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Is free music too expensive for SpiralFrog?

Start-up that made a splash a year ago has yet to launch online music service. Despite setbacks, company isn't ruling out public offering.

Greg Sandoval Former Staff writer
Greg Sandoval covers media and digital entertainment for CNET News. Based in New York, Sandoval is a former reporter for The Washington Post and the Los Angeles Times. E-mail Greg, or follow him on Twitter at @sandoCNET.
Greg Sandoval
7 min read
Miniscule revenues, no users and plenty of debt haven't stopped SpiralFrog executives from "studying options" for listing the company on a stock exchange.

The company made a splash a year ago by promising to offer consumers free advertising-supported music. But getting that business off the ground has proved a challenge to a revolving executive team led by Joe Mohen, SpiralFrog's founder and chairman. Now faced with hard-to-fulfill commitments to investors, Mohen isn't ruling out going public, despite his company's still-embryonic situation.

Two weeks ago, privately held SpiralFrog made available a 10SB form it filed with the U.S. Securities and Exchange Commission. That's a form that is usually reserved for small companies that aren't financially strong enough, or operationally ready, to file for an initial public offering. Some of these companies, which are looking to bring in money with the sale of their stock, will try other means, such as merging with a publicly traded company before they hit the public market, said Mike Sullivan, a securities attorney with Howard Rice Nemerovski Canady Falk & Rabkin. Sullivan is not associated with SpiralFrog.

In the case of SpiralFrog, the 10SB form is designed to satisfy an agreement with a group of mostly British backers who required as a condition of investment that the company trade on a public exchange in either the United States of the United Kingdom by now, Mohen said. In an interview with CNET News.com last week, he said that with the filing, SpiralFrog is "publicly reported" and that should be enough to satisfy investors. "We do believe we have fulfilled our commitments," Mohen said.

"We have customers, we have revenues and we're about to have users. We are confident from our cash flow from operations and other steps we've taken that we will be successful."
--Joe Mohen, SpiralFrog founder and chairman

Never say never, but it's hard to imagine SpiralFrog will attempt an IPO that would most likely be panned by Wall Street. Without a live Web site (it's expected to go live in another few weeks), the company had generated just $3,102 in revenue as of June 30, according to the documents. Nonetheless, the filing with the SEC goes a long way toward illustrating the predicament the 4-year-old company (which was in stealth mode for nearly three years) is facing as it tries to appease investors and creditors.

In August 2006, SpiralFrog leaped on to the music scene with a promise of free songs and a signed contract to license music from Universal Music Group, the largest of the top four record labels. SpiralFrog hoped to draw music fans away from illegal file-sharing sites by offering free music supported by advertisers.

Since then, SpiralFrog has seen its original executive team walk out and is eight months behind a self-imposed deadline for launching a Web site.

Providing free music has proved to be a pricey proposition for the New York company. To secure its licensing deal with Universal, SpiralFrog initially paid $2.2 million and since had to pony up an additional $1 million. Since signing that agreement with Universal, SpiralFrog has failed to land another major label. A spokesman for Universal declined to comment.

One music industry executive familiar with ad-supported services said SpiralFrog likely overpaid. "I haven't heard of anybody paying the record companies those kinds of fees in a long time," the executive said. "Over the past couple of years, the labels were desperate to distribute their content through different services and were willing to reduce prices."

But Hank Barry, an attorney with Howard Rice Nemerovski Canady Falk & Rabkin and a former venture capitalist and CEO of Napster, says the Universal deal is a pretty good one for SpiralFrog because Universal isn't charging SpiralFrog each time a song is downloaded.

"There doesn't seem to be a floor on per-download fees," Barry said. "Rather, (Universal) is taking 50 percent of 'gross receipts' related to its sound recordings. And there is an additional fee for publishing rights. This is very good for SpiralFrog, because they can just get what they can get in the ad market and pay half of that to (Universal), rather than having a (per-play fee) of some large number."

According to a copy of the contract that was included in SpiralFrog's SEC documents, SpiralFrog can recoup some of the $3.3 million it paid as an advance when it makes $6.6 million in advertising.

