band Metallica. Yale University took similar steps Wednesday after being named in the Metallica lawsuit.

Metallica's lawyer said the band's actions have prompted more than 10 artists to call him about suing Napster as well. One of those artists is rap star Dr. Dre, who on Wednesday sent a letter to Napster, giving the company until today to remove his songs from its directory.

Even with the threat of litigation, some investment firms believe that it is only a matter of time before the money begins to flow, although none seem anxious to step forward in the middle of Napster's problems.

"I think the only way a high-quality venture group will invest is if they thought they could help bring all the parties together," said Bob Kagle, general partner at Benchmark Capital, who added that his firm has been in talks with the company but has no commitments to invest. "Napster is a project that many VCs will have a hard time feeling comfortable about, but somebody in our industry will likely take a leadership role in working through these issues."

Those "issues" are a euphemism for broad concerns ranging from expensive legal fights with powerful record labels to possible conflicts with other partners that feel threatened by Napster's technology. Many believe that music is only the first battleground for Napster-like file-sharing technology, which could be used to download all types of digital content--including films and computer software--by newly emerged rivals such as Scour.com, Gnutella and Wrapster.

In the long run, some venture capitalists say that working with entrenched media players may be the key to opening doors for a company such as Napster. Accel Partners' Theresa Ranzetta points to one of the companies her firm has invested in, RealNetworks, as a pioneer that has equally forged a new path for music and that has been thoughtful about its relationship with the incumbent players.

"In the short term you can shake things up to get people's attention, but you have to have a plan in the long term to bring it all together (and partner with the incumbents)," noted Ranzetta, who said her firm is familiar with Napster, though she would not say whether it is considering an investment.

The temptation
Still, many venture capitalists find Napster hard to resist, especially because it has achieved a wide following in such a short time. Its file-sharing software "democratizes" the computer by giving any PC user status as a client and server, allowing thousands of Internet users to request files from each other at any time.

Not everyone believes that funding will be a problem for Napster, be it from VCs or other sources.

"They have more money chasing them than they know what to do with," said an Internet executive close to Napster.

But whether the company can close a deal soon may be another matter, given the recent stock market scare and pending litigation over MP3 files traded using its service.

Sources say firms including Hummer Winblad and Redpoint Ventures have held talks with Napster. Hummer Winblad partner Hank Berry said this week that the firm does not have an agreement with the company but wouldn't elaborate. Other venture capitalists and individuals, including early backers of Napster, declined to discuss their investment plans.

Last year, Napster raised seed funding of $2 million from investment firm Angel Investors, ValiCert chief executive Yosi Amram and Excite founder Joe Kraus.

Investing in Napster is thought of as a unique opportunity by Ravi Mhatre, general partner of Weiss, Peck & Greer Venture Partners. "If Napster is successful, it will reinvent the way music is distributed," Mhatre said.

That's something the recording industry is hell-bent on stopping.

In addition to the Metallica lawsuit, the Recording Industry Association of America (RIAA), which represents the major U.S. record labels, is seeking up to $100,000 in damages for each copyright-protected song allegedly exchanged illegally using Napster software.

Lawyers for Napster are testing the edges of the Digital Millennium Copyright Act (DMCA) by using it as their chief line of defense against the lawsuits. By claiming status as an Internet service provider, Napster can tap the law's safe harbor provision, which states that ISPs are not responsible for content traded through their services.

Because every piece of litigation requires a response, however, the company could deplete all of its energy and resources defending itself in court. Still, Napster has said that it will not back down.

"Personally, I think part of the goal behind these lawsuits is to scare off the venture capitalists," said Malcolm Maclachlan, media analyst at research firm International Data Corp. "Napster without a lot of money--especially without money to hire lawyers--is not nearly as scary."

News.com's Evan Hansen contributed to this report.