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Inside the short, troubled life of a music start-up

Hyped music service SpiralFrog had money, big partners, and promising traffic. But it lacked effective leadership and a strong business model.

The dot-com era had eToys, Webvan, and The digital-entertainment boom has SpiralFrog.

The day SpiralFrog likely reserved a corner in the pantheon of the Web's most noteworthy busts came on July 14, 2008. At 2 a.m. that day, an agitated Amir Khan, an executive at hedge fund 3V Capital Management, SpiralFrog's main financial backer, e-mailed several fellow board members at the pioneering ad-supported music service.

"We were claiming super-unique user growth while we knew we were just getting users to bounce off our site. Our approach was not far from hiring Internet users in India to click on our home page."
--Former SpiralFrog CTO in e-mail to founder

Khan was frustrated by SpiralFrog's marketing efforts. In one case, the start-up spent $300,000 to host a video from pop singer Alicia Keys that managers claimed would draw 1 million new users. But without any of her hit songs in the clip, only 5,000 visitors showed up. Khan then zeroed in on SpiralFrog's spending.

The costs associated with search engine and affiliate marketing, which he termed as "buying traffic," were too high. In addition, Khan warned that investors and advertisers were sure to figure out that visitors to the site did little there but land and leave.

"The people we seem to be attracting to our site from the affiliate-marketing programs are NOT interested in music," Khan wrote. "Hence the low registration rate, pages per visit, time on our site, high bounce rate. I refuse to believe that people in the advertising world and the potential acquirers will not see this as buying traffic."

As for the Keys debacle, Khan aimed a thinly veiled attack at then-CEO Mel Schrieberg and his staff. These "marketing programs accomplished just one thing: they made me sick."

A January income statement shows that SpiralFrog lost $26 million in 2008 on revenue of $1.2 million. Screenshot by Greg Sandoval/CNET

While efforts were later made to improve user loyalty, Khan's warning went largely unheeded. Costs continued to balloon, and a business model that required the start-up to spend 10 cents to earn a penny was never fully re-evaluated. The company, which some had predicted could snatch away the digital-download throne from the reining power, Apple's iTunes, lost a staggering amount of money and flamed out.

On March 19, 2009, the day the service folded, SpiralFrog owed more than $40 million. In 2008, records show, the company burned through $26.3 million while generating sales of just $1.2 million.

Plenty of pundits blamed the company's demise on the big music labels and the large licensing fees they charge, as well as the economic crisis that gripped the country last fall. Certainly, both played a part. But former insiders paint a much broader picture of SpiralFrog's spinout.

CNET News has examined the company's rapid tumble and reviewed dozens of communications, legal records, invoices, and expenditures--documents that were provided by former board directors, executives, and employees. Many of those individuals agreed to be interviewed, though most requested anonymity.

SpiralFrog's story will sound familiar to anyone who was paying attention to technology during the Internet bubble era. It had all the traits of many late-1990s dot-coms: an inexperienced and divided leadership, wild spending, and what former executives there now conclude was a flawed business model.

In a two-day report, CNET News offers a rare look inside a sinking start-up whose tale could explain much about ad-supported music services' continuing challenges. SpiralFrog, like its ad-supported music peers, was supposed to provide an attractive and legal alternative to music piracy, but these sites have yet to prove that free music can translate into profits.

Ruckus, an ad-supported service catering to college students, for example, closed this year, just ahead of SpiralFrog. Another popular but profitless streaming site, Imeem, ran into serious financial trouble earlier this year, before negotiating better terms from the music labels. Imeem is now rejiggering its business model and is "headed toward profitability," a company representative said.

Look out, iTunes
Founded in 2004, SpiralFrog would wait three years before finally launching its Web site. The company's goal was to give away music and support itself by selling advertising, just as traditional radio had done for decades. Instead of broadcasting music, SpiralFrog would offer digital downloads, a la iTunes.

One of SpiralFrog's main weaknesses, however, was that its downloads were incompatible with Apple's iPod, the world's best-selling digital-music player. Another was that it secured licensing deals with only two of the four major music labels.

"The smoking gun is if the traffic disappears when you stop buying. The idea is not to buy traffic. It's to generate loyalty."
--Andrew Frank, Gartner analyst

Nonetheless, SpiralFrog executives claimed that fans of illegal peer-to-peer sites would flock to a legal source of free music, and advertisers would follow. SpiralFrog's management also believed that the record companies would rush to do business with anyone who competed directly with illegal peer-to-peer sites.

By licensing its vast music library to SpiralFrog in May 2006, Vivendi-owned Universal Music Group, the largest of the top four recording companies, handed SpiralFrog almost instant credibility. SpiralFrog became the first company to convince a major music label to offer downloads on an ad-supported basis.