First, of course, SpiralFrog has to start providing music. The start-up has burned through most of its cash--having already spent more than $4 million this year--and has begun funding operations by borrowing money, according to the filings. Things got tight enough last March to prompt SpiralFrog to borrow $63,000 from an executive. The company was then forced to fork over an additional $3,300 when it was late paying him back, according to the documents.

The financial crunch didn't stop executives from drawing big paychecks, however. Last year, as SpiralFrog was on its way to losing $6.7 million, Mohen received more than $422,000 in "consulting fees" and back pay, according to the filings. Robin Kent, the company's former CEO, earned $340,000 for the year--all in salary. According to Kent, all the members of the seven-person management team agreed to forgo deferred compensation except for Mohen and the company's secretary. Mohen strongly disputes this. He said that he and the company's secretary were the only ones entitled to receive back pay.

Mohen defends the salaries. "It's not uncommon for a company to pay people before a company launches," Mohen said, adding that the upcoming launch of the Web site might ease financial burdens. "We're prepared now to launch the service and we have advertisers lined up ready for launch. We will be earning material revenue from operations as we go forward."

When SpiralFrog announced plans to provide free, ad-supported music, the approach wasn't new. But unlike companies with similar business models, SpiralFrog had some muscle behind it: Universal Music Group, the largest music label, had signed on. To some pundits, this was enough to qualify the company as the latest "iTunes killer."

But after that big August splash last year, SpiralFrog was quiet. There were no announcements with the other major labels: Sony BMG, Warner Music Group and EMI. SpiralFrog may have run into a perception problem: Many in the business were leery about putting their songs next to the word "free," according to one music executive, who spoke on the condition of anonymity.

The thinking went something like this: The Internet was already responsible for undercutting the value of music. Why contribute any more to the idea that songs don't have financial value? Some decision makers at the labels were also skeptical of SpiralFrog's service. A song took as long as 90 seconds to download, which left ample time to present ads to users, but also enough time to irritate them.

Instead of launching the site in December as promised, SpiralFrog's management team, which included Kent, Chief Financial Officer Tom Patrylak, Chief Strategy Officer Bob Goodale, and Lance Ford, director of sales and marketing, left the company following a split with Mohen. They were followed by nearly half the members of SpiralFrog's board. Mohen ="9711371">replaced Kent and the departed board members and in recent months has launched test versions of SpiralFrog's Web sites in Canada and the United States.

Does SpiralFrog have enough gas?
Once SpiralFrog launches, which is expected to happen in the next several weeks, it will be competing with a library consisting of about 770,000 songs. By comparison, Apple offers more than 6 million songs on iTunes.

The other concern is whether the company has the resources to pay for additional licenses. SpiralFrog this year sold $10 million in secured notes, according to the SEC documents. The notes are essentially loans, and next month the company must begin paying down the annual 12 percent interest on those notes. This means that in addition to the licensing fees it must pay, SpiralFrog is also going to be paying off debt.

SpiralFrog said in the 10SB filed with the SEC that its independent accountant "expressed substantial doubt about our ability to continue as a going concern." But Mohen downplayed financial worries. The item by the accountant is required for any company that hasn't generated profits in a year, he said, adding that any profitless start-up would receive the same boilerplate paragraph.

"What is changing is that SpiralFrog is now launching its Web site across the United States and Canada," Mohen said. "We have customers, we have revenues and we're about to have users. We are confident from our cash flow from operations and other steps we've taken that we will be successful."

SpiralFrog's troubles haven't shaken the faith of those who support the ad-supported business model. Ruckus Network, a free music service that has managed to sign all four major labels, offers more than 3 million songs and has operated for more than a year.

The difference between SpiralFrog and Ruckus is that the latter company targets college students. Herndon, Va.,-based Ruckus has deals to offer ad-supported music at more than 170 schools. Mike Bebel, president and CEO of privately held Ruckus, declined to discuss SpiralFrog specifically but did say that the trick to making money in the ad-supported business was offering a large music library.

"That means our users spend a lot of time on our service diving into our catalog," Bebel said. "Spending more time on the site means more ad impressions and that's what advertisers like to see."