Can Napster survive the Bertelsmann deal?

Bertelsmann loaned Napster just over $50 million for a restricted right to take a controlling interest in the company, sources says, in a deal that could lead to a radical overhaul of the service.

Jim Hu Staff Writer, CNET News.com
Jim Hu
covers home broadband services and the Net's portal giants.
Jim Hu
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Bertelsmann loaned Napster just over $50 million for a restricted right to take a controlling interest in the company, sources said, in a deal that leaves many details unresolved and could lead to a radical overhaul of the service.

Tuesday's stunning announcement of a truce between the German media conglomerate and the free music-swapping start-up was thin on specifics. But sources close to the deal told CNET News.com that Bertelsmann was granted warrants that would give it a 58 percent equity stake in Napster, subject to dilution should the company line up future investors.

While the arrangement offers Napster new hope of survival, some industry insiders say it gives Bertelsmann a kill switch that signals the end of the current freewheeling service.

"This is the end of Napster," said MP3.com chief executive Michael Robertson. "There's simply no way to start charging and have a secure music system and right next door have all the music in the world for free."

The loan and warrants come with significant restrictions, sources said: Bertelsmann cannot convert the loan to equity unless the partners create a legal pay-to-play service--an outcome that almost certainly hinges on bringing in record labels and music publishers. In addition, Napster can't use the loan to defend itself in a high-stakes copyright infringement suit brought by the record industry, which includes Bertelsmann's BMG Entertainment label.

"Nothing will happen unless they create a legitimate service," said one source close to the deal.

The new face of Napster?
Whatever form the final service takes, it appears clear that the likelihood of the original Napster surviving is small.

The two companies have said they plan a joint strategy, with a free component similar to today's Napster and a fee-based membership service with more features. The service would retain its support of the MP3 and Windows media file formats and would continue to be a wholly peer-to-peer system, without central servers making songs available for download, Barry said Tuesday.

"Same service, different business model," Barry repeated through several rounds of skeptical questioning Tuesday.

The companies face several huge hurdles in getting to this stage, however, all of which promise to undermine the current unrestricted system.

Chief among the difficulties is bringing the rest of the music companies on board--and keeping them happy--in an environment where Bertelsmann appears dead set on keeping control of, if not a majority stake in, the company.

Bertelsmann's potential 58 percent stake stands to be diluted as new investors come on board, but new investors will most likely include record labels and music publishers, creating a consortium that together could make up a controlling block.

Bertelsmann hopes to maintain at least a 51 percent stake, according to sources close to the deal, although that may not be possible.

Sources close to the deal have said that different ideas are already being discussed as ways to mollify the other media conglomerates, such as creating spinoffs that would focus on video or game distribution and giving the other companies larger stakes in these.

But a distribution system in which one content provider holds a dominant equity stake is inherently unstable, say others in the industry.

"It definitely creates an imbalance," MP3.com's Robertson said. "Eyebrows are definitely going to be raised when it sounds like BMG has the controlling interest, and therefore has access to all the data and maybe ability to control how content is positioned."

Nor is it likely that a consortium of major labels, which have spent the last year and millions of dollars to kill Napster's service, will allow the current unregulated service to be maintained alongside a paid service. Once the record companies take control of the company, the vision of the original founders is likely to disappear.

"At the end of the day, a controlling interest means control of the business model," notes Robert Kohn, chairman of EMusic, which runs its own MP3 subscription service.

Devil's in the details
The agreement was hammered out at the end of last week, with final details resolved remotely between Napster executives in San Mateo, Calif., and Bertelsmann leaders in Gutersloh, Germany. Bertelsmann chairman Thomas Middelhoff and Bertelsmann Ecommerce Group head Andreas Schmidt led the talks, sources said.

Negotiations started when Napster installed music industry veteran and Hummer Winblad partner Hank Barry as chief executive. Immediately after he was appointed in May, Barry met with BMG executives including the label's CEO, Strauss Zelnick, and senior vice president of worldwide marketing and new technology, Kevin Conroy. Those conversations broke down, however, as the companies became mired in disputes over the details of creating a legal version of the service, including pricing.

Negotiations were revived outside BMG under the code name "Project Thunderball," headed by Schmidt, according to sources. The new negotiating team brought a different perspective to the talks, focusing on getting a deal done first and working out the details later.

That is the task that the two new partners now face.

Beyond business issues, the service must work through a raft of technical and legal issues.

Many lawyers Court: Shut down Napster say the deal will do little to stave off court action that could potentially shut down Napster in the short term, even if it might improve its legal position over the course of a longer trial.

Aside from that case, Bertelsmann and Napster will have to figure out how to account for royalties and pay individual artists and music publishers. The unregulated Napster, which does not track downloads and pays no royalties, has not had to deal with this. An authorized version will have to overcome severe logistical difficulties and ongoing expenses to make it work.

Details are slim on how the company expects to track songs and deliver royalties. Napster attorney David Boies alluded Tuesday to a statistical sampling system, which wouldn't track individual songs.

Simply paying the music publishers--who have yet to sign on to the model--could wind up being prohibitively expensive. Publishers have rights to more than 7 cents for every copy of a song made, which mounts into the millions of dollars quickly given an audience of Napster's size.

Nor have royalty rights for artists covering this type of situation been worked out in previous contracts. That's one issue that has slowed music companies from quickly offering digital music distribution and could be a stumbling block in creating an unambiguously legal Napster, some say.

Despite these hurdles, many in the digital music world welcome the deal as a sign that the major labels are warming further to Net music.

"I think in the long run all these issues are going to be worked out," EMusic's Kohn said. "These are major transitional problems that will be with us for a few more years. But what Bertelsmann is doing is a bold step in the right direction."