But even then, there were leadership troubles. A nasty fight for control of the company between Joe Mohen, SpiralFrog's founder and chairman, and then-CEO Robin Kent resulted in Kent's departure on December 26, 2006.

With Kent out, some of SpiralFrog's original financial backers stopped funding the company. The New York-based company ran into its first financial troubles before debuting the site on September 17, 2007.

Six months later, SpiralFrog made the bold claim that its 850,000 registered users made it "the third-largest legal music download site in (the United States) and Canada." Only iTunes and Rhapsody, operated by RealNetworks and MTV, were larger--or so the company said.

At about the same time, SpiralFrog appeared to have come into big money. The staff swelled from 12 in early 2007 to more than 30 by springtime the next year. Several longtime music industry veterans joined the company, and in June 2008, SpiralFrog cut a licensing deal with EMI, its second major label. To some observers, the fledgling music service was on a roll.

"We built a very strong brand and image in the marketplace in a short period of time," said Schrieberg, SpiralFrog's CEO from January 2007 until October 2008. "(We) did not have the opportunity to fully realize our potential."

According to documents and insiders, however, most of SpiralFrog's accomplishments were a mirage.

Traffic jam
SpiralFrog executives always had a simple plan to grow their business: build an audience through aggressive marketing and then turn casual visitors into loyal users. Schrieberg and the board agreed that the main goal should be to attract what the former CEO calls "tier-1 advertisers," companies such as Nike, AT&T, and McDonald's.

SpiralFrog's traffic for two years. The dramatic July 2008 falloff coincides with the board's decision to cut spending on affiliate marketing. Traffic bottoms out in October, when money starts running out. Google Analytics

"When I visited McDonald's and some other tier-1 accounts," Schrieberg said in an interview, "we found that in order for a tier-1 account to place ads on a site like SpiralFrog, (it) needed a minimum of 5 million monthly unique (visitors). Our thought was that we needed to build volume and then swing over to quality. If you didn't build the volume, you could never get ads on the site from tier-1 advertisers."

That was the plan. The execution was something different.

SpiralFrog managers began dabbling in search engine marketing early in 2008. That's the practice of paying search engines to map Web site links and small ads to the results pages for particular search terms. This helped the company top 2 million visitors in March 2008 and 3 million the next month.

The growth was good, but SpiralFrog's leaders wanted more. Schrieberg and the board then tried affiliate-marketing programs, mostly at AOL's Platform-A. AOL promised to spread the start-up's brand across its own sites, as well as hundreds of affiliated sites.

In June, the company exceeded its original traffic goal when it recorded 6 million visitors for the month. But instead of celebrating, a few at the company were chewing their fingernails. To attract those visitors, the company had paid dearly.

According to a list of projected expenditures from July 2008, SpiralFrog expected to spend $2.8 million with Google that year and $1.5 million with Yahoo. Charges at rival MSN are unclear. The tab for AOL's affiliate marketing in 2008 was more than $3 million, an AOL attorney confirmed. According to a copy of an income statement completed in January 2009, SpiralFrog's 2008 sales and marketing expenses came to $11 million--nearly twice the $5.6 million the company paid in music licensing that year.

"Uniques are great, but hedge funds want to see revenue,"
--Scott Stagg, manager of a hedge fund that lost $34 million on SpiralFrog

Not all of that was search engine marketing. There were the promotional costs, which included the $300,000 sunk into the much-ignored Alicia Keys video, $200,000 tied to the National Football League, and $500,000 plunked down on "microsite"

While the Keys video cost the company about $60 for each of the 5,000 registered users it brought to the site, the NFL deal saw even worse results. SpiralFrog paid about $490 for each of the registered users it generated, records show. SpiralFrogClub, meanwhile, attracted a dismal 225 registrations in the first month and was scuttled by September 2008.

None of these missteps were lost on the man who paid most of SpiralFrog's bills: Scott Stagg, the managing director of 3V Capital Management (now called Stagg Capital), the Connecticut-based hedge fund that bankrolled the company for nearly two years. On May 18, 2008, in a response to an e-mail from Schrieberg about the importance of unique visitors, Stagg clarified what he thought the company should focus on.

He noted that SpiralFrog had initially projected 2008 revenue at $55 million, then reduced estimates in January that year to $25 million, then reduced them again three months later to $3 million. "Uniques are great, but hedge funds want to see revenue," he implored.

Stagg e-mailed Mohen and Schrieberg again on June 3, saying he wouldn't be able to "lend the company any more money" and he suggested that Schrieberg "might be prudent to conserve the cash you have by slowing down significantly the paid searches, especially since we are not generating advertising dollars."

Despite all the spending on marketing, SpiralFrog was generating little ad revenue and seeing hardly any increase in active users, according to Khan, the No. 2 man at 3V.

AOL's delivered clicks, but SpiralFrog couldn't turn that traffic into registrations. SpiralFrogClub's lone purpose was to promote the music service. But what would promote the promotion site? Screenshot by Greg Sandoval/CNET

"(Management) said, 'We are starting to get orders from advertisers at a pretty high CPM (cost per thousand ad impressions),'" investor Khan said in an interview. "They did get a few, and they said they would get a lot more. We had doubts. Stagg initially thought (Schrieberg) was right, but eventually, he swung around to the opinion that this was just a waste of time. Nothing was getting converted into real traffic. But by that time, we were in the middle of talks with Viacom."

In the summer of 2008, Viacom, the conglomerate behind MTV and Paramount Pictures, had expressed interest in investing in SpiralFrog. According to Khan, the start-up's leadership couldn't pull back on marketing for fear that a drop-off in traffic would spook Viacom out of the deal.

SpiralFrog had built an image as a digital-music up-and-comer by buying traffic. To preserve that image, the company needed to keep buying.

"Amir and I have been having many discussions concerning our site traffic," Schrieberg wrote to several board members in an August e-mail that asked for the authorization to spend $250,000 on search engine marketing. "We both agree that we need to achieve in the area of 5 million monthly uniques to preserve the Viacom strategic alliance."

Self-deception, a little secret
There's nothing illegal or unethical about paying for clicks. Thousands of companies do it every day to advertise their Web sites and services. Google's AdWords service, which supports pay-per-click advertising, is what fueled the company's meteoric rise. Google earned $21 billion from AdWords last year alone.

Like many other companies, SpiralFrog tried to market itself as a popular service to improve its chances of attracting advertisers, according to documents and former employees. The problem was that its traffic couldn't be sustained without costly search engine and affiliate marketing.

Sites with loyal followings usually don't have to do this, said Andrew Frank, an analyst at research firm Gartner. While some advertisers are happy with raw traffic, most typically want to partner with sites that attract lots of return visitors and maintain engaged audiences, he said.

"The smoking gun is if the traffic disappears when you stop buying," Frank said. "The idea is not to buy traffic. It's to generate loyalty...Most of the top sites don't talk clicks. They talk about active users, people who come back multiple times in a month."

In October 2008, SpiralFrog got a chance to see how the site fared without the marketing efforts. The month before, Viacom had informed SpiralFrog's leadership that it would not invest. Following that, Stagg cut off funding. When the marketing programs were halted, traffic numbers crashed. SpiralFrog saw just 775,547 unique visitors in October, a fraction of the site's monthly peak of 7 million. Records show that the number of monthly visitors hovered around the 800,000 mark until the site shut down its operations.

One person who was with SpiralFrog from start to finish was Vesa Suomalainen, its chief technology officer. According to Khan, Suomalainen's tech team was the only SpiralFrog unit that performed well. In multiple e-mails during 2008, Suomalainen revealed his skepticism of the company's spending.

On September 24, 2008, as SpiralFrog prepared to push on without Stagg's money, Suomalainen began an e-mail debate with Mohen, the company's founder and chairman. Suomalainen urged Mohen not to spend more resources on search engine or affiliate marketing.

Click the image above to read our story on what SpiralFrog tells us about ad-supported music. Stories on SpiralFrog's internal strife and customers' private information will appear Tuesday.

"For a while, I guess we all were sold...on the 'momentum theory,'" Suomalainen wrote. "The belief was that if we demonstrated solid user growth and increased the number of unique visitors, it would open more doors for us at advertisers and music labels, and amongst the press and music industry. The cost did not matter, since the exposure would be temporary, and we would switch from paid to organic growth in a matter of months, if not weeks.

"I started arguing in late spring that this is, if not outright least self-deception," he continued. "We were claiming super-unique user growth while we knew we were just getting users to bounce off our site. Our approach was not far from hiring Internet users in India to click on our home page to get the unique-visitor number to continue growing.

"Anyone who'd ask (SpiralFrog) direct questions about average...time spent on (the) site, or average number of page views, or retention of registered users would immediately find out our little secret," he wrote. "These figures stay permanently in our books for incoming investors to look at and ask us after the fact. How do we explain spending $1.5 million in marketing in the month of June when our resulting revenue was $69,711--an oops?"

Editors' note: Another story about SpiralFrog's last days, called "How turf wars and miscues crippled SpiralFrog," will appear Tuesday